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Edited Transcript of AROC earnings conference call or presentation 30-Apr-19 4:00pm GMT

Q1 2019 Archrock Inc Earnings Call

HOUSTON May 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Archrock Inc earnings conference call or presentation Tuesday, April 30, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* D. Bradley Childers

Archrock, Inc. - President, CEO & Director

* Douglas S. Aron

Archrock, Inc. - Senior VP & CFO

* Paul A. Burkhart

Archrock, Inc. - VP, Finance

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Conference Call Participants

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* Daniel Joseph Burke

Johnson Rice & Company, L.L.C., Research Division - Senior Analyst

* John H. Watson

Simmons & Company International, Research Division - VP & Senior Research Analyst of Oil Service

* Thomas Patrick Curran

B. Riley FBR, Inc., Research Division - Senior VP & Equity Analyst

* Torrey Joseph Schultz

RBC Capital Markets, LLC, Research Division - Analyst

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Presentation

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Operator [1]

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Good morning. Welcome to the Archrock First Quarter 2019 Conference Call. Your host for this morning's call is Paul Burkhart, Treasurer and Vice President of Investor Relations at Archrock. I will now turn the call over to Mr. Burkhart. You may begin.

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Paul A. Burkhart, Archrock, Inc. - VP, Finance [2]

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Thank you, Dana. Hello, everyone, and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Doug Aaron, Chief Financial Officer of Archrock.

Yesterday, Archrock released its financial and operating results for the first quarter of 2019. If you have not received a copy, you can find the information on the company's website at www.archrock.com.

During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, based on our current beliefs and expectations as well as assumptions made by and information currently available to Archrock's management team. Although management believes that the expectations reflected in such forward-looking statements are reasonable, they can give no assurance that such expectations will prove to be correct.

Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements made during this call.

In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage and cash available for dividend. For reconciliations of these non-GAAP financial measures to our GAAP financial results, please see our press release from yesterday and February 19, 2019, in addition to our forms 8-K furnished to the SEC.

I'll now turn the call over to Brad to discuss Archrock's first quarter results and to provide an update of our business.

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [3]

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Thank you, Paul, and good morning, everyone. I'm pleased with our solid first quarter performance, as Archrock continues to deliver strong earnings growth while increasing our operating horsepower in multiple U.S. basins.

The supportive market conditions we experienced in 2018 remain in place today, as evidenced by our strong level of customer commitments.

Our primary focus for the first quarter was on executing accretive growth opportunities to deliver strong results to our investors.

With that in mind, I'd like to highlight several of our first quarter accomplishments. Our first quarter net income of $19 million was up $17 million compared to the first quarter of 2018. Adjusted EBITDA increased by 13% as compared to the prior year period. Our dividend was 10% higher over the prior year period, and we delivered strong dividend coverage of 2.8x.

We grew contract operations revenue by 13% compared to the prior year period, reflecting an increase of 8% in our average operating horsepower and the benefit of further price increases.

We delivered strong results in our aftermarket services business as well. Revenues at AMS were up by more than 5% compared to the prior year period on an attractive gross margin of 18%.

Leverage at the end of the first quarter was 4.4x, reflecting the reductions we achieved over the past year. And we remain on target to realize sub-4x leverage in 2020.

Our first quarter outperformance keeps us on pace to achieve our full year 2019 guidance of adjusted EBITDA of between $370 million and $400 million.

Turning to our operations. Our contract operations business delivered disciplined growth and solid financial performance. We are executing well, and for the eighth quarter in a row, we grew our operating fleet of compression assets. We believe the abundance and low-cost supply of natural gas in the United States is driving a structural change in the global nature of gas demand, which continues to drive midstream infrastructure development and demand for new compression assets.

From a basin perspective, our largest growth was in the Permian, but we also experienced new activity in the SCOOP/STACK, Marcellus and Eagle Ford.

Compression utilization across the industry remains strong, and we're seeing 20% year-over-year price increases on the high-demand units we're deploying to our customer sites.

