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 the fiscal ended December 31, 2021 filed with the U.S. Securities and Exchange Commission (the “SEC”) and the unaudited consolidated financial statements and accompanying notes included herein. Comparative segment revenues and related financial information are discussed herein and are presented in Note 17 to our unaudited consolidated financial statements. See “Forward Looking Statements” in this report and “Risk Factors” included in our filings with the SEC, including our Quarterly Reports on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, for a description of important factors that could cause actual results to differ from expected results. Our historical financial information may not be indicative of our future performance. 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. 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 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, such as our related party ProFrac Services, LLC, 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 our 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, natural gas liquids (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 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 31 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 conditions we perceive today. Changes often occur. Energy We expect North American and International onshore energy, exploration and production activity to continue to improve throughout 2022 from third quarter levels. Going into 2023 we believe that we are in the early years of a tight supply cycle triggered by underinvestment in infrastructure and new sources of oil and gas production. While shorter demand cycles will come and go depending on the fluctuating macroeconomic backdrop, the tight supply cycle is durable and will provide underlying support to oil prices for multiple years. 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 oilfield service companies and believe sales through indirect channels to the exploration and production companies and oilfield service companies could accelerate in 2023. Industrial The Company has 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, solvents and a multitude of proprietary chemistries for industrial, commercial and consumer use. The Company believes these adjacent markets diversify and expand the Company’s portfolio of chemistry solutions to meet the growing demand. 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. We believe Verax analyzers have 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. We believe 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. We anticipate the Company’s products and services could 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® 32 (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, we believe 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 sale of our products and services that we believe can help the customer achieve a greener goal. 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 continuing throughout 2022 according to Secretary of Transportation Peter Buttigieg. We expect the anticipated supply chain activity increases will strain supply chains generally. The principal supply issues facing our industry for the next twelve months will include: • Fluctuating freight costs; • Delays due to port congestion; • Labor shortages and • Demand forecasting. All bidding will require the risk of shipping costs and delays to 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 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. COVID-19 The imp acts 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. 33 Consolidated Results of Operations (in thousands) Three months ended September 30, Nine months ended September 30, 2022 2021 2022 2021 Revenue Revenue from external customers $ 15,206 $ 8,847 $ 38,412 $ 29,782 Revenue from related party 30,417 1,332 49,462 1,332 Total revenues 45,623 10,179 87,874 31,114 Cost of goods sold 47,465 4,022 92,500 26,876 Cost of goods sold % 104.0 % 39.5 % 105.3 % 86.4 % Gross profit (loss) (1,842) 6,157 (4,626) 4,238 Gross profit (loss) % (4.04) % 60.5 % (5.3) % 13.6 % Selling general and administrative 9,035 4,092 21,345 14,379 Selling general and administrative % 19.8 % 40.2 % 24.3 % 46.2 % Depreciation and amortization 177 233 554 793 Research and development 985 1,186 3,515 4,194 (Gain) loss on sale of property and equipment (10) 14 (1,916) (55) Gain on lease termination — — (584) — Change in fair value of contract consideration convertible notes payable 4,250 — (9,016) — Income (loss) from operations (16,279) 632 (18,524) (15,073) Operating margin % (35.7) % 6.2 % (21.1) % (48.4) % Interest and other income, net (2,508) (120) (4,653) 766 Income (loss) before income taxes (18,787) 512 (23,177) (14,307) Income tax expense (7) (3) (101) (30) Net income (loss) $ (18,794) $ 509 $ (23,278) $ (14,337) Consolidated revenue for the three and nine months ended September 30, 2022, increased $35.4 million, or 348%, and $56.8 million or 182%, respectively, versus the same period of 2021, primarily driven by activity under the ProFrac contract which commenced in the second quarter of 2022 and continued increased activity across our customer base, particularly in the Chemistry Technologies segment. Consolidated cost of goods sold for the three and nine months ended September 30, 2022, increased $43.4 million or 1080%, and $65.6 million or 244%, respectively, versus the same periods of 2021, primarily attributable to the increase in revenues. Cost of goods sold in 2022 were negatively impacted by one- time expenses incurred due to the ramp up of ProFrac activity and the write down of inventory of $1.0 million in the three months ended September 30, 2022, relating to the decision to cease the manufacture and sale of hand sanitizers. Cost of goods sold in three months ended September 30, 2021, benefited from the release of accrued costs of $7.6 million subsequent to the agreement of a settlement with ADM, see Note 12, “Commitments and Contingencies”. 