Flotek Industries, Inc. (FTK) Q4 2016 Earnings Report, Transcript and Summary

Good morning and welcome to the Flotek Industries Inc. Fourth Quarter 2016 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. [Operator Instructions] This conference is being recorded. At this time I would now like to turn the conference over to Mr. Rich Walton, Flotek's Chief Financial Officer. Please go ahead, sir.

Thank you, and good morning. Our press release was distributed last evening and is available on Flotek's Web site. In addition today's call is being webcast and a replay will be available on our Web site as well. 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, and other applicable statutes, reflecting Flotek's views about future events and our 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 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 would like to introduce Mr. John Chisholm, Flotek's Chairman of the Board, President and Chief Executive Officer. John?

Thank you, Rich. Thank you all for joining today's call which is being hosted from our new global research and innovation headquarters in Houston. Joining me today is Rich Walton, our Chief Financial Officer who you just heard from; Josh Snively, Florida Chemical President and Executive Vice President of Research and Innovation; and Robert Bodnar, Executive Vice President, Performance and Transformation Officer. I will begin by giving a summary of our quarterly results and attempt to add some color regarding current operations as well as a sense of our future, followed by Rich who will share our fourth quarter highlights and provide additional financial context. Robert will then talk about our work with data and analytics and I will end with some closing remarks before taking your questions. Before we get into the numbers, I will just briefly mention that during the fourth quarter of 2016 we confirmed the strategic repositioning of our enterprise, playing to the strengths of our core businesses in energy, chemistry and consumer and industrial chemistry. We are in the process of divesting our joint technologies and production technologies segment, and as Rich will explain, these businesses are now classified as discontinued operations. Given for some of the complexity of this accounting treatment, if we don’t answer the questions in the type of detail you would like, we will be glad to take one-on-one calls next week to give you further explanation. All of the results we will share today are for our continuing operations which consist of our energy chemistry technologies and consumer and industrial chemistry technology segments. Flotek's revenue was up 9.7% sequentially and down 2.6% year-over-year, a remarkable outcome in the face of a 43% drop in completion activity in 2016 according to the U.S. EIA, which also followed a 38% drop from the previous year. For the full year, revenue was $262.8 million compared with $270 million from 2015. Results were in line with expectations we outlined in December 2016. In 2016, a key part of our business strategy focused on expanding our global footprint. For the first time in Q4, we shipped products to China, the Ukraine and Iraq, extending the reach and application of our technology to potentially key growth markets. We see a meaningful opportunity for Flotek to continue to expand globally. As part of this global opportunity, I was recently appointed to the board of directors of Anton Oilfield Services Group based in China, an important business partner for Flotek. Anton has operations in the Middle East and the Americas in addition to China and it's worth noting that Schlumberger also holds a significant investment in Anton. I see this board position as complementary to my responsibilities at Flotek as it enables me to help guide the way our technology is used in a region that is currently witnessing intense innovation and growth in the oil and gas sector. It also gives me a new vantage point to observe the challenges and needs of producers in these key regions and extend our network. This partnership is mutually beneficial and I am honored to be included on their board. Turning to our businesses, we reported continued strong results from energy chemistry technologies, which includes our patented suite of complex nano-Fluid products. Sequentially, quarterly revenues increased 22.4%, primarily because of a 12.4% increase in CnF sales volumes. Margins in the fourth quarter were lower by 4.1% resulting primarily from higher freight costs and field services costs associated with the start-up of our new PCM service line, increased citrus terpene cost and a product mix. Margins are expected to recover during 2017 as the company implements price increases, product reformulations and optimizes our PCM service offering. Although year-over-year energy chemistry technology revenue decreased 11.9%, gross margin increased 1.2 percentage points. Most notably, CnF sales volumes increased 14.7% year-over-year which is impressive as this took place during the worst industry activity slump to date. This means the energy chemistry segment as a whole clearly outperformed the broader completion market as key sales volumes rose despite U.S. well completions plunging by more than a third in 2016. CnF has and will remain a consistent and significant percentage of revenue. Flotek clients' are reporting success raising EURs or expected ultimate recovery using our patented chemistry technologies that facilitate better flows in conventional and unconventional wells. A growing number of operators in the Permian Basin of Texas have spoken to investors recently about their successful use of nano-Fluids and their plans to use them in a larger number of wells. More specifically, we would like to congratulate two of our clients, Brigham Resources and Silverback Exploration for their recent asset sales in the Delaware Basin. Brigham in particular worked with us to determine the optimum concentration amount of CnF by changing only the CnF concentration in their completion recipe for multiple wells. All other variables in the completion technique including perforation design, proppant concentration, flow back rates etcetera, were held constant while testing concentration of CnF up to 2.5 gallons per 1000 gallons of fluid pumped. Though an economic analysis in this case proved that more is not necessarily the optimum strategy, Brigham observed their maximum return at 1.5 gallons per 1000 and it was clearly evident that the CnF was superior to other industry products and was a significant contributor to their expected ultimate recovery uplift. To quote, Eric Hoover, Brigham's Executive Vice President of Operations, Flotek's nano technology was a game changer for us in the Southern Delaware Basin, without a doubt it was an important driver in making our Pecos County acreage a huge success. Silverback has also been one of our premiere clients and we would like to congratulate them as well on their recent transaction of selling their acreage in company. Their COO, Steve Lipari, sent me a note thanking us for the collaboration between our two organizations. Steve specifically felt that our prescriptive chemistry approach used in their completion program was important in maximizing their expected ultimate recovery. Silverback took the time to use chemical tracers to help validate our chemistry prescriptions and were also open to using CnF in non-traditional applications in their completion process that will benefit us and our clients in the future. Their technical curiosity created a true chemistry experience that benefited both of us. Consumer and industrial chemistry technologies or CICT reported record revenue of $74.6 million, up 32.3% year-over-year. Importantly, we received ISO certification for food grade activities and added two small distillation units to expand our capacity and variability to manufacture high flavor compounds. Increased costs for raw materials drew down our quarterly gross profit by 32%, but our gross profit for the year increased by $1.7 million or 11.9% from 2015. Drilling technologies had the best quarter of the entire year with revenue up 5.6% from Q3 to Q4 though as part of our ongoing plans to transform our business, we have an active divestiture process under way and are now treating the business as a discontinued operation for our financial reporting purposes. Rich will have more on that in just a moment. Revenue for our production technologies segment increased 5.3% sequentially to the highest quarter of the year, while gross margin for the year was down 12.1%. Quarterly margins grew by 4.4% on increased revenue and improved pricing. This segment is also treated as a discontinued operation for financial reporting purposes. I would also like to note that despite our decision to discontinue these two segments, our team managed to deliver special results for the quarter exhibiting the utmost work ethic and professionalism. The Flotek Store continues to drive transparency in the market for accurate pricing of prescriptive chemistry solutions. We are pleased to tell you that about 40% of our energy chemistry and revenue now comes through the virtual store. The store brings us closer to our clients while offering them greater control and direct benefits. When I reflected on 2016, I am proud that despite the most significant activity downturn ever in both depth and duration, Flotek has done remarkably well by continuing to grow sales volumes of products during each succeeding quarter of 2016 at a pace that has outperformed changes in activity levels in the broader U.S. onshore market. I will now turn it over to our CFO, Rich Walton, to deliver our financial results. Rich?

