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Archrock, Inc. - Quarter Report: 2020 September (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2020

or

 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from         to        

Commission File No. 001-33666

Archrock, Inc.

(Exact name of registrant as specified in its charter)

Delaware

74-3204509

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

9807 Katy Freeway, Suite 100, Houston, Texas 77024

(Address of principal executive offices, zip code)

(281) 836-8000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

  

Trading Symbol

  

Name of exchange on which registered

Common stock, $0.01 par value per share

AROC

New York Stock Exchange

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No

Number of shares of the common stock of the registrant outstanding as of October 27, 2020: 152,931,907 shares.

Table of Contents

TABLE OF CONTENTS

Page

GLOSSARY

3

FORWARD-LOOKING STATEMENTS

4

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

5

Condensed Consolidated Balance Sheets

5

Condensed Consolidated Statements of Operations

6

Condensed Consolidated Statements of Comprehensive Income

7

Condensed Consolidated Statements of Equity

8

Condensed Consolidated Statements of Cash Flows

10

Notes to Condensed Consolidated Financial Statements (unaudited)

11

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

32

Item 3. Quantitative and Qualitative Disclosures About Market Risk

42

Item 4. Controls and Procedures

42

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

44

Item 1A. Risk Factors

44

Item 2. Purchases of Equity Securities by Issuer and Affiliated Purchasers

45

Item 3. Defaults Upon Senior Securities

45

Item 4. Mine Safety Disclosures

45

Item 5. Other Information

45

Item 6. Exhibits

46

SIGNATURES

47

2

Table of Contents

GLOSSARY

The following terms and abbreviations appearing in the text of this report have the meanings indicated below.

2013 Plan

Archrock, Inc. 2013 Stock Incentive Plan

2019 Form 10-K

Archrock, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2019

2020 Plan

Archrock, Inc. 2020 Stock Incentive Plan

2021 Notes

$350.0 million of 6% senior notes due April 2021, issued in March 2013

2022 Notes

$350.0 million of 6% senior notes due October 2022, issued in April 2014

2027 Notes

$500.0 million of 6.875% senior notes due April 2027, issued in March 2019

2028 Notes

$500.0 million of 6.25% senior notes due April 2028, issued in December 2019

AETR

Annual effective tax rate

Archrock, our, we, us

Archrock, Inc., individually and together with its wholly-owned subsidiaries

ASC 606 Revenue

Accounting Standards Codification Topic 606 Revenue from Contracts with Customers

ASC 842 Leases

Accounting Standards Codification Topic 842 Leases

ASU 2016-13

Accounting Standards Update No. 2016-13—Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments

ASU 2018-13

Accounting Standards Update No. 2018-13—Fair Value Measurement (Topic 820): Changes to the Disclosure Requirements for Fair Value Measurement

ASU 2019-12

Accounting Standards Update No. 2019-12—Income Taxes (Topic 740)—Simplifying the Accounting for Income Taxes

ASU 2020-04

Accounting Standards Update No. 2020-04—Reference Rate Reform (Topic 848)—Facilitation of the Effects of Reference Rate Reform on Financial Reporting

CARES Act

Coronavirus Aid, Relief, and Economic Security Act, Public Law No. 116-136, a tax stimulus and economic stabilization bill signed into law on March 27, 2020

COVID-19

Coronavirus disease 2019

Credit Facility

$1.25 billion asset-based revolving credit facility due November 2024, as governed by Amendment No. 2 to Credit Agreement, dated November 8, 2019, which amended that Credit Agreement, dated as of March 30, 2017

Elite Acquisition

Transaction completed on August 1, 2019 pursuant to the Asset Purchase Agreement entered into with Elite Compression on June 23, 2019

Elite Compression

Elite Compression Services, LLC

ERP

Enterprise Resource Planning

Exchange Act

Securities Exchange Act of 1934, as amended

FASB

Financial Accounting Standards Board

Financial Statements

Condensed consolidated financial statements included in Part I Item 1 of this Quarterly Report on Form 10-Q

GAAP

U.S. generally accepted accounting principles

Harvest

Harvest Four Corners, LLC

Harvest Sale

Transaction completed on August 1, 2019 pursuant to the Asset Purchase Agreement entered into with Harvest on June 23, 2019

Hilcorp

Hilcorp Energy Company

JDH Capital

JDH Capital Holdings, L.P.

July 2020 Disposition

Sale completed in July 2020 of the turbocharger business included within our aftermarket services segment

LIBOR

London Interbank Offered Rate

March 2020 Disposition

Sale completed in March 2020 of certain contract operations customer service agreements, compressors and other assets

NOL

Net operating loss

OTC

Over-the-counter, as related to aftermarket services parts and components

PDVSA

PDVSA Gas, S.A.

ROU

Right-of-use, as related to the lease model under ASC 842 Leases

SEC

U.S. Securities and Exchange Commission

SG&A

Selling, general and administrative

Spin-off

Spin-off completed in November 2015 of our international contract operations, international aftermarket services and global fabrication businesses into a standalone public company operating as Exterran Corporation

U.S.

United States of America

3

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FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains “forward-looking statements” intended to qualify for the safe harbors from liability established by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact contained in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of Section 21E of the Exchange Act, including, without limitation, statements regarding the effects of the COVID-19 pandemic on our business, operations, customers and financial condition; our business growth strategy and projected costs; future financial position; the sufficiency of available cash flows to fund continuing operations and pay dividends; the expected amount of our capital expenditures; anticipated cost savings; future revenue, gross margin and other financial or operational measures related to our business; the future value of our equipment; and plans and objectives of our management for our future operations. You can identify many of these statements by words such as “believe,” “expect,” “intend,” “project,” “anticipate,” “estimate,” “will continue” or similar words or the negative thereof.

Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Quarterly Report on Form 10-Q. Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, no assurance can be given that these expectations will prove to be correct. Known material factors that could cause our actual results to differ materially from the expectations reflected in these forward-looking statements include the risk factors described in our 2019 Form 10-K and in Part II Item 1A “Risk Factors” of this Quarterly Report on Form 10-Q, and those set forth from time to time in our filings with the SEC, which are available through our website at www.archrock.com and through the SEC’s website at www.sec.gov.

All forward-looking statements included in this Quarterly Report on Form 10-Q are based on information available to us on the date of this Quarterly Report on Form 10-Q. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this Quarterly Report on Form 10-Q.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ARCHROCK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value and share amounts)

(unaudited)

    

September 30, 2020

    

December 31, 2019

Assets

 

  

 

  

Current assets:

 

  

 

  

Cash and cash equivalents

$

1,476

$

3,685

Accounts receivable, trade, net of allowance of $3,223 and $2,210, respectively

 

113,607

 

144,865

Inventory

 

65,311

 

74,467

Tax refund receivable

 

17,250

 

Other current assets

 

14,056

 

9,186

Total current assets

 

211,700

 

232,203

Property, plant and equipment, net

 

2,434,728

 

2,559,398

Operating lease ROU assets

 

20,134

 

17,901

Goodwill, net

 

 

100,598

Intangible assets, net

 

65,636

 

77,471

Contract costs, net

 

32,686

 

42,927

Deferred tax assets

 

58,536

 

36,642

Other assets

 

30,245

 

29,934

Noncurrent assets associated with discontinued operations

 

12,003

 

12,901

Total assets

$

2,865,668

$

3,109,975

Liabilities and Equity

 

  

 

  

Current liabilities:

 

  

 

  

Accounts payable, trade

$

29,021

$

60,215

Accrued liabilities

 

103,296

 

67,845

Deferred revenue

 

4,007

 

10,683

Total current liabilities

 

136,324

 

138,743

Long-term debt

 

1,731,459

 

1,842,549

Operating lease liabilities

 

17,775

 

16,094

Deferred tax liabilities

 

681

 

1,289

Other liabilities

 

21,215

 

16,829

Noncurrent liabilities associated with discontinued operations

 

8,529

 

8,508

Total liabilities

 

1,915,983

 

2,024,012

Commitments and contingencies (Note 20)

 

  

 

  

Equity:

 

  

 

  

Preferred stock: $0.01 par value per share, 50,000,000 shares authorized, zero issued

 

 

Common stock: $0.01 par value per share, 250,000,000 shares authorized, 159,971,356 and 158,636,918 shares issued, respectively

 

1,599

 

1,587

Additional paid-in capital

 

3,422,324

 

3,412,509

Accumulated other comprehensive loss

 

(5,973)

 

(1,387)

Accumulated deficit

 

(2,384,602)

 

(2,244,877)

Treasury stock: 7,002,164 and 6,702,602 common shares, at cost, respectively

 

(83,663)

 

(81,869)

Total equity

 

949,685

 

1,085,963

Total liabilities and equity

$

2,865,668

$

3,109,975

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ARCHROCK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Revenue:

 

  

 

  

 

  

 

  

Contract operations

$

175,223

$

198,337

$

570,146

$

567,102

Aftermarket services

 

30,408

 

46,612

 

105,498

 

152,396

Total revenue

 

205,631

 

244,949

 

675,644

 

719,498

Cost of sales (excluding depreciation and amortization):

 

Contract operations

 

60,444

 

75,941

 

202,485

 

221,197

Aftermarket services

 

25,709

 

37,625

 

89,386

 

123,742

Total cost of sales (excluding depreciation and amortization)

 

86,153

 

113,566

 

291,871

 

344,939

Selling, general and administrative

 

18,681

 

29,526

 

78,052

 

87,133

Depreciation and amortization

 

47,279

 

48,409

 

145,950

 

137,997

Long-lived and other asset impairment

 

10,727

 

7,097

 

72,132

 

18,821

Goodwill impairment

99,830

Restatement and other charges

 

 

 

 

445

Restructuring charges

2,900

7,036

Interest expense

 

25,221

 

27,401

 

80,664

 

76,972

Debt extinguishment loss

 

 

 

3,971

 

3,653

Transaction-related costs

 

 

4,905

 

 

7,772

Gain on sale of assets, net

(9,146)

(7,859)

(11,073)

(9,644)

Other (income) loss, net

 

(324)

 

49

 

(1,317)

 

(381)

Income (loss) before income taxes

 

24,140

 

21,855

 

(91,472)

 

51,791

Provision for (benefit from) income taxes

 

5,808

 

1,448

 

(18,236)

 

232

Income (loss) from continuing operations

 

18,332

 

20,407

(73,236)

51,559

Loss from discontinued operations, net of tax

 

 

 

 

(273)

Net income (loss)

$

18,332

$

20,407

$

(73,236)

$

51,286

Basic and diluted net income (loss) per common share

$

0.12

$

0.14

$

(0.49)

$

0.38

Weighted average common shares outstanding:

 

  

 

  

 

  

 

  

Basic

 

150,974

 

142,931

 

150,730

 

133,170

Diluted

 

151,038

 

142,965

 

150,730

 

133,206

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ARCHROCK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Net income (loss)

$

18,332

    

$

20,407

    

$

(73,236)

    

$

51,286

Other comprehensive income (loss), net of tax:

 

  

 

  

 

  

 

  

Interest rate swap gain (loss), net of reclassifications to earnings

 

935

 

(1,415)

 

(4,586)

 

(9,960)

Total other comprehensive income (loss)

 

935

 

(1,415)

 

(4,586)

 

(9,960)

Comprehensive income (loss)

$

19,267

$

18,992

$

(77,822)

$

41,326

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ARCHROCK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF EQUITY

(in thousands, except share and per share amounts)

(unaudited)

Accumulated

Common

Additional

Other

Treasury

Stock

Paid-in

Comprehensive

Accumulated

Stock

    

Amount

    

Shares

    

Capital

    

Loss

    

Deficit

    

Amount

    

Shares

    

Total

Balance at June 30, 2019

$

1,369

 

136,899,297

$

3,182,247

$

(2,772)

$

(2,267,235)

$

(80,719)

 

(6,577,558)

$

832,890

Treasury stock purchased

(1,150)

(125,044)

(1,150)

Cash dividends ($0.145 per common share)

 

  

 

  

 

  

 

  

 

(22,062)

 

 

  

 

(22,062)

Shares issued in employee stock purchase plan

 

 

20,288

 

192

 

  

 

  

 

  

 

  

 

192

Stock-based compensation, net of forfeitures

 

 

26,041

 

2,276

 

  

 

  

 

  

 

 

2,276

Shares issued for Elite Acquisition

 

217

21,656,683

225,663

 

225,880

Comprehensive income

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

Net income

 

  

 

  

 

  

 

  

 

20,407

 

  

 

  

 

20,407

Interest rate swap loss, net of reclassifications to earnings

 

  

 

  

 

  

 

(1,415)

 

  

 

  

 

  

 

(1,415)

Balance at September 30, 2019

$

1,586

 

158,602,309

$

3,410,378

$

(4,187)

$

(2,268,890)

$

(81,869)

 

(6,702,602)

$

1,057,018

Balance at June 30, 2020

$

1,598

 

159,810,336

$

3,419,512

$

(6,908)

$

(2,380,626)

$

(82,703)

 

(6,860,984)

$

950,873

Treasury stock purchased

 

  

 

  

 

  

 

  

 

  

 

(960)

 

(138,922)

 

(960)

Cash dividends ($0.145 per common share)

 

  

 

  

 

  

 

  

 

(22,308)

 

  

 

  

 

(22,308)

