Flotek Industries, Inc.
Q3 2020 Earnings Call Transcript

Published: 17 Nov 2020

[Operator:]

Good morning, and welcome to Flotek Industries' Third 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 begin.

[Danielle Allen:]

Thank you, and good morning, everyone. We appreciate your participation. Joining me today and participating on the call are John Gibson, Chairman, Chief Executive Officer and President; Michael Borton, Chief Financial Officer; TengBeng Koid, President of Global Business; and Ryan Ezell, President of Chemistry Technologies.

[John Gibson:]

Thanks, Danielle, and thank you to our employees, our shareholders, our customers, and to our Board of Directors. I'm extremely grateful for the strong support that Flotek has received. Additionally, I'm truly inspired by our employees; they've remained focused and committed to executing our vision every day, while juggling dynamic demands at home and work, a patchwork of return to school procedures, and evolving challenges related to the pandemic. My gratitude for their dedication cannot be overstated, and it's a great honor to work alongside them. Now, before we dive deeper into the quarter, I wanted to welcome Mike Fucci to Flotek's Board of Directors. As the Former Chairman of Deloitte, U.S., Mike is an incredibly respected and influential leader who has spanned his career contributing to the strategic vision of one of the world's most respected professional services and accounting firms. Additionally, over the course of his career, Mike has become a thought leader on human capital, diversity and inclusion, and business transformation. We are very fortunate to have Mike join us. Thank you, Mike for joining Flotek's Board; I really look forward to working with you. Now, let's turn to the third quarter. Now overall, our quarterly performance showed some positive signals, we are by no means satisfied with our results, and we have more work to do. As I said last quarter, navigating through this global market disruption caused by COVID and demand destruction, has been the most challenging environment that I've had experienced in my career. And even so, I remain very optimistic about the future of Flotek. We're doing everything possible to position ourselves to be a stronger company in 2021; that means having the discipline to make some hard decisions today.

[TengBeng Koid:]

Thank you, John. As John mentioned, while we faced challenging market conditions, we've utilized this time to accelerate our strategy to penetrate the international market, transition our business model, and focus on targeted applications of our game-changing technology.

[Ryan Ezell:]

Thank you, Koid. As reminder, our chemistry technology segment includes both, our energy chemistry technologies, as well as our emerging janitorial and sanitizer businesses, and I'm deeply proud of our teams who are executing successfully. I'll first provide an update on our janitorial supply business, which is referred to as JanSan. The last quarter we launched Flotek's line of FDA quality hand sanitizers for industrial and consumer applications. Our initial efforts were cultivated as a result of community outreach that began in the first quarter when we started producing and donating hand sanitizer to local communities, first responders, hospitals, schools, homeless shelters, and senior residential communities. Subsequently, we recognized the opportunity to diversify our corporate revenue stream into a rejuvenated high-growth potential market that was a natural extension of our specialty chemistry experience. By leveraging our technical -- our chemical production capabilities, and ISO certified facilities, we applied our world-class R&D footprint to deliver an expanding line of high quality FDA and EPA registered products. Today, we're actively selling FDA and EPA registered janitorial and sanitizer products into multiple markets, including hospitals and medical facilities, the travel and hospitality industry, food services, ecommerce and retail, sports and entertainment, and other industrial and consumer markets.

[Michael Borton:]

