FLOTEK INDUSTRIES INC/CN/ 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Annual Report on Form 10-K for year-end December 31, 2021 filed with the U.S. Securities and Exchange Commission (the “SEC”) and the consolidated financial statements and accompanying notes included herein. Executive Summary Flotek Industries, Inc. (“Flotek” or the “Company”) creates solutions to reduce the environmental impact of energy on air, water, land and people. A technology-driven, specialty green chemistry and data technology company, Flotek helps customers across industrial, commercial, and consumer markets improve their ESG performance. The Company serves specialty chemistry needs for both domestic and international energy markets as well as applications of U.S. manufactured surface cleaners, disinfectants for industrial, commercial and consumer use. The Company has two operating segments, CT and DA, which are both supported by the Company’s continuing Research and Innovation advanced laboratory capabilities. Company Overview Chemistry Technologies 27 The Company’s CT segment provides sustainable, optimized chemistry solutions that maximize our customer’s value by elevating their ESG performance, lowering operational costs, and delivering improved return on invested capital. The Company’s proprietary green chemistries, specialty chemistries, logistics, and technology services enable its customers to pursue improved efficiencies and performance throughout the life cycle of its desired chemical applications program. The Company designs, develops, manufactures, packages, distributes and markets optimized chemistry solutions that accelerate existing sustainability practices to reduce the environmental impact of energy on the air, water, land and people. Customers of the CT segment include those of energy related markets as well as consumer and industrial applications. Major integrated oil and gas companies, oilfield services companies, independent oil and gas companies, national and state-owned oil companies, geothermal energy companies, solar energy companies and advanced alternative energy companies benefit from best-in-class technology, field operations, and continuous improvement exercises that go beyond existing sustainability practices. Data Analytics The DA segment delivers real-time information and insights to our customers to enable optimization of operations and reduction of emissions and their carbon intensity. Real-time composition and physical properties are delivered simultaneously on their refined fuels, NGLs, natural gas, crude oil, and condensates using the industry’s only field-deployable, in-line optical near-infra-red spectrometer that generates no emissions. The instrument's response is processed with advanced chemometrics modeling, artificial intelligence, and machine learning algorithms to deliver these valuable insights every 15 seconds. Customers using this technology have obtained significant benefits including additional profits by enhancing operations in crude/condensates stabilization, blending operations, reduction of transmix, increasing efficiencies and optimization of gas plants, and ensuring product quality while reducing giveaways i.e., providing higher value products at the lower value products prices. More efficient operations have the benefit of reducing their carbon footprint e.g., less flaring and reduction in energy expenditure for compression and re-processing. Our customers in North America include the supermajors, some of the largest midstream companies and large gas processing plants. We have developed a new line of Verax analyzers for deployment internationally which was recently certified for compliance in hazardous locations and harsh weather conditions. Research & Innovation R&I supports the acceleration of ESG solutions for both segments through green chemistry formulation, specialty chemical formulations, FDA and EPA regulatory guidance, technical support, basin and reservoir studies, data analytics and new technology projects. The purpose of R&I is to supply the Company’s segments with enhanced products and services that generate current and future revenues, while advising Company management on opportunities concerning technology, environmental and industry trends. The R&I facilities support advances in chemistry performance, detection, optimization and manufacturing. Outlook Our business is subject to numerous variables which impact our outlook and expectations given the shifting conditions of the industry and weather volatility. We have based our outlook on the market and weather conditions we perceive today. Changes often occur. Energy We expect North American and International onshore activity to continue to improve throughout 2022 from first quarter levels for the next nine months provided that commodity prices remain at or above current levels. The strongest potential growth throughout 2022 will likely comes from private, rather than publicly traded exploration and production companies. Private exploration and production companies operate the majority of U.S. land rigs and react quickly to changing commodity prices. In the current commodity price environment, we expect the private companies to increase activity and publicly traded companies to have modest spending increases in the year ahead. Additionally, we have reestablished our ability to sell product through other service companies and believe sales through indirect channels should accelerate in 2022. Industrial In 2020, the Company launched a diversified line of EPA and FDA compliant products that target industrial, agricultural and consumer markets with particular focus on customers that are seeking to accelerate their focus on sustainability and minimized impact on the environment. The Company’s product line includes adjuvants, disinfectants, surface cleaners, degreasers, 28 solvents and a multitude of proprietary chemistries for industrial, commercial and consumer use. The Company believes these