Volume II, Issue 1 (released on June 02, 2015)
Flotek Industries, Inc: Built To Survive and Thrive In the Current Commodity Environment
- Strong financial health enables Flotek Industries, Inc. (FTK) to survive in the current commodity price environment
- FTK demonstrates the best operational efficiency of its peer group in the industry
- Strong demand for FTK’s key products, particularly its “green” fracking fluids, will help it capture and defend market share and generate strong cash flow
- Existing competitive advantages enable FTK to experience strong organic growth in both foreign and domestic markets
- Current market valuation offers long-term upside potential to FTK’s current share price
I am very grateful for the assistance of Thomas Beevers, the CEO and founder of StockViews, who provided substantive suggestions that greatly improved this article. The fault for any errors or omissions is, of course, my own. The format of many of the worksheets in my “Valuation Analysis” excel document was largely influenced by a book entitled “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions,” written by Joshua Rosenbaum and Joshua Pearl.
If you would like to download my "Valuation Analysis" excel model please click the following link: FTK Valuation Analysis (Presentation Version - Final)
This article is structured to follow the points of the above investment thesis, after first providing a detailed description of FTK’s business segments, market operations, and leadership team. A Discounted Cash Flow (DCF) Analysis is used in section 5 to calculate the following implied share prices under five different “operating scenarios,” which are explained in detail in that section:
A Comparable Companies Analysis is used in conjunction with the DCF Analysis to determine a Final Implied Share Price for FTK. The Final Implied Share Price supports my conclusion that FTK provides significant upside potential from its current share price of $11.49; I have a fairly conservative one-year price target of $16.00 (+39.3%) and a long-term (two-years+) price target of $28.00/share (+143.7%). Furthermore, I believe that the potential downside risk in a scenario where the price of oil does not recover in the next year is FTK’s price declining to $10.00/share (-13.0%); if the price of oil does not recover in the next two years, my downside price estimate is $7.45/share (-35.2%), which is in-line with the Implied Share Price in “Downside Case 2” above. These estimates result in an approximate 3 to 1 return/risk ratio over the next 1 year and a 4 to 1 return/risk ratio over the next 2 years.
Company Description and Background:
Flotek Industries, Inc. (FTK) is a diversified, Houston-based oilfield technologies company that supplies its clients in the oil, gas and mining industries with drilling services and equipment, and with specialty chemicals to aid in the exploration and production of crude oil and natural gas. While its products have other uses, such as in the food and beverage industry, FTK principally participates in the Oil & Gas Services industry.
FTK grew through several major corporate transitions over its 30 year history. FTK was originally incorporated in British Columbia in 1985. In 2001, FTK moved its corporate domicile to Delaware, underwent a 120 to 1 reverse stock split, and completed a reverse merger with Chemical and Equipment Specialties, Inc. (CESI). In 2007, FTK began trading on the New York Stock Exchange (NYSE).
FTK gained a following when it experienced a meteoric rise in price from an intraday low of $1.01/share on July 09, 2010, to its current 52-week high of $32.92/share on June 24, 2014, but even the Company’s most enthusiastic followers have had their faith challenged after watching its stock price fall 65% from its 52-week high.Since the end of 2010, when its share price ended the year at $5.45, FTK’s fully diluted market capitalization has grown from $248.2 million to $625 million today, with its number of fully diluted shares outstanding increasing from 45.5 million to 54.4 million in that period (fully diluted shares outstanding was calculated using the “Treasury Stock Method” for options/warrants and the “If-Converted Method” for convertible senior notes and preferred stock).
A. Business Segments
FTK operates through four business segments. Descriptions of each of these business segments are as follows (summarizing descriptions found in the Company’s financial statements):
Energy Chemical Technologies provides clients with specialized chemicals that aid in recovering the maximum amount of oil and natural gas from new and mature fields, including enhanced oil recovery (EOR) markets. This segment’s patented Complex nano-Fluid technologies (CnF products) are cost-effective, proven performance-enhancing additives that are composed of renewable, plant derived cleaning ingredients and oils that are certified as biodegradable. FTK’s suite of CnF products, coupled with the FracMax analytical model, help to distinguish the Company from its competitors in the Oil and Gas Services industry, and they will be the major drivers behind the segment’s performance going forward.
Consumer and Industrial Chemical Technologies (CICT), added through the acquisition of Florida Chemical in May 2013, sources citrus oil domestically and internationally. The addition of this segment turned FTK into one of the world’s largest processors of citrus oils. FTK derives high value compounds from processed citrus oil for use by customers in the flavors and fragrances markets and, more lucratively, as environmentally friendly chemicals in oil and gas exploration and production.
Drilling Technologies helps establish FTK as a leading provider of downhole drilling tools as well as specialized equipment used in drilling activities. It sells, rents, and inspects these tools at strategic locations throughout the United States and is branching into international markets. FTK sells drilling motor components, mining equipment, and cementing accessories. Some of FTK’s rental tools include drill collars, measurement while drilling (MWD) tools, and the recently introduced Stemulator tool (used during downhole drilling). FTK’s Teledrift product line and Stemulator tool look to drive significant sales growth for the segment in the future.
Finally, Production Technologies deals with the production of pumping system components that aid in the movement of oil and natural gas from their producing horizons to the surface. Products within FTK’s patented Petrovalve product line help optimize pumping efficiency in wells under varying conditions, and other products manufactured by the Company help to address various production challenges for oil and gas companies. On January 28, 2015, FTK announced an agreement to purchase substantially all of the assets of International Artificial Lift, LLC (“IAL”), demonstrating FTK’s intent to significantly increase its focus on this segment going forward. The segment’s next-generation hydraulic pumping units, acquired from IAL, and its existing Petrovalve product line, will drive the segment’s future growth.
Revenue, operating income, and gross profit in 2014 are broken down by segment in the chart below:
Data Source: FTK 10-K Filing for 2014
All of FTK’s segments, with the exception of the CICT segment, principally compete in the Oil and Gas Services industry, which ranked #26 out of #49 in terms of industry revenue on the 2015 Bloomberg Industry Leaderboard with $456.78B in total industry revenue (as of August 30, 2014). Data from the Industry Leaderboard shows that ten companies account for approximately 40% of the market in the industry, with a median market share in the industry of 3.45%. The recently announced merger of Halliburton Co. (HAL) and Baker Hughes, Inc. (BHI) into one standalone entity reflects the current trend of consolidation within the Oil and Gas space, a trend that should continue if the price of crude oil remains suppressed – forcing smaller debt-laden companies to file for bankruptcy or otherwise making them acquisition targets. FTK is well-positioned to capitalize on these market conditions, as discussed below.
B. Market Operations
FTK markets its products to major Oil and Gas Services companies, who then sell them to their clients (i.e. usually exploration and production companies). FTK currently generates over 55% of its total sales, and 90% of its chemistry product sales, through a distribution business model. FTK’s direct and indirect customers include major integrated and independent oil and gas producers, national and state-owned oil companies, oilfield service providers, pressure pumping service companies, and international supply chain management firms. FTK’s chemistry clients include the three largest companies in the Oil and Gas Services industry, Schlumberger (SLB), Halliburton Co., and Baker Hughes, Inc.; the Company’s clients on the Enhanced Oil Recovery side includes Chevron Corporation (CVX), Kinder Morgan, Inc. (KMI), and Anadarko Petroleum Corporation (APC). In addition, through its CICT segment, FTK sells to companies in the flavor and fragrance industry, household and industrial cleaning product providers, and even food and beverage companies, including International Flavors and Fragrances Inc. (IFF), Coca-Cola, and Pepsi.
In 2014, FTK’s three largest customers accounted for approximately 16%, 7% and 6% of consolidated sales respectively and, “in aggregate, the Company’s largest three customers collectively accounted for 29%, 30% and 35% of consolidated sales for the years ended December 31, 2014, 2013 and 2012, respectively” (FTK 2014 10-K Filing). In 2013 and 2012, FTK’s largest customer accounted for 16.2% and 15.6% of consolidated sales in each year, with over 94% of the sales being attributed to the Energy Chemical Technologies segment. This data demonstrates that, although three customers currently account for a large portion of its consolidated sales, FTK has been working hard to diversify its customer base, and the Company’s largest customer has consistently bought more of FTK’s chemistry products over each of the last three years (the largest customer accounted for approximately $72.3 million, $60.1 million, and $48.8 million in sales for 2014, 2013, and 2012 respectively).
C. Management Team
FTK’s management team is led by president and CEO John Chisholm, who has been associated with FTK since 1999, when he became a Director. Mr. Chisholm was appointed CEO in March 2012, has served as FTK’s president since August 2010, and served as interim president from August 2009 through August 2010. Chisholm previously co-founded ProTechnics, a service company providing completion diagnostic services to the energy industry in 1985, and ran an investment fund targeting mid-size energy service companies. Chisholm helped FTK recover from the brink of bankruptcy in 2009 and led the Company through a period of rapid expansion from 2010 to 2014.
FTK’s fairly recent acquisition of Florida Chemical Company, Inc. led to that company’s president, Josh Snively, joining FTK as the Executive Vice President of Chemistry Research. FTK has also worked hard to retain critical contributors of intellectual property e.g., its two-year consulting agreement with Anthony Rea after acquiring patents he developed through ARC Fluid Technologies, LLC in April 2014.
FTK keeps executive compensation relatively modest, with CEO Chisholm receiving “total annual cash compensation of $2,006,950” in 2014. All of FTK’s major executives either own shares of the Company’s common stock or have sizable amounts of stock options; major executives currently own 3.7% of the Company’s outstanding shares, excluding stock options.
1. Strong financial health enables FTK to survive in the current commodity price environment
The spot price (EOD) of crude oil WTI closed at $60.23/barrel on May 29, 2015, after having fallen approximately 44% in the last eleven months from its 52-week high of $107.68/barrel on June 13, 2014. The decline in North American rig count has followed oil prices quite closely, with the total number of rigs operating in North America having fallen 52.9% from its level on May 30, 2014. As a result, major oil and gas companies are aggressively cutting costs, and many producers are at risk of experiencing large asset write-downs. These factors will lead to consolidation as larger companies merge and weaker companies are bought. This consolidation will reinforce existing barriers to entry in the industry, as new entrants would require significant expertise and cash to compete. Consolidation also deprives investors of options, especially those seeking financially stable small-cap companies with significant upside potential.
FTK is well-positioned to survive the current downturn in the oil and gas industry because of its low debt, strong cash flow, and workforce productivity. These points are discussed in detail below.
1a. FTK’s Excellent Financial Health Relative to that of Comparable Companies
Note: The debt figures discussed in this article are “all-inclusive” and were calculated as follows: All-Inclusive Debt = Long-Term Debt + Short-Term Debt + Value of Capitalized Operating Leases + Other Obligations. “Other Obligations” include various contractual obligations that specific companies will be forced to pay in the near future (see “comments” in excel file for more details).
As noted above, in 2009 FTK had a brush with bankruptcy, due to its large debt burden and the drop of oil and natural gas prices during the recession, combined with FTK’s fairly high operational leverage. Since 2009, FTK’s financial health has drastically improved, with its Debt-to-Capitalization ratio decreasing from roughly 80.3% in 2009 (based on FTK’s closing price and outstanding share count on December 31, 2009) to its current level of 8.9%. This trend was not completely smooth, as the FTK’s debt level spiked after its acquisition of Florida Chemical Company, but the Company’s management team appears committed to preventing a repeat of its 2009 near-bankruptcy experience. For example, when the total amount of long-term debt on FTK’s balance sheet reached $88.8M following the Florida Chemical acquisition (i.e. at the end of Q2 2013), the Company’s management team made it a goal to reduce debt significantly by the end 2014. FTK’s management team achieved that goal, reducing the Company’s long-term debt by $18.1M (29.1%) in 2014, and by $44.7M (50.4%) since Q2 2013.
FTK’s strong balance sheet puts it in a great position to capitalize upon any market opportunities made available by the ongoing consolidation within the oil and gas services industry. FTK currently has an extremely small amount of “all-inclusive” debt (approximately $61.4 million in total and $58.9 million in net debt) when compared to both its Total Capitalization and its EBITDA (current Debt/Capitalization =8.9% and Debt/EBITDA = 0.8x). Furthermore, FTK has a much smaller amount of debt proportionally than do many of its peers, as demonstrated by the chart below that compares FTK’s Debt-to-Capitalization percentage to the respective percentages of ten comparable companies:
Data Source: Bloomberg Terminal and 10-K Filings for Respective Companies In 2014
FTK’s financial health relative to comparable companies is supported by a Benchmarking Analysis. As detailed in Appendix Image #1, FTK’s leverage, coverage, and liquidity ratios for the Last Twelve Months (LTM) are far better than both the means and the medians of comparable companies’ respective ratios. For example, FTK’s Debt-to-EBITDA ratio of 0.8x, Interest Coverage Ratio (EBIT/Interest Expense) of 32.1x, and Current Ratio of 2.7x are not only substantially better than the both the mean and the median of each respective ratio for all ten of the chosen companies (the mean of each of the three ratios is 2.4x, 11.1x, and 2.4x respectively while the median of each of the three ratios is 1.9x, 9.0x, and 2.1x respectively), they are also some of the best ratios achieved by any of the 10 total benchmarked companies.