Thank you, Ryan, and good morning, everyone. Since joining Flotek in early August, I've been extremely focused on evaluating the quality of the books including the balance sheet, counting processes, spending prioritization, expense commitments, and our cash management, cutting our banking relationships by also spending time with our new auditors. During the first three months at Flotek, I've started implementing several strategic priorities that will help us to create a stronger organization. Additionally, based on my prior experiences with multiple technology companies, where we were able to successfully transition to a recurring revenue model, we have reset the financial framework and underlying assumptions going forward for JP3. We must ensure JP3 is optimized structure to minimize the cash needed as we transition to a new model, where we recognize a revenue multi over a number of years, or that at the time of installation. This means the company will have cash outlays for the inventory upfront to require more cash than at one-time product sale with an impact on both, revenue and cash. That said, JP3 has enough inventory on hand to indicate the actual cash outlays in the near-term. I want to pause here to emphasize the benefit of transitioning to a subscription-based revenue model is that it leads to a longer term higher margin recurring revenue stream with an associated higher multiples given it's predictability. In short, as John noted, we are making and will continue to make the necessary business decisions to minimize our use of cash. First, let me address the impairment we've reported this quarter for JP3. As we resolve the extended impact of COVID-19, and the continued decline in oil and gas demand and spending budgets, especially in the refinery and mid and downstream markets, we recorded goodwill impairment charge of $11.7 million and intangible asset impairment charge of $12.5 million. These adjustments were completed in conjunction with an independent valuation company and the auditors. Secondly, we also took the opportunity to evaluate our inventory across the company. Over the past several months, I've been working with our new and very talented VP of Supply Chain, Shane Wise. As a result of that initiative, we have adopted new policies and rationalized a large portion of our inventory by reducing hundreds of underperforming product SKUs. Consequently, during the third quarter, we have taken an excess of obsolete reserves of $9.6 million. The charge is made up of two parts; first is the reserve of $5.7 million, related to the chemistry technology segment, and $3.9 million for JP3. In addition, during our inventory assessment following the JP3 acquisition, the company identified measurement period adjustments totaling $2.3 million that were made to the initial purchase price accounting. I would like to emphasize that these adjustments are all one-time in nature, and as a result of these actions, we can better manage our inventory position and profitability moving forward. Next, as far as the purchase agreement terms for the JP3 acquisition and the earnout conditions associated with the Flotek stock performance; the company recorded a liability of $2.5 million in the third quarter. The payment was transferred to the escrow account in early October for the acquisition terms. The $2.5 million transfer to escrow replaces the previously escrowed 3 million shares; those shares were distributed to JP3 shareholders in the fourth quarter. I'd like to note that there are now provisions and a change in the fair value estimate, we're not considering acquisition purchase price adjustment and thus Flotek record $3.2 million charges that impacted operating income during the third quarter. We also want to remind you that in the second quarter we changed our reporting technology -- methodology, as a result of the JP3 acquisition, and are presenting our results in two new reportable segments; chemistry technologies and data analytics. The chemistry technology segment was previously referred to the energy chemistry technology segment, but now includes our recently launched janitorial and sanitizer operations that Ryan just described. The data analytics business was created in conjunction with the acquisition of JP3. Also, please note, our third quarter results are the full first quarter that included business operations and expenses for JP3. Prior discussion of our financial performance is in more detail. As John previously mentioned, we faced a challenging third quarter driven by continued lower global demand and industry pressures, impacting both our segments. Moving on to the income statement; during the third quarter, consolidated revenue was $12.7 million, up 43.5% from an $8.9 million in the second quarter, and below the $21.9 million during the same period last year. The sequential improvement was primarily driven by an uptick in energy chemistry activity, as demand picked up both, domestically and international markets from the second quarter dip. The sharp decline in revenue year-over-year is largely a result of continued volatility in the macro environment for onshore drilling and completion activity impacted by political and economic events in foreign markets. In addition, COVID-19 impacted our productivity as a result of reduced customer demand for our services and products with the exception of our sanitizer operations, which just recently ramped up during the second quarter of 2020. Consolidated operating expenses were $29.5 million in the third quarter of 2020, and increased 24.47% from last year's level of $23.6 million in third quarter. Excluding these one-time adjustments of $9.7 million of inventory and $3.2 million of acquisition-related expenses, we were pleased to report that expenses declined nearly 30% year-over-year. Corporate G&A declined $3 million to $2.7 million versus $5.7 million last year due to a reduction in overall compensation spending, lower discretionary spending, including professional fees, partially offset by one-time severance charges. Our depreciation and amortization expenses declined $1.5 million to $500,000 in third quarter versus $2.1 million last year. Research and development costs were at $1.5 million in the third quarter, slightly below the second quarter level of $1.6 million, and down from $2.3 million last year. We reported a loss from continuing operations of $45.2 million or $0.66 loss per diluted share in the third quarter of 2020, compared to a loss of $11.2 million or $0.19 loss per diluted share last year. EPS included negative impact of the JP3 impairment of $0.36, rationalization of inventory of $0.14 in JP3 continued consideration of 5%. These three one-time items represented vast majority of the total record loss per diluted share. Our adjusted EBITDA for the third quarter was a loss of $6.5 million, which narrowed from a loss of $8.2 million last year. The improvement in adjusted EBITDA is probably due to lower expenses as previously discussed. Now, moving on to the balance sheet performance. As John mentioned previously, our cash position remains healthy, and we are focused on preserving our liquidity. As of the end of the third quarter, we had cash and equivalents of $49.1 million versus $59.9 million in the second quarter. As fully disclosed, the company and JP3 combined had $5.7 million of loans outstanding pursuant to the Paycheck Protection Program. As mentioned previously, we are absolutely focused on managing our inventory position. During the quarter, within the chemistry technology division, we reduced SKUs by 35% as we focus on managing our inventory in an efficient manner. We estimate that SKU reduction will result in annual savings of more than $1.3 million in inventory carrying costs. Let me pass over the call back to John for some final remarks.