Shares issued in employee stock purchase plan

 

 

30,351

 

155

 

  

 

  

 

  

 

  

 

155

Stock-based compensation, net of forfeitures

 

1

 

130,669

 

2,657

 

  

 

  

 

  

 

(2,258)

 

2,658

Comprehensive loss

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

Net income

 

  

 

  

 

  

 

  

 

18,332

 

  

 

  

 

18,332

Interest rate swap gain, net of reclassifications to earnings

 

  

 

  

 

  

 

935

 

  

 

  

 

  

 

935

Balance at September 30, 2020

$

1,599

 

159,971,356

$

3,422,324

$

(5,973)

$

(2,384,602)

$

(83,663)

 

(7,002,164)

$

949,685

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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Accumulated

Common

Additional

Other

Treasury

Stock

Paid-in

Comprehensive

Accumulated

Stock

    

Amount

    

Shares

    

Capital

    

Income (Loss)

    

Deficit

    

Amount

    

Shares

    

Total

Balance at December 31, 2018

$

1,358

135,787,509

$

3,177,982

$

5,773

$

(2,263,677)

$

(79,862)

(6,381,605)

$

841,574

Treasury stock purchased

 

  

 

  

 

  

 

  

 

  

 

(2,007)

 

(212,080)

 

(2,007)

Cash dividends ($0.409 per common share)

 

  

 

  

 

  

 

  

 

(56,499)

 

  

 

  

 

(56,499)

Shares issued in employee stock purchase plan

 

 

69,089

 

599

 

  

 

  

 

  

 

  

 

599

Stock-based compensation, net of forfeitures

 

11

 

1,089,028

 

6,134

 

  

 

  

 

  

 

(108,917)

 

6,145

Shares issued for Elite Acquisition

 

217

21,656,683

225,663

 

225,880

Comprehensive income

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

Net income

 

  

 

  

 

  

 

  

 

51,286

 

  

 

  

 

51,286

Interest rate swap loss, net of reclassifications to earnings

 

  

 

  

 

  

 

(9,960)

 

  

 

  

 

  

 

(9,960)

Balance at September 30, 2019

$

1,586

 

158,602,309

$

3,410,378

$

(4,187)

$

(2,268,890)

$

(81,869)

 

(6,702,602)

$

1,057,018

Balance at December 31, 2019

$

1,587

 

158,636,918

$

3,412,509

$

(1,387)

$

(2,244,877)

$

(81,869)

 

(6,702,602)

$

1,085,963

Treasury stock purchased

 

  

 

  

 

  

 

  

 

  

 

(1,794)

 

(235,079)

 

(1,794)

Cash dividends ($0.435 per common share)

 

  

 

  

 

  

 

  

 

(66,655)

 

  

 

  

 

(66,655)

Shares issued in employee stock purchase plan

 

1

 

140,606

 

521

 

  

 

  

 

  

 

  

 

522

Stock-based compensation, net of forfeitures

 

11

 

1,193,832

 

8,616

 

  

 

  

 

  

 

(64,483)

 

8,627

Contribution from Exterran Corporation

678

678

Impact of ASU 2016-13 adoption

 

 

 

 

  

 

166

 

  

 

  

 

166

Comprehensive loss

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

Net loss

 

  

 

  

 

  

 

  

 

(73,236)

 

  

 

  

 

(73,236)

Interest rate swap loss, net of reclassifications to earnings

 

  

 

  

 

  

 

(4,586)

 

  

 

  

 

  

 

(4,586)

Balance at September 30, 2020

$

1,599

 

159,971,356

$

3,422,324

$

(5,973)

$

(2,384,602)

$

(83,663)

 

(7,002,164)

$

949,685

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ARCHROCK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

Nine Months Ended

September 30, 

    

2020

    

2019

Cash flows from operating activities:

  

  

Net income (loss)

$

(73,236)

$

51,286

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

  

 

  

Loss from discontinued operations, net of tax

 

 

273

Depreciation and amortization

 

145,950

 

137,997

Long-lived and other asset impairment

 

72,132

 

18,821

Goodwill impairment

99,830

Inventory write-downs

 

915

 

662

Amortization of operating lease ROU assets

 

2,555

 

2,151

Amortization of deferred financing costs

 

4,179

 

4,569

Amortization of debt discount

 

187

 

726

Debt extinguishment loss

 

3,971

 

3,653

Interest rate swaps

 

2,094

 

(1,063)

Stock-based compensation expense

 

8,423

 

6,145

Non-cash restructuring charges

1,660

Provision for credit losses

 

2,235

 

979

(Gain) loss on sale of assets, net

 

1,402

 

(9,644)

Gain on sale of business

(12,475)

Deferred income tax benefit

 

(18,288)

 

(330)

Amortization of contract costs

 

20,286

 

16,834

Deferred revenue recognized in earnings

 

(17,183)

 

(33,538)

Changes in assets and liabilities, net of acquisition:

 

  

 

  

Accounts receivable, trade

 

31,134

 

(7,005)

Inventory

 

3,244

 

2,584

Other assets

 

(23,539)

 

13,272

Contract costs, net

 

(10,390)

 

(20,975)

Accounts payable and other liabilities

 

10,679

 

8,996

Deferred revenue

 

10,696

 

27,390

Other

 

373

 

111

Net cash provided by continuing operations

 

266,834

 

223,894

Net cash used in discontinued operations

 

 

(269)

Net cash provided by operating activities

 

266,834

 

223,625

Cash flows from investing activities:

 

  

 

  

Capital expenditures

 

(130,343)

 

(303,467)

Proceeds from sale of business

 

32,914

 

Proceeds from sale of property, plant and equipment and other assets

 

14,043

 

55,674

Proceeds from insurance and other settlements

1,391

2,830

Cash paid in Elite Acquisition

 

 

(214,233)

Net cash used in investing activities

 

(81,995)

 

(459,196)

Cash flows from financing activities:

 

  

 

  

Borrowings of long-term debt

 

871,500

 

1,685,250

Repayments of long-term debt

 

(988,500)

 

(1,386,250)

Payments for debt issuance costs

 

(943)

 

(8,829)

Proceeds from (payments for) settlement of interest rate swaps that include financing elements

 

(1,856)

 

1,123

Dividends paid to stockholders

 

(66,655)

 

(56,499)

Proceeds from stock issued under employee stock purchase plan

 

522

 

599

Purchases of treasury stock

 

(1,794)

 

(2,007)

Contribution from Exterran Corporation

 

678

 

Net cash provided by (used in) financing activities

 

(187,048)

 

233,387

Net decrease in cash and cash equivalents

 

(2,209)

 

(2,184)

Cash and cash equivalents, beginning of period

 

3,685

 

5,610

Cash and cash equivalents, end of period

$

1,476

$

3,426

Supplemental disclosure of non-cash investing and financing transactions:

Non-cash consideration received in July 2020 Disposition

$

6,500

$

Issuance of Archrock common stock pursuant to Elite Acquisition, net of tax

225,880

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ARCHROCK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of Business and Basis of Presentation

We are an energy infrastructure company with a pure-play focus on midstream natural gas compression. We are the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two business segments: contract operations and aftermarket services. Our predominant segment, contract operations, primarily includes designing, sourcing, owning, installing, operating, servicing, repairing and maintaining our owned fleet of natural gas compression equipment to provide natural gas compression services to our customers. In our aftermarket services business, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.

The accompanying unaudited condensed consolidated financial statements included herein have been prepared in accordance with GAAP and the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP are not required in these interim financial statements and have been condensed or omitted. Management believes that the information furnished includes all adjustments, consisting of normal recurring adjustments, which are necessary to present fairly our consolidated financial position, results of operations and cash flows for the periods indicated. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements presented in our 2019 Form 10-K, which contains a more comprehensive summary of our accounting policies. The interim results reported herein are not necessarily indicative of results for a full year. Certain prior year amounts have been reclassified to conform to the current year presentation.

2. Recent Accounting Developments

Accounting Standards Updates Implemented

Credit Losses

In June 2016, the FASB issued ASU 2016-13, which changes the impairment model for financial assets measured at amortized cost and certain other instruments, and requires entities to use a new current expected credit loss model that results in recognition of expected losses over the contractual life of an asset. We adopted ASU 2016-13 on January 1, 2020 using the modified retrospective approach. The adoption resulted in a $0.2 million decrease in our allowance for credit losses and a corresponding pre-tax cumulative effect adjustment to retained earnings in our condensed consolidated balance sheet at January 1, 2020. Comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.

Our financial assets measured at amortized cost consist of cash equivalents and trade receivables from revenue transactions within the scope of ASC 606 Revenue. We believe our temporary cash investments have a zero loss expectation because we maintain minimal balances in our cash investment accounts and have no history of loss. Trade accounts receivable are due from companies of varying size engaged principally in oil and natural gas activities throughout the U.S. We review the financial condition of customers prior to extending credit and generally do not obtain collateral for trade receivables. Payment terms are on a short-term basis and in accordance with industry practice. We consider this credit risk to be limited due to these companies’ financial resources, the nature of the products and services we provide and the terms of our customer agreements.

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Due to the short-term nature of our trade receivables, we consider the amortized cost to be the same as the carrying amount of the receivable, excluding the allowance for credit losses. We recognize an allowance for credit losses when a receivable is recorded, even when the risk of loss is remote. We utilize an aging schedule to determine our allowance for credit losses, and measure expected credit losses on a collective (pool) basis when similar risk characteristics exist. We rely primarily on ratings assigned by external rating agencies and credit monitoring services to assess credit risk and aggregate customers first by low, medium or high risk asset pools, and then by delinquency status. We also consider the internal risk associated with geographic location and the services we provide to the customer when determining asset pools. If a customer does not share similar risk characteristics with other customers, we evaluate the customer’s outstanding trade receivables for expected credit losses on an individual basis. Trade receivables evaluated individually are not included in our collective assessment. Each reporting period, we reassess our customers’ risk profiles and determine the appropriate asset pool classification, or perform individual assessments of expected credit losses, based on the customers’ risk characteristics at the reporting date.

The contractual life of our trade receivables is primarily 30 days based on the payment terms specified in the contract. Contract operations services are generally billed monthly at the beginning of the month in which service is being provided. Aftermarket services billings typically occur when parts are delivered or service is completed. Loss rates are separately determined for each asset pool based on the length of time a trade receivable has been outstanding. We analyze two years of internal historical loss data, including the effects of prepayments, write-offs and subsequent recoveries, to determine our historical loss experience. Our historical loss information is a relevant data point for estimating credit losses, as the data closely aligns with trade receivables due from our customers. Ratings assigned by external rating agencies and credit monitoring services consider past performance and forecasts of future economic conditions in assessing credit risk. We routinely update our historical loss data to reflect our customers’ current risk profile, to ensure the historical data and loss rates are relevant to the pool of assets for which we are estimating expected credit losses. Judgement is used to determine the expected credit loss for customers that do not share similar risk characteristics with other customers, based on customer specific items such as legal proceedings, past experience with the customer and/or ongoing customer negotiations.

The following table summarizes the changes in our allowance for credit losses balance during the nine months ended September 30, 2020 (in thousands):

Balance at December 31, 2019

      

$

2,210

Impact of adoption of ASU 2016-13 on January 1, 2020

(216)

Provision for credit losses

2,235

Write-offs charged against allowance

(1,006)

Balance at September 30, 2020

$

3,223

Fair Value Measurements

On January 1, 2020, we adopted ASU 2018-13, which amends the required fair value measurements disclosures related to valuation techniques and inputs used, uncertainty in measurement and changes in measurements applied. These amendments resulted in new, prospective disclosures of the range and weighted average of the significant unobservable inputs used to develop our Level 3 fair value measurements related to our idle and previously-culled compressors. The adoption of ASU 2018-13 had no impact on our condensed consolidated financial statements.

Income Taxes

On January 1, 2020, we adopted ASU 2019-12, which simplifies the accounting for income taxes by, among other things, removing certain exceptions related to the incremental approach for intraperiod tax allocation, the year-to-date loss methodology for calculating income taxes in an interim period and the recognition for deferred tax liabilities on outside basis differences. ASU 2019-12 also clarifies other aspects of the accounting for income taxes in order to improve consistency of application. The adoption of ASU 2019-12 had no impact on our condensed consolidated financial statements.

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Accounting Standards Updates Not Yet Implemented

Reference Rate Reform

In March 2020, the FASB issued ASU 2020-04, which provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued as a result of reference rate reform. ASU 2020-04 is effective for all entities as of March 12, 2020 through December 31, 2022. Entities may elect to apply the amendments for contract modifications as of any date from the beginning of an interim period that includes or is subsequent to March 12, 2020, or prospectively from a date within an interim period that includes or is subsequent to March 12, 2020. Modifications to our interest rate swap and Credit Facility agreements during the effective period of this amendment will be assessed and if the modifications meet the criteria for the optional expedients and exceptions, we intend to adopt ASU 2020-04 and apply the amendments as applicable.

3. Business Transactions

July 2020 Disposition

On July 9, 2020, we completed the sale of the turbocharger business included within our aftermarket services segment. In connection with the sale, we entered into a supply agreement to purchase a minimum amount of turbocharger goods and services over a two-year term. In addition to cash of $9.5 million received upon closing, an additional $3.0 million is due on the first anniversary of the closing date and $3.5 million will be received through the purchase of turbocharger goods and services under the supply agreement. We recognized a gain on the sale of $9.3 million in gain on sale of assets, net in our condensed consolidated statements of operations during the three and nine months ended September 30, 2020.

