Flotek Industries, Inc. (FTK) Q3 2015 Earnings Report, Transcript and Summary

Good morning and welcome to the Flotek Industries, Inc. Third Quarter 2015 Earnings Conference Call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of the company’s prepared remarks. An operator will provide instructions on how to ask your questions at that time. [Operator Instructions] This conference is being recorded. At this time, I would now like to turn the conference over to Mr. Chris Edmonds. Mr. Edmonds, you may begin.

William, thank you and good morning. Today’s call is being webcast and a replay will be available on Flotek’s website. Our earnings and operational update press release, as well as our quarterly report with the U.S. Securities and Exchange Commission were filed and distributed last evening and are also available on the Flotek website. Before we begin our formal remarks, I wish to remind everyone participating in this call, listening to the replay or reading a transcript of this call, of the following: Some of the comments made during this teleconference may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as well as other applicable statutes reflecting Flotek’s views about future events and their potential impact on performance. Words such as expects, anticipates, intends, plans, believes, seeks, estimates and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements on this call. These matters involve risks and uncertainties that could impact operations and the financial results and cause our actual results to differ from such forward-looking statements. These risks are discussed in Flotek’s filings with the U.S. Securities and Exchange Commission. Now, I’d like to turn the call over to Mr. John Chisholm, Flotek’s Chairman of the Board, President and Chief Executive Officer. John.

Chris, thank you. I would also like to welcome each of you to Flotek’s third quarter 2015 conference call. We are glad you are here. With me today are Rob Schmitz, Flotek’s Chief Financial Officer; Steve Reeves, our Executive Vice President of Operations; Josh Snively, President of our Florida Chemical subsidiary as well as our Executive Vice President of Research and Innovation; Rich Walton, Flotek’s Chief Financial Officer, Emeritus; Chris Edmonds, who you just heard from, our Senior Director of Corporate Finance and Strategy. Also I’m honored to welcome John Ely sitting to my left, Principal of Ely & Associates, a leading international completion analytics and consulting firm based here in Huston. In addition to being a Founder of one of the most recognized completion consultancies in the world, John has spent his entire 50 year career focused on optimizing completion design as they celebrated oilfield chemist analyzing and gas tinkering [ph] with completion chemistries around the globe. John is here to discuss the recently announced partnership between Flotek and his firm, his views on advanced completion chemistries, as well as answer your questions regarding our partnership, as well as on completion design and the uses of various chemistries and optimizing completions with the result in maximizing production. John, we are glad you are here. Last evening we filed our quarterly report with the U.S. Securities and Exchange Commission, but we won’t take your valuable time to regurgitate those filings. We will provide a summary of the results, attempt to add some color regarding current operations, as well as a sense of our future and be happy to answer your questions. However, before doing so a couple of opening comments. As noted last night Flotek reported revenue for the quarter ended September 30, 2015 of $87.9 million, a 1% increase compared with second quarter 2015. In our view the worst oil field operating environment in my 30 plus years in the business and one that became consistently less attractive throughout the third quarter, Flotek’s ability to post both revenue and profit growth is a testament to the commitment of the woman and men of Flotek, as well as the continued acceleration of acceptance of Flotek’s key completion chemistries, a fact we will discuss in more detail shortly. Not only did Flotek post sales growth in the quarter, such growth resulted in improved profit as well. Flotek posted profits of $2 million or $0.04 per fully diluted common share that compares to fully diluted earnings of $0.02 per share last quarter excluding non-recurring items. Over the course of my six years at Flotek we worked diligently to position our company as a technology leader in the oil field, especially in the area of completion chemistry. Our third quarter we believe shows that effort has been effective as we expect to be one of the only oil field concerns that will show both top and bottom line growth. Moreover, our energy chemistry segment not only continues to achieve strong market penetration due to our hallmark CnF completion chemistry. The segment also showed meaningful growth in both gross margins and operating margins. Again, primarily due to growth in CnF revenues and pricing stability in CnF. Specifically as noted in the press release last evening, like product pricing among CnF remain nearly constant in the third quarter, contrary to some erroneous reports. To be able to say third quarter energy chemistry gross profits were 18.8% above second quarter levels and operating income was over 20.1% higher than the previous quarter, in this operating environment is in my view a near heroic achievement and breathtaking. Moreover, that didn’t happen by chance, but rather by the incredible effort of the nearly 500 people at Flotek who care about making the difference to our shareholders, and it happens because we have worked tirelessly to ensure we have a chemistry technology that has empirically shown to improve completion outcomes and as a result making a difference in the economic performance for our clients. That is the reason that with activity down over 50% in the course of the year, CnF sales volumes in the third quarter of 2015 were 59% above third quarter 2014 sales and increased 34% sequentially. That said, we understand that isn’t good enough. As such while pleased with our progress, especially in energy chemistry, we are not yet satisfied. Our progress and success in the quarter simply makes us more enthused about future opportunities and we will continue to work smarter and harder to ensure we remain focused and continually gain market share with our technologies and as importantly are appropriately positioned to turn current market challenges into opportunities for Flotek and its stakeholders. While that may not happen overnight or even in the fourth quarter, we are convinced we are positioned as a company and with partners like John Ely, so that 2016 will be better than 2015 and we will create new opportunities to create value for you, our shareholders. No doubt we are realistic about the industry headwinds and challenges we face in the short term. With the challenges already faced in 2015, combined with the holidays quickly approaching, we understand there is a real possibility that oil field activity in the last several weeks of the year could slow precipitously. However, we have a strong backlog of validations in the pipeline, including projects with major independence that we believe will continue to move forward, albeit perhaps more deliberately as we approach year end and we expect those projects to re-energize into the New Year. And who knows, several of our analysts were skeptical that third quarter chemistry sales could be better than second quarter results, but they were. Our goal is to improve each and every day regardless of the hand we are dealt. While realistic, we will look for every opportunity to operationalize that mantra even in the fourth quarter. As we have said many times, the adoption or transformation of game changing technology is not a linear process. But as our results over the past two quarters strongly suggest, the rate of adoption of our production maximizing precision customized chemistries can grow in the environment presented over the past six months, we are certain the long term future of Flotek is as wide as ever and expect significant opportunities for growth in the coming year. Before I turn the call over to Rob Schmitz to provide additional financial review, I want to take a minute to discuss an issue of interest to all Flotek investors of which all of us around this table today are. We appreciate the thoughts and work and effort that many of the analysts who cover Flotek provide and we understand how difficult the economic analysis of a company like Flotek can be, especially in an environment with such high levels of uncertainty. That said, the challenges and the analysis business also create challenges for companies like Flotek, especially when one erroneous estimate can have such a disproportionate impact on consensus numbers, which is what happened in the third quarter. Removing just that one estimate in the mix provides a more cogent view of consensus taken and makes Flotek’s third quarter results not only at or near the top of the service sector, but slightly ahead of the mainstream consensus. Please understand, we appreciate the effort of those in the complete and accurate coverage of our company and have no interest in the debate over valuation and reading calls that are based on factual and accurate information. That is what makes the U.S. public market so robust. However, accurate based mathematics, factual statements that don’t involve blind conjectural or guess as to material facts such as customers or key chemistry performance and correct statements of fact about items such as the current status of credit agreements and the like that can easily be located in our public filings seem like basic tenants of objective thorough securities research. While we have little control over what is published in today’s world, I would say we welcome firms and analysts that have an interest in factual, constructive evaluation and will feel compelled going forward to mention those who appear to potentially have agendas other than objective securities analysis and critic. That said, the Flotek team is acutely focused on what we can control, especially in challenging times like today. By creating best-in-class for the field chemistry, providing support to our clients to ensure optimal completion design and execution, creating objective evaluation tools that show performance of our chemistry, working to improve our processes to ensure maximum operational efficiency, looking for opportunities to expand our reach and grow our business both intrinsically and extrinsically by maintaining a superior affinity profile and operating a business guided, our core principles for safety, fairness and a sense of ecos [ph] unrivaled by our peers. We will be vigilant in our scrutiny of cyclical variables outside our direct control using them as guides to help optimize our operations through the cycle. As I said on each call since I took the hand over six years ago, it continues to be my privilege to serve as President of the company. I remain immensely proud and humble by the commitment and support of member of the Flotek team that believe as a group we can make a difference in the future of Flotek combined to our vision, that technology can make the difference for all of our stakeholders. Regardless of the challenges presented by the current operating environment, I remain enthused through the efforts of our people, the future that’s filled with opportunities to create value for our stakeholders. With that, I’d like to turn the call over to Rob Schmitz to review our third quarter financial highlights and provide some additional color on certain financial issues. Rob.

