Greetings, and welcome to the Target Hospitality Second Quarter 2020 Earnings Conference Call. It is now my pleasure to introduce your host, Mr. Mark Schuck, Senior Vice President of Investor Relations.
Thank you. Good morning, everyone, and welcome to Target Hospitality's Second Quarter 2020 Earnings Call. The press release we issued this morning outlining our second quarter results can be found in the investors section of our website. In addition, a replay of this call will be archived on our website for a limited time. Please note the cautionary language regarding forward-looking statements contained in the press release. This same language applies to statements made on today's conference call. This call will contain time-sensitive information as well as forward-looking statements, which are only accurate as of today, August 10th, 2020. Target Hospitality expressly disclaims any obligation to update or amend the information contained in this conference call to reflect events or circumstances that may arise after today's date, except as required by applicable law.
For a complete list of risks and uncertainties that may affect future performance, please refer to Target Hospitality's periodic filings with the SEC. We will discuss non-GAAP financial measures on today's call. Please refer to the table in our earnings release posted in the Investors section of our website to find a reconciliation of non-GAAP financial measures referenced in today's call and their corresponding GAAP measures. Leading the call today will be Brad Archer, President and Chief Executive Officer, followed by Eric T. Kalamaras, Executive Vice President and Chief Financial Officer. After their prepared remarks, we will be joined by Troy Schrenk, Chief Commercial Officer, and open the call for questions. I will now turn the call over to our Chief Executive Officer, Brad Archer.
Thanks, Mark. Good morning, everyone, Thank you for joining us on the call today. In addition to discussing our second quarter performance, I will touch on our continued focus around capital discipline and cost reductions, as well as the recent trends we have seen from our energy end-market customers. In this challenging environment created by the COVID-19 pandemic and simultaneous shocks to global commodity markets, Target delivered solid second quarter results. We took decisive steps in reaction to what was a pronounced reduction in customer activity and utilization levels. These steps aligned Target with customer demand and supported continued strong cash generation, with discretionary cash flow for the second quarter of approximately $15 million. As the COVID-19 pandemic accelerated in entering the second quarter, Target quickly implemented an operational response plan to ensure the health and well-being of our employees and customers.
We have maintained this focus, and as a result, we have not had any cases of COVID-19 impact our business. We also took immediate action to appropriately position the business for what we anticipated to be a challenging 2020. Amidst sharply declining utilization, we began dynamically managing capacity across our network to align with demand and our customers' needs while quickly reducing costs across the organization. Our cost reduction initiatives remain on track, and our second quarter results reflect meaningful reductions in capital spending, cost of services, and recurring corporate expenses. These cumulative steps have allowed Target to maintain operating leverage and preserve robust cash generation in this challenging environment. We have positioned Target for long-term success, and as market dynamics evolve, there is a potential to organically gain additional market share as we return to a more normalized pace of activity.
Now turning to the recent trends we have seen across the business. As we exited the second quarter, we began to see signs of activity stabilizing from our energy end-market customers and incremental gains in Target's occupancy and utilization trends. We have seen improvement in these metrics from lows that occurred in late May. Albeit modest, we have seen these positive trends continue through June and July. As a result, we have reopened several lodges that were temporarily closed early in the second quarter to meet increasing customer demand in both the Bakken and Permian. Like many other industries, as we continue to move through 2020, there is downside risk from potential slower economic recovery or multiple waves of COVID-19 related shutdowns.
We remain cautious on a meaningful increase in activity levels through the remainder of 2020 but do anticipate marginal improvements as we move into the third and fourth quarter, followed by seasonal deceleration late in the year. Even with incremental improvements in the second half of 2020, progress is likely to be uneven in the near term. As activity progresses towards normalizing, we will provide the market a revised 2020 outlook when enough clarity is available. We have positioned Target to be successful through a variety of business cycles. While this one is certainly different. We will benefit from incremental improvements in activity levels as a result of our high-quality, top-tier customer base and expansive networks in the most economical basin. These are key factors that differentiate Target, allowing us to appropriately manage the business in challenging environments.