[John Gibson:]

I'd like -- thank you, Mike. I'd like to take a moment to share a few closing remarks. When I joined Flotek in January, I laid out a few strategic objectives for growth including reducing our dependence on rig count, expanding new product lines that create a greater amount of backlog and/or annually recurring revenue, and further differentiating our offering from competitors while enhancing our capability to provide digital transformation of chemistry, and strengthening our market share for our current product lines. At that time, of course, none of us knew how dramatically the market would be disrupted. However, we've adapted our business while focusing on executing against our strategy, which still holds even in this market. And while nowhere near satisfactory to me in terms of progress today, we are making progress and laying a strong foundation for 2021 and beyond. First, we're committed to preserving our liquidity and maintaining a healthy balance sheet. We're fortunate to have Mike at the company to support retention of our capital, and to help drive a culture with a commitment to the leanest cost structure while delivering superior customer service. We are building a more diverse income stream. Through the acquisition of JP3, we're diversifying our business and offering downstream, midstream and upstream customers' access to unique digital transformation of products and services. We also have the potential to take this offering into the greenhouse gas and ESG segments, and we're investigating that; while at the same time looking at all of this digital transformation to build us a recurring revenue model. Additionally, with the launch of our janitorial and sanitizing products and logistic services, we further diversified our business beyond hydrocarbon markets to include industrial and consumer markets. From an operational standpoint, we have available unsold manufacturing capacity in the chemistry technology business for both energy and JanSan products, with the capabilities to deploy to the most attractive market opportunities. Without adding very much additional cost, we've created additional products that can really help us on the revenue side and Flotek. We also see a notable international opportunity set for all of our businesses in the oil and gas focused products to include both JP3 and the energy chemical technologies, where we believe we're going to see much less volatility in the days ahead versus domestic markets. And so we're very pleased that we've expanded into the international segment already. In closing, chemistry is our core competency. We have developed three strong business labs centered around creating value from chemistry. While it's difficult to determine when the world returns to normal, we're putting in place the right measures and investments to emerge in 2021 and beyond as a stronger company prepared for the future with optionality. We still have a lot of work to do and we're committed. And I'll turn it back to you now for some questions. Thanks so much.

[Operator:]

We will now begin the question-and-answer session. Our first question today comes from Joseph Von Meister with Intermarket. Please go ahead.

