FTS International's Recovery Is Not In Sight Yet

About: FTS International, Inc. (FTSI)
by: Badsha Chowdhury

Pricing pressure and completions activity slowdown will continue in Q1 2019.

FTS International’s in-house manufacturing allows it to produce fluid-end and power-end pressure pumps at low costs.

FTSI is reducing debt, but still has a high leverage ratio.

I do not expect FTSI’s stock price performance to improve in the short-term.

FTSI may continue to struggle in the short-term

FTS International (FTSI) provides hydraulic fracturing services in North America. It operates in the major unconventional basins including the Permian Basin, the SCOOP/STACK Formation, the Marcellus/Utica Shale, the Eagle Ford Shale and the Haynesville Shale. I do not expect FTSI’s stock price to show positive momentum in the short-term. The lack of hydraulic fracturing activity growth and an excess supply of frac equipment in the market have put substantial pressure on the pricing. The company, despite the de-leveraging process, still has a high debt-to-equity ratio.

To counter the headwinds, FTSI relies on its strong in-house manufacturing to minimize some of its operating costs. The company is focusing on the Northeast region, where growth is recovering. In the latter half of 2019, as the infrastructure bottleneck issues are resolved, the U.S. E&P industry should regain some momentum.

In the past year, FTS International’s stock price has crashed by 56% while VanEck Vectors Oil Services ETF (OIH) declined by nearly 34% during the same period. OIH represents the oilfield equipment & services (or OFS) industry.

Analyzing FTSI’s Q4 2018 performance

In Q4 2018, FTS International’s top line declined by 26% compared to Q3 2018. On a year-over-year basis, the company’s revenue declined even more sharply in Q4 2018. From Q4 2017 to Q4 2018, the revenues decreased by 46%. A large part of FTSI’s weaker Q4 performance can be attributed to lower pricing for FTSI’s offerings and lower hydraulic fracturing fleet count as demand for fracking fell steeply during Q4. FTSI’s bottom-line also weakened in Q4 2018. Its reported net income fell by 71% in Q4 2018 over a year ago. If you look at the industry indicators, it becomes obvious why the parameters went south for FTSI in Q4. The crude oil price decreased by 35% in Q4 over Q3. On top that, the industry witnessed a tightness in the upstream customers’ budget and a slowdown in completion activity due to the overbuild of frac horsepower. So a reduction in pressure pumping activity and pricing caused lower profit margin for FTSI.

Analyzing FTSI’s FY2018 performance

Despite the less-than-impressive result in Q4, FTSI’s FY2018 performance bettered the FY2017 results. During this period, its revenues and net income increased by 6.7% and 28.7%, respectively. Although the weakness was palpable in Q4, the WTI crude oil price did recover following the 2014-16 crash. From the beginning of 2018 till the end, the U.S. rig count remained resilient, while the number of completed wells in the EIA-designated key shales went up by 23%.

FTSI’s manufacturing base advantage

FTSI’s in-house manufacturing capability provides cost savings at the operating level, while it lowers its capex needs. The company’s manufacturing base helps protect margin, mainly when the growth potential is limited and cost management becomes essential. FTSI manufactures fluid-end and power-end pressure pumps at a cost that is significantly lower than purchasing them from outside suppliers. By the end of 2018, FTSI claims it increased the useful life of the fluid end pumps by ~40%. On-going design developments could add 20% extra life-span to the fluids. This can be a significant improvement because pressure pumps typically have high wear-and-tear costs involved. FTSI’s innovation also permeates into the identification of mechanical failures of rig components, where it analyses vibration data. It now uploads the operating data to the cloud to allow for improved decision making by making a real-time analysis. FTSI expects to field automated pump control by the end of 2019. The company’s management believes that the application of data analysis would further enhance the useful life and help reduce costs.