The second quarter results are indicative of our ability to navigate an unprecedented situation and remain focused on ensuring the long-term success of Target Hospitality. I'll now turn the call over to Eric to discuss our second quarter results in more detail.
Thank you, Brad, and good morning, everyone. I will begin with a discussion of our results, review our capital program, and conclude with details on our progress mitigating financial impacts from the economic uncertainty we are experiencing. As we anticipated, we experienced a sharp decline in utilization in the second quarter due to the COVID-19 pandemic and decline in global commodity markets. However, in this challenging environment, we were able to produce strong quarterly results. Second quarter 2020 total revenue was approximately $54 million. Adjusted EBITDA was approximately $14 million, and discretionary cash flow was approximately $15 million. Turning to our segment performance, the Permian Basin delivered second quarter revenue of $21 million compared to $52 million in the same period last year. This decrease was driven by lower utilization as customer demand was sharply reduced in response to the accelerating global pandemic and crude oil price volatility.
In the Bakken, as a result of the temporary closure of all our communities in May, second quarter revenue was negligible. We have seen incremental improvements in customer activity and demand in the region and have recently reopened lodges in response to this increase in demand. Our government segment remains consistent with quarterly revenue of approximately $17 million. Our all other segment, which consists primarily of construction fee revenue from TC Energy pipeline project, had revenues of approximately $16 million for the second quarter compared to $3 million in the same period last year. Revenue increased as a result of TC Energy's announcement to proceed with the project in March. As a result of the Supreme Court ruling in July, we anticipate limited activity associated with this project for the remainder of 2020. Recurring corporate expenses for the quarter were approximately $7 million.
We took decisive steps to reduce cash expense across the company and restructured the organization to match activity where appropriate. These measures contributed to an over 7% reduction in recurring corporate expenses from the first quarter. We are on track to contribute annualized savings of approximately 20%. With our expense reductions, we anticipate recurring corporate expenses to remain around $6 million-$7 million per quarter for the remainder of 2020. We generated cash flow from operations of approximately $15 million for the second quarter, and a 27% discretionary cash flow yield off revenue, which illustrates the significant resiliency in our business model. Even in this challenging environment, we expect to continue generating robust operating and discretionary cash flow, providing sufficient capacity to fund all normal course business activities as well as to strengthen our balance sheet.
Capital expenditures for the second quarter were approximately $1 million, including minimal maintenance capital. As a result of lower aggregate demand and reduced customer activity levels, Target anticipates capital expenditures to be less than $3 million for the remainder of 2020 or $7 million-$10 million for the full year. We ended the quarter with $425 million of long-term debt, including $85 million drawn on our revolving credit facility and consolidated net leverage of 3.4x . As a reminder, our long-term debt consists of $340 million in senior secured notes due 2024 and $125 million ABL facility, which have no near-term maturities or immediate financial covenants, providing us significant flexibility and liquidity within our capital structure. In addition, we anticipate our assuming debt balance to be reduced in the second half of 2020 from a continued cash generation, which will only further our available liquidity.
Now turning to the progress we've made in mitigating the effects of the ongoing economic uncertainties. The second quarter results illustrate the pronounced reduction in activity and utilization levels we anticipated. However, we took decisive action to reduce costs during the quarter and were able to reduce our Permian and Bakken cost of service by over 30% compared to the first quarter. As we previously outlined, we took proactive steps to modify select commercial contracts for the long-term benefit of Target. These discussions resulted in a mutually beneficial outcome, providing lower committed beds to our customers in 2020 while maintaining contract integrity by preserving ADR and margins for Target in future years. In addition, we gained greater visibility on long-term revenue and cash flow by extending contract commitments, including exclusivity, from 2021 into 2025.
As part of our negotiations, we obtained approximately $60 million of additional minimum revenue commitments at attractive margins. This also significantly reduces near-term contract renewal risk that was coming up into 2021. These modifications appropriately position Target to participate in increased demand given our enhanced market share capture as we progress to a more normal operating environment next year. Our cumulative response to these economic uncertainties has been taken with the focus of preserving liquidity, protecting our balance sheet, and retaining financial flexibility. Our cost reduction initiatives, along with our focus on capital discipline, allowed us to exit a challenging quarter with approximately $60 million in liquidity, an increase of $14 million from the first quarter of this year.