In summary, FTK’s low debt levels give it the financial flexibility to pursue attractive growth opportunities presented in the current downturn of the Oil & Gas Services industry.
1b. Strong Cash Flow Generation
FTK improved its financial health since 2009 because its overall profitability significantly increased, which allowed its Cash from Operations to grow very rapidly. This is depicted in the chart below:
Data Source: Bloomberg Terminal and FTK 10-K Filings for the Respective Years
- Notes: The gross profit and operating income figures were adjusted to exclude non-recurring items and include implied interest from operating leases.
FTK’s Free Cash Flow generation over the last few years was strong enough that the Company’s board authorized, in November 2012, the repurchase of up to $25 million of the Company's common stock (FTK 2014 10-K Filing). FTK chose not to repurchase any shares until Q4 2014, when it spent $10.3M to do so; the Company now has $12.0M remaining in its current share repurchase program, after it repurchased $2.7M worth of shares.
The Discounted Cash Flow Analysis valuation model in section five of this article supports the assumption that FTK will maintain a high level of Free Cash Flow growth going forward, allowing the Company to aggressively pursue growth opportunities, reduce outstanding debt, orlaunch further share repurchase programs.
2. FTK demonstrates the best operational efficiency of its peer group in the industry
FTK is significantly more operationally efficient than any of the 10 selected comparable companies, due primarily to two factors: (1) the Company’s exceptional workforce productivity; and (2) improved operational efficiency over the past five years.
2a. Workforce Productivity
FTK’s revenue per employee reached a new all-time high of $857,200 in 2014:
Data Source: FTK 10-K Filings for 2003–14
- Notes: Figures calculated by dividing FTK’s total consolidated revenue by the average of the total number of employees at the beginning and end of each year. Employee numbers were sourced from the Company’s 10-K filings; employee data for 2004 and 2007-09 were not as of December 31st.
Over the past 10 years, FTK’s revenue per employee has grown at a Compound Annual Growth Rate (CAGR) of 13.2%. Similarly, FTK’s operating income per employee has improved significantly, achieving a 10-year CAGR of 16.4%. Notably, that performance has not been consistent, given FTK’s negative operating income, Adj. in 2009 and 2010:
Data Source: Bloomberg Terminal and FTK 10-K Filings for 2003-2014
- Notes: Figures calculated by dividing FTK’s adjusted operating income by an average of the total number employees at the beginning and end of each year. All operating income figures were adjusted to exclude the impact of all non-recurring items and to include implied interest from operating leases. Employee numbers were sourced from the Company’s 10-K filings; employee data for 2004 and 2007-09 were not as of December 31st.
FTK’s management team has said many times that the Company’s sales and operating income per employee are “at or near the top of its industry,” and this is supported by a Benchmarking Analysis (see Appendix Image #2) that shows both the Company's revenue and operating income per employee are more than double the mean and median of FTK’s comparable companies’ respective metrics.
Unlike many of those who are working for most of FTK’s comparable companies, and industry peers in general, Flotek employees are neither covered by a collective bargaining agreement nor part of a labor union, and the Company is not required to fund a retirement benefit plan. This gives FTK a significant long-term advantage relative to its competitors. Six out of the ten comparable companies provide postretirement benefits for their employees, and all six of them reported unfunded retirement obligations as of December 31, 2014; this means postretirement benefits were added to equity value when calculating enterprise value (treating them as a “debt equivalent”). On average, the six comparable companies with unfunded retirement obligations had enterprise values that were 0.73% higher than they would have been if the companies did not offer postretirement benefits, and this adversely affects their valuation multiples relative to peers who do not offer postretirement benefits.
2b. Improved Operational Efficiency
FTK has improved its operational efficiency over the past five years, with a consequent reduction of costs and improvement in margins, for three reasons: (1) acquisitions that provided significant long-term benefits for the Company; (2) new products and innovations; and (3) direct capital investment.
FTK became vertically integrated after it acquired Florida Chemical Company and, although the Company’s Energy Chemical Technologies segment did not see a sustainable increase in its gross margin following the acquisition, the purchase helped stabilize and reduce COGS by allowing the Company to secure the long-term supply of citrus oil (d-Limonene) necessary to make its CnF products. This is significant, given that Florida orange production was severely affected by disease (“citrus greening”) during the 2013–14 season and the USDA recently estimated an additional 1% decline in the 2014-15 crop. During the 2013-14 orange supply shock FTK’s management team told investors that absent the Florida Chemical acquisition, FTK’s “chemistry input cost would be 30% to 40% higher” than they were at that time. The acquisition, in short, significantly helped FTK by allowing the Company to maintain a stable supply of citrus oil during a major supply shock, which helped it meet heightened demand for its CnF products, and by helping it reduce (all else being equal) chemistry input costs.
Second, over the past five years FTK developed new products that increased overall margins by either being more cost-effective to produce or by increasing marginal product demand from customers. In addition, FTK instituted company-wide innovations that reduced costs associated with warehouse management, product manufacturing, and product transportation, which included an Enterprise Resource Planning (ERP) system implemented in early 2013.
Many of these innovations caused FTK’s Degree of Operating Leverage (DOL) to increase, because they reduced variable costs and thereby – allowed fixed costs to account for a larger portion of total costs. In 2014, FTK’s DOL, calculated by dividing the percentage change in annual EBIT, Adj. by the percentage change in annual sales, rose from 0.2 to 1.7, and it reached 5.3 in Q1 2015. While having high operating leverage is definitely a risk, as it can cause a company’s profit to decline quite dramatically if that company’s operating environment weakens, different industries have different levels of operating leverage. In FTK’s case, a DOL of 1.7 in 2014 was lower than its comparable companies’ average figure (FTK’s 10 comparable companies had an average DOL of 2.1 in 2014), however, its DOL of 5.3 in Q1 2015 was higher than its comparable companies’ average DOL of 3.3. FTK’s DOL experienced such a large increase in Q1 2015 for one main reason: given that FTK is a company that sells premium products, whenever a major macroeconomic event occurs that affects demand for its products (like a significant decrease in the price of oil) it begins to experience pricing pressure and lower demand for its more expensive products, which hurts its profit margins.
The marginal cost of additional innovations within FTK’s existing product line is very low, which supports the conclusion that the Company’s trend of continuing to innovate will continue going forward. CnF 2.0, the innovation to FTK’s previously existing line of Complex nano-Fluid chemistry products introduced in Q3 2012, is an excellent example of this concept, as the products that are part of CnF 2.0 achieve even better results than earlier CnF products when run at half the concentration. The result is an implied 50% reduction in the volume of fluids, which significantly reduces input costs, and this innovation likely contributed to the increase in the Energy Chemical Technologies segment’s gross margin from 39.8% in 2011 to 43.9% in 2014. Future innovations to FTK’s existing product lines may bring further improvements to margins through reduced production costs and increased product utility.
Finally, FTK has increased its investments in operational efficiency. In 2013, FTK had approximately $15M in capital expenditures, much of which was spent with the goal of improving its domestic supply chains and overall company-wide logistics. For example, in Q3 2013 FTK debuted a new 20,000 sq. ft. warehouse and truck scales facility in Marlow, Oklahoma, which followed up on an initial expansion of the chemical production facility in Marlow that was completed in the beginning of 2012. The new warehouse and truck scales facility “further[ed] the company's bulk delivery and efficiency efforts” and, as shown in Appendix Image #3, significantly increased throughput while decreasing production costs – resulting in improved operational efficiency. In addition, in Q3 2013, FTK relocated mid-continent operations for the Drilling Technologies segment to Oklahoma City, allowing FTK to consolidate all drilling technology products in one location and positioning its base of operations closer to customers. The relocation is expected to increase margins by increasing operational efficiency and reducing shipment costs.
The improvement in FTK’s efficiency ratios over the last five years can be seen in the chart below:
Data Source: FTK 10-K Filings for 2008–14
- Notes: Ratios were calculated using an average of each balance sheet figure at the beginning and end of the indicated year. The Fixed Asset Turnover Ratio was calculated using an average of Net PP&E and Asset Value of Operating Leases at the beginning and end of each indicated year.
The decline in FTK’s efficiency ratios since 2012 is likely the result of FTK’s effort to expand its domestic manufacturing footprint by increasing its number of manufacturing and warehouse facilities from 30 (12 owned 18 leased) at the beginning of 2013 to 36 (15 owned 11 leased) by the end of 2014 (FTK 2014 10-K Filing). Despite this decline, FTK’s efficiency ratios remained much higher than many of those achieved by its comparable companies in 2014, as seen in the picture below:
Data Source: Bloomberg Terminal and 10-K Filings for Respective Companies in 2011 – 2014
- Notes: Ratios were calculated using an average of each balance sheet figure at the beginning and end of the indicated year. The Fixed Asset Turnover Ratio was calculated using an average of Net PP&E and Asset Value of Operating Leases at the beginning and end of each indicated year.
FTK’s Q1 2015 10-Q filing provided expected capital expenditures for 2015, which reflect the Company’s continued effort to improve operational efficiency through direct capital investment. FTK projected $21 million in capital expenditures in 2015, which is approximately 5.5% and 39.9% more than the amounts spent in 2014 and 2013, respectively. Of the projected $21 million in capital expenditures in 2015, approximately $10 million is expected to go towards construction of two major facilities, a new global research and innovation headquarters in Houston and a chemistry manufacturing and research facility near Sohar, Oman, which is being developed through a joint venture with Gulf Energy (FTK Q1 2015 10-Q Filing). By dedicating a large portion of its capital spending in 2015 to building these new facilities, FTK demonstrates its continued commitment to improving company-wide efficiency.
3. Demand for FTK’s key products, particularly its “green” fracking fluids, will help it capture market share and generate strong cash flow
Demand for FTK’s products is tied to changes in oil and gas production. U.S. Field Production of Crude Oil reached its all-time high of approximately 10.04M barrels of oil per day in November 1970, and thereafter experienced a downtrend that lasted approximately the next 40 years; domestic production hit a low of 3.98M barrels of oil per day in September 2008, and consolidated in the 5-6M barrels of oil per day range until late 2011. Beginning in 2012, domestic production of crude oil saw a steep uptrend of over 140% over the 2008 low to reach its current level of approximately 9.56M barrels of oil per day (as of May 22, 2015), turning the U.S. into “the world’s largest oil and natural gas liquids producer” in 2014.
This “renaissance” in domestic production, as it is often called, was largely driven by hydraulic fracturing (“fracking”) and horizontal/directional drilling, which allowed producers to extract oil and natural gas from rock formations (especially shale formations) that were previously considered to be both “uneconomic” and “unconventional.” Companies that pioneered fracking experienced significant sales growth in a global market that grew at an estimated CAGR of 30.1%, from 2009 to 2014, reaching approximately $40B in 2014 (see Appendix Image #4).
Recent declines in the prices of crude oil and natural gas may cause domestic production to decline in the short term, as Exploration & Production (E&P) companies suspend production at their highest cost locations (or at all their locations). Long-term U.S. crude oil production estimates from the Energy Information Administration (EIA), however, indicate that domestic crude production is expected to increase to a high of 10.60M barrels of oil per day by 2020 and then decrease to 9.43M barrels of oil per day by 2040. This can be seen in the picture below:
Image Source: U.S. Energy Information Administration, Annual Energy Outlook 2015 (PDF Document)
- Note: These estimates are for the EIA’s “Reference Case” for crude oil production, which includes the assumption that crude oil WTI spot prices go to $73/barrel by 2020 and to $136/barrel by 2040.
FTK’s management team consistently tells investors that it operates under the assumption that “one thing is certain: oil is a finite resource and each incremental barrel that is discovered today is as costly, if not more so, to produce than the barrel before.” Furthermore, FTK’s management team believes that “the easy oil has already discovered, so more costly unconventional and enhanced recovery projects are leading the sources of future supply. The marginal cost of recovery will continue to inch higher, hence the long-term pricing trend can only be higher.” Obviously the scenario described by FTK’s management team is bullish for Flotek, so long as the Company is able to distinguish its products from those offered by its competitors by having them be significantly more cost-effective and beneficial to use.
FTK has five main products/product lines that appear to be either superior to those offered by its competitors or relatively unique: (1) Complex nano-Fluid technologies (CnF products); (2) the FracMax analytical model; (3) the Teledrift product line; (4) the Stemulator tool; and (5) the Petrovalve product line. Although it is unclear exactly what percentage of FTK’s total sales these five products/product lines account for, due to the fact that the Company does not publicly release that information, they certainly account for more than 50% of total sales (a rough estimate is that they account for 60% of total sales) and they will likely be responsible for the majority of the Company’s sales growth going forward. This section also addresses FTK’s ability to defend its market share through its ownership of intellectual property rights for many of its key products. The ongoing turmoil in the Oil & Gas Services industry will allow FTK to leverage its superior products to increase market share.