Thank you, John. As John mentioned, in the fourth quarter we began a strategic repositioning to focus on our core businesses and energy chemistry and consumer and industrial chemistry. The company is executing a plan to divest our drilling technologies and production technologies segments. We have retained an investment bank adviser to assist us with the sale and will update the market once we have additional information to share. Effective December 31, 2016, the company classified the assets, liabilities and results of operations for these two segments as discontinued operations. Beginning with this Form 10-K and going forward, Flotek is reporting the results in two business segments, energy chemistry technologies and consumer and industrial chemistry technologies as continuing operations. I will refer you to our 10-K filing made available yesterday afternoon for additional historical financials on each of our four reporting segments. For the full year 2016, we reported total revenue of $262.8 million, compared with $270 million in 2015. For the fourth quarter, we reported total revenue of $70.6 million compared with $63.9 million in the prior-year period. On a sequential basis, revenue was up 9.7%. Our strong top line growth was primarily driven by the strength of our energy chemistry technologies business, which reported a 22.4% sequential revenue growth with major account increases from significant clients. Our consumer and industrial segment was down 19.9%, sequentially, from the seasonal impact on flavors and fragrances and lower terpene sales in light of the high demand from our energy chemistry clients. Turning to revenue from our discontinued operations, drilling technologies revenues increased 5.6% sequentially to the highest quarterly revenue for the year but margins declined on lower international revenue. Revenue from our production technologies segments increased 5.3%, our highest quarterly revenue of the year. Our full year 2016 operating margin was negative 2.8% and was negative 7.9% for the fourth quarter due to product mix of sales, higher average raw material costs and higher field service and delivery costs in the energy chemistry business, as well as lower revenues and product mix of sales in the consumer and industrial chemistry unit. Additionally, our R&D spending for the full year 2016 was $9.3 million, compared to $6.7 million in 2015. This increase was due to the opening of our global research and innovation center. Our selling, general and administrative expenses as a percentage of sales increased to 30.5% in 2016, compared to 26% in the prior year. The year-over-year increase was primarily due to higher professional and legal fees and increased headcount in our energy chemistry technology segment. I would like to note that our corporate SG&A spending is not allocated to discontinued operations and we do envision reductions following the sale of our drilling technologies and production technologies businesses. For the full year, Flotek reported net income from continuing operations of $1.9 million representing earnings per share of $0.3 on a fully diluted basis. Flotek's strategic repositioning which includes the sale of our drilling technologies and production technologies segments will allow our business to move forward and continue toward profitability in 2017. For the fourth quarter, Flotek reported net income from continuing operations of $3.9 million, representing earnings per share of $0.07 on a fully diluted basis. Our fourth quarter net income included a gain of $12.7 million before taxes from a legal settlement related to disgorgement of potential short term, short swing trading profits from a shareholder. Flotek recorded income tax expense of $1.2 million yielding an effective tax rate of 39.3% for the year ended December 31, 2016, compared to an income tax expense of $3.5 million, yielding an effective tax rate of 32.7% in 2015. At December 31, 2016 Flotek had accounts receivable of $47.2 million, compared to $35.5 million at December 31, 2015. At December 31, 2016, days revenue and accounts receivable was approximately 63 days. For both of the years ended December 31, 2016 and December 31, 2015, the provision for doubtful accounts was less than $1 million. At December 31, 2016, inventories for continuing operations totaled $58.3 million versus $50.9 million for the prior year. Our inventory turnover is currently approximately 3.0 times per year. For the fourth quarter, capital expenditures totaled $3.3 million bringing our total capital expenditures for 2016 to $14 million, down $2.4 million from 2015. We are continuing to invest in new strategic growth initiatives while maintaining prudent management of our cash position. As a reminder, our financial statements report the continuing operations of our energy chemistry technology and consumer and industrial chemistry technology segments. The Form 10-K provides a description and analysis of our discontinued operations as drilling technologies and production technologies in the foot notes and also in management's discussion and analysis. We will continue to provide updates on the sale of these two business units. In 2017, we are focused on monitoring capital expenditures, protecting our liquidity and growing our core businesses in energy chemistry technology and consumer and industrial chemistry technology. John, back to you.

