Flotek Industries: A Small Cap Making The Right Moves

| About: Flotek Industries, (FTK)

In February 2013, I wrote an article on Flotek Industries (NYSE:FTK). The article entitled Small Cap with Strong Balance Sheet in a Good Sector looked at some of the financial highlights of the company as well as some of the valuations. As stated in the article, Flotek has been "showing strength in all aspects of its profitability, including the asset turnover, gross profit margin, ROA and TL&A ratio." But the article did indicate that the company is "showing some weakness in its current ratio". This ratio indicates that the company does not have the liquidity that it did a couple of years ago.

"Flotek's vision is to be the premier energy services company focused on best-in class technology, cutting-edge innovation and exceptional customer service all standing in the support of our never-ending commitment to provide superior returns for our stakeholders. Flotek Industries Inc., is a diversified global supplier of drilling-and production-related products and services to the energy and mining industries."

On May 10th 2013, Flotek purchased all the outstanding stock of Florida Chemical Company Inc. Under the terms of the agreement "Flotek will pay $49.5 million in cash and 3,284,180 shares of Flotek common stock for the outstanding shares of privately-held Florida Chemical."

The acquisition of Florida Chemical Company Inc. should prove to be a positive long-term acquisition for Flotek. Flotek Industries and Florida Chemical have been working together over 15 years on the development of specialty oilfield chemistries. Under the new agreement, Florida Chemical will have access to new sources of capital to continue its growth while Flotek will have additional research capabilities to meet growing demand for high-performance oilfield chemistries with an environmental focus.

Flotek intends to fund the cash portion of the acquisition ($49.5 million) through the proceeds from both a term loan and revolving credit facility. As indicated in Flotek's March 31st 10-Q report, the terms of the agreement with PNC Bank (NYSE:PNC) were as follows, "The interest rate on the term loan varies based on the level of borrowing under the revolving credit facility. Rates range between PNC Bank's base lending rate plus 1.5% to 2.0%". As of March 31st, Flotek was paying an interest rate of 4.75% to PNC Bank . To help supplement this loan and provide liquidity for Flotek, PNC Bank raised its total facility to $125 million to be comprised of a $50 million term loan (for the purchase of Florida Chemical) and a $75 million revolving credit facility.

As this purchase has added some debt to Flotek's bottom line, it is important to assess managements past performance regarding capital employed. To analyze this we must find the cost of debt, cost of equity and WACC. Once we establish this, we can find the cost of capital employed to see the efficiency of money borrowed.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

8. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.

9. Current tax rate

  • 2011 - $16 million / $49 million = 32.65%
  • 2012 - $8 million / $59 million = 13.56%
  • 2013 TTM - $6 million / $54 million = 11.11%

2011 - 2012 3-year average = 19.11%

From 2011 - 2013 TTM Flotek has averaged tax rate of 19.11%.

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors (for example, shareholders) to compensate for the risk they undertake by investing in their company.

  • Risk Free Rate = U.S. 10-year bond = 1.88% (Bloomberg)
  • Average Market Return 1950 - 2012 = 7%
  • Beta = (MSN Money) Flotek's Beta = 2.01

Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

  • 1.88 + 2.01 (7- 1.88)
  • 1.88 + 2.01 x 5.12
  • 1.88 + 10.29 = 12.17%

Currently, Flotek has a Cost of Equity or R Equity of 12.17%, so investors should expect to get a return of 12.17% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very "general." This approach is based off of the S&P average return from 1950 - 2012 at 7%, the U.S. 10-year bond for the risk-free rate, which is susceptible to daily change and Google Finance beta.)

Weighted Average Cost of Capital or WACC

The WACC calculation is a calculation of a company's cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 19.11%

Cost of Debt (before tax) or R debt = 5.25%

Cost of Equity or R equity = 12.17%

Debt (Total Liabilities) for 2013 TTM or D = $56 million

Stock Price = $17.52 (May 13th, 2013)

Outstanding Shares = 47.72 million

Equity = Stock price x Outstanding Shares or E = $836.05 million

Debt + Equity or D+E = $892.05 million

WACC = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .1911) x .0525 x ($0.056/$.89205) + .1217 ($.83605/$.89205)

.8089 x .0525 x .0628 + .1217 x .9372

.0027 + .1141

= 11.68%

Based on the calculations above, we can conclude that Flotek pays 11.68% on every dollar that it finances, or 11.68 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.1168 plus the cost of the investment for the investment to be feasible for the company.

From the information presented, we can conclude that Flotek has a cost of debt of 5.25%, cost of equity of 12.17% and WACC of 11.68%. Now that we have established how much money Flotek must make on its capital, the next step is to see if management has been able to make money on the capital employed.

Return on capital employed = EBIT / (Total Assets - Current Liabilities)

This ratio indicates the efficiency and profitability of a company's capital investments. The higher the percentage the better.

ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice-versa. A good ROCE is one that is greater than the rate at which the company borrows.

  • 2010 = $55 million / $198 million = 27.78%
  • 2012 = $53 million / $178 million = 29.78%
  • 2013 TTM = $58 million / $184 million = 31.52%

According to the list above, all of Flotek's calculated return on capital employed ratios are much higher than the rate at which it has borrowed. In fact, as the ratio has increased over the past couple years this implies that management has become more efficient and profitable with its capital employed.

On May 10th 2013, Flotek Industries purchased Florida Chemical Company for $49.5 million in cash and 3,284,180 shares of Flotek common stock. This acquisition looks to benefit both parties as, Florida Chemical will get capital to continue its growth while Flotek will have additional research capabilities. From a financial standpoint, Flotek had to add debt and increase it debt facility to pay for the purchase. This has added financial risk to the company and ultimately the shareholder. But, over the past few years management has proven to be efficient with its purchases, as the return on capital employed has been increasing and much higher than the company's cost of debt, cost of equity and most importantly the WACC.

Based on the information above, the addition of Florida Chemical looks to be a positive acquisition for Flotek industries. The acquisition will add research capabilities to meet the high demand for high-performance oilfield chemistries with an environmental focus. This in turn will add to the bottom line of the company over the long haul. As the bottom line improves for Flotek Industries this should add value to the stock price and ultimately the shareholder.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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