Flotek Industries Inc/Cn/ Q1 FY2020 Earnings Call

Greetings and welcome to Flotek Industries’ First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow management's prepared remarks. As a reminder, this conference is being recorded. It is now my pleasure to introduce Danielle Allen, Senior Vice President, Chief of Staff for Flotek. Thank you. You may now begin.

Thank you and good morning everyone. We appreciate your participation. Joining me today are John Gibson, Chairman, Chief Executive Officer and President; Matt Thomas, President of JP3; and Elizabeth Wilkinson, our Chief Financial Officer. On today's call, we will first provide prepared remarks concerning our business and results for the quarter. Following that, we will answer any questions you have. Yesterday, we released our earnings announcement for the first quarter, which is available on our website. Today's call is being webcast and a replay will also be available on our website. In addition, we have an investor presentation which will supplement the earnings call. Please note that any comments we make on today's call regarding projections or our expectations for future events are forward-looking statements. Forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control. These risks and uncertainties can cause actual events to differ materially from our current expectations. We advise listeners to review our earnings release and the risk factors discussed in our filings with the SEC. Also, please refer to our reconciliations provided on our earnings press release as management may discuss non-GAAP metrics on this call. So, with that, I'm happy to turn it over to John.

Thanks, Danielle. Hope everyone is healthy and safe and I just wanted to thank all of our employees, the Flotekers for their hard work and commitment to our organization during this challenging time. The start of this year has been simply unreal, the oil and gas industry experienced an oversupply of oil and undersupply of storage and the decimation of demand by the global reaction to COVID-19. COVID-19 has forced us to transition to distance leadership, with Teams and Zoom usurping most of my days and all of the employees' days as well. Amazingly, what has emerged is less dependence on real estate and face-to-face engagement and a complete and utter focus on our mission. This market has created such chaos that numerous growth opportunities, both organic and inorganic have emerged. We've been disciplined in vetting those opportunities with a desire to reduce our dependence on rig count, reduce our dependence on the U.S. unconventional market and establish an offering in the digital transformation market, particularly chemistry in the cloud. As part of this assessment, we're excited to share the news of our acquisition of JP3, a high-growth data and analytics technology company, which diversifies our company's business mix and helps us transform our company for the next stage of profitable growth. Today, I'd like to first address today's acquisition announcement. We've uploaded a presentation that we will be referencing this morning. We're pleased to have Matt Thomas, President of JP3 join our call and share his thoughts on the deal as well. Next, we'll address ongoing cost measures related to the near-term challenges and our long-term goals to right-size our cost structure, and then briefly discuss our Q1 financial performance. Let me begin by providing you with an overview and a rationale around today's announcement of our acquisition of JP3. We acquired 100% ownership of JP3 in a cash and stock transaction, which is comprised of $25 million in cash and 11.5 million shares in Flotek's stock, with an additional $5 million earn-out based upon appreciation of Flotek's stock and the transaction closed yesterday, May 18. The acquisition offers compelling strategic and financial benefits as we've outlined on Slide 4. First, the transaction diversifies Flotek's business across all segments of the hydrocarbon value chain. Second, JP3 is a high-growth business with significant upside. Over the past four years, JP3 has generated a robust revenue growth rate of 58% with more than 60 clients. There's an addressable market of about $1 billion annually in the U.S. alone with significant growth opportunities outside of the U.S. that we can leverage by taking advantage of Flotek's international market access. Third, Flotek's strong liquidity position can fuel growth opportunities by accelerating JP3's data as a service or DaaS product offerings. Finally, JP3's continued transition to the DaaS business model will yield a high-margin recurring revenue stream that is sustainable even in a more volatile commodity market. We have a vision for being the platform that will optimize profitability all the way from the reservoir to the refined product's final destination. Flotek's innovative chemistry has increased the ultimate recovery reserves and JP3's data enables a new dimension to this vision by measuring the injected chemistry's effectiveness. The reach and power of JP3's data go far beyond that. Refinery optimization requires consistent feedstock until the development of JP3's data solutions; buyers used API gravity as a proxy for the composition of hydrocarbons. With the deployment of JP3 systems, the actual composition of the crude can be determined at the wellhead, allowing refiners to purchase oil matching the refinery’s design or to blend production from numerous locations to create the most profitable feedstock. Further, having the knowledge of the cut most valued by refineries, such as the components that go into gasoline or diesel, will allow us to design reservoir chemicals for producers to enhance recovery of the most valuable molecules. In the simplest terms, we can begin refining within the reservoir. In short, the more we know about hydrocarbons, the more efficient, clean, safe, and profitable we become as an industry. I'm going to turn this over to Matt Thomas, President of JP3 for some remarks. Very excited to have you here, Matt; why don't you take over and tell us about JP3.

