Solaris Energy Infrastructure, Inc. (SEI) FY 2021 MD&A

Item 7.      Management’s Discussion and Analysis of Financial Condition and Results of Operations

Unless the context requires otherwise, references in this Annual Report to the "Company," "Solaris," "we," "us" and "our" refer to (i) Solaris Oilfield Infrastructure, LLC ("Solaris LLC") and its consolidated subsidiaries prior to the completion of our initial public offering and (ii) Solaris Oilfield Infrastructure, Inc. ("Solaris Inc.") and its consolidated subsidiaries following the completion of our initial public offering. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and related notes. This section of this Form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Part II, Item 7. “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020. The following discussion contains “forward-looking statements” that reflect our plans, estimates, beliefs and expected performance. Our actual results may differ materially from those anticipated as discussed in these forward-looking statements as a result of a variety of risks and uncertainties, including those described above in “Cautionary Statement Regarding Forward-Looking Statements” and “Risk Factors” included elsewhere in this Annual Report, all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forward-looking events discussed may not occur. We assume no obligation to update any of these forward-looking statements except as otherwise required by law.

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Overview

We design and manufacture specialized equipment, which combined with field technician support, logistics services and our software solutions, enables us to provide a service offering that helps oil and natural gas operators and their suppliers to drive efficiencies and reduce oil and gas development costs and environmental impact. The majority of our revenue is currently derived from providing equipment and services related to our mobile proppant and fluid management systems and our last mile logistics management services. We also generate revenue from new technology and offerings that work in conjunction with our mobile proppant and fluid management systems, including our AutoBlend™ integrated electric blender and proprietary top fill equipment. Our systems and equipment are deployed in most of the active oil and natural gas basins in the United States.

Recent Trends and Outlook

The oil and natural gas industry is continuing its broad recovery since 2020, as global supply and demand dynamics are improving. Tightening supply fundamentals, together with growing global demand, drove WTI oil prices to a high of over $90 per barrel in February 2022 from $52 in January 2021. While the improvement in commodity prices has driven an increase in drilling and completion activity in North America, overall activity levels in North America have been impacted by capital discipline among many operators.

North American land activity improved throughout 2021 as the Baker Hughes Land rig count increased 66% since the start of the year to 571 rigs at year-end, compared to a 49% increase in our fully utilized systems since the fourth quarter of 2020. Overall, demand for our offerings is predominantly influenced by the level of oil and natural gas well drilling and completion activity. While our fully utilized systems are highly correlated with US land rig count activity over longer periods, timing differences between drilling and completion activity can result in lags of one to two quarters or longer.

The sustainability of favorable supply-demand dynamics and a strong commodity environment will depend on multiple factors, including any further supply chain disruptions or potential regulatory changes. Recent consolidation amongst some of our E&P and oil service customers combined with financial discipline from publicly traded energy companies has reduced industry-wide capital spending, resulting in activity levels that remain below pre-pandemic levels despite the recovery in commodity prices. Additionally, consolidation can drive procurement strategy changes, which has historically resulted in both market share gains and losses for the Company. We expect both consolidation and financial discipline will likely continue to be important themes for the energy industry going forward.

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Results of Operations

Year Ended December 31, 2021 Compared to Year Ended December 31, 2020

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Revenue

Revenue increased $56.2 million, or 55%, to $159.2 million for the year ended December 31, 2021 compared to $103.0 million for the year ended December 31, 2020. Revenue increased mainly due to an increase increase in demand for our products and services. Mobile proppant systems on a fully utilized basis increased from 45 systems for the year ended December 31, 2020 to 57 systems for the year ended December 31, 2021, in response to higher overall activity levels of our customers, driven primarily by stronger commodity prices.

Cost of Services

Cost of services, excluding depreciation and amortization expense increased $49.7 million, or 76%, to $115.5 million for the year ended December 31, 2021 compared to $65.8 million for the year ended December 31, 2020. The increase was primarily due to operating costs related to an increase in demand for our products and services. Cost of services as a percentage of revenue was 73% and 64% for the year ended December 31, 2021 and 2020, respectively.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, excluding depreciation and amortization increased $2.8 million, or 17%, to $19.3 million for the year ended December 31, 2021 compared to $16.5 million for the year ended December 31, 2020. The increase is primarily due to increases in headcount and professional fees.