3a. Industry Trends Impacting Demand for CnF Products
FTK’s patented CnF products anticipate increasing environmental regulation in the fracking industry. CnF products are mixtures of surfactants, solvents, and water that organize molecules into nano structures (“nanodroplets”). A surfactant is “a molecule designed to modify surfaces and interfaces,” while a solvent acts to “dissolve common organic oilfield deposits” (FTK Website). Currently, FTK’s CnF products are mainly used as surfactant packages (“additives”) during primary fracks; however, the number of ways in which they can be used is growing. To that end, FTK now has CnF products that are specially designed for well remediation and restimulation (described later in this article), and the Company has expanded the applications of its CnF products so that they can be optimized for conventional wells, deep water wells, disposal wells, and to enhance the delivery of acidizing packages (FTK 2015 Investor Day Presentation).
D-Limonene is highly soluble and it is the main solvent used in CnF products. The nanoscopic structure of the molecules in a CnF additive makes them smaller than the “pores” of the oil formations they are used on, which allows them to disperse the solvent (d-Limonene) throughout the structure of a well much more effectively than additives provided by most competitors are able to do. FTK can customize its CnF chemistry products to adapt for variability in shale formations and even the specific design of wells within a small area of a formation. E&P companies seeking alternative methods to maximize production can send core samples from their wells to FTK’s laboratories for analysis, and the Company’s chemists then determine the CnF chemistry mixture that best optimizes the well completion process, given the specific location of the well. This capability of customization to varying rock formations in many different basins gives FTK’s CnF products a significant advantage over the chemistry products offered by the Company’s competitors. Due to all of these factors, FTK’s CnF products are able to significantly increase a well’s production rate, when compared to those wells that do not use CnF products for completion (i.e. wells using a competitor’s product), and give E&P companies a significant, sustainable increase in Estimated Ultimate Recovery (EUR).
- Notes: Data for production rate increases in wells using CnF products vary depending on the source and the date on which the information was published. In October 2012, CEO John Chisholm told an interviewer that wells using CnF products have seen production rates improve “from 5% to over 200% when compared to neighboring wells in the same plays without CnF.” However, at the Investor Day Presentation on July 29, 2013, Jim Crafton, a third party researcher, reported that wells using CnF products experienced “30-day oil recovery” rate increases of 66-300% (compared to wells not using CnF products), with the 300% improvement occurring when the effect of shut-ins is taken into account.
Company data indicates that, of the 714 E&P companies that have drilled and completed wells in the U.S. and provided data to FracFocus, CnF products have been used by 234 unique clients in the last 2½ years (approximately 32.8% of the 714 catalogued U.S. operators). In addition, data from FracMax shows that 68,193 out of 77,855 total registered wells in the U.S. (87.6%) currently do not use CnF products (Data From FTK’s Investor Presentation At IPAA New York). FTK thus has significant growth opportunity, in terms of both encouraging current customers to use its CnF products on all their wells and seeking out new customers.
3b. CnF Products Anticipate Future Environmental Regulations
D-Limonene is a natural component of the oil (“citrus oil”) extracted from the rinds of citrus fruits (the “skins” of oranges), and it quite possibly the most environmentally friendly solvent currently being used in the fracking and well completion processes. D-Linomene is classified as Generally Recognized As Safe (GRAS) by the FDA and Designed for Environment (DfE) by the EPA.
Due to the fact that they use d-Limonene as their main solvent, CnF products can be said to anticipate future environmental regulations by complying with all potential future chemical usage restrictions. Over the last decade, as new oil & gas production techniques (i.e. fracking and horizontal drilling) gained widespread acceptance among E&P companies, pressure for stricter environmental regulations on the chemicals used during oil & gas production has increased dramatically. On March 20, 2015, the Obama administration, through the Bureau of Land Management, unveiled the nation’s first major federal regulations on hydraulic fracturing. These are the first changes to well-drilling regulations in the last 30 years, and they cover about 100,000 oil and gas wells drilled on public lands (while allowing individual states to retain jurisdiction over drilling on private and state-owned land). The new federal regulations, which will go into effect on June 18th (90 days after they were released), will: (1) allow government officials to inspect and validate concrete barriers lining fracking wells; and (2) require companies to publicly disclose chemicals used in the fracking process, using an industry-run website called FracFocus.
These new federal regulations blaze a trail for those seeking to propose tighter restrictions on the types of chemicals permitted for use in fracking. Increased fracking regulation is most certainly a long-term trend, and oil and gas producers will increasingly look for new, environmentally friendly chemicals that can withstand the new regulations. With its highly effective CnF products, FTK therefore stands at the forefront of a “green” technology movement in domestic oil and gas production. FTK is positioned to gain share in markets with stricter environmental regulations, due to the huge increases in production rates operators can see by using its CnF products.
Just how “green” are FTK’s CnF products, and does being green reduce the benefit they can provide? D-Limonene competes with BTEX-type solvents, which are “volatile aromatic compounds typically found in petroleum products” that are either used as additives in fracking fluids or released underground during the fracking process. Xylene, one of four main BTEX compounds, is a known environmental hazard and many of the other BTEX-type solvents are also considered “contaminants.”
CnF products also help operators significantly reduce the environmental impact of their drilling sites. FTK asserts use of CnF products allows operators to source and consume 20-40% less water and proppant, resulting in less truck traffic, vehicle emissions, equipment on location, and water and flowback waste to manage (2013 Investor Day Presentation). CnF products’ ability to reduce water consumption in the fracking process assists FTK in gaining customers in those geographic regions where significant rainfall is temporarily (in the case of a drought) or permanently lacking; for example, oil producers in California used 70 million gallons of water for fracking last year, despite the state’s historic drought, and if any water usage restrictions were to go into effect local E&P companies would seek out those products that could minimize their water usage. The ability to reduce water usage in the fracking process also serves FTK well when it comes to entering global markets (e.g., the Middle East) that have limited supplies of water. In short, being both green and highly effective allows CnF products to provide many benefits, both environmental and economic, that many other products on the market simply cannot hope to match.
Having green products also allows FTK to sell to markets that very few of its competitors can enter due to extremely strict environmental regulations. For example, certain CnF products have been approved for use in the North Sea, “which has some of the most stringent oil field environmental standards in the world” (FTK 2014 10-K Filing), and FTK recently had its chemistry products used in wells in California (a state with particularly strict environmental regulations concerning oil & gas production).To further penetrate these highly regulated markets, FTK plans to introduce a new Fully Disclosable CnF product in the first half of 2015, to increase its market penetration in California and enter highly regulated foreign markets such as Australia.
Several companies offer “green” fracking fluids that compete against CnF products, but FTK’s multiple patents limit competitors’ options. By far the most well-known of the competing products is Halliburton’s CleanStim Hydraulic Fracturing Fluid System, which uses a fracking fluid formulation that is made with ingredients supplied by companies in the food industry. Despite the obvious similarities between CnF products and CleanStim fluids (they both are made from food grade materials), there are material differences. First and foremost among these differences is the patented nanoscopic structure of FTK’s CnF products, which is what CnF additive “droplets” to work as effectively on shale formations as they. Halliburton is the largest distributor of CnF products, accounting for 16.1% of FTK’s total consolidated sales in 2014, and it is unlikely that Halliburton would distribute CnF if its own product was superior.
Publicly-traded companies such as Solazyme (SZYM) and Baker Hughes (BHI) have environmentally friendly products that are used in oil & gas production. Many of these products, however, do not directly compete against FTK’s CnF products. SZYM’s lubricant, “Encapso,” is designed to deliver lubricants to points of friction in order to increase “drilling speed and control,” and this is not an area in which CnF products currently have much of an application. Similarly, BHI’s fracturing fluid, VaporFrac, is designed for “water-sensitive and/or low-pressure reservoirs,” which is also an area in which FTK does not specialize. In addition, there are a number of small, privately-held, specialist companies that have developed “greener” fracking fluids, including Chem Rock Technologies and Rapid Drilling Fluids; while other companies have developed environmentally friendly methods of water treatment and waste disposal at fracking sites (e.g., WaterTectonics), these companies do not compete directly with CnF products.
3c. Significant Growth Expected For CnF Products
CnF additives are cost-effective, and usage in horizontal wells typically has a payback period of less than a month even at current oil prices (see Appendix Image #5). Moreover, on February 23, 2015, FTK announced the introduction of new CnF chemistries to aid in the remediation and restimulation of existing wells. These new products allow operators to consider alternatives to increasing production solely by drilling new wells, and CEO John Chisholm reported that the Company’s “data suggest[s] that a remediation or restimulation treatment of a well using a tailored CnF chemistry design can reinvigorate production by 30-70% and, in some cases, return the well to its original production profile… at a fraction of the cost of drilling and completing a new well.” This alternative is particularly attractive when compared to the high cost of drilling and completing a new well, and it is only one of the many areas in which CnF products have significant growth potential going forward. For the additional environmental reasons explained above, FTK’s CnF products offer the company material advantages in their markets.
3d. FTK’s FracMax Analytical Software
FTK’s FracMax analytical software, its second key product that will drive the Energy Chemical Technologies segment going forward, is a patent-pending application for comparing the performance of wells using CnF against those using conventional (non-CnF) products. Although there are many drilling analytics and simulation tools on the market, FracMax is fairly unique in that it has an exceptionally large number of applications and because it is driven by an analytical model that aggregates disparate information on well performance in a single dataset, which allows for exceptionally thorough analysis.
FracMax sources comparison data primarily from the national hydraulic fracturing chemical registry, FracFocus.org, which contains data provided by well operators as a means of reporting chemicals used for hydraulic fracturing. Thus only the software’s method of analyzing and presenting data, not the data itself, is proprietary. FracMax allows operators to compare the results of wells that use CnF products to those that do not, using various industry metrics to gauge a well’s results. Furthermore, FracMax enables producers to conduct a simulated “sensitivity analysis” on its wells using many key variables such as drilling costs, operating costs, oil and natural gas spot prices, and assumptions related to Net Present Value (i.e., discount rate and number of years). Of all the metrics that FracMax software is able to show producers, a CnF product “cost recovery timeline” is likely the most important right now, given the challenging commodity price environment (see Appendix Image #5).
As shown below, FracMax is able to demonstrate to operators that FTK’s CnF products are extraordinarily cost-effective and operators can still expect to see their wells achieve a positive Net Present Value even with oil and natural gas prices at $50.69/barrel and $2.95/MMBtu respectively:
Image Source: 2015 Investor Days Presentation, February 2, 2015
FracMax is a marketing tool that FTK uses market its CnF products, and the Company does not generate any sales directly from the tool (i.e., FTK only generates sales indirectly from FracMax, via incrementally larger quantities of CnF products sold as a direct result of an improved marketing capability using the tool). FTK only recently began benefiting from FracMax, because the tool was only released in Q2 2014. Like many other data analysis tools, FracMax software is highly scalable; as it collects more data it is easily able to analyze and incorporate that data into its models, which ultimately provides better results. In the short time since its introduction, FracMax incorporated data from approximately 80,000 wells across key U.S. basins. FTK intends to maximize FracMax’s potential through a new wholly-owned subsidiary, FracMax Analytics, LLC, a research and data analysis company providing well- and basin-specific statistical analysis. The ability to provide customized data analysis sets FTK apart from its competitors and provides a defensible competitive advantage.
FracMax has already significantly helped accelerate the acceptance of FTK’s CnF products by giving the Company’s marketing team the means to convey the products’ economic benefits to both service companies and E&P end-users. Statements made by CEO John Chisholm in FTK’s Q4 2014 and Q1 2015 earnings calls revealed that interest in the Company’s CnF products grew significantly following the introduction of FracMax, despite declining oil prices and massive spending cuts from exploration and production companies, and there was “a record number of corporate inquiries regarding [the Company’s] Complex nano-Fluid chemistries and FracMax analysis” during Q4 2014. FTK’s CnF products are starting to get interest from major operators that were not receptive to them prior to the introduction of FracMax, and validation projects with two such operators occurred in Q1 2015.
The introduction of FracMax analytics software has also shortened the sales cycle for CnF products (now down to around four weeks after previously taking up to two months), increased FTK’s rate of converting validation clients into commercial users, and led to a significant increase in the number of companies signed up for validations. Although FTK has historically had a very high success rate in converting validation clients into commercial users, the introduction of FracMax pushed the rate from around 80% to well above 90% in Q1 2015 (FTK’s management said in its Q1 2015 earnings call that the Company’s success rate would have been 100% if it was not for a few companies completely suspending all production). Information from FTK’s Q1 2015 earnings call and press release indicates that the Company initiated “nearly 30 new validations” in the quarter, which was “nearly double the number started in the first half of 2014,” and there are “over three-dozen validations” in the Company’s pipeline with “over 40 active validations” currently underway.
While it is definitely impressive that companies are continuing to sign up for validation projects with FTK for its CnF products, one should expect the Company’s sales cycle to lengthen as companies attempt to delay any additional expenditures as long as possible while oil prices remain low. In addition, a concerning development has begun to take place during the beginning of 2015: E&P companies are starting to wait before completing their wells. This concept was discussed in a Bloomberg article, dated March 05, 2015, which described how “from North Dakota to Texas, there are more than 3,000 wells that have been drilled but not tapped, based on estimates from Wood Mackenzie Ltd. and RBC Capital Markets LLC,” and underlines a potentially negative trend for FTK.
