Flotek short – A summary of our key conclusions are below:
Flotek Industries Inc. (“FTK”, “Flotek” or the “Company”) is primarily a supplier of specialty chemicals to oil and gas exploration and oilfield service companies. Flotek began trading on the NYSE in 2007 under the ticker “FTK”. Flotek’s “crown jewel” and primary driver of revenue and profitability is their suite of “Complex-nano Fluid®” products (“CnF”) used primarily by operators engaged in hydraulic fracturing in the United States. FTK markets CnF as the industry leading suite of superior, environmentally responsible surfactants that significantly enhances oil production from horizontal well completions. Flotek claims oil production uplift of 30-70%,1 states that operators have cost themselves $70 billion in revenue in Texas plays alone by not using CnF,2 and touts an independent study claiming production uplift of nearly 60% for wells using the product.3
FourWorld has analyzed the independent reports issued by Flotek, conducted a series of studies analyzing the efficacy of CnF and performed in-depth due diligence of the Company. To assist in our analysis, FourWorld hired RK Trading LLC (“RK Trading”) and Sylvania LLC (“Sylvania”), two Houston based consulting firms with substantial experience in horizontal completions and performance measurement. Our primary conclusions are as follows:
- The independent studies commissioned by Flotek were based on incomplete data and failed to consider key variables in the oil production process.
- The impact of CnF on well productivity is indistinguishable from zero when using a full data set.
- Flotek has experienced 85% attrition of CnF end users (i.e. oil and gas operators) over the last four years.
- All other things being equal, if CnF were repriced to the level of other generic surfactants, revenues would fall $60-90 million per annum (2016 estimated total revenue is $297 million) and adjusted EBITDA would be negative $50-$80 million per annum (2016 estimated adjusted EBITDA is $12.5 million).
Flotek – Background Information
Hydraulic Fracturing, Surfactants and Complex nano-Fluids (“CnF”)
In the process of hydraulic fracturing (“fracking”), a well is drilled, casings and liners (i.e., pipes) are cemented into place and then perforated with directional explosives or opened through tiny ports. Fracturing fluids are then pumped down the well under extreme pressure to crack open the rock, which allows oil to flow out. Fracturing fluids are roughly 99.5% sand and water and 0.5% specialty chemicals. CnF is a specialty chemical known as a surfactant. It is used with a concentration of roughly 1.3 gallons of CnF per thousand gallons of water (0.13%). Surfactants are used to reduce surface tension (e.g., soaps and detergents are common surfactants). Generic surfactant products are manufactured by the likes of Baker Hughes (BHI) and NalcoChampion and sold to oil and gas operators by companies like Halliburton (HAL) and Schlumberger (SLB) at prices in the $3 to $6 per gallon range, with gross margins of 15 to 20%. This is in stark comparison to the price of CnF, which Flotek sells for $12-15 per gallon (2-4x generic products) with gross margins over 40%. FTK sells CnF directly to operators via the Flotek Store and also distributes products through service providers (i.e., HAL, BHI, SLB), who generally repackage CnF and sell it to operators under a white labelled trade name (i.e., product name, such as HAL’s “OilPerm FMM-2” and “GasPerm 1100” or BHI’s “Flo-back Prime”).
Flotek’s History, Business Segments and CnF Reliance
According to the Company’s 2016 Annual Report, Flotek was originally incorporated in British Columbia in 1985. In 2001, Flotek moved the corporate domicile to Delaware and completed a reverse merger with Chemical and Equipment Specialties Inc. (“CESI”), including a 120 to 1 reverse stock split, creating an OTC traded company (OTCBB: “FLTK”) with a market cap of approximately $15 million. In 2003, the Company “purchased what would become the CnF technology for about $100,000 and a few thousand shares of Flotek’s stock”4 (Flotek’s stock price in 2003 was $0.30 to $0.50 with a market cap of $3 to $8 million). This would prove to be fortuitous timing, as over the next ten years, CnF would grow to become the “flagship of Flotek’s technology portfolio” as the fracking boom took off in the United States. On the brink of collapse in 2009, FTK issued new equity (at $1.27 per share) and restructured its debt, including the exchange of a $36 million convertible note and a new $40 million term loan. Since completing its restructuring in early 2010, FTK’s stock price (and market capitalization) has gone from $1.27 ($30 million) to a high of $32.66 ($1.75 billion) on June 19, 2014, to its current price of $13.18 ($747 million) as of December 2, 2016.5
Flotek has four business units, the largest and most profitable of which is Energy Chemistry Technologies (“ECT”) which primarily sells specialty chemicals (mostly CnF) to the oil and gas industry at gross margins over 40%. The table below shows key statistics by segment.
ECT is FTK’s primary driver of revenue and profit. For the last twelve months (“LTM”) ended September 30, 2016, ECT generated 62% of consolidated revenue, 74% of consolidated gross profit, and $32.7 million of income from operations versus a consolidated loss of $55.1 million (includes a $40.4 million write-down in inventory and long-lived assets for the Drilling Technologies and Production Technologies segments in Q1 2016). CnF currently represents approximately 70% of ECT sales. We understand that CnF is actually responsible for a higher percentage of sales, as lower margin products are bundled with CnF and sold as a package.
The Consumer and Industrial Chemical Technologies (“CICT”) unit primarily sells chemical products to the flavor and fragrance industries at a gross margin of approximately 22% and is the only other significant contributor to revenue and profit. For the twelve months ended September 30, 2016, CICT generated 25% of consolidated revenue, 16% of consolidated gross profit and $10.5 million of income from operations. FTK’s other two business units, Drilling Technologies and Production Technologies, combined account for less than 15% of consolidated revenue and had a loss from operations of $55.3 million. FTK has stated they “continue to consider a wide range of options” for these businesses that are “less essential” as they evolve “to an enterprise with a more acute focus on chemistry technology, primarily in the energy arena.”6
By all measures, Flotek is heavily reliant on the success of CnF. If CnF were repriced to the top of the range for generic surfactants ($6 per gallon, which we estimate is $2 per gallon below the manufacturing cost of CnF), at current CnF sales volume, ECT revenues (all other products being equal) would drop by $60 to $90 million per annum.7 This revenue loss would result in an estimated adjusted EBITDA of negative $50-$80 million and a consolidated operating loss of $80 to $100 million per annum. With SG&A plus R&D at approximately $105 million per annum, we have seen no evidence that would lead us to believe that Flotek could cut enough expenses to offset this loss of revenue. The table below shows key financial statistics by quarter since Q4 2015 and estimates for FY 2016 from Bloomberg.
Bronte Capital Report, SEC Inquiry and the Flotek Special Technical Committee
In November of 2015, Bronte Capital Management Pty Ltd (“Bronte”) questioned production data that FTK used in its marketing materials. Bronte pointed out that production data generated from FTK’s FracMAXTM software (FracMAXTM was Flotek’s patented iPad application used as a sales tool to demonstrate the impact of CnF) was inconsistent with official production data from the State of Texas. Bronte showed that the official production data for the non-CnF wells were reduced by 40% before comparing with CnF wells, resulting in the misleading conclusion that CnF wells significantly outperformed non-CnF wells.8 After conceding the data error highlighted by Bronte (which raised material questions about the efficacy of both CnF and FracMAXTM as a data management tool), FTK formed a Special Technical Committee (“STC”) of the Board to handle, among other things, a related SEC inquiry and to evaluate the performance of CnF. The last mention of FracMAXTM by the Company was at an industry conference in April 2016, when John Chisholm stated “we continue to make progress on a new version of the Company’s proprietary measurement software and expect to discuss progress on FracMax 2.0 in the future.”9
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