Impairment Losses

As a result of risks and uncertainties associated with volatility in global oil markets, which were exacerbated by COVID-19, and the expected impact on our business, results of operations and earnings, we recorded impairment losses and other charges of $37.8 million, $4.2 million, $2.8 million, $2.6 million and $0.4 million in relation to property, plant and equipment, goodwill, right of use assets, and inventories and other assets, respectively, in the year ended December 31, 2020. We did not record impairment losses in the year ended December 31, 2021.

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Other Operating (Income) Expense

Other operating (income) expense decreased $8.1 million, or 140% to income of $2.4 million for the year ended December 31, 2021 compared to the expense of $5.8 million for the year ended December 31, 2020. The Company qualified for federal government assistance through employee retention credit provisions of the Consolidated Appropriations Act of 2021. During the year ended December 31, 2021, the Company recorded $3.1 million of employee retention credits in other income on its consolidated income statements. As of December 31, 2021, $1.2 million of the credits have been received and $1.9 million is included in prepaid expenses and other current assets on the consolidated balance sheet. The calculation of the credit is based on employees continued employment and represents a portion of the wages paid to them. For income tax purposes, the credit will result in decreased expense related to the wages it offsets in the period received. Other operating expenses in the year ended December 31, 2020 primarily relate to credit losses, loss on disposal of assets, severance costs and the write off of prepaid purchase orders that were not fulfilled.

Provision for Income Taxes

During the year ended December 31, 2021, we recognized a combined United States federal and state expense for income taxes of $0.6 million, an increase of $9.6 million as compared to the $9.0 million income tax benefit we recognized during the year ended December 31, 2020. This change was attributable to lower operating losses. The effective combined United States federal and state income tax rates were (98.7)% and 14.9% for the year ended December 31, 2021 and 2020, respectively. The effective tax rate differed from the statutory rate primarily due to Solaris LLC’s treatment as a partnership for United States federal income tax purposes. The effective tax rate for 2021 was higher than the effective tax rate for 2020 primarily due to the impact of permanent differences on a smaller operating loss.

Comparison of Non-GAAP Financial Measures

We view EBITDA and Adjusted EBITDA as important indicators of performance. We define EBITDA as net income, plus (i) depreciation and amortization expense, (ii) interest expense and (iii) income tax expense, including franchise taxes. We define Adjusted EBITDA as EBITDA plus (i) stock-based compensation expense and (ii) certain non-cash items and any extraordinary, unusual or non-recurring gains, losses or expenses.

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EBITDA and Adjusted EBITDA should not be considered in isolation or as substitutes for an analysis of our results of operation and financial condition as reported in accordance with accounting standards generally accepted in the United States (“GAAP”). Net income is the GAAP measure most directly comparable to EBITDA and Adjusted EBITDA. EBITDA and Adjusted EBITDA should not be considered alternatives to net income presented in accordance with GAAP. Because EBITDA and Adjusted EBITDA may be defined differently by other companies in our industry, our definitions of EBITDA and Adjusted EBITDA may not be comparable to similarly titled measures of other companies, thereby diminishing their utility.

The following table presents a reconciliation of Net income to EBITDA and Adjusted EBITDA for each of the periods indicated.

Year Ended December 31, 2021 Compared to Year Ended December 31, 2020: EBITDA and Adjusted EBITDA

EBITDA increased $59.7 million to $26.9 million for the year ended December 31, 2021 compared to $(32.9) million for the year ended December 31, 2020. Adjusted EBITDA increased $4.5 million to $30.1 million for the year ended December 31, 2021 compared to $25.6 million for the year ended December 31, 2020. The increases in EBITDA and Adjusted EBITDA were primarily due to the changes in revenues and expenses, discussed above.

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Liquidity and Capital Resources

Overview

Our primary sources of liquidity to date have been cash flows from operations, borrowings under our credit agreements and proceeds from equity offerings. Our primary uses of capital have been to fund ongoing operations, capital expenditures to support organic growth, including our fleet development and related maintenance and fleet upgrades, repurchase shares of Class A common stock in the open market, and pay dividends. Although no assurance can be given, depending upon market conditions and other factors, we may also have the ability to issue additional equity and debt if needed.

