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.
Summary
• 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.
My
Take
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.