Thank you, Rich. And now I would like to introduce our Executive Vice President, Performance and Transformation Officer, Robert Bodnar, to share safety updates, some efficiency metrics and give more context around our data and analytical initiatives, an area that he had spearheaded and done a phenomenal job since joining the company over five years ago. Robert?

Thank you, John. As we look through this downturn, we understood that our clients were going to require more out of every drop of our chemistry. This was a key driver for our focus on data and analytics this past year and I would like to share some updates on what we have accomplished to the benefit of our client. In June 2014, we developed a data analytics visualization software application. The introduction of this type of digital open record of data is still growing in acceptance by the industry but it will be an increasingly important differentiator for us as we advance new, cognitive computational technology to uncover key insights and trends about our client's wells and our how our chemistry can better enable and protect their reservoirs. We feel strongly that open source data will be at the forefront of innovation for our industry and we will continue to accelerate improvements of our chemistry design for our clients. As a testament to the industry's growing acceptance of this data movement, Core Laboratories and Baker Hughes, both shared related remarks in recent earnings calls acknowledging that E&Ps want service and equipment providers to deliver on the vast promise of data analytics to enable them to make the right decisions and investments at the right time, to quote Baker Hughes CEO, Martin Craighead. These comments serves as affirmations to our own strides in data and analytics over the last few years, which has uniquely positioned us ahead of the curve with respect to meeting client demands to address productivity looking beyond cost as the end all and be all in this industry. I will now give you an update on our new research and innovation center which has allowed us to accelerate the pace of our prescriptive analytical chemistry business approach. Our patent portfolio has continued to grow with four more patents granted surrounding our polymer activities last year, bringing the total to more than a dozen. Our total filed or pending patents now number more than 70, including 40 unique CnF formulations, demonstrating our commitment to continuing to be the leader in the specialty chemistry sector. Clients innovations were also up significantly due in part to the collaborative capabilities of this new unparalleled global research and innovation facility. Since we completed construction, we have secured six new clients due to business to the center. We have also held four events that brought together key industry leaders, academics and leading minds for a monthly Pursuit of Knowledge Institute series and have completed construction of our Canadian Research Center in Calgary. We have also developed and continue active partnerships with eight universities and educational institutions. Turning to our health, safety and environmental efforts, we have maintained an excellent best-in-class safety record. Flotek's total recordable incident rate has consistently declined over the last few years falling 64% to 0.78 in 2016 from 2.19 in 2012. This total recordable incident rate or TRIR, as you know, is the number of recordable accidents per 200,000 hours worked. Our TRIR is much lower than averages for other economic sectors tracked by OSHA. I would also like to mention that lost time and light duty injuries plunged to essentially zero in 2016 from 5 in 2015, as we further build upon our strong safety culture. While we are very pleased with our performance and the dedication to safety shown by our employees, we continue to hold monthly safety meetings and reviews with all of our managers. Our executive leadership is very involved in our continued review and enhancements regarding the safety of our employees as well as the environment. We also transformed our process to improve employee efficiency at the same time increasing the number of gallons of prescriptive chemistry produced per employee by 20% and exceeding our employee retention levels from 2015. And with that I will turn it back over to you, John.

