A rising tide is supposed to lift all boats, but the rising tide of American energy has left shares of Flotek Industries (FTK 3.03%) stuck on the coastline of the industry's recovery.
While domestic oil and gas producers have repositioned themselves in recent years to profit in even the toughest pricing environments, shares of the chemistry solutions supplier are still 89% off their mid-2014 peak. Flotek Industries stock is now near a seven-year low.
Turns out Wall Street's prolonged punishment may have been justified so far. The company's first-quarter 2018 earnings results demonstrated that its energy segment got off to a depressingly slow start to the year. But given the technology platform's historical success, and the continued rise in American oil production, investors may be wondering if this is a turnaround stock worth paying attention to. Is Flotek Industries a buy despite its troubles?
Image source: Getty Images.
By the numbers
To be fair, management did the right thing by warning investors that the first quarter of 2018 was going to be accompanied by some pretty awful numbers for its energy technologies (ECT) segment. How bad was it? Well, Flotek Industries shares dropped over 36% on the warning alone. Then, two weeks after that, the stock fell again.
That's not surprising after taking a look at the numbers. The company's consumer and industrial chemistry technologies (CICT) segment, which is supposed to provide a reprieve from energy industry volatility, saw year-over-year operating income fall 34%. And that was the good news.
|
Metric |
Q1 2018 |
Q1 2017 |
Change (YOY) |
|---|---|---|---|
|
ECT revenue |
$41.1 million |
$60.8 million |
(32.4%) |
|
CICT revenue |
$19.4 million |
$19.2 million |
1.3% |
|
Total revenue |
$60.5 million | $79.9 million | (24.3%) |
|
ECT operating income |
($0.2 million) |
$8.5 million |
N/A |
|
CICT operating income |
$2.4 million |
$3.7 million |
34.2% |
|
Total operating income |
($6.8 million) |
($0.6 million) |
N/A |
|
Net income |
$0.07 million |
($11.9 million) |
N/A |
|
Operating cash flow |
($11.7 million) |
($2.6 million) |
N/A |
Data source: SEC filing. YOY = year over year.
The year-over-year improvement in net income was provided by multiple accounting items, including an enormous benefit from the new American corporate tax rates in the first quarter of 2018 and a giant loss from discontinued operations in the year-ago period. There are more concrete efforts to boost margins underway, too. Flotek Industries has worked to reduce cash used in selling, general, and administrative expenses over 30% from the prior-year period. Even with that effort, this business is struggling. What's the culprit?
Management originally identified weather-related disruptions in its warning to investors, but the numbers above indicate that was only a partial factor. The real issue stems from a key natural resource in the company's supply chain: oranges. It makes sense with a little more explanation.
Image source: Getty Images.
Minor technical details
Flotek Industries has a unique portfolio of products for both of its operating segments. They derive their unique characteristics from specialty ingredients found in citrus oils, which are largely sourced from citrus crops, such as oranges. Problem is, America's orange crop has been devastated in recent years by an imported pathogen called citrus greening disease. The persistent biosecurity threat has led to a steadily declining output of oranges.
The result: Prices for the raw ingredients (such as citrus terpene) Flotek Industries needs to manufacture its products have doubled in just two years. That has had an immediate impact on the company's gross margin, operating margin, and the competitiveness of its products in the broader market. The timing couldn't be worse, as energy producers are ruthlessly prioritizing profitability over production volumes.
Well, actually, it does get worse. In 2017, Hurricane Irma wiped out an estimated 40% of America's orange crop overnight -- and that's from a baseline that includes the ravaging effects of years of citrus greening disease. The existence of the pathogen means output won't recover anytime soon (if ever). It's all bad news for Flotek Industries, which has built its entire business on citrus oils.
Image source: Getty Images.
Orange ya glad you stayed away from this one?
Management has committed to prioritizing the development and introduction of new products and, most importantly, new chemistries (meaning those not based on citrus oils). A hard pivot will be the only way to potentially save the business, but replacing an entire portfolio of products won't be cheap or easy. It may be difficult to believe, but oranges pose an existential threat to this energy stock. They're also why investors should avoid Flotek Industries at all costs.
