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Edited Transcript of WTTR.N earnings conference call or presentation 5-Aug-20 2:00pm GMT

·32 min read

Q2 2020 Select Energy Services Inc Earnings Call GAINESVILLE Oct 26, 2020 (Thomson StreetEvents) -- Edited Transcript of Select Energy Services Inc earnings conference call or presentation Wednesday, August 5, 2020 at 2:00:00pm GMT TEXT version of Transcript ================================================================================ Corporate Participants ================================================================================ * Chris George Select Energy Services, Inc. - VP of IR & Treasurer * Holli C. Ladhani Select Energy Services, Inc. - President, CEO & Director * Nicholas L. Swyka Select Energy Services, Inc. - CFO & Senior VP ================================================================================ Conference Call Participants ================================================================================ * Ian MacPherson Piper Sandler & Co., Research Division - Research Analyst * Kurt Kevin Hallead RBC Capital Markets, Research Division - Co-Head of Global Energy Research & Analyst * Ryan James Pfingst B. Riley Securities, Inc., Research Division - Associate * Sean Christopher Meakim JPMorgan Chase & Co, Research Division - Senior Equity Research Analyst ================================================================================ Presentation -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- Greetings, and welcome to the Select Energy Second Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded. It is now my pleasure to introduce your host, Mr. Chris George. Thank you. You may begin. -------------------------------------------------------------------------------- Chris George, Select Energy Services, Inc. - VP of IR & Treasurer [2] -------------------------------------------------------------------------------- Thank you, operator, and good morning, everyone. We appreciate you joining us for the Select Energy Services conference call and webcast to review our financial and operating results for the second quarter of 2020. With me today are Holli Ladhani, our President and Chief Executive Officer; and Nick Swyka, Senior Vice President and Chief Financial Officer. Before I turn the call over, I have a few housekeeping items to cover. A replay of today's call will be available by webcast and accessible from our website at selectenergyservices.com. There will also be a recorded telephonic replay available until August 19, 2020. The access information for this replay was included in yesterday's earnings release. Please note that the information reported on this call speaks only as of today, August 5, 2020 and therefore, time-sensitive information may no longer be accurate as of the time of the replay listening or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views of Select's management. However, various risks, uncertainties and contingencies could cause our actual results, performance or achievements to differ materially from those expressed in the statements made by management. The listener is encouraged to read our annual report on Form 10-K for the year ended December 31, 2019, our subsequent quarterly reports on Form 10-Q and our current reports on Form 8-K to understand those risks, uncertainties and contingencies. Also please refer to our second quarter earnings announcement released yesterday for reconciliations of non-GAAP financial measures. And now I would like to turn the call over to our President and CEO, Holli Ladhani. -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [3] -------------------------------------------------------------------------------- Thanks, Chris. Good morning, everyone, and thanks for joining us today. The second quarter of 2020 was one of the most challenging periods we've ever been through as a company and as an industry. Although our industry is used to the cycles, the past few months have presented their own unique challenges. First and foremost, as an essential service, we've been focused on keeping our people safe while continuing to support our customers' critical operations. I'd like to thank our employees for their continued dedication and incredible hard work over the last few months. And our thoughts are with all of those affected directly or indirectly by COVID-19. While our second quarter financial results were clearly challenged, we did have continued success in our cash generation efforts, and our cost management strategy is certainly delivering results. In a moment, Nick will review the quarter's financial results in more detail, but first, I'd like to touch on a few macro points, provide you with some updates on the specific actions we've taken to meet the challenges of today's market, and then review our positioning looking forward. Although crude prices have since recovered off the trough levels seen in April and May, the impact on our second quarter results was significant. Gas basins held in better than oil basins, but there was really nowhere to hide during the second quarter. We experienced activity reductions across the board over the course of the second quarter, with total U.S. rig count down 55%, horizontal completions declining more than 60% and the number of active frac fleets declining approximately 70%. It's always challenging to manage cost downward as fast as activity can drop particularly when the pace of the decline is as steep as it was in the second quarter. That said, the speed and immediate impact of our cost management decision can clearly be seen in our second quarter results, and we anticipate seeing further benefits from this in the back half of the year. The core of our strategy continues to center on providing premier solutions to our customers, protecting our strong balance sheet and liquidity, and emerging on the other side of this downturn in a position to capitalize on the significant