John, thank you. As John mentioned, Flotek filed our Form 10-Q for the period ended September 30, 2015 with the U.S. Securities and Exchange Commission yesterday afternoon. In our filing we reported that revenue for the third quarter ended September 30 was $87.9 million compared to $116.8 million for the three months ended September 30, 2014 and $87 million for the second quarter of 2015. Third quarter 2015 revenue increased 1% sequentially but decreased 24.7% when compared to the 2014 period. The decrease in year-over-year revenue was driven by the steep decline in oilfield activity; however, the increase in sequential revenue was driven almost entirely by increased sales of our Complex nano-Fluid completion chemistries, a direct result of the growing interest in our precision, customized completion chemistries, generated through the use of FracMax data and validation results. For the three months ended September 30, 2015, we reported net income of $2 million or $0.04 per common share compared to net income of $14.3 million or $0.26 per common share, fully diluted for the same period of 2014 and net income of $1.1 million or $0.02 per common share, excluding non-recurring, non-cash charges in the second quarter of this year. Adjusted Earnings before Interest, Taxes, Depreciation and Amortization or Adjusted EBITDA for the three months ended September 30, 2015 was $7.3 million compared to $25.2 million for the three months period ended September 30, 2014. We included a reconciliation of these items in GAAP net income in last evening’s press release. Cash flow from operations for the nine months ended September 30, 2015, was $17.8 million, compared to $39.9 million for the nine months ended September 30, 2014. Operating cash flow for the 2015 period was used primarily to expand capital facilities and to make required payments on our current notes. Borrowings under the revolving line of credit were primarily used to repurchase stock in open market transactions and for tax withholdings upon the vesting of employee stock awards. Inventories of $84.4 million for the period ended September 30, 2015 were essentially unchanged compared to inventories ending in the second quarter of 2015. Outstanding receivables as of September 30, 2015 were $52.1 million compared to $56.5 million as of June 30, 2015. Our day sales outstanding improved to 54 days at the end of the third quarter compared to 59 days at the end of the second quarter of 2015. The allowance from doubtful accounts represented approximately 1.7% of receivables at September 30, 2015. Depreciation and amortization expense, excluding D&A included in cost of sales for the three months ended September 30, 2015 increased by $0.3 million when compared to the same period in 2014. Interest and other expense decreased $0.1 million for the three months ended September 30, 2015 as compared to the same period of 2014. As John noted earlier, we are pleased with our financial performance, especially when compared to overall industry activity. However we look forward to continuing to balance growth with efficiency and find ways to improve our financial performance metrics. We will be acutely focused on costs, especially if the environment in which we operate continues to present more significant challenges and most importantly in a challenging market environment we will continue to focus on our liquidity position where we have consistently been a market leader over the past several quarters. We continue to believe that the superior liquidity profile places Flotek in a unique position to capture strategic opportunities as we emerge from the fall of the cycle. Thank you. I would now like to turn the call back over to John to discuss our current business environment and strategic initiatives. John.