Thank you, John. It's a pleasure to be here. We're truly excited to be a part of Flotek's family and see many ways in which JP3 is now well-positioned for accelerated growth. Given Flotek's strong liquidity position and their reach in the global marketplace, JP3 will be able to build on our track record of double-digit growth and fast-track the ongoing transition to recurring revenue in a DaaS model. We will continue to drive increased profitability for our clients by maximizing the value of their hydrocarbons using the data created with our real-time optical analyzer systems. JP3 is the leading analyzer and data delivery platform in the oil and gas market. And we were excited for our technologies to be recognized as the benchmark in the industry earlier this year with the adoption of the Midstream Industry Association’s GPA 2119 Standard. We originally launched our line of advanced Verax analyzers in 2012, providing our clients with real-time composition and physical properties of their liquid and natural gas hydrocarbon streams from the wellhead to fuel terminals, while cost-effectively overcoming the limitations of traditional technologies. In conjunction with our Viper cloud analytics platform, illustrated on Slide 5 of the accompanying deck, we now deliver data to everyone from small independent producers to midstream MLPs to major refineries across North America. Even in the midst of the industry's current state of disruption, JP3's proprietary data platform is enabling our clients to generate increased revenues and higher profits on their existing product streams. Now with Flotek's capital behind us, we will be able to expand our DaaS sales and marketing efforts, accelerate the development of next-generation technologies, and create international sales opportunities through Flotek's global reach. As you can see on Slide 6, JP3's data products enhance value across the industry and upstream crude analysis at the wellhead, eliminating outdated API gravity proxies, and aligning production contract pricing with finished goods value. In midstream, gas plant balancing, optimization, and give-away reduction; and in refinery optimization of crude feedstock blends and distillation tower performance. To further illustrate the power of the data provided by our analytics systems, I want to highlight one downstream distribution application of particular importance. Last week, we were pleased to announce our joint initiative with Phillips 66 to launch a revolutionary data service solution in the refined fuels market aimed at substantially increasing profits for refined fuel producers, transporters, and distribution terminal operators. First, some context using Slide 11 to illustrate. When refined fuel product streams leave a refinery, they travel in a common pipeline carrying gasoline, jet fuel, diesel, and other products to their end markets. Natural mixing occurs between adjacent batches of these fuels and this interface transportation mixture or transmix must be separated and routed to special holding tanks for reprocessing, leading to net losses for operators. Our Verax data platform is now enabling companies to reduce the level of product downgrades due to transmix and improve profitability by as much as 50%. The automation and control solutions inherently depend on the real-time data produced by our data platform. JP3's innovative joint marketing agreement with Phillips 66 for DaaS sales and refined fuels validates the power of our platform and the profitability that our customers are seeing with the use of our data. Phillips 66 already enjoys a strong position in the refined fuels market and together we can significantly expand our market share and capture increased value in this space. With the power of JP3 technology platforms and the performance data that Phillips will provide, there is a huge opportunity to expand our presence in the downstream distribution market. And this is just one example of how our clients are using our real-time data to change the financials of their business. In summary, JP3 brings a differentiated technology platform with hundreds of demonstrated applications with growth in the marketplace and a clear runway to a $1 billion domestic addressable market. And now as a part of Flotek, JP3 will be able to accelerate our top-line growth and recurring revenue model significantly. Not only are there major opportunities within the oil and gas industry, but our data platform is scalable to other industrial markets as well. We look forward to being a part of the Flotek team and to helping build shareholder value. And now I'll turn it back over to John. Thanks, John.