We believe the strength of our balance sheet and cash position, along with a continued focus on capital stewardship, will provide the opportunity for Target to prevail a stronger, more resilient company as we return to a more balanced market. With that, I will turn the call back over to Brad for closing comments.
Thanks, Eric. We anticipated the second quarter to be challenging, and it was. We witnessed a significant reduction in our energy end-market customer activity, which resulted in a pronounced reduction in utilization across our network. In a challenging environment, our strong second quarter results are a testament to Target's ability to quickly react to an unprecedented situation. We protected our balance sheet and exited the quarter with an enhanced liquidity position. We have intentionally established Target's expansive network within the most economical basins in North America while aligning with first-class customers and the best operators in the region. These factors underscore our ability to continue to succeed in challenging environments. While the scale and pace of an improving economic outlook is difficult to predict, Target is well-positioned to adapt to changing market conditions and take advantage of the eventual recovery.
I appreciate everyone joining us on the call today, and thank you again for your interest in Target Hospitality. Operator, you may now open the line for questions.
Thank you. The floor is now open for questions. Our first question is coming from Jeff Grampp of Northland Capital Markets. Please go ahead.
Morning, guys. I was curious, first off, appreciate the commentary on inter-quarter and 2Q and what you guys are seeing thus far in 3Q. I was hoping to dive in on that a little bit more. Do you guys have any sense, I guess, or any level of confidence at this point to be able to say that 2Q was kind of the trough, if we look at just the energy business ex Keystone? I know that's a separate kind of dynamic there. If we just look at the core Permian-Bakken exposure, do you guys feel that 2Q was the trough given what you've seen thus far in 3Q? Can you just kind of talk about how you're seeing directionally the remainder of the year playing out?
Yeah, Jeff, this is Brad. Let me take that first, and Eric can jump in as well. We do believe it's the trough. I think the question is how fast and how steady does it continue to rise, right? If you look at the trough in May, we've seen 10 consecutive weeks now of increase in our occupancy. We think that definitely sheds some light on us calling it the trough. I think there's definitely things out there that could change it depending on what happens with COVID and how it goes. If it's a steady state, we believe it's still a slow crawl up. We see better occupancy as we continue to move into the third and fourth quarter.
Hey, Jeff, it's Eric. Good morning. I think, as we indicated last quarter, I wouldn't say a lot has changed in our outlook as we think about the back half of the year. Certainly, the one positive thing that has been helpful is that the movement off the trough is a little faster than what we had initially modeled, which is helpful. I think what Brad indicated, as you look out going into Q3 and into Q4, to some extent, we do expect this movement up. I think from a planning perspective, we're cautiously optimistic, but we are being sober about there are certainly a number of unknowns, and we'll just have to play those out as we move through the year. We're certainly looking forward to some positive momentum as we continue some trajectory here.
Great. Really helpful. My follow-up, on the ADR side, Permian outperformed quite a bit than what we were expecting. Was up a decent amount sequentially. Anything going on there that you can kind of point to? Is that a good baseline to think about going forward? Or just how we should think about maybe ADR kind of going for the rest of the year? Thanks.
Sure. Great question. You're right. Yes, there is something going on there. If you recall, we had worked through some contract modifications with a handful of large key customers. In some of those discussions, there were amounts owed to us that we imputed as part of the change in contract. What you're seeing in particularly this quarter was some of that revenue coming through and hitting ADR positively. Certainly doing it with no increase in utilization, and certainly no cost of service attached to it. That had the net benefit of increasing the ADR above and beyond what you otherwise would have expected. I think you look to normalize those out. If I'm you, I would take a few dollars off of that as we look out in the future.
I wouldn't think your ADR will be much different than it was, let's say, in first quarter. If you think about first quarter relative to third and fourth quarter, that probably puts you in a better spot moving forward.