Rob, thank you very much. Before we take questions I’d like to make a handful of additional comments on current business conditions, strategy, our expectation for the coming months and add a few concluding thoughts. There is no doubt that Flotek’s energy chemistry technology segment and more specifically growing acceptance of Flotek’s CnF conclusion chemistries drove the company’s strong third quarter performance. In fact, as noted earlier, Flotek’s third quarter CnF volumes grew 34% sequentially to 59% year-over-year in a market which activity declined between 40% and 60% depending on your favorite metric. While such strong performance might be expected in a market with strong industry fundamentals, this type of growth may seem anomalous to some given the current headwinds based in the oil and gas industry. Yet not only did volumes accelerate, prices remained nearly constant on the same product basis since earlier this year. Moreover as we recently noted, there is little doubt in our mind that CnF has now reached the tipping point of most North American basis which suggests operators are more inclined to consider using CnF than not. That fact is best demonstrated by a couple of key metrics we also discussed in our release last night. First, the number of committed users of our precision customized completion chemistries continues to grow from under a dozen a year ago. Flotek now has nearly three dozen CnF power users; companies that use CnF chemistry on nearly all of their completions. These companies represent both some of the largest operating companies in North America, as well as a smaller focus production companies that are known for their innovations and acceptance of new technologies. While growth is accelerated in recent months, largely a result of successful validations and support from empirical data provided by FracMax, we believe 2016 will provide even greater adoption velocity. Our confidence comes from the fact that validation opportunities continue to grow as well. Even in the third quarter we saw overall oil field activity continue to slow. Moreover, we have several key validations with larger North American centric independence underway and untapped for the balance of the year and into early 2016. In addition, our experience suggests a number of new opportunities will result as the positive impact of CnF chemistries continues to spread from current CnF adopters to operators that have not yet been directly exposed to the benefits of CnF. In fact just this week we gained new introductions to operators that have heard from peers of the positive attributes of CnF that should lead the new validations and we believe commercial customers in the coming months. That said, not only are we not at all surprised at the results, we expect growth to continue into the New Year, notwithstanding the continued challenges facing the industry and while at the same time understanding our short term transient concerns about the fourth quarter. Quite simply, transformational technologies like CnF are just as likely to impact an industry during the periods of instability as they are when all the planets are aligned. Our entire energy chemistry team of scientists and engineers, our sales and market specialists have worked tirelessly through operators and our service company partners to deliver the consistent message and advanced custom design chemistry. Specifically CnF provides the best opportunity to maximize the production potential of a well. Secondly, as we discussed in recent months, we introduced FracMax, the company’s patent-pending data analytics and visualization software application, allowing operators and others to compare the performance of wells using Flotek’s advanced next generation CnF chemistries versus those that use conventional surfactants or nothing at all, which accelerated the conversation about the efficacy of Flotek’s innovative chemistry. FracMax continues to expand now with over a 100,000 wells in the completion database and many more in the historical database across nearly all North American basins. Not only does such a large database provide us compelling evidence of the impact of CnF on production, it also allows us to estimate the aggregate economic benefit of CnF usage for our clients. As we’ve noted in the past, data derived from FracMax suggested the use of CnF has added billions in incremental economic value to the over 250 operators who have chosen to use Flotek’s advanced chemistries in their completion systems. Finally, while still very early in its evolution, the final variable we believe is having a meaningful impact on the growth of interests in our completion chemistries with the recent introduction of the Flotek store, the company’s nomenclature for our strategy to market, sell and deliver CnF directly to the oil and gas operators, those who directly benefit from increased production, resulting from the use of CnF. As noted when we first introduced the Flotek store, as well as in our recent Investor Day in New York City, the direct to market path is both prudent and opportunistic in today’s environment in which operators are acutely focused on performance enhancing technologies, direct proof of concept effectively validated by FracMax and best value pricing and ability to maintain multiple completion partner relationships, a result of an abundance of available hydraulic horsepower. While we are still early in the process of establishing direct relationships, the reception has been quite positive and opens up an entirely new group of customers from major independence to family run production companies that are more involved in completion designs and procurement and as a result were difficult for Flotek to reach. Let me be clear; we value our relationships with our service partners and will continue to sell to those companies as we have in the past. In short, the Flotek store simply introduces another path for Flotek to service our clients, both old and new, which in turn creates another path for Flotek to create value for its shareholders. One of the unique attributes created by the Flotek store is the ability to pack each other value added services in the sales process with Ely. One of the first additions to our service stable is our collaboration with John Ely and his firm Ely & Associates, a leading international completion consultant. Through this partnership Flotek clients who procured the company’s CnF completion chemistries through the Flotek store will have the opportunity to utilize Ely & Associates completion and valuation services which would be included with the purchase of Flotek completion chemistries. This process will ensure the execution of completion company process is performed, the specification of the right mix and loading chemistry providing the Flotek client with additional assurances that the completion chemistry process is optimized. We are delighted to have our new partner John Ely with us today to introduce himself, his firm and discuss our new relationship. John, welcome!

