Description

Forum Energy Technologies, Inc. (“FET”) 9% convertible senior secured notes due 8/3/25 currently trade at 62% of par, offering an attractive risk reward with a 14.5% current yield and 22.1% yield to maturity.  Additionally, if the E&P space experiences a recovery, the conversion feature of the notes offers potential upside well in excess of 100%.  Following a recent debt exchange, FET removed bankruptcy risk.  The current debt maturity gives the company five years to wait for a recovery; meanwhile, FET will continue adjusting its cost structure to return to profitability and convert its significant excess inventory to cash.

FET is an oilfield equipment and consumables manufacturer initially formed in August 2010 by SCF Partners.  FET grew through more than $2 billion of acquisitions and sells a diversified portfolio of products with 86% of its revenue coming from consumables and activity-based equipment used in drilling, well construction/completion, and oil and gas transportation/processing.  The company’s September 2020 Investor Presentation provides lists and visuals of the company’s various products (Page 10 and Page 14 – 23).

Like most other companies in the E&P space, FET’s business has been severely impacted by the recent oil demand shock.  FET saw topline decline 54% in 2Q2020 and faced significant near-term solvency risk with $400 million of senior notes outstanding due on Oct 1, 2021.  Without a refi, the company would also lose its revolver availability in July 2021, adding potential liquidity risk.  Between May and June 2020, FET bought back $71.9 million of senior notes due 2021 at 38.4% of par.  Then, the company executed a debt exchange on August 3, 2020 with 96.1% of its senior noteholders swapping the old notes due 2021 for the new notes due 2025.  The new notes pay 6.25% annual cash interest plus 2.75% PIK (or 9% cash interest at the election of the company), and a portion of the notes is convertible into FET’s common stock at a conversion price of $1.35/sh.

Amid the extremely harsh operating environment, FET removed $100 million of annualized cost in 2Q2020 and accelerated its inventory reduction efforts, resulting in minimal cash burn of $3.6 million in 1H2020.  Although the recovery in E&P activities has been slow, completion activities in the US have been rebounding since the May bottom and US rig count has increased since August.  We believe FET will see sequential results improve going forward given the activities-driven nature of FET’s products and that the company will generate positive free cash flow in 2020 despite the collapse in the E&P space.  There is potential for FET outperformance given widespread cannibalization of parts on idled equipment.  These parts will need to be replaced when idled equipment is brought back online requiring many FET products.

We expect FET to generate significant free cash flow in the next two years regardless of the speed of recovery in E&P activities.  FET has a highly variable cost structure, low capex requirements, and minimal contractual obligations.  Importantly, the company’s $378 million of inventory as of June 30, 2020 and long-term inventory turnover target imply over $200 million of inventory reduction if sales remain at today’s level.  This excess inventory resulted from prior management’s aggressive 2018 inventory build for a strong E&P rebound that did not materialize.  FET has been working down its inventory since 2019 and targets 2.5x inventory turnover over time, a significant improvement over the 1.0x turnover we saw in 2Q2020.  As we anticipate a rebound in activity levels, we believe $200 million is aggressive, but we do believe the company can convert $100-150 million of excess inventory into cash over two years. 

US crude oil production peaked at around 13 million barrels per day in early 2020 and has dropped by 18% to 10.7 million barrels per day as of September 2020.  We estimate that around 550 rigs are needed in the US to sustain the current production level, more than double the 261 currently active rigs.  If US crude oil production drops to 8.7 million barrels per day, or 33% below its peak, we estimate 400 rigs are needed in the US to maintain that level of production.  Therefore, we should see a material rebound in the coming quarters.

In a reasonable rebound scenario, we see FET’s US sales recovering to 30% below 2018/2019 average and international sales recovering to 20% below 2018/2019 average in 2022.  This means $734 million of annual sales and $66 million of EBITDA at 9% prior mid-cycle EBITDA margin.  Assuming FET converts $115 million of excess inventory into cash by year-end 2022, the company will reduce net debt by $77 million to $229 million at year-end 2022.  Valued at FET’s historical average multiple of 9x EBITDA results in an enterprise value of $595 million.  With the bond’s conversion feature, these notes have 148% upside.

Even if E&P activities never rebound, FET will have sufficient liquidity to pay the cash coupon on these notes through maturity, resulting in ~34 points of recovery.  In this scenario, we expect FET to downsize even further to minimize losses, and to accelerate conversion of inventory into cash.  Therefore, at 2025 note maturity, the company would still have $80 million of cash and over $140 million of net working capital, or additional 25 points and 45 points of recovery, respectively.  It’s also likely that parts of FET’s portfolio will be profitable and can be monetized, and the secured nature of these notes will allow additional recovery from asset sales.  Therefore, we see limited downside to these bonds at the current price.

FET’s broad product portfolio means that it has exposure to just about any energy market rebound.  We aren’t trying to predict the exact timing or the magnitude of the rebound, but the cliché is that low prices (and low activity) are the cure for low prices (and low activity).  FET’s insiders are incentivized to turn the company around given they own 21% of the company’s stock.  And while it can’t be discerned from the stock chart, FET’s CEO Chris Gaut (former CFO of Haliburton) has an excellent reputation in the industry.  He was brought back to FET out of retirement in late 2018 to help de-lever the company.  In the last 2.5 years, he helped reduce the company’s net debt by $167 million, or 35%.  The recent debt exchange was a result of enormous efforts between the company and its top creditors, and it gave the company the necessary time it needs to execute a plan to make itself sustainable.  Since the debt exchange, there were even modest insider purchases of FET’s stock, perhaps a sign the business is returning to solid footing.  In the medium term, we believe FET’s flexible cost structure and ability to convert excess inventory into cash position the company well for even a modest E&P recovery, and that the 2025 notes have significant upside relative to downside.

Catalyst

Recovery in E&P activities in the next several quarters

Debt reduction through free cash flow generation