adjacent markets provide an opportunity to diversify and expand the Company’s portfolio of chemistry solutions to meet the growing demand. We have signed four manufacturing sales representation groups with 150+ sales personnel covering 48 states. We will be training and educating their representatives during the next two quarters. The leverage sales effort is anticipated to accelerate sales in the second half of 2022. Digital Analytics The use of data and digital analytics is a growing trend in all industries where technology is leveraged to analyze large datasets of operational information to improve performance, as well as for predictive maintenance, advanced safety measures and reduced environmental impact of operations. Verax has gained a foothold in North American markets for critical applications where compositional information is needed in real-time. The technology delivers real-time insight on valuable operations data like vapor pressure, boiling point, flash point, octane level, API gravity, viscosity, BTU and more, simultaneously. We continue to work with our customers to identify further facilities and applications where our technology has the highest value. We expect to open and establish our international customer base with our new generation of internationally certified online analyzers. The new analyzers are specifically designed to withstand routine exposure to extreme outdoor environments, ambient temperatures up to 55°C/131°F and sandstorm pollution common to important international environments. We anticipate international sales to increase over the next twelve months because of the newly certified equipment. To drive recurring revenue, we continue to build on the modular nature of our sensor and analysis packages with new data processing techniques that enhance the value of our installations. AIDA (Automated Interface Detection Algorithm) provides real-time detection of interfaces in a liquids pipeline without the need for additional sampling or chemometric modeling. The application can identify products such as refined fuels, crude and NGLs with its advanced machine learning algorithms and detect interfaces within 60 seconds. This allows operators to cut batches quickly and accurately, reduce transmix and minimize off-spec product that requires downgrades. ESG ESG-focused solutions continue to be an emphasis for the Company as the energy, industrial and consumer markets are seeking to accelerate their focus on sustainability and minimized impact on the environment. The Company’s products and services offer a significant benefit to businesses seeking to improve their ESG performance, including improving safety, reliability and efficiency of their operations. The Company offers sustainable chemistry solutions, tailoring product selection to enable operational efficiencies, improve water management and reduce greenhouse gas emissions for its customers in the exploration and production sector of the oil and gas industry. Further, the Company’s patented line of Complex nano-Fluid® (also known as CnF®) products are formulated with highly effective, plant-based solvents offering safer, renewable and sustainable alternatives to toxic BTEX-based (benzene, toluene, ethylbenzene and xylene) chemicals. Benzene is a carcinogenic chemical that can cause acute physical damage, chronic blood disorders, reproductive disorders, leukemia and when exposed to the atmosphere, benzene creates smog, which can be carried to the ground through rain and contaminates water bodies and soil. Additionally, the Company’s real-time sensor technology helps to enable process and operational efficiencies, minimize waste and processing and reduce emissions. The Company believes the industry focus on maintaining a “social license to operate” provides the platform to accelerate the adoption of our greener practices and chemistries. We believe the performance-driven ESG focus of the Company assists in reducing environmental liabilities and improving returns for our customers. Supply Chain During 2020 and 2021 challenging supply chain issues emerged that “are already continuing into 2022” according to Secretary of Transportation Peter Buttigieg. The anticipated activity increases will strain supply chains generally. The principal supply issues facing our industry for the next twelve months will include: • Rising Freight Costs; • Delays due to Port Congestion; • Labor Shortages and • Demand Forecasting. All bidding will require the risk of shipping costs and delays be factored into proposals. Trucking availability and pricing will impact North American opportunities while sea-freight costs will impact sales of North American manufactured goods being 29 delivered internationally for the foreseeable future. The import of raw materials from China will also incur price increases. Accelerating tensions between China and the U.S. could also result in supply disruption. Weather During the first three months of 2022 there were no major weather events that had a material impact on first quarter results. COVID-19 The impacts of COVID-19 continue to affect the U.S. and global economy. We believe our protocols and processes established to maintain business continuity with COVID-19 have proven robust enough to diminish concern about business disruption unless new variants emerge. The resumption of travel has begun to accelerate and we estimate that in person customer visits that began in earnest during the first quarter of 2022 will continue to accelerate. Consolidated Results of Operations (in thousands) Three months ended March 31, 2022 2021 Revenue Revenue from external customers $ 10,382 $ 11,770 Revenue from related party 2,497 — Total revenues 12,879 11,770 Cost of goods sold 13,358 12,080 Cost of good sold % 103.7 % 102.6 % Gross profit (loss) (479) (310) Gross profit (loss) % (3.7) % (2.6) % Selling general and administrative 4,879 6,082 Selling general and administrative % 37.9 % 51.7 % Depreciation and amortization 195 