Robert, thank you very much. Before we take questions, I would like to add a few concluding thoughts. With numerous shale oil producers and oilfield suppliers now forecasting a low double-digit growth rate in 2017, Flotek is uniquely positioned for an activity rebound, especially in light of our August acquisition of International Polymerics, IPI, a leading supplier of natural polymers such as guar, that complements our work with citrus based nano-Fluids. IPI has also brought us a strategically located staging center in the Permian basin that will help our cost curve as we serve the many independent and innovative E&P companies in the fast changing and most active area in the U.S. shale industry. What we have seen among our large and small independent clients as well as privately funded companies, is a trend of embracing technology sooner than their larger counter parts, and thereby becoming more illustrative of what the industry is capable of being. While an oversupply of pumping equipment currently exists, pumping companies that have recapitalized are differentiating themselves competitively with technology such as with our prescriptive chemistry solutions. Additionally, a looming shortage of small mesh proppant is having an effect on the type of fluid being used in completions which will increase demand for other solutions as companies seek to lift IRRs and EURs or expected ultimate recoveries. As the playing field continues to evolve and activity levels begin to rise, we are positioned for growth and have initiated a double-digit price increase effective this quarter. As we announced on January 30, Michelle Adams, Worldwide Vice President of IBM Watson Platform, has joined Flotek's board of directors, bringing a wealth of first class expertise and innovation, entrepreneurship and sustainability. We are excited to have her on our board and inspect to leverage her unique background in technology and cognitive learning. Michelle becomes our eighth board member and will serve on our governance committee. I am confident that having an executive of Michelle's stature join our board is a tremendous statement about our future business opportunities as cyber security and technology are now considered to be must have competencies insides the boardroom. I am also pleased to tell you that since the announcement of the Flotek Store, we are in more direct communication with exploration and production operating companies. With the opening of the Flotek Store and the launch of our prescriptive chemistry management business offering, we are becoming increasingly involved in the entire lifecycle of the well. We are investing an additional subsurface characterization competencies to design, execute and analyze applications of chemistry in oil and gas wells, drawing on disciplines including geology and geophysics, or G&G, photography and reservoir completion and production engineering. We continue to strengthen our team. William Hill recently joined Flotek as Director of Geology. He was most recently at BP America and has over 35 years of varied geo-science experience. Flotek is succeeding in a tough market because we treat our clients' reservoirs and their capital like they were our own, meaning we do not prescribe a gallon more of fluid than we would if it was our own well. We earn their trust by letting the results of our products speak for themselves as many of our clients have attested to and that is truly special. For the first quarter 2017, we are anticipating continued improvement in completion activity. In addition, we are experiencing continued strong demand in energy chemistry and are focused on delivering improved margins through strategic pricing increases and process efficiency. In consumer and industrial chemistry, we continue to expect yearly growth in our net revenue and gross margins and expect to make substantial progress on the divestment of drilling technology and production technology businesses this quarter. As always, we are focused on maintaining strong liquidity to fund our business. We also recently posted a new video series called Catalyst for Change, Conversations with Flotek's Directors. Featuring our board members, which can be found on our Web site's Investor Relations page. Today's shareholders are expressing more interest in learning more about, hearing from and understanding the board of directors capabilities, as well as their positions on company decisions. Therefore, we created this video series to proactively showcase our board members as they share their thoughts on Flotek's business and corporate citizenship, which is very important to us as a company. To that end our social responsibility work which we see as part of our broader sustainability efforts, continued this past year. In January, Flotek foundation made donations to food banks that helped them funds an estimated 1.3 million meals for families and children experiencing food insecurity, most notably in the communities surrounding our work in energy centers such as Pittsburgh, Oklahoma City, Dallas, Houston, Midland-Odessa and Denver. This was a result of a hunger initiative we held in September which was supported by our clients as we donated a certain percentage of sales revenues from that month to local food banks. For more information about these efforts, we encourage you to visit our website makingadifference.com, to see other examples on how we are creating change in the communities in which we operate. We would like to take this opportunity to thank our employees around the globe who believe in making a difference each and every day, not only for our clients but also for our shareholders, community and environment. Thank you for your continued interest in Flotek. We will continue to work hard each day delivering improving financial and operational results and do all we can to maximize our significant and unique opportunity. And with that, operator, we will now open the call to questions.

