Flotek Industries, Inc. (FTK) Q3 2018 Earnings Report, Transcript and Summary

Good morning, and welcome to the Flotek Industries Inc., Third Quarter 2018 Earnings Conference Call. All participants will be in a listen-only mode. And there will be an opportunity for you to ask questions at the end of the Company’s prepared remarks. And operator will provide instructions on how to ask questions at that time. [Operator Instructions] This conference is being recorded. At this time, I would like to turn the conference over to Matt Marietta, Flotek's Executive Vice President of Finance and Corporate Development. Mr. Marietta, you may begin.

Thank you, and good morning on behalf of the Flotek team. Joining me this morning are John Chisholm, Flotek's Chairman, President and Chief Executive Office; Rich Walton, our Chief Accounting Officer; and Josh Snively, Executive Vice President and Head of Operations as well as other members of our leadership team. Our earnings press release was distributed yesterday afternoon in conjunction with the third quarter earnings supplement presentation, both of which are available on our website. In addition, today's call is being webcast, and a replay will be available on our website. Before we begin our formal remarks, I would like to remind participants that during this call, some of the comments made 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, comments or expectations about future events and their potential impact on performance. Words such as expects, anticipates, plans, believes, estimates and similar expressions or variations of such words are intended to identify forward-looking statements, but are not an exclusive means of identifying such forward-looking statements. These matters involve risks and uncertainties that could cause our actual results to differ from such forward-looking statements. Risks are discussed in our SEC filings, including our Form 10-K. Also please refer to our reconciliations provided in our earnings press release as management may discuss non-GAAP metrics on this call. With that, I'll turn the call over to John Chisholm.

Thanks Matt. And thanks for hanging in there and being under the weather. And thank you all for joining today's call. I'd like to thank all of the Flotek employees for their hard work and our stakeholders for their support. The structure of today's call will be a little bit different from previous quarters. We posted a supplemental slide deck to our website, which will serve as a useful visual guide to some of the key items discussed today. Additionally, in the interest of being direct, concise and transparent to our shareholders, and to leave more time for Q&A, I'll take you through key highlights for the quarter; let Matt come back, provide a brief financial update, and then return with my thoughts on today's industry context, how Flotek is providing value to the market, and conclude with outlook and guidance. We will then open the line for questions for which Josh Snively and Matt and our leadership group will be available to elaborate. In the context of recent reports on the industry activity levels in the third quarter and into the fourth quarter, I'm proud of what we have accomplished in the progress made today. Flotek’s third quarter consolidated revenues increased 20% sequentially due to increased demand for Complex nano-Fluid known as CnF, driven by unconventional activity in the Middle East by NOCs. Adjusted EBITDA of $2 million represents a 51% incremental margin from last quarter and a $6 million sequential improvement from the second quarter. These strong incrementals were made possible by increased CnF sales abroad, our continued expansion in the higher margin Flavor and Fragrance opportunities at Florida Chemical and our relentless focus on cost reduction. In fact, we removed an additional $3 million of annualized cash SG&A during the quarter and have now reduced cash SG&A by an annual run rate of $28 million compared to our year-end 2016 reference point. We have put into place further structural cost savings to streamline logistics, IT systems, and other administrative functions, which will drive greater operational efficiencies going forward. As a result, we believe we can achieve cash SG&A levels down to 15% of revenues into 2019. This is cost cutting from top to bottom as referenced in our earnings supplemental slides. We've made great strides, particularly in the areas of salaries and benefits, travel and entertainment and variable incentives. Our Energy Chemistry Technologies or ECT segment revenues increased 36% sequentially, which exceeded both our initial expectations and our revised guidance in August due to higher than expected activity as we exited the quarter. We are experiencing continued global uptake of our Chemistry Technologies evidenced by CnF orders to the Middle East. During the quarter, the Middle East surpassed Canada to become our largest international geo market and it should be noted our momentum in this region is not limited to a single project, a single product or a single country. Our domestic ECT business continues to gain traction with operators seeking to decouple their consumables. Our full-fluids Prescriptive Chemistry Management or PCM platform comprises the majority of our domestic ECT sales today as we see a significant uptick in operators requesting full-fluids delivery of our chemistry applications directly to the well site. As a testament to our business has evolved more than 75% of our clients today use value-added chemistry as part of their fluid systems delivered through PCM. Additionally, our research and innovation team is more engaged than ever with our clients and their reservoirs. To substantiate this with specific metrics and as referenced on Slide 5, our third quarter average domestic revenue per client increased by 7% sequentially as we continue to gain AFE share on spending. And our major domestic clients of size increased by 16%, which speaks to both the depth and breadth of our direct client engagement. What is unique to Flotek is our pipeline of domestic opportunities into year end, even in the face of industry headwinds. Despite expectations for budget exhaustion and typical year-end holiday and weather delays, we expect our domestic ECT revenues will increase sequentially as a number of clients transition to our direct-to-operator PCM market channel. This is supported by our preliminary October domestic ECT revenues, which were up compared to the third quarter run rate. In our Consumer and Industrial Technologies, or CICT segment, revenues decreased by 12% sequentially based on lower terpene sales. However, adjusted EBITDA and adjusted EBITDA margins both increased. Additionally, by investing in our extraction capabilities, we are expanding into new citrus opportunities, which is in line with our strategy of targeting higher margin sales opportunities in Flavor and Fragrance as referenced on Slide 6. Consumer demand for natural ingredients is opening up a wide runway of growth for Florida Chemical as evidenced by recent sales activity in the past week, which had the highest weekly orders year-to-date. I will now hand the call back to Matt, who will give us a brief update on our financial positioning and strategy.