Maintenance expense was slightly higher during the first quarter, but we remain confident that we will deliver gross margins within our guidance range of 60% to 62% for the year.

Our aftermarket services business continues to benefit from supportive market dynamics as customers require maintenance and parts of their compression fleets, particularly in the Permian and the Rockies.

The strong market and high-level of customer demand is supporting our focus on profitable revenue growth. We continue to expect 2019 activity levels to be similar to or better than those we realized in 2018 and to follow normal seasonal patterns with Q2 and Q3 being our busiest quarters.

Now let me update our take on the market. The market for U.S. contract compression remains extremely strong, backed by a high level of customer demand, long lead times for new equipment and strong utilization of compression equipment overall. Conversations with customers regarding their future compression needs, together with market forecasts for natural gas production increases, give me confidence that there continues to be increasing long-term demand for our services across geographies. This would include in the Permian, the Eagle Ford, Niobrara, Marcellus and Utica shale plays.

Our book of business is robust, with strategic customers planning well in advance for their compression needs and placing orders up to a year in advance, and at attractive pricing levels. As I've said for several quarters in a row, our customer commitments for contract compression horsepower to be placed into service in 2019 and even extending to 2020 remained at elevated levels. Indeed, nearly 95% of the new horsepower of which we will take delivery in 2019 has already been committed and contracted with our customers.

In addition to positive indications from our customers and near-term market forecasts, the long-term macro backdrop continues to support the profitable expansion of our business. U.S. natural gas production is forecasted to increase over 7 bcf a day or about 9% in 2019, a production increase for the U.S. that is second only to the record natural gas production increase we experienced in 2018.

Rising U.S. natural gas production and demand for compression is a result of the sustained structural increase in the global demand for and expanding use of natural gas. It is not merely driven by commodity price cycles. Stable and competitive natural gas prices over nearly a decade have allowed for the economic development of U.S. LNG as well as supported expanding shipment by pipeline to Mexico. And these exports are driving a step change in the demand levels for outsourced compression services.

Further development of gas gathering and processing infrastructure is being developed to handle these record volumes of U.S. natural gas production, and compression is a critical component of this long-lived production infrastructure.

This opportunity for our business has been amplified by the current market sentiment toward disciplined capital allocation and free cash flow. Concurrently, this, one of the largest buildouts of natural gas production infrastructure in the United States, combined with our customers heightened focus on their expansion CapEx, has created an unprecedented opportunity for our business to support this expansion with our services.

While we've taken a strategic capital allocation approach to invest to meet our customers' needs at this time, we also see the opportunity ahead for our business to achieve positive free cash flow, a point I will come back to shortly.

In addition to increases in natural gas production, growth in U.S. crude oil production is driving demand for compression and Gas Lift applications, which now comprise about 25% of our operating fleet. Expected increases in U.S. crude production should continue to support demand for Gas Lift applications, particularly in the Permian Basin. In sum, indications from customers, short and longer term, as well as from the market, are positive. There is an abundance of natural gas that needs to be compressed and customers are looking to Archrock to help them safely and efficiently do the job.

Turning to our capital allocation strategy. Our focus remains on creating value and maximizing returns for our shareholders as we continue to balance 3 key objectives: first, to selectively meet our customers' needs by investing in capital-efficient, high-return assets; second, to further reduce leverage to below 4x in 2020; and finally, to continue to -- our track record of returning capital to shareholders in the form of quarterly dividends. Our latest quarterly dividend is 10% higher than the first quarter dividends last year. We have been consistent in this communication of our capital allocation since the time of the merger of Archrock Partners into Archrock, and we remain committed to achieving these objectives.

Now, we're starting to look beyond to our next objectives, which will include managing the business to generate positive free cash flow, which we expect to achieve by the late 2020 or early 2021 timeframe.

In summary, we are off to a solid start on what we expect to be a year of further profit improvement and growth as we continue our focus on operational execution. We will be setting new horsepower, diligently managing our operations, investing in technology and delivering safe and excellent customer service. These activities, combined with our commitment to our capital plan, will deliver strong returns and value to our investors over the near and long term.