John, thank you. I’m glad to be here and very much appreciate the time and more important the confidence you’ve shown in our company. I’ve known John Chisholm for more than 20 years. I cannot tell you how delighted I am to have an opportunity to even work with him and the exceptional team of chemist and field experts we have assembled here at Flotek. I’ve been around the oil field and completion chemistry for nearly half a century and can say I’ve seen few oil field chemistry innovations as compelling as CnF during those five decades. Those of you who know me and my history know that I am generally skeptical when it comes to the lectures that are said to improved well performance. I have generally being critical with the use of surfactants and other chemistry completions; finding a little or no compelling evidence of the positive impact on well performance. However I’ve even more skeptical, really almost cynical of those who said you can simply pump higher volumes of conventional surfactants. It’s really nothing more than so, to get better production designs. That said, in my 50 years around the oil field chemistry business, Flotek’s developments are Complex nano-Fluids, is one of the most important and one of the few advances in the oil field chemistry I have seen. Including my direct experience with CnF, and well completions, defined with the compelling empirical data [indiscernible]. There is no doubt that the chemical combination of the de-lemoning [ph] solvent that’s specialized and now creates a nano partial molecular clusters that now create a reservoir compound and further leads to significantly enhance the production and [indiscernible]. When pumped at our current specification of two gallons per thousand of the frac fluid system, then it ever will benefit from the use of CnF when compared to those that were also used to support wells [indiscernible]. Let me be clear, our analysis suggest that CnF has unique molecular attributes that result in better completion and as a result better well performance. Some might suggest pumping more common surfactants to buy the same results. There is no data to support that conclusion. It is a molecular size combined with a unique citrus solvent. Flotek’s proprietary chemistry design and delirious results cannot be achieved through ordinary surfactant chemistry, regardless of the quantity. We look forward to working very closely with Flotek in the coming weeks and months in the development and advanced well completion protocols and existing Flotek’s clients, many of which are our clients. Over the years that we’ve had been worked with or more than 20 years, to better understand the completion process and to ensure production is maximized, that’s what we’re about, through exciting the completion and execution and we’re delighted to be working with Flotek and John we appreciate very much the opportunity to collaborate. I really believe it’ll be a very successful venture.