Finally, FTK sees product uptake over time with new customers. Operators choosing to use FTK’s CnF products do not immediately use them on all their wells, they first conduct “validations” on some of their wells in order to first see if the products achieve the desired increases in production. Over time, these operators increase the number of wells using the products; the FracMax analytical tool helps close this gap, by forecasting production comparison results and making the economic advantages of FTK’s CnF products readily apparent when they materialize. As shown below, the FracMax model calculates that $53,915,745,415 in total sales potential was lost in 12 months for the 32,115 wells in Texas that do not use FTK’s CnF products (i.e. Non-CnF Wells); this estimate uses an oil spot price of $50.69/barrel, thus the advantages of using CnF products will become even more apparent as oil prices rise (wells using CnF products generate an even larger return compared to those that do not when the price of oil rises, given the increased production rates).
Image Source: 2015 Investor Days Presentation
3e. Teledrift Product Line
Note: Teledrift is a division of FTK’s Drilling Technologies segment, but is referred to here as a product line so as to align with the terminology used in FTK’s 2014 10-K filing.
FTK currently has six measurement and three survey tools in its Teledrift product line. Of the measurement products, four are Measurement While Drilling (MWD) tools that provide operators with inclination measurements for drilling in real time. Telepulse, a horizontal guidance MWD tool, was FTK’s first tool for horizontal, not vertical, drilling and it can be combined with the Company’s other products in a complete package to maximize results. Even before the addition of Telepulse, the Teledrift product line was the market leader in North America (as of Q3 2014) and had captured a large portion of the market in both the Middle East and South America (e.g., Teledrift is now used on “nearly 40% of all Saudi Aramco rigs” and “55% of all rigs drilling in [Argentina]”). Now, with Telepulse, the Teledrift product line is poised for significant growth in terms of units rented/sold, both domestically and internationally, and it should continue to capture market share.
3f. The Stemulator Tool
FTK’s Stemulator tool “induce[s] axial vibration in the drill string to reduce friction drag and sticking,” accelerates drill bit penetration in horizontal wells, and makes the drilling process more cost-efficient. The Stemulator tool can be used on horizontal wells, a significant advantage given producers’ increasing focus on this type of drilling. Since its introduction in Q3 2013, the Stemulator has leveraged the global interest in technologically-advanced drilling products that was generated by systems such as SoftSpeed II technology, which was created by National Oilwell Varco, Inc. (NOV) in 2009. The Stemulator competes well with NOV’s technological drilling system, and it can be combined with Telepulse and downhole motors to further increase drilling efficiencies. FTK’s management team expects the Stemulator to take the No. 2 spot behind NOV’s product, and the Company’s ability to generate new product synergies (between the Stemulator and the Telepulse products) further supports the significant long-term growth potential of the Stemulator.
- Note: NOV has a patent that covers some of the processes conducted by its SoftSpeed II Technology; it is unclear whether FTK’s Stemulator infringes on that patent in any way (given similarities in the two products). However, the absence of any legal action by NOV over the past 18 months suggests that a patent infringement suit is unlikely, and the Stemulator almost certainly does not infringe upon NOV’s patent.
- Note: Without the Teledrift product line and the Stemulator tool, the Drilling Technologies segment would drag FTK’s total sales lower in the present price environment (see valuation section for detailed sales projections for the Drilling Technologies segment).
3g. PetrovalveProduct Line
The Petrovalve product line is part of FTK’s Production Technologies segment, which provides pumping system components to aid in the efficient, safe extraction of oil and natural gas from wells. FTK created its Petrovalve products to solve a “ball and seat failure” problem that “the vast majority of producing wells” encounter, which ultimately results in recurring costs that negatively impact cost-effective extraction from a well. Petrovalve sales grew significantly in 2014, with sales of Petrovalves and lifting units rising by $4.6 million (+152.9% y/y), but there is still to expand the reach of this product line because Petrovalves can be used on any type of artificial lift well, “including but not limited to high gas/oil ratios, H2O/oil, heavy crude, and sandy wells” (FTK Website – Petrovalve Plus PDF Description).
3h. FTK Pursues a Strategy of Aggressively Developing and Defending Intellectual Property
FTK’s intellectual property portfolio discourages competitors from introducing similar products and helps protect market share once captured. This portfolio contains numerous patented and patent pending applications on various downhole drilling tools and chemical products, with FTK’s number of patent applications soaring from around 10 in January 2008 to approximately 70 by January 2015 (FTK 2015 Investor Days Presentation). FTK has existing or pending patents related to four of the five products/product lines described above (CnF, FracMax, Teledrift, and Petrovalve). The patents either completely cover all aspects of the products, in the case of FTK’s patented CnF product line and patent-pending FracMax analytical software, or relate to the design of the products (i.e. casing centralizer design and ProSeriestool design), in the case of FTK’s Petrovalve and Teledrift product lines. The majority of FTK’s patented products sell for a premium, producing company-wide margins significantly higher than those seen by comparable companies (see Benchmarking Analysis in Appendix for further details).
FTK is committed to growing its intellectual property portfolio and, although many of FTK’s patented products were developed by the Company itself, the Company historically has been willing to obtain patents by either buying them from their original owners or by acquiring entire companies with the patents included. For example, the recent acquisition of International Artificial Lift, LLC (IAL) provided FTK with patented designs for hydraulic pumping units that give FTK a “tangible competitive advantage” by “providing precision pumping functions with the fewest component,” which increases overall system reliability and reduces maintenance downtime. FTK paid a total of $2.25 million to acquire IAL; while a very small acquisition, the Company’s management team made sure to remind investors that “good things come in small packages at Flotek. It was just over a decade ago that Flotek purchased what would become the CNF technology for about $100,000, and a few thousand shares of Flotek's stock. Today, it is the flagship of Flotek's technology portfolio.” The acquisition of IAL, therefore, reaffirms FTK’s commitment to focusing on developing and selling niche value-adding technology-based products.
4. Existing competitive advantages enable FTK to experience strong organic growth in both foreign and domestic markets
FTK has significant domestic expansion opportunities in the current market environment, yet there are two obstacles it must overcome to increase its domestic penetration rate: (1) as noted above, with a few exceptions large domestic E&P companies have yet to embrace FTK’s CnF products; and (2) operators need to pay a fairly high premium for CnF products over more conventional fracking fluids, and it is difficult to convince them to do so in the current market environment. Indeed, large E&P companies have proven historically resistant to accepting new technologies of any type.
FTK is working hard to overcome these two obstacles and it has already begun to see positive results in relation to overcoming the first of them. FTK’s Q4 2014 earnings call revealed that the Company’s CnF products are starting to get interest from major operators who were receptive to marketing efforts prior to the introduction of FracMax; validation projects with two such operators were scheduled for Q1 2015, and indicate meaningful progress with major operators despite the current market environment. Acquiring large operators, those with thousands of wells under their control, as customers takes a fairly large amount of time for a company as small as FTK, however, the Company’s management team believes that significant progress has already been made in this regard and interest in CnF products from large operators has never been higher than it is right now.
Pricing pressure is definitely a major risk for FTK in the current commodity price environment, and it has already affected the Company’s margins in Q1 2015. As one might expect, margins were a hotly discussed topic in the Q4 2014 and Q1 2015 earnings calls and, while CEO Chisholm told investors in the Q4 2014 earnings call that the Company “expect[s] some margin degradation,” it definitely shocked investors to see FTK’s adjusted gross margin fall from 38.9% in Q4 2014 to 32.2% in Q1 2015. Although FTK’s gross margin in Q1 2015 may not make it apparent (at first glance), FTK’s management team states it has an ongoing plan for how it intends to protect the Company’s margins going forward. FTK’s management team intends to look at pricing for all of its products on a case-by-case basis, with an eye towards retaining its most important customers (i.e., FTK is willing to either accept a lower margin project or sell its products for a slightly lower price if it is entering into a contract with a customer that it believes will provide meaningful sales opportunities in the future), and it expects its supply chain to be fairly flexible – with the Company able to maneuver so as to get the best prices on the raw materials needed to manufacture its products. In the Company’s Q1 2015 earnings call, FTK’s management team told investors that “we have gone out of our way to protect the margin on the patented complex of nano-fluid chemistry,” which is definitely a reasonable long-term strategy for a Company known for selling premium products to take, but that does imply that margins will continue to be pressured in the short-term. In summary, although FTK experienced significant pricing pressure in the first quarter of 2015, the Company’s management team believes that company-wide margins will improve going forward, as every effort is made to cut costs and negotiate deals that are favorable for the Company in both the short-term and long-term.
- Note: Pricing pressure, and its effect on FTK’s margins, is discussed in more detail in the “Potential Risks” section at the end of the article.
Finally, the appreciation of the U.S. dollar has provided FTK with a positive economic tailwind, as less than 1% of the Company’s sales was demarcated in non-US dollar currencies in 2014 (FTK 2014 10-K Filing). As a result, FTK currently has very little exposure to foreign currency risk, and currently has no foreign currency hedges; this will change as its international expansion plans begin to unfold.
Since 2007, when 95.2% of its total sales came from the U.S., FTK has become a much more geographically diverse company and it now operates in 20 domestic and international markets (FTK 2014 10-K Filing), and in many key basins around the globe. The growth in FTK’s international sales over the last 10 years can be seen in the chart below:
Data Source: FTK 10-K Filings for 2004-14
- Notes: Notes: Numbers for 2004-2006 are approximations based on information sourced from the MD&A section of 10-K filings. Prior to 2004, "substantially all of [the Company's] sales and operations [were] derived and conducted, respectively, within the United States" (10-K Filing For 2003).
Despite achieving a CAGR of 37.5% over the last 10 years, international sales only accounted for 17.6% of FTK’s total sales in 2014 (19.1% of total sales in the last twelve months). Although this figure was quite low when compared to the percentages recorded by many of FTK’s comparable companies in 2014 (on average international sales accounted for 49.3% of total sales for FTK’s 10 comparable companies in 2014), it is the highest that it has been in the past 10 years, and the Company expects international sales will increase significantly going forward. As one can see in Appendix Image #6, which depicts both a historical and projected breakdown of the international and domestic portions of FTK’s total sales in the “Base Case 1” scenario (see valuation section for additional details), international sales is projected to reach 38% of total sales by 2034. The breakdown of international and domestic portion of total sales was used as a driver for FTK’s operating tax rate in the DCF valuation analysis, and the projected increase in the international portion of total sales is expected to cause the Company’s operating tax rate to decline from its level of 34.5% in 2014 to 30.7% by 2034 in “Base Case 1” scenario. All of these projections are consistent with figures calculated for FTK’s most comparable companies (as seen in the “Valuation Analysis” excel document).
- Note: Operating Tax Rate calculations are not described in the valuation section of this article. To find out how FTK’s Operating Tax Rate was calculated and projected, look at the worksheet entitled “Driver – Operating Tax Rate” in the “Valuation Analysis” excel document.
FTK is dedicated to expanding its international operations, and to do so it is focused on geographic regions with the largest quantities of natural resources, which can be seen in the picture below:
Image Source: 2015 Investor Days Presentation on February 2, 2015
Although the picture above does not provide numbers, it provides a sense of oil and natural gas resources by geographic region. FTK’s CnF products work best on “tight” shale reservoirs, because their extremely small molecular structure allows them to work much more effectively on shale rock than many other products can due to shale rock formations’ very small “pores.” This fact makes CnF products ideal for use in geographic regions where tight gas, shale gas, and shale oil are plentiful. FTK’s expansion (either planned or ongoing) into some of international regions depicted in the chart above is focused on a few key markets where such formations are present.
First, the international market that FTK has already expanded into the most is Canada, and the Company’s expansion into Canada serves as a model for how it will likely try to expand into other international markets. Indeed, FTK’s success expanding into Canada bodes well for its international expansion plan. Canada is one of FTK’s fastest growing markets, with the number of Canadian service companies using FTK products having doubled over the past year while the number of FTK’s products used by those companies tripled (Investor Presentation in February, 2015 – IPAA Florida Oil and Gas Investment Symposium). FTK’s monthly Canadian sales growth accelerated significantly during the first half of 2014 and reached a year-over-year growth rate of 400% in July, with approximately 80% of that business being attributed to CnF product sales. Overall, FTK significantly grew its presence in Canada during 2014 while overcoming obstacles such as the seasonal “spring breakup” (“spring thaw”), which the Company’s management team believes “reduced CnF sales by about $3 million in April and May,” and it plans to further expand its presence in Canada in 2015.
FTK recently estimated that the CnF market potential for acidizing and fracturing in Canada is $125 million (Investor Presentation in February, 2015 – IPAA Florida Oil and Gas Investment Symposium). Data from FTK’s recently introduced FracMax Canada product (released on January 09, 2015) shows that only 828 of the 7,662 total catalogued wells in Canada currently use CnF products, meaning there is 89.2% of the Canadian market that FTK has yet to penetrate. The FracMax Canada product uses data specific to Canadian oil and gas markets to provide “a broad representation of Canadian production across nearly all Western Canadian producing basins,” which supports accelerating growth for FTK in the country “with nearly every Canadian-based pressure pumping company now pumping CnF completion chemistries in a number of projects” (Investor Presentation in February, 2015 – IPAA Florida Oil and Gas Investment Symposium).
