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Near a 7-Year Low, Is This Energy Stock a Buy?

By Maxx Chatsko – May 21, 2018 at 8:35AM

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American oil and gas production is booming and crude oil prices are headed higher. Can Flotek Industries capitalize?

A rising tide is supposed to lift all boats, but the rising tide of American energy hasn't helped shares of Flotek Industries (FTK -0.98%).

While domestic oil and gas producers have repositioned themselves in recent years to profit in even the toughest pricing environments, shares of the chemical supplier are still 89% off their mid-2014 peak. The inability to share in the fortunes of its core customer base means 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 product portfolio's historical success and the continued rise in American oil production, investors may be wondering if this is a potential turnaround stock worth paying attention to. Is Flotek Industries a buy despite its troubles?

An oil rig in a field.

Image source: Getty Images.

By the numbers

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 chemistry technologies (ECT) segment, which supplies a range of chemicals needed to drill oil and gas wells. How bad was it? Well, Flotek Industries' shares dropped over 36% on the warning alone. Then, two weeks after that, the stock fell again when the quarterly numbers were finally announced.

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: Flotex 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 under way to boost margins, too. Flotek Industries has worked to reduce 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 from winter storms in its warning to investors, but the numbers above indicate that that was only a partial factor. The real issue stems from a key natural resource in the company's supply chain: oranges.

Slices of oranges scattered on a table with a small vial of citrus oil laying in the middle.

Image source: Getty Images.

How citrus crops are tanking the business

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 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 of citrus greening disease has led to a steadily declining output of oranges, with Florida's total crop down over 50% since the disease was first discovered in 2005. An estimated 80% of all citrus trees in the state are now infected, and Florida is experiencing its worst harvest this year since 1945. 

The result: Prices for citrus oils (and the raw ingredients derived from them, such as citrus terpene) that 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 for several years now. The timing couldn't be worse, as energy producers are ruthlessly prioritizing profitability over production volumes. The company's products have now lost significant market share in an expanding market for drilling fluids. 

Well, actually, the timing does get worse. In 2017, Hurricane Irma wiped out another 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.

Management has committed to prioritizing the development and introduction of new products and, most important, new chemistries (meaning those not based on citrus oils). A hard pivot will be the only way to potentially save the business, and provides a thread for opportunistic investors to pull on. Could Flotek Industries be the ultimate turnaround play? 

A chart drawn on a chalkboard where the steadily rising line is badly erased halfway up and redrawn as a sharply negative slope.

Image source: Getty Images.

It seems unlikely from where things stand today. Replacing an entire portfolio of products encompassing Flotek's business and supply chain won't be cheap or easy. Flotek Industries doesn't have the cash ($2.8 million at the end of March) or cash flow (negative $11.7 million in operating cash flow in the first three months of the year) to fund the pivot itself. The core business is deteriorating, with income from continuing operations falling each year since 2014 (and likely to be worse still this year), which makes it unlikely to be sold off to generate a quick infusion of cash. Not only will that cause losses to pile up, but oil and gas customers will continue to look elsewhere -- and they could be difficult to get back. 

Orange ya glad you stayed away from this one?

Flotek's turnaround strategy is in the earliest stages and has gained no signs of traction just yet. While much of the oil and gas industry is rebounding thanks to booming production in American shale basins, Flotek Industries has been unable to share in the improving outlook. Investors that dig a little deeper into the details will realize that it's not a fluke. The problems facing the business aren't something that can be fixed quickly or will repair themselves on their own if they can be fixed at all. 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.

Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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