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  • Volume II, Issue 3

LGR Newsletter

Volume II, Issue 3 (released on October 20, 2015)

 

Summary

  • Investors should expect FTK to experience a large move in price on Thursday, after the company has reported financial results for Q3 2015.
  • I estimate FTK will generate adjusted EPS of $0.08 and sales of $98.0 million in Q3 2015, both of which are higher than analysts' consensus estimates.
  • I believe that FTK will continue to outperform analysts’ consensus estimates, as they currently stand, through the end of 2016.

 

Previous Articles On FTK:

8 Things To Look For In Flotek's Upcoming Earnings Report - Pre-earnings article for Q2 2015

Flotek Industries Is Built To Survive And Thrive In The Current Commodity Environment - In-depth initiation article

 

Introduction:

In Q2 2015, Flotek Industries, Inc. (NYSE:FTK) reported total sales of $87.0 million and adjusted EPS of $0.02, which beat analyst estimates for sales and EPS by $17.6 million and $0.09, respectively; the company's stock price reacted by surging 37.9% higher. When compared to my own financial estimates for the quarter, which I presented in my pre-earnings article entitled "8 Things To Look For In Flotek's Upcoming Earnings Report," FTK's sales beat by a smaller margin of $11.0 million while adjusted EPS was in-line with my estimate of $0.02 (I had not anticipated the impairment charge). The main reason why my estimate for sales in Q2 2015 was lower than the actual result while my EPS estimate was in-line with the actual adjusted result was that I had estimated that FTK would achieve a gross margin of 35%, which turned out to be higher than the 33.6% gross margin actually achieved.

After FTK substantially beat analysts' consensus estimates in Q2 2015, analysts revised their estimates upward. As one can see in Appendix Images #1-4, the trend in analysts' consensus estimates (from Bloomberg) completely reversed course after FTK released its Q2 2015 earnings report on July 22, 2015, and since then estimates for sales and adjusted EPS for Q3 2015 and full-year 2015 have been trending higher.

For Q3 2015, I again believe that FTK will beat analysts' consensus estimates and that the stock's price will experience a significant rally afterwards. Furthermore, I believe that FTK will continue to outperform analysts' consensus estimates, as they currently stand, over the following five quarters, which can be seen in the picture below:

  • Note: Consensus estimates were extracted from a Bloomberg terminal and represent the average estimates from three different firms who cover FTK (4-5 firms contributed to the estimates for Q3 2015 and Q4 2015).

 

                   1. FTK Will Likely Experience A Large Move In Price On Thursday

FTK is an extremely volatile stock, and investors should expect a large move in price on Thursday. As one can see in the chart below, FTK has a history of beating analysts' estimates and moving sharply in one direction or the other after an earnings report:

  • Notes: Historical consensus estimates were found on Seeking Alpha and various other publicly available sources. The price performance figures for Q1 2015 were based on FTK's price action on the day that preliminary results were released (preliminary financial results were released pre-market on April 21, 2015 and actual earnings were released after-hours on April 22, 2015).

As one can see in the picture above, over the last 17 quarters FTK has outperformed analysts' consensus EPS and sales estimates by 12.2% and 1.9%, respectively, and the stock has on average outperformed OIH (the Oil & Gas Services ETF) by 3.3% on the first trading day following the company's release of its financial results (Note: over the past 17 quarters FTK has also outperformed the S&P 500 by an average of 3.3% on the first trading day following the release of its earnings reports). In addition, one can see that over the last 17 quarters FTK's price has moved by an average of 8.5%, in one direction or the other, on the first trading day following its earnings report and this, in combination with the fact that Bloomberg lists the stock's post-earnings one-day implied price move as 7.2% (Bloomberg describes this as the "absolute percent change in price around the next earnings date estimated from option volatilities"), supports my belief that FTK will move approximately 10% on Thursday.

Given that FTK's price is currently trading at roughly $19.50 (as of midday on Tuesday, October 20th), if the stock is able to rise by over 10% that would put it very close to reaching a new high in 2015 (FTK's current high in 2015 is $21.72). Bloomberg lists short interest as a percentage of float as 22.15%, with 13.3 days to cover, so there is certainly potential for a "short squeeze" if FTK does well during its earnings report.