March 2020 Disposition

On March 1, 2020, we completed the sale of certain contract operations customer service agreements and approximately 200 compressors, comprising approximately 35,000 horsepower, used to provide compression services under those agreements as well as other assets used to support the operations. We allocated customer and contract-related intangible assets and goodwill based on a ratio of the horsepower sold relative to the total horsepower of the asset group. We recognized a gain on the sale of $3.2 million in gain on sale of assets, net in our condensed consolidated statements of operations during the nine months ended September 30, 2020.

Elite Acquisition

On August 1, 2019, we completed the Elite Acquisition whereby we acquired from Elite Compression substantially all of its assets, including a fleet of predominantly large compressors comprising approximately 430,000 horsepower, vehicles, real property and inventory, and certain liabilities for aggregate consideration consisting of $214.0 million in cash and 21.7 million shares of common stock with an acquisition date fair value of $225.9 million. The cash portion of the acquisition was funded with borrowings on the Credit Facility.

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The Elite Acquisition was accounted for using the acquisition method, which requires, among other things, assets acquired and liabilities assumed to be recorded at their fair value on the acquisition date. The excess of the consideration transferred over those fair values is recorded as goodwill. The following table summarizes the purchase price allocation based on the estimated fair values of the acquired assets and liabilities as of the acquisition date (in thousands):

Accounts receivable

    

$

9,007

Inventory

 

7,987

Other current assets

 

608

Property, plant and equipment

 

286,158

Operating lease ROU assets

 

682

Goodwill

 

100,598

Intangible assets

 

40,237

Accounts payable, trade

 

(2,079)

Accrued liabilities

 

(2,973)

Operating lease liabilities

 

(326)

Purchase price

$

439,899

Our valuation methodology and significant inputs for fair value measurements are detailed by asset class below. The fair value measurements for property, plant and equipment and intangible assets are based on significant inputs that are not observable in the market and therefore represent Level 3 measurements.

Goodwill

The goodwill resulting from the acquisition is attributable to the expansion of our services in various regions in which we currently operate and was allocated to our contract operations segment. All of the goodwill recorded for this acquisition is expected to be deductible for U.S. federal income tax purposes.

Property, Plant and Equipment

The property, plant and equipment is primarily comprised of compression equipment that will be depreciated on a straight-line basis over an estimated average remaining useful life of 15 years. The fair value of the property, plant and equipment was determined using the cost approach, whereby we estimated the replacement cost of the assets by evaluating recent purchases of similar assets or published data, and then adjusted replacement cost for physical deterioration and functional and economic obsolescence, as applicable.

Intangible Assets

The intangible assets consist of customer relationships that have an estimated useful life of 15 years. The amount of intangible assets and their associated useful life were determined based on the period over which the assets are expected to contribute directly or indirectly to our future cash flows. The fair value of the identifiable intangible assets was determined using the multi-period excess earnings method, which is a specific application of the discounted cash flow method, an income approach, whereby we estimated and then discounted the future cash flows of the intangible asset by adjusting overall business revenue for attrition, obsolescence, cost of sales, operating expenses, taxes and the required returns attributable to other contributory assets acquired. Significant estimates made in arriving at expected future cash flows included our expected customer attrition rate and the amount of earnings attributable to the assets. To discount the estimated future cash flows, we utilized a discount rate that was at a premium to our weighted average cost of capital to reflect the less liquid nature of the customer relationships relative to the tangible assets acquired.

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Unaudited Pro Forma Financial Information

Unaudited pro forma financial information for the three and nine months ended September 30, 2019 was derived by adjusting our historical financial statements in order to give effect to the assets and liabilities acquired in the Elite Acquisition. The Elite Acquisition is presented in this unaudited pro forma financial information as though the acquisition occurred as of January 1, 2019, and reflects the following:

the acquisition of substantially all of Elite Compression’s assets, including a compression fleet of approximately 430,000 horsepower, vehicles, real property and inventory, and certain liabilities;
borrowings of $214.0 million under the Credit Facility for cash consideration exchanged in the acquisition; and
the exclusion of $4.8 million and $7.4 million of financial advisory, legal and other professional fees incurred related to the acquisition and recorded to transaction-related costs in our condensed consolidated statements of operations during the three and nine months ended September 30, 2019, respectively.

The unaudited pro forma financial information below is presented (in thousands) for informational purposes only and is not necessarily indicative of our results of operations that would have occurred had the transaction been consummated at the beginning of the period presented, nor is it necessarily indicative of future results.

Three Months Ended

Nine Months Ended

September 30, 2019

    

September 30, 2019

Revenue

$

251,505

$

763,776

Net income

 

26,925

 

63,146

The results of operations attributable to the assets and liabilities acquired in the Elite Acquisition have been included in our condensed consolidated financial statements as part of our contract operations segment since the date of acquisition. Revenue attributable to the assets acquired from the date of acquisition, August 1, 2019, through September 30, 2019 was $13.1 million. We are unable to provide earnings attributable to the assets and liabilities acquired since the date of acquisition as we do not prepare full stand-alone earnings reports for those assets and liabilities.

Harvest Sale

On August 1, 2019, we completed an asset sale in which Harvest acquired from us approximately 80,000 active and idle compression horsepower, vehicles and parts inventory for cash consideration of $30.0 million. We recorded a $6.6 million gain on this sale to gain on sale of assets, net in our condensed consolidated statements of operations during the three and nine months ended September 30, 2019. The assets were previously reported under our contract operations segment.

4. Discontinued Operations

In 2015 we completed the Spin-off. In order to effect the Spin-off and govern our relationship with Exterran Corporation after the Spin-off, we entered into several agreements with Exterran Corporation which include, but are not limited to, the separation and distribution agreement and the tax matters agreement.

The separation and distribution agreement specifies our right to promptly receive payments from Exterran Corporation based on a notional amount corresponding to payments received by Exterran Corporation from PDVSA in respect of the sale of Exterran Corporation’s previously-nationalized assets after such amounts are collected by Exterran Corporation. During the nine months ended September 30, 2020, we received $0.7 million from Exterran Corporation pursuant to this term of the separation and distribution agreement. We also entered into an assignment from Exterran Corporation so that any future payments by PDVSA would be received directly by us.

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The tax matters agreement governs the respective rights, responsibilities and obligations of Exterran Corporation and us with respect to tax liabilities and benefits, tax attributes, the preparation and filing of tax returns, the control of audits and other tax proceedings and certain other matters regarding taxes. Subject to the provisions of this agreement, we and Exterran Corporation agreed to indemnify the primary obligor of any return for tax periods beginning before and ending before or after the Spin-off (including any ongoing or future amendments and audits for these returns) for the portion of the tax liability (including interest and penalties) that relates to their respective operations reported in the filing.

As of both September 30, 2020 and December 31, 2019, we had $8.5 million of unrecognized tax benefits (including interest and penalties) related to Exterran Corporation operations prior to the Spin-off recorded to noncurrent liabilities associated with discontinued operations in our condensed consolidated balance sheets. We had an offsetting indemnification asset of $8.5 million related to these unrecognized tax benefits recorded to noncurrent assets associated with discontinued operations as of both September 30, 2020 and December 31, 2019.

The following table presents the balance sheets for our discontinued operations (in thousands):

    

September 30, 2020

    

December 31, 2019

Other assets

$

8,529

$

8,508

Deferred tax assets

3,474

4,393

Total assets associated with discontinued operations

$

12,003

$

12,901

Deferred tax liabilities

$

8,529

$

8,508

Total liabilities associated with discontinued operations

$

8,529

$

8,508

The following table presents the statements of operations for our discontinued operations (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Other income, net

 

$

    

$

(31)

    

$

(20)

    

$

(1,463)

Provision for income taxes

 

31

 

20

 

1,736

Loss from discontinued operations, net of tax

$

$

$

$

(273)

5. Inventory

Inventory consisted of the following (in thousands):

    

September 30, 2020

    

December 31, 2019

Parts and supplies

$

58,906

$

66,121

Work in progress

 

6,405

 

8,346

Inventory

$

65,311

$

74,467

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6. Property, Plant and Equipment, Net

Property, plant and equipment, net consisted of the following (in thousands):

    

September 30, 2020

    

December 31, 2019

Compression equipment, facilities and other fleet assets

$

3,460,362

$

3,653,930

Land and buildings

 

45,337

 

50,743

Transportation and shop equipment

 

112,111

 

116,057

Computer hardware and software

 

97,366

 

93,695

Other

 

17,573

 

15,308

Property, plant and equipment

 

3,732,749

 

3,929,733

Accumulated depreciation

 

(1,298,021)

 

(1,370,335)

Property, plant and equipment, net

$

2,434,728

$

2,559,398

7. Goodwill

Our goodwill was recognized in connection with the Elite Acquisition and represents the excess of consideration transferred over the fair value of the assets and liabilities acquired. All of the goodwill was allocated to our contract operations reporting unit. We review the carrying amount of our goodwill in the fourth quarter of every year, or whenever indicators of potential impairment exist, to determine if the carrying amount of our contract operations reporting unit exceeds its fair value, including the goodwill. Beginning in the first quarter of 2020, the COVID-19 pandemic caused a significant deterioration in global macroeconomic conditions, including a collapse in the demand for oil coupled with an oversupply of oil, which commenced substantial spending cuts by our customers and a decline in production. This global response to the pandemic significantly impacted our market capitalization and estimates of future revenues and cash flows, which triggered the need to perform a quantitative test of the fair value of our contract operations reporting unit as of March 31, 2020. The quantitative test determined that the carrying amount of our contract operations reporting unit exceeded its fair value and we recorded a full impairment loss on goodwill in the first quarter as a result.

Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions, which have a significant impact on the fair value determined. We determine the fair value of our reporting unit using an equal weighting of both the expected present value of future cash flows and a market approach. The present value of future cash flows is estimated using our most recent forecast and the weighted average cost of capital. The market approach uses a market multiple on the earnings before interest expense, provision for income taxes and depreciation and amortization expense of comparable peer companies. Significant estimates for our reporting unit included in our impairment analysis are our cash flow forecasts, our estimate of the market’s weighted average cost of capital and market multiples.

The following table presents the change in the carrying amount of goodwill during the nine months ended September 30, 2020 (in thousands):

Balance at December 31, 2019

$

100,598

Dispositions

(768)

Impairment loss

 

(99,830)

Balance at September 30, 2020

$

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8. Hosting Arrangements

In the fourth quarter of 2018 we began a process and technology transformation project that will, among other things, upgrade or replace our existing ERP, supply chain and inventory management systems and expand the remote monitoring capabilities of our compression fleet. Included in this project are hosting arrangements that are service contracts related to the cloud migration of our ERP system and cloud services for our new mobile workforce, telematics and inventory management tools. Certain costs incurred for the implementation of our hosting arrangements that are service contracts are capitalized and amortized on a straight-line basis over the term of the respective contract. Amortization begins in the period in which an individual component becomes ready for its intended use.

As of September 30, 2020 and December 31, 2019, we capitalized $6.9 million and $5.5 million, respectively, of implementation costs related to our hosting arrangements that are service contracts to other assets in our condensed consolidated balance sheets. Accumulated amortization was $0.2 million at September 30, 2020. We recorded $0.1 million and $0.2 million of amortization expense to SG&A in our condensed consolidated statements of operations during the three and nine months ended September 30, 2020, respectively.

During the three and nine months ended September 30, 2020, we impaired $1.6 million of capitalized implementation costs related to the hosting arrangements of the mobile workforce component of our project due to the termination of the agreement, which was included in long-lived and other asset impairment in our condensed consolidated statements of operations.

9. Long-Term Debt

Long-term debt consisted of the following (in thousands):

    

September 30, 2020

    

December 31, 2019

Credit Facility

$

746,000

$

513,000

2028 Notes

 

500,000

 

500,000

Less: Deferred financing costs, net of amortization

 

(7,357)

 

(8,090)

 

492,643

 

491,910

2027 Notes

500,000

 

500,000

Less: Deferred financing costs, net of amortization

(7,184)

 

(7,999)

492,816

 

492,001

2022 Notes

 

 

350,000

Less: Debt discount, net of amortization

 

 

(2,046)

Less: Deferred financing costs, net of amortization

 

 

(2,316)

 

 

345,638

Long-term debt

$

1,731,459

$

1,842,549

Credit Facility

As of September 30, 2020, there were $12.4 million letters of credit outstanding under the Credit Facility and the applicable margin on borrowings outstanding was 2.5%. The weighted average annual interest rate on the outstanding balance under the Credit Facility, excluding the effect of interest rate swaps, was 2.7% and 4.3% at September 30, 2020 and December 31, 2019, respectively. We incurred $0.4 million in commitment fees on the daily unused amount of the Credit Facility during each of the three months ended September 30, 2020 and 2019, and $1.5 million during each of the nine months ended September 30, 2020 and 2019.

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We must maintain certain consolidated financial ratios as defined in our Credit Facility agreement. As of September 30, 2020, the ratio requirements did not constrain our undrawn capacity and as such, $491.6 million was available for additional borrowings. As of September 30, 2020, we were in compliance with all covenants under the Credit Facility agreement.