opportunities we expect will be available. Doing so has required very difficult and far-reaching decisions to rightsize the business for the activity environment we find ourselves in today. We began to aggressively manage costs downward in mid-March and this continued throughout the second quarter. To that point, I'd like to follow-up on some of the key cost management initiatives from our first quarter call and update you on our latest actions and targets. First, we achieved our previously targeted SG&A savings ahead of schedule and have increased our target, now expecting our third quarter 2020 annualized run rate to be down 40% to 45% relative to our 2019 fourth quarter run rate, and down approximately 50% relative to our 2019 total SG&A. While particularly challenging, our employee headcount has been reduced by approximately 60% relative to the peak in the first quarter. We've implemented furlough programs and reduced base pay by at least 10% nearly across the board, with further reductions beyond that for executive management and our Board of Directors. We've terminated dozens of leases for facilities and housing units as we consolidated our operations. We've renegotiated payment terms across a number of our lease charge and facilities, and we've simplified our operational structure. We've negotiated discounts and adjusted pricing terms with a number of our vendors to help manage through this challenging time. And finally, with normal course asset sales outpacing CapEx, we effectively reduced our net CapEx to 0 during the second quarter, and we're confident we'll come in well under our net CapEx target of $20 million for the year. While revenue declined 67% during the quarter, generally in line with activity levels, we were able to hold decremental margins to approximately 21% at both the gross margin and adjusted EBITDA margin levels, significantly outperforming our historical decremental target, which reinforces the variable nature of our cost structure and the team's execution to get costs out quickly. The significant amount of political and economic uncertainty remains underpinned by the effects of COVID-19, but we're cautiously optimistic that activity levels' bottom delayed during the second quarter. We've seen modest frac crew additions in recent weeks as well as customers reevaluating their shut-in production, and we're getting more visibility into workflows for the coming months. That said, potential Q4 seasonality and the ongoing uncertainty regarding the COVID-19 pandemic will likely result in a slow and steady long-term recovery that's more muted in the near-term rather than a deep V-shaped recovery. As we look forward, I think it's important to consider what will be different about the recovery in this cycle for Select. A handful of areas, in particular, stand out: capital availability, the competitive landscape, asset availability, structural changes to our business and our healthy balance sheet. When you combine the challenging broader economic conditions with the general recent track record of oil and gas industry returns, we anticipate that both debt and equity capital availability, whether through private or public markets, will be more limited for our industry going forward as compared to the last downturn. This will require the industry to solve many of its own challenges out of free cash flow, resulting from increased efficiency, consolidation and improved capital discipline. We believe we'll see the shale upstream landscape continue to consolidate into fewer, larger well-capitalized and more disciplined organizations, with many smaller players being consolidated or exiting the market. These surviving operators will be keenly focused on driving towards a more efficient and sustainable shale development model. Ultimately, this will impact our own competitive landscape to the detriment of narrower, more commoditized service providers. Our competitive landscape has been changing for a while now and even prior to the current downturn, we've had many competitors struggling to keep up with the operational efficiency, the scale and the technical expertise that's necessary to excel in this environment. Select has not only the financial means, but the people, experience and expertise to continue to extend the gap between ourselves and our competition in the quarters ahead. We remain very focused on continuing to advance our strategies around data, technology and water life cycle sustainability that we believe are particularly important to these key customers. The water solutions space is unique when compared to many other OFS subsectors, partly driven by the consolidation efforts we undertook back in 2017 with the Rockwater merger. Unlike other sectors, there are very few large players we compete with and even fewer with the balance sheet and capital availability that will be necessary to support the major operators in the recovery ahead. While our equipment is underutilized today, our space was not overbuilt during the last upturn in the same manner as many other OFS subsectors. This positions us very well to continue to capture and grow our market share across the service line and generate returns on the capital we've deployed. In addition to the cost reduction efforts I outlined earlier, we've taken the opportunity to rethink how we're organized and how we execute our operations. Based on that review, in addition to reducing meaningful variable costs, we've implemented a number of structural changes to our organization. We've streamlined our operations, significantly reducing the number of operating yards and simplified our reporting structure. Additionally, we've removed the layers across the various business lines with a particular focus on further integrating our water and chemicals operations to provide more comprehensive solutions to our customers. As the water sourcing supply chain continues to become more complex and the opportunities