Description

2 years ago, Flotek (“FTK”) was a levered money losing diversified oil services company operating 3 oil focused segments, as well as a citrus chemical segment (“CICT”) that the market wasn’t quite sure what to make of. Today, FTK is an oil services focused specialty chemical company with one segment (“ECT”) that  trades at less than 0.3x pro forma EV/sales, has 2/3rds of its pro forma market cap in net cash, sells a non-commodity product that represents a small portion of total cost for their customers, while significantly improving customer IRRs, and that has formed a “Strategic Capital Committee” led by a known small cap activist that has skin in the game. 

IMPORTANTLY, THE MARKET IS MOSTLY UNAWARE OF THIS OPPORTUNITY BECAUSE ~$170M IN GROSS CASH ATTACHED TO THE SALE OF THE CITRUS SEGMENT HAS NOT YET APPEARED ON THE COMPANY’S BALANCE SHEET, a situation that will be rectified upon the closing of the transaction in Q1, and subsequent publication of Q1’19 financials in early May (and alluded to when the company reports FY18 on 3.6.19).  

I believe that in the very near future, Flotek will:

1)     Return capital to shareholders

2)     Appreciate significantly as quant based screeners digest the updated capital structure (see below), which will take place in a few weeks: 

3)  be sold to a strategic, who would likely pay at least 1.0x EV/ECT sales (~75% upside) for access to the company’s patents and technology             

The possibility for additional per share upside exists in the potential to:

1)  repurchase a large amount of stock before pursuing a sale and 

2)  realize a sale multiple significantly higher than 1.0x EV/sales, which is entirely possible based on precedent transactions, present unadjusted multiples, comp multiples, and the potential for very large synergies.

Importantly, even if a sale process disappoints vs. the above mentioned estimates, it is hard to imagine that the quant focused mechanical screeners that dominate the markets will not take notice of a company that has not reported net income in 4 years (due to cyclical end markets, and a bloated cost structure) switching from ~$45M in net debt to ~$120M in net cash on the balance sheet (assuming no operational change to cash), and since the deal is not expected to close until the end of Q1, the consolidated trailing revenue number will not fall off a cliff until after Q2.

Importantly, if a sale process is not pursued, I believe the company can stand on its own merits as they are continuing to cut costs, and their technology has recently been validated by major players in the energy world, which should lead to an uptick in sales independent of oil prices. Further, I believe that a recent change in go to market strategy negatively impacted T12M sales, but is in the process of correcting itself.

Lastly, while I acknowledge the unpredictability of oil related end markets, if the cycle does indeed turn for the worse, even before the presence of a known capital allocator leading the “Strategic Capital Committee,” the company showed a willingness to repurchase shares, suggesting that a near term downturn in oil markets would likely lead to a better outcome for investors with patient capital that are able to look through the vagaries of the cycle. 

If the cycle does improve, FTK has the potential to generate multi-bagger returns. 

Pro Forma Business Overview

FTK is in the business of maximizing horizontal frac well productivity through the production and sale of Complex Nano-Fluids (CnF), which are essentially combinations of surfactants, solvents, and other chemical compounds that are injected into a frac well in order to reduce surface tension, which eases the recovery of oil and gas.  I’m not an engineer, so in my crude (pun!) speak, basically, this stuff makes rocks slippery so oil can flow through them. The core of the chemistry is citrus based (ever notice how many soaps are citrus?), which means that the products are generally regarded as safe by the EPA.

The company has 50+ formulations, with 30+ regularly commercialized, covered by 50+ patents, and 78 pending patent applications.  The different formulations can be used to meet different needs, most notably around the local geology (ie one basin might require formula 1 due to the specific type of rock, and another might require formula 2 etc etc) and specific hydrocarbon in question.  Increasingly, the company is moving toward even more specifically crafted products through an offering they call Prescriptive Chemistry Management (PCM), in which they deliver a whole suite of customized chemistries direct to the customer, formulated for a specific well.

The products are more expensive than off the shelf additives, but numerous studies have shown that they improve well productivity to an extent that makes the upfront cost worth it as the oil is recovered faster, and the total cost of the well is lower, which improves IRRs and reduces spend. It should however be noted that a few years ago there was a short case claiming that this stuff was essentially snake oil (more on this below).

 How did we get here?   

As oil prices cratered in 2015-2016, the company announced a strategic review of the business, which led to cost cutting efforts (just like every other oil related business) and the sale of the commoditized Drilling Technologies and Production Technologies segments in 2017. The cost cutting efforts are ongoing (and in my opinion underwhelming to date), but the company has struggled to be profitable for the last few years as oil markets have suffered, and as the company made some operational changes. 