Now I'd like to turn the call over to Doug for a review of our first quarter performance.

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Douglas S. Aron, Archrock, Inc. - Senior VP & CFO [4]

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Thanks, Brad, and good morning. Archrock delivered another quarter of strong financial results. Revenues for the first quarter totaled $236 million, reflecting an increase of 11% compared to the prior year period.

Adjusted EBITDA for the first quarter was $91 million, an increase of 13% over the first quarter of 2018 driven by higher operating horsepower and improved pricing.

Net income for the first quarter of 2019 was $19 million, a substantial increase compared with the $2 million in the first quarter of 2018. In contract operations, revenue improved for the eighth consecutive quarter, to $183 million, up 13% from the first quarter of 2018. This increase resulted primarily from higher operating horsepower across our fleet, and again, secondarily, from rate increases. We achieved a gross margin of 59%, benefiting from price increases implemented in January, partially offset by scheduled maintenance activities and ongoing inflationary pressures across the industry. We continue to expect a full year margin of 60% to 62% as we benefit from strong execution, pricing strength and ongoing cost management.

In our aftermarket services segment, we reported first quarter revenues of $54 million, an increase of 6% over the prior year quarter. Gross margins for AMS was 18%, compared to 17% in the prior year first quarter and consistent with our full year expectation of between 17% and 19%.

SG&A totaled $29 million for the first quarter compared to $28 million last year. For the full year, we continue to expect SG&A to total between $118 million and $124 million. For the first quarter, our growth capital expenditures totaled $111 million. Maintenance CapEx for the first quarter of 2019 was $15 million, consistent with our full year 2019 guidance of between $57 million and $63 million. We generated -- we've generated $11 million from asset sales in the first quarter, which keeps us on track to meet our target of $30 million for the year, driven by our continued focus on honing our fleet with removals of underperforming assets.

We exited the quarter with debt of $1.6 billion, up $53 million compared to the fourth quarter, as our growth CapEx was partially funded with debt in the quarter. We successfully completed a $500 million senior notes offering during the quarter. These senior notes, which mature in 2027, replace $350 million of existing senior notes that were due to mature in 2021 and provide an extension in our maturity profile and greater liquidity to fund ongoing initiatives.

Additionally, Moody's and S&P both gave improved credit ratings on our new senior notes. For the first quarter, leverage remained unchanged at 4.4x. We continue to closely manage our capital position and remain firmly committed to our leverage-reduction goals, with leverage expected to be below 4.0x in 2020. We exited the quarter with available liquidity of $486 million, up from $392 million at year-end.

We continue to closely balance our capital targets and the demand we're seeing for our service. Our full year 2019 CapEx guidance remains on pace, which includes between $250 million and $300 million of growth investment in our fleet. This spending will support between 285,000 and 345,000 of new horsepower additions. These 2019 investments are focused on large horsepower units that support stable midstream applications tied to natural gas and oil production in the key growth plays.

We recently declared a first quarter dividend of $0.132 per share, or $0.528 on annualized basis, unchanged from the prior quarter and up 10% as compared to the first quarter of last year. Our latest dividend represents a yield of approximately 5% based on yesterday's closing price, and a total dividend payment of $17 million.

Our first quarter dividend will be paid on May 15 to all shareholders of record at the close of business on May 8. Cash available for dividend for the first quarter of 2019 totaled $48 million, leading to first quarter dividend coverage of 2.8x.

Earlier this year, we provided our full year 2019 outlook. Our first quarter results keep us on pace to achieve our guidance, including adjusted EBITDA of between $370 million and $400 million, and we expect we will be able to tighten our guidance range as the year progresses. With that, Dana, I believe we'd now like to open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of TJ Schultz with RBC Capital Markets.