307 Research and development 1,415 1,542 Loss on sale of property and equipment 8 2 Gain on lease termination (584) — Change in fair value of convertible notes payable 3,892 Loss from operations (10,284) (8,243) Operating margin % (79.9) % (70.0) % Interest and other income, net (444) (51) Loss before income taxes (10,728) (8,294) Income tax benefit/ (expense) 4 (6) Net Loss $ (10,724) $ (8,300) Net loss % (83.3) % (70.5) % Consolidated revenue for the three months ended March 31, 2022, increased $1.1 million, or 9.4%, versus the same period of 2021. Revenue during the three months ended March 31, 2022 reflected an increase of revenue in the CT segment of $1.5 million driven by the impacts of industry consolidation of customers and increased related party activity, see further discussion in Note 15, “Related Party Transaction”. This increase was partially offset by a decrease in revenue in the DA segment of $0.4 million due to one-time orders from customers in the three months ended March 31, 2021 not repeated in 2022. Consolidated cost of goods sold for the three months ended March 31, 2022, increased $1.3 million, or 10.6% versus the same period of 2021 primarily attributable to the increase in revenue with the change in margin being due to sales mix. Selling general and administrative (“SG&A”) expenses are not directly attributable to products sold or services provided. SG&A expenses for the three months ended March 31, 2022 , decreased $1.2 million, or 19.8%, versus the same period of 2021. 30 S G&A expenses decreased as a result of a reduction in professional fees due to a decrease in contract labor and consulting and, legal fees partially offset by increased advisor fees relating to work around the ProFrac/PIPE deal and other items. Corporate marketing costs also decreased primarily due to nonrecurring marketing fees and other initiatives. Depreciation and amortization expense decreased $0.1 million, or 36.4% for the three months ended March 31, 2022, versus the same period of 2021 The decrease is as a result of asset disposals and the reclassification of assets relating to the Monahans, Texas and Waller, Texas facilities to assets held for sale in 2021. Research and development (“R&D”) costs decreased $0.1 million, or 8.2% for the three months ended March 31, 2022, versus the same period of 2021 due to lower personnel costs as a result of our reduction in workforce and lower non-labor cost primarily from the re-negotiation of a contract which resulted in a credit for past expenses taken. Loss from operations worsened by $2.0 million, or 24.8% for the three months ended March 31, 2022 , versus the same period in 2021. The loss from operations increase is primarily a result of the revaluation of the convertible note payable partly offset by a gain from lease termination of $0.6 million, increased revenue and the reduction in expenses for SG&A, depreciation and amortization and R&D described above. Loss before income taxes for the three months ended March 31, 2022 , was impacted by interest charges of $0.4 million versus $0.05 million for the same period in 2021. The Company’s income tax benefit for the three months ended March 31, 2022 and expense for the same period in 2021 was minimal. Results by Segment (in thousands): Chemistry Technologies Results of Operations: Three months ended March 31, 2022 2021 Revenue $ 11,808 $ 10,302 Loss from operations (6,057) (3,589) CT revenue for the three months ended March 31, 2022, increased $1.5 million compared to 2021. The increase in revenue during 2022 compared to 2021 was driven by impacts from industry consolidation and increased related party activity, see further discussion in Note 15, “Related Party Transaction”. W hile the pandemic continued to weigh on economic activity in 2021, global supply and demand has steadily normalized through the second half of 2021 and into 2022. Loss from operations for the CT segment for the three months ended March 31, 2022, worsened $2.4 million, or (68.8)% compared to 2021. The reduction is a result of the revaluation of the convertible note of $3.9 million. Excluding the revaluation of the note there was an overall improvement. The improvement in loss from operations is due to increased revenues, lower personnel costs due to reduced headcount and lower rental fees for International Organization for Standardization (ISO) tanks. The improvement in loss from operations was partially offset by an increase in the bad debt provision. Data Analytics Results of Operations: Three months ended March 31, 2022 2021 Revenue $ 1,071 $ 1,468 Loss from operations (808) (292) DA revenue for the three months ended March 31, 2022 , decreased $0.4 million compared to the same period in 2021 due to one time orders not repeated in 2022. Loss from operations for the DA segment for the three months ended March 31, 2022 worsened by $0.5 million or 176.7% compared to the same period in 2021. The worsening loss from operations is primarily the result of the decrease in revenues and the fair value adjustment of the JP3 earnout. 31 Capital Resources and Liquidity Overview The Company’s ongoing capital requirements relate to the acquisition and maintenance of equipment and funding working capital requirements. During the first three months of 2022, the Company funded working capital requirements with proceeds from convertible notes of $20.0 million and cash on hand. As of March 31, 2022, the Company had available cash and cash equivalents of $24.8 million, as compared to $11.5 million at December 31, 2021. During the three months ended March 31, 2022, the Company had an operating loss of $10.7 million, $8.5 million of cash used in operating activities and $20.0 million of cash provided by financing activities. Cash provided by investing activities was minimal. Liquidity The Company currently funds its operations and growth primarily from cash on hand. The ability of the Company to grow and be competitive in the marketplace is dependent on