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 September 30, 2022, increased $4.9 million or 121% versus the same period of 2021. $1.9 million of the increase related to bonus accruals. No bonus amounts had been accrued previously during 2022 and nil was accrued as of the same period in the prior year. The remainder of the increase was largely driven by increased professional fees. SG&A expenses for the nine months ended September 30, 2022, increased $7.0 million or 48%, versus the same period of 2021 as a result of increased personnel costs mainly attributable to higher year on year bonus costs and 2021 benefiting from an Employee Retention Credit, (“ERC”). Professional fees for the nine months ended September 30, 2022 were higher due to costs associated with potential financing transactions, partially offset by lower legal fees. Depreciation of property and equipment decreased $0.1 million or 24%, for the three months ended September 30, 2022, versus the same period of 2021. Depreciation of property and equipment decreased $0.2 million or 30% for the nine months ended September 30, 2022. 34 Research and development (“R&D”) costs for the three and nine months ended September 30, 2022, decreased $0.2 million or 17% and $0.7 million or 16%, respectively, versus the same period of 2021 due to lower personnel costs as a result of a reduction in workforce and lower non-labor cost. Loss from operations decreased by $16.9 million or 2676% for the three months ended September 30, 2022, versus the same period in 2021. The increased loss from operations is partly attributable to the negative gross margin, increased SG&A costs and the loss on fair value of Contract Consideration Convertible Notes Payable. For the nine months ended September 30, 2022, the loss from operations increased by $3.5 million or 23% attributable mainly to the negative gross margin and increased SG&A costs. This was partially offset by the gain on sale of property and equipment and lease termination and a credit relating to the change in fair value of Contract Consideration Convertible Notes Payable. Loss before taxes for the three months ended September 30, 2022, was impacted by interest charges of $2.3 million versus $18 thousand for the same period in 2021. For the nine months ended September 30, 2022 and 2021 interest charges were $4.6 million and $53 thousand respectively. The increased interest cost relates to payment in kind interest expense on the Convertible Notes Payable and the Contract Consideration Convertible Notes Payable. The Company’s income tax expense for the three and nine months ended September 30, 2022 and 2021 was minimal. Results by Segment (in thousands): Chemistry Technologies Results of Operations: Three months ended September 30, Nine months ended September 30, 2022 2021 2022 2021 Revenue $ 43,928 $ 9,376 $ 84,395 $ 27,365 Income (loss) from operations (10,603) 4,399 (1,716) (3,009) CT revenue for the three and nine months ended September 30, 2022 increased $34.6 million, and $57.0 million, respectively, compared to the same periods of 2021. The increased revenue in 2022 is driven primarily by the ProFrac Agreements which commenced in the second quarter of 2022, of which the Company recognized $30.4 million and $48.1 million, for the three and nine months ended September 30, 2022, respectively. Income (loss) from operations for the CT segment for the three months ended September 30, 2022 decreased by $15.0 million or 341% compared to the same period of 2021. The decline is attributable to the loss on revaluation of the Contract Consideration Convertible Notes Payable of $4.3 million, increased costs primarily due to bonus accruals and the gross margin decrease driven by the inventory write down of $1.0 million and cost of goods sold for the three months ended September 30, 2021 benefiting from the release of accrued costs relating to the ADM settlement of $7.6 million. The loss from operations for the nine months ended September 30, 2022 decreased by $1.3 million or 43% compared to the same period of 2021. The improvement relates mainly to the revaluation of the Contract Consideration Convertible Notes Payable of $9.0 million and the gain on sale of property and equipment and lease termination, partially offset by the lower gross margin and increased costs primarily due to bonus accruals. Data Analytics Results of Operations: Three months ended September 30, 2022 Nine months ended September 30, 2022 2022 2021 2022 2021 Revenue $ 1,695 $ 803 $ 3,479 $ 3,749 Loss from operations (745) (1,071) (2,751) (2,138) DA revenue for the three months ended September 30, 2022 increased $0.9 million or 111% compared to the same period of 2021 due to significant revenues from three new customers and several existing customers. DA revenue for the nine months ended September 30, 2022 decreased $0.3 million or 7% compared to the same period of 2021. Loss from operations for the DA segment for the three months ended September 30, 2022 decreased by $0.3 million or 30% compared to the same period for 2021 due to increased revenues and improved margins partially offset by an increase in costs driven primarily by bonus accruals. Loss from operations for the DA segment for the nine months ended September 30, 2022 35 worsened by $0.6 million or 29%, compared to the same period of 2021. The worsening loss from operations is primarily as a result of increased R&D expense and decreased revenues partially offset by lower personnel cost. 