for produced water reuse continue to grow, the interplay of the relationship between water quality and the chemistry behind the frac fluid system continues to garner increased focus from our customers, particularly the larger operators with clear ESG ambitions. Some these efforts have taken a bit of a pause during the current market downturn, but we believe these trends will continue in the recovery. The comprehensive nature of our existing customer relationships, service capabilities and technical expertise across both water and chemicals will allow us to more effectively grow our business, further differentiate our market-leading position and advance our strategy to be the full solutions provider. Finally, our balance sheet affords us a significant amount of flexibility to pursue new solutions for our customers, while maintaining a focus on free cash flow generation. Our intention is to maintain a business model that allows us to limit our maintenance capital to 1/3 or less of EBITDA through the cycles. We've seen the benefits of this recently as we've shown a significant amount of flexibility to control our capital spending during the downturn without detrimentally impacting our capabilities or our ability to support our customers in a future recovery. We'll continue to pursue opportunities to grow organically, and we'll evaluate investments in technology and accretive acquisitions that support our long-term strategy. That said, we'll be disciplined in our approach to growth and acquisitions just as we've been in the past. We recognize we still have tough days ahead of us, but we also know that the future will belong to those companies who are the most efficient, the best capitalized and act the fastest to transform their businesses to match the market. With that, I'll hand it over to Nick to walk through our second quarter financial performance in more detail. -------------------------------------------------------------------------------- Nicholas L. Swyka, Select Energy Services, Inc. - CFO & Senior VP [4] -------------------------------------------------------------------------------- Thank you, Holli, and good morning, everyone. While the second quarter was certainly difficult from an industry activity perspective, we effectively matched our best free cash flow quarter ever as a public company and exited the quarter with unprecedented balance sheet strength. Our $56 million of free cash flow generated during the second quarter demonstrates the resilience of our business model and our disciplined capital structure as well as our nimble and resolute approach to cost rationalization. The roughly 80% decline in completions activity from peak levels earlier this year makes for an extremely difficult hill to climb in terms of taking costs out quickly enough to keep pace with declines in activity in what was effectively a free-falling market. We eliminated significant costs from both the field and back office, and after adjusting for nonrecurring expenses, we achieved our SG&A target reduction a quarter early, with more savings to come. As Holli mentioned, our ability to hold decrementals to near 20% levels in the face of revenue declines we've never before seen as a company represents a significant achievement. While these cost-saving measures were unable to prevent adjusted EBITDA from going negative during the second quarter, given the speed of the revenue declines, we've seen continued improvements in July with modest revenue growth and adjusted EBITDA projections approaching breakeven. I feel optimistic that we're positioned to return to adjusted EBITDA levels of breakeven or better in the third quarter, supported by moderate revenue improvements, but I'd caution that forecasting certainly remains a difficult proposition in this environment. Our $97 million of year-to-date free cash flow has further bolstered our already pristine balance sheet and provides us with increasing optionality in a distressed landscape. We now have over $166 million of cash on hand as of the end of the quarter, with 0 debt and a fully undrawn revolver, providing for overall liquidity of $262 million. With the downturn, we swiftly cut back to effectively 0 net CapEx for the quarter, which benefited our cash flows in tandem with significant collections from our accounts receivable balances. Turning to our results in more detail. Select generated total revenue of $92 million in the second quarter, declined due to the industry downturn from $278 million in the first quarter, though this rapid downward trend showed signs of having troughed by June. Gross margins before depreciation and amortization fell precipitously to 1.9% during the second quarter due to the magnitude of the revenue declines, insufficient utilization to cover certain fixed costs and the nonrecurring impact of severance and yard closure costs, among others. Adjusted for these nonrecurring costs, consolidated gross margin before D&A would increase by more than 400 basis points to 6.1% during the second quarter. Adjusted EBITDA, which decreased from $24 million in the first quarter to negative $8.3 million in the second quarter, was impacted by these gross margin declines as well as an additional bad debt accrual of a little over $2 million. We had total adjustments this quarter of $18 million, most notably for asset impairments, severance and noncash losses on asset sales. We had a net loss for the second quarter of $53 million versus a net loss of $291 million in the first quarter, which was greatly impacted by a $276 million goodwill impairment. The Water Services segment's revenues decreased 63% sequentially to $56 million in the second quarter from $150 million in the first. With the exception of our steadier produced water-hauling business, our service lines generally declined in line with completions activity. The segment generated gross profit before depreciation and amortization of $1.8 million in the second quarter