Got it. Really helpful. Thanks for the time, guys.
Thank you. Our next question is coming from Stephen Gengaro of Stifel. Please go ahead.
Thanks, good morning, everybody. I guess while you're on the topic you were just on, I'll ask you this. Your Permian gross profit margin was down. I know occupancy was down and the market was awful. Given that ADR move, if you get back to a similar ADR going forward, I guess what I'm getting at, how much of the change is ADR related and how much is under absorption as we try to think about back half margins in the Permian?
Sure. Let's take a step back. You're asking a great question, but let's take a step back, though. When we looked at the contracts and had the discussions with some of the counterparties, we made the election this year to be constructive and work with our customers, and a handful of customers at that, which did impact how we think about the business and the performance of the business as we move through 2020. It has a positive impact to us in 2021 through nearly 2025 at this point. Okay. There were absolutely some positive things to us. When you think about your question, it's really a function of occupancy at that point. We came out of this with a better contract structure.
The reality is, the occupancy was down substantially, and we did give on some of the committed revenue that we otherwise would have expected, which had the net impact of hurting the margin. We expect to get a substantial portion of that back into 2021, and particularly in 2022. I think when you look at it, you have to look at it in totality and not just look at it in 2020.
Okay, thank you. Then, can you talk about-- When we look at the Permian numbers, they were better than expected in aggregate. When we look at the monthly progression through the quarter, then we look at July, we're on August 10th, I think you have pretty good visibility into August by now. What's that trajectory look like? How is the third quarter occupancy shaping up relative to the second quarter and the monthly progression? You're halfway through the quarter almost. I figure you have pretty good sense for the first couple of months.
I'll take this, and again, Eric can jump in if he wants. Trajectory's a little slow. It started off fast, fairly quick. It hit the bottom, as I said, 10 straight weeks of increase in our occupancy. We've seen that it's still on a trajectory going upwards, but it slowed some in the past few weeks. We look for that to continue upwards as we continue into the third and fourth quarter. The question is how fast, right? Right now, we believe that's going to be a slow crawl up, definitely throughout 2020 and parts of 2021.
Yeah, I think, Stephen, look, you're asking great questions. I think the reality is this. There are so many unknowns that we are not expecting what I'll call something that's a meaningful improvement until mid next year, based upon what we know today. We're not getting that feedback necessarily from customers. We're giving that feedback from our experience in these businesses and how long it takes to typically come off cycles and peak to trough and all that. I'm not saying there's a peak in one year, certainly, either. I'm saying that we don't expect, though, to see meaningful improvement. I think, look, we're planning on 12 to 18 months before we are at approaching levels of utilization and ADR peaks that are consistent with what we would have expected in this business on a mid-cycle basis.
We think we're a little bit away from that. We're continuing to make some improvements.
Thank you. Just one more, if you don't mind, then I'll get back in line. When I think about the Permian revenue, and you look at the revenue for the quarter, the occupancy, the utilized rooms. Are the utilized rooms physically utilized or just rooms that are paid for?
The utilization definition are rooms that are effectively paid for. Remember, we modified a select number of contracts that drove the lion's share of that down this quarter and into Q3 as well, okay? You have to bear that in mind. In the short run, it feels much more like occupancy until we get into 2021, where those modifications and the contracts will start taking hold in a more firm way in terms of minimum revenue commitments. It looks a little bit different than what you're used to seeing, but it is technically off of the revenue, which gets us back to the utilization.
Great. Thank you.
Once again, ladies and gentlemen, that is star one if you would like to register a question at this time. Our next question is coming from Kevin McVeigh of Credit Suisse. Please go ahead.
Great, thanks. Hey, I wonder if you could just give us a sense, with some of those contract renegotiations, what you were able to benefit from. Obviously, you're working with those partners pretty close, but is there anything you'd call out, we should look forward just based on incremental benefit to Target?
