# FLOTEK INDUSTRIES INC/CN/ (FTK) FY 2023 MD&A

Verbatim Item 7 Management's Discussion and Analysis from FLOTEK INDUSTRIES INC/CN/'s 10-K for fiscal year 2023.

SEC filing source: https://www.sec.gov/Archives/edgar/data/928054/000092805424000023/ftk-20231231.htm
Accession: 0000928054-24-000023
Filing date: 2024-03-15
Report date: 2023-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/FTK/
All MD&A years: /company/FTK/mda/
Previous year: /company/FTK/mda/fy2022/ (FY 2022)
Next year: /company/FTK/mda/fy2024/ (FY 2024)

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes thereto, which have been prepared in accordance with U.S. GAAP, included elsewhere in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the safe harbor created by those sections. As a result of many risks and uncertainties, including those factors set forth in Item 1A -Risk Factors of this Annual Report, our actual results could differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. For more information, see “Forward-Looking Statements.” These forward-looking statements are made as of the date of this report, and we do not intend, and do not assume any obligation, to update these forward-looking statements, except as required by applicable law. All dollar amounts stated herein are in U.S. dollars unless specified otherwise.

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.

22

During 2022 the Company entered into the ProFrac Agreement, (see Note 9, “Debt and Convertible Notes Payable” and Note 17, “Related Party Transactions”) which has resulted in a significant increase in revenue for the years ended December 31, 2023 and 2022.

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 its desired chemical applications program. The Company’s CT segment 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 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.

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 lower cost field gas instead of diesel to generate power 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 segments through green chemistry formulation, specialty chemical formulations, 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.

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 June 1, 2023 through December 31, 2023. The minimum purchase requirements were not met during the current measurement period, and as a result, related party revenues for the year ended December 31, 2023 reflect Contract Shortfall Fees of $20.1 million, of which $10.0 million was collected through March 11, 2024 with the remainder due on or before April 8, 2024.

23

Consolidated Results of Operations (in thousands)

[[GREPCENT_TABLE]]
[["","","","","","","Years ended December 31,"],["","","","","","","","","2023","","2022"],["Revenue"],["Revenue from external customers","","","","","","","","$","66,518","","","$","54,344"],["Revenue from related party","","","","","","","","121,540","","","81,748"],["Total revenues","","","","","","","","188,058","","","136,092"],["Cost of sales","","","","","","","","163,795","","","142,792"],["Cost of sales %","","","","","","","","87.1","%","","104.9","%"],["Gross profit (loss)","","","","","","","","24,263","","","(6,700)"],["Gross profit (loss) %","","","","","","","","12.9","%","","(4.9)","%"],["Selling, general and administrative","","","","","","","","27,873","","","27,124"],["Selling, general and administrative %","","","","","","","","14.8","%","","19.9","%"],["Depreciation","","","","","","","","734","","","734"],["Research and development","","","","","","","","2,486","","","4,438"],["Severance costs","","","","","","","","(46)","","","\u2014"],["Gain on disposal of property and equipment","","","","","","","","(38)","","","(2,916)"],["Gain on lease termination","","","","","","","","\u2014","","","(584)"],["Gain in fair value of contract consideration convertible notes payable","","","","","","","","(29,969)","","","(75)"],["Impairment of goodwill","","","","","","","","\u2014","","","\u2014"],["Income (loss) from operations","","","","","","","","23,223","","","(35,421)"],["Operating margin %","","","","","","","","12.3","%","","(26.0)","%"],["Paycheck protection plan loan forgiveness","","","","","","","","4,522","","","\u2014"],["Interest expense and other income, net","","","","","","","","(2,883)","","","(6,906)"],["Income (loss) before income taxes","","","","","","","","24,862","","","(42,327)"],["Income tax (expense) benefit","","","","","","","","(149)","","","22"],["Net income (loss)","","","","","","","","$","24,713","","","$","(42,305)"],["Net income (loss) %","","","","","","","","13.1","%","","(31.1)","%"]]
[[/GREPCENT_TABLE]]

Consolidated revenue for the year ended December 31, 2023 increased $52.0 million, or 38%, versus the same period of 2022. The significant increase in revenue during the year ended December 31, 2023 was driven primarily by a full year of activity under the ProFrac Agreement which commenced in the second quarter of 2022. In addition, revenues increased due to continued increased activity with new and existing domestic customers particularly in the CT segment, partially offset by reduced international activity.