John, thank you very much and we are glad you are here. Before we take your questions I’d like to conclude with a couple of additional observations and final thoughts. We continue to see opportunities in international markets and work to continue to grow in those new markets. While Canada presents as many if not more challenges in the lower 48, we continue to see growth opportunities, completion chemistry established and have established a direct distribution program North of the border. In the Middle East we continue to gain traction in Saudi working closely with Aramco on a number of key chemistry projects that we believe will continue to grow our presence in the Kingdom this year and into 2016. We’re also working on a warehousing and blending relationship in the UAE and should lead to new and more efficient opportunities in the region. In South America we’re in the process of beginning new CnF validations in Argentina and Chile before the end of the year. While there is no question the headwinds are strongest in our drilling technologies business, there are signs as one of the strongest players with a multi-region footprint that we are gaining market share as weaker competitors continue to exit the market. While it is hard to see a few cyclical troughs at this point, we expect the fourth quarter to look very similar to the third quarter and we continue to adjust our cost structure as we work to reduce cash burn rates in this business. In production technology, we continue to see opportunities, directly related to the acquisition of the international artificial lift, including a contract for the sale and installation of four new hydro lift units. Additionally Flotek is proceeding with the launch of its next generation electrical submersible pump sales program beginning in the fourth quarter. Preliminary product introductions have been well received both from current and potential customers. Our new global research and innovation lab is on track to open in mid-2016 with signings in initial construction well underway in North Huston. The 50,000 square foot facility will bring Flotek’s research team together under one roof and provide next generation technology in an interactive setting allowing clients to collaborate directly with Flotek’s research professionals, creating a more complete client experience. In fact the extra space is coming just in time to meet the growing demand for our reservoir analysis business. In the past several weeks we’ve added additionally scientific and analytical resources to process the growing number of cores and other well samples arriving daily from new and existing clients. We expect this demand to accelerate, in part due to the growing number of samples arriving into our research facilities related to new clients coming through the Flotek Store. Finally, we continue to pursue additional opportunities for our dream big-data analytics and visualization platform, both in the oil and gas segment, where we are in the process of introduction FracMax Centric and across other segments that may benefit from our mobile platform, as well as our ability to spatially stratify data. We appreciate the advice and counsel of several of our stakeholders with experience in this arena who have been willing to spend the time and effort in support of creating additional value for all Flotek’s shareholders. I have never been more excited about the further of Flotek than I am today, and I have never been more confident in our prospects and capacity to execute. Even with the industry headwinds in front of us, I am convinced we have the right people in the right places to grow our business in the coming weeks and months and with either even greater acceleration in the coming year. Very simply, Flotek is changing the completion paradigm, as well as the way services are delivered in the oil filed. A combination of world class research and innovation, precession, customized chemistry for the unique needs of each client and a direct distribution model that provides greater efficiency and quality for each of our clients, are the hallmarks of our new paradigm. We are certain that Flotek clients are benefiting from a more complete experience, one that proves completing benefits from the reservoir to the balance sheet. We look forward to continuing to share the successes from journey in the coming months and well into 2016 and beyond. We are acutely focused on making a difference for our clients and as a result for you our shareholders. I pledge to you today as I did on our first call now six years ago is that my team and I will come to work each and every day knowing that you have placed your confidence and trust in us as stewards of our capital. We will take that responsibility very seriously and work hard each day to earn that trust. Let me be clear, the success of Flotek is the result of the hard work and untiring efforts of a group of people who believe they can shape the future. As a leadership team, it is encumbered on us to communicate our vision, challenge the spirit and ensure our team has the tools to exceed even their wildest expectations. Thank you for your interest in Flotek. I’m glad to be here and we look forward to sharing our journey, both challenges and successes with you in the coming months. With that operator, we will now open the call to questions.

Thank you. [Operator Instructions]. And our first question comes from the line of Matt Marietta with Stephens Inc. Please go ahead with you question.

Yes, thanks for taking the question, and good morning guys.

Hello Matt.

Congrats on the success here in CnF volume sales and really the ability to generate adjusted earnings in the third quarter. But I really want to hit on something in more detail as it relates to the non-CnF chemicals within the ECT segment. First, are you willing to offer the percent of revenues within the segment that were CnF and that weren’t? If not, maybe remind us of the range that you’ve spoken to in the past and then secondly on the same sort of subject there, what sort of pricing and volume pressure is being experienced in the non-CnF chemicals within that segment. You know maybe helps us understand the dynamic of work here where CnF growth is boosting the margins, but non-CnF energy chemical technologies is likely offset that margin expansion and top line to a degree and kind of the cross current that’s associated with the different chemicals within the segment.

Sure. As you know Matt and the others on the call, for competitive and strategic reasons we’ve kept the CnF number as kind of a bracket. But there has been such increased interest in trying to get a closer number of that, we are going to give more clarity to that today and Rob Schmitz, our CFO will walk you through that a little bit.

Thanks John. So for the quarter our CnF sales revenue was about 60% of our total ECT revenue. And that numbers ranged from low to mid-40’s up to – this is probably as high as its been. So that kind of tells you the impact of CnF and I would say, when you look at the overall ECT margins, that really is the impacting factor. There is not a lot of margin movement in the non-CnF product lines. It’s just that the CnF product line had such a more dramatic impact in the quarter because it had such a dramatic increase relative to the non-CnF products. Does that answer your question?

Yes, that’s very helpful. And as you talk about the margin, I guess what I’m trying to understand back into here, but any color you can provide is appreciated. What the gross margin difference would be as you talk about CnF and then the variety of other chemistries with the segment. How much of a difference are we really talking about?

Well, certainly CnF is our strongest margin product line. The other products, there is really a number of different ranges from just commoditized products that we are buying and supplying to customers because they ask us to provide a full set of products. Those can be pretty commoditized product lines, and then there is other products that are kind of mid-range between the CnF margins and the lower margins. I think we’d like to stay away from getting any more specific than that relative to margins on specific product lines.

Understandable. And then a follow-up here from me; I wanted to dig into the market penetration rate as a percentage of the term that you guys have discussed in the past. I recall from the Analyst Day, you’ve seen the market penetration expand from 8% to 10% to 12% depending on basins. You know on the latest FracMax data if you have it, can you maybe elaborate on where that penetration rate is and maybe provide some insight to where you think it can head over to the next 12, 18, 14 months, because certainly the growth in CnF sequentially is outpacing the activity levels. So if you have the latest data to that regard that would be helpful in understanding the penetration rate.

