Description

Flowtek is a provider of chemicals that help oil and gas to flow more rapidly through the pores in shale rock.  Terpenes are naturally occurring solvents present in many plants. Pine Sol floor cleaner is perhaps the most familiar use of terpenes as a solvent.  The clean feel of your hands after peeling an orange is because terpenes are present in orange peels also. Flowtek obtains terpenes as a leftover product from Florida Chemicals manufacture of natural citrus flavorings used in foods.  They engineer the terpenes by attaching various surfactants to the terpene solvent core resulting in 50+ different varieties of complex nanofluids (CnF). The surfactants break surface tension between the oil and/or gas and the walls of the pores in the shale.  Adding CnF’s to fracking water helps the oil and gas to leak out of shale in years instead of decades. Commodity chemicals also can improve flow rates, but the nano-scale molecules in CnFs are especially proficient in penetrating tiny pores in shale rock resulting in superior production.  Flowtek’s CnF’s are protected by 70 granted patents.

Flowtek has a notorious history.  In 2014, investors were quite excited about the relatively new CnF technology and bid the stock to $32.  In the spring of 2015, a well-know value investor, David Nierenberg, bought shares around $14. Today the stock trades near $2.  Nierenberg went activist joining the board of directors in the summer of 2018, and there’s been big changes at the company since.  A new respected CFO joined in December of 2018. Much needed cost-cutting including two rounds of layoffs followed, and inventory reductions have generated cash.  A new accomplished V.P. of sales joined in April 2019. The sales force has already been reworked hiring new people with chemistry expertise while parting with others that were less suitable for the new prescriptive chemistry business model.  On Dec. 22, 62 year old geologist and oil & gas emerging technology investor John Gibson Jr. joined as CEO and COB. His compensation is heavy on incentives including 570K shares of restricted stock and 2 million options priced at $1.93 that vest contingent on the stock price reaching targets prior to 2024.  Full vesting requires a stock price of $7.20. Flowtek’s complex nanofluids effectiveness has been a question, and Gibson previously “led a team focused on opportunities in emerging oil and gas technologies”.  He should understand what he’s getting into.  Paul Hobby, from the family for which Hobby Airport in Houston is named, also sits on the board now and the capital allocation committee in particular.  His addition was part of a standstill agreement in the Spring of 2019 with BLR partners, a significant shareholder. Hobby airport is named after his father, but Paul is accomplished in oil & gas investment himself.  Notably, his firm purchased an enhanced oil recovery company earlier this year and that's an area Flotek is pursuing. Ryan Ezell joined the company from Halliburton in September as V.P. of Operations. This company is no longer run by the people that ran it into the ground.

In February, 2019 the company sold Florida Chemical to ADM for $175 million and paid off all their debt.  Nierenberg and the new CFO co-chaired a committee to evaluate, with the assistance of Citi advisers, what should be done with the remaining $1.70 per share in cash.  On the 2nd quarter conference call in early August, Nierenberg reported the committee’s findings.  On the 1st quarter call, Nierenberg had suggested a special dividend or dutch auction was under consideration, but the conclusion was that there would be no return of cash to shareholders.  He cited the reason, “If I may borrow from Ronald Reagan, there definitely is a pony in this room”. This is a reference to one of President Reagan’s favorite jokes where an excessively “optimistic” 8 year-old boy receives manure for Christmas and interprets it as a sign that Santa brought him a pony; he just couldn’t find it yet.  It’s a fitting reference for Flowtek , as the manure the company has produced is visible to all, but Nierenberg thinks there definitely is a hidden “pony in this room”. In fact, he continued and specifically identified the pony. “If I may borrow from Ronald Reagan, there definitely is a pony in this room, … and the pony’s name is CnF”.  The plan is to use the cash from the Florida Chemical sale to survive the current oil and gas downturn, and then grow the CnF business organically and with a synergistic acquisition. Pursuit of acquisition opportunities has been delayed, but with the addition of Gibson as ceo now may pick up again. Gibson and Hobby are both oil & gas technology experts so the cash should get spent well. A production services provider to create synergies with their new enhanced oil recovery effort seems to be the desired target.