2022 Notes Redemption

On April 1, 2020, the 2022 Notes were redeemed at 100% of their $350.0 million aggregate principal amount plus accrued and unpaid interest of $10.5 million with borrowings from the Credit Facility. A debt extinguishment loss of $4.0 million related to the redemption was recognized during the nine months ended September 30, 2020.

10. Accumulated Other Comprehensive Income (Loss)

Components of comprehensive income (loss) are net income (loss) and all changes in equity during a period except those resulting from transactions with owners. Our accumulated other comprehensive income (loss) consists of changes in the fair value of our interest rate swap derivative instruments, net of tax, which are designated as cash flow hedges.

The following table presents the changes in accumulated other comprehensive income (loss) of our derivative cash flow hedges, net of tax, during the three and nine months ended September 30, 2020 and 2019 (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Beginning accumulated other comprehensive income (loss)

$

(6,908)

$

(2,772)

$

(1,387)

$

5,773

Loss recognized in other comprehensive income (loss), net of tax benefit of $18, $0, $1,764 and $0, respectively (1)

 

(69)

 

(933)

 

(6,635)

 

(7,761)

(Gain) loss reclassified from accumulated other comprehensive income (loss) to interest expense, net of tax benefit of $267, $0, $545 and $0, respectively (1)

 

1,004

 

(482)

 

2,049

 

(2,199)

Other comprehensive income (loss)

 

935

 

(1,415)

 

(4,586)

 

(9,960)

Ending accumulated other comprehensive loss

$

(5,973)

$

(4,187)

$

(5,973)

$

(4,187)

(1)Includes adjustments of $0.3 million and $2.1 million related to an increase in the valuation allowance recorded to offset the tax effect of other comprehensive loss recorded during the three and nine months ended September 30, 2019, respectively.

See Note 17 (“Derivatives”) for further details on our interest rate swap derivative instruments.

11. Equity

Elite Acquisition

In August 2019, we completed the Elite Acquisition. A portion of the acquisition’s purchase price was funded through the issuance of 21.7 million shares of common stock with an acquisition date fair value of $225.9 million, which was recorded to common stock and additional paid-in capital in our condensed consolidated statements of equity. See Note 3 (“Business Transactions”) for further details of this acquisition.

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Cash Dividends

The following table summarizes our dividends declared and paid in each of the quarterly periods of 2020 and 2019:

    

Declared Dividends

    

Dividends Paid

    

per Common Share

    

(in thousands)

2020

 

  

 

  

Q1

$

0.145

$

22,171

Q2

0.145

22,176

Q3

0.145

22,308

2019

 

  

 

  

Q1

$

0.132

$

17,231

Q2

 

0.132

 

17,206

Q3

 

0.145

 

22,062

Q4

 

0.145

 

22,031

On October 30, 2020, our Board of Directors declared a quarterly dividend of $0.145 per share of common stock to be paid on November 18, 2020 to stockholders of record at the close of business on November 12, 2020.

12. Revenue from Contracts with Customers

The following table presents our revenue from contracts with customers disaggregated by revenue source (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Contract operations (1):

  

  

  

  

0 - 1,000 horsepower per unit

$

51,409

$

66,026

$

175,877

$

193,448

1,001 - 1,500 horsepower per unit

 

73,205

 

81,755

 

236,083

 

231,693

Over 1,500 horsepower per unit

 

50,142

 

49,572

 

156,351

 

138,966

Other (2)

 

467

 

984

 

1,835

 

2,995

Total contract operations (3)

 

175,223

 

198,337

 

570,146

 

567,102

Aftermarket services (1):

 

  

 

  

 

  

 

  

Services (4)

 

17,961

 

28,888

 

62,492

 

95,689

OTC parts and components sales

 

12,447

 

17,724

 

43,006

 

56,707

Total aftermarket services (5)

 

30,408

 

46,612

 

105,498

 

152,396

Total revenue

$

205,631

$

244,949

$

675,644

$

719,498

(1)We operate in two segments: contract operations and aftermarket services. See Note 22 (“Segments”) for further details regarding our segments.
(2)Primarily relates to fees associated with owned non-compression equipment.
(3)Includes $1.4 million and $1.6 million for the three months ended September 30, 2020 and 2019, respectively, and $4.5 million and $6.0 million for the nine months ended September 30, 2020 and 2019, respectively, related to billable maintenance on owned compressors that was recognized at a point in time. All other contract operations revenue is recognized over time.
(4)Included a reversal of $0.7 million of revenue during the three and nine months ended September 30, 2019 related to changes in estimates of performance obligations partially satisfied in prior periods.
(5)All service revenue within aftermarket services is recognized over time. All OTC parts and components sales revenue is recognized at a point in time.

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Performance Obligations

As of September 30, 2020, we had $387.6 million of remaining performance obligations related to our contract operations segment. We do not consider the effects of the time value of money, as the expected time between the transfer of services and payment for such services is less than one year. Our remaining performance obligations will be recognized through 2025 as follows (in thousands):

    

2020

    

2021

    

2022

    

2023

    

2024

    

2025

    

Total

Remaining performance obligations

$

105,933

$

195,902

$

74,732

$

9,694

$

1,196

$

116

$

387,573

We do not disclose the aggregate transaction price for the remaining performance obligations for aftermarket services as there are no contracts with customers with an original contract term that is greater than one year.

Contract Assets and Liabilities

As of September 30, 2020 and December 31, 2019, our receivables from contracts with customers, net of allowance for credit losses, were $102.8 million and $139.4 million, respectively.

Freight billings to customers for the transport of compression assets, customer-specified modifications of compression assets and milestone billings on aftermarket services often result in a contract liability. As of September 30, 2020 and December 31, 2019, our contract liabilities were $4.9 million and $11.4 million, respectively, which were included in deferred revenue and other liabilities in our condensed consolidated balance sheets. The decrease in the contract liability balance during the nine months ended September 30, 2020 was primarily due to $17.2 million recognized as revenue during the period, partially offset by revenue deferral of $10.7 million, each primarily related to freight billings and milestone billings on aftermarket services.

13. Long-Lived and Other Asset Impairment

We review long-lived assets, including property, plant and equipment and identifiable intangibles that are being amortized, for impairment whenever events or changes in circumstances, including the removal of compressors from our active fleet, indicate that the carrying amount of an asset may not be recoverable.

In the first quarter of 2020, we determined that the impairment of our contract operations reporting unit’s goodwill was an indicator of potential impairment of the carrying amount of our long-lived assets, including our compressor fleet and associated customer and contract-based intangible assets. Accordingly, we performed a quantitative impairment test of our long-lived assets, by which we determined that they were not also impaired. No similar impairment has been indicated subsequent to the first quarter.

Compression Fleet

We periodically review the future deployment of our idle compression assets for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. Based on these reviews, we determine that certain idle compressors should be retired from the active fleet. The retirement of these units from the active fleet triggers a review of these assets for impairment and as a result of our review, we may record an asset impairment to reduce the book value of each unit to its estimated fair value. The fair value of each unit is estimated based on the expected net sale proceeds compared to other fleet units we recently sold, a review of other units recently offered for sale by third parties or the estimated component value of the equipment we plan to use.

In connection with our review of our idle compression assets, we evaluate for impairment idle units that were culled from our fleet in prior years and are available for sale. Based on that review, we may reduce the expected proceeds from disposition and record additional impairment to reduce the book value of each unit to its estimated fair value.

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The following table presents the results of our compression fleet impairment review as recorded to our contract operations segment (dollars in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Idle compressors retired from the active fleet

 

105

 

60

 

640

 

240

Horsepower of idle compressors retired from the active fleet

 

28,000

 

28,000

 

235,000

 

84,000

Impairment recorded on idle compressors retired from the active fleet

$

8,137

$

7,097

$

69,542

$

18,821

Other Impairment

During the three and nine months ended September 30, 2020, $1.7 million of capitalized implementation and unamortized prepaid costs related to the mobile workforce component of our multi-year process and technology transformation project was impaired. See Note 8 (“Hosting Arrangements”) for further details.

14. Restructuring Charges

During the first quarter of 2020, we completed restructuring activities to further streamline our organization and more fully align our teams to improve our customer service and profitability. We incurred severance costs during the first quarter related to these activities. No additional costs will be incurred related to these restructuring activities.

In response to the decreased activity level of our customers that resulted from the COVID-19 pandemic beginning in the second quarter of 2020, we incurred severance costs to right-size our business. We are not currently able to estimate the total amount of restructuring costs to be incurred as a result of the COVID-19 pandemic, as the magnitude and duration of the pandemic and its impact on our operations remain difficult to predict.

During the third quarter of 2020, a plan to dispose of certain non-core properties was approved by management. During the three and nine months ended September 30, 2020, we recorded a charge of $1.5 million associated with the disposal of these properties. We are not currently able to estimate the total amount of restructuring costs to be incurred as a result of our property disposals, as the timing of the disposal and magnitude of the financial impact of their ultimate disposition remain difficult to predict.

The severance and property disposal costs incurred under the above restructuring plans were recorded to restructuring charges in our condensed consolidated statements of operations.

The following table presents the changes to our accrued liability balance related to restructuring charges during the nine months ended September 30, 2020 (in thousands):

Organizational

Pandemic

Property

Restructuring

Restructuring

Restructuring

Total

Balance at December 31, 2019

    

$

    

$

    

$

    

$

Charges incurred (1)

 

1,695

 

3,843

 

1,498

 

7,036

Non-cash expense (2)

(61)

(101)

(1,498)

(1,660)

Payments

(1,634)

(3,742)

(5,376)

Balance at September 30, 2020

$

$

$

$

(1)Includes a loss on sale of $0.9 million and an impairment loss of $0.6 million related to the property restructuring during the nine months ended September 30, 2020.
(2)Represents accelerated vesting of stock awards related to the Q1 and pandemic restructuring activities and the loss on sale and impairment loss related to the property restructuring during the nine months ended September 30, 2020.

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The following table presents, by segment, restructuring charges incurred during the three and nine months ended September 30, 2020 (in thousands):

    

Contract

Aftermarket

Operations

Services

Other (1)

Total

Three months ended September 30, 2020

Organizational restructuring

$

(20)

$

$

(13)

$

(33)

Pandemic restructuring

546

644

245

1,435

Property restructuring

Loss on sale

915

915

Impairment loss

583

583

Total property restructuring

1,498

1,498

Total restructuring charges

$

526

$

644

$

1,730

$

2,900

Nine months ended September 30, 2020

Organizational restructuring

$

458

$

625

$

612

$

1,695

Pandemic restructuring

1,932

931

980

3,843

Property restructuring

Loss on sale

915

915

Impairment loss

583

583

Total property restructuring

1,498

1,498

Total restructuring charges

$

2,390

$

1,556

$

3,090

$

7,036

(1)Represents expense incurred within our corporate function and not directly attributable to our segments.

The following table presents, by cost type, restructuring charges incurred during the three and nine months ended September 30, 2020 (in thousands):

Three Months Ended

Nine Months Ended

September 30, 2020

September 30, 2020

Severance costs

 

Organizational restructuring

$

(33)

 

$

1,695

Pandemic restructuring

1,435

 

3,843

Total severance costs

1,402

5,538

Property restructuring

Loss on sale

915

915

Impairment loss

583

583

Total property restructuring

 

1,498

 

1,498

Total restructuring charges

$

2,900

$

7,036

15. Income Taxes

CARES Act

On March 27, 2020, President Trump signed into law the CARES Act, which includes, among other things, refundable payroll tax credits, deferment of employer side social security payments, NOL carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. The CARES Act provisions did not have a material impact on our condensed consolidated financial statements. Future regulatory guidance under the CARES Act or additional legislation enacted by Congress in connection with the COVID-19 pandemic could impact our tax provision in future periods.

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Valuation Allowance

The amount of our deferred tax assets considered realizable could be adjusted if projections of future taxable income are reduced or objective negative evidence in the form of a three-year cumulative loss is present or both. Should we no longer have a level of sustained profitability, excluding nonrecurring charges, we will have to rely more on our future projections of taxable income to determine if we have an adequate source of taxable income for the realization of our deferred tax assets, namely NOL carryforwards and tax credit carryforwards. This may result in the need to record a valuation allowance against all or a portion of our deferred tax assets.

Effective Tax Rate

The year-to-date effective tax rate for the nine months ended September 30, 2020 differed from our statutory rate primarily due to an increase in unrecognized tax benefits. Our quarterly income tax provision is determined based on our estimated full year effective tax rate, adjusted for tax attributable to infrequent or unusual items, which are recognized on a discrete period basis in the income tax provision in the period in which they occur. Our year-to-date income tax provision included a $22.6 million tax benefit recorded discretely on the nonrecurring goodwill impairment loss of $99.8 million. See Note 7 (“Goodwill”) for further details on the goodwill impairment.

Unrecognized Tax Benefits

As of September 30, 2020, we believe it is reasonably possible that $2.7 million of our unrecognized tax benefits, including penalties, interest and discontinued operations, will be reduced prior to September 30, 2021 due to the settlement of audits or the expiration of statutes of limitations or both. However, due to the uncertain and complex application of the tax regulations, it is possible that the ultimate resolution of these matters may result in liabilities that could materially differ from this estimate.