Sure. So I think everyone on this call knows the lag in the reporting of frac focused data which really is the most, we believe empirical way to track the penetration of CnF is like in many cases a 90 day or 120 lag. But we believe based on current information we are somewhere over 12% of the number of wells that are completed, that are using CnF. What we have said is that exiting 2017 we believe the tripling, the CnF revenue is attainable, and that is through increased penetration of the market, but also increased loading of CnF inside these fractured treatments. One very key benefit of instituting the Flotek Store is that since that happened in May, every validation that has been conducted, has been conducted at 2 gallons per 1,000 on the loading versus what was previous 1 gallon per 1,000 due to the pricing uplift charged by the distributors. All of our laboratory data and all of our data that has indicated where we’ve used 2 gallons per 1,000 before indicates you get much more of an uplift versus the cost of going from 1 gallon to 2 gallons per 1,000. We would estimate that somewhere over still 85% of our clients use just 1 gallon per 1,000 and so that is how we get to our belief that exiting 2017 we will triple the revenue of CnF.

That’s great color. I really appreciate that and I’ll hop back into the queue to ask some more questions. Thanks.

Thanks a lot Matt.

Thank you. Our next question comes from the line of Georg Venturatos with Johnson Rice. Please go ahead with your question.

Hey, good morning guys.

Hi George.

Hey John, just to get a little more clarity to on the margins as well. Obviously a really nice gross margin number up over 400 basis points sequentially. Sounds like it was largely mix, positive mix shift on CnF, but wanted to get a sense for a couple of the other potential variables. I know we talked about raw material costs and formulations coming down a little bit and a few versions of CnF. And then also an update on kind of the percentage of total revenue that’s been solid direct, if that’s changed meaningfully over the last quarter in terms of what could be more sustainable on the margin side.

Okay. So I think the question that – we’ll gain try to give as much clarity as we feel confident in giving on the margin situation of CnF, is that is over doubled the margin of other chemicals solid at Flotek. That is why we are so protective of the intellectual property portfolio that we have talked about in the last months as to how we have surrounded the core patent on that product with additional patents that have been issued by the U.S. patent office. And as Rob mentioned, that is what drives the uplift in the margin which is as I mentioned earlier, in this environment frankly breathtaking. With respect to the Flotek Store, we are not today, nor do I believe in the further going to give with great specificity the revenue or the number of folks that are coming through the Flotek Store, again for strategic and competitive reasons at this point in time. We may change that view in the further, but as of right now that’s our posture. However, the mission of the Flotek Store was to improve the awareness of the performance of CnF and what has happened as a result of the Flotek Store is that pricing charged by the distributors on the margin markup has decreased substantially from the opening of the store to pre-store pricing, and that in itself is a reason why the activity has increased in the third quarter; whether people have bought though the store or not is the clients are experiencing a different pricing number from there distributor. Does that help?

That is helpful John. It sounds like it’s largely mix shift, it is the important here and then obviously Flotek Store has the ability to grow over time. I wanted to talk about the big five operators that you guys have mentioned in the past. Obviously we see this as a potential step change in revenue as we move into ’16 on potential conversions. Any further detail you can give us on timing expected there? I know we had one lager that you thought may start up by the end of November last time which added, but any update on timing and how long you think those operators are going to need to see well data before making a decision.

Right. So for the folks that may not be familiar with the clients that we identified, we mentioned, it was I think a level of transparency in this industry that I am not aware that other companies have provided, that Range, Apache, EOG, Chesapeake and Encana, all have had a business model of purchasing as many of their services as directly as profitable. Those operators were excluded from the pre-Flotek business model, which has been the industry’s business model for the last 50 years until we opened the Flotek Store. By the middle of November everyone of those operators will have been in validations with the possible exception of one, which we are still confident will happen by the end of the year, that have never used CnF before. Now, the challenge is with these larger companies, that in themselves have their own bureaucracy, they have different criteria as to the period of time that they want to evaluate the performance of wells that there is just absolutely nothing we can do to change. If some of them want to see the performance for 90 days, that’s what they are going to do. If they want to see it for 120 days, that’s what they are going to do. But the important things is, is that we’ve opened up the market to those five players that have never pumped CnF before, and they are all in validation programs, like I say or will be by the middle of November.

Perfect, thanks a lot John and last one for me and maybe I’ll re-queue after this. But on the non-CnF side, just doing a quick math and correct me if I’m wrong, but you’re looking at a sequential decline in the 15%, 20% range in the quarter. Just wanted to know maybe more detail that was it one or two large customers that maybe from a timing issue fell off a little bit and maybe you expect to recoup some of that going into 4Q and 1Q or anything other than just market activity levels.

Yes. So Rob will give you a little bit more color on that. But again, everyone needs to keep in mind, that there is a significant drop-off in the usage of hydraulic horsepower in this industry, and those conventional, more commoditized chemicals are directly related to that. And that’s the biggest reason. But Rob will give you a little bit more clarity on that.

Yes, I think with regard to your question about whether you can recoup this business, it’s certainly business that’s out there for us to get back when the market turns. There is nothing in particular about that decline that would mean we couldn’t recover that business as the market declined. It’s just with products that quite honestly we don’t have a stronger strategic position with and so people are really bidding the lowest price out there. So its business that certainly kind of win and we would expect it to certainly come back to us as the market develops next year.

