Description

Flotek Industries (“FTK”, the “Company”) is an underappreciated "net-net" investment opportunity, with limited downside and the potential for significant appreciation. I believe Flotek is a particularly compelling investment today for the following reasons:

• The company now has an impressive CEO (especially relative to the size of the company), who has taken all the right steps to improve the business

• The stock is down ~33% YTD (likely due to the taint of being an oilfield services company) despite the vast majority of the Company’s value being in the net cash on the balance sheet and an acquisition FTK made at the bottom of the market

• The recent acquisition of JP3 appears to be well-timed and underappreciated

• The company has the network and cash balance to source small deals from private owners seeking liquidity

The company now has an impressive CEO who has taken all the right steps: John Gibson Jr, who joined in late December of 2019, is a geologist and oil & gas industry veteran with a surprisingly notable track-record given the current fortunes of Flotek (his background is described well in previous writeups) Moreover, he joined with a compensation package that heavily aligned his incentives with those of his shareholders (570k shares of restricted stock and 2 million options priced at $1.93 that vest contingent on the stock price reaching various targets prior to 2024—vesting in full around $7.20). Subsequently, Gibson quickly rectified a “parting gift” from the previous management team—a legacy supply contract to purchase turpentines at above-market prices from ADM when sale volumes were much higher (they disclosed the previous arrangement required the purchase of approximately twice the value of the terpene required to support the current business) that was associated with the sale of the Florida Chemical division. Additionally, Gibson quickly moved to cut costs (committed to breakeven by the end of the year) and revamp the internal sales team.

The company has the network and cash balance to source small deals from private owners seeking liquidity:

Gibson has a valuable network, from his 25+ year experience as an industry executive, through which he can source deals from private owners of energy related enterprises needing liquidity during these unprecedented times. Given the size of the prospective deals, the state of the current industry, and the ability to act decisively using cash without need for bank approval—I believe Gibson can find compelling acquisitions in the current environment.

The company made a well-timed, underappreciated acquisition:  Flotek recently acquired JP3 Measurement LLC, a privately-held data and analytics technology company, using $25mm in cash and roughly $11.5mm of stock, in addition to an incremental $2.5mm of compensation subject to certain performance milestones. In a very broad sense, JP3’s product is a measurement technology that allows for operators to obtain real-time ( < 30 seconds) data on the composition and physical properties of hydrocarbons across a variety of upstream, midstream, downstream, and distribution use cases. The data is predominately used by operators to assist in process optimization efforts and boasts a diverse range of applications:

• Enhanced Oil Recovery (composition, liquid/gas separation, vapor recovery)

• Gas gathering

• Gas processing

• Propane and propane blending

• Ethane pipeline composition

• Crude quality analysis (composition, vapor pressure, API gravity, boiling point distribution curve)

• Butane blending applications

• Fuel gas monitoring

• Truck/rail loading and off-loading composition and RVP

Insight Analytical, an authorized reseller of the product, provides some useful information on the platform and its various use-cases. What differentiates JP3’s product (which uses infrared spectroscopy) vs conventional analyzers (which often employ chromatography) is its ease of implementation and minimal maintenance requirements (eliminates the need for an expensive “analyzer house” and the use of consumables). Furthermore, it seems that much of the IP resides with the database JP3 has accumulated over time which it uses to make inferences about the hydrocarbons it measures. The company does a little over ~$14mm in revenue and despite a pull-back in upstream demand, managed to grow in a challenging 2019 environment by increasing its downstream book of business—announcing partnerships with players such as Phillips 66. Although gross margins are not disclosed, I believe they are in the range of 40-60%. Users of the JP3 platform that I have spoken to have been very complementary of the technology.