16. Earnings per Share

Basic net income (loss) per common share is computed using the two-class method, which is an earnings allocation formula that determines net income (loss) per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Under the two-class method, basic net income (loss) per common share is determined by dividing net income (loss), after deducting amounts allocated to participating securities, by the weighted average number of common shares outstanding for the period. Participating securities include unvested restricted stock and stock-settled restricted stock units that have nonforfeitable rights to receive dividends or dividend equivalents, whether paid or unpaid. During periods of net loss, only distributed earnings (dividends) are allocated to participating securities, as they do not have a contractual obligation to participate in our undistributed losses.

Diluted net income (loss) per common share is computed using the weighted average number of shares outstanding adjusted for the incremental common stock equivalents attributed to outstanding options, performance-based restricted stock units and stock to be issued pursuant to our employee stock purchase plan unless their effect would be anti-dilutive.

The following table shows the calculation for net income (loss) attributable to common stockholders, which is used in the calculation of basic and diluted net income (loss) per common share (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Income (loss) from continuing operations

$

18,332

$

20,407

$

(73,236)

$

51,559

Loss from discontinued operations, net of tax

 

 

 

 

(273)

Net income (loss)

 

18,332

 

20,407

 

(73,236)

 

51,286

Less: Earnings attributable to participating securities

 

(439)

 

(302)

 

(1,083)

 

(876)

Net income (loss) attributable to common stockholders

$

17,893

$

20,105

$

(74,319)

$

50,410

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The following table shows the potential shares of common stock that were included in computing diluted net income (loss) per common share (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Weighted average common shares outstanding including participating securities

152,973

144,692

152,790

135,081

Less: Weighted average participating securities outstanding

 

(1,999)

 

(1,761)

 

(2,060)

 

(1,911)

Weighted average common shares outstanding used in basic net income (loss) per common share

 

150,974

 

142,931

 

150,730

 

133,170

Net dilutive potential common shares issuable:

 

 

  

 

  

 

  

On exercise of options and vesting of performance-based restricted stock units

 

57

33

 

 

33

On settlement of employee stock purchase plan shares

 

7

1

 

 

3

Weighted average common shares outstanding used in diluted net income (loss) per common share

 

151,038

 

142,965

 

150,730

 

133,206

The following table shows the potential shares of common stock issuable that were excluded from computing diluted net income (loss) per common share as their inclusion would have been anti-dilutive (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

On exercise of options where exercise price is greater than average market value for the period

85

 

154

 

102

 

154

On exercise of options and vesting of performance-based restricted stock units

57

On settlement of employee stock purchase plan shares

19

Net dilutive potential common shares issuable

85

154

178

154

17. Derivatives

We are exposed to market risks associated with changes in the variable interest rate of our Credit Facility. We use derivative instruments to manage our exposure to fluctuations in this variable interest rate and thereby minimize the risks and costs associated with financial activities. We do not use derivative instruments for trading or other speculative purposes.

As of September 30, 2020, we had $300.0 million notional value of interest rate swaps outstanding, which expire in March 2022 and were entered into to offset changes in expected cash flows due to fluctuations in the associated variable interest rates. The counterparties to our derivative agreements are major financial institutions. We monitor the credit quality of these financial institutions and do not expect nonperformance by any counterparty, although such nonperformance could have a material adverse effect on us. We have no collateral posted for the derivative instruments.

We have designated these interest rate swaps as cash flow hedging instruments. Changes in the fair value of the interest rate swaps are recognized as a component of other comprehensive income (loss) until the hedged transaction affects earnings. At that time, amounts are reclassified into earnings to interest expense, the same statement of operations line item to which the earnings effect of the hedged item is recorded. Cash flows from derivatives designated as hedges are classified in our condensed consolidated statements of cash flows under the same category as the cash flows from the underlying assets, liabilities or anticipated transactions unless the derivative contract contains a significant financing element; in this case, the cash settlements for these derivatives are classified as cash flows from financing activities.

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We expect the hedging relationship to be highly effective as the interest rate swap terms substantially coincide with the hedged item and are expected to offset changes in expected cash flows due to fluctuations in the variable rate. We perform quarterly qualitative prospective and retrospective hedge effectiveness assessments unless facts and circumstances related to the hedging relationships change such that we can no longer assert qualitatively that the cash flow hedge relationships were and continue to be highly effective. We estimate that $4.8 million of the deferred pre-tax loss attributable to interest rate swaps included in accumulated other comprehensive loss at September 30, 2020 will be reclassified into earnings as interest expense at then-current values during the next 12 months as the underlying hedged transactions occur.

As of September 30, 2020, the weighted average effective fixed interest rate on our interest rate swaps was 1.8%.

The following table presents the effect of our derivative instruments designated as cash flow hedging instruments on our condensed consolidated balance sheets (in thousands):

    

September 30, 2020

    

December 31, 2019

Other current assets

$

$

12

Total derivative assets

$

$

12

Accrued liabilities

$

4,767

$

593

Other liabilities

 

2,794

 

1,175

Total derivative liabilities

$

7,561

$

1,768

The following tables present the effect of our derivative instruments designated as cash flow hedging instruments on our condensed consolidated statements of operations (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Pre-tax loss recognized in other comprehensive income (loss)

$

(87)

$

(933)

$

(8,399)

$

(7,761)

Pre-tax gain (loss) reclassified from accumulated other comprehensive income (loss) into interest expense

 

(1,271)

 

482

 

(2,594)

 

2,199

Total amount of interest expense in which the effects of cash flow hedges are recorded

25,221

27,401

80,664

76,972

See Note 10 (“Accumulated Other Comprehensive Income (Loss)”) and Note 18 (“Fair Value Measurements”) for further details on our derivative instruments.

18. Fair Value Measurements

Assets and Liabilities Measured at Fair Value on a Recurring Basis

On a quarterly basis, our interest rate swap derivative instruments are valued based on the income approach (discounted cash flow) using market observable inputs, including LIBOR forward curves. These fair value measurements are classified as Level 2. The following table presents our derivative asset and liability measured at fair value on a recurring basis, with pricing levels as of the date of valuation (in thousands):

    

September 30, 2020

    

December 31, 2019

Derivative asset

$

$

12

Derivative liability

 

7,561

 

1,768

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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Goodwill

In the first quarter of 2020, we determined that the significant deterioration in global macroeconomic conditions caused by the COVID-19 pandemic was an indicator of potential impairment of our goodwill, and we performed a quantitative impairment test as of March 31, 2020 that resulted in a $99.8 million impairment of our goodwill. Significant estimates used in our impairment analysis included cash flow forecasts, our estimate of the market’s weighted average cost of capital and market multiples, which are Level 3 inputs. See Note 7 (“Goodwill”) for further details of the valuation methodology used in connection with the goodwill impairment.

Properties

During the three months ended September 30, 2020, a plan to dispose of certain non-core properties was approved by management. As of September 30, 2020, the properties not sold at auction were impaired and written down to fair value. The commercial real estate market where these properties are located is not an active market. Our estimate of fair value included inputs from offers received as well as market transactions for similar properties, which are Level 3 inputs. The fair value of our impaired properties was as follows (in thousands):

    

September 30, 2020

Impaired properties

$

430

The significant unobservable inputs used to develop the Level 3 fair value measurements for the properties were the estimated sale values in an inactive market. In reviewing sales trends for the past three years, the probable price range based on market comparisons was as follows (in thousands):

    

Range

    

Weighted Average

Estimated sale proceeds

$100 - $600

$427

See Note 14 (“Restructuring Charges”) for further details on our approved plan of disposal.

Compressors

During the nine months ended September 30, 2020, we recorded nonrecurring fair value measurements related to our idle and previously-culled compressors. Our estimate of the compressors’ fair value was primarily based on the expected net sale proceeds compared to other fleet units we recently sold and/or a review of other units recently offered for sale by third parties, or the estimated component value of the equipment we plan to use. We discounted the expected proceeds, net of selling and other carrying costs, using a weighted average disposal period of four years. These fair value measurements are classified as Level 3. The fair value of our impaired compressors was as follows (in thousands):

    

September 30, 2020

    

December 31, 2019

Impaired compressors

$

2,561

$

5,859

 

The significant unobservable inputs used to develop the above fair value measurements were weighted by the relative fair value of the compressors being measured. Additional quantitative information related to our significant unobservable inputs as of September 30, 2020 follows:

    

Range

    

Weighted Average (1)

Estimated net sale proceeds

$0 - $372 per horsepower

$21 per horsepower

(1)Calculated based on an estimated discount for market liquidity of 78%.

See Note 13 (“Long-Lived and Other Asset Impairment”) for further details.

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Other Financial Instruments

The carrying amounts of our cash, receivables and payables approximate fair value due to the short-term nature of those instruments.

The carrying amount of borrowings outstanding under our Credit Facility approximates fair value due to its variable interest rate. The fair value of these outstanding borrowings is a Level 3 measurement.

The fair value of our fixed rate debt is estimated using yields observable in active markets, which are Level 2 inputs, and was as follows (in thousands):

    

September 30, 2020

    

December 31, 2019

Carrying amount of fixed rate debt (1)

$

985,459

$

1,329,549

Fair value of fixed rate debt

 

953,000

 

1,400,000

(1)Carrying amounts are shown net of unamortized debt discounts and unamortized deferred financing costs. See Note 9 (“Long-Term Debt”).

19. Stock-Based Compensation

Stock-based compensation expense consisted of the following (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Equity awards

$

2,645

$

2,276

$

8,423

$

6,145

Liability awards

 

243

 

274

 

537

 

1,880

Total stock-based compensation expense

$

2,888

$

2,550

$

8,960

$

8,025

The following table presents restricted stock, restricted stock unit, performance-based restricted stock unit and cash-settled performance unit activity during the nine months ended September 30, 2020 (shares in thousands):

Weighted

Average

Grant Date

Fair Value

    

Shares

    

Per Share

Non-vested awards, December 31, 2019

 

2,022

$

10.25

Granted

 

1,454

 

9.40

Vested

 

(901)

 

10.43

Canceled

 

(61)

 

10.19

Non-vested awards, September 30, 2020 (1)

 

2,514

 

9.69

(1)Non-vested awards as of September 30, 2020 are comprised of 454,000 cash-settled restricted stock units and cash-settled performance units and 2,060,000 restricted stock and stock-settled performance units.

As of September 30, 2020, we expect $16.0 million of unrecognized compensation cost related to unvested restricted stock, stock-settled restricted stock units, performance units, cash-settled restricted stock units and cash-settled performance units to be recognized over the weighted average period of 1.8 years.

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2020 Plan

The 2020 Plan was adopted in April 2020 and provides for the granting of stock options, restricted stock, restricted stock units, stock appreciation rights, performance awards, other stock-based awards and dividend equivalent rights to employees, directors and consultants of Archrock. Under the 2020 Plan, the maximum number of shares of common stock available for issuance is 8,500,000. Each stock-settled award granted under the 2020 Plan reduces the number of shares available for issuance by one share. No additional grants may be made under the 2013 Plan following the adoption of the 2020 Plan. Previous grants made under the 2013 Plan continue to be governed by that plan and the applicable award agreements.

20. Commitments and Contingencies

Performance Bonds

In the normal course of business we have issued performance bonds to various state authorities that ensure payment of certain obligations. We have also issued a bond to protect our 401(k) retirement plan against losses caused by acts of fraud or dishonesty. The bonds have expiration dates in 2020 through the fourth quarter of 2022, and maximum potential future payments of $2.2 million. As of September 30, 2020, we were in compliance with all obligations to which the performance bonds pertain.

Tax Matters

We are subject to a number of state and local taxes that are not income-based. As many of these taxes are subject to audit by the taxing authorities, it is possible that an audit could result in additional taxes due. We accrue for such additional taxes when we determine that it is probable that we have incurred a liability and we can reasonably estimate the amount of the liability. As of September 30, 2020 and December 31, 2019, we accrued $5.7 million and $2.5 million, respectively, for the outcomes of non-income-based tax audits. We do not expect that the ultimate resolutions of these audits will result in a material variance from the amounts accrued. We do not accrue for unasserted claims for tax audits unless we believe the assertion of a claim is probable, it is probable that it will be determined that the claim is owed and we can reasonably estimate the claim or range of the claim. We believe the likelihood is remote that the impact of potential unasserted claims from non-income-based tax audits could be material to our consolidated financial position, but it is possible that the resolution of future audits could be material to our consolidated results of operations or cash flows.

Subject to the provisions of the tax matters agreement between Exterran Corporation and us, both parties agreed to indemnify the primary obligor of any return for tax periods beginning before and ending before or after the Spin-off (including any ongoing or future amendments and audits for these returns) for the portion of the tax liability (including interest and penalties) that relates to their respective operations reported in the filing. The tax contingencies mentioned above relate to tax matters for which we are responsible in managing the audit. As of September 30, 2020 and December 31, 2019, we had an indemnification liability (including penalties and interest), in addition to the tax contingency above, of $1.6 million and $2.8 million, respectively, for our share of non-income-based tax contingencies related to audits being managed by Exterran Corporation.

During the three and nine months ended September 30, 2020, we settled a certain sales and use tax audit for which we recorded a $12.4 million net benefit in our condensed consolidated statements of operations. This net benefit was primarily reflected as decreases of $4.4 million and $7.9 million to cost of sales (excluding depreciation and amortization) and SG&A, respectively. As of September 30, 2020, these settlements were reflected in our condensed consolidated balance sheets as a $17.3 million tax refund receivable and an offsetting $4.9 million in accrued liabilities.