[Joseph Von Meister:]

Hi, guys. Can you tell us what the hand sanitizer sales were in the third quarter and where you'd like to see that business in a year from now?

[John Gibson:]

I'll start out. We're not breaking it out because we were really trying to maintain some competitive advantage in the marketplace associated with competitors. But I will say that it was depressingly lower than what I would have expected and we didn't see growth quarter-to-quarter and mainly because of what Ryan stated earlier, we saw a lot of people that dumped sanitizer and at the time it's at the beginning of the quarter, we were principally looking at sanitizer. But over the last three months, we've diversified that product line where we can be a real JanSan player, because people want to buy a portfolio of products in that segment. They're not interested in a single product sale. Ryan, jump in there.

[Ryan Ezell:]

I think you're correct. And to reemphasize that, John, I think when we first -- on our philanthropic efforts is where our first commercial sales and the JanSan business came from and quickly after being in there for a few weeks, we become to realize as we were looking at long-term sustainable business, we needed to address the full portfolio that not only talked about the hand sanitizers, the various dispensable options, but we then start talking about the full service market around them on the JanSan business, which is substantially larger as a whole than just hand sanitizer. So that's when we moved into a lot of the areas of the surface disinfectants, the sprays, the wipes, the degreasers, the cleaners, all those things that are our core competency chemistry related to Flotek, and don't cause any burden on us to move in that transition. Since then we've launched a substantial line in that area and seeing good movement. And what we're starting to see now is building blocks of reoccurring customers of on a longer term contracts with fixed orders on a monthly basis, which is the target of what we want to be in the sustainability side of the market.

[Joseph Von Meister:]

And then on JP3, I know that the pipeline guys and refinery guys have been under a lot of pressure, but what's the outlook for the Phillips 66 JV and business opportunities related to that.

[TengBeng Koid:]

Good. Thank you for the question. Related to the Phillips 66 partnership. So with Phillips 66, through the introduction were presented to quite a number of potential customers. Many of them have progressed, but I understand one of them has even progressed to a proposal. So I think the value that is deriving from applying the technology for that transmits is huge. So, response has been positive and we are looking forward to some positive results in the near-term.

[John Gibson:]

The other part that I like about where we are on JP3 and cohort leadership is, we see a pretty extensive set of opportunities on the international market. However, we're being a bit cautious and predicting when we'll be able to get to those because we're still getting all of the certifications and registrations required for the international markets. You can't just ship there and violate any of the U.S. law. So we're being very particular and there are laws associated with shipping fiber and fiber are different links, and encryption associated with any of the models we might put on the chip. So we're being careful, we see a way forward and it's clear. So I'm expecting that we'll be able to report back on that and JP3 .

[Joseph Von Meister:]

Thanks, guys. Great job in the tough quarter, really.

[John Gibson:]

Thanks, Joseph.

[Operator:]

Our next question will come from Daniel Burke with Johnson Rice. Please go ahead.

[Daniel Burke:]

Let's see. John, maybe a question for you and another one on JP3. In terms of the performance of the business in Q3, maybe not quite up to your initial expectations, I guess I was just trying to better-understand if that's the consequence of maybe under-appreciating just the intensity of the COVID-related impacts that business has seen in terms of its end markets, or if it's really more about the pivot to a subscription based model and that taking longer to effect or being a little trickier to effect than maybe previously anticipated. Can you help me understand that?

