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 2023 Annual Report 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 2023 Annual Report, 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 creates unique 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 and commercial markets improve their environmental 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 (“R&I”) advanced laboratory capabilities. Company Overview Chemistry Technologies We believe that the Company’s CT segment provides sustainable, optimized chemistry solutions that maximize our customers value by improving return on invested capital, lowering operational costs, and providing tangible environmental benefits. 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 their 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, with whom we have a long-term supply agreement, as well as 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. ProFrac Supply Agreement On February 2, 2022, the Company entered into the Initial ProFrac Agreement, which was subsequently amended on May 17, 2022 and February 1, 2023 (collectively, the “ProFrac Agreement”). The ProFrac Agreement contains minimum requirements for chemistry purchases. If the minimum volumes are not achieved within the applicable measurement period, ProFrac Services, LLC is required to pay to the Company, as liquidated damages, an amount equal to twenty-five percent (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 the measurement period (“Contract Shortfall Fees”). The current measurement period for Contract Shortfall Fees is January 1, 2024 through December 31, 2024. The Company does not expect that the minimum purchase requirements will be met during the current measurement period, and as a result, revenues for the three months ended March 31, 2024 reflect Contract Shortfall Fees of $8.7 million. Because the measurement period for 2023 was June 1, 2023 through December 31, 2023, there are no Contract Shortfall Fees reflected in revenues for the first quarter of 2023. 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. We believe 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, allowing for the use of significantly lower cost field gas instead of diesel to generate power, lower 32 emissions and protect equipment, 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 line of Verax™ analyzers for deployment internationally which was certified for compliance in hazardous locations and harsh weather conditions. Research & Innovation R&I supports both business segments through green chemistry formulation, specialty chemical formulations and Environmental Protection Agency (“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 business 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. For the three months ended March 31, 2024 and 2023, the Company incurred $0.4 million and $0.6 million, respectively, of research and development expense. The Company expects that its 2024 research and development investment will continue to support new product development, especially in support of enhanced environmental demands, increased adoption of green chemistry and conventional customization initiatives for its clients. 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 The demand for oil and gas and related services fluctuates due to numerous factors including weather and macroeconomic and geopolitical conditions. Despite the near term volatility in commodity pricing, leading to the recent weakness in onshore drilling and completion activity, the fundamentals for energy related services remain strong. The overall expansion of the global economy should continue to create substantial demand for all forms of energy which will increase service intensity. Independent 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 these companies operating in oil-weighted basins to maintain or increase activity while companies operating in gas-weighted basins are expected to maintain or decrease activity over the next 12 months. In general, we expect the major exploration and production companies to maintain activity levels over the next 12 months. 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 insight on valuable operations data like vapor pressure, boiling point, flash point, octane level, API (American Petroleum Institute) gravity, viscosity, BTU (British Thermal Unit) and more, simultaneously. We continue to collaborate with our customers to identify further facilities and applications where our technology has the highest value. 