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Torrey Joseph Schultz, RBC Capital Markets, LLC, Research Division - Analyst [2]

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I think, just first, the producers, the heightened focus on capital allocation and free cash flow, that's pretty well discussed at this point on our end. I'm just curious, is there a noticeable change in discussions with the customers that translates this better -- to better line of sight on your growth. Whether that's showing up and just being able to contract horsepower sooner? Is it tighter supply benefiting rates? Just how should we best think about the customer change in behavior playing out to your benefit?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [3]

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Sure. The way we're experiencing this is that our customers, we believe, are tipping the balance between outsourced and owned currently to favor more outsourced equipments, especially in the high-growth markets. I think the dynamic is driven by a lot of the characteristics that we provide in our business to our customers to begin with, which is the great footprints; we're already where they need to grow with great servicing capabilities as well as access to equipment.

My point is that it's -- their focus on free cash flow has really been, I think, a factor amplifying that push to outsource -- it probably isn't limited to compression, but I'm speaking about our business -- to outsource more of their compression activity today in high-growth areas than they would have in the past is amplified by their focus on their own capital allocation priorities.

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Torrey Joseph Schultz, RBC Capital Markets, LLC, Research Division - Analyst [4]

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Okay. Good. Makes sense. And then aftermarket services, you've pointed out before that newer compression is approaching a major maintenance cycle. Can you just flesh that out a bit more? Is that something you see accelerating this year, or is the outlook in aftermarket benefiting from this cycle something that's kind of beyond 2019?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [5]

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The comment that we share there is that as more compression equipment has entered the market over the past years, more major maintenance activities around that customer-owned equipment is good. Fortunately, [this half] is our aftermarket services parts, maintenance and shop businesses to help them with those major maintenance activities.

And since the amount of compression that's owned by our customer base has steadily grown year-over-year, it's good for our aftermarket services business. So we intend to utilize that growing market to both capture revenue -- incremental revenue as well as to continue to improve the profitability of the segment, which is part of what you're seeing already in our performance.

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Torrey Joseph Schultz, RBC Capital Markets, LLC, Research Division - Analyst [6]

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Got it. Just -- lastly from me, just any general expectations on growth CapEx in 2020 just directionally from 2019, especially as you're thinking about lead times for orders next year?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [7]

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So this is Q1 in 2019, we're pretty happy that we just initiated annual guidance for the first time, and we're working with that, and 2020 is still a ways ahead. But part of my commentary does lead to, I believe, some idea that natural gas production, which is the biggest driver of our business, we expect growth in natural gas production to continue but to moderate in future years, including, we think, starting in around 2020 and 2021. That does imply we expect to have a moderating CapEx spend as we look into those out years, and that is our overall forecast right now, but it's based on production growth, which continues, it just moderates nicely to support our capital priorities.

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Operator [8]

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Our next question comes from the line of Daniel Burke with Johnson Rice & Company.

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Daniel Joseph Burke, Johnson Rice & Company, L.L.C., Research Division - Senior Analyst [9]

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Brad, question for you. You alluded to -- on a look in -- at positive free cash flow in later 2020. I want to make sure I understand what that means. Is that -- are you defining free cash flow as total operating cash flow less CapEx? Predividend? Postdividend? Just want to make sure we understand what you're contemplating.

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [10]

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Yes. So look, we're looking at a total free cash flow number. How far we get into predividend and postdividends is really the issue, but clearly post CapEx, the way we're thinking about free cash flow, and that includes growth CapEx. So that's the way we're targeting it right now. Ultimately, we think that business should be funded to generate total free cash flow.

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Daniel Joseph Burke, Johnson Rice & Company, L.L.C., Research Division - Senior Analyst [11]

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Okay. Got it. So think of it as a 2-step process. Is there a sense yet -- shifting that CapEx query, is there a sense yet for whether this year's growth CapEx is trending towards the higher or lower end of the bound of $250 million, $300 million?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [12]

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No. Too early to tell. We're in the -- we stayed in our range that we articulated, I think, a mere 8 or 9 weeks ago. And we believe that right now we're in our guidance. We like the guidance range that we remain in. But this year still has some dynamics to see play out on how much we spend to support growth in the year versus in an out period. And so this guidance range that we're in, we're still comfortable with.