Thank you, John. In an effort to streamline the earnings call, I believe the line item detail of our financial review to the earnings press release and our Form 10-Q, which has been filed with the Securities and Exchange Commission and does contain important disclosures. I will focus on steps we are taking to improve our cash flow efficiency as we manage our balance sheet. Our aggressive cost reduction programs continue across our organization and we have even started a program that directly incentivizes our employees to find areas of further savings. This initiative has been met with great enthusiasm across our Company. More details of our SG&A reduction progress have been shared on Slide 4 in a slide deck published to our website yesterday afternoon. We remain committed to lowering our SG&A as a percentage of revenue to a level that maximizes our free cash flow. We have made changes in our ECT logistic strategy and focused heavily on freight expenses, which were relative context if you were to assume a static product mix and shipments is designed to benefit our gross margins by approximately 5 percentage points on a run rate basis by year-end compared to the third quarter. Our balance sheet remains larger than we would like due to our inventory position of which is mostly citrus oils as a result of greater purchases from South America to start the year and underperformance of internal consumption we have faced within our Energy segment in the first half of 2018. We have limited committed purchases of inventory remaining for the year and we expect that consolidated inventory balances to decline by roughly $10 million into year-end. Additionally, our DSOs have extended due to a greater component of international sales in the third quarter, which customarily carry longer terms than domestic sales. Also a larger than normal accrual in our direct-to-operator sales within our PCM platform at quarter end took place. As our field delivery utilization climbed during September and is currently approaching full utilization. Specifically, we have a significant amount of international receivables that mature in the fourth quarter, which upon collection our average DSOs should retreat back towards the average of around 60 days unlocking further sources of working capital. Availability on our credit facility at September end was $15.2 million in cash was $1.8 million at October end, our estimated availability is approximately $18 million and our cash balances were $1.1 million, expanding our estimated total liquidity, including cash by roughly $2.1 million during the month of October. This increased liquidity occurred while the balance in our accounts payable accounts had declined to $28 million. November is due to be a large collection month in our international receivables, providing opportunity for collections to materially outpaced cash outflows. We have reduced our CapEx from an initial range of $12 million to $16 million entering the year to a run rate of approximately $6 million as we exit. We appreciate that our shareholders have asked for better visibility into balance sheet management, a subject we take seriously and hope these statistics help on that front. I want to remind our shareholders that we reported net working capital of key accounts in excess of $116 million at quarter end in zero PP&E is pledged against our borrowings. Our credit facility does not mature until 2022, but it is required to be reported as a current liability for the purpose of SEC reporting on the balance sheet. With that, I'll hand the call back over to John.