Sure. I'll kind of give them to you at a higher level and then what we were trying to accomplish and what we effectively did accomplish. We gave, certainly to some extent, for 2020, and really gave them a relief that many of them needed. Again, we're talking about a handful of large customers. So large of our customers. Kind of giving them breaks of over six to nine months. In return, what we're getting are two things. One, meaningful extensions at the back end, some of which we're talking about, which we've put in the release. The $60 million of additional revenue commitments. In addition to that, we have extended term on the initial contracts that we're dealing with today. Those are two positives. Third thing we're getting is, in many cases, in nearly all cases, we've kept ADR nearly static.
In some cases, have increased. We've kept pricing and kept margin. What happens is, as we move through time, you have the minimum revenue commitments kick in at an escalating rate as we move through time, at margins that are nearly equal to, or in some cases better than what we're at today. While we're doing that, we're also able to remove a number of deferral mechanisms, which were in other contracts. When we look at this, Kevin, in total, we look at it and say, "Look, we gave some things in 2020." When we look at the structure of the contract and we look at the duration of the contracts and we look at the present value of the revenues going further out in time, we think we did quite well for the long-term benefit of Target.
No, that makes sense. Just on the competitive side, obviously there's a lot of uncertainty, but any just thoughts on that use of cash? Do you keep it? Is there maybe any strategic acquisitions? Just any thoughts on the capital allocation within the context, just some of your competitors.
Yeah. Look-
Hey, Brad.
Hey. How you doing, Kevin? What you're not going to see us is going and spending the money in the Permian doing acquisitions or anything like that. I think, the cash flows will be put towards debt. I think we've been pretty open about that. I think the great thing is we were able to reset our costs. We did not have to negotiate on these contracts, we could've had a much better 2021 than what we're sitting here today telling you. We think renegotiating them, being a good partner with our customers allows us to really do even much better in the outer years. I think, the cash, as you talked about, definitely continues to grow. We continue to put that towards, at this point, towards the debt. I would also tell you, we've been talking about diversification for a while.
It's something we still have top of mind, something we will do. Looking at different facilities management, catering, those types of things. It's what we already do in some of our locations. We think that's a business that we can scale pretty quickly. It helps diversify us into many other industries. It's something we're going to keep a focus on. It's nothing that we have right at hand today, but we think it comes.
I think, Kevin, the other thing I would add is that when we think about transactional activity, and as Brad mentioned, we don't see the need or reason to do a lot in the Permian. One of the reasons for that is that we have already picked up effective market share, just based upon what's happened in the environment there, what's happened with our competition. The contractual modifications we've made and the extending exclusivity out a number of years, for contracts that maybe we had exclusivity on a year or two, have now been moved out three, four, five years. We have picked up effective market share, and we see much less of a need to go out and do something transactional in the Permian.
What that allows us to do in the meantime is strengthen the balance sheet, as Brad mentioned, but two, really focus much more diligently on expanding the diversification around cash flows.
Understood. Very helpful. Thank you.
Thank you. Our next question is coming from Stephen Gengaro of Stifel. Please go ahead.
Thanks. Just to follow up one more time on this so I understand the dynamics. If you thought about the second quarter margins in the Permian, and then you sort of thought about, it doesn't really matter exactly what timeframe, but whether it's back half of this year or first half of 2021 and the progression, what are the stepping stones? I think you have costs out, you have ADRs normalizing from second quarter levels, and then you maybe have higher occupancy. I'm just trying to think about the cost structure that's in place relative to the occupancy and the variable costs associated with adding maybe some more people to the rooms. I'm just trying to get a better handle on what we should think about from a progression perspective.
Stephen, is your question around margin expansion and the movement [crosstalk]
Yeah. What are the puts and takes to the margins as we go over the next several quarters?
Okay. A couple of things. In the midst of the pandemic, when it was happening right around mid-March, we did not start seeing any sort of meaningful impact to us until really the first or second week of April. We were probably behind things by about a month from where you were feeling it in real time. What I think ends up happening is we ended up moving cost down low pretty substantially, but it was albeit delayed from probably where people might expect, just because we had to still continue to facilitate the customer. Now what we're looking at is a spot where I feel like we have costs almost completely caught up.