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Daniel Joseph Burke, Johnson Rice & Company, L.L.C., Research Division - Senior Analyst [13]

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Got it. And then maybe one last quick one. I assume we're just seeing some sort of frictional impacts, but it looks as though overall utilization dipped just a touch, if we look at the total fleet at end Q1 versus end of year. Is there anything to point to other than some frictional elements there? It looks like you've still got most of this year's newbuild fleets deliver across the course of the next few quarters.

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [14]

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Overall utilization remains strong, and it's very supportive of what we think, it's not -- it's less than a percent. It's rounding and movement and the timing of how fleet activity occurs, both from a start and a stop perspective. So the fact that it moved around a little bit at a very high utilization rate is nothing to make anything of yet. I think we're still in a very constructive growth environment, very constructive pricing environment, and we intend to make sure that we're leveraging both.

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Operator [15]

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Our next question comes from the line of John Watson with Simmons Energy.

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John H. Watson, Simmons & Company International, Research Division - VP & Senior Research Analyst of Oil Service [16]

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Brad, on the horsepower retirements, I want to dig in there. I think it's been about 100,000 retired annually in recent years. Is that a reasonable expectation for 2019 where we sit today? I'm trying to get a feel for where available horsepower could be at year-end given the expectation for 285,000 to 345,000 of growth additions?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [17]

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John, stepping back and thinking about the fleet overall at a 3.6 million horsepower level we've grown to and are very proud of, we still see that the fleet will likely have horsepower drop out at a rate of, pick a number, 3 percent-ish a year, which is just thinking about a 30 year kind of life of that equipment. So that would be a natural fallout from a 30-year life if all the equipment had been added ratably. So your number is responsible along the lines of that math. But we don't actually forecast impairments or [CLOV] activity, in fact, it's really based upon the horsepower that comes back in from our customers after earning a good return in the field for a while. We reassess whether or not that equipment is both operationally still what we want to put out in the field and whether it's going to generate the right economic returns. And based upon that assessment as that horsepower comes in, is how we determine the CLOV . It's not based upon a forward look or a periodic plan regarding a particular category or set of horsepower. And so that makes it lumpy quarter-to-quarter and a little less predictable, I know. But at the macro level, thinking about a 30-year fleet of 3.6 million horsepower, I would say your math is responsible.

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John H. Watson, Simmons & Company International, Research Division - VP & Senior Research Analyst of Oil Service [18]

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Okay. Great. That's very helpful. You mentioned the pricing increase year-over-year for high-demand units, the larger horsepower units. I was wondering if you could help us think about that on a gross margin basis or a gross margin per horsepower basis, if we look at the Q1 number. What's the gap between a unit that you're deploying today and what you printed in Q1? Can you give us any qualitative color there?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [19]

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I'm thinking -- not a lot, because a couple of dynamics. One, what we're referring to on that 20% price level is really spot pricing from a year-over-year perspective. And as you probably know, when you put units out, the number of units that are new, they go out in a particular quarter on a 3.6 million horsepower base makes it pretty challenging to move the overall gross margin number radically. So that makes it a challenge to give you. The only other thing I'd point out is that our -- first quarter for us was a good quarter, I'm very pleased with how we performed, and we still believe we're in our annual guidance range of 60% to 62%. So we see improving profitability as we move through the year, and we're going to capture that.

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John H. Watson, Simmons & Company International, Research Division - VP & Senior Research Analyst of Oil Service [20]

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Okay, great. And lastly from me, on newbuild units today, for the larger horsepower units, what's a good number for per horsepower build cost for us to be thinking about as we model into 2020 and beyond?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [21]

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Yes. We would guide -- with the amount of large horsepower we're building right now, that newbuild cost has come down on a per horsepower basis compared to what we've seen historically. So I think you're responsible to stay in the $800 to $850 a horsepower range.

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Operator [22]

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(Operator Instructions) Our next question comes from the line of Tom Curran with B. Riley FBR.