Thanks very much, Matt. Well, let's move to the second item here, which is really addressing the market conditions and cost, given the difficult market conditions that we've been facing. We've developed several cost measures to help mitigate the risk across the business and increase efficiency and effectiveness. We remain disciplined in our expense controls in order to enhance our financial flexibility. Recent actions include lowering the salaries of the executive team, decreasing fees for the Board of Directors, as well as reducing the size of the Board from seven to five, reducing headcount, and cutting back discretionary spending across the entire organization. These actions have not been taken lightly, but are necessary in today's market environment. As we look forward, our priority is to focus on derisking our business as the oil and gas industry fundamentals have significantly changed. We've been busy identifying additional opportunities for cost reduction so that we can regain profitability over the mid-term. Last quarter, we discussed our priority to right-size and reprice our relationship with Florida Chemical Company. In February, we worked with FCC to amend our terpene supply agreement, which will enable us to materially improve our cost and cash flow through the term of the contract and help us better manage our inventory. Given these changes, we're now in a position to be more competitive in the market with regard to our procurement in specialized chemistry portfolios. This also opens up opportunities to pursue new channels to market, such as utilizing proprietary technology for data analysis to the full hydrocarbon stream from our acquisition of JP3. For these new opportunities, we will be able to reduce operating costs and maximize our profitability. As Q1 2020 unfolded, we revealed substantial disruption in our operating environment. We recorded an impairment charge of $57.5 million in the first quarter related to the impairment of property, plant and equipment, right to use assets and intangibles. We also have taken various actions to improve the financial strength of our company as we align our workforce and operations with the level of activity that we are seeing in today's environment, which will enable us to operate more effectively in a completely different world. Additionally, Elizabeth will fill us in on the consolidation of our office spaces. Lastly, we also want to quickly highlight our team's efforts in giving back to the community and our customers. I'm extremely proud to see how Flotek came together to utilize our excess capacity from our manufacturing facilities and competence in chemistry to produce alcohol-based hand sanitizer. As a result, we were able to produce about 12,000 gallons of hand sanitizer to donate to first responders, hospitals, schools, homeless shelters, and senior residential communities in the areas where we serve. With that, I'm going to turn it over to Elizabeth to discuss our financial results in more detail. Elizabeth?