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 nine months ended September 30, 2022, the Company funded working capital requirements with net cash proceeds from the issuance of Convertible Notes Payable for $20.1 million, prefunded warrants issued for $18.3 million and cash on hand. As of September 30, 2022, the Company had available cash and cash equivalents of $8.5 million, as compared to $11.5 million at December 31, 2021. During the nine months ended September 30, 2022, the Company had an operating loss of $18.5 million, $47.2 million of cash used in operating activities, $4.0 million cash provided by investing activities and $38.2 million of cash provided by financing activities. Liquidity The Company currently funds its operations and growth primarily from cash on hand and other liquid assets. The ability of the Company to grow and be competitive in the marketplace is dependent on the availability of adequate capital. The Company has a history of losses and negative cash flows from operations and expects to utilize a significant amount of cash in the twelve months subsequent to the date of filing the consolidated financial statements. The availability of capital is dependent on the Company’s operating cash flow principally derived from its long-term supply agreement with ProFrac Services, LLC (see Note 16, Related Party Transactions). We believe that our cash and other liquid assets and our forecasted operating cash flows expected to be generated from the ongoing execution of the long-term supply agreement with ProFrac Services, LLC 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 twelve months. However, the Company cannot guarantee a sufficient level of cash flows in the future. The consolidated financial statements have been prepared assuming that the Company will continue as a going concern. Cash Flows Consolidated cash flows by type of activity are noted below (in thousands): Nine months ended September 30, 2022 2021 Net cash used in operating activities $ (47,166) $ (18,279) Net cash provided by investing activities 4,040 43 Net cash provided by (used in) financing activities 38,199 (451) Effect of changes in exchange rates on cash and cash equivalents 211 (70) Net change in cash, cash equivalents and restricted cash $ (4,716) $ (18,757) Operating Activities Net cash used in operating activities was $47.2 million and $18.3 million during the nine months ended September 30, 2022 and 2021, respectively. Consolidated net loss for the nine months ended September 30, 2022 and 2021 were $23.3 million and $14.3 million, respectively. During the nine months ended September 30, 2022, non-cash adjustments to net income (loss) totaled $0.3 million as compared to $4.9 million for the same period of 2021. During the nine months ended September 30, 2022, changes in working capital used $23.6 million of cash as compared to providing $0.9 million for the same period of 2021. • For the nine months ended September 30, 2022, changes in working capital resulted primarily from an increase in accounts receivable, accounts receivable related party and inventories of $5.7 million, $24.6 million and $11.4 million, respectively, due to the significant revenue increase. Contract assets increased $3.6 million relating to transaction fees 36 paid, associated with Contract Consideration Convertible Notes Payable. This is partially offset by an increase in accounts payable of $22.0 million relating primarily to purchases made to support our contract with ProFrac. • For the nine months ended September 30, 2021, the cash provided by working capital primarily resulted from routine operations, including a reduction in accounts receivable and inventory of $2.4 million, offset by an increase of other assets of $1.7 million. Investing Activities Net cash from investing activities for the nine months ended September 30, 2022 was $4.0 million from the sale of the manufacturing facility in Waller, Texas which closed on April 18, 2022 partially offset by capital additions. Net cash from investing activities for the nine months ended September 30, 2021 was negligible. Financing Activities Net cash provided by financing activities was $38.2 million for the nine months ended September 30, 2022, primarily from the proceeds of the issuance of convertible notes and prefunded warrants partially offset by issuance costs. Net cash used in financing activities was $0.5 million for the nine months ended September 30, 2021, primarily for purchases of common stock related to tax withholding requirements. Off-Balance Sheet Arrangements 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. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported. Note 2, “Summary of Significant Accounting Policies” of the Notes to Unaudited Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q and in the Notes to Consolidated Financial Statements in Part II, Item 8 of the Annual Report on Form 10-K for the fiscal year ended December 31, 2021 describe the significant accounting policies and methods used in the preparation of the Company’s condensed consolidated financial statements.