FTK also plans to encourage growth by using FracMax Canada to help convince Canadian clients to conduct additional validation tests of CnF chemistries at their other projects throughout the country. FTK's sales team has been so successful in Canada that "every project taken on for Canadian customers by the Research and Innovation team in the Woodlands has turned into sales for Flotek.” FTK’s ability to capitalize upon this success will come from future development in Canada, including “an increased headcount, local laboratory and Microsolutions drilling technology” (Investor Presentation – 4th Annual Ultimate Energy Conference), but it will also come from forming strong partnerships with Canadian services companies.
FTK also is aggressively pursuing expansion opportunities in the Middle East - North Africa (MENA) region, as oil and gas production in the region is expected to see consistent long-term growth. FTK formed a joint venture in November 2013 with Gulf Energy, LLC and Tasneea Oil and Gas Technologies, LLC. The venture formed two Omani-based LLCs, Flotek Gulf and Flotek Gulf Research, to construct and operate an oilfield chemistry production and research facility near Sohar, Oman. FTK and Gulf Energy recently completed negotiations with an engineering and construction company for the development of Flotek Gulf’s Omani facility, and completion of this facility is expected in the first half of 2015 (Information From 2014 10-K Filing And Recent Company Announcements). FTK has been trying to ramp up its Lost Circulation Material (LCM) business in the Middle East for five years, and the company is currently awaiting word on whether it has won its LCM tender to distribute Lost Circulation products to more than three rigs in the United Arab Emirates. FTK also plans to continue its coiled-tubing (CT) product development, so that it can expand further into the Middle East, and the Company was recently chosen to be a supplier of CT products for four CT companies in the Middle East. FTK’s management team is very focused on the CT market in the Middle East and it is fast tracking local supply of acidizing and cementing chemicals for that reason. In addition, FTK plans to add a regional lab facility in Abu Dhabi in the near future to help facilitate CT product development (Information from 2015 Investor Days Presentation and Webcast).
FTK recently furthered its Middle East expansion plans by forming a strategic agreement with SZYM, whereby they will “develop and market advanced drilling fluid technologies, including globally commercializing and marketing the Flocapso drilling fluid additive.” While this agreement will help expand FTK’s operatins in many international markets, it will particularly help the Company’s expansion efforts in the Middle East because “Solazyme has granted Flotek exclusive distribution rights to sell and market Encapso as a drilling fluid lubricant in certain territories in the Middle East.” As part of the arrangement, FTK “agreed to certain minimum purchases of Encapso from Solazyme in the initial year of the Agreement,” which should give investors confidence in the Company’s Middle East expansion efforts because it would not have agreed to “minimum purchases” if it was not confident in its ability to sell the product.
As for Latin and South America, FTK is pursuing business opportunities in Mexico and Argentina. FTK is in the final stages of a CnF product validation with Petróleos Mexicanos (“Pemex”), the Mexican state-owned petroleum company, and management “expect[s] the multiple well validation project to continue through the early part of this year and believe[s] there are meaningful sales opportunities towards the end of 2015.” FTK is also working to overcome import restrictions in Argentina by utilizing local blending of its products, and the Company has reported that there is strong local demand for its products due to pressures on the state enterprise Yacimientos Petrolíferos Fiscales (YPF) to increase production after being nationalized in 2012. YPF has recently increased its drilling activity and adopted pad drilling, which gives FTK an opportunity to assist YPF in maximizing its production (FTK 2015 Investor Days Presentation).
Finally, FTK seeks to grow its business in Australia. With proved natural gas reserves of over 43 trillion cubic feet (Tcf) as of 2014 and estimated proved plus probable commercial reserves of 132 Tcf (“99 Tcf of traditional natural gas and 33 Tcf of coal bed methane-CBM”) as of 2012, Australia has one of the largest natural gas reserves in the world and there is a huge amount of sales to be gained by those companies who are allowed to help extract it. The problem for many operators is that Australia has a strict “full disclosure” policy on all chemical products that are used to extract natural gases using hydraulic fracturing, and many operators have a difficult time overcoming these regulations (for either environmental or IP reasons). With the introduction of its new Fully Disclosable CnF product expected in the first half of 2015, FTK is on the brink of being able to enter the Australian market. If FTK can enter the CBM market in Australia, it will be able to leverage its business relationship with Halliburton, who already has operations in Australia, to help maximize its market penetration potential. FTK hopes its FracMax analytical software will help to introduce CnF products to Australia, possibly by creating a completely new FracMax model specifically designed for the Australian market (like it did with FracMax Canada), and it views Australia’s coal bed methane (CBM) market as a “huge target” for the Company in the first half of 2015.
- Note: Horizontal drilling and hydraulic fracturing are the most common extraction methods for CBM. Gary Flock, FTK’s VP of International Business, described the Company’s goal of entering Australia’s CBM market in the webcast of the 2015 Investor Days Presentation in February 2015.
- Note: “Established in legislation of 1989, the National Industrial Chemicals Notification and Assessment Scheme (NICNAS) examines new compounds from a public-health viewpoint and maintains a FracFocus-style record called the Australian Inventory of Chemical Substances (AICS). Under this regime, full disclosure is a baseline expectation.
5. Current market valuation offers long-term upside potential to FTK’s share price
FTK had very positive tailwinds going into 2015, but its performance in Q1 2015 suggests potential short-term weakness that the Company will need to overcome if it is to be a good investment. This uncertainty is addressed in the subsections below, and it is concluded that FTK’s current price offers significant long-term upside potential.
5a. A Difficult Start to 2015 Despite Positive Tailwinds
FTK saw significant success in 2014. The company had record sales of $449.2M, achieved sales and Diluted EPS, Adj. growth of 21.0% and 42.1% (y/y) respectively for the year, and saw sequential growth in Q4 2014 of 6.7% and 11.5% (q/q) for sales and Diluted EPS, Adj. respectively. FTK’s success in 2014 was largely the result of continued growth in FTK’s Energy Chemical Technologies segment, which saw sales growth of 33.8% (y/y) and EBIT growth of 29.7% (y/y) that was driven primarily by increased market penetration for CnF products (helped by the introduction of FracMax). Moreover, FTK’s largest clients sales volume for CnF products by over 25% from 2013’s levels, and sales attributed to FTK’s largest client increased by 20.3% for the year. In addition, with the introduction of FracMax in Q2 2014, FTK continued to add many new validation clients through the end of 2014 and entered 2015 in a very strong position. To meet the increase in demand for its CnF products, FTK’s CESI Chemical Division increased the scientists on its payroll by 20% (as stated in an investor presentation), yet FTK’s workforce productivity metrics (revenue and operating income per employee) still achieved record highs. In addition, FTK planned significant market and product introductions in early 2015 that suggested the prior year’s trend would continue.
On April 21, 2015 (pre-market), however, FTK reported preliminary Q1 2015 results that were significantly below analysts’ consensus estimates. The Company’s stock price fell 18.5% over the course of the next four trading days, with the preliminary results confirmed by actual reported results on April 22, 2015. For Q1 2015, FTK recorded total sales of $82.4M (-19.7% y/y) vs. an analyst consensus estimate of $103.3M and GAAP EPS of $-0.03 (-113.6% y/y) vs. an analyst consensus estimate of $0.14. The reported EPS figure included “an administrative penalty of $410,868,” related to “alleged violations involv[ing] procedural and registration issues” at FC Pro (a division of Florida Chemical) that took place before FTK acquired the parent company in May 2013. Even when those non-recurring items are excluded, however, the Company would still have reported adjusted EPS of -$0.02 for the quarter. Adjusted gross margin for Q1 2015 was 32.2%, which was down significantly from 42.6% in Q1 2014 and 38.9% in Q4 2014, bringing FTK’s adjusted gross margin for the last twelve months to 38.7% (down from 40.7% for full-year 2014). Adjusted EBIT margin for Q1 2015 was -1.1%, and this was largely attributed to the fact that SG&A expenses increased significantly as a percentage of sales (from 21.0% in Q1 2014 to 29.0% in Q1 2015).
There were positive elements of the Q1 2015 earnings report and earnings call, with FTK showing strong international sales growth (+19.2% YoY), significant sales growth in the Teledrift product line (+45% YoY), and CEO John Chisholm telling investors that the Company is in discussion to potentially create a FracMax product for Saudi Arabia. In addition, FTK reported a success rate at converting validation clients using CnF products to commercial users of nearly 100%, and a shortening of its “conversion cycle” to 30-45 days on average, with the “vast majority” taking place in under 30 days. FTK also achieved an effective tax rate of 21.1% in Q1 2015 (vs. 34.7% last year) and announced it expected to see the rate be between 28% and 32% going forward.
While FTK’s Q1 2015 earnings report looks very negative at first glance, it is important to understand that FTK’s year-over-year sales decline in the quarter was smaller than the roughly 23% (y/y) decline in average North American rig count that took place from Q1 2014 to Q1 2015 (calculated by taking the average of North American rig count at the beginning and end of each quarter). Furthermore, an inventory drawdown at FTK’s distributors caused February to be the only truly bad month in the quarter; the remaining months saw sales barely down (y/y) and EPS was positive, so if February’s performance had been in-line with performance during January and March the Company’s sales and EPS would have been much higher. FTK’s gross margin degradation was due largely to sales mix among its product lines (i.e., the percentage of total sales generated by each product line, which each have different margins), not to pricing pressure for CnF products, suggesting underlying strength. FTK plans to decrease its operating expenses significantly going forward; the Company has already reduced headcount in its Drilling Technologies segment by 16%, with more reductions to come if market conditions worsen, and it is in the process of consolidating some of the segments’ field locations.
Despite the positive signs in FTK’s Q1 2015 earnings report and conference call, the downward trend in the Company’s financial performance could certainly continue. Companies in the Oil & Gas Services industry typically have their worst quarter of financial performance in the second quarter of the year (March 31 – June 30), due to the spring thaw (or “spring breakup”) in Canada. The spring thaw causes roads to become muddy, making it nearly impossible for heavy drilling equipment to be transported. Drilling activity typically comes to a standstill in most parts of Canada as drilling rigs suspend operations and wait for the ground to dry. As a direct result of the spring breakup, Canada’s rig count has historically reached a yearly bottom during the second quarter, usually in either April or May, and last year (in the Company’s Q2 2014 earnings call) FTK’s management team estimated that “the spring breakup reduced CnF sales by about $3 million in April and May.”
The Discounted Cash Flow (DCF) analysis below addresses these issues.
5b. Background Information on DCF Analysis and Approach Towards Operating Scenarios
FTK is a commodity-driven company and its financial performance is strongly correlated to the price of oil whenever it experiences a major move higher or lower. Like other companies in the Oil & Gas Services industry, FTK depends on Capex spending from exploration & production (E&P) companies. E&P spending likewise is highly dependent on the price of oil, and it is usually positively correlated to the price of oil over the long term. E&P spending, which can be roughly gauged using “indicators” like rig count and well count, typically lags the price of oil by a fairly short period of time (rig count follows the price of oil closely whenever it makes a major move in either direction, and usually “lags” the price of oil by a few weeks or months).
Over the long term, FTK’s company-wide gross margins have three key drivers: 1) sales mix; 2) new products and innovations to existing product lines; and 3) pricing/general competition. FTK’s sales mix derives from the sales generated by each of its four business segments. If, over time, the segments with the highest gross margins a higher sales growth rate than the sales growth rate generated by the segments with lower gross margins, they account for a larger portion of total sales and FTK’s company-wide gross margin would increase even if the gross margins for individual segments do not change (the results of this scenario are magnified, for better or worse, when gross margins for individual segments change). The development of new products drives company-wide gross margins because, as previously mentioned, only a few key products and product lines are expected to drive the majority of FTK’s financial performance going forward, and whether or not a newly developed product can be sold for a premium (compared to other products offered by competitors or by FTK itself) will drive gross margins. Similarly, innovations to existing product lines drive gross margins because they can either reduce FTK’s COGS (example: CnF 2.0) or justify the Company’s ability to sell a new or existing product for a premium. Pricing competition, and competition in general, drives gross margins because the less competition FTK has the better its margins will be, and the longer that FTK can remain at (or near) the forefront of its field the longer it will be able to maintain its high margins.
Five operating scenarios were created for the DCF model to take into account the unpredictable future of the oil price and the nature of FTK’s business: (1) Base Case 1 with analysts’ estimates; (2) Base Case 2 with modified estimates; (3) Upside Case; (4) Downside Case; and (5) Extreme Downside Case. Due to the fact that FTK is highly dependent on E&P spending, these five scenarios were derived from different assumptions for the price of oil and the direction of E&P spending over the course of the next three years (i.e. through the end of 2018). All five operating scenarios, however, depend on a single assumption: the price of oil will rise above $80/barrel by at least the end of 2018, and afterwards will remain roughly within the $80-$120/barrel range until 2034, the final year of the DCF model’s 20-year projection period. As a result, a premise of this article is that readers (potential investors in FTK) believe that the price of crude oil WTI will rise above $80/barrel at some point in the next three years. One who does not agree with this premise would not consider buying shares of a company in the Oil & Gas Services industry in the first place. Furthermore, it is the author’s opinion that if the price of oil does not rise above $80/barrel by mid-2017 at the latest, FTK is not a worthy investment. The five scenarios, therefore, vary as to how long it will take for a “recovery” in the price of crude oil to take place, which is defined by the price of crude oil WTI rising (and remaining) above $80/barrel.