the availability of adequate capital. Access to capital is dependent, in large part, on the Company’s cash flows and the availability of and access to debt and equity financing. The Company has a history of losses and negative cash flows from operations and expects to utilize a significant amount of cash in operations in the following year. Uncertainty surrounding the long- term stability and strength of the oil and gas markets, or reduced spending by our customers could have a further negative impact on our liquidity On February 2, 2022, the Company completed a Private Investment in Public Equity (PIPE) transaction with a consortium of investors, including with related parties, through the issuance of $21.2 million in aggregate principal amount of convertible notes that resulted in net cash proceeds of approximately $19.5 million. Also, on February 2, 2022, the Company entered into a long-term supply agreement with ProFrac Services, LLC (the “ProFrac Agreement”) upon issuance of $10 million in aggregate principal amount of convertible notes. Under the ProFrac Agreement, ProFrac Services, LLC is obligated to order chemicals from the Company at least equal to the greater of (a) the chemicals required for 33% of their hydraulic fracturing fleets and (b) a baseline measured by the first ten hydraulic fracturing fleets deployed by ProFrac Services, LLC. If minimum volumes are not achieved in any given year, the Company receives liquidated damages equal to 25% of the difference between (i) the aggregate Purchase Price of the quantity of Products comprising the Minimum Purchase Obligation and (ii) the actual purchased volume during such calendar year. The term of the ProFrac Agreement is three years starting on April 1, 2022. The Company also sold and its manufacturing facility in Waller, Texas. These facilities were classified as held for sale as of March 31, 2022. Subsequent to March 31, 2022, the Company executed a contract to sell its Waller facility for $4.3 million of gross proceeds. The sale closed in April 2022. Based on our cash and liquid assets, including the transactions subsequent to March 31, 2022 described above and in Note 17 - “Subsequent Events”, we believe that our cash and liquid assets will provide us with sufficient financial resources to fund operations and meet our capital requirements and anticipated obligations as they become due in the next 12 months. However the Company cannot guarantee a sufficient level of cash flows in the future. Cash Flows Consolidated cash flows by type of activity are noted below (in thousands): Three months ended March 31, 2022 2021 Net cash used in operating activities $ (8,474) $ (5,265) Net cash provided by (used in) investing activities 24 (17) Net cash provided by (used in) financing activities 19,993 (81) Effect of changes in exchange rates on cash and cash equivalents 8 23 Net change in cash, cash equivalents and restricted cash $ 11,551 $ (5,340) Operating Activities Net cash used in operating activities was $8.5 million and $5.3 million during the three months ended March 31, 2022 and 2021, respectively. Consolidated net loss for the three months ended March 31, 2022 and 2021, were $10.7 million and $8.3 million, respectively. 32 During the three months ended March 31, 2022, non-cash adjustments to net income totaled $5.6 million as compared to $1.2 million for the same period of 2021. • For the three months ended March 31, 2022, non-cash adjustments included $3.9 million for the change in fair value of convertible notes, $0.7 million stock compensation expense, $0.5 million PIK interest expense, $0.2 million provision for doubtful accounts and $0.2 million for depreciation. A benefit of $0.6 million was included for the gain on lease termination. • For the three months ended March 31, 2021, non-cash charges included $0.3 million for depreciation, and a $0.3 million decrease in the fair value of contingent consideration. During the three months ended March 31, 2022, changes in working capital used $3.3 million of cash as compared to providing $1.9 million for the same period of 2021. • For the three months ended March 31, 2022, changes in working capital resulted primarily from a decrease in accrued liabilities of $2.6 million partially due to payment of the ADM Settlement (Note 11) and an increase in inventories of $1.0 million. • For the three months ended March 31, 2021 the cash provided by working capital primarily resulted from routine operations, including a reduction in accounts receivable and other current assets totaling $0.5 million combined with an increase of accounts payable of $0.7 million, partially offset by a decrease in accrued liabilities of $0.3million. Investing Activities Net cash from investing activities for the three months ended March 31, 2022 and 2021 was negligible. Financing Activities Net cash provided by financing activities was $20.0 million for the three months ended March 31, 2022, primarily from the proceed from the issuance of convertible notes. Net cash used in financing activities was $0.1 million for the three months ended March 31, 2021, primarily from purchases of common stock related to tax withholding requirements. Off-Balance Sheet Arrangements There have been no transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose entities” (“SPEs”), established for the purpose of facilitating off balance sheet arrangements or other contractually narrow or limited purposes. As of March 31, 2022, the Company was not involved in any unconsolidated SPEs. The Company has not made any guarantees to customers or vendors nor does the Company have any off-balance sheet arrangements or commitments that have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, change in financial condition, revenue, expenses, results of operations, liquidity, capital expenditures, or capital resources that would be material to investors other than the long term terpene agreement discussed in Note 11 - Commitments and Contingencies