Thanks again, Matt. Over the past year, the new reality of some of the issues facing the energy industry is now more apparent than ever. While we have said this for some time, operators are seeing diminishing returns on increased profit loading, fluid loading and lateral length evidence as analysts and clients alike review production data from the last three years and operators are now defining an upper boundary for these mechanical factors in their completion designs. Further supporting this point, Raymond James and the economist recently issued independent reports indicating well productivity growth is slowing depicted in Slide 7 and 8 in our accompanying presentation. Thus, the drive for capital efficiency to get more barrels out for lower costs is becoming the most critical focus of operators today and an opportunity for Flotek to help our clients, deliver more value, greater returns through a prescriptive chemistry experience. We're doing this by partnering with operators to optimize their fluid designs and increase their capital efficiency as highlighted in Slide 9. In one specific case, as this highlighted in Slide 10, we partnered with a Mid-Con operator to design and tailor their fluid system for their reservoir. By switching to a more effective fluid system, we were able to reduce overall chemistry spend per well, optimize horsepower efficiency and reduce fluid reservoir in compatibility. In total, our clients $1.9 million per month, which translates to more than $20 million in cost benefit per year for their program, while producing better wells. I also want to point out our fluid system benefited our service company partner due to lower required operational horsepower needed to deliver profit and less overall wear and tear on their fluid ends. Another key challenge for our clients in the industry to achieving greater capital efficiency is infill development programs, which are at risk due to down spacing concerns and unit production underperformance. This is a multi base in challenge. It is costing the industry billions of dollars were child and parent wells are negatively impacting production. This is another instance in which are advanced chemistry targeted for the reservoir can make a significant impact to mitigate the negative effects of frac hits and underperforming wells. In a Woodford study recently published in partnership with a client. Our CnF remediation chemistry solutions were prescribed to improve production and recovery in underperforming wells and in wells with frac hits. Our advanced chemistries impacted the reservoir by changing the rock fluid interfacial tension, breakdown pressures, phase trapping and controlling clay swelling and fines migration. While reducing the potential for high viscosity emotions to increase flow capacity in the reservoir. The impact of the program can be viewed on Slide 11. Where chemistry and the knowledge of how to apply it specifically for the reservoir translated into restored production to pre frac hit rates. Finally, as mentioned increasing production is the most significant driver of capital efficiency for our clients. In our recent Eagle Ford study of 100 wells over two years, wells with Flotek prescribed chemistry outperformed the proppant normalized production rates of non-treated wells. While producing an incremental 33,000 barrels of oil equivalent over the first year, while also improving the gas to oil ratio as seen in Slides 12 and 13. Importantly, wells with CnF had higher production with virtually equivalent proppant loadings. In summary, shale operators continue to focus on improving production and capital efficiency and Flotek is partnering with them to achieve their goals through prescriptive reservoir-centric chemistry. This is why we are taking a segmented approach with our partnerships as we recognize that each operator and service company is uniquely positioned on a value growth spectrum. Some are committing to investor objectives for lower cost and return of cash flow, which naturally curtails grow spending. While others are focused on proving their acreage and driving future growth. Multi basin operators will have different objectives across different basins. With all of these dynamics, it is becoming undeniable for our technologically advanced clients that a customized approach is essential for the optimum performance of the reservoir. As a result, our technical solutions teams focus on partnering with our clients to solve their challenges through a wide ranging product portfolio across the spectrum of price points delivered directly to the well site do our PCM platform. Additionally, we are seeing established PCM clients move up the value