JP3 has surprisingly achieved this level of sales and growth in an extremely challenging environment with only 3 full-time sales individuals prior to Flotek’s acquisition of the business, further testimony to the efficacy of the product. In my conversations with management they suggested that they would shortly ramp up the JP3 salesforce to better capture the market opportunity. Three weeks ago, JP3 posted job listings for 11 new positions, including a Senior Director of DaaS Sales and Business Development, a Director of Upstream Field Sales, and a Director of Product and Industry Marketing. This comes in addition to the recent onboarding of TengBeng Koid (who worked with Gibson during their shared time at Landmark and then Haliburton), the new President of Global Business. TengBeng was previously the President of Emerson’s Energy Solutions Division. David Nierenberg remarked in the associated press release:

“In my four decades of investment experience, he is one of the greatest revenue drivers I have ever seen"

Although it remains to be seen whether Flotek will be able to transition JP3 from being largely an equipment sales company (its current business model is predominately “one-time” device sales) to a recurring revenue type model (DaaS), I am optimistic about the potential for further high-margin, non drill-count dependent, growth by way of investments in a robust sales team. While I would have preferred JP3 to have approached FTK, the company was one that Gibson had a long term relationship with, the selling shareholders were largely individuals with limited oil & gas expertise, and the deal allowed JP3 to remain a good deal of autonomy (vs becoming a small division in large company) which I heard was particularly attractive to senior management. Thus, I remain optimistic that Flotek’s shareholders received a good deal.

Attractive Current Valuation: At current prices, FTK’s shares offer compelling value and strong downside protection. Unless you believe that management will destroy value through M&A or run the CnF business at a loss into perpetuity, it seems hard to construct a reasonable case where the shares are worth much less than $1. FTK’s cheapness was easier to rationalize when Chisholm remained at the company, the CnF business was subscale relative to the overhead of a publicly traded company, and the likelihood of cash flow break-even appeared slim. Now, the business is run by a competent CEO, is less rig-count dependent, and has a segment that has demonstrated meaningful growth over the past 3 years despite the sector backdrop. Furthermore, despite COVID’s negative impacts to drilling activity, it has also led to an ~$11mm cash infusion into the Company (due to COVID-related government policies, the Company has been able to claim a $6.1mm NOL carryback refund and has received a $4.8mm PPP grant). Lastly, although I am uncertain of the value of CnF, I do think there are well-substantiated reasons (adequately chronicled in the previously-mentioned VIC writeup) to support ascribing some value to the business (either resulting from a pick-up in the current environment, as a result of a renewed sales effort, or through an outright sale to a larger chemical company). I have heard that at the current prices for CnF (which is now priced more similarly to other surfactants) commanding at least a gross margin of 20% should be achievable (especially without the burden of the previously mentioned onerous supply contract).

My valuation makes the following assumptions:

•  Instead of reaching management’s estimated breakeven by the end of the year—the business continues to maintain a run-rate burn of ~6.5 MM per quarter for the next four quarters, for the sake of conservatism.

• In my bear case I assume the CnF business is worth nothing, and that the JP3 is worth ~30% less than FTK paid for it

• In my base case, I assume that the CnF business never improves sales from its current all-time lows and is worth ~4x GP and that JP3 ends up being worth ~25% more than FTK paid for the business as the salesforce expansion efforts bear fruit in accelerating sales.

• In my bull case, I assume CnF is worth roughly 5x GP — reflective of either an uptick in the business from an improved environment or a potential strategic sale to a larger chemical company looking to leverage its own internal distribution/selling infrastructure. I also assume that JP3 can replicate its past results by doubling sales within the next 2-3 years as it benefits from a reinvigorated salesforce. It is not difficult to envision further upside.  

•  My cash number debits the 3/31 cash balance by $26mm for the acquisition and the cost associated with the realization of an identified cost cutting effort. It also credits the cash balance for the value of the NOL related tax receivable and the balance of the PPP loan (at the present moment I effectively treat it as a grant):

Catalyst

- Evidence of revenue growth acceleration in the JP3 business

- Returning to cashflow breakevem