compared to $20 million in the first, reflecting a decline in segment gross margin from 14% to 3.2%, or a 20% decremental margin. Absent the effect of severance, yard closure costs and other nonrecurring costs, margins would have been 6.9%. We believe this adjusted margin can be achieved in the third quarter even on flat or modestly lower revenue as the upward completion activity trajectory we currently forecast is unlikely to be a mirror image of the downward slope of Q2. The Water Infrastructure segment saw revenues decline from $58 million in the first quarter to $15 million in the second. Gross profit before D&A decreased from $10 million to $1.4 million quarter-on-quarter, and gross margin before D&A decreased from 17% during the first quarter to 9.3% in the second quarter, representing a 20% decremental margin. This segment was not as impacted by special items like severance or yard closures, so adjusted for the $0.2 million of charges incurred, gross margins would have held in double digits at 10.6% during the quarter. More impactful were the large reductions in pipeline volumes during the quarter, especially for our high-margin Bakken pipelines, which drove a big hit to revenue and especially margins. While pipeline volumes are unlikely to return to first quarter levels in the near term, we are seeing a modest recovery in purchases in the Bakken, and our Northern Delaware pipeline volumes should see an incremental increase as well in the third quarter. These developments should drive sequential revenue growth and a return to double-digit margins in Q3. As a quick reminder on the accounting treatment for the Northern Delaware pipeline, while we reconcile cash payments annually for the anchor tenant early in the following year for the terms of the take-or-pay contracts, we recognize only the revenue for actual barrels sold in the applicable period. The Oilfield Chemicals segment dropped from $71 million of revenue in the first quarter to $21 million in the second. Gross margin before D&A declined from 16% to negative 6.8%, with a gross loss before D&A of $1.4 million as compared to a gross profit of 1 -- of $11 million in the first quarter, representing a 25% decremental margin. The segment was challenged by pricing declines for finished products relative to higher cost raw materials inventory purchased early in the year. Additionally, severance, inventory reserve adjustments and costs related to yard closures and early rental equipment returns, most notably relating to the idling of our Tyler manufacturing facility, attracted approximately $1.6 million from gross profit or nearly 800 basis points. Adjusted for these items, gross margins would have remained positive at approximately 1%. We expect modestly higher revenue in mid- to high single-digit margins for the segment for the third quarter. The decisive actions we took to reduce SG&A yielded a $7.6 million reduction for the quarter, or 30%, to $17.7 million from $25.3 million in the first quarter. Considering the reductions made during the quarter and our June run rate, we expect these savings to continue to accumulate in the third quarter, resulting in SG&A reductions of 40% to 45% relative to Q4 of 2019 to an expense of approximately $13.5 million to $15 million for the third quarter. Below the line, we accrued a slight tax benefit during the second quarter, while depreciation and amortization declined slightly to $26 million. We expect to see D&A continue to decline modestly in the coming quarters given the CapEx reductions made. We continue to have 0 bank debt and enjoy a net cash position of $166 million as of June 30. While we certainly won't repeat the $97 million free cash flow year-to-date in the second half of the year. At this time, we do anticipate a modest positive free cash flow number over the balance of the year. Finally, during the second quarter, we bought back 1.14 million shares or approximately $3.8 million at an average price of $3.36 per share. In the near term, we will likely reduce share repurchases for the second half of the year as we further assess broader capital allocation opportunities in the market. Our 10 consecutive quarters of positive free cash flow has eliminated our past debt, funded new investments and left us with significant optionality in the form of dry powder in a time of severe market dislocation. As we evaluate our options, we'll continue to execute on our core priorities of driving free cash flow and preserving a strong balance sheet while keeping our goal of shareholder value creation central to everything we do. With that, I'll turn it over to the operator, and we'll take your questions before Holli wraps up with some concluding remarks. Operator? ================================================================================ Questions and Answers -------------------------------------------------------------------------------- Operator [1] -------------------------------------------------------------------------------- (Operator Instructions) Our first question comes from Kurt Hallead with RBC. -------------------------------------------------------------------------------- Kurt Kevin Hallead, RBC Capital Markets, Research Division - Co-Head of Global Energy Research & Analyst [2] -------------------------------------------------------------------------------- I think the -- we're getting a lot of commentary about a pickup in frac activity going into the third quarter. But again, some mix read as to what that may look like going out into the fourth. So understanding that nobody really has a crystal ball here and can see things clearly, just want to get your perspective on your discussions with varying customers and maybe with your ear to the ground on the E&P side of the business. What is your expectation for frac activity? Do you think you could maintain momentum going into fourth quarter? Or do you think that there's still some risk of maybe a decline