Thanks, John. As we mentioned in prior calls, the financial tables in our press release present the operations of our CICT segment as a discontinued operation for all periods. I will focus my discussion today on quarterly results for our continuing operations, which include Energy Chemistry business, which we will refer to as ECT, as well as our supporting research and innovation and corporate functions. As we review our financial results, revenue for the first quarter was $19.4 million compared to $43.3 million for the same period last year, but generally in line on a sequential basis, with the $19.5 million from the prior quarter. ECT operating expenses were $22.8 million in the first quarter of 2020 versus $44 million in Q1 of last year, reflecting a 48% reduction year-over-year. Included in the first quarter of 2020 was a $2.3 million charge, reflecting a loss on terpene purchase commitments and an incremental reserve against terpene inventory on hand. As a result of the work done in 2019 to improve supply chain and operational efficiencies, coupled with our negotiation of the amendment to our terpene contract in February, we will be able to dynamically manage our inventory to lower levels going forward. Corporate G&A decreased to $4.5 million in the first quarter of 2020 versus $7.3 million in the first quarter of last year, due to a reduction in headcount and other costs, as well as incurring a lower severance charge of $0.5 million in the current quarter versus $1.6 million a year earlier. We reported a loss from continuing operations of $64 million, or a $1.07 loss per diluted share for the first quarter of 2020, compared to a loss of $15.2 million, or a $0.26 loss per diluted share for the first quarter of the prior year. The loss of $64 million included a $57.5 million impairment charge related to a tempering of our long-term forecast in connection with the developments in the current economic and political environment. Our adjusted EBITDA for the first quarter was a loss of $6.5 million, which narrowed from last year's loss of $7.6 million. The improvement in adjusted EBITDA is primarily due to a significantly lower headcount and significant expense reductions in freight, equipment, and travel and entertainment expenses. Please refer to our table in the release for more details. Turning to the balance sheet, we continue to be pleased with the strength of our balance sheet position. As of March 31, 2020, we had cash and equivalents of $80.3 million, no debt outstanding, and $6.6 million in escrow funds on the balance sheet reflecting our claim to the remaining balance of the indemnity escrow related to the sale of Florida Chemical to Archer Daniels Midland. In addition, as of March 31, we recorded a tax receivable of $6.1 million related to tax refund pursuant to the CARES Act provision for extending the net operating loss carryback period. Furthermore, in Q1, management finalized its plans to consolidate office space in Houston, where all corporate personnel will be moving to our Houston Global Research and Innovation Centre at the end of this month. In conjunction with this plan, a termination of our Houston headquarters lease has been negotiated at an attractive discount, which is anticipated to save the company approximately $900,000 annually between mid-2020 and mid-2023. So with that, we will now open it up for questions. Operator?

Our first question is from Daniel Burke from Johnson Rice. Please proceed.

John, first of all, congrats on the deal. I do have a couple of questions on JP3, but maybe one on the existing business first. The pace of this decline in the oilfield, and particularly on the completion side, has been pretty precipitous. What insight, if any, can you give us on how Q2 and Q3 look internally and just the ability to manage towards a cash-neutral position over that period of time? I mean, liquidity is a scarce resource right now.

Well, I really haven't changed the goal of getting to breakeven which I stated last quarter. And so we're working hard on the cost side of that. Cost of goods sold does come down when your activity levels drop as precipitously as they have. And then we are managing the other costs as tightly as we can. For Q2, I mean, we're basically up to our elbows in that at the moment, and I don't really see an increase in market activity in Q2, nor do I see any of our competitors talking about an increase. We are seeing some stabilization in our customer base, Daniel, in terms of because the price has come back from a ridiculously low level to something that's at least tolerable and they'll continue to produce, whereas we were beginning to think that shutting in was going to be a predominant activity. I think the shut-ins will decline some and we're going to see people continue to produce. The storage capacity didn't get to a point where it was critical. So we've got a reasonable market. We don't have a good market. So we'll manage our costs to doing that and continue to work on reducing those. For Q3, I don't have a crystal ball here, so I'm having a hard time forecasting COVID-19 and its impact and also in Q4 because it's hard for us to ascertain exactly how rapidly the virus will ramp back up as we go into the fall. We think that's going to be a bigger driver on activity than oil and gas price. I think that's where we're going to see some difficulty in getting back to work. But as you can see from our numbers, we took out a lot of costs. And I think we're down 47.5% in our costs year-over-year, and that includes costs of goods sold, but it shows a real focus on that and we're going to continue to do that as we go forward. Happy to take another question. Daniel, I rambled too long on that one.

No, no, that's helpful, John. Let me pivot to JP3 then; certainly an interesting deal. And let me ask one or more immediate question. I mean, given JP3's sort of midstream, downstream orientation, I would imagine the impacts to their business this year have been modest, but just can you give us any footing or perspective on how their business has fared over the last few months?

I mean, obviously, it has slowed down a little bit as a result of COVID, but still strong with a lot of opportunities. As part of diligence, I've talked to several of their customers that are committed not only to what they're doing today but to have use cases that would allow us to expand the company, which is the reason that we're so excited about it. I don't see them being impacted in the same way through the rest of the year that drill bits are impacted. One of the important parts of this was moving ourselves from being rig count-oriented and drill bit-oriented into having availability in the totality of the market. We think the midstream, the downstream, and the distribution systems continue to stay strong and have less volatility. We're very excited to derisk where we think the company's going over the next few years by acquiring JP3.

