Stock Flotek Industries: a transformation point, but wait! (NYSE:FTK)

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Investment thesis

Flotek Industries, Incorporated (NYSE: FTK) underperformed the market the previous year, but has outperformed the market since the start of the year. The outperformance is exclusively attributable to the 98% increase in the share price in response to the company’s agreement with ProFrac Assets (PFHC), a vertically integrated energy company.

% change in FTK price
Data by YCharts

The operation can indeed prove to be a turning point for the company and have a significant positive influence on the company and the performance of its share. Still, the recent surge has driven the stock price up much faster than the company’s financials, resulting in a significant premium to the stock’s intrinsic value.

Additionally, after the maturity of the convertible bonds issued by the company, the stock will be significantly diluted, weighing heavily on EPS. Since there is no quantifiable evidence of improvement yet, only the most risk-tolerant investors will go ahead with the investment.

I’m hesitant to rate the company as a buy because it lacks reliable historical financial performance due to fundamental operational issues. Given the impending stock dilution, Flotek must address these issues to improve shareholder confidence.

Company presentation

Flotek is a specialist green chemistry and data technology solutions provider that helps clients in industrial, commercial and consumer markets improve their ESG performance and operational goals. It operates through two segments:

  • The Chemical Technologies (CT) Segment develops, manufactures, distributes and markets these specialty chemicals, intended for companies in the energy sector, improving their profitability, reducing operating costs and offering a better return on invested capital. It also provides professional compounds that clean surfaces in commercial and personal environments to help reduce the spread of bacteria, viruses and germs.
  • The Data Analytics (DA) segment was formed by the acquisition of JP3 in 2020, whose real-time data platforms combine its only energy industry field-deployable online optical analyzer with proprietary cloud visualization and analytics and offer increased profitability to its customers. It maximizes the value of its customers’ hydrocarbon-related processes by providing real-time data and analytics, optimizing operations, preventing waste, reducing reprocessing, emissions and carbon intensity, and enabling users to continue automating their hydrocarbon flows, maximizing profitability and improving ESG performance.

The company will cease reporting on a segment basis in future quarterly reports and will begin reporting on a consolidated basis. In the wake of the recently concluded PIPE agreement, the company is undergoing major changes.

Highlights of the PIPE Agreement

Flotek recently entered into a private equity investment (PIPE) agreement in February 2022 to secure growth capital, raising $19 million in net cash proceeds by issuing 10% convertible notes with a term of ‘a year.

Subsequently, the stock price almost doubled overnight due to the announcement of the contract expansion. As part of the expansion, Flotek expects its backlog to grow by more than $2 billion over the next 10 years, including revenues of more than $200 million in 2023.

As part of the expanded contract, FTK issued an additional 10% of convertible bonds with a principal amount of $50 million and granted nomination rights to ProFrac, for four of FTK’s seven board members. ProFrac would own up to approximately 48% of Flotek’s common stock on an as-converted basis.

Under the agreement, ProFrac will be obligated to purchase a minimum supply above either a baseline determined by reference to ProFrac’s first 30 hydraulic fracturing fleets deployed, or 70% of ProFrac’s requirements for ten years.

Weakened profitability

The company failed to bounce back from the pandemic with the rest of the market. Its revenues increased from $119.4 million in 2019 to $53.1 million in 2020 and $43.3 million in 2021.

FTK industries revenue and cost of goods sold
Data by YCharts

At first glance, cost of revenue appears to be out of step with revenue, accounting for just over 103% of revenue in Q1 2022, 92.5% in 2021 and 154% in 2020, leading to volatile profit margins. However, a one-time gain of $7.6 million recorded in 2021 due to a contract termination resulted in lower cost of revenue, meaning higher cost of revenue is the norm.

FTK Operating Margin, Gross Profit Margin and Profit Margin
Data by YCharts

The company’s profitability lags that of its peers and has earned it the lowest rating, F, in Seeking Alpha’s rating system.

FTK Profitability Summary

Looking for Alpha

The company’s 5-year averages were badly damaged due to loss-making 2019 and 2020, but its revenue and gross margin declined for nearly a decade. Excluding the $7.6 million adjustments from the previous year, this would have resulted in a gross loss of $4.2 million.

FTK revenue and cost of goods sold
Data by YCharts

The company’s operating loss also paints a better picture in 2021 with a 78% improvement. However, this is due to the reduction of the impairment charge from $81 million in 2020 to $8 million in 2021, which subsequently resulted in a 70% decrease in the amortization charge of approximately 3 $.4 million in 2020 to $1 million in 2021.

Flotec operating margin
Data by YCharts

According to the company’s latest 10-K filing, the impairment charge was recorded in accordance with the following:

For the DA reporting unit, output growth is still expected to be weaker in the near term as operators continue to exercise strong fiscal discipline in development spending. Intermediate volumes remained well below capacity levels. Although we expect production growth to pick up, it is likely to do so at a more cautious pace.

Unsustainable liquidity

Reducing non-cash expenses doesn’t really excite me right now because the company needs to get its cash position under control. The company’s annualized operating cash burn rate is unsustainable despite the recent addition of growth capital.

The second-quarter earnings report will show an increase in the company’s cash balance as it issued the $50 million convertible notes as part of the expanded deal. Still, the leveraged FCF margin of nearly -60% and the sequential deterioration of FCF per share makes me doubt the company’s ability to convert to cash.

FTK operating cash and cash and cash equivalents
Data by YCharts

The company’s balance sheet could do better, but it looks particularly bad without a closer look due to the accumulated deficit and convertible notes. The Altman Z score of minus 5.45 is heavily influenced by the accumulated deficit of over $319 million, and the leverage metrics relate strongly to convertible notes.

With the upcoming inflow of around $50 million against other loan notes, I expect these metrics to deteriorate before they likely start to improve in 2023.

Valuation: 680% premium over book value

Since the company is not reporting positive numbers at the net income level and cash flow is also negative, we will use its revenue and balance sheet numbers to value the company. It has contrasting advanced and TTM-based metrics due to the PIPE agreement.

TTM P/S and EV/sales ratios of 1.9 and 2.3 are more than 50% above the industry median. In contrast, the P/S and EV to sales ratios of 0.65 and 0.74 are almost equally below industry medians, exposing the post-deal transformation line drawn by the company.

Flotek PS and VE ratio to revenue
Data by YCharts

The company’s P/E ratio of 6.8 is extremely above the industry median of 1.89, which is particularly concerning as FTK has almost religiously deteriorated its book value since the first quarter of 2019, rising from more from $4 per share to $0.18 at the MRQ.

Chart
Data by YCharts

Conclusion

For a small-cap company like FTK, the risks and rewards are almost always higher than large-cap stocks, but an unreliable operating history, weak balance sheet, and 680% premium on a declining book value make the action too risky for me. .

I would have rated the stock as a sell based on its current position, but due to the transformation deal, which could start yielding positive results in early 2023, I am neutral on the stock.

Opening a small position in anticipation of the potential upside by risk-tolerant investors may hold water, but the high volatility of the stock due to its low market capitalization and high risk, coupled with the general market slowdown, predicts bleak outlook.

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