The varying assumptions for the price of crude oil (WTI) under each of the five different operating scenarios can be seen in the chart below:
- Note: After the price of oil reaches $80/barrel in each of the operating scenarios, it is assumed that the price will remain in the $80-$120/barrel range thereafter. No projections for the price of oil are made after it reaches $80/barrel. The author derived the $80-$120/barrel long-term oil price range after conversing with money manager Kirk Spano, from www.americanresourceboom.com, and it is fairly consistent with long-term crude oil price estimates in the EIA’s “Reference Case” from its Annual Energy Outlook 2015, which was published in April 2015.
The five different operating scenarios are described, in greater detail, as follows:
- Base Case 1: Assumes the price of Crude Oil WTI performs a “double bottom,” again dropping to approximately $50/barrel by the end of 2015; oil rises and reaches $80/barrel by the end of 2016, and remains in the $80-$120/barrel range thereafter. E&P spending bottoms towards the end of 2015 and remains near this bottom through the end of 2015; E&P spending then rises through the end of 2016 and thereafter, until it reaches a sustainable level commensurate with the price of oil.
- Base Case 2: Same assumptions for oil prices and E&P spending as “Base Case 1.” The Base Case scenarios differ only in their expectations for FTK’s profitability. Base Case 1 applies the consensus estimates of analysts, which were viewed as being overly conservative; Base Case 2 applies estimates explained in greater detail below.
- Upside Case: Assumes the price of Crude Oil WTI has already reached its bottom, ends 2015 at $80/barrel, and remains in the $80-$120/barrel range thereafter. E&P spending bottoms in the summer of 2015 (after the negative effects of the spring thaw dissipate), begins to rise towards the end of 2015, and continues to rise until it reaches a sustainable level commensurate with the price of oil.
- Downside Case 1: Assumes the price of Crude Oil WTI stays below $70/barrel through the end of 2016; reaches $70/barrel in early 2017; reaches $80/barrel by the end of 2017; and remains in the $80-$120/barrel range thereafter. E&P spending bottoms in 2016 and rises in 2017, and continues to rise until it reaches a sustainable level commensurate with the price of oil.
- Downside Case 2: Assumes the price of Crude Oil WTI stays below $70/barrel through the end of 2017; reaches $70/barrel in the beginning of 2018; reaches $80/barrel at the end of 2018; and remains in the $80-$120/barrel range thereafter. E&P spending bottoms in 2016, rises slightly in 2017, rises by a larger amount in 2018, and continues to rise until it reaches a sustainable level commensurate with the price of oil.
5c. Summary of Conclusions For DCF Analysis
A summary of the DCF analysis for FTK under each operating scenario is as follows:
- Note: The Implied Share Prices were calculated using the Perpetuity Growth Method.
The summary above lists important Compound Annual Growth Rates (CAGR), a few other key variables, and Implied Share Prices under each of the five operating scenarios. The subsection below gives detailed projections for FTK’s financial performance during the next five years and the final year (year 20) of the projection period for the DCF valuation model, under each of the five operating scenarios described above. All projections assume that FTK does not acquire any other companies during the 20-year projection period.
5d. Conclusions of DCF Analysis by Operating Scenario
In the DCF Analysis, sales, COGS, operating expenses, Depreciation & Amortization, and Capex were projected by segment, which can be seen in the “Segment Breakdown” worksheet in the Valuation Analysis excel document. This subsection discusses financial projections for the Company as a whole (not individual segments), based on each of the five operating scenarios, and also describes how the WACC used in the DCF model was calculated.
Operating Scenario 1: Base Case 1
Base Case 1 provides an Implied Exit Multiple of 6.1x and an Implied Share Price of $17.15, using a 2.5% Perpetuity Growth Rate to calculate FTK’s Terminal Value. The following paragraphs provide detailed descriptions of how FTK’s financial projections were derived for the first few years and final year (year 20) of the projection period for the DCF valuation model.
In Base Case 1 it is projected that FTK’s sales will decline 22.0% (y/y) in 2015, a slightly larger decline than the 19.7% (y/y) decline experienced in Q1 2015, due largely to an expected weak quarter in Q2 2015. In 2016, sales is projected to increase by 13.9% (y/y), with FTK’s YoY sales growth rate steadily increasing over the year as the price of oil rises from its projected “double bottom” in Q1 2016, and as FTK’s Global Research & Innovation headquarters in Houston and new chemistry manufacturing and research facility in Oman begin to help the Company generate incremental sales due to their strategic locations and ability to expand the Company’s marketing efforts. FTK’s new facility in Oman should help to significantly increase FTK’s international sales, which will help to offset slow domestic sales growth. With the price of crude oil WTI reaching the projected level of $80/barrel by the end of 2016, E&P spending will continue to rise in 2017 as E&P companies conservatively begin to increase their number of rigs in operation and begin to complete more wells (working through any “backlog” of uncompleted wells that may exist at that time), and this trend supports FTK’s continued growth in sales in 2017 and thereafter. By 2034, FTK is projected to reach a sales growth rate of 3.0%, which is slightly higher than its projected Perpetuity Growth Rate.
In Base Case 1, FTK’s gross margin is projected to reach 36.0% in 2034 (the final year of the projection period). Furthermore, under Base Case 1, FTK’s gross margin is projected to return to its historical long-term range of 40-42% by the end of 2016 (when it reaches 40.1%). It is projected to increase from 40.1% in 2016 to a high of 42.2% in 2019, which means that it is projected to reach roughly its second highest level since 2005 in 2019.
FTK’s gross margin has been roughly in the 40-42% range since 2011, and it was also in this range prior to the financial crisis; FTK’s gross margins therefore tend to naturally fall in the 40-42% range under “normal market conditions” (i.e., when the price of oil is fairly high, but not unsustainably high, and E&P companies are spending money and not trying to aggressively cut costs). The margin expansion from 2016-2019 will be driven by higher margins in the Energy Chemical Technologies segment (projected to rise from 43.0% in 2016 to 44.8% in 2019), the recent addition of new high margin products (e.g., hydraulic pumping units and TelePulse), and a more beneficial sales mix (i.e., FTK’s segment with the highest gross margins, the Energy Chemical Technologies segment, is projected to account for 56.1% of total sales in 2016 and 57.6% of total sales in 2019, and this naturally helps to increase FTK’s margins). FTK’s gross margin of 36.0% by 2034 reflects a gradual decrease in margins due to heightened competition in the long term. This 36.0% gross margin appears reasonable given that it is 4.0% below the 40-42% range and still reflects FTK’s niche product focused business model, which gives the Company a much higher gross margin (but a smaller total sales figure) than its comparable companies.
In Base Case 1, FTK’s EBIT margin is projected to reach 19.0% in 2034 (the end of its projection period). The main driver for FTK’s EBIT margin long-term is how much it plans to spend on expanding its operations, on marketing (“advertising”) its products, and on salaries for its employees. Under Base Case 1, FTK’s EBIT margin is projected to improve steadily from its level in 2015 until it reaches a high of 20.8% in 2020, after which it declines steadily (along with projected gross margin) until it reaches 19.0% in 2034. Unlike FTK’s projected gross margin, EBIT margin is expected to be higher in 2034 than in 2014, because over time FTK is projected to spend less on attempting to expand product awareness (marketing/advertising costs) and will continue to streamline operations (reducing general/administrative costs as a percentage of sales).
The main driver behind the projections for Depreciation & Amortization (D&A) and Capex in Base Case 1 was comparing D&A and Capex (as a percentage of sales) to the same figures calculated for each of FTK’s 10 comparable companies for each of the last three years, using averages of comparable companies’ figures to derive future projections. D&A and Capex as a percentage of individual comparable companies’ different business segments were reviewed to gain additional insight, which was necessary seeing as D&A and Capex were projected for FTK based on a percentage of each of the Company’s four business segment’s sales. Base Case 1 selected percentage figures in line with those from comparable companies.
Under Base Case 1, therefore, D&A is projected to increase from 4.0% of total sales in 2014 to 6.6% of total sales in 2034, which is slightly higher than an average of 6.4% of total sales for the 10 comparable companies selected in 2014. Given that D&A has historically accounted for less than 4.0% of total sales, projecting that D&A would reach 6.6% of total sales by 2034 appears reasonable. Likewise, Capex is projected to increase from 4.4% of total sales in 2014 to 7.4% of total sales in 2034, which is lower than an average of 9.4% of total sales for the 10 comparable companies selected in 2014. Capex increased as a percentage of total sales quicker in the last 10 years of the projection period than it did in the first 10 (going from 6.3% in 2025 to 7.4% in 2034 vs. 5.9% in 2015 to 6.2% in 2024), because it was projected that FTK would need to increase Capex as a percentage of sales in order to grow its sales at a moderate rate later in the projection period.
The key variables used for projecting Current Assets and Current Liabilities, and thus Net Working Capital (NWC = Current Assets – Current Liabilities), are: Other Current Assets (as % of total sales), Days Sales Outstanding, Days Inventory Held, Accrued Liabilities (as % of total sales), Other Current Liabilities (as % of total sales), and Days Payable Outstanding. These variables were projected using averages of the same figures for comparable companies as reference points. Under Base Case 1, Other Current Assets is projected to increase from 3.1% of total sales in 2014 to 4.4% of total sales in 2034, which compares to an average of 5.9% (5.4% excluding minimum and maximum) for FTK’s 10 comparable companies and 5.0% (4.6% excluding minimum and maximum) for FTK’s closest 5 comparable companies in 2014. Taking into account key variables (Days Sales Outstanding, Days Inventory Held, Accrued Liabilities, Other Current Liabilities, and Days Payable Outstanding), each estimated after referencing the same figures calculated for FTK’s 10 comparable companies and excluding maximum and minimum values, Net Working Capital is projected to decrease from 25.1% of total sales in 2014 to 23.1% of total sales in 2034. This compares to an average of 29.1% (29.9% excluding min and max) for FTK’s 10 comparable companies and 33.0% (32.8% excluding min and max) for FTK’s closest 5 comparable companies in 2014.
Operating Scenario 2: Base Case 2
Base Case 2 provides an Implied Exit Multiple of 6.1x and an implied share price of $16.17, using a 2.5% Perpetuity Growth Rate to calculate FTK’s Terminal Value. This conclusion was reached as follows.
Base Case 2 was designed to replicate all projections in Base Case 1 except for projections for FTK’s financials over the first five years of the projection period. Analyst consensus estimates, derived from a Bloomberg terminal, for Sales, Gross Profit (Gross Margin), EBIT (EBIT Margin), and Capex were used for the first three years of the projection period (2015, 2016, and 2017) in Base Case 2. By 2019 (year 5 of the projection period), FTK’s total sales figure is roughly the same for both Base Case 1 and Base Case 2, and it proceeds to grow at approximately the same rate in both operating scenarios thereafter.
As a result of this approach, one can see the difference in Implied Share Price when analyst consensus estimates are used and when they are not used (by comparing the Implied Share price in Base Case 1 to the Implied Share Price in Base Case 2).
Operating Scenario 3: Upside Case
The Upside Case provides an Implied Exit Multiple of 6.9x and an implied share price of $27.98, using a 2.5% Perpetuity Growth Rate to calculate FTK’s Terminal Value. The following paragraphs provide detailed descriptions of how FTK’s financial projections were derived for the first few years and final year (year 20) of the projection period for the DCF valuation model in Upside Case.
Given that the price of oil is projected to have already bottomed in 2015 in the Upside Case, reaching $80/barrel by the end of 2015, FTK is projected to only have its sales experience an 11.5% decline in 2015. Total sales is projected to increase (q/q) throughout the rest of 2015, and is projected to grow by 23.9% in 2016. This allows FTK to reach an all-time high level of sales by 2016. A relatively high sales growth rate persists throughout a large portion of this operating scenario, with FTK’s sales growing at 10%+ per year until 2021 (year 7 in the projection period). FTK’s sales growth rate slows significantly in the final years of the projection period, and it eventually grows at only 3.0% in 2034, when it is projected to reach approximately $2.0 billion in total sales.
Under the Upside Case, Gross and EBIT margins are projected to improve from 38.4% and 13.7% respectively in 2015 to highs of 43.5% and 23.7% respectively in 2019. Both gross margin and EBIT margin then decline steadily until they reach 37.0% and 21.0% respectively in 2034. These projections have similarities to assumptions made in the other operating scenarios, given that all operating scenarios show the gradual erosion of gross margins and the gradual improvement of EBIT margins over time. A 21.0% EBIT margin is higher than all EBIT margins achieved by FTK’s comparable companies in 2014; however, a 21.0% projected EBIT margin appears reasonable for the Upside Case seeing as FTK has much higher gross margins than any of its comparable companies.
In the Upside Case, D&A is projected to rise from 4.0% of total sales in 2014 to 7.0% in 2034, which is higher than the projected 6.6% of total sales in 2034 for both of the Base Cases. Likewise, Capex is projected to rise from 4.4% of total sales in 2014 to 6.6% in 2034, which is lower than the projected 7.4% of total sales in 2034 for both of the Base Cases. The lower projected Capex figure reflects a smaller required amount of Capex spending to achieve the sales growth rate seen in the Upside Case when compared to the Capex spending required to achieve the sales growth rates in both Base Cases.