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

Congrats on effectively managing through the trough of the downturn here over the last 12 months. Certainly an exciting outlook from here. But, John, for those newer to the story, I wanted to go back to why and maybe remind us why the Flotek Store is so important. What issues Flotek experienced in the supply chain that led Flotek to opening the door to price transparency as well as product quality control? And maybe explain how this is changing the way E&P companies procure their chemistries for their wells.

Yes. Great question and I am sure others have the same thought and it will take a bit of an expanded answer. But every company in every industry that has transformational technology or a product wants a direct path to the end user. For full appreciation of that technology and for many, many decades in this industry that was just not the case. And what we had was probably the most amazing brand nullification that I have ever seen. When we sold our technology through the distributed networks, there must have been 55 different plus brands names that represented complex nano-Fluid, and that was just not a sustainable business model because you become dependent on that distributor's interest, pricing and technology sharing with the ultimate end user. So we felt after a lot of examination that in May of 2015, when we made that decision it would certainly transform us, and we did not really realize how much it was probably also going to transform this segment of the industry. What we had observed, not in any way intentionally but what certainly what we had observed, was some dilution of chemistry and really kind of a lack of interest of getting the right prescription of the chemistry into the well. These hydraulic stimulation jobs are very complicated, lot of equipment, lot of manpower. Quite frankly, sometimes whether you are pumping a 1.5 gallon per 1000 or 1 gallon is probably not the highest on everyone's mind. That exposed us to companies like [John Eli] [ph], [John Blevins] [ph], companies that consult on the well side to ensure quality assurance and gave us a better appreciation as to how the chemistry itself should be applied. And from that, as I mentioned in my earlier remarks, with a tighter relationship with these E&P clients, it has led to greater value for them, as I mentioned two in particular, Brigham and Silverback, and greater value for us because we had a direct way to communicate how we would change the variability of certain chemistries to get to the optimum prescription and in some cases that might be less chemistry but in all cases it was designed for what is best for the reservoir. Along with that, came price transparency that the industry needed. And so now I think as a lot of folks on this call know, more and more of the overall additives whether it's proppant, whether it's acid, is now decoupled from the way those services were provided for decades and at the end of the day it creates the opportunity for the most efficient technology to be conveyed to the end user. And so it took us really I think about two years to make CnF synonymous with Flotek chemistry. And now what our vision is, is where we want to be is when clients want the best prescriptive chemistry system, not necessarily the cheapest, they are going to think of one company and that is Flotek, and the Flotek virtual store created that opportunity. Hopefully, that answers your question for you.

That does. I think that is a helpful summary in what has taken place over the last two years strategically for the company. And maybe shifting gears here to a little bit more of a detailed question or difficult question to answer, on the customer concentration. When we do the math, it appears that the non-customer a, customer b growth in the fourth quarter was significantly above the EI completion data. And in the 10-K, you mentioned that there was a significant new contract with a large operator as well as increased sales to several operators. Can you maybe, and I know you hit on this earlier, but can you maybe elaborate on the trends that you are seeing on the demand side from the customer base as obviously the non, I guess we can call them legacy customers, expanded, and how you expect further diversification of the customer base because of things like the Flotek Store.