The real item of note is that on January 11^th, the company announced it would be selling its citrus chemicals business (known as Florida Chemical) to ADM for $175M (21.4x T12M segment EBITDA, 2.4x T12M segment sales).  After deal costs and working capital adjustments, remain-co FTK should receive somewhere between $165 and $170M, with negligible tax concerns due to existing NOLs (which will be mostly exhausted by this deal).

As the stock ended 2018 close to the $1 level and jumped to $2.75 on the deal announcement it would be a mistake to claim that “no one realizes what is going on” here, but I would argue that until the quants can scrape the fresh filings post deal close and realize that what was a money losing indebted company is now likely a breakeven at worst (more below) company with 2/3rds of its market cap in cash, there is still reason to believe that there is significant upside to the stock on a trading basis alone… especially when you consider that there is still ~14% of the float short.

Does it actually work: the short case 

As mentioned above, in years past there had been a short case based around the idea that Flotek’s CnFs were essentially snake oil, supported by the fact that years ago Flotek management was pitching an iPad based sales tool that allegedly could pull data on all oil wells in a specific geography and allow for productivity comparisons from well to well based on if FTK products were used or not used. The brief version is that shorts figured out that the data set was wrong and/or manipulated, which led to the belief that FTK’s products were garbage.  

To their credit, management did come out and say that there were in fact problems with the data, and this iPad based sales tool, which was once the focus of all the IR presentations, disappeared.  A class action suit claiming that there was intentional data manipulation was launched and then subsequently thrown out, which seems to vindicate management to an extent.

Further to the short case were claims that FTK’s studies that showed the product worked were cherry picked from small sample sizes. Additionally, declining sales through 2016 were pointed to as evidence that end users had realized that the product was garbage, and were abandoning it.  

From my perspective, first and foremost, the technology passes the common sense test. We all use a different household cleaner on our dishes than we do on our clothes, than we do on our windows, etc. etc. This is because different chemistries have different effects on different stains and different surfaces.  Common sense would suggest that different chemistries would also have different effects on different rock formations and different hydrocarbons.

Beyond the common sense angle, fears about the product being snake oil seem to have finally been put to rest by numerous studies that cover larger sample sizes, and the fact that the company has said that a year ago less than half of their customers were purchasing value added chemistries, while today more than 75% of them are.  Perhaps most importantly, in Q2’18 Saudi Arabia placed the single largest CnF order ever after “multiple years of research, testing and validation.” CEO John Chisholm later clarified that the relationship with Saudi Arabia is designed to be muti-year, and not just a one time order. While I suspect that the Saudi’s diligence was top notch, I have also spoken with a U.S. based independent engineer who assured me that the product does indeed work, and the increasing adoption seems to speak for itself.

In contrast to the short’s claims that the product just didn’t work, our diligence suggests that problems with poor performance and declining sales were largely tied to user error and the economic realities of the oil drilling business respectively. On the first point, a few years ago FTK’s CnFs were largely white labeled and sold and applied by the majors (HAL, SLB, etc.).  This led to over and/or under dosing, as well as problems getting the right formula to the right geography, both of which negatively impacted efficacy, and ultimately sales. If you want to lean toward the conspiracy theory side, it is worth noting that in 2015 Flotek announced they would be opening the “Flotek Store,” which allowed drillers to purchase directly from Flotek at wholesale prices, essentially cutting out the middle men… who then had user error issues.

Regardless, the real damage to sales came as oil prices cratered through 2016ish.  At this time, drillers were desperate to protect their balance sheets and prove that their completion costs were as low as possible so that they could access capital markets. As FTK’s products cost a driller more up front, with the full benefit only realized over the life of the well, drillers that were only concerned with near term cash flows dropped the product.

In sum, it was a good short when FTK was a $25 stock trading at 20+x peak earnings and management was (unintentionally) using suspect data to tell their story, but at this point the product has been validated, and the stock is trading for pennies on the dollar.

Item of note: normalized sales

Further to past difficulties with revenues, I believe that T12M ECT revenue significantly understates true potential. As mentioned previously, back in 2015 the company announced the Flotek Store, and they started rolling it out in 2016. For obvious reasons this did not please HAL, SLB and other big oil services players who had been taking white label FTK product and marking it up. Despite this displeasure, HAL and FTK continued to work together in N. America until Q1’18, at which point the company announced a change in go to market strategy and/or HAL – formerly FTK’s largest customer -  dumped FTK. The loss of this distributor relationship led to a 25% decline in sequential sales for the ECT segment at a time when rig count suggested sales should have been flat to up, and in Q2’18, the company took a $37M goodwill impairment charge in the ECT segment.  It should be noted that the company preannounced that Q1’18 would be soft on 4/23/18 and the stock traded down from $6 and change to $4 and change on the news.  At the time they cited “weather” and only later did the Haliburton angle become clear.  The stock continued to drift lower until the Q2 goodwill impairment saw the stock decline by another third.