in frac activity for seasonal purposes? -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [3] -------------------------------------------------------------------------------- Yes. It's a great question, Kurt. And as you would imagine, the answers you get varies greatly between customers and how they've managed their capital program. But clearly, there was a heavy weighting towards building of ducts in the first half of the year, so we do expect to see the dollars first going towards completions. And we've seen that in the frac crew count as it's been increasing over the course of July. And as we -- if you think about trajectory, it's absolutely heading in the right direction. We would expect it to get to triple digits. The question then, to your point, becomes what happens in Q4? And we had gotten into a pretty good routine of understanding, while it wasn't any fun, we knew that Q4 would drop off fairly meaningfully because of the capital exhaustion and seasonality. Because we're starting from such a lower base this year, I don't expect the falloff to be as extreme as it has been the last few fourth quarters, but I think just based on behavior and the holidays and everything else as people reset and recharge for 2021, we will see some decline in the fourth quarter. So we're expecting a fairly steady ramp over the course of the third quarter. And then that November-December time frame, we're certainly going to be prepared for a situation where activity levels scale back. -------------------------------------------------------------------------------- Kurt Kevin Hallead, RBC Capital Markets, Research Division - Co-Head of Global Energy Research & Analyst [4] -------------------------------------------------------------------------------- Got it. Okay. I appreciate that. Now you're in a very enviable position with no debt on the balance sheet and continued positive free cash flow from -- based on your commentary here for the second half of the year. Can you just help us -- kind of remind us what your priorities might be in terms of cash allocation? And do you feel like any external pressures to have to do anything with that spare cash? -------------------------------------------------------------------------------- Nicholas L. Swyka, Select Energy Services, Inc. - CFO & Senior VP [5] -------------------------------------------------------------------------------- Yes, Kurt. So as you noted, we are in an enviable position here. I'd say returns to shareholders are a priority through the cycle. But as I mentioned, probably something that we'll step back from a little bit on a quarterly basis while we survey the market. So we, I believe, talked about we're interested. We know there's dislocation. There may be some good franchises out there that need new homes or new capital, and so we're going to look around for that. But we don't feel any outside pressure to rush off and do anything that wouldn't be in shareholders' interest. We're going to carefully evaluate everything. If we see a great opportunity, we're going to look into it further. If we don't, then we'll wait for a better time and keep looking. -------------------------------------------------------------------------------- Operator [6] -------------------------------------------------------------------------------- Our next question comes from Ian MacPherson with Simmons & Company. -------------------------------------------------------------------------------- Ian MacPherson, Piper Sandler & Co., Research Division - Research Analyst [7] -------------------------------------------------------------------------------- I wanted to make sure I understand where we are in the cost resizing park, if you will. So you're a bit cautious on Q4 seasonality. But just hypothetically, if fourth quarter revenues on a consolidated basis were pretty flat from Q3 into Q4, would you still -- in that case, still expect a bit of margin improvement because of [scheduled] cost restructuring benefit playing out through a full quarter? Or do you think that the margins that you've described for Q3 are a good template as you stabilize run rate going forward? -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [8] -------------------------------------------------------------------------------- Yes, there's probably, I'll say, a little bit of room of improvement in there if revenue were to remain flat, Ian, just because to your point, we won't get a full quarter's benefit of some of this. And as your business ramps back up, similar to the way down, you're never as efficient. And so we'll have some fits and starts of how we add resources back, people, things like that, that will probably make the third quarter a little less than optimal. So if we were in to a steady state, a flat revenue in the fourth quarter, we would expect that you could find some incremental benefits. But what I think is, obviously, quite important is the team was able to manage the business so carefully and make structural changes. We've been able to take, as we mentioned in the prepared remarks, 20% decrementals for this business, but we would expect what I'll call historical incrementals. And that is because of the permanent elimination of certain costs that will certainly benefit the business and provide some tailwinds. -------------------------------------------------------------------------------- Ian MacPherson, Piper Sandler & Co., Research Division - Research Analyst [9] -------------------------------------------------------------------------------- Okay. That's helpful. So if we got into what we hope will be some recovery trajectory next year, and just to throw out bogeys, 20% or 30% recovery if frac crew activity allows for that, are the 25%, 30% gross margin incrementals that we've talked about historically, are those amplified going forward? Or are they pretty consistent? -------------------------------------------------------------------------------- Nicholas