Finally, in the Upside Case, NWC is projected to decline from 25.1% of total sales in 2014 to 19.1% in 2034, which is lower than the projected 23.1% of total sales in 2034 for Base Cases 1 and 2. The lower projected NWC figure reflects an improvement in FTK’s ability to delay payment of Accounts Payable (thus increasing Days Payable Outstanding), a slight lengthening of the amount of time required to receive payment for its accounts receivable (thus increasing Days Says Outstanding slightly), and a significant shortening of the amount of time required to sell through its inventory (thus significantly decreasing Days Inventory Held).
Operating Scenario 4: Downside Case 1
Downside Case 1 provides an Implied Exit Multiple of 5.2x and an Implied Share Price of $11.23, using a 2.5% Perpetuity Growth Rate to calculate FTK’s Terminal Value. The following paragraphs provide detailed descriptions of how FTK’s financial projections were derived for the first few years and final year (year 20) of the projection period for the DCF valuation model in Downside Case 1.
In Downside Case 1, given the operating scenario’s assumption that the price of oil would reach $80/barrel only by the end of 2017, FTK is projected to have its Sales experience a 30.5% decline in 2015, followed by 5.3% growth in 2016 and 10.2% growth in 2017. The sales growth in 2016 and 2017 reflects that E&P spending would bottom in late 2015 along with oil prices, and then both of them would remain relatively low until late 2017. The sales growth in 2016 reflects favorable YoY comps for sales (i.e., given the severe decline in sales in 2015, FTK would experience YoY sales growth in 2016 after E&P spending flattens and begins to rise slightly). The projected 10.2% sales growth in 2017 is driven by increasing E&P spending towards the end of the year, as the price of oil rises slowly towards $80/barrel by the end of 2017. After oil reaches this level, FTK’s sales is projected to grow by 22.2% in 2018, as oil prices continue to rise; E&P spending would follow and rise at an even faster pace than the price of oil over the following 1-2 years. FTK’s total sales is projected to reach approximately $1.35 billion by 2034, with sales growth subsiding to 3.0% that year.
In Downside Case 1, FTK’s Gross margin is projected to improve from 32.1% in 2015 to a high of 40.8% in 2020. EBIT margin is projected to improve from -0.5% in 2015 to a high of 19.3% in 2022. Both Gross margin and EBIT margin decline steadily from their highs until they reach 35.0% and 18.0% respectively in 2034. These projections are in-line with projections for the other scenarios, as they show the gradual erosion of gross margins and gradual improvement of EBIT margins over time.
Depreciation and Amortization (D&A) in Downside Case 1 is projected to rise from 4.0% of total sales in 2014 to 5.9% of total sales in 2034, which is lower than the projected 6.6% of total sales in 2034 for Base Cases 1 and 2. In Downside Case 1, Capex is projected to rise from 4.4% of total sales in 2014 to 8.0% of total sales in 2034, which is higher than the projected 7.4% of total sales in 2034 for Base Cases 1 and 2. The higher projected Capex figure reflects a larger required amount of Capex spending to achieve the sales growth rate seen in Downside Case 1 when compared to the amount of Capex required to achieve the sales growth rates in both Base Cases 1 and 2.
NWC is projected to increase from 25.1% of total sales in 2014 to 26.5% in 2034, which is higher than the projected 23.1% of total sales in 2034 for Base Cases 1 and 2. The higher projected NWC figure reflects a tiny improvement in FTK’s ability to delay payment of Accounts Payable (thus barely increasing Days Payable Outstanding), a significant lengthening in the amount of time required to receive payment for its accounts receivable (thus significantly increasing Days Says Outstanding), and a significant shortening in the amount of time required to sell through its inventory (thus decreasing Days Inventory Held by a large amount). All projections were in-line with figures achieved by FTK’s comparable companies in the last three years.
Operating Scenario 5: Downside Case 2
Downside Case 2 provides an Implied Exit Multiple of 4.5x and an implied share price of $7.44, using a 2.5% Perpetuity Growth Rate to calculate FTK’s Terminal Value. The following paragraphs provide detailed descriptions of how FTK’s financial projections were derived for the first few years and final year (year 20) of the projection period for the DCF valuation model in Downside Case 2.
In Downside Case 2, given the operating scenario’s assumption that the price of oil would not reach $80/barrel until the end of 2018, FTK is projected to have its sales experience a 32.2% decline in 2015, followed by a 2.8% decline in 2016; 9.6% growth in 2017; 16.2% growth in 2018, and 22.8% growth in 2019. The sales growth in 2017 and 2018 reflects that while the price of oil remained very low through the end of 2016 (projected to reach $60/barrel by the end of 2016 in Downside Case 2), it then proceeded to rise steadily. After the price of oil reaches $80/barrel by the end of 2018, FTK’s sales is projected to grow 22.8% in 2019 as oil prices continue to rise, with E&P spending following and rises at an even faster pace. FTK’s total sales figure is projected to reach approximately $1.2 billion by 2034 and sales growth has subsided to 3.0% in 2034.
Gross margin in Downside Case 2 is projected to improve from 30.7% in 2015 to a high of 39.8% in 2019. EBIT margin is projected to improve from -3.9% in 2015 to a high of 17.9% in 2021. Both Gross margin and EBIT margin decline steadily from their highs until they reach 34.0% and 17.0% respectively in 2034. These projections are in-line with projections for the other scenarios, given that they show the gradual erosion of Gross margins and the gradual improvement of EBIT margins over time.
In Downside Case 2, Depreciation and Amortization (D&A) is projected to rise from 4.0% of total sales in 2014 to 5.5% in 2034, which is lower than the projected 6.6% of total sales in 2034 for Base Cases 1 and 2. In Downside Case 2, Capex is projected to rise from 4.4% of total sales in 2014 to 8.6% in 2034, which is higher than the projected 7.4% of total sales in 2034 for Base Cases 1 and 2. The higher projected Capex figure reflects a larger required amount of Capex spending to achieve the sales growth rate seen in Downside Case 2 when compared to the amount of Capex spending required to achieve the sales growth rates in Base Cases 1 and 2.
NWC in Downside Case 2 is projected to increase from 25.1% of total sales in 2014 to 29.2% in 2034, which is higher than the projected 23.1% of total sales in 2034 for Base Cases 1 and 2. The higher projected NWC figure reflects a lack of improvement in FTK’s ability to delay payment of Accounts Payable (thus decreasing Days Payable Outstanding), a lengthening of the amount of time required to receive payment for its accounts receivable (thus increasing Days Says Outstanding), and a significant improvement in the Company’s ability to sell through its inventory (thus decreasing Days Inventory Held).
5e. Other Key Variables
The following key variables underlie the DCF analysis, and apply to the company as a whole and not to individual business segments.
WACC: FTK’s WACC was calculated using CAPM to calculate the Cost of Equity and 3.60% as the Company’s pre-tax Cost of Debt.This figure is the “BofA Merrill Lynch US Corporate BBB Effective Yield” on May 28, 2015. Even though FTK currently does not have an S&P Corporate Rating, it was assumed that it would be rated BBB. As one can see in the Benchmarking Analysis (Appendix Image #1), a corporate rating of BBB is fairly consistent with the ratings for many of FTK’s comparable companies. To obtain a conservative WACC calculation, FTK was assumed to already be at its “target capital structure,” although it is reasonable to expect that the company will likely raise more debt in the coming years to fund growth opportunities if its generated FCF proves insufficient, and this would be more likely if the price of oil takes longer to recover than expected in both of the Base Cases (i.e., if the oil price of oil does not rise to, and remain above, $80/barrel by the end of 2016 or sooner). In the short term, given FTK’s high cost of equity and current capital structure, if FTK raises more debt it would actually help decrease the company’s WACC (provided, of course, that its cost of debt does not rise substantially). A “toggle function” was created in the Excel Model that would allow re-calculation of FTK’s WACC if it was deemed to not currently be at its target capital structure; however, given that FTK’s WACC would decrease from 10.7% to 9.4% (7.9% without the added Size Premium of 2.0%) if the toggle function is used to determine FTK’s target capital structure based on the capital structures of its most comparable companies, it was assumed that FTK is currently at its target capital structure to be as conservative as possible.
Cost of Equity was calculated using the basic CAPM formula with a small adaptation. The Cost of Equity formula used was as follows:
- Cost of Equity = Rf +BL x (Rm - Rf) + SP.
- Rf = Risk-free Rate = 2.63%. This is the Daily Treasury Yield Curve Rate on a 20-year Treasury as of May 29, 2015.
- BL = Levered Beta = 1.45. This is the “Adjusted Beta” figure found on a Bloomberg terminal (more information on Bloomberg’s Adjusted Beta found HERE).
- (Rm – Rf) = Market Risk Premium = 5.80%. This is the Implied Equity Risk Premium (ERP) as calculated by Professor Damodaran at the Stern School of Business at New York University.
- SP = Size Premium = 0.50%. The concept of a Size Premium is discussed in Joshua Rosenbaum and Joshua Pearl’s book entitled “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions.” On page 157 of the second edition of the book it says “the concept of size premium is based on empirical evidence suggesting that smaller-sized companies are riskier and, therefore, should have a higher cost of equity.” A size premium of 0.50% was chosen because it was large enough to make a difference on the WACC calculations, but not so large as to significantly increase FTK’s already high Cost of Equity (Cost of Equity = 11.0% and WACC = 10.3% without the size premium).
A full breakdown of all of these calculations can be seen below:
5f. Segment Breakdown
This subsection includes a detailed qualitative analysis of the drivers behind each of FTK’s four business segments, and it does not contain any numerical projections. Wherever possible in the DCF model FTK’s financials were projected by segment, and all of the numerical projections (assumptions) for each segment can be found in the Valuation Excel Document.
Energy Chemical Technologies Segment: As mentioned in the beginning of this article, this Segment’s key products are its CnF fracking fluids, the FracMax marketing tool, and other chemical products. Its current status is strong,as the Segment has the biggest prospect book in its history (number of scheduled validation projects) and a 90-100% success rate at converting validation clients into commercial users (i.e. customers for commercial jobs). The drivers for the Segment’s product demand are the number of wells drilled (considered to be more important for this segment than rig count is), well completion rate/number of wells completed, and service intensity/volume of product used. Regardless of the number of wells drilled, it is the completion of the well (“well completion rate”) that drives the Segment’s sales.
This Segment is impacted significantly by the price of oil in two significant respects. First, even if wills are drilled, it costs additional money to “complete” a well after drilling it, and if the price of oil is extremely low, or stays low for a long time, E&P companies will sometimes not complete wells after drilling them (this situation has been taking place for a few months now). Simply put, when oil prices are low, drilling companies do not want to pay to increase extra money their production rates, and will resort to simply extracting oil and natural gas at the cheapest cost possible, which means they will sometimes not pay FTK and other service providers for products needed to “complete” a well in as effective a manner as possible. Second, once a well is completed, the Segment measures “Service intensity,” the amount (volume) of FTK’s products used to complete the well. When the price of oil is low, E&P companies want to try to complete wells using as small an amount of products from Oil & Gas Services companies as possible.
These factors are mitigated when oil prices are low by the fact that well “restimulations and remediations” are cheaper than drilling new wells, and the Segment’s products are used for these activities. FTK not only benefits from the increased demand as a result of its ability to help with well restimulations and remediations, it also generates a slightly larger amount of sales per job, however, restimulations and remediations do not create significant additional demand for FTK’s adjacent products and jobs themselves are smaller (i.e. FTK sells “more CnF on a loading basis” but the jobs themselves are smaller). That said, FTK is the pioneer in this category, and customers looking for the lowest cost solution increasingly find that restimulating old (previously unproductive) wells is cheaper than drilling new wells. Finally, as previously mentioned, international opportunities significantly mitigate the potential downside of low oil prices for this Segment.
Drilling Technologies Segment: As mentioned in the beginning of this article, this Segment’s key products are members of its Teledrift product line (especially Telepulse), and the Stemulator tool. With the fairly recent introduction of Telepulse and Stemulation, the Company believes that “combining Telepulse, Stemulator and our downhole motors provides operators a complete package that will further accelerate drilling efficiencies and, at the same time, provide new sales and profit opportunities for Flotek.” The Segment finds that its new product introductions and international opportunities are partially offsetting lower demand and lower domestic activity. The principal demand driver for the Segment’s products is the long-term industry trend that has seen a shift from vertical drilling to horizontal drilling, and (as mentioned previously) the major growth is in horizontal drilling. This will continue as the market improves, and as horizontal drilling is more expensive than vertical drilling, drilling activities are increasingly sensitive to oil prices. The Segment has only just recently released new products that are designed for horizontal drilling, consistent with a long-term industry trend that focuses on higher-tech products and MWD technology. The Segment’s rental activities offers a cheaper alternative to buying products outright, and rental activity should offset purchases in a low commodity price environment.
Consumer and Industrial Chemical Technologies Segment: As mentioned in the beginning of this article, this Segment’s key products are its Citrus Oil, which has industrial uses and is an ingredient used by companies in the flavor and fragrance industry. The Segment also sources internally for FTK’s chemical products. FTK expects that “current inventory and crop expectations are sufficient to meet the Company’s needs to supply its flavor and fragrance business as well as the industrial markets. However, market price volatility may result in sales and margin fluctuations from quarter to quarter” (FTK 10-K Filing For 2014 – Outlook). Significantly, the outlook for the Segment’s products will be driven by the availability of Florida oranges, from which FTK derives its citrus oil.