Okay, great. I appreciate the answers guys.

Sure.

Thank you. [Operator Instructions]. Our next question comes from the line of Mark Brown with Seaport Global Securities. Please go ahead with you question.

Hi.

Hi Mark.

Just wanted to ask about the, you guys have started talking about big data analytics and visualization software and wanted to ask if maybe you could give us an update on your plans and one of the questions related to this is what can you do with FracMax for your customers in addition to measuring surfactant usage and the performance of different surfactants. What other types of value add could you provide with the FracMax database?

Yes, great question, that I am sure is on the mind of a lot of folks listing in on the call. So as most people that are familiar with this industry know and the guy sitting on my left knows this probably better than anyone. There are all types of different ways that folks feel that you can effectively try to complete a well with different products, additives, sands, you name it. So all of those variables are identified through frac focus; whether its acid, whether its 100M of sand, whether its ceramic sand, whether its friction reducer, whether its gel and the FracMax database has all of that identified and categorized, so that any additive, irrespective of whether its CnF or not, can be analyzed for its effect on the performance of that well. For example, you can look at client who may have chosen to use an iron sequestering agent on half of his wells and not on the other, and to those wells perform differently with the use of that iron sequestering agent. You can look at an operator that may have pumped 8 million gallons of fluid in a frac job on any number of wells and 11 million gallons of fluid and see what the difference is in the performance. You can see what the mass distribution is of proponed per lateral foot to see what the difference is in performance. So it is no longer just a, what is the benefit of CnF validation marketing application, but it has evolved into a complete reservoir completion economic application that will give the clients the ability to see through public data, how their completions are stacking up against their peers in surrounding areas which I don’t believe has ever been done before.

Well, thank you that’s great. I had a separate topic, a question just in terms of your G&A and R&D expenses seem to increase slightly sequentially and you referenced in the press release that you’ve increased the headcount in your sales organization to pursue growth opportunities and I assume the Flotek Store was one of those, as well as some of your R&I. I was wondering if you could just clarify if that happen this quarter or its been over the past couple of quarters and whether you are sort of at the full staffing level you need to support these new growth opportunities like the Flotek Store.

Okay great, question Mark, and I think for the folks listening on the call, we have not added any person in what you would call strictly the administrative function of Flotek in headquarters. Any person that we’ve added has been directly aligned with the expanding activity of the chemistry side or the research and innovation side as we mentioned that has seen increasing demand of the analytical powers of our folks. So quite frankly, as many of these larger service companies as you’ve heard on their earlier calls are going through further reductions, if we see talent that will add to the value of Flotek and therefore our shareholders that may have been let go, taken early retirement, whatever, from some of the more larger service companies, we are going to hire that talent, because they will make a difference in the way we are approaching the value proposition for our clients. I’d said it’s kind of like the baseball team or a football team. Sure we’ve got to look at ourselves from a salary cap, but if we got a free agent that we think can bring value to a particular client base for our overall shareholder effort, we will hire that person. But again, in terms of what it takes to look after the management, the leadership of this company, there has been no addition into that part of our SG&A.

All right. Well, thank you very much. I’ll turn it back.

Thanks Mark.

Thank you. Our next question comes from the like of Sean Milligan with Coker Palmer. Please go ahead with your question.

Hey guys, good morning. I’ll ask the G&A question – I’ll ask the calls question differently. So looking forward to ’16 as you start to build out the research facility more fully, is there going to be a step-up change in terms of corporate G&A?

Yes, with R&I there will be a slight increase, but it’s not some type of, as you characterize a step change. We’ll give better clarity on that on our end of the year call in January, again based on when the R&I facility will be opened in June, because I think we’ve been very transparent on that with folks. But there is not going to be a step change that we can see at this point in time.

Okay, thanks and then one more and then I’ll get back in the queue. But on the consumer and industrial side, it’s a little bit weaker from an EBITD perspective this quarter than it had been in the first part of the year. So can you address and you’ve had the seasonality there with respect to 3Q and how you think about that business kind of moving forward.

Sure. One thing to point out in the third quarter and I know folks really sometimes don’t look back on history. They are always wondering what’s going to happen in the future. Third quarter really was probably the best third quarter that that segment has had over the last three years. But Josh will give you a little bit more clarity on that, because it all has to do with the global pricing of citrus and all that and Josh will give you some more clarity on that.

Good morning Sean. Yes we certainly pulled back a little bit in the third quarter ’15 compared to the second quarter. But just to put that in perspective, the second quarter was very, very strong for us. I think on the last call we had indicated the third quarter will be down slightly from that and then as John had indicated, when you look at the performance of the CRCT group over the last three years, year-to-date September 15 is the best operating income that the unit has produced. So we continue to feel real good about where we are and where we are going and the performance of that unit.

Thanks.

Thank you. Our last question comes from the line of Matt Marietta with Stephens Inc. Please go ahead with your question.