While this sales drop was jarring, management had been – and continues to – pitch moving away from reliance on third parties as a positive as drillers attempt to take better control of their supply chain and costs in a world where $50-$70 price per barrel seems more likely than $100-$150. Specifically, management has noted that in 2015 less than 10% of their sales were direct to operator. Today, management has indicated that somewhere between 60% and 90% of sales are direct to operator, with the wide range a result of the fact that different people touch different products in different ways, so it is hard to get a clean compare.  In any case, after spending 2 quarters at depressed levels, sales have started to tick back up as FTK has adapted to life without relying on third party distributors. 

The real point of this is just to illustrate that while I rely on T12M ECT sales for valuation throughout this writeup, there is reason to believe that T12M ECT sales significantly understate potential due to this disruption.

Item of note: cost cutting

Like everyone else in the oil patch, when oil prices started falling down toward $30 per barrel in 2015 the company realized they had to make some cuts. Annualizing last quarter’s Corporate G&A indicates a $30M run rate (vs. $40M 2 years ago), and on the call following the CICT sale announcement, management announced they expected to cut another $5.5 million in SG&A.

necdotally, I have heard that CEO/Chairman Chisholm is more of a sales guy than an operator, and that there is still a lot of low hanging fruit that he simply can’t or won’t address.  Of particular note, last year he made it a point to call out on a conference call that he expected FY’17 executive salaries to be down by 15% YoY. Despite this call out, his personal comp was up 12%, which doesn’t make much sense when one figures that the business has been much simplified, and revenue much reduced. I believe this and other failures to act aggressively helped lead to the appointment of 2 new independent directors last summer…

Who are we partnered with?   

At the moment, the fate of investors seems to rest in the hands of David Nierenberg, who is leading the company’s Strategic Value Committee, which was formed when it became clear that $170M would shortly be landing in their lap. Nierenberg may be familiar to VIC members through his past associations with the Value Investing Congress, Manual of Ideas, and other activities that tend to catch the eye of VIC members.  It isn’t exactly clear to me if he has converted to a family office at this point in his life, but for ~30 years he ran a concentrated portfolio of 8-10 mostly micro and small cap stocks through the D3 Family of Funds. Throughout this period, he has taken activist stances and board seats on numerous occasions.  He is also the Chair of Glass Lewis’s Research Advisory Council, and Chair of the Ira Millstein Center at Columbia University, which is dedicated toward advancing corporate governance. 

Nierenberg first joined the board in summer of 2018, along with Kate Richards, who was previously a Goldman banker and PM at Serengeti and MSD, before founding a $1.5B AUM energy focused PE group known as Warwick Group. It may also be worth noting that Ms. Richards seemingly has deep and broad contacts in the energy world as her family founded ~$13B market cap company Devon Energy. As the linked article makes clear, Ms. Richards has extensive experience in data driven well economics, and I view her presence here as further confirmation of  the efficacy of FTK’s technology as she has surely done hands on well-level diligence. In my view, the addition of Nierenberg and Richards represents a significant change as the board is now tilted toward capital allocators and away from life-long energy guys that probably laugh about capital destruction in the oil industry while playing golf together.

Nierenberg has owned shares since 2015, owns ~3% of the company (about $5M worth), and appears to be deeply underwater on his position. $5M is obviously not huge dollar wise, but it does give him more ownership than anyone else on the board.  Combined with his impressive corporate governance credentials and the fact that he was chosen to lead the Strategic Capital Committee, I think it is safe to say that he has significant influence here.

For the most part, the rest of the board is unremarkable, with the CEO/Chairman John Chisholm owning about 1.8% of the company, and all executives and officers ex-Nierenberg owning about 4.8% of the company. It may be worth noting however that the CEO/Chair and other executives made open market purchases around the $3.40 level about a year ago… and it is further worth noting that CEO/Chairman John Chisholm would get about $7.3M in a change of control scenario.