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Insurance Matters

Our business can be hazardous, involving unforeseen circumstances such as uncontrollable flows of natural gas or well fluids and fires or explosions. As is customary in our industry, we review our safety equipment and procedures and carry insurance against some, but not all, risks of our business. Our insurance coverage includes property damage, general liability and commercial automobile liability and other coverage we believe is appropriate. We believe that our insurance coverage is customary for the industry and adequate for our business; however, losses and liabilities not covered by insurance would increase our costs.

Additionally, we are substantially self-insured for workers’ compensation and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses up to the deductible amounts are estimated and accrued based upon known facts, historical trends and industry averages. We are also self-insured for property damage to our offshore assets.

Litigation and Claims

In the ordinary course of business, we are involved in various pending or threatened legal actions. While we are unable to predict the ultimate outcome of these actions, we believe that any ultimate liability arising from any of these actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends. However, because of the inherent uncertainty of litigation and arbitration proceedings, we cannot provide assurance that the resolution of any particular claim or proceeding to which we are a party will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends.

21. Related Party Transactions

In connection with the closing of the Elite Acquisition, we issued 21.7 million shares of our common stock to JDH Capital, an affiliate of our customer Hilcorp. As long as JDH Capital, together with affiliates of Hilcorp, owns at least 7.5% of our outstanding common stock, it will have the right to designate one director to our Board of Directors. Jeffery D. Hildebrand, founder and executive chairman of Hilcorp, was appointed Director in August 2019 and served until his resignation on July 29, 2020, at which time Jason C. Rebrook, President of Hilcorp, was appointed Director to fill the resulting vacancy. Mr. Hildebrand did not receive and Mr. Rebrook receives no compensation for their role as Director. As of September 30, 2020, JDH Capital owned 14.2% of our outstanding common stock.

Revenue from Hilcorp and affiliates was $9.8 million and $9.7 million during the three months ended September 30, 2020 and 2019, respectively, and $30.7 million and $20.1 million during the nine months ended September 30, 2020 and 2019, respectively. Accounts receivable, net due from Hilcorp and affiliates was $4.9 million and $5.1 million as of September 30, 2020 and December 31, 2019, respectively.

22. Segments

We manage our business segments primarily based on the type of product or service provided. We have two segments which we operate within the U.S.: contract operations and aftermarket services. The contract operations segment primarily provides natural gas compression services to meet specific customer requirements. The aftermarket services segment provides a full range of services to support the compression needs of customers, from parts sales and normal maintenance services to full operation of a customer’s owned assets.

We evaluate the performance of our segments based on gross margin for each segment. Revenue includes only sales to external customers.

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The following table presents revenue and gross margin by segment during the three and nine months ended September 30, 2020 and 2019 (in thousands):

    

Contract

    

Aftermarket

    

    

Operations

    

Services

    

Total

Three months ended September 30, 2020

 

  

 

  

 

  

Revenue

$

175,223

$

30,408

$

205,631

Gross margin

 

114,779

 

4,699

 

119,478

Three months ended September 30, 2019

 

  

 

  

 

  

Revenue

$

198,337

$

46,612

$

244,949

Gross margin

 

122,396

 

8,987

 

131,383

Nine months ended September 30, 2020

 

  

 

  

 

  

Revenue

$

570,146

$

105,498

$

675,644

Gross margin

 

367,661

 

16,112

 

383,773

Nine months ended September 30, 2019

 

  

 

  

 

  

Revenue

$

567,102

$

152,396

$

719,498

Gross margin

 

345,905

 

28,654

 

374,559

The following table reconciles total gross margin to income (loss) before income taxes (in thousands):

Three Months Ended

    

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Total gross margin

$

119,478

$

131,383

$

383,773

$

374,559

Less:

 

  

 

  

 

  

 

  

Selling, general and administrative

 

18,681

 

29,526

 

78,052

 

87,133

Depreciation and amortization

 

47,279

 

48,409

 

145,950

 

137,997

Long-lived and other asset impairment

 

10,727

 

7,097

 

72,132

 

18,821

Goodwill impairment

99,830

Restatement and other charges

 

 

 

 

445

Restructuring charges

2,900

7,036

Interest expense

 

25,221

 

27,401

 

80,664

 

76,972

Debt extinguishment loss

 

 

 

3,971

 

3,653

Transaction-related costs

 

 

4,905

 

 

7,772

Gain on sale of assets, net

(9,146)

(7,859)

(11,073)

(9,644)

Other (income) loss, net

 

(324)

 

49

 

(1,317)

 

(381)

Income (loss) before income taxes

$

24,140

$

21,855

$

(91,472)

$

51,791

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited Financial Statements and the notes thereto included in this Quarterly Report on Form 10-Q and in conjunction with our 2019 Form 10-K.

Overview

We are an energy infrastructure company with a pure-play focus on midstream natural gas compression. We are the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two business segments: contract operations and aftermarket services. Our contract operations services primarily include designing, sourcing, owning, installing, operating, servicing, repairing and maintaining our owned fleet of natural gas compression equipment to provide natural gas compression services to our customers. In our aftermarket services business, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.

Recent Business Developments

July 2020 Disposition

On July 9, 2020, we completed the sale of the turbocharger business included within our aftermarket services segment. We recognized a gain on the sale of $9.3 million during the three months ended September 30, 2020. See Note 3 (“Business Transactions”) to our Financial Statements for further details of this transaction.

2022 Notes Redemption

On April 1, 2020, we repaid the 2022 Notes with borrowings from our Credit Facility. See Note 9 (“Long-Term Debt”) to our Financial Statements for further details of this transaction.

March 2020 Disposition

On March 1, 2020, we completed the sale of certain contract operations customer service agreements and approximately 200 compressors, comprising approximately 35,000 horsepower, used to provide compression services under those agreements as well as other assets used to support the operations. We recognized a gain on the sale of $3.2 million during the nine months ended September 30, 2020. See Note 3 (“Business Transactions”) to our Financial Statements for further details of this transaction.

COVID-19 Pandemic

In the first quarter of 2020, the COVID-19 pandemic caused a deterioration in global macroeconomic conditions, including a collapse in the demand for oil and natural gas coupled with an oversupply of oil, which led to substantial spending cuts by our customers and a decline in production. This global response to the pandemic has significantly impacted our market capitalization, revenue and cash flows. Though demand has shown modest improvement since the lows reached in the second quarter as economies have started to reopen, much uncertainty still exists surrounding the timing of a full and sustained recovery.

The key driver of our business is the production of U.S. crude oil and natural gas. Approximately 75% of our operating fleet is deployed for midstream natural gas gathering and wellhead applications with the remaining fleet being used in gas lift applications to enhance oil production. Changes in oil and natural gas production spending therefore typically result in changes in demand for our services. According to the EIA’s October 2020 Short-Term Energy Outlook, both crude oil and dry natural gas production are expected to decline in 2020 and 2021 as the result of the decrease in demand. U.S. crude oil production is estimated to decrease 7% in 2020 and 3% in 2021. U.S. dry natural gas production is estimated to decrease 3% in 2020 and 4% in 2021.

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Our customers have substantially cut spending and activity in 2020 as a result of the significant declines in oil and natural gas prices and demand. The duration of decreased spending and activity levels and the timing of their full impact on production remain difficult to predict, as do the magnitude and duration of the pandemic and resulting economic downturn. In anticipation of the lower customer activity levels, we implemented a plan in the second quarter of 2020 to reduce our annual operating, corporate and capital costs by between $75 million and $85 million. Horsepower, utilization and revenue experienced declines in the second and third quarters and are expected to remain at lower levels through the end of 2020 and into 2021 as compared to 2019 in both our contract operations and aftermarket services businesses.

The impact of the COVID-19 pandemic on our 2020 results is primarily visible in the $99.8 million non-cash impairment of our goodwill and the impairment’s resulting impact on income taxes. Revenue, cost of sales, long-lived asset impairment and restructuring charges have also been significantly impacted. See “Financial Results of Operations” below and Note 7 (“Goodwill”), Note 13 (“Long-Lived and Other Asset Impairment”), Note 14 (“Restructuring Charges”) and Note 15 (“Income Taxes”) to our Financial Statements for further discussion.

Operating Highlights

The following table summarizes our available and operating horsepower and utilization (in thousands, except percentages):

Three Months Ended

Nine Months Ended

 

September 30, 

September 30, 

 

    

2020

    

2019

    

    

2020

    

2019

    

Total available horsepower (at period end)(1)

    

4,153

    

4,441

    

    

4,153

    

4,441

Total operating horsepower (at period end)(2)

3,465

 

3,916

 

3,465

 

3,916

Average operating horsepower

3,536

 

3,770

 

3,731

 

3,644

Horsepower utilization:

  

 

  

 

  

 

  

Spot (at period end)

83

%  

88

%  

83

%  

88

%

Average

85

%  

88

%  

86

%  

89

%

(1)Defined as idle and operating horsepower. New compressors completed by a third party manufacturer that have been delivered to us are included in the fleet.
(2)Defined as horsepower that is operating under contract and horsepower that is idle but under contract and generating revenue such as standby revenue.

Non-GAAP Financial Measures

Management uses a variety of financial and operating metrics to analyze our performance. These metrics are significant factors in assessing our operating results and profitability and include the non-GAAP financial measure of gross margin.

We define gross margin as total revenue less cost of sales (excluding depreciation and amortization). Gross margin is included as a supplemental disclosure because it is a primary measure used by our management to evaluate the results of revenue and cost of sales (excluding depreciation and amortization), which are key components of our operations. We believe gross margin is important because it focuses on the current operating performance of our operations and excludes the impact of the prior historical costs of the assets acquired or constructed that are utilized in those operations, the indirect costs associated with our SG&A activities, our financing methods and income taxes. In addition, depreciation and amortization may not accurately reflect the costs required to maintain and replenish the operational usage of our assets and therefore may not portray the costs of current operating activity. As an indicator of our operating performance, gross margin should not be considered an alternative to, or more meaningful than, net income (loss) as determined in accordance with GAAP. Our gross margin may not be comparable to a similarly-titled measure of other entities because other entities may not calculate gross margin in the same manner.

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Gross margin has certain material limitations associated with its use as compared to net income (loss). These limitations are primarily due to the exclusion of SG&A, depreciation and amortization, impairments, restatement and other charges, restructuring charges, interest expense, debt extinguishment loss, transaction-related costs, (gain) loss on sale of assets, net, other (income) loss, net, provision for (benefit from) income taxes and loss from discontinued operations, net of tax. Because we intend to finance a portion of our operations through borrowings, interest expense is a necessary element of our costs and our ability to generate revenue. Additionally, because we use capital assets, depreciation expense is a necessary element of our costs and our ability to generate revenue and SG&A is necessary to support our operations and required corporate activities. To compensate for these limitations, management uses this non-GAAP measure as a supplemental measure to other GAAP results to provide a more complete understanding of our performance.

The following table reconciles net income (loss) to gross margin (in thousands):

Three Months Ended

Nine Months Ended

September 30, 

September 30, 

    

2020

    

2019

    

2020

    

2019

Net income (loss)

$

18,332

$

20,407

$

(73,236)

$

51,286

Selling, general and administrative

 

18,681

 

29,526

 

78,052

 

87,133

Depreciation and amortization

 

47,279

 

48,409

 

145,950

 

137,997

Long-lived and other asset impairment

 

10,727

 

7,097

 

72,132

 

18,821

Goodwill impairment

99,830

Restatement and other charges

 

 

 

 

445

Restructuring charges

2,900

7,036

Interest expense

 

25,221

 

27,401

 

80,664

 

76,972

Debt extinguishment loss

 

 

 

3,971

 

3,653

Transaction-related costs

 

 

4,905

 

 

7,772

Gain on sale of assets, net

(9,146)

(7,859)

(11,073)

(9,644)

Other (income) loss, net

 

(324)

 

49

 

(1,317)

 

(381)

Provision for (benefit from) income taxes

 

5,808

 

1,448

 

(18,236)

 

232

Loss from discontinued operations, net of tax

 

 

 

 

273

Gross margin

$

119,478

$

131,383

$

383,773

$

374,559

Financial Results of Operations

Summary of Results

Revenue. Revenue was $205.6 million and $244.9 million during the three months ended September 30, 2020 and 2019, respectively, and $675.6 million and $719.5 million during the nine months ended September 30, 2020 and 2019, respectively.

The decrease in revenue during the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was due to decreases in revenue from our contract operations and aftermarket services businesses.

The decrease in revenue during the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 was due to a decrease in revenue from our aftermarket services business, which was slightly offset by an increase in revenue from our contract operations business.

See “Contract Operations” and “Aftermarket Services” below for further details.

Net income (loss). We had net income of $18.3 million and $20.4 million during the three months ended September 30, 2020 and 2019, respectively, and a net loss of $73.2 million and net income of $51.3 million during the nine months ended September 30, 2020 and 2019, respectively.

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The decrease in net income during the three months ended September 30, 2020 compared to the three months ended September 30, 2019 was primarily driven by a decrease in gross margin from our contract operations and aftermarket services businesses and increases in provision for income taxes, long-lived and other asset impairment and restructuring charges, partially offset by decreases in SG&A, transaction-related costs, interest expense and depreciation and amortization and an increase in gain on sale of assets, net.