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Thomas Patrick Curran, B. Riley FBR, Inc., Research Division - Senior VP & Equity Analyst [23]

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Brad, when it comes to the commitments on your large horsepower newbuilds that you've inked since late 2018, have there been any meaningful shifts in the composition of basins and/or customers relative to the mix of commitments you secured during last summer? Or do you have any reason or perhaps, emerging signs to expect any type of meaningful mix shift?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [24]

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Sure. Yes, thanks. So look, overall the question is no, but with a few nuances. So overall, no, we still see that our build is about 50% moving into the Permian, that's still where we see the largest amount of growth. The other half is moving to other plays, very consistent with what we saw in 2018. But in the mix of the other plays, we have noted an increment of activity in the Northern Rockies as well as in the Marcellus/Utica that's moved up incrementally. And we've noted a slowdown that we believe is likely to be short-lived in the midcontinent plays of the SCOOP and STACK, as producers are sorting through some of their subsurface issues. Those are the nuances, but it's -- overall, my open is still the same, which is 50% moving into the Permian and 50% into other plays and more demand than I think we can meet. We're still at the point where we are restraining our CapEx to our capital priorities; even though we're growing really well with some -- with our customers where we can support them, there's still a tremendous amount of need in the marketplace that's beyond our current capital spend.

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Thomas Patrick Curran, B. Riley FBR, Inc., Research Division - Senior VP & Equity Analyst [25]

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That's helpful. And then I was struck that the winning bidder in the sale of Kodiak Gas Services proved to be a European player based in Stockholm, a multinational PE firm, no less. As far as I know, this is the first time we've seen smart, experienced European money come into the U.S. contract compression niche, at least in recent history. What are you seeing out there in the M&A landscape? And how has the pipeline of prospects evolved since last summer in terms of both the number of deals and their attractiveness?

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [26]

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Well, as you know, we don't really comment on M&A activity. Just as an observation, I would say it's always good to see new CapEx come in -- new capital come into the marketplace. We think that the infrastructure investment opportunities in U.S. natural gas and oil production right now are at a peak level. They are extreme, capital is needed. And so it's good to see fresh capital coming into the market in whatever form it's coming into. On the M&A landscape itself, we also still believe that the market has room for some consolidation. We'd love to see more consolidation occur. If it's value-adding for our investors to do so, we intend to be a player in the space and an aggregator and a consolidator. And if it's something that others would find more efficiency in, we're happy to see others consolidate as well, because we think all consolidation is good for our space. So that's about as far as I can go.

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Douglas S. Aron, Archrock, Inc. - Senior VP & CFO [27]

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Tom, I might just highlight a nuance in there that I think is important, and Brad touched on it when he used the word infrastructure. But the buyer of those assets is distinctly an infrastructure fund, which as you -- look, I'm relatively new, having joined Archrock last August, but I think when I first joined, there was still very much, within the banks that cover us and institutions that cover us, this sort of: do we bucket compression into oilfield service or into infrastructure? And I think we've been trying to pound the table for a while that we very much are part of the infrastructure landscape. You look at the natural gas that's growing and the infrastructure that's required to support it, I would highlight that as an important part of -- I think it's EQT, right? EQT infrastructure fund out of Europe that purchased Kodiak. And so that to me was a strong positive and says that now we might have a very different audience as folks think about compression in the U.S.

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Thomas Patrick Curran, B. Riley FBR, Inc., Research Division - Senior VP & Equity Analyst [28]

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Doug, I think that's a great point. I couldn't agree more, you're a quick study.

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Douglas S. Aron, Archrock, Inc. - Senior VP & CFO [29]

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Well, well-thought anyway.

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Operator [30]

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There are no more questions. Now I'd like to turn the call back over to Mr. Childers for final remarks.

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D. Bradley Childers, Archrock, Inc. - President, CEO & Director [31]

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Great. Well, thank you, everyone, for joining our call this morning. 2019, will benefit from strong dynamics that are driving oil and natural gas production growth in the U.S. We hit the ground running in 2019 and look forward to updating you on our second quarter results later this summer. Thanks, everyone, and have a great day.

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Operator [32]

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This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.