As of December 31, 2021, cash and cash equivalents totaled $36.5 million. We have no borrowings outstanding under our Credit Agreement and have $50.0 million of available borrowing capacity. We believe that our cash on hand, operating cash flow and available borrowings under our Credit Agreement will be sufficient to fund our operations for at least the next 12 months. See Note 8. “Senior Secured Credit Facility” under Item 8. “Financial Statements and Supplementary Data” for additional information regarding our Credit Facility.

Cash Flows

The following table summarizes our cash flows for the periods indicated:

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Analysis of Cash Flow Changes for Year Ended December 31, 2021 Compared to Year Ended December 31, 2020

Operating Activities. Net cash provided by operating activities was $16.5 million for the year ended December 31, 2021, compared to net cash provided by operating activities of $43.9 million for the year ended December 31, 2020. The decrease of $27.4 million in operating cash flow was primarily attributable to changes in working capital, including an increase in accounts receivable and prepaid expenses.

Investing Activities. Net cash used in investing activities was $19.5 million for the year ended December 31, 2021, compared to $3.8 million for the year ended December 31, 2020. The increase in investing activities of $15.7 million is primarily due to capital expenditures related to enhancements to our fleet and for new technologies.

Financing Activities. Net cash used in financing activities of $20.8 million for the year ended December 31, 2021, was primarily related to quarterly dividends of $19.2 million and $0.8 million of payments related to vesting of stock-based compensation. Net cash used in financing activities of $46.6 million for the year ended December 31, 2020 was primarily related to $26.7 million of share repurchases and quarterly distributions and dividends of $19.0 million.

Future sources and uses of cash

Our material cash commitments consist primarily of obligations under our Credit Agreement, Tax Receivable Agreement, finance and operating leases for property and equipment, and purchase obligations as a part of normal operations. We have no material off balance sheet arrangements as of December 31, 2021, except for purchase commitments under supply agreements disclosed below.

In 2022, we expect to pay approximately $0.2 million in commitment fees on our Credit Agreement, calculated based on the unused portion of lender commitments, at the applicable commitment fee rates of 0.25% and 0.375%.

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We currently expect to make payments of approximately $1.2 million under the Tax Receivable Agreement within the next twelve months. Future amounts payable under the Tax Receivable Agreement are dependent upon future events. See Note 10. “Income Taxes” under Item 8. “Financial Statements and Supplementary Data” for additional information regarding the Tax Receivable Agreement.

See Note 7. “Leases” under Item 8. “Financial Statements and Supplementary Data” for additional information regarding scheduled maturities of finance and operating leases.

As of December 31, 2021, we had purchase obligations of approximately $9.3 million payable within the next twelve months. See Note 12. “Commitments and Contingencies” under Item 8. “Financial Statements and Supplementary Data” for information regarding scheduled contractual obligations.

Critical Accounting Policies and Estimates

The preparation of financial statements requires the use of judgments and estimates. Our critical accounting policies are described below to provide a better understanding of how we develop our assumptions and judgments about future events and related estimates and how they can impact our financial statements. A critical accounting estimate is one that requires our most difficult, subjective or complex estimates and assessments and is fundamental to our results of operations.

We base our estimates on historical experience and on various other assumptions we believe to be reasonable according to the current facts and circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We believe the following are the critical accounting policies used in the preparation of our combined financial statements, as well as the significant estimates and judgments affecting the application of these policies. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in this report.

Revenue Recognition

Our revenue is derived from short-term contracts and consists of fees charged to customers for the use of our equipment and labor services, mobilization and transportation of our equipment, services coordinating the transportation of proppant delivery to our equipment, transloading services and for inventory software services, each of which are considered to be separate performance obligations.

The majority of our contracts contain multiple performance obligations, such as work orders containing a combination of equipment, transportation, and labor services. We allocate the transaction price to each performance obligation identified in the contract based on relative stand-alone selling prices, or estimates of such prices, and recognize the related revenue as control of each individual product or service is transferred to the customer, in satisfaction of the corresponding performance obligations. We measure progress using an input method based on resources consumed or expended relative to the total resources expected to be consumed or expended. We assess our customers’ ability and intention to pay, which is based on a variety of factors including historical payment experience and financial condition and we typically charge our customers on a weekly or monthly basis.

Variable consideration typically may relate to discounts, price concessions and incentives. The Company estimates variable consideration based on the amount of consideration we expect to receive. The Company accrues revenue on an ongoing basis to reflect updated information for variable consideration as performance obligations are met.