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 real-time versus traditional lab analysis. We believe this allows customers to cut batches quickly and accurately, reduce transmix and minimize off-spec product that requires downgrades. We are also gaining traction leveraging the Verax™ in applications where operators and service companies are using field gas as a substitute for diesel in dual fuel engines as the market moves to Tier 4 equipment and eFleets. Analyzing this in real-time allows companies to maximize the field gas for diesel substitution rate providing significant cost savings while lowering emissions, reducing fuel consumption/costs, and protecting the equipment from damage. Supply Chain The principal supply issues facing our industry for the next twelve months will include: • Fluctuating freight costs for shipping to our customers; 33 • Availability of raw materials; • 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 security of delivery for sea-freight could impact sales of North American manufactured goods being delivered internationally for the foreseeable future. The overall flow of materials globally could experience price increases. Military conflicts in the Middle East could also result in supply disruption. Consolidated Results of Operations (in thousands) Three months ended March 31, 2024 2023 Revenue Revenue from external customers $ 13,180 $ 11,652 Revenue from related party 27,194 36,355 Total revenues 40,374 48,007 Cost of sales 31,553 46,127 Cost of sales % 78.2 % 96.1 % Gross profit 8,821 1,880 Gross profit % 21.8 % 3.9 % Selling general and administrative 6,084 6,451 Selling general and administrative % 15.1 % 13.4 % Depreciation 220 176 Research and development 406 614 Severance costs 3 2,223 Gain in fair value of Contract Consideration Convertible Notes Payable — (26,095) Income from operations 2,108 18,511 Operating margin % 5.2 % 38.6 % Interest and other (expense) income, net (304) 2,840 Income before income taxes 1,804 21,351 Income tax (expense) benefit (242) (9) Net income $ 1,562 $ 21,342 Net income % 3.9 % 44.5 % Consolidated revenue for the three months ended March 31, 2024 decreased $7.6 million, or 16%, versus the same period of 2023, driven by lower related party activity under the ProFrac Agreement, partially offset by accrued Contract Shortfall Fees and increased revenue from external customers. Related party revenues in the CT segment are net of $1.3 million and $1.3 million of contract assets amortization for the three months ended March 31, 2024 and 2023, respectively. Consolidated cost of sales for the three months ended March 31, 2024 decreased $14.6 million, or 32%, versus the same period of 2023, primarily due to decreased product sales and lower freight costs, partially offset by increased tank rental and maintenance costs. Consolidated cost of sales percentage improved to 78.2% for the three months ended March 31, 2024 from 96.1% in the same period in 2023 as a result of accrued Contract Shortfall Fees, which have no associated costs, and cost management initiatives. SG&A expenses for the three months ended March 31, 2024 decreased $0.4 million, or 6%, versus the same period of 2023. The decrease relates primarily to decreased professional fees. Severance costs for the three months ended March 31, 2024 decreased $2.2 million versus the same period of 2023. Severance costs during the 2023 period related to senior management changes. 34 Research and development (“R&D”) costs for the three months ended March 31, 2024 decreased $0.2 million, or 34%, versus the same period of 2023 due to lower personnel cost driven by headcount optimization. Income from operations decreased $16.4 million for the three months ended March 31, 2024, versus the same period in 2023. The decrease is primarily driven by the gain in fair value of the Contract Consideration Convertible Notes Payable of $26.1 million for the three months ended March 31, 2023 with no corresponding fair value change in the same period of 2024. This gain was partially offset by a $6.9 million increase in gross profit for the three months ended March 31, 2024 as compared to the same period of 2023. Interest and other expense for the three months ended March 31, 2024 increased $3.1 million, or 111%, driven by the $4.5 million gain for the three months ended March 31, 2023 related to the partial forgiveness of the Flotek PPP loan with no corresponding activity in 2024. The increase in interest and other expense was partially offset by a $1.4 million decrease in interest payments, which related primarily to interest on the Contract Consideration Convertible Notes Payable, which matured and converted in 2023. The Company’s income tax expense for the three months ended March 31, 2024 and 2023 was minimal. Results by Segment (in thousands): Chemistry Technologies Results of Operations: Three months ended March 31, 2024 2023 Revenue from external customers $ 11,685 $ 9,225 Revenue from related party 27,014 36,265 Income from operations 6,106 23,379 CT revenue from external customers for the three months ended March 31, 2024 increased $2.5 million, or 27%, compared to the same period of 2023 driven primarily by domestic activity partially offset by decreased international activity. Revenue from related parties for the three months ended March 31, 2024 decreased $9.3 million, or 26%, compared to the same period of 2023 primarily driven by decreased activity partially offset by $8.7 million of accrued Contract Shortfall Fees. There were no corresponding Contract Shortfall Fees for the same period of 2023. Income from operations for the CT segment for the three months ended March 31, 2024 decreased $17.3 million compared to the same period of 2023. The decrease is primarily due to the gain in fair value of the Contract Consideration Convertible Notes Payable of $26.1 million for the three months ended March 31, 2023 