The last executive worth highlighting is new CFO Elizabeth Wilkinson, who joined in late December. Reviewing her CV suggests she is a hired gun of sorts, as she has done numerous short stints over the years, and until recently was a consultant.  Reading the tea leaves, the fact that the company went with Ms. Wilkinson rather than a more established industry insider suggests that this position may be short term as well due to a pending sale.

Scenario Analysis & Valuation

There are a few different ways that things could go in the coming months as 1) cash from the sale of the CICT division hits the balance sheet and 2) the Strategic Capital Committee lays out the next steps for the company.  Importantly, even in the bear scenarios, there appears to be approximately zero downside in the near term (absent a complete implosion in oil prices, which can be easily hedged)

Scenario #1 – Worst Case Scenario

While I believe the most likely outcome of the Strategic Capital Committee’s process will be a sale of the company, the conference call following the sale of the CICT segment also mentioned the possibility of investing $20-$30 million in previously identified organic growth capital projects.  Absent poor M&A, which I view as unlikely due to the Strategic Capital Committee and because they have been a seller, not a buyer, in a worst case scenario, I would imagine that the company spends that $30M on internal projects, and gets no return from it, resulting in a $30M hit to cash, and no bump to sales or profit.

Further, in this scenario I suggest that the market views FTK as an undifferentiated commodity service provider, and only values FTK at .7x EV/ T12M ECT sales, in line with where the company traded prior to the Q4’18 market sell off (on consolidated sales). Additionally, I would again note that T12M ECT sales likely understates potential due to the aforementioned change in go to market strategy, and that not all EVs are created equally… in other words, when facing cyclical end markets, an EV that is attached to a market cap that is 66% net cash is more attractive than an EV that is attached to a debt stack.

In this scenario, at .7x EV/T12M ECT Sales FTK stock would be worth $3.90, or roughly 30% upside, before considering any upside tied to repurchasing shares, which would be a distinct possibility given that even after earmarking $30M for internal projects the company would have ~$90 million in cash.                 

I would further note that in this scenario, despite a much improved balance sheet, additional investment into the business, on-going cost cutting, and recent positive sales trends, I am inexplicably forecasting significant multiple compression from today’s levels, which I believe provides an ample margin of safety. Quite simply, it is very difficult to imagine that the multiple will collapse upon receipt of 93% of the business’s market cap in gross cash. For reference, if the market simply adapts to today’s multiples upon receipt of cash (net of internal investment), shares would trade to $5.50, representing ~75% upside with no multiple expansion.  

Scenario #2 – Company Sale

As noted earlier, acceptance and adoption of value added chemistry in the oil patch is accelerating. While this comes with some positives, it also invites competition. Simply stated, Flotek is under-scaled to face this competition. For example, Haliburton – formerly FTK’s largest North American customer/distributor, and presently their Middle East distributor – spent $390M on R&D last year, a number that dwarfs FTK’s revenue.  Other large oil services firms, as well as specialty chemical groups, spend similar amounts, and while FTK has a patent portfolio and existing client base that should shield them in the near and intermediate term, longer term it would be difficult to remain relevant as an under-scaled operator.

M&A has been rampant in the space as lower oil prices have strained operating structures, and notably 3 of the companies listed in FTK’s proxy as comparable companies have been purchased in the last ~1 year at ~1.2x EV/sales. The pure play nature of FTK’s business means that these comps are not perfect compares due to their more diversified businesses, but one could argue that FTK’s business is on the higher end of quality vs the diversified comps.  

In the case of Flotek, an acquiror could keep the patents and technology, while essentially removing all corporate costs and most of the segment level selling and admin costs as the acquiror will already have reps visiting well sites etc.  It seems obvious that Flotek’s technology can be best nurtured inside a larger organization, and given the creation of the Strategic Value Committee, hiring of the current CFO, and the fact that the other segments have all already been jettisoned, this seems like the most likely outcome. The fact that the CEO has a $7M golden parachute doesn’t hurt either.

I believe that 1.0x EV/ECT Sales, or $5.25 per share, is a conservative estimate for value in a sale based on the present (pre receipt of CICT cash) multiple, comp multiples, and precedent transactions. Further, I estimate that a strategic acquiror could generate $30M in segment EBITDA (~15% margin) on T12M sales of $190M vs. $19M in T12M in segment EBITDA.  There is of course an element of “finger in the air” here, but I would note that anecdotally I have heard from informed parties that “they could definitely cut costs,” which is not hard to believe in context of the CICT segment having been sold at 21.4x segment EBITDA, which implies quite a bit of fat to trim. Further to that point, public citrus chemical competitor TET.LN reported 12.9% EBITDA margins on a fully loaded basis in their most recent half year, while FTK’s citrus segment had been ticking along at ~10% segment margins.  It is also worth noting that ECT generated 16.8% segment margins on $243M in revenue for FY17, again suggesting that assuming $30M of normalized run rate EBITDA for an acquiror is conservative.