The change from net income to net loss during the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 was primarily driven by goodwill impairment of $99.8 million, increases in long-lived asset impairment, depreciation and amortization and restructuring charges and a decrease in gross margin from our aftermarket services business, partially offset by increases in gross margin from our contract operations business and benefit from income taxes and decreases in SG&A and transaction-related costs.

Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019

Contract Operations

(dollars in thousands)

 

Three Months Ended

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Revenue

$

175,223

$

198,337

(12)

%

Cost of sales (excluding depreciation and amortization expense)

 

60,444

 

75,941

(20)

%

Gross margin

$

114,779

$

122,396

(6)

%

Gross margin percentage (1)

 

66

%  

 

62

%  

4

%

(1)Defined as gross margin divided by revenue.

Revenue decreased primarily due to returns of horsepower amidst the market downturn, the strategic disposition of other horsepower throughout 2019 and 2020 and a decrease in contract operations rates, which was driven by customer shifts to standby status and rate concessions given to customers impacted by the COVID-19 pandemic. Partially offsetting these decreases was the full-quarter benefit in 2020 of significant horsepower additions in 2019, including a $5.6 million increase in revenue associated with the horsepower acquired in the Elite Acquisition completed in August 2019.

Gross margin decreased due to the overall decrease in revenue discussed above, which was partially offset by a decrease in cost of sales. The decrease in cost of sales was primarily due to decreases in costs to mobilize compression packages and maintenance, which were driven by the decreases in operating horsepower mentioned above, a decrease in lube oil expense, which was driven by the decrease in operating horsepower and a decrease in its price, and a decrease in sales and use tax as the result of audit settlements in the third quarter of 2020. Despite the decrease in gross margin, gross margin percentage increased due to a significantly larger decrease in cost of sales, which was largely the result of our cost savings plan implemented in response to the COVID-19 pandemic, as compared to the decrease in revenue.

Aftermarket Services

(dollars in thousands)

 

Three Months Ended

 

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Revenue

$

30,408

$

46,612

 

(35)

%

Cost of sales (excluding depreciation and amortization expense)

 

25,709

 

37,625

 

(32)

%

Gross margin

$

4,699

$

8,987

 

(48)

%

Gross margin percentage

 

15

%  

 

19

%  

(4)

%

The decrease in revenue was due to decreases in service activities and parts sales, which were primarily driven by commodity price declines, customer deferral of maintenance activities as a result of the COVID-19 pandemic and the sale of our turbocharger business at the start of the quarter.

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Gross margin and gross margin percentage decreased due to the decrease in revenue mentioned above, partially offset by a decrease in cost of sales, which was primarily driven by the decrease in service activities and parts sales.

Costs and Expenses

(dollars in thousands)

 

Three Months Ended

September 30, 

    

2020

    

2019

Selling, general and administrative

$

18,681

$

29,526

Depreciation and amortization

 

47,279

 

48,409

Long-lived and other asset impairment

 

10,727

 

7,097

Restructuring charges

2,900

Interest expense

 

25,221

 

27,401

Transaction-related costs

 

 

4,905

Gain on sale of assets, net

(9,146)

(7,859)

Other (income) loss, net

 

(324)

 

49

Selling, general and administrative. The decrease in SG&A was primarily due to a $6.7 million decrease in sales and use tax that was mainly driven by audit settlements, a $1.4 million decrease in compensation and benefits, $0.7 million decreases in each of bad debt expense and employee travel and meeting expense and a $0.4 million decrease in costs related to our technology transformation project.

Depreciation and amortization. The decrease in depreciation and amortization expense was primarily due to a decrease in depreciation expense resulting from assets reaching the end of their depreciable lives as well as the impact of asset impairments during 2019, partially offset by an increase in depreciation expense associated with fixed asset additions during 2019, including the fixed assets acquired in the Elite Acquisition.

Long-lived and other asset impairment. Each quarter, we review the future deployment of our idle compressors for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. In addition, we evaluate for impairment idle units that have been culled from our compression fleet in prior years and are available for sale. See Note 13 (“Long-Lived and Other Asset Impairment”) to our Financial Statements for further details. The following table presents the results of our compression fleet impairment review, as recorded to our contract operations segment (dollars in thousands):

 

Three Months Ended

September 30, 

    

2020

    

2019

Idle compressors retired from the active fleet

 

105

 

60

Horsepower of idle compressors retired from the active fleet

 

28,000

 

28,000

Impairment recorded on idle compressors retired from the active fleet

$

8,137

$

7,097

Also during the three months ended September 30, 2020, $1.7 million of capitalized implementation and unamortized prepaid costs related to the mobile workforce component of our multi-year process and technology transformation project was impaired. See Note 8 (“Hosting Arrangements”) to our Financial Statements for further details.

Restructuring charges. We recorded $2.9 million of severance and property disposal costs related to restructuring activities during the three months ended September 30, 2020. See Note 14 (“Restructuring Charges”) to our Financial Statements for further details.

Interest expense. The decrease in interest expense was due to a decrease in the weighted average effective interest rate, partially offset by an increase in the average outstanding balance of long-term debt.

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Transaction-related costs. We incurred $4.9 million of financial advisory, legal and other professional fees during the three months ended September 30, 2019 related primarily to the Elite Acquisition. 

Gain on sale of assets, net. The increase in gain on sale of assets, net was primarily due to a $9.3 million gain on the July 2020 Disposition, partially offset by a $6.6 million gain on the Harvest Sale in 2019 and a $2.0 million net loss on compression assets sold in 2020 as compared to 2019.

Other (income) loss, net. The change in other (income) loss, net was primarily due to a $0.5 million decrease in indemnification expense incurred pursuant to our tax matters agreement with Exterran Corporation.

Provision for Income Taxes

(dollars in thousands)

 

Three Months Ended

 

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Provision for income taxes

$

5,808

$

1,448

 

301

%

Effective tax rate

 

24

%  

 

7

%  

17

%

The increase in provision for income taxes was primarily due to the tax effect of the increase in book income during the three months ended September 30, 2020 compared to the three months ended September 30, 2019, and a reduction in a valuation allowance recorded during the three months ended September 30, 2019.

Nine Months Ended September 30, 2020 Compared to Nine Months Ended September 30, 2019

Contract Operations

(dollars in thousands)

 

Nine Months Ended

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Revenue

$

570,146

$

567,102

1

%

Cost of sales (excluding depreciation and amortization)

 

202,485

 

221,197

(8)

%

Gross margin

$

367,661

$

345,905

6

%

Gross margin percentage

 

64

%  

 

61

%  

3

%

During the nine months ended September 30, 2020, revenue included the benefit from significant horsepower additions in the second half of 2019, including a $45.4 million increase in revenue associated with the horsepower acquired in the Elite Acquisition completed in August 2019, which was partially offset by the strategic disposition of other horsepower throughout 2019 and 2020. The increase in revenue was also offset by the impact of returns of horsepower amidst the market downturn and a decrease in rebillable freight due to decreased mobilization activity.

Gross margin and gross margin percentage increased due to a decrease in cost of sales and the overall increase in revenue discussed above. The decrease in cost of sales was primarily driven by decreases in costs to mobilize compression packages, maintenance and lube oil expense, which were driven by the decreases in operating horsepower mentioned above, and a decrease in sales and use tax as the result of audit settlements in the third quarter of 2020. These decreases were partially offset by increases in maintenance and lube oil expense associated with the horsepower acquired in the Elite Acquisition.

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Aftermarket Services

(dollars in thousands)

 

Nine Months Ended

 

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Revenue

$

105,498

$

152,396

 

(31)

%

Cost of sales (excluding depreciation and amortization)

 

89,386

 

123,742

 

(28)

%

Gross margin

$

16,112

$

28,654

 

(44)

%

Gross margin percentage

 

15

%  

 

19

%  

(4)

%

The decrease in revenue was due to decreases in service activities and parts sales, which were primarily driven by commodity price declines and customer deferral of maintenance activities as a result of the COVID-19 pandemic.

Gross margin and gross margin percentage decreased due to the decrease in revenue mentioned above, partially offset by a decrease in cost of sales, which was primarily driven by the decrease in service activities and parts sales.

Costs and Expenses

(dollars in thousands)

 

Nine Months Ended

September 30, 

    

2020

    

2019

Selling, general and administrative

$

78,052

$

87,133

Depreciation and amortization

 

145,950

137,997

Long-lived and other asset impairment

 

72,132

18,821

Goodwill impairment

99,830

Restatement and other charges

 

445

Restructuring charges

7,036

Interest expense

 

80,664

76,972

Debt extinguishment loss

 

3,971

3,653

Transaction-related costs

 

7,772

Gain on sale of assets, net

(11,073)

(9,644)

Other income, net

 

(1,317)

(381)

Selling, general and administrative. The decrease in SG&A was primarily due to a $5.9 million decrease in sales and use tax that was mainly driven by audit settlements, a $2.3 million decrease in compensation and benefits, a $1.5 million decrease in professional expenses and a $1.3 million decrease in employee travel and meeting expenses. These decreases were partially offset by a $1.3 million increase in bad debt expense.

Depreciation and amortization. The increase in depreciation and amortization expense was primarily due to an increase in depreciation expense associated with fixed asset additions during 2019, including the fixed assets acquired in the Elite Acquisition, partially offset by a decrease in depreciation expense resulting from assets reaching the end of their depreciable lives as well as the impact of asset impairments and compression asset sales during 2019.

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Long-lived and other asset impairment. Each quarter, we review the future deployment of our idle compressors for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. In addition, we evaluate for impairment idle units that have been culled from our compression fleet in prior years and are available for sale. See Note 13 (“Long-Lived and Other Asset Impairment”) to our Financial Statements for further details. The following table presents the results of our compression fleet impairment review, as recorded to our contract operations segment (dollars in thousands):

 

Nine Months Ended

September 30, 

    

2020

    

2019

Idle compressor units retired from the active fleet

 

640

 

240

Horsepower of idle compressor units retired from the active fleet

 

235,000

 

84,000

Impairment recorded on idle compressor units retired from the active fleet

$

69,542

$

18,821

Also during the nine months ended September 30, 2020, $1.7 million of capitalized implementation and unamortized prepaid costs related to the mobile workforce component of our multi-year process and technology transformation project was impaired. See Note 8 (“Hosting Arrangements”) to our Financial Statements for further details.

Goodwill impairment. During the nine months ended September 30, 2020, we recorded $99.8 million of goodwill impairment due to the decline in the fair value of our contract operations reporting unit. See Note 7 (“Goodwill”) to our Financial Statements for further details.

Restructuring charges. We recorded $7.0 million of severance and property disposal costs related to restructuring activities during the nine months ended September 30, 2020. See Note 14 (“Restructuring Charges”) to our Financial Statements for further details.

Interest expense. The increase in interest expense was primarily due to an increase in the average outstanding balance of long-term debt, partially offset by a decrease in the weighted average effective interest rate.

Debt extinguishment loss. We recorded a debt extinguishment loss of $4.0 million during the nine months ended September 30, 2020 as a result of the redemption of the 2022 Notes. We recorded a debt extinguishment loss of $3.7 million during the nine months ended September 30, 2019 as a result of the redemption of the 2021 Notes. See Note 9 (“Long-Term Debt”) to our Financial Statements for further details.

Transaction-related costs. We incurred $7.8 million of financial advisory, legal and other professional fees during the nine months ended September 30, 2019 related primarily to the Elite Acquisition. 

Gain on sale of assets, net. The increase in gain on sale of assets, net was primarily due to a $9.3 million gain on the July 2020 Disposition, a $3.2 million gain on the March 2020 Disposition, which included a $4.8 million gain on the compression assets sold, and a $1.3 million year-over-year increase in the gain on sale of transportation and shop equipment. These increases were partially offset by a $6.6 million gain on the Harvest Sale in 2019 and a $5.7 million net loss on other compression assets sold during 2020 as compared to 2019.

Other income, net. The increase in other income, net was primarily due to a $0.9 million decrease in indemnification expense incurred pursuant to our tax matters agreement with Exterran Corporation.

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Provision for (Benefit from) Income Taxes

(dollars in thousands)

 

Nine Months Ended

 

September 30, 

Increase

    

2020

    

2019

    

(Decrease)

Provision for (benefit from) income taxes

$

(18,236)

$

232

 

(7,960)

%

Effective tax rate

 

20

%  

 

%  

20

%

The change in provision for (benefit from) income taxes was primarily due to the tax effect of the decrease in book income during the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019, partially offset by a reduction in a valuation allowance and the release of an unrecognized tax benefit due to the settlement of a tax audit recorded during the nine months ended September 30, 2019.

Liquidity and Capital Resources

Overview

Our ability to fund operations, finance capital expenditures and pay dividends depends on the levels of our operating cash flows and access to the capital and credit markets. Our primary sources of liquidity are cash flows generated from our operations and our borrowing availability under the Credit Facility. Our cash flow is affected by numerous factors including prices and demand for our services, oil and natural gas exploration and production spending, conditions in the financial markets and other factors. Beginning in the first quarter of 2020, the COVID-19 pandemic has caused a deterioration in global macroeconomic conditions, which has significantly impacted our estimates of future revenues and cash flows. However, we have no near-term maturities and believe that our operating cash flows and borrowings under the Credit Facility will be sufficient to meet our future liquidity needs.

