FTK (Flotek Industries, Inc.): Battleground Story Belies Underlying Fundamentals
Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.
• Flotek develops and distributes oilfield products, services, and equipment to the oil, gas, and mining industries in the U.S. and internationally. Its stock is under a cloud after allegations that well production data was misrepresented
• Management has appointed a special team and retained independent consultants to investigate the accuracy of these claims
• Oil & gas completion environment has further pressured the stock as Middle Eastern producers try and squeeze shale oil producers out of the market
• FTK has potential to trade back to its October highs as the CnF demand story comes back into focus following the annual report
Flotek Industries, Inc. (NYSE: FTK) has languished over the last six weeks. In early November, activist hedge fund manager John Hempton published a research report refuting the well production data related to Flotek’s key Complex nano-Fluid (CnF) product, and investors have been skittish around the stock ever since.
CnF and other products in Flotek’s Energy Chemical Technologies segment represent over 60% of the company’s revenue and essentially all its profit. CnF is a specialty chemistry solution designed to help shale oil producers get more oil out of the ground – the product acts as a surfactant, getting between oil and shale rock and reducing surface tension in order to help oil flow to the surface more easily. Following the oil price crash in the second half of 2014, oil producers and services companies have scrambled to find a way to get wells to produce more oil in an effort to recover the high sunk costs of a shale well and to generate cash flow to cover high-cost debt payments. Many of these companies – including the world’s largest services companies, Schlumberger and Haliburton – have turned to specialty chemical solutions like CnF to get the job done.
What’s Hempton Saying?
John Hempton ran the numbers and determined that some of the well production data Flotek used in investor presentations did not line up with public information published by the Texas Railroad Commission, the regulator of the oil and gas industry in Texas. Hempton wrote a scathing research report characterizing management as either fraudulent or inept, and concluded that CnF didn’t work as well as advertised – in fact, maybe it did not even add any economic value to the well.
The company quickly issued a mea culpa, saying that it had indeed detected certain coding errors in its FracMax software package – basically a sales tool used to demonstrate the efficacy of CnF to potential customers – that led to the misreporting of the Texas RRC data. The issue arises from differences in the way that multi-well and single-well data is aggregated, and management believes the problem affects a small number of wells reported by FracMax.
Hempton’s conclusion may be more concerning if the only thing dictating CnF sales were the numbers reported by FracMax – but this is not the case. It is important to recognize that the big players in the energy industry have their own validation systems in place to ensure that the products and processes used to get oil out of the ground are the most efficient and effective methods available. A major oil company will not blindly accept the results published by a supplier and continue to buy a product that doesn’t improve well performance. Put bluntly, Haliburton would not be buying and using CnF if it didn’t get the job done, and it is abundantly clear that reorder volumes from large customers have been strong over the last year.
What Do the Financials Say?
With some of the biggest players in the industry behind the technology, it should come as no surprise that sales of the product have grown rapidly. CnF sales volumes grew 59% year over year and – perhaps more impressively – by 34% quarter over quarter in the quarter ended September 30, 2015. This growth happened in an environment where drilling rig counts fell nearly 60% year over year and completion activity significantly slowed.
Despite this decline in activity, Flotek has also been able to hold pricing on CnF since 1Q15. Low oil prices have forced producers to pressure every link of their supply chains in an effort to cut costs and protect cash in an effort to stay solvent – in fact, prices for some services and products used in the fracking process have fallen by 40% or more over the last year. CnF has been largely immune to this pricing pressure – in fact, Energy Chemical Technology segment gross margins have actually expanded by 300 basis points year over year. Clearly, producers see the value in the product even if Hempton does not.
The underlying business is in as good of shape as any in the energy industry. Flotek has continued to produce strong operating cash flows despite the weakness of the larger energy market and has a solid balance sheet with plenty of liquidity. The business fundamentals and long-term demand story are unchanged and the potential for growth is unparalleled within the energy sector. Despite Hempton’s math, there is ample evidence that the CnF product is highly effective in squeezing more oil out of a shale well, and I believe specialty chemistry products will continue to be a vital part of the fracking process into the future.
The stock has been strong over the last six weeks – it cratered 50% the week of Hempton’s report, however, it regained nearly 30% and its trading behavior suggests investors are entirely discounting the upside potential from the Energy Chemical Technologies segment. Management believes it will be able to share the report of the independent consultants in January 2016, and I believe that report and the annual financial report should serve as the catalysts for the stock’s re-rating to recognize the company’s fantastic growth potential. I believe we can see Flotek trade back in the mid-teens by mid-2016 irrespective of what happens to the broader energy industry.