Value of Long-Lived Assets, Definite-Lived Intangible Assets and Goodwill

We carry a variety of long-lived assets on our balance sheet including property, plant and equipment, goodwill and other intangibles. Impairment is the condition that exists when the carrying amount of a long-lived asset exceeds its fair value, and any impairment charge that we record reduces our operating income. Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. We conduct impairment tests on goodwill annually, on October 31, or more frequently whenever events or changes in circumstances indicate an

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impairment may exist. We conduct impairment tests on long-lived assets, other than goodwill, whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Key estimates relate to the fair value and recoverability of carrying values of long-lived assets, definite-lived intangible assets and goodwill. These estimates include management’s short-term and long-term forecast of operating performance, including revenue growth rates and expected profitability margins, estimates of the remaining useful life and service potential of the assets, a discount rate based on our weighted average cost of capital, forecasted capital expenditures and the timing of expected future cash flows based on market conditions. Impairment assessments also incorporate inherent uncertainties, including projected commodity pricing, supply and demand for our services and future market conditions, which are difficult to predict in volatile economic and actual results could materially differ from the estimated assumptions utilized in our forecasts.

See Note 2. “Summary of Significant Accounting Policies — Recently Issued Accounting Standards” under Item 8. “Financial Statements and Supplementary Data” for impairments and other charges recorded during the year ended December 31, 2020. If market conditions further deteriorate, including crude oil prices significantly declining and remaining at low levels for a sustained period of time, we could be required to record additional impairments of the carrying value of our long-lived assets, definite-lived intangible assets or goodwill in the future which could have a material adverse impact on our operating results.

Income Taxes

Solaris Inc. is a corporation and, as a result, is subject to United States federal, state and local income taxes. For the year ended December 31, 2021 we recognized a combined United States federal and state expense for income taxes of $0.6 million. For the year ended December 31, 2020 we recognized an income tax benefit of $9.0 million. Solaris LLC is treated as a partnership for United States federal income tax purposes and therefore does not pay federal income tax on its taxable income. Instead, the Solaris LLC members are liable for federal income tax on their respective shares of the Company’s taxable income reported on the members’ United States federal income tax returns.

We determine deferred tax assets and liabilities on the basis of the differences between the book value and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period in which the enactment date occurs.

We routinely evaluate the realizability of our deferred tax assets by assessing the likelihood that our deferred tax assets will be recovered based on all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, estimates of future taxable income, tax planning strategies and results of operations. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including revenue growth and operating margins, among others. As of December 31, 2021 and 2020, we had $62.9 million and $59.8 million of deferred tax assets, respectively.

See Note 10. “Income Taxes” under Part II, Item 8. “Financial Statements and Supplementary Data.” for additional information.

Tax Receivable Agreement

As described in Note 10. “Income Taxes” under Part II, Item 8. “Financial Statements and Supplementary Data”, Solaris Inc. is a party to the Tax Receivable Agreement under which it is contractually committed to pay the TRA Holders 85% of the net cash savings, if any, in United States federal, state and local income tax and franchise tax that Solaris Inc. actually realizes or is deemed to realize in certain circumstances in periods after our initial public offering as a result of certain increases in tax basis, and certain tax benefits attributable to imputed interest as a result of Solaris Inc.’s acquisition (or deemed acquisition for United States federal income tax purposes) of Solaris LLC Units in connection with the IPO or pursuant to an exercise of the Redemption Right or the Call Right (each as defined in the Solaris LLC Agreement) and additional tax basis arising from any payments Solaris Inc. makes under the Tax Receivable Agreement.

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The projection of future taxable income involves estimates which require significant judgment. Actual taxable income may differ from our estimates, which could significantly impact the liability relating to the Tax Receivable Agreement. The Company accounts for amounts payable under the Tax Receivable Agreement in accordance with Accounting Standard Codification (“ASC”) Topic 450, Contingencies.

Recent Accounting Pronouncements

See Note 2. “Summary of Significant Accounting Policies — Recently Issued Accounting Standards” under Item 8. “Financial Statements and Supplementary Data” for a discussion of recent accounting pronouncements.

Under the JOBS Act, we meet the definition of an “emerging growth company,” which allows us to have an extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act, however, we elected to opt out of such exemption (this election is irrevocable).

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