Consolidated cost of sales for the year ended December 31, 2023 increased $21.0 million, or 15%, versus the same period of 2022. The increase is primarily driven by the activity with ProFrac Services, LLC and higher freight and equipment rental costs due to the increased volume of business. The reduction in cost of sales as a percentage of revenue in 2023 was the result of revenue from Contract Shortfall Fees, which have no associated costs, and numerous initiatives to reduce the cost of freight and logistics and secure better pricing of materials.

Selling general and administrative (“SG&A”) expenses are not directly attributable to products sold or services provided. SG&A expenses for the year ended December 31, 2023, increased $0.7 million, or 3%, versus the same period of 2022.

Research and development (“R&D”) costs decreased $2.0 million, or 44%, for the year ended December 31, 2023, versus the same period of 2022 driven by lower personnel costs resulting from headcount optimization.

Operating income increased by $58.6 million to $23 million for the year ended December 31, 2023, versus an operating loss of $35 million during the same period in 2022. The improvement was driven primarily by an increased gross profit of $31.0 million resulting from increased related party and external customer revenue, including accrued Contract Shortfall Fees, the gain in fair value of the Contract Consideration Convertible Notes Payable of $30.0 million compared to the same period of 2022, and a $2.0 million decrease in research and development costs. The improvement was partially offset by an increase in

24

SG&A expenses of $0.7 million and a decrease in gains on the sale of assets and lease termination of $2.9 million and $0.6 million, respectively.

Interest expense and other income for the year ended December 31, 2023 increased $8.5 million, driven primarily by a $4.5 million gain for the forgiveness of the Flotek PPP loan and a $4.2 million decrease in interest expense related to the maturity of the Contract Consideration Convertible Notes Payable in the first half of 2023.

Results by Segment (in thousands):

Chemistry Technologies Results of Operations:

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2023","","2022"],["Revenue from external customers","$","59,016","","","$","48,960"],["Revenue from related party","120,903","","","81,618"],["Income (loss) from operations","39,043","","","(14,729)"]]
[[/GREPCENT_TABLE]]

CT revenue from external customers for the year ended December 31, 2023, increased $10.1 million, or 21%, compared to 2022 due to increased domestic sales with both new and existing customers. Revenue from related parties, including accrued Contract Shortfall Fees, increased $39.3 million, or 48%, driven by the ProFrac Agreement which commenced in the second quarter of 2022.

Income from operations for the CT segment for the year ended December 31, 2023 increased $53.8 million, compared to 2022. The increase was driven by an increase in gross profit of $27.7 million attributable to increased activity and accrued Contract Shortfall Fees along with an increase in the gain in fair value of the Contract Consideration Convertible Notes Payable of $30.0 million for the year ended December 31, 2023 compared to $0.1 million for the same period in 2022.

Data Analytics Results of Operations:

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2023","","2022"],["Revenue from external customers","$","7,502","","","$","5,384"],["Revenue from related party","637","","","130"],["Loss from operations","(53)","","","(2,877)"]]
[[/GREPCENT_TABLE]]

DA external customer revenue for the year ended December 31, 2023, increased $2.1 million, or 39%, compared to revenue for 2022. The increase was driven by increased product sales. Related party revenue increased by $0.6 million compared to 2022 relating to services provided to ProFrac Services, LLC outside of the ProFrac Agreement.

Loss from operations for the DA segment for the year ended December 31, 2023 decreased $2.8 million, or 98%, compared to 2022. The improvement was primarily due to increased activity and decreased R&D expense and personnel costs.

Corporate and Other Results of Operations:

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2023","","2022"],["Loss from operations","$","(15,767)","","","$","(17,815)"]]
[[/GREPCENT_TABLE]]

Loss from operations for the year ended December 31, 2023 decreased by $2.0 million, or 11%, compared to the same period of 2022, due to decreased salaries and benefits from reduced headcount, including lower stock compensation costs.

Capital Resources and Liquidity

Overview

The Company’s ongoing capital requirements relate to the acquisition and maintenance of equipment and funding of working capital. During 2023, the Company funded working capital requirements with cash on hand and borrowings under the ABL (as defined below) entered into in August 2023.

25

As of December 31, 2023, the Company had unrestricted cash and cash equivalents of $5.9 million, as compared to $12.3 million at December 31, 2022. In addition, at March 11, 2024, the Company had approximately $0.5 million in borrowings outstanding under its ABL, as compared to $7.5 million at December 31, 2023. During the year ended December 31, 2023, the Company had operating income of $23.2 million, $11.3 million of cash used in operating activities, $1.0 million of cash used in investing activities and $5.9 million of cash provided by 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 $10 million of initial 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. On October 5, 2023, the ABL was amended to increase its maximum borrowing base from $10.0 million to a total of $13.8 million.