with no corresponding valuation changes in the same period of 2024. The decrease was partially offset by increased gross profit of $8.0 million, which was related to accrued Contract Shortfall Fees and improved cost measures, and severance costs of $0.6 million for the three months ended March 31, 2023. Data Analytics Results of Operations: Three months ended March 31, 2024 2023 Revenue from external customers $ 1,495 $ 2,427 Revenue from related party 180 90 (Loss) income from operations (424) 457 DA revenue from external customers for the three months ended March 31, 2024 decreased $0.9 million, or 38%, compared to the same period of 2023 primarily due to reduced unit sales. Revenue from related party customers for the three months ended March 31, 2024 was $0.2 million relating to services provided to ProFrac compared to $0.1 million for the same period in 2023. Income from operations for the DA segment for the three months ended March 31, 2024 decreased $0.9 million compared to the same period for 2023 primarily driven by decreased activity. 35 Corporate and Other Results of Operations: Three months ended March 31, 2024 2023 Loss from operations $ (3,574) $ (5,325) Loss from operations for the three months ended March 31, 2024 decreased $1.4 million, or 28%, compared to the same period of 2023 attributable to decreased professional fees and severance costs. Capital Resources and Liquidity Overview The Company’s capital requirements relate to the acquisition and maintenance of equipment and funding working capital requirements. During the three months ended March 31, 2024, the Company funded working capital requirements with cash on hand and borrowings under the ABL (as defined below). As of March 31, 2024, the Company had unrestricted cash and cash equivalents of $5.2 million compared to $5.9 million on December 31, 2023. In addition, at May 7, 2024 , the Company had approximately $8.0 million in available borrowings under its ABL. During the three months ended March 31, 2024, the Company had $2.1 million of operating income, $3.9 million of cash provided by operating activiti es, $0.2 million of cash used in investing activities and $4.4 million o f cash used in financing activities. Asset Based Loan On August 14, 2023, the Company entered into a 24-month revolving loan and security agreement in connection with an Asset Based Loan (the “ABL”). The ABL provides up to $13.8 million of credit availability, which is limited by a borrowing base consisting of (i) 85% of eligible accounts receivable, plus (ii) 60% of the value of eligible inventory not to exceed 100% of the eligible accounts receivable. As of March 31, 2024, the Company had $3.1 million outstanding under the ABL. During the three months ended March 31, 2024, the Company incurred $0.2 million in interest and fees related to the ABL. As of March 31, 2024, the Company recorded $0.1 million of amortized deferred financing costs related to the ABL. Borrowings under the ABL bear interest at the Wall Street Journal Prime Rate (subject to a floor of 5.50%) plus 2.5% per annum. The interest rate under the ABL was 11.0% as of March 31, 2024. The ABL contains an annual commitment fee equal to 1.0% of the ABL’s borrowing base. Additionally, the Company will be assessed a non-usage fee of 0.25% per quarter based on the difference between the average daily outstanding balance and the borrowing base limit of the ABL. If the ABL is terminated prior to the end of its 24-month term, the Company is required to pay an early termination fee of 2.50% of the borrowing base limit of the ABL (if terminated with more than 12 months remaining until the maturity date) or 1.50% of the borrowing base limit of the ABL (if terminated with less than 12 months remaining until the maturity date). The ABL contains customary representations, warranties, covenants and events of default, the occurrence of which would permit the lender to accelerate the payment of any amounts borrowed. The ABL requires the Company to maintain a minimum Tangible Net Worth (as defined in the ABL) of not less than $11 million. In addition, the ABL provides the lender a blanket security interest on all or substantially all of the Company’s assets. The Company was in compliance with all of the covenants under the ABL as of March 31, 2024. Sources and Uses of Liquidity These unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) assuming the Company will continue as a going concern. The going concern assumption contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company currently funds its operations with cash on hand, availability under the ABL (see Note 9, “Debt and Convertible Notes Payable” in Part I, Item 1 of this Quarterly Report) and other liquid assets. The Company recognized $8.8 million and $1.6 million of gross profit and net income, respectively, during the three months ended March 31, 2024. While we believe that our cash, liquid assets, and availability under the ABL will provide us with sufficient financial resources to fund operations to meet our capital requirements and anticipated obligations as they become due, uncertainty surrounding the long-term stability and strength of the oil and gas markets could have a