As we increase occupancy, as we move through time and have some ADR pickup through some additional service, what I expect is that we have margin expansion because now we've got costs better in balance. I think that's the piece that, I don't want to put a number on that, Stephen, but I'll just tell you that there should be a better, bigger spread between revenue and costs at this point as we move forward in time.
Yeah, because there's always a static cost. It's just not going to go down. As utilization increases, it should pick up, as you say, on the percentage.
We've talked before about the split, roughly 70/30, when we look at cost of services, and this is average, but about 30% is more of a fixed nature, about 70% is more of a variable nature. Obviously, as you bring the revenue pool down, your fixed pool is going to start becoming a bigger allocation of that. As we start moving revenue back up and occupancy increasing, now your fixed spread is going to start coming back down on you. You should start seeing some margin expansion as we move through time.
To go back, were July and August better than June?
From a margin basis or just in general?
From a revenue perspective. Maybe if you don't want to answer that directly.
It is directionally, as we've indicated, it is continuing to be directionally positive. I think what Brad was saying before was that the pace from May through June, that positive slope of that curve was quite high. What we're seeing now is the slope of that curve is coming down, but it's still upward sloping.
Got it.
The answer is yes, it is positive. I think we just want to caution, look, don't make it linear through the model, is all we're saying. We just don't know what end of Q3 and Q4 really looks like. Is that fair?
I understand that. Yeah, that's fair. Just one more, and that is when you think about your occupancy, and I look at a market right now that will seemingly have a meaningfully lower average rig count in the third quarter on a rising completion count and more frac crews. Is there a way to think about those competing factors on your utilization? Even maybe not your third quarter, but just going forward. Are there more people on the completion side, more people on the drilling side? Is it fairly close? If we get completion rising 20% and drilling falling 10%, is that good or bad? Is there a way to think about those two dynamics?
It's getting pretty binary.
Well, because it's clear the completion activity is rising and drilling is falling, right?
Yeah. To be fair, there are more people that are doing the servicing when you're doing perforations and frackings and refrac and all that than there is in actually drilling. There's no question about that. What we are seeing are customers taking advantage of lower rig rates. Producers are drilling more wells but t hey are not completing them. I think what you would expect to see over time, as pricing allows it, is for an influx of completions, which then provides more opportunity for human capital to come in. Look, there's a lot that can happen between here and there.
Okay. The data we see suggests that completion crews are rising pretty nicely and drilling activity down quarter-over-quarter, just on average.
If you looked at who's in our lodges, it's definitely the completion crews that came back.
Got you. Yep.
We're definitely seeing that. I think, again, our question goes back, how does that continue going forward? How fast? What's the pace of that? We've had some of these come back really nicely, especially our larger customers. We like where that's headed. It's just not as fast as we'd like to see it at this point.
Okay. I think you did make a note earlier that you've gained some share throughout this.
Yeah. We've done this in the last time it happened in North Dakota. Here, what we're seeing is, and I don't think it's a secret, but you're going to see the larger customers be a bigger spend of capital in the Permian. From the larger E&Ps and then your larger service companies are going to get the lion's share of that. We're starting to see that today. Some of the bankruptcies that have taken place, they're affecting us in a nice way. You've seen Chevron buy Noble. We all know they're a customer of ours. Does that affect us? We think at some point it affects in a positive way. We don't think the consolidation in the basin is done. When we're setting with these contracts and the reason we wanted to work with a customer, many reasons, but one of them is we believe in the basin.
We believe there's going to be more and more CapEx spent there as the market recovers, and we're going to be sitting in a very good position to take advantage of that.
Great. This is very good color. Thank you, gentlemen.
You bet.
Thank you. This brings us to the end of the question and answer session. I would like to turn the floor back over to Mr. Brad Archer for closing comments.
Sure. Thank you. Thanks everyone for your time today. We appreciate your continued interest in Target Hospitality, and we look forward to speaking again next quarter. Thanks.
Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect or log off at this time, and have a wonderful day.