Sure. So what was interesting in the fourth quarter is our highest price CnF product was the most used CnF product due to a specific prescriptive design for a particular client. That is number one. Number two, many of these private equity funded companies like Brigham, like Silverback and there is others, there is more of a communication network with those private equity funds that are funding those and they are becoming aware of the increased ultimate recoveries and we believe that is going to be a channel that probably was not around three years ago, that broadens the reach of what the Flotek chemistry experience can do. And so in the fourth quarter, we actually had an ABC client. There was a time in this company that was only an a client, and we think that speaks very well to the continuing broadening of the interest and the performance of the chemistry. And this industry as everyone knows, is in a state of evolution and just a different business model. It's not the majors that are controlling the activity now. It's private equity that's investing with experienced management teams that have idea, a dream, to create their company, to create good wells and like I mentioned, in many cases those companies are embracing technology sooner than the larger more integrated companies and I think that speaks right into the clients' that are attractive to Flotek.

Thanks. And then finally out of me, when you look about the divestment of the drilling tech business, artificial lift business, you couple that with what is appearing to be a positive cash flow outlook into the recovery for Flotek and the clean balance sheet as it sits today. Can you help us with what the company plans to do with the potential cash growth on the balance sheet? Is a buy back worth considering, acquisition, special dividends? How do you guys think about the use of cash as you inflect here to positive cash flow and potential wind falls associated with the sale of those segments?

Well, yes, you hit on certainly three of the alternatives you can have when you have that flexibility and that luxury and we consider all those. I think most of our stakeholders on this call envision Flotek as a growth company. And a dividend program even a special one, I think they kind of feel like if we can put the money to work, whether it's an acquisition or whatever, that's probably their preference. We are very pleased with the balance sheet that we have. You have identified that in the near future it will become even stronger and I think that speaks well to our flexibility as this industry continues to change, but I think the take away is, the folks who know us know that we look after this capital as though it is our own money we have put into this and we are very respective of that. And be assured we will do everything we know how to put it to good use and it will be one of those nice problems to have but thanks for pointing that out.

And our next question comes from the line of George Venturatos with Johnson Rice. Please go ahead.

I just wanted to start, I guess on the pricing side. Nice to see you guys talk about strategic price planning increases through '17. Just wanted to get, one, a little more detail on anticipated kind of cadence and magnitude maybe as we work through '17. And then additionally obviously we are seeing it within the sales growth on the CnF side. But what are you more specifically hearing from or seeing from customers that makes you feel like you are ready for that and certainly things that they are going to absorb that well?

Sure. So we are essentially, and companies like us traditionally do this. I use the term we are essentially drafting alongside the larger integrated service companies. I think the folks on this call have listened to the previous ones in the quarter and have talked about what their clients expect in terms of pricing increasing in '17, which [isn't] [ph] a double digit number. So it is prudent on us. We have got an increasing cost structure from a raw materials standpoint that this will more than offset. And we say it is strategic in nature, but it is essentially across the board. There are certain chemical products that are very commodity price driven that there is not as much flexibility but where we have our premiere complex nano-Fluid in the solution that will drive a lot of this price increase. And again, the indications we received so far is positive that our clients are fully expecting this to be an event and such that they believe their return continually still outweighs the increase. So as we mentioned, starting this quarter we will get more of a full effect in the second quarter and we expect it to be important for us as the year plays out.

Perfect. That is all good to hear. As it relates to PCM, and you made an interesting comment in terms of optimizing that in terms of more efficiency in terms of how freight costs and service costs. Can you give us a little more detail on where you stand there, how quickly that can happen and just kind of that whole process, just as that kind of side of the business ramps up?

Sure. So we are kind of adjusting to this on the fly and what I mean is kind of in real time. And I spoke to this in our prepared remarks and, again, many of the folks on this call are familiar with because of the looming sand shortage people are changing fluids, some less slick water, more to guar, which fits into our IPI strategy. The Monahans staging area that we have turned into kind of a micro blending facility, we believe we will feel the real cost improvement effects for that in the first quarter. If that was a ramping up in the fourth quarter of the way we needed to manage, if you will, the last mile of freight that goes from that facility to these locations. And so we feel like we have got our hands around that a lot better than we did heading into the fourth quarter, but again, when you are kind of embracing a new business model as we are, there is a bit of a learning curve, but we have got some really smart folks that have accelerated that learning curve. So that is why we talked about, we expect this margin number from an efficiency to improve. One thing we telegraphed a couple of calls ago is that as more and more people embrace a more complete chemical solution, some of these chemicals don't carry the same type of gross margin structure, but our mission really is to generate more revenue with more chemistry, with more clients that will translate to more operating income, even though the gross margin may not be as high as what people are accustomed to in the past because it's a more diverse, sustainable chemistry business model. And hopefully that makes sense. From an efficiency standpoint we know we can improve the cost of delivering the solution, but further as we move on through this first quarter and early in the second quarter, we will continue to share more about how not all of these products that we deliver carry the same type of gross margin and hopefully that answers it for you.