L. Swyka, Select Energy Services, Inc. - CFO & Senior VP [10] -------------------------------------------------------------------------------- Yes. The -- we have a good operating leverage, especially with our pipelines in our chemicals business. So in Q2, we saw very little activity in the pipeline, especially the Bakken. That's changing here in the third quarter, and we hope that trajectory continues. And as far as chemicals, it's more of a manufacturing business. So the ability to fully utilize that manufacturing facility is critical to efficiently absorb the costs as well. So we'd see about 30% to 35% incrementals overall for the business when kind of blending the 3 segments together and thinking about some of those -- that low-hanging fruit we have, especially in pipelines. -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [11] -------------------------------------------------------------------------------- And when you think about the target gross margins for the individual segments and some of the guidance we've given in the past, what will be critical there is what happens with pricing and then what is the contribution. To Nick's point, if our pipelines are contributing more than I think getting back to our historical margins on the infrastructure segment should be possible, when we look at services and Water Services and when we look at chemicals, we'll have to follow pricing quite closely. And one of the -- as I mentioned again in my prepared remarks, we haven't seen the same overbuild in our space. So if we get back to a -- I'll call it, a reasonable activity level in 2021, we think there could be a tightening of supply and demand for services that we offer and see some support for pricing. And if that does play out, then I think some of the historical margins that we generated and targeted would be possible. -------------------------------------------------------------------------------- Operator [12] -------------------------------------------------------------------------------- (Operator Instructions) Our next question comes from Sean Meakim with JPMorgan. -------------------------------------------------------------------------------- Sean Christopher Meakim, JPMorgan Chase & Co, Research Division - Senior Equity Research Analyst [13] -------------------------------------------------------------------------------- I'd love to hear more feedback on your expectations for completions activity in the third quarter versus the second quarter. We touched on it in a bit. It sounds like you're guiding flat to up trajectory quarter-over-quarter for Water Services. Doesn't seem unreasonable within the band of feedback across other completions companies this quarter. But in terms of frac fleet count, it sounds like July was up modestly off of June but still down 20% off the 2Q average. So I guess I'd just love to hear more about, based on your customer discussions, confidence in terms of the ramp in August and September being sufficient given the relatively tough comp you have in April. -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [14] -------------------------------------------------------------------------------- Yes. That -- you just hit on it, Sean, that the shape in the quarters is so vastly different, it's actually hard to make any sort of apples-to-apples comparison. But we're not expecting the slope of the, I'll say, the improvement in Q3 to be as extreme as the fall in Q2. So April was still well above 100 frac crews. And then you saw in May and June, you get down to the low 60s and maybe the high 60s, and yes, we have seen an improvement in that in July. And then it's going to become -- and maybe we're in the 80s, 90-ish frac crews here in the very near term and could see that break the triple-digit mark. But I think it's just we're not going to have the benefit in Q3 that we had in Q2 of that April month. And to your point, that's why we would expect Water Services to be flat to maybe slightly down. But I would note that we expect chemicals to be up. And part of that is just because they can be a little bit of a leading indicator if you think about your -- largely, that's a product business versus a service. And so during the downturn, our customers will consume their inventory. And then as things pick up, they need to rebuild a little bit of inventory. So it should be -- it should improve a little more quickly than the services space. And then on the infrastructure side, we had essentially no contribution from the North Dakota pipeline system, and we are seeing contribution in the third quarter. And then on the New Mexico system, we expect volumes to be flat to up there as well. So I think our infrastructure segment, we would also expect to see some improvement there Q3 relative to Q2. -------------------------------------------------------------------------------- Sean Christopher Meakim, JPMorgan Chase & Co, Research Division - Senior Equity Research Analyst [15] -------------------------------------------------------------------------------- Got it. Yes, that's helpful clarification. And then I want to touch on chemicals a bit more as well. So negative gross margins in the quarter. You noted some inventory drag, higher-priced inventory and then, of course, some pricing concessions, and so you expect revenue to be up sequentially in the third quarter. Can you talk more about what drives this sequential improvement? Is the production coming back online? Is it just some restocking? And how should we think about the implications for gross margin in the third quarter? -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [16] -------------------------------------------------------------------------------- Yes. When you -- if you think about our chemicals business, 10-ish percent or less is Production Chemicals, so that's not going to drive the segment. We are seeing wells coming back online. So we do expect an improvement in our