Yes. Hey, thanks for letting me back in here. I wanted to hit on the potential commercialization of FracMax. How can we think about that market opportunity longer term? And is there any update you can provide relating to how you view the pricing structure. Is this a recurring subscription model? Could it be based on usage or any color on how you guys are thinking about that potential commercialization could be really helpful.

Sure. And I’ll give you that question in one second Matt. I want to take just a second and maybe provide even a little bit addition color for why John Ely and his group we feel is just really a special development for Flotek. Those of us who have followed Flotek know that we’ve created the analogy of the Flotek Store similar to the Apple Store. That although there is not a store per say, it’s a channel to create a more complete experience than having the distributive network that’s been in place for over 50 years, where there is someone between you and the ultimate beneficiary of what we have to sell. That’s especially true where what you have to sell has a value increasing component, which is true with CnF. While when you go into the Apple Store, you get the benefit of the Genius Bar and what we felt we could do is extend that Genius Bar analogy out to the well side by having this partnership with John Ely and 20 years plus ago when he started his business, I want just everyone to keep in mind that at that time everybody thought all these jobs were completed just the way they were designed and John through his experience had enough understanding to know there’s a reason for having quality assurance on location to give that client the best chance for the best well and John can give you just a little bit more color as to how that whole thing has evolved over 20 years and how he really was transformational and so he’s matched up with another transformational office in Flotek, in kind of the next chapter as he sees what’s going on. But I just wanted John to have a chance to further delineate what the history was with Ely and then Matt I’ll answer your question for you in just a second.

I appreciate it.

Okay, I’ve been sitting here real quiet and just to give a little perspective, I was very fortunate in my career and that I did a great deal of work with the gas research institute and part of that, that came our was exactly what John talked about. It was the development of its own site, real-time evaluation of the performance of the service companies. I think there was a feeling in the industry that and not to degrade the Haliburton’s and the Slumber J’s and so forth with that; what was reported and put together with beakers in the laboratory with what’s being pumped in the field. We kind of stumbled around and figured out that that was dramatically wrong. In fact we found the chemistry involved was so critical that the industry had to change the chemistry. We developed a system. We call it intense quality control, where we basically and even though we had much development in the management of chemicals and proportionate of chemicals, we found out that these instruments are still in there and we have human beings that monitor exactly what’s pumped and not surprisingly we get tremendous results. Our company’s success has been built around that and at the same time we’ve been in a very generic industry where most of the products have been around as long as I have and most of them have not been changed dramatically in that time. And when we talk about FracMax, for me is like a young person in a candy store. We’re pretty good at that. The 50,000 foot observation what’s working in the industry. But to have an objective analysis of what’s going on can dramatically change your industry and what’s happened here is I mentioned earlier is, we’ve got a development of a product that indeed is working and what I see in this company is a group of people who are dramatically – are working that dramatically, are working very hard to understand all the emphasis of it and to optimize that product for the future. Our industry is in a really strange twist point or turning point and that what’s happened with the Flotek Store is it has been happening with other suppliers for some time. I think we’re seeing the use of innovation, of performance and products and that’s why we’re excited about it, in working with the product, that there is in truth something that is changing force in the industry.

Thanks John. The inner section of custom chemistry, big data in the reservoir has really never been understood in this industry until we’ve shown it and that is absolutely indubitable. Our understanding of that intersection is defining the future development of the products that we are working on and we are just getting started because of FracMax that shows what’s going on with the chemistry and the reservoir. Now to address your point Matt, to be fair we’re still looking at the price points of how this will be on a subscription basis, not limited by user, because I think one of the things in the past was software in this industry, when it’s been allocated by a feet or a number of users is invariably clients restrict that, because they look at an economic threshold and they probably restrict the number of people that could be accessed to a particular software. So our approach is going to be – it’s going to be unlimited. Its mobile. It will be on a iPad. The iPad Pro which Apple says will be coming out sometime in the first week of November is what the FracMax centric is being designed on right now. We’re able to design it even though the iPad is not commercial and as you can imagine, segment the subscription based on smaller companies like a Brigham Resources or a Tall City versus a subscription rate for folks like a Marathon or a Devon [ph] or a Pioneer and the whole idea will be to try to bring a completion reservoir econometric app to be able to be shared across all types of boundaries inside these clients. If geology can look at it, reservoir can look at it, completion can look at it and be able to share that information back and forth in essentially real time, and that’s the approach we’re taking. We’ll give much more clarity on this at our end of the year call, because again we’re kind of limited to the timing of the release of the iPad Pro with Apple, but I think it would be fair to say there has been interest from the industry, from our current clients and you’re not going to have to be a CnF user to be eligible to get a subscription to FracMax centric. We think more than likely folks will, but that’s not a requirement and again, we’ll give you more clarity through the end of the year as the information develops and hopefully that helps you.

Thanks. We’re looking forward to that update. I appreciate it.

Sure.

Thank you. There are no further questions at this time. I will now turn the call back over to John Chisholm. Please go ahead.

Thank you very much William and I thank all of you for joining us and for your interest in Flotek. We look forward to visiting with you in the coming weeks and months and if we don’t see you before that, have a nice holiday start of the season. Thank you.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.