As shown below, orange crop has been significantly reduced over the past two years, driving the price of oranges (and therefore citrus products) much higher. This scenario causes decrease in overall sales for the Segment and an increase in gross margin; the Segment can hold onto margins in the very short term as orange supply improves and, therefore, FTK should be able to sell more product at a higher price when Florida’s orange supply improves.
Image Source: 2015 Investor Days Presentation On February 2, 2015
Production Technologies Segment: As mentioned in the beginning of this article, this Segment’s key products are its Petrovalve and Hydraulic pumping units (acquired from IAL). Sales for Segment grew 57.6% (y/y) in Q1 2015 “due to increased sales of rod pump equipment from a new location opened in the third quarter of 2014” FTK 2014 10-K Filing). This growth was also at least partially due to the IAL acquisition, and the fact that it isn’t hard for a segment with a small total sales figure to see a high sales growth rate. The Segment is very small but has significant growth potential; the Petrovalve product line is doing well, and its hydraulic pumping units have significant potential given their competitive advantages (established through the Company’s acquired patents). Products from this Segment largely depend on rig count and wells drilled and its ability to package and cross-sell with other FTK products; it is also experiencing significant international expansion opportunities.
5g. Background Information On Comparable Companies Analysis
Potential comparable companies were selected using a Bloomberg terminal and various other online financial platforms (e.g., Yahoo Finance), and then a more intensive research process was done to determine their comparability to FTK. Comparable companies were selected with the following basic guidelines: 1) they were in the Oil & Gas Services industry; 2) sales derived from providing well completion and production solutions accounted for a fairly large portion of their total sales; 3) they preferably had at least two business segments, so that those segments could be compared to FTK’s four diverse segments and to avoid selecting single-product “specialist” companies; and 4) a similar size (market cap) preferred but not required, however, at least three companies of a similar size had to be chosen.
Despite the difficulty of comparing large companies to a small company, quite a few companies that are many times larger than FTK were chosen because they compete in markets with one (or more) of FTK’s segments, have a similar business structure, and could help gauge FTK’s financial profile (i.e., total sales, working capital requirements, etc.) when the Company reaches its “terminal state” in the Discounted Cash Flow Analysis. For example, HAL has the largest footprint in the fracking industry and is the largest distributor of FTK’s chemistry products; NOV offers products that compete against some of the Company’s key products (i.e. NOV’s SoftSpeed II technology vs. FTK’s Stemulator product) and provides a strong baseline for the Company’s Drilling Technologies segment; and SLB has a very similar business structure to that of FTK and likewise has historically had higher margins, valuation multiples, etc., than most other companies in the industry. The ten comparable companies were then separated into two “tiers” based on their main areas of focus, which was determined by looking at a sales breakdown by segment for each comparable company.
Five of the ten comparable companies were then deemed to be “most comparable” to FTK, and they collectively served as the baseline for many of the assumptions for key variables, in the DCF Analysis, as well as for implied valuation ranges, in the Comparable Companies Analysis. These five companies are HAL, BHI, WFT, NR, and CRR. All five generated more than 40% of their total sales in 2014 from well completion and production services, with four of the five relying on well completion and production services for 55% or more of their total sales in 2014. The actual breakdown of each of the five companies’ total sales by segment is described below:
Halliburton Co. (HAL):
- Completion and Production – 61.62% of total sales in 2014
- Drilling and Evaluation – 38.38% of total sales in 2014
Baker Hughes Inc. (BHI):
- Completion and Production – 59.35% of total consolidated sales in 2014
- Drilling and Evaluation – 35.09% of total consolidated sales in 2014
- Industrial Services – 5.56% of total consolidated sales in 2014
Weatherford International PLC (WFT):
- Formation Evaluation and Well Construction – 58% of total sales in 2014
- Completion and Production – 42% of total sales in 2014
Newpark Resources Inc. (NR):
- Fluids Systems – 86.29% of total sales in 2014
- Mats and Integrated Services –13.71% of total sales in 2014
Carbo Ceramics Inc. (CRR):
- Nearly 100% of sales comes from the sale of ceramic proppants
CRR and NR were chosen because they are both similar to FTK in terms of market cap, derive a very large portion of their total sales from completion and production services, and, especially in the case of CRR, have a fairly similar capital structure.
It should be noted that it was taken into account that BHI has been trading at a healthy premium relative to most other companies in its industry after the merger between it and HAL was announced. This merger announcement caused BHI’s share price to rally nearly 28% over the course of three trading days, and BHI was not considered a “relevant” comparable company when calculating FTK’s final implied share price. Despite this fact, BHI was still considered to be one of the “most comparable companies” because it has many similar business characteristics to FTK, it is one of the largest distributors of CnF products, and its non-valuation-related metrics (e.g., driving variables for Net Working Capital, etc.) still helped provide a baseline for the assumptions in the DCF Analysis. In addition, although TTI is very similar to FTK in both size and “business focus,” its amount of total debt recently increased very significantly due to a large acquisition, and it was ultimately excluded from the “most comparable companies” list because its resulting higher debt balance drastically affected its valuation multiples involving enterprise value.
Despite all of the research that was done to select ten comparable companies, none of the ten are truly comparable to FTK when every aspect is taken into account, and the inability to find truly comparable companies is the main reason why it was ultimately decided that Comparable Companies Analysis would account for only 20% of the final implied share price.
5g. Comparable Companies Analysis: Valuation
The Comparable Companies Analysis was done using the following valuation multiples; EV/Sales, EV/EBITDA, EV/EBIT, and P/E. All valuation multiples for each company were calculated based on financial metrics for the Last Twelve Months (LTM) and projected financial metrics for both 2015 and 2016 (2015E and 2016E). All estimates for 2015E and 2016E financial metrics are analyst consensus estimates from Bloomberg (via a Bloomberg terminal). A picture depicting all of the valuation multiples calculated as part of the Comparable Companies Analysis can be seen below:
Data Source: Bloomberg Terminal and 10-K Filings For Respective Companies In 2014
These valuation multiples were then used to determine the valuation ranges seen in the picture below:
The ranges for each valuation multiple were determined by looking at the valuation multiples of FTK’s comparable companies and defining a range that most accurately depicts the approximate multiple range within which the comparable companies are currently trading. Although the best range for each valuation multiple is definitely open to interpretation, the “Multiple Range(s)” depicted in the picture above were selected in order to be conservative.
5h. Football Field & Final Implied Share Price
The “Football Field” chart below shows FTK’s range of implied share prices using both Comparable Companies Analysis, with every valuation multiple range included, and DCF Analysis (in the “Base Case 1” operating scenario):
- Note: The blue line denotes the Company’s stock price as of its close on May 29, 2015 and the green line denotes a price target of $16.00/share.
The implied share price ranges for “2015E Adjusted EV / EBIT,” “2015E Adjusted EV / EBITDA,” and “2015E Adjusted P / E” are clearly outliers, and they reflect the fact that analysts believe FTK will barely be profitable in 2015 (none of these ranges are reliable and they were only included for demonstration purposes).
After reviewing analyst estimates and the implied share price ranges in the chart above, it was determined that the EV/Sales valuation multiples are likely the most reliable, because they do not take into account profit margins and are not subject to estimates that either FTK or one of its comparable companies will be unprofitable (or nearly unprofitable) in 2015. In addition, given the fact that there are very few truly comparable companies to FTK, it is believed that a DCF Analysis is the most accurate way of determining the Company’s implied value, and it was for this reason that the DCF Analysis was given an 80.0% weighting when determining a FTK’s Final Implied Share Price.
The picture below depicts a “weighted average” calculation method for determining FTK’s Final Implied Share Price, which was done by giving Comparable Analysis (EV/Sales valuation method chosen) a 20.0% weighting and DCF Analysis (“Base Case 1” scenario) 80.0% weighting:
When the weighted average calculation method depicted above is used to calculate a Final Implied Share Price using either EV/EBIT, EV/EBITDA, or P/E valuation multiples for the Comparable Analysis and “Base Case 1” scenario for the DCF Analysis, the calculated Final Implied Share Prices range from $15.16 to $16.25, which indicates that FTK is currently trading at 32.0% - 41.4% discount to its Final Implied Share Price.
A 1-year price target of $16.00/share was ultimately determined, which presents the belief that FTK has 39.25% upside potential in the next year.
In the long term, FTK has significant potential upside than what is indicated by the $16.00/share price target, supporting a 2-year+ price target of $28.00/share, which presents the belief that FTK has 143.7% upside potential in the next two years. While a 2-year+ price target of $28.00/share may seem overly optimistic, the Upside Case in the DCF Analysis defines a reasonable scenario in which that share price would be achievable (the Upside Case supported an implied share price of $27.98/share). Further, investors seeking to buy and hold shares of FTK should consider sell if the stock price rises into the $30 - $40/share range, because selling for anything less would result in losing the value of the stock’s future growth potential.
This section discusses the risks associated with an investment in FTK; risks faced by all companies in the Oil & Gas Services industry are not discussed. In addition, risks typically discussed in 10-Q and 10K filings will not be mentioned, as such risks are readily available to all investors. After a risk is described, a counterpoint will also be presented.
1. Risks due to declining oil prices and capital spending
- Product demand is derived from operator capital spending.
- Low oil price environment for extended period of time
- Counter: Competitive advantages & value proposition, business expansion, and FracMax
2. Risks due to expected pricing pressure and margin degradation
- Management said it expects margin degradation in 2015 and we have already seen some of that in Q1 2015 when FTK posted results that showed its gross margin had dropped to 32%.
- Counter: Business expansion, new patented products, and sales breakdown
3. Risks due to reliance on marketing efforts
- Large E&P companies slow to accept new technologies – Market Penetration
- Counter: FracMax – Two large validation clients, 90% success rate, and prospect book
- Counter (Long-Term): Increasing regulations and potential product rollout across all of operators’ wells
4. Risks due to customer concentration
- Top three customers account for 29% of sales in 2014, with 94% of this attributed to ECT segment
- Counter: Customer concentration is dropping (35% down to 29%) and largest customer ordering more yearly
5. Risks due to d-Limonene price and supply volatility
- Reliance on citrus oil (d-Limonene) for the manufacturing of its CnF products, and citrus oil is currently subject to significant price and supply volatility due to the severe drop in Florida’s orange production (from “citrus greening”).
- Counter: Florida Chemical Company acquisition and CnF 2.0. Without Florida Chemical “chemistry input cost would be 30% to 40% higher” – stable margins for ECT segment. The creation of CnF 2.0 greatly reduced this risk for FTK, because its increased efficiency (50% of chemical volume to produce same results as earlier version of CnF products) significantly decreased the Company’s reliance on a supply of D-limonene.
6. Risks due to share price volatility
- Since Flotek began trading on the NYSE in 2007, its share price has experienced significant volatility. Fluctuations in FTK’s share price, since 2007, range from an all-time high of $55/share (October 30, 2007) to an all-time low of $0.96/share (December 22, 2009), and then back to FTK’s recent 52-week high of $32.92/share (June 24, 2014). While this volatility may be deter some investors, it should be noted that FTK’s level of volatility as measured using beta (comparing FTK’s daily returns to those of the S&P 500), has begun to decline; FTK’s 1-year beta (calendar year 2014) is 1.76, while its 7-year beta (calendar years 2008-14) is 2.09.
- Counter: FTK’s share price appears to getting less volatile and its beta will eventually decrease toward 1.00, which is accounted for in my DCF model by using Bloomberg’s formula for calculating “adjusted beta.
Data Source: Bloomberg Terminal and 10-K Filings For Respective Companies In 2014
Appendix Image #2: Benchmarking Analysis – Page 2
Data Source: Bloomberg Terminal and 10-K Filings For Respective Companies In 2014
- Notes: Workforce Productivity metrics use average total employee figures (i.e. average of the number of employees at beginning of 2014 and end of 2014) that were calculated using total employee numbers found in each company’s respective 10-K filings in 2014 and 2013; and many of those figures are only approximations, with most rounded to nearest hundred or thousand. Total employees figures include both full-time and part-time workers. All non-employee figures were as of December 31, 2014, and they are reported on an “adjusted” basis.
Appendix Image #3: Operational Efficiency Improvements in Marlow
Image Source: 2015 Investor Days Presentation on February 2, 2015
Appendix Image #4: Global Fracking Market
Image Source: 2015 Investor Days Presentation on February 2, 2015
- Note: The red sections on the chart on the right depict the international portion of the global fracking market, while the blue depicts the North American portion.
Appendix Image #5: CnF Payback Period
Image Source: 2015 Investor Days Presentation on February 2, 2015
Appendix Image #6: Domestic vs. International Portion of Total Sales (Historical and Projected)
Data Source: 10-K Filings for 2004-14 and DCF Analysis Projections
- Notes: Percentages for 2004-2006 are approximations based on information sourced from the MD&A section of 10-K filings. Prior to 2004, "substantially all of [the Company's] sales and operations [were] derived and conducted, respectively, within the United States" (10-K Filing For 2003).