 

                   2. My Financial Estimates

All of my financial estimates for the next six quarters can be seen in the picture below:

  • Note: These estimates are subject to change, which is very likely over the next few quarters. A more detailed version of these estimates, complete with historical financials and full balance sheet projections by line item, will be made available upon request (requests can be made through thecontact page of my website).

Income Statement Projections: Sales, gross margin, and EBIT margin were all projected segment by segment and then consolidated to form company-wide figures. The Energy Chemical Technologies (ECT) segment's sales and margins are the main driving force behind FTK's strong expected performance in Q3 2015 relative to peers in the industry, and as recently as October 5th the company's management team reported that after looking at initial Q3 2015 results "CnF sales increased at least 25% when compared to second quarter CnF sales… The growth in CnF sales should result in higher margins in the Energy Chemistry Technologies segment and gross profit which are expected to show an increase of at least 15% when compared to the second quarter segment gross profit." I projected that the ECT segment's margins would expand gradually through the rest 2015 and through the first half of 2016 (the segment's gross margin is projected to rise by an average of 20 bps per quarter and reach 37.0% in Q2 2016) before beginning to expand more rapidly in the second half of 2016 (rising by an average of 75 bps per quarter to reach 38.5% in Q4 2016), which was based on the assumption that the prices for products sold through the Flotek Store would increase gradually through the beginning of 2016 before increasing more rapidly towards the end of 2016. As one can see in Appendix Image #5, FTK's "highest CnF price" is expected to increase incrementally in Q3 2015 and lead to a slightly higher gross margin for the ECT segment as a whole, which is consistent with my projection that the ECT segment's gross margin will increase 20 bps (q/q) in Q3 2015 and reach 36.4%. Support for my assumption that prices for products sold through the Flotek Store will increase significantly comes from the fact that FTK's management team, in its Q2 2015 earnings call, said that prices in the Flotek Store will increase by approximately 20% over time and my belief that most of the benefits from that pricing increase will be seen towards the end of 2016.

Given the fact that it has been widely publicized that the ECT segment is expected to report strong results in Q3 2015, I believe that the main reason why my financial estimates for Q3 2015 are likely higher than consensus estimates is that I am very bullish on FTK's Consumer Industrial Chemical Technologies (CICT) segment and believe that it will perform better over the next six quarters than most analysts expect it to. With that being said, the CICT segment's sales and margins appear to be fairly seasonal, based on historical figures, so I took that into account when projecting them on a quarter-by-quarter basis; I projected that while the segment's total sales would increase 13% (q/q) in Q3 2015, the figure would then decline by 5% in Q4 2015. The CICT segment's margins directly benefit from higher volumes of chemical products being sold by the ECT segment, due to the fact that there is higher internal demand for terpenes (this was discussed briefly by Josh Snively in the company's Q2 2015 earnings call), and I projected that the CICT segment's gross margin and EBIT margin would expand (on a year-over-year basis) in every quarter in 2016.

I projected that FTK's Drilling Technologies and Production Technologies segments would see declines in sales of 15.0% (q/q) and 10.0% (q/q), respectively, in Q3 2015, which are in-line with the declines in sales that many small Oil & Gas Services are expected to experience in the quarter. Furthermore, I conservatively projected that both segments would experience slight contractions in gross margins compared to their respective levels in Q2 2015, however, I projected that both segments' adjusted EBIT margins would improve slightly quarter-over-quarter as benefits from cost cutting measures (such as headcount reductions) are realized.

Cash Flow Statement Projections: Depreciation & Amortization (D&A) and capex were projected segment by segment. Capex typically accounts for roughly 2-4% of the ECT segment's sales in any given quarter, however, in Q3 2015 I projected that the figure would reach 9.0% to account for the fact that some of the company's "non-base" (i.e. not used for general or expansionary purposes) capex associated with the building of its chemistry manufacturing and research facility near Sohar, Oman will likely be attributed to the ECT segment (it is possible that the company will instead attribute the capex to the "Corporate & Other" segment, in which case the ECT segment's capex as a percentage of sales will likely be in the 3.5-4.0% range). I projected that capex and D&A would decrease on a sequential basis for both the Drilling Technologies and Production Technologies segments, however, I projected that both capex and D&A would increase on a sequential basis for the CICT segment. My projections resulted in negative Free Cash Flow (FCF) estimates for Q3 2015 and Q4 2015; however, FCF was projected to increase substantially in 2016 (reaching $20.2 million in full-year 2016). For full-year 2015, my projection that capex would total $26.9 million was within management's guidance for $25-30 million in capex for the year.