negative impact on our liquidity. The availability of capital is dependent 36 on the Company’s operating cash flow, which is currently expected to be principally derived from the ProFrac Agreement (see Note 9, “Debt and Convertible Notes Payable” and Note 16, “Related Party Transactions”). During April 2024, the Company collected the final payment related to the $20.1 million in 2023 Contract Shortfall Fees under the ProFrac Agreement. Related party revenues for the three months ended March 31, 2024 included Contract Shortfall Fees of $8.7 million. Related party receivables as of March 31, 2024 included accrued Contract Shortfall Fees of $13.7 million comprised of the remaining 2023 Contract Shortfall Fees payment of $5.0 million, which was collected in April 2024, and $8.7 million of accrued 2024 Contract Shortfall Fees, which will be due in the first quarter of 2025 under the terms of the ProFrac Agreement. Based upon our outlook for future cash flows from operations, which includes the collection of the Contract Shortfall Fees, combined with cash on hand and availability under the ABL, the Company believes it has sufficient financial resources to fund operations and meet its capital requirements and anticipated obligations as they become due in the next twelve months. The Company cannot guarantee a sufficient level of cash flows in the future, the unaudited condensed 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): Three months ended March 31, 2024 2023 Net cash provided by operating activities $ 3,887 $ 1,140 Net cash used in investing activities (152) (157) Net cash used in financing activities (4,411) (818) Effect of changes in exchange rates on cash and cash equivalents 42 (21) Net change in cash and cash equivalents and restricted cash $ (634) $ 144 Operating Activities Net cash provided by operating activities was $3.9 million during the three months ended March 31, 2024 compared to $1.1 million for the same period of 2023. Consolidated net income for the three months ended March 31, 2024 was $1.6 million compared to net income of $21.3 million for the three months ended March 31, 2023. During the three months ended March 31, 2024, non-cash adjustments to net income totaled $3.1 million as compared to $27.8 million for the same period of 2023. • For the three months ended March 31, 2024 non-cash adjustments included non-cash positive adjustments of $0.3 million of stock compensation expense, $1.3 million amortization of contract assets and $0.7 million non-cash lease expense. • For the three months ended March 31, 2023 non-cash adjustments included $26.1 million for the change in fair value of Contract Consideration Convertible Notes Payable and $4.5 million related to the partial forgiveness of the PPP loan, partially offset by $1.6 million paid-in-kind interest expense and $(1.1) million of stock compensation expense. During the three months ended March 31, 2024, changes in working capital used $0.8 million of cash as compared to $7.6 million for the same period of 2023. • For the three months ended March 31, 2024, changes in working capital resulted primarily from an increase in related party accounts receivable of $4.1 million and net inventories of $1.3 million along with decreased accrued liabilities and operating lease liabilities of $2.5 million and $0.9 million, respectively, partially offset by increases in accounts payable of $4.2 million, third party accounts receivable of $2.9 million and other assets of $0.9 million. • For the three months ended March 31, 2023, changes in working capital resulted primarily from an increase in accounts payable and accrued liabilities of $9 million and $1.2 million, respectively, partially offset by a decrease in operating lease liabilities of $1.2 million. Investing Activities Net cash used in investing activities for the three months ended March 31, 2024 and 2023 was $0.2 million and $0.2 million, respectively, driven by capital expenditures in both periods. 37 Financing Activities Net cash used in financing activities for the three months ended March 31, 2024 was $4.4 million and relates primarily to $4.4 million in net payments on the ABL, payments for forfeited stock options, payments to tax authorities for shares withheld from employees and payments for finance leases, partially offset by proceeds from the issuance of stock. Net cash used in financing activities was $0.8 million for the three months ended March 31, 2023, and relates primarily to payments for forfeited stock options, payments to tax authorities for shares withheld from employees and payments on finance leases, partially offset by proceeds from stock issuances. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. GAAP 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. Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of the Company’s 2023 Annual Report describes the critical accounting policies and estimates used in the preparation of the Company’s condensed consolidated financial statements. 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 2023 Annual Report describe the significant accounting policies and methods used in the preparation of the Company’s condensed consolidated financial statements.