We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.

Capital Requirements

Our contract operations business is capital intensive, requiring significant investment to maintain and upgrade existing operations. Our capital spending is primarily dependent on the demand for our contract operations services and the availability of the type of compression equipment required for us to provide those contract operations services to our customers. Our capital requirements have consisted primarily of, and we anticipate will continue to consist of, the following:

growth capital expenditures, which are made to expand or to replace partially or fully depreciated assets or to expand the operating capacity or revenue-generating capabilities of existing or new assets; and
maintenance capital expenditures, which are made to maintain the existing operating capacity of our assets and related cash flows, further extending the useful lives of the assets.

The majority of our growth capital expenditures are related to the acquisition cost of new compressors that we add to our fleet. In addition to the cost of newly-acquired compressors, growth capital expenditures can also include the upgrading of major components on an existing compression package where the current configuration of the compression package is no longer in demand and the compressor is not likely to return to an operating status without the capital expenditures. These latter expenditures substantially modify the operating parameters of the compression package such that it can be used in applications for which it previously was not suited. Maintenance capital expenditures are related to major overhauls of significant components of a compression package, such as the engine, compressor and cooler, which return the components to a like-new condition, but do not modify the applications for which the compression package was designed.

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We generally invest funds necessary to purchase fleet additions when our idle equipment cannot be reconfigured to economically fulfill a project’s requirements and the new equipment expenditure is expected to generate economic returns over its expected useful life that exceed our cost of capital. In response to the impact that we anticipate the COVID-19 pandemic will have on our customer demand, we decreased our planned capital expenditures for 2020, and currently plan to spend a total of approximately $128 million to $140 million, primarily consisting of approximately $75 million to $80 million for growth capital expenditures and approximately $30 million to $33 million for maintenance capital expenditures.

Financial Resources

Credit Facility

During the nine months ended September 30, 2020 and 2019, the Credit Facility had an average daily balance of $711.8 million and $826.5 million, respectively. The weighted average annual interest rate on the outstanding balance under the Credit Facility, excluding the effect of interest rate swaps, was 2.7% and 4.3% at September 30, 2020 and December 31, 2019, respectively. As of September 30, 2020, there were $12.4 million letters of credit outstanding under the Credit Facility.

We must maintain certain consolidated financial ratios as defined in our Credit Facility agreement. As of September 30, 2020, the ratio requirements did not constrain our undrawn capacity and as such, $491.6 million was available for additional borrowings. As of September 30, 2020, we were in compliance with all covenants under the Credit Facility.

2022 Notes Redemption

On April 1, 2020, the 2022 Notes were redeemed at 100% of their $350.0 million aggregate principal amount plus accrued and unpaid interest of $10.5 million with borrowings from the Credit Facility. A debt extinguishment loss of $4.0 million related to the redemption was recognized in the second quarter of 2020. See Note 9 (“Long-Term Debt”) to our Financial Statements for further details.

Cash Flows

Our cash flows from operating, investing and financing activities, as reflected in our condensed consolidated statements of cash flows, are summarized below (in thousands):

 

Nine Months Ended

September 30, 

    

2020

    

2019

Net cash provided by (used in):

 

  

 

  

Operating activities

$

266,834

$

223,625

Investing activities

 

(81,995)

 

(459,196)

Financing activities

 

(187,048)

 

233,387

Net decrease in cash and cash equivalents

$

(2,209)

$

(2,184)

Operating Activities

The increase in net cash provided by operating activities was primarily due to decreases in costs of sales, cash SG&A expenses, contract costs, transaction-related costs and accounts receivable. These cash inflows were partially offset by decreases in revenue and deferred revenue, the receipt of cash proceeds in 2019 from sales and use tax audit settlements and an increase in restructuring charges.

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Investing Activities

The decrease in net cash used in investing activities was primarily due to $214.2 million cash paid in the Elite Acquisition in 2019, a $173.1 million decrease in capital expenditures and proceeds of $33.0 million from the March 2020 and July 2020 dispositions, partially offset by a $41.6 million decrease in proceeds from other sales of property, plant and equipment, $30.0 million of which related to proceeds from the Harvest Sale in 2019.

Financing Activities

The change in net cash provided by (used in) financing activities was primarily due to $117.0 million of net repayments of long-term debt in 2020 compared to $299.0 million of net borrowings in 2019 and a $10.2 million increase in dividends paid to stockholders, partially offset by a $7.9 million decrease in payments for debt issuance costs.

Dividends

On October 30, 2020, our Board of Directors declared a quarterly dividend of $0.145 per share of common stock to be paid on November 18, 2020 to stockholders of record at the close of business on November 12, 2020. Any future determinations to pay cash dividends to our stockholders will be at the discretion of our Board of Directors and will be dependent upon our financial condition, results of operations and credit and loan agreements in effect at that time and other factors deemed relevant by our Board of Directors.

Off-Balance Sheet Arrangements

For information on our obligations with respect to letters of credit and performance bonds see Note 9 (“Long-Term Debt”) and Note 20 (“Commitments and Contingencies”), respectively, to our Financial Statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk associated with changes in the variable interest rate of our Credit Facility. We use derivative instruments to manage our exposure to fluctuations in this variable interest rate and thereby minimize the risks and costs associated with financing activities. We do not use derivative instruments for trading or other speculative purposes.

As of September 30, 2020 and December 31, 2019, after taking into consideration interest rate swaps, we had $446.0 million and $113.0 million, respectively, of outstanding indebtedness that was effectively subject to variable interest rates. A 1% increase in the effective interest rate on our outstanding debt subject to variable interest rates at September 30, 2020 and December 31, 2019 would have resulted in an annual increase in our interest expense of $4.5 million and $1.1 million, respectively.

See Note 17 (“Derivatives”) to our Financial Statements for further information regarding our use of interest rate swaps in managing our exposure to interest rate fluctuations.

Item 4. Controls and Procedures

This Item 4 includes information concerning the controls and controls evaluation referred to in the certifications of our Chief Executive Officer and Chief Financial Officer required by Rule 13a-14 of the Exchange Act included in this Quarterly Report as Exhibits 31.1 and 31.2.

Management’s Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management to allow timely decisions regarding required disclosures.

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As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act), which are designed to provide reasonable assurance that we are able to record, process, summarize and report the information required to be disclosed in our reports under the Exchange Act within the time periods specified in the rules and forms of the SEC. Based on the evaluation, as of September 30, 2020 our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to management, and made known to our principal executive officer and principal financial officer, on a timely basis to ensure that it is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of business, we are involved in various pending or threatened legal actions. While we are unable to predict the ultimate outcome of these actions, we believe that any ultimate liability arising from any of these actions will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends. However, because of the inherent uncertainty of litigation and arbitration proceedings, we cannot provide assurance that the resolution of any particular claim or proceeding to which we are a party will not have a material adverse effect on our consolidated financial position, results of operations or cash flows, including our ability to pay dividends.

Item 1A. Risk Factors

The following risk factors became significant to us in the nine months ended September 30, 2020 and should be read in conjunction with the risk factors previously disclosed in our 2019 Form 10-K.

The COVID-19 pandemic is expected to significantly reduce demand for our services, and may have a material adverse impact on our financial condition, results of operations and cash flows.

The effects of the COVID-19 pandemic, including actions taken by businesses and governments, have resulted in a significant and swift reduction in U.S. economic activity. These effects have materially adversely affected the demand for oil and, to a lesser extent, natural gas, and are expected to have a negative impact on demand for our services and products. The collapse in the demand for oil caused by this unprecedented global health and economic crisis, coupled with oil oversupply, is expected to adversely impact the demand for our services, which in turn could adversely impact our financial condition, results of operations and cash flows.

While the magnitude and duration of potential social, economic and labor instability as a direct result of the COVID-19 pandemic cannot be estimated at this time, we are closely monitoring the effects of the pandemic on commodity demands and on our customers, as well as on our operations and employees. These effects may include adverse revenue and net income effects; disruptions to our operations and supply chain; customer shutdowns of oil and gas exploration and production; employee impacts from illness, school closures and other community response measures; and temporary inaccessibility or closures of our facilities or the facilities of our customers and suppliers.

The extent to which our operating and financial results are affected by the COVID-19 pandemic will depend on various factors and consequences beyond our control, such as the duration and scope of the pandemic; additional actions by businesses and governments in response to the pandemic; and the speed and effectiveness of responses to combat the virus. The COVID-19 pandemic, and the volatile regional and global economic conditions stemming from the pandemic, could also aggravate the other risk factors that we identify in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019. The COVID-19 pandemic also may materially adversely affect our operating and financial results in a manner that is not currently known to us or that we do not currently consider to present significant risks to our operations.

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Our ability to use NOLs to offset future income may be limited.

Our ability to use any NOLs generated by us could be substantially limited if we were to experience an “ownership change” as defined under Section 382 of the Code. In general, an “ownership change” would occur if our “5-percent stockholders,” as defined under Section 382 of the Code, including certain groups of persons treated as “5-percent stockholders,” collectively increased their ownership in us by more than 50 percentage points over a rolling three-year period. An ownership change can occur as a result of a public offering of our common stock, as well as through secondary market purchases of our common stock and certain types of reorganization transactions. We have experienced ownership changes, which may result in an annual limitation on the use of its pre-ownership change NOLs (and certain other losses and/or credits) equal to the equity value of our stock immediately before the ownership change, multiplied by the long-term tax-exempt rate for the month in which the ownership change occurs. Market volatility due to reduced demand from the COVID-19 pandemic and oil oversupply may cause increased interest in our common stock, which may result in an additional ownership change. Due to the COVID-19 pandemic, the U.S. Federal Reserve has lowered the long-term tax-exempt rate. Additionally, our equity value has decreased due to the above-mentioned impacts of the COVID-19 pandemic and oil oversupply. Both of these changes could further limit our use of pre-ownership change NOLs if we experienced an additional ownership change. Furthermore, the IRS has recently proposed regulations that would prevent us from using unrealized built-in gains to increase this limitation. If these regulations were finalized and we experienced an ownership change our ability to use our NOLs may be limited. Such a limitation could, for any given year, have the effect of increasing the amount of our U.S. federal income tax liability, which would negatively impact the amount of after-tax cash available for distribution to our stockholders and our financial condition.

Item 2. Purchases of Equity Securities by Issuer and Affiliated Purchasers

The following table summarizes our purchases of equity securities during the three months ended September 30, 2020:

Maximum

Number of Shares

Total Number of

That May Yet be

Average

Shares Purchased

Purchased Under

Total Number

Price

as Part of Publicly

the Publicly

of Shares

Paid per

Announced Plans

Announced Plans

Purchased (1)

Share

or Programs

or Programs

July 1, 2020 — July 31, 2020

    

    

$

    

N/A

    

N/A

August 1, 2020 — August 31, 2020

 

138,922

 

6.92

 

N/A

 

N/A

September 1, 2020 — September 30, 2020

 

 

 

N/A

 

N/A

Total

 

138,922

6.92

 

N/A

 

N/A

(1)Represents shares withheld to satisfy employees’ tax withholding obligations in connection with the vesting of restricted stock awards during the period.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

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Item 6. Exhibits

Exhibit No.

    

Description

2.1

Asset Purchase Agreement, dated as of June 23, 2019, by and among Archrock Services, L.P., Archrock, Inc. and Elite Compression Services, LLC, incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed on June 24, 2019

2.2

Asset Purchase Agreement, dated as of June 23, 2019, by and between Archrock Services, L.P. and Harvest Four Corners, LLC, incorporated by reference to Exhibit 2.2 of the Registrant’s Current Report on Form 8-K filed on June 24, 2019

3.1

Composite Certificate of Incorporation of Archrock, Inc. (as amended as of November 3, 2015), incorporated by reference to Exhibit 3.3 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2015

3.2

Third Amended and Restated Bylaws of Exterran Holdings, Inc. (now Archrock, Inc.), incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed on March 20, 2013

3.3

Amendment No. 1 to Third Amended and Restated Bylaws of Archrock, Inc., incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K filed on May 5, 2020

4.1

Indenture, dated as of March 21, 2019, by and among Archrock Partners, L.P., Archrock Partners Finance Corp., the guarantors party thereto and Wells Fargo Bank, National Association, as trustee, incorporated by reference to Exhibit 4.1 of the Registrant’s Current Report on Form 8-K filed on March 21, 2019

4.2

Indenture, dated as of December 20, 2019, by and among Archrock Partners, L.P., Archrock Partners Finance Corp., the guarantors party thereto and Wells Fargo Bank, National Association, as trustee, incorporated by reference to Exhibit 4.1 of the Registrant’s Current Report on Form 8-K filed on December 20, 2019

31.1*

Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2*

Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1**

Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2**

Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.1*

Interactive data files pursuant to Rule 405 of Regulation S-T

104.1*

Cover page interactive data files pursuant to Rule 406 of Regulation S-T

*      Filed herewith.

**    Furnished, not filed.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Archrock, Inc.

By:

/s/ Douglas S. Aron

Douglas S. Aron

Senior Vice President and Chief Financial Officer

(Principal Financial Officer)

By:

/s/ Donna A. Henderson

Donna A. Henderson

Vice President and Chief Accounting Officer

(Principal Accounting Officer)

November 3, 2020

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