Balance Sheet Projections: I projected that FTK will have repurchased approximately $3.0 million worth of shares during Q3 2015, with all of those shares being repurchased prior to the company's release of its Q2 2015 earnings report on July 22, 2015 (after-hours). I based my assumption for $3.0 million worth of shares being repurchased on the fact that the company repurchased approximately $3.2 million worth of shares per month during Q2 2015, then estimated out how shares it likely repurchased for that dollar figure by calculating FTK's average closing share price from July 01, 2015 to July 22, 2015 (calculated to be $12.80) and then dividing $3.0 million by the average closing share price (equaling roughly 234,000 shares). Throughout the remainder of my projection period (i.e. through the end of 2016), I assumed that FTK's management team would decide not to repurchase any more shares, because I believe that so long as the company's stock price remains above $16.00/share management will look to use all available cash to expand the company's operations.

FTK's total debt figure was projected to increase by approximately $2.4 million in Q3 2015, with all of that added debt coming from the company's revolving credit facility, however total debt levels were projected to decrease in all following quarters as the company begins to pay down some of its short-term debt. Net Working Capital was projected to remain relatively stable as a percentage of total sales throughout the entire projection period.

  • Note: Detailed projections for each line item on FTK's balance sheet can be made available upon request.

 

Risks Associated With My Projections:

One major potential risk with my projections is that FTK's margins will be unable to expand as much as I projected them to if the company is forced to continue discounting its products (particularly its CnF products) in order to grow sales. While I certainly believe that it is possible that FTK may have reached a short-term "ceiling" in terms of what prices it is able to get customers to pay for its CnF products, I do think that the ECT segment's margins will expand over the long-term if the commodity price environment, and the pricing power of companies in the Oil & Gas Services industry, begins to improve.

Another potential risk that could cause my financial projections to be overly optimistic is posed by the fact that FTK still generates a significant portion of its total sales from a small number of clients, and when a recovery in the Oil & Gas space does eventually take place not all large E&P companies and Oil & Gas Services companies (i.e. FTK's largest clients) will likely recover at the same pace and be willing to purchase more of the company's products. This risk also extends to FTK's smaller clients, because if a recovery in the oil & gas space takes longer than initially expected to occur some small oil & gas companies could choose to cease some (or all) of their operations and, as a result, stop purchasing/renting the company's products.

The largest potential risk with my projections is that a recovery (or improvement) in the commodity price environment could take longer than initially expected to materialize, which would negatively impact FTK's financial results through the end of 2016 and potentially cause my projections to be overly optimistic. I projected that FTK's Drilling Technologies segment would experience its first year-over-year increase in revenue in Q3 2016, so most of my projections are based on the assumption that a recovery in the Oil & Gas Services industry will begin to take place during the second half of 2016.

 

Conclusion:

If my projections are accurate, FTK will beat analysts' consensus estimates for both sales and adjusted EPS in Q3 2015, which will likely prompt analysts to raise their estimates for future sales and EPS. Regardless of the financial results that FTK reports for Q3 2015, and regardless of whether or not they beat consensus estimates, I expect the stock's price to move over 10% in one direction or the other on the first trading day following the release of the earnings report (i.e. on Thursday, October 22, 2015).

 

Disclosure: I am long FTK.

 

Appendix Images:

Appendix Image #1: Adjusted EPS Consensus Estimate For Q3 2015 (From Bloomberg) vs. Stock Price 

Image Source: Bloomberg terminal

Appendix Image #2: Adjusted EPS Consensus Estimate For FY 2015 (From Bloomberg) vs. Stock Price 

Image Source: Bloomberg terminal

Appendix Image #3: Sales Consensus Estimate For Q3 2015 (From Bloomberg) vs. Stock Price 

Image Source: Bloomberg terminal

Appendix Image #4: Sales Consensus Estimate For FY 2015 (From Bloomberg) vs. Stock Price 

Image Source: Bloomberg terminal

Appendix Image #5: Management's Guidance For CnF Pricing And The ECT Segment's Gross Margin

Image Source: Flotek Investor Day 2015 NYC (Part 2) Presentation - Page 87 In PDF

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