That does, John. And last one for me and then I will re-queue, but just on kind of bigger picture. Looking at obviously a place where you have got strong activity in the Permian and you have seen some acreage change hands and M&A going on there. Maybe you can talk about just your positioning there with obviously largest producer and word of mouth and how that may benefit you as some of these operators that come in and get a little more active obviously than their predecessor was with their acreage. And one of them that kind of caught my attention obviously was Noble's for Clayton Williams and the history you have there with Noble and the D-J, just kind of wanted to get your thoughts on how that changing of hands across that landscape may be beneficial for you going forward.

Yes. Great question. There is absolutely in my now forty years experience in this industry, I will call it chatter between clients than ever before. What used to be regarded as very tight hole information, now really through social media a lot of these younger engineers communicate to their friends in the industry and everybody talks about the Permian Basin because it is the most active. But social media really is driving a lot of informal sales on our part and I am sure other companies that they are sharing their experiences, whether it's a Flotek product or whether it's the amount of sand they are putting in per lateral foot, these folks are just sharing that information. The other thing that is happening is there is, and again, folks on this call know this, there is more and more lease swapping that is occurring where clients may have the desire to drill a longer lateral but that would require going into someone else's lease so they will swap that and then immediately that person who swaps it becomes informed of how the completion is being done that otherwise they may not. And that just wasn’t happening two or three years ago. Still there is vestiges of the kind of old traditional oilfield, even though you have got social media going, at the same time these companies, and you mentioned Noble, in many cases operate like different companies. Although their pay checks all have Noble on it, the Midland effort is different than the D-J basin effort. But what is kind of coincidentally is more and more of these companies that have acquired companies I have seen in the last 45 days, have acquired companies that have been using Flotek chemistry. And obviously we think that is a good thing. Still those acquiring companies have to feel confident that the companies they acquire had a good total benefit analysis. And so it's still a process but the industry certainly has changed not only for us but I am sure others, in large part because of the lease swapping and also of all things social media.

And our next question comes from the line of Mark Brown of Seaport Global Securities. Please go ahead.

John, congratulations on this strategic shift to your core chemistry focus to really drive your growth. I wanted to ask a quick question. I think in the 10-K you disclosed that you have already sold a portion of drilling technologies in late December and I was just curious, it also said you expect the sale to be completed by the end of 2017. Is there any kind of update you can give on the timing of that disposal process?

Well, sure. We sold a small part of downhole technologies in the northern part of the United States. And by accounting rules, you have a year to divest once you do this discontinued operations accounting treatment. So by accounting, we have to have it completed by the end of the year but practically we have a professional advisor that is running the program. Our expectation is to, by the end of the first quarter, early the second quarter, have a resolution that is satisfactory to us, to our shareholders, to the potential buyer for both of those entities. So we will keep obviously everyone informed. We have felt that having both of these as evidenced by their performance in the fourth quarter as ongoing entities should create a larger value of the divestment, as opposed to shuttering them and saying, okay, take what you want. And we think that will be the case. We will see. But, again, I think the next 60 to 90 days will be very important for that process.

Okay. Good. Very helpful. I also wanted to just see if you can give a little more color on the disgorgement of potential short swing trading profits from a stockholder, $12.7 million. If there is any commentary you can give around what that is exactly.

Well, I don't not want to run the risk of putting anyone to sleep on this call because it is somewhat complicated. I will let our good man, Rich, speak to it at a very high level and then we will go from there.

This is an issue that comes under section 16B of the Securities Exchange Act of 1934 and it relates to affiliates of the company. Those would be folks that would have potentially have inside information. So if there are any transactions in the company's stock with affiliates as they are defined by the SEC, then there is a, it really turns out it's a mathematical computation and we do disclose these are potential short swing profits. We don't know if there are actual short swing profits. So the rules require any possible potential profits that are recognized be disgorged to the company and that's what's occurred in this case.

Does that help?

Yes. Thank you. I will just ask one more. Just with your 8-K, the special committee recommended some improvements in your software development and disclosure procedures. I don't know if you can just at a high level, what their recommendation was in that regard.