Production Chemicals business in Q3 versus Q2, but it's really not that material. So the majority of the benefit will come from our completions and treatment WCS businesses. And that's just -- that's partly, to your point, of the restocking of inventory, but it's driven by activity levels. And when we think about the margins, again, a manufacturing business is going to have more fixed costs. So we would expect our margins to get back to the mid-single digits, certainly in chemicals in Q3. And certainly, as we can start to increase our volumes through our plants, that will have a material difference on those margins. -------------------------------------------------------------------------------- Operator [17] -------------------------------------------------------------------------------- Our next question comes from Ryan Pfingst with B. Riley. -------------------------------------------------------------------------------- Ryan James Pfingst, B. Riley Securities, Inc., Research Division - Associate [18] -------------------------------------------------------------------------------- Can you provide some detail on how, for Water Services, temporary transfer pricing progressed throughout the quarter and into the early part of 3Q thus far? And have you seen competitors actually price themselves out of business yet? -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [19] -------------------------------------------------------------------------------- It's an interesting question because you really have to, I'll say, peel back the layers of the onion when you think about pricing. Because as you can imagine, of the frac crews that are working today, the customers, the operators that are actually supporting that business, it's a pretty wide range size-wise and leverage-wise. And some of your smaller operators are incredibly price sensitive. And many of those operators will make a decision based solely on price. And frankly, they're working with vendors and suppliers that are smaller organizations that -- many of which I have to assume are reaping the benefits of the payroll protection act. So they're essentially getting their labor subsidized. So there are jobs being bid and executed at, I'll say, historically low pricing levels. We are not participating with those customers. It doesn't fit our model for a lot of different reasons. One is the price, obviously, the other is just the consistency of the work. I'd also add that the credit quality of those customers, we would be particularly concerned about in this particular market. So I think that the labor subsidy is probably keeping more of the competitive landscape on life support than we would have seen in prior cycles. But that will eventually go away. And I think that's when you will start to see -- even though it's on a deferred or a lag basis, you'll start to see the competitors unable to support their businesses when they have to fully price in their labor. -------------------------------------------------------------------------------- Ryan James Pfingst, B. Riley Securities, Inc., Research Division - Associate [20] -------------------------------------------------------------------------------- I appreciate all that detail. And then turning to Water Infrastructure, you guys mentioned that the Bakken system will make a bit of a comeback in 3Q. But can you provide some additional color on how you view utilization for the Northern Delaware through the rest of the year, both for your anchor tenant and otherwise? -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [21] -------------------------------------------------------------------------------- Yes. You know, we certainly saw a drop in Q2 on that system from the first quarter. But again, we are expecting a slight improvement in Q3. And then Q4 will be, again, that's where I wish I had a better crystal ball, but I would expect some seasonality there. And with regards to the anchor tenant, keep in mind, that is a take-or-pay contract. But the way it works is that if we don't deliver the volume this year, we won't be paid this year. It gets trued up in the early part of the following year, so we wouldn't recognize earnings for the benefit of that take-or-pay. So depending on how those volumes move, that will obviously have implications from a timing perspective on when we're able to recognize those revenues. -------------------------------------------------------------------------------- Operator [22] -------------------------------------------------------------------------------- Ms. Ladhani, there are no further questions at this time. I'd like to turn the floor back over to you for closing comments. -------------------------------------------------------------------------------- Holli C. Ladhani, Select Energy Services, Inc. - President, CEO & Director [23] -------------------------------------------------------------------------------- Well, again, thanks for your time today. We all know that there's a tough market in front of us, but I hope one of the key messages that you all took away is that Select's quite well positioned to deal with this recovery, as Nick mentioned. I think our capital allocation discipline over the last couple of years to eliminate all of our debt, to be sitting here in the cycle with cash on our balance sheet, creates a lot of options. And certainly, what we're hopeful for is that when the time is right, we'll be playing offense while some others are playing defense. And we'll stay focused on our core business and making sure that we start to generate the right sort of cash flow again to support investments across the space. But again, thanks for your time, and have a good week. -------------------------------------------------------------------------------- Operator [24] -------------------------------------------------------------------------------- Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines, and have a wonderful day.