Okay. And then when we think about JP3, maybe just over this initial timeframe from inception here through sort of the end of this year, it seems like it should be a pretty capital-light business, but you guys want to invest in the business; you want to foster its growth. I mean, is this business a consumer of capital over the remainder of the year, or is it a generator of cash over the remainder of this year?

I don't see it primarily as a generator of cash or earnings. Instead, it's an investment opportunity; a small company with significant growth potential that can generate substantial gross margins as we move ahead. The investments you mentioned are the correct perspective to have. While it’s not a capital-intensive business, it has faced challenges on the sales front. We aim to add sales resources that will help continue or even accelerate growth. Additionally, we believe there are other actions we can take to introduce use cases into our business at Flotek. In simple terms, we want to understand how efficient and effective we are in treating reservoirs. If we pump in 1,000 gallons and get none back, we should have pumped more. If we pump in 1,000 gallons and get back 500, we over-pumped by 100%. We want to ensure we're making the right treatments. We believe this will also help create some use cases for us regarding reservoir chemistry.

Our next question is from Brian Bode from Excelsior Capital Partners. Go ahead.

Just wondering if you could discuss the other alternatives for capital allocation at the corporate level relative to stock buybacks versus growth opportunities like JP3.

In truth, Brian probably won't make everybody happy. But I'm not focused on stock buybacks. I'm really focused on stock appreciation. We were talking this morning as a management team here about really focusing on the growth of our company and the growth in our equity value, so that we can do more of these acquisitions. There are some great high-growth, high-margin companies available out there that are in that space where there's not an IPO market for them today. They're in line with chemistry and we can provide a platform for them to be public. The use of our equity value to transition those companies into our space, we want to bring those companies in, and so I'm focused on growth in the share value and the ability to really build a platform of high-growth companies and high-growth activities going forward.

Okay. That's good color. How did you guys find JP3, or how did they find you? And maybe with that in mind, could you speak to kind of current pipeline or current opportunities that are under evaluation?

Well, this is sort of a disclosure moment here for me, I guess. Before joining Flotek, I was in investment banking at TPH doing their emerging technologies in energy technologies group, and we identified JP3 then. I can honestly say that I thought it was a great company when I was at the bank. When I got to Flotek out of the whole portfolio, it matched Flotek the best in diversification. I had to make sure that everyone knew I was not conflicted in this transaction. I chose not to take any bonus from this deal from TPH. There will be no remuneration there. I've known about this company for at least a year. Several of the customers we talked to are customers I introduced JP3 to, so I've been on their sales staff already for about 12 months and understand the technology. It wasn't something that just came about in the last few months.

Our next question is from Peter Rabover from Artko Capital. Go ahead.

I guess great deal. I just want to echo the previous question a little bit more. John, you've said you're focused on high growth opportunities. I'm just wondering, is there any growth in the business? What gives you the confidence that the growth will be there, given how disarrayed the oil and gas market is and how it might take years for it to shake out?

It's a great question. I said in the opening comments that we're trying to diversify our way from being rig count-driven or drill bit-driven. I do think that the core properties in the Permian and the Bakken, among others, will come back because those can be produced profitably even at lower price points, but maybe not all of the acreage will return in the same way. I'm expecting a softening in what we think is obviously a high conventional market. As a result, we think it's still a good market; it's going to be a smaller market. We wanted to make sure that we brought on things that have no constraint on growth. We still believe there's going to be huge demand for energy. We think that operators will continue to produce and solutions that improve profitability in the midstream, like the transmix solution that we're working on with Phillips 66, are going to see continued growth. All the markets dealing with refineries will continue to grow. We wanted to move over into a high growth market. The acquisition was to ensure the business does not depend solely on drilling activity.