Sure. It's a broad range of things in the effort of continuous improvement. We have a much more rigorous testing program of the software, that's not a direct reason because there were other value reasons as to why Michelle Adams is on the board. But I think when you do something new and certainly our data analytics effort in 2014 was a breakthrough in this industry in terms of using open source data, you are going to make mistakes and we have admitted those. But at the same time you want to take on those mistakes and build to a more thorough and complete solution because we are just a believer. And as we mentioned, as Robert mentioned earlier, the use of data in the right way in this industry has a chance to create significant benefit to the E&P companies. So although that affected us in the past, it wasn't anything meaningful, Mark. You know we put maybe a little bit more rigor into the testing and validation of the releases of software as part of the overall committee but, again, we felt it was important to say that part of the process has been done and we are moving forward.

And our last question comes from the line of Sean Milligan of Coker Palmer. Please go ahead.

You are talking about double-digit price increases and at the same time some inflation in citrus costs. Can you kind of frame up for me what the net increase would be for you? So in other words, are you seeing 10% increase in citrus costs? How do I think about that as we go forward from here?

Well, as much as we would like to tell you, from competitive reasons we are not going to give the exact delta of what we think will be the outcome of this double-digit price increase, along with our increasing cost of raw material. I just don't think that would be prudent on our part. But safe to say that the net of that will improve our margin and this whole pricing of the terpene in itself is a bit of a challenge. Although we have got long term contracts when you are buying 50% of your citrus oil from Brazil that in itself and, Josh, you can add some additional color. But we want to be really kind of mindful of the competitive balance in trying to answer your question but still being respective of the pricing model but go ahead.

Hey, Sean. Obviously, the citrus oil markets have been a little bit volatile here over the last 12 months, given the crop reductions that we have seen certainly in Florida as well as Brazil during the current cycle. We do see Brazil's crop coming back up next season. There will be a little bit of a delay in the price relief, but we do have, as John indicated, short and long term contracts to position us well on those raw materials. That being said, we will feel some of the increase. To John's point that increase will be more than passed on in our pricing increases of our finished products. So, again, not getting into the specifics of what those numbers are, we do see the ability to pass the increases on to our customers and CICT as well as ECT.

Okay. Great. And then earlier in the call someone asked about the trajectory of non-customer a, customer b volumes. You know what I was going to ask about was customer a. So it looked like there was a step down in sales volumes to customer a during the fourth quarter relative to activity levels. Was just curious if you had any insight there, if that was either de-stocking related and obviously that customer probably buys through the Flotek Store, so if there is any kind of forward commentary that would be helpful.

Yes. So I kind of urge everyone on the call, these quarterly variances will fluctuate in the case of when it's going through a distributor on whether they have contracts with certain clients that may have run out and other clients are coming in and there may be a lag there. In terms of someone that is coming through the Flotek store, it may be what their completion program looks like at the time, whether they have caught up to the drilling program. I think as we have tried to telegraph for some period of time, this industry now truly is a just in time industry. There's people are ordering this week for completions for next week at the most in two weeks. So it's not like there is a increase in stocking that has to be worked off. It's pretty much more from an operational standpoint, as I mentioned, whether certain completion programs have run down, if it's going through a service company, or whether the completions have caught up if they are going through the Flotek Store. So I wouldn't spend a whole lot of time on the way that fluctuates. You know, what we are most interested in is nothing would make us happier two quarters from now to have A, B, C, D and E, and that's what we are striving for. Not so much whether A is slightly up or slightly down in the quarter, that will all take care of itself. Hopefully that answered it for you, Sean.

Okay. Thanks. You mentioned actually in prepared remarks continued strong demand in ECT. Any kind of commentary about how the first quarter this year started, how January volumes maybe looked for CNS relative to accelerating activity levels and taking up some new customers?

Sure. You know, we have had a policy we really hate to get into looking at this on a month to month thing and just prefer not to do that. I think the comments really kind of speak for themselves of the demand that we see. I think at the end of the week, the EIA report comes out as to what the completions looked liked in January and we see every reason to believe and I think that's one of the benefits of the Flotek Store, is we have greater visibility out than what we had before. And so with a level of confidence from what we can see the first quarter will be a very nice quarter in terms of, as has happened in the past, us having a level of activity that should be greater than what the completion activity increases. I don't think there is any reason that would make us think anything differently than that as we have done throughout all of 2016.

And we have no other questions at this time.

Thank you, operator. We would like to again thank everyone's interest for being on the call, wherever you may be calling in from and coming in through the Web site. We appreciate your confidence and like I say, continued interest in Flotek. We'll look to see some of you in the near future and talk to you again at the end of April. Like you all to have a great day. Thanks for joining Flotek.

And ladies and gentlemen, that does conclude our conference call for today. We thank you for your participation. Everyone have a great rest of the day and we ask that you please disconnect your line.