Nierenberg had just reviewed with Citi all the company’s operations including data on the effectiveness of CnFs.  He evidently thinks CnFs are as good as getting a pony for Christmas when you’re eight years old. He’s been backing this assessment with open market purchases this year, with the bulk purchased around $3.50 in June.  This optimism is quite a contrast to the history of this company, and the recent history of CnF sales. In 2017, Flowtek sold about $250 million in chemicals. In early 2018, Halliburton stopped distributing CnFs and for the year sales fell to $180 million.  In the just reported quarter, sales ran at an annualized rate of just $87 million. There’s a long history of financial losses like you’d expect from a company with a stock price that fell from $32 in 2014 to $2 and change today. A few years ago, there was a short-seller article that alleged that the CnF chemicals didn’t work.  Sales data, Halliburton’s discontinuance, and Flowtek’s subsequent stock price seems consistent with the short seller’s opinion.

There’s a prior VIC recommendation and a Seeking Alpha article on Flowtek.  Both emphasize how cheap the stock is. Cash amounts to $1.82 a share with tangible book at $2.89 a share.  Mr. Market is pleading with you to please take some shares from him. The perception is that the company’s business is worse than worthless.  Nierenberg had the opportunity to distribute cash to shareholders, however, and declined. For that matter, he could have just sold the remaining fracking chemicals business and wrapped this all up as some investors on conference call have counseled. Nierenberg believes their patented chemicals have value and there's exceptional opportunities in the distressed oil & gas sector to use the cash.

That fracking chemicals business is sub-scale.  The fixed costs are too high for the current revenue run rate, and the company is losing money.  They need $45 million in revenue to break even, and they only got $35 million in Q2 and $22 million in Q3.  Flowtek only gets paid when an E&P fracks a well, and this year well completions are falling. Many fracking companies have been operating on bond sales bought by pension plans desperate for yield for the baby boomers’ cash.  This year, the flow of money seems to be cut off as investors demand positive cash flows. Nierenberg notes on the Q2 call that many formerly mighty oil and gas companies are now trading below a dollar. So why is Nierenberg holding onto the Florida Chemical cash to invest further into a sub-scale business with an apparently failed product sold to an oil & gas industry that is crashing?  

The short article was right.  The company was selling premium priced CnF’s to well operators who were not getting any extra oil or gas.  The CnF’s were flawed. But some well operators were getting more oil, 30% to 40% more, with a quick payback of the extra cost.  The early science of fracking is described in the book Saudi America as being based on “Hey look what Jim is doing over there.”  Start-up fracking companies had no clue; Jim poured CnF’s into one well and the oil gushed, so let’s pour the same stuff into every well.  It’s now understood that the chemistry of the specific well matters. High levels of brine kill the effectiveness of some CnFs, the minerals present matter, the clay present matters, the drill length matters.  Sometimes the CnF mix worked, and sometimes it didn’t. Flotek’s reputation and the reputation of CnFs have been trashed by customers and competitors that observed “no work” results.

The thesis here is that the shorts were right a few years ago, but so is Nierenberg now.  The company had a problem, but has fixed the problem. The clue is that in addition to the 70 granted patents, the company has an additional 70 patents pending.  It takes about 3.5 years to get a patent granted, so the 15+ year-old company has doubled up on its I.P. in the last 3.5 years. In the 3rd quarter of 2016, the company opened a new Research and Innovation center in Houston and retained a lot of Ph.D’s.  R&D spend in 2017 was $13.6 million and has continued at a significant (although lower) rate since. Data analytics, including the use of IBM’s Watson, was used to analyze production data from wells in all the basins along with other available data like the chemistry of cuttings, drill length, oil and water sample testing, etcetera.  The company now knows which of their 50+ CnFs will work for an individual well based on well data and the well’s test results on samples and cuttings. They prescribe chemistry that will work for that particular well. If they don’t have a CnF that works, they’ll just prescribe a commodity surfactant instead, like the stuff that’s in dishwashing liquid.  They’ll deliver the custom chemicals themselves instead of having Halliburton dump some general mix of chemicals into every well. “Prescriptive chemistry management” just started in 2017, and the company is still convincing justifiably skeptical customers to try it. There’s six E&P’s that are currently taking advantage of Flotek’s “performance-based pricing” to try CnF’s against commodity mixes to see if they realize increased production for themselves.  Success in these trials is the company’s path to get to $45 million per quarter in revenue and ebitda break even.