As of December 31, 2023, the Company had $7.5 million outstanding under the ABL. During the year ended December 31, 2023, the Company incurred $0.5 million in interest and fees related to the ABL, which included the annual fee of $0.1 million. As of December 31, 2023, the Company had incurred origination costs of $0.5 million related to the ABL that was recorded as deferred financing costs to be amortized over the term of 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% as of December 31, 2023. 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 December 31, 2023.

Sources and Uses of Liquidity

The Company currently funds its operations with cash on hand, availability under the ABL (see Note 9, “Debt and Convertible Notes Payable” in Part II, Item 8 of this Annual Report) and other liquid assets. Although the Company has a history of negative cash flows from operations and losses, the Company recognized $24.3 million and $24.7 million of gross profit and net income, respectively, during the year ended December 31, 2023. 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.

As discussed in Note 17, “Related Party Transactions” in Part II, Item 8 of this Annual Report, 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 (“Contract Shortfall Fees”), 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. The current measurement period for Contract Shortfall Fees is June 1, 2023 through December 31, 2023. The minimum purchase requirements were not met during the current measurement period, and as a result, related party revenues and receivables for the year ended and as of December 31, 2023 include $20.1 million in Contract Shortfall Fees of which $10.0 million has been collected through March 11, 2024. The Company expects to receive the remaining $10.1 million on or before April 8, 2024. For 2024, the measurement period will be January 1, 2024 through December 31, 2024. If the minimum purchase requirements are not met during the year ended December 31, 2024, there will be additional Contract Shortfall Fees due during the first quarter of 2025.

Based upon the improvement in our outlook for future cash flows from operations that includes the collection of the Contract Shortfall Fees related to 2023 of $20.1 million, 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. However, the Company cannot guarantee a sufficient level of cash flows in the future. The Company had previously disclosed in the consolidated financial statements as of and for the year ending December 31, 2022, that substantial doubt about the Company’s ability to continue as a going concern existed. As described, the Company

26

has concluded that those conditions and events raising the substantial doubt no longer exist. 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):

[[GREPCENT_TABLE]]
[["","Years ended December 31,"],["","2023","","2022"],["Net cash used in operating activities","$","(11,297)","","","$","(44,632)"],["Net cash (used in) provided by investing activities","(1,014)","","","5,331"],["Net cash provided by financing activities","5,928","","","38,267"],["Effect of changes in exchange rates on cash and cash equivalents","(54)","","","100"],["Net change in cash, cash equivalents and restricted cash","$","(6,437)","","","$","(934)"]]
[[/GREPCENT_TABLE]]

Operating Activities

Net cash used in operating activities was $11.3 million and $44.6 million during the years ended December 31, 2023 and 2022, respectively. Consolidated net income for the year ended December 31, 2023 was $24.7 million compared to a net loss of $42.3 million for the same period of 2022.

During the year ended December 31, 2023, non-cash adjustments to net income totaled $22.8 million as compared to $12.8 million for the same period of December 31, 2022.

•For the year ended December 31, 2023, non-cash adjustments included a $30.0 million gain on the fair value valuation of the Contingent Convertible Notes, a gain of $4.5 million for the Flotek PPP loan forgiveness, paid-in-kind interest on the Convertible Notes Payable and Contract Consideration Convertible Notes Payable of $2.3 million, amortization of contract assets and convertible note issuance costs of $5.0 million and $0.1 million, respectively, and stock compensation expense of $0.3 million. The non-cash adjustment for the provision for excess and obsolete inventory was $1.0 million and depreciation was $0.7 million. Non-cash lease expense was $3.0 million primarily due to ROU Asset amortization for equipment leases which were added in 2022.

•For the year ended December 31, 2022, non-cash adjustments included paid-in-kind interest on the Convertible Notes Payable and Contract Consideration Convertible Notes Payable of $6.0 million, amortization of contract assets and convertible note issuance costs of $3.4 million and $1.0 million, respectively, and stock compensation expense of $3.3 million.

During the year ended December 31, 2023, changes in working capital used $13.2 million of cash as compared to using $15.2 million for the same period of 2022.

•For the year ended December 31, 2023, changes in working capital resulted primarily from increases in accounts receivable, including related party of $6.5 million, and a decrease in inventories of $1.9 million due to reduced ProFrac sales in late 2023. Accounts payable and accrued liabilities decreased $1.7 million and $2.6 million, respectively. The decrease in accrued liabilities is primarily due to accrued severance, sales taxes and professional fees, partially offset by higher bonus accruals. Operating lease liabilities decreased $3.4 million primarily due to payments on equipment leases.