Returning to ECT, presumably a strategic acquiror could essentially remove the entire sales organization, and achieve other efficiencies up and down the operating structure (admin, procurement, R&D etc. etc). For reference, as of Q3’18 consolidated segment selling and administrative expenses were run rating at $30M. It is impossible to know what percent of that $30M was tied to ECT vs. CICT, but if we assume that the split was proportionate to revenue, then selling expenses at the ECT segment are annualizing at $21M, making the suggestion that an acquiror can realize $11M of segment level synergies appear to be sufficiently conservative.

In this scenario I do not punish the EV for the potential $30M in internal investment, as I believe an acquiror would value this spend at face value, and essentially add it to any valuation derived from trailing sales or EBITDA figures.  I do however adjust for change of control payments.

1.0x EV/T12M ECT sales suggests an EV/strategic EBITDA multiple of 6.4x, which is very low for any kind of specialty chemical transaction, and at the moment comps are trading anywhere from 8.0x – 14.0x EBITDA, again suggesting that a price of $5.25 should be conservative. Additionally, this does not assume any additional upside from a tender offer or other return of capital.  

For reference, conservatively assuming $30M in acquiror’s EBITDA, and applying a 10x multiple would result in a $7.10 stock, or 125% upside. For additional reference and noting that Q1 and Q2 of 2018 appear to have greatly suffered from the previously mentioned change in go to market strategy, if we were to assume that “normal” sales were $230M, at 1.0x EV/Sales FTK would be worth $6.00 share, and at 1.2x sales worth $6.70 per share. If “normal” sales are $230M and an acquiror could achieve 20% segment EBITDA margins – not unreasonable considering that FTK did almost 17% in 2017, at an 8.0x EV/EBITDA multiple would be worth $8.25, or ~150% upside.  At 10x, which is basically middle of the range for recent comp transactions, shares would trade hands at $9.85, or 212% upside. These are not base cases, but they are well within the realm of possibility, and are meant to illustrate that given the cyclicality, operating leverage, and synergy possibilities, this could work out very well.

Scenario #3 – Going Concern

If a sale does not come to pass and the company chooses to go at it alone, we are basically back at scenario #1, which as previously demonstrated, has quite a bit of upside even assuming multiple contraction. The big risk of course would be an under-incentivized management team and board squandering capital, but the creation of the Strategic Value Committee, changes to the C suite, and addition of skilled capital allocators to the board makes this unlikely.  Thus, the first move would likely be a tender offer or other return of capital simultaneous with continued cost cutting so that the business can be profitable even at this point in the cycle.  From there, the stock would of course be subject to the vagaries of the cycle, but if the cycle goes up, the operating leverage will be significant, resulting in multi-bagger potential, and if the cycle goes down and the stock goes with it, the balance sheet is such that intrinsic value per share for patient investors that are able to ride out the cycle will go up.  This stuff can be modeled an infinite amount of ways, but for me it is enough to just know that if the cycle turns negative, we have the balance sheet and capital allocators to ride it out with an eye toward larger eventual upside.

Closing remarks

FTK is an usual opportunity where the market is just completely asleep at the wheel. If nothing else, I think all readers should appreciate the fact that in late December this company had a $60M market cap and $100M EV, and then sold the smaller of their two divisions for $175M a month later. I know I for one look forward to using this example when talking about efficient markets with prospective investors.

This extreme mispricing helps illustrate why the company is so cheap today, even after rising more than 200% from $1 to $3.15 over the last few weeks.  This is obviously a tough chart to buy, but in my view, if you consider the merits of the business and the fact that the Strategic Value Committee is driving the ship, we can see that another 100-200% upside is well within the realm of possibility.  At the same time, having a balance sheet that is ~66% net cash and a business with value add technology and recent strong validations provides very solid downside protection.

That kind of skew is unusual.

Risks  

The company is due to report FY’18 earnings on March 6^th, and management has hinted that Q4 revenue might be a bit soft sequentially. I would think that any update on cost cutting and the Strategic Value Committee would supersede the relevance of the Q4 print, but you never know. Oil price, which is easy to hedge

DISCLAIMER: This isn’t investment advice and I could be wrong about everything, so please do your own work.

Catalyst

Receiving 93% of the market cap in gross cash

Sale of the business

New management and continued right sizing of the operating structure