Our next question is from Peter Rabover from Artko Capital again.

Hey, sorry guys. I think I put it on mute, and then it got disconnected. But I just wanted to follow up on the question about the acquisitions and given how much cash you had and what a massacre was last few months, I assume you probably have hundreds of calls from guys like JP3. I'm just curious, what made them special relative to everybody else? Were they head and shoulders above everybody else? How many more opportunities like that are you seeing?

Interestingly, we vetted a number of companies, one with a similar technology that had a different approach to measuring chemistry in real-time. Because we believe that to make money, you cannot manage what you cannot measure. We looked at several companies. The first one we looked at was a large company with great technology and great people, but it would have required a $10 to $15 million investment to get the product commercial, and it wasn't ready for the market. After evaluating, we decided to pass because we weren't here to invest in venture capital. We want to invest in growth markets where you have a product. We received many offers, but we called JP3; JP3 did not call us. So, it was a perfect fit. Matt, I'm sure you've seen other people call as well.

To build on what John was saying, from our perspective, we looked at this as a really great fit for a few reasons. First of all, certainly the strong liquidity position that Flotek brings can accelerate our growth. The access to the international markets that we don't have today is very attractive for us. But also, this is a very strong management team with an impressive track record. As you probably know, John has a successful history of acquisitions, around 25 to 30 acquisitions in his career, and we looked at that and said this is the next step in the growth of JP3 that we've been looking for. So it really made an attractive fit for us.

Okay. Thank you. I guess I know you guys have not disclosed financials, but I'm just more curious on how you see your cash position shaking out with this investment. Is it a loss-making investment? Cash flow? How much cash do you think you'll need to invest in sales staff? Any extra color you can provide would be really appreciated.

Obviously, we spent $25 million, so you're going to expect that amount to come out of our cash position. For the investment side, we're going to work hard to stay within our costs. We still have a goal to get to breakeven this year. I have not backed off on that, even though the market is challenging. The hurdle has certainly become higher recently. We're focused on finding the necessary funds to enhance their sales strategy. Part of it involves training some of our sales staff, but also bringing in their existing salespeople, as this is a different market. We have made inquiries to some senior staff that we believe would significantly help speed up our growth and have reached out to them early in the process.

Our next question is from Vishal Mishra from Mishra Capital. Go ahead.

Hi, John and Matt, congratulations on the deal. You mentioned in your 10-K, as well as John, you said on the Q1 call that if you were to see a tremendous reduction in drilling, it should not impact your ability to go out and make a difference on the wells that have been completed. I know that was at a different time, but I'm wondering what it would take for you to reset that comment? Given the pandemic, is it difficult to gain market share in the wells that are drilled?

Vishal, you were breaking up a bit. It sounded like you were asking about how we're going to grow market share in our core business. Being nimble and small is really important. We had a meeting where we emphasized the need for flexibility in a market like this. We're exploring how our chemistry can do more than just enhance production initially. Our focus is on enhanced oil recovery (EOR). In reservoirs where the wells are already in place, there's a tremendous opportunity to use chemicals to enhance product recovery. We're focusing our efforts there to ensure we're doing what our customers need in the coming months. If they don't drill, they'll still produce and they may want to produce more. We're examining recovery factors and studying how chemicals impact EOR. We believe there's a big opportunity as oil prices fluctuate.

This concludes our question-and-answer session. I would now like to turn the conference back over to John Gibson, Chairman of the Board, CEO and President.

I just want to say thanks to everybody for joining us today. We're excited about the acquisition of JP3. We do believe it'll accelerate our growth, complementing Flotek's chemistry applications. The strength of our underlying liquidity and market access positions us for a successful and bright future. We appreciate the support of our shareholders. We’re listening to where you think the future is. We'll continue to update everyone on our efforts as we move into our next stage of growth. I hope to hear from me before next quarter. You all have a good day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

Thank you.