[John Gibson:]

Well, Daniel, do you win an award for insightful question. I was hugely optimistic about JP3. We acquired it and thought COVID would abate much sooner than it has. And so we did fail on what we thought would be the projections for the remainder of the year. But primarily due to the fact we did not have access to customers, we did not have access to sites. Even recently, in trying to do an installation for sale, we had an employee that had a COVID-related exposure that prevented us from doing the install immediately. So this was the operational difficulties of these tags. So COVID, I would say that's 80% of the shortfall. The other part of the shortfall is transitioning the sales force -- the move from selling hardware to selling subscriptions and that's been more challenging towards doing quite a good job there. We've got a new salesperson here in the U.S. This was her entire background, is delivering subscription based models and she has bought in 100%. I'd rather talk to her than to almost anybody because of her enthusiasm for what we'll be able to do. But we have another international salesperson that Koid brought in, very similar, and that they have a subscription based experience set and they understand how to position that and how to sell it. We also need to transition the customers that had bought hardware into subscription models and that process is underway as well. I would say it was more difficult than we thought to go back, but I think mostly because of COVID, but partly because there is with some customers the desire to just own hardware. So the final remark on this would be we're not entirely sure. So even on our go-forward forecasts that impacted the impairment, how to explain the mix to you? Because there may be some countries that require us to sell hardware and then maintenance agreements, which we'll have to try to explain it to you from a subscription perspective, because there'll be regulations associated with whether or not they can use cloud services. Not all countries are in the same place there. So we've got a bit of understanding to go on, but I'm excited about it. James Silas is here with us. We were talking earlier about it. I'm excited about as we move forward to greenhouse gas measurements and how do we add sensors? James, if you give a comment on that.

[James Silas:]

Sure, John. We are exploring our options right now on new detection mechanisms and we won't be able to leverage the capability of the existing JP3 system. And with new sensors and modeling techniques, we're excited about the possibilities of being able to meet those emerging needs in the market.

[John Gibson:]

Another question, Daniel?

[Daniel Burke:]

Yes. I'm still with you guys. That's very helpful, John. I guess the other one I had, maybe a little more straightforward. Could you talk about maybe either the timeline or if it's easier, maybe the revenue top line that you see at this point after the cost reductions you've affected this year, your latest thoughts on where that top line needs to be to kind of get closer to an EBITDA breakeven type of level? Thanks.

[John Gibson:]

Well, one of the reasons we have Mike is he keeps reducing our costs, so the top line is coming down. We're still focused on that and we've got to be relentless because unfortunately, I can't answer your question. And the reason I can't answer it is because there's still so much uncertainty that if I go out beyond Q4, I begin to lose my clarity on how the market's recovering. I would have thought COVID would have abated, did not. In fact, surging in the northern hemisphere, so that's impacting us again. We see vaccines and we have no enthusiasm yet around vaccines from this management team primarily because there's still a lot of uncertainty and when it'll be available? How many will be available? How it will be distributed? And so our predictions, I'm just going to say, we're going to really work hard, but I can't forecast with the accuracy that I'd like. So the thing that I can do is manage cost with a vengeance and that's where we're going to have to focus in the near term.

[Daniel Burke:]

Fair enough. Okay. All right, guys. I'll leave it there. Thank you for the time.

[Michael Borton:]

Thanks, Daniel.

[Operator:]

Our next question will come from Eric Swergold with Firestorm Capital. Please go ahead.

[Eric Swergold:]

Good morning, guys. I've got three questions for you, all, unrelated to each other. The first one is, are we going to have NOLs from the chargers you took this quarter to protect earnings going forward? And can you quantify that?

[John Gibson:]

Better turn that over to Mike.

[Michael Borton:]

So it's going to be timing. As you probably know, we had roughly about $50 million of NOLs coming into 2020. That had a 20-year carryback and 100% use. 2020, the good news is tax losses in 2020 will go up forever, but only to be able to use at 80%. Now let's talk about the inventory write downs. Until we actually dispose of that inventory, we can't take the tax benefit of it. But our goal is to get rid of that inventory quickly. Because you'd like to cash. Whoever values we can get, it's based on the write downs and that would be a tax benefit at that time.

[Eric Swergold:]

Okay. Second question is on the JanSan product line something that's going to be Flotek branded, or private labeled or both?