chain towards higher value added chemistries like CnF as the importance of chemistry and upfront investment becomes a critical driver of improving their ROI. At the end of last year, less than 50% of our PCM clients were using value added chemistry. And as mentioned earlier today, greater than 75% of our PCM clients are purchasing value added chemistry, including CnF and MicroSolv. Additionally, our approach to partnering with clients extends to service companies to. We work with service providers to satisfy operator's needs both domestically and abroad, but also working together to develop unique and distinctive chemistry. In our Florida Chemical segment, we're executing on our growth strategy in the Flavor and Fragrance. Florida Chemical is uniquely positioned to capitalize on strong consumer demand tailwinds for natural flavors, given our energy segments, internal consumption of d-limonene, which is the primary byproduct of processing citrus oil, to derive the Flavor and Fragrance molecules. Without a doubt this is an underappreciated business segment by the market and we are committed to maximizing value to all our shareholders. As we look ahead into the fourth quarter and 2019, we see a number of growth opportunities both in ECT and CICT. In ECT visibility is clouded by budget exhaustion around the holiday season the magnitude of which has become clear with Q3 earnings reports. Full quarter guidance has the potential for volatility due to limited visibility around December and the magnitude of the holiday slowdown. However, from where we stand today, we expect domestic ECT revenues will increase sequentially as supported by our preliminary October revenue, which we estimate to have increased in the high single-digits compared to the third quarter run rate. Additionally, November commitments already indicate a sequentially higher month above October. We expect our international ECT revenue to decline sequentially due to the choppiness in large orders. Net-net, we believe ECT segment revenues will decline less than 10% sequentially. In CICT, we expect revenues to increase in the mid-to-high single digits with sequential improvement of adjusted EBITDA margin. Given our recent product line expansion presence in Asia and the development of our flavor application technologies, we realized our largest weekly sales activity for all of 2018 in the past week. We have invested in the foundation of this business and we expect this will enhance our high margin flavor and fragrance opportunities. At the same time, we will continue to reduce our cash and non-cash costs while we manage our balance sheet to realize working capital benefits and drive toward positive operating cash flow. Starting at the end of last year, we experienced the changing dynamic in our channels to market which necessitated an agile response to grow our PCM platform faster than ever even we had initially anticipated, while simultaneously undertaking aggressive cost reductions and efficiency improvements. Through this evolution, our organization demonstrated its resiliency and I want to highlight two key facts. First, our employee retention rate is over 90% during this period of rapid and dynamic change. Secondly, we've had just one minor lost time incident in over 8 million man hours, demonstrating our commitment to safety. I can tell you, and as you can imagine, things have not always been smooth nor easy, but the process of transformation never is. Flotek is executing on a strategy based around long-term value creation for our shareholders, which will continue to play out over the course of many quarters to come. As I've said before, one month or one quarter does not establish a trend and our quarterly results may not be linear. However, Flotek is well positioned to collaborate with our clients to deliver chemistries that addressed the industry's need for innovative technology that increases production at cost effective prices, which is bringing greater capital efficiency to our clients and our shareholders. I would like to humbly thank our shareholders, employees, and our clients, and I look forward to updating all of you on Flotek’s progress. We are working hard and we are committed to delivering results. As we approach Veterans Day, I would also like to express our appreciation to our country's veterans. We have made a concerted effort at Flotek to hire veterans whenever possible with a meaningful percentage of our new hires having come from the armed services. To all those who have made the ultimate sacrifice, we honor them. From all of us at Flotek, we are greatly thankful for your service. With that, operator we will now open the line for questions.