There appears to be some new products to address some previously “no work” conditions.  A new CnF that works in high brine conditions was recently introduced (hence pending patents).  Nierenberg refers to the commercialization of newly developed products as part of the go-forward strategy (hence the pending patents).   However, even more significant is the company’s development of chemical enhanced oil recovery (EOR) methodology (hence the pending patents) using existing CnFs.  The company has a technical presentation on it available here https://www.flotekind.com/index.php/newsroom/item/1209-flotek-presentation-chemical-eor-in-tight-oil-pools.  EOR uses CnF’s for many months and years after a well is fracked to keep the oil flowing.   EOR could be attractive both to operators and Flowtek.  In tough times, cash-strapped operators reduce expensive well completions. EOR , however, can enhance their short-term cash flow by getting more oil out of existing wells without capital expenditures.  Flowtek could benefit in tough times from recurring sales of CnFs for EOR, just when their well-completion sales fall off a cliff. EOR requires a different delivery infrastructure, however.  Frackers show up at a well and are present for a few months.  They use CnFs while they are fracking a well. Then they are on their way to another well site.  EOR requires repeated applications to a well over perhaps 3 years. This requires repeated visits to the well, and Flowtek needs an efficient way to continually deliver their chemicals.  It could be that Nierenberg is hanging onto the cash to acquire or partner with a company that currently makes repeated well services visits. Adding Flowtek’s EOR services to the acquisition’s existing product line could be very efficient.  Finally, the new ceo in his introductory press release cites the “frack hit” problem.  " I believe the Company is ideally suited to address the industry's long-term needs, including increasing complexity surrounding well spacing and optimized completions variables."   This is a major problem where fracking of child wells destroys production in the parent well.  Flowtek can use chemicals to prevent the problem and/or resolve the problem at least in some cases.  The new ceo citing it indicates there may be real opportunity here.

Despite Flowtek’s history of producing only manure for many years, there’s potential for this to be a very nice business.  The CnFs they sell are a small part of the cost of drilling and operating an oil well, but they can boost production by 30%-40%.  The company’s presentations show paybacks in 2 or 3 months even at current oil prices. EOR is a lower cost operation, but still a CnF that can boost production pays for itself in just a couple of months.  Flowtek’s proprietary CnF-based completion fluids should be able to carry healthy margins. Publicly-traded Tetra Tech breaks out the financials for their proprietary CS Neptune conventional oil & gas completion fluids product line.  They’ve averaged 20% ebidta margins the last three years. Flowtek’s business is capital light, so with healthy margins, return on equity can be very nice. Furthermore, the company’s addressable market is $4 billion according to their investor presentations, so growth for a long time is possible.

Flowtek’s problems, management that operated poorly and didn’t control costs, CnF’s that sometimes didn’t work, and a business dependent on highly cyclical well completions, are all being addressed.  They may need an acquisition yet to make their new EOR business efficient. Acquisition prices in the fragmented and distressed oil and gas services area are currently right, and Flowtek has the cash to make an acquisition happen.   It’s not clear what will happen with Flowtek, but it’s possible this could turn into a nice business and a multi-bagger stock. Nierenberg just studied the company in detail, and he says there’s a pony in the room. He’s been backing his opinion with his own money.  Gibson is knowledgeable about fracking and agreed to take the ceo spot for a relatively modest salary and more generous incentives also. There’s a wide range of outcomes here, but the risk reward is attractive.

Risks: If Flowtek’s chemicals don’t gain traction there may be significant costs in shutting the business down.  They have leases to break on facilities in Houston, employees to pay severance, and a terpene supply contract with ADM.  The stock is trading only a little above cash, but in the worst case investors could lose significant money.

Catalyst

A massive restructuring is in process with replacement of ineffective management with very capable people