[John Gibson:]

I'll start out and let Ryan finish up here, Eric. The answer to that is yes. We looked at our ability to produce chemicals, whether they be for energy chemistry, such as the CNF products or for disinfectants, sanitizer, surface cleaners. For us, that's capacity. And we intend to try to get to maximum use of our capacity to blend in sand chemicals. And so whether we're doing it for the energy side or for the JanSan side, it turns out that we have the same labor, we have the same facilities, were have the same equipment, our assets are roughly the same, we did modify a small portion so that we could get FDA registration. It's so efficient that anything that we do on the JanSan side is very accretive to our overall chemistries, revenues and profitability. But we plan to do whatever makes a profit for our shareholders. Ryan?

[Ryan Ezell:]

Just to add on a little bit more details along with John, is that what we're looking at is we've done a significant investment into a high velocity, study on what were the best options for Flotek in terms of the commercial markets, which we include industrial and institutional buyers, versus the retail side and some cost effectiveness on how we go about approaching both of those. Basically what we're seeing is our advancement into the commercial side, whether being institutional or industrial plays into our strong suit around our ability to deliver logistically our cost structure, how we can leverage our supply and cost advantage and get out there? And for that, that's a blend of what we would consider to be private manufacturing a white labeling and establishing the Flotek brand because these institutional buyers are driven by EPA and FDA compliance which is a strong suit for us. Now as we establish our self in that market, we feel that through our ecommerce businesses, kind of a training sandbox for that and brand development, that will start to be able to establish a stronger Flotek brand inside potential retail business. But those are all weighted against the fact of the significant investment it takes on the marketing side that goes straight out and address a retail market. So those are some of the strong points in that we're looking at why we like the commercial markets better, all these initial outgo and that balance of private contracting and establishing Flotek brand inside institutional buyers.

[Eric Swergold:]

Great, thank you. And the third unrelated question -- this has been a super informative call so far but -- there was there was a recent industry conference where Flotek presented some new data on a new and improved CNF product line that was resulting and I don't remember the percentage of extra lift it was getting beyond your prior product. But do you have any early indications of consumer response to the new and improved product?

[John Gibson:]

Dr. Silas?

[James Silas:]

Sure. I'd be happy to comment on that. That was in in particular with a couple of clients that we're exploring within the Midland basin. Based upon our expertise and experience in the area, we recommended some slight changes and some modifications along the CnF product line. We're very happy with what we're seeing with us. We think we have a satisfied customer in that, using that particular product and we're excited about being able to introduce that to more customers in the area as well. Again, this is part of our reservoir-based chemistry knowledge and experience coming to play.

[Eric Swergold:]

Great, thanks very much. Go get them guys.

[John Gibson:]

Thank you.

[Operator:]

I'm showing no questions.

[John Gibson:]

Yes. Let me sum up here where we are. I wouldn't normally give any guidance, but I'm going to give a bit of Q4 macro environment guidance at the moment. We've seen a lot of consolidation in the U.S. domestically. It's one of the reasons I'm excited about the expansion internationally. NOCs don't tend to combine in less volatility in those markets. So our commitment to being international is important to us. But that is going to potentially slow down some of the potential sales that we have in Q4, just because while consolidating people tend to take their eye off their operational ball. The second one is we're coming up on holidays. And so the COVID is an excuse to go home early and not spend any more of your capital budget. So we do have customers that may take off Thanksgiving through January 7. And then finally, COVID resurging. So while we are still in here, playing away every day, I'd say Q4 is going to be more the result of industry activities and I'm not really excited about it and yet I'm not depressed about it. We've got the right things going on, we're talking to the right customers. I leave in just a few days to go on a trip throughout Oklahoma and Texas to visit with customers that we're excited to talk to and explain what we do. But how quickly that turns into revenue? I'm concerned about COVID, I'm concerned about the holidays and I'm concerned about consolidation, because it's involving some of our better customers. With that, thank you very much. We really appreciate you, guys. Our focus entirely is on getting some returns for shareholders and so we'll stay at it. Have a good holiday, and we'll talk soon.

[Operator:]

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