[Operator Instructions] And we have a question from Georg Venturatos with Johnson Rice. Please go ahead.

Hey. Good morning, guys.

Good morning, Georg.

Well, John, appreciate all those details there. I think where I kind of wanted to start was Energy Chemistry and the thing that was the largest positive surprise here in the release other than quarterly results, so just your outlook, and it seems like your visibility into October and November, which kind of bucks the trend, which we've heard a lot across the service side. So I just wanted to get a sense of where you kind of see that that direct sale percentage of a ECT sales kind of an exit rate basis this year and just kind of how that's helping you see the market a little clearer, at least a couple months ahead of time albeit I know December is a big wildcard, but just wanted to hear you talk a little bit more about that and how that's kind of coming together?

Sure. Well, we have felt this for some time, Georg that is more of these clients move directly to engaging us. We do have better visibility. November is the best visibility we've had of any month. And more of this business is, we wouldn't say is contracted, but it is more scheduled is we're following more and more frac fleets, so it's not as spot as it was when we started this whole PCM initiative a year ago. So it's becoming more regular, more predictable and a greater interaction directly with the operator. And as I mentioned in our commentary, that is growing undeniably. Josh, you may want to chime in anything. But again, the visibility is at the highest we've seen it.

Yes, thanks John, and good morning, Georg. The direct operator model takes a little more coordination and getting our chemistries on site, so that gives us a tighter connection with our clients, allows us to do our supply chain better and does give us better visibility into our field utilizations. So the model is helping us as we've evolved over the last 10 months and getting better at this visibility and working with our clients on what their frac schedules are and what products are we’ll need on site. That in turn takes our efficiencies up greatly, not only from field crew utilization, but also our logistics activities as well.

Georg, maybe to be a little bit more direct for you and for the folks listening in domestically, right around two-thirds of our revenue is directly through the PCM model, which is directly to the EMP operator. Does that help?

Got it. That's good. Thanks John. And then just given what you're seeing over the last or at least October, November and you talked a little bit about, you talked to about it from a customer perspective and revenue per customer, but just from a base in perspective, particularly given the pressure we're anticipating in Q4 relative to Permian takeaway, just anything that jumps out from a base in a perspective that is out of the ordinary?

Sure. I'm not sure we describe it as out of the ordinary, but it was a pleasant surprise. The Anadarko area has doubled in our revenue base since the start of the year. And that's undoubtedly help counterbalance some of the issues in the Permian, although the Permian, like everybody else, we're still overweighed that's our number one area. And I would again refer you and our listeners to Slide 5. One thing that's happening is the average revenue per client is up. In a period where people are still obviously focusing on a lot of costs, but I think we've tried to really translate cost into benefit and also the number of major domestic clients is defined by us is up 16% in the quarter over the second quarter. So it's a broadening of the base and that client base is getting more and more comfortable of the expenditure on chemistry. The one case study I mentioned in the prepared remarks though, keep in mind, part of that success was we actually provided less dollar chemistry to create the capital efficiency and that led to and has led to an ongoing relationship. So it's not so much selling more dollars initially. It's to prescribing the right chemistry to be able to have the reservoir create the best opportunity for capital efficiency.

Got it. Internationally, you guys mentioned the decline sequentially, but it sounds like that is at least the Middle East as a whole is continuing to be a growing market for you guys and on a baseline perspective – the NOC contract that impacted 3Q, would you anticipate that baseline revenue out of the region is sequentially higher in Q4?

Yes, we do. I think a lot of the people on the call listening in have an appreciation of this have not the international activity typically takes longer to sell and the business model is not near as uniform as it is that everybody's accustomed to here in the United States. Just to give you one example, for heaven sakes, it's very difficult to get two or three stages off per day when you're dealing with 120 degrees temperature is just very hard. So it's a mistake to apply domestic performance into some of these international areas. That's what's relates to the choppiness. But to get back to your central question, again in the Middle East, the market is expanding both geographically inside the Middle East overall and from a client perspective as well.

Okay. And then maybe John or Matt. I wanted to just touch on the balance sheet side and you guys mentioned, after the working cap requirements this quarter, expect that had positive benefit in Q4, but just maybe you can elaborate a little bit more on the working, the parts of that. Just I know you mentioned international receivables that were going to be helpful. But just elaborate on that and then also any targets for kind of availability as we work through 2019 on the revolver side?

Yes, Georg, I'll take the first question there. We were able to provide that from number on inventory and the prepared remarks. As we look at accounts receivable and try to do some math on those accounts or that account, we do anticipate that we could release as much as $10 million out of accounts receivable based on a revenue expectation. But of course, if our revenue expectation approved to be conservative, we'll happily fund more accounts receivable growth in the fourth quarter, but based on what we've put out there as our initial expectations that that would be the math. So we do anticipate working capital to be a significant source of funds, but further to that – further reductions in SG&A are on going to help improve the performance of the business. 2019, is a bit difficult to comment on today. We haven't seen a lot of capital budget announcements from our client base. So it's a little bit challenging, but we are focused on monetizing the inventory position on the balance sheet and are doing things today commercially to push that inventory through our P&L. So we're obviously aware of where we're at in working capital, but we do have a plan in place and we are executing on the plan to relieve some of that working capital before the end of the year.

Got it. Appreciate the answer guys. End of Q&A

[Operator Instructions]

Thank you, operator for conducting the call. Thanks for all of our folks that listen in. We hope the slides were helpful. It's a new approach. I imagine we're going to continue that as we move forward and as we mentioned, we'll look forward to be giving you progress as we move through the rest of the year heading into 2019. And again, we certainly appreciate everyone's support. Thank you very much.

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