•For the year ended December 31, 2022, changes in working capital resulted primarily from increases in accounts receivable and inventories of $28.7 million and $7.9 million, respectively, due to the significant increase in revenues. Contract assets increased $3.6 million related to transaction fees paid associated with Contract Consideration Notes Payable. This was partially offset by an increase of accounts payable of $25.8 million, attributable to the increase in activity.

Investing Activities

Net cash used by investing activities for the year ended December 31, 2023 was $1.0 million primarily due to system enhancements and capital additions. Net cash provided by investing activities for the year ended December 31, 2022 was $5.3 million primarily related to the sale of assets.

27

Financing Activities

Net cash provided by financing activities was $5.9 million for the year ended December 31, 2023, primarily from net proceeds from the ABL. Net cash provided was partially offset by severance payments attributed to former CEO’s forfeited vested stock options, loan origination fees, and payments for shares withheld for taxes.

Net cash provided by financing activities was $38.3 million for the year ended December 31, 2022, primarily from the proceeds of the issuance of convertible notes of $21.2 million and prefunded warrants of $19.5 million, partially offset by issuance costs of $2.3 million.

Critical Accounting 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. Our most significant accounting policies are described in Note 2, “Summary of Significant Accounting Policies,” in Part II, Item 8 — “Financial Statements and Supplementary Data,” of this Annual Report. The Company believes the following accounting estimates are critical due to the significant subjective and complex judgments and estimates required when preparing the consolidated financial statements. The Company regularly reviews judgments, assumptions and estimates related to the critical accounting estimates.

Contract Assets

The Company’s contract assets represent consideration which was issued in the form of convertible notes (Contract Consideration Convertible Notes Payable as discussed in Note 9, “Debt and Convertible Notes Payable” in Part II, Item 8) and other incremental costs related to obtaining the ProFrac Agreement in 2022. The contract assets are amortized over the term of the ProFrac Agreement based on forecasted revenues. As goods are transferred to ProFrac Services, LLC, the amortization is presented as a reduction of the transaction price included in related party revenue in the consolidated statements of operations. The contract assets are tested for recoverability on a recurring basis and the Company will recognize an impairment loss to the extent that the carrying amount of the contract assets exceeds the amount of consideration the Company expects to receive in the future for the transfer of goods under the contract less the direct costs that relate to providing those goods in the future. Significant or unanticipated changes to our forecast could impact the recoverability of the contract assets.

Reserve for Excess and Obsolete Inventory

Inventories consist of raw materials and finished goods and are stated at the lower of cost, or market determined using the weighted-average cost method, or net realizable value. Finished goods inventories include raw materials, direct labor and production overhead.

The Company reviews inventories on hand and current market conditions to determine if the cost of raw materials and finished goods inventories exceed current market prices and impairs the cost basis of the inventory accordingly. Obsolete inventory or inventory in excess of management’s estimated usage requirement is written down to its net realizable value if those amounts are determined to be less than cost. Write-downs or write-offs of inventory are charged to cost of sales.

At December 31, 2023 and 2022, the reserve for excess and obsolete inventory was $6.1 million and $8.2 million, or 32.3% and 34.3% of inventory, respectively. Significant or unanticipated changes to our estimates and forecasts could impact the amount and timing of any additional provisions for excess and obsolete inventory.

Fair Value of Contract Consideration Convertible Notes Payable

The Company accounted for the Contract Consideration Convertible Notes Payable, which was issued related to obtaining the ProFrac Agreement, as liability classified convertible instruments in accordance with FASB ASC 718, “Stock Compensation” (see Note 9, “Debt and Convertible Notes Payable” in Part II, Item 8 of this Annual Report). Under ASC 718, liability classified convertible instruments are measured at fair value at the grant date and at each reporting date with the change in fair value included in the consolidated statements of operations. At each reporting date preceding the date of maturity, the Contract Consideration Convertible Notes Payable were remeasured by means of a Monte Carlo simulation which utilized key inputs such as the risk-free interest rate, stock price, expected volatility and term until liquidation. Significant changes to the key inputs such as the Company’s stock price and volatility would impact the estimated fair value. The Contract Consideration Convertible Notes matured and were converted during the year ended December 31, 2023 in accordance with their terms.

Recent Accounting Pronouncements

Recent accounting pronouncements which may impact the Company are described in Note 2, “Summary of Significant Accounting Policies - Recent Accounting Pronouncements,” in Part II, Item 8 — “Financial Statements” of this Annual Report.