Such efficiencies and innovations would become the differentiator in the fracking equipment industry, which has already been hit by lower completion activity and upstream companies’ budget exhaustion. As has been noted historically, efficiency tends to fall in Q4 and Q1 following the holiday effect and winter when upstream activities subside. However, for Q1 2019, FTSI’s management did not more upbeat. Here is what the management explained in the Q4 call:

I think efficiencies will be up in the first quarter just because there was so much slack in the fourth quarter. In the second quarter we'll probably see an increase as well. But there's not a big surge of demand at this point that's enough to give pricing power to the pressure pumpers.

Sourcing regional sand: Investors may note that FTSI has been trying to improve its cost efficiency by sourcing more regional sands, which is cheaper than the Northern White Sands. Currently, it is pumping ~60% regional sand. However, due to its prior-commitment for fixed volume contracts for Northern White sand, its FY2018 adjusted EBITDA were worse off by $19.2 million. FTSI is actively looking to re-allocate a portion of its sand volume to the regional sand mines, which is likely to lead to higher operating margin in the coming quarters.

FTSI’s frac stages start to decline

FTSI prefers dedicated frac agreements, and to this objective, it strives to foster a long-term partnership with the upstream customers that have long-term drilling and completion goals. A stable relationship enables FTSI to drill more stages per month on contract, rather than changing drilling plans based on the spot market rate which can be volatile. A dedicated plan would typically encompass 12 months. In this background, let us see how FTSI’s drilling stages have been trending. While the metric has remained relatively steady from 2017 to 2018 on an annual basis, FTSI’s completed stages declined by ~14% in Q4 2018 compared to Q3 2018. This was primarily driven by fewer active fleets which averaged 19.3 in Q4 compared to 21.8 in Q3. Stages per count did not change much during this period. Lower stages reflect the current weakness in the hydraulic fracturing market.

FTSI’s outlook for Q1 and FY2019

Since the start of 2019, the crude oil price slippage seems to have halted. The WTI price has recovered by 24% so far in 2019, while the U.S. rig count has also steadied. By the end of FY2018, FTSI had 19 frac fleets. It now has 20 and expects to exit with 21 by Q1. However, the company has set a specific benchmark of $2 million average cash flow per fleet for re-deploying the fleets. Achieving this may not be easy for FTSI, especially given that its revenue per fleet declined by 16% in Q4 owing to the competitive pressure in the market and low demand. The company’s management expects pricing to drop by a further 10% in Q1 2019. Given that lower pricing contributed to half of the falling revenue in Q4, the effect of lower pricing could turn out to be significant in Q1.

So the pricing headwind will more than offset any efficiency gain in Q1 and would lower the adjusted EBITDA per fleet by $5 million. This translates into 38% lower adjusted EBITDA per average active fleet from the Q4-level.

Out of its 20 active fleets, FTSI has 12 these located in the Permian. While there has been an excess capacity of frac assets in the Permian following a production surge, there was a lack in corresponding capacity addition in infrastructure, namely takeaway pipeline build-up. The capacity bottleneck in the Permian has led to reduced local crude oil pricing as compared to WTI and Brent-linked benchmarks. So the region’s pipelines constraints have prompted its customers reducing their drilling and completion activities. In particular, the Mid-Con and South Texas region had low pricing power and seen fewer requests for proposal. This could be one of the reasons why FTSI looks beyond the Permian. The management expects the Northeast region to garner higher inquiry for upstream activities in Q1. This can improve FTSI’s outlook in 2019 because this region is expected to recover following a significant activity decline in 2H 2018.

FTSI’s balance sheet looks cleaner

FTSI repaid $625.0 million in FY2018, which more than halved its total debt as of December 31, 2018, compared to a year ago. In February 2018, the company issued shares and received net proceeds of $303.0 million from the offering. It used the money primarily for debt repayments. FTSI has continued to de-leverage in FY2019.

Despite the de-leveraging, FTSI’s debt-to-equity stands at 4.7x. Such high leverage ratio is the result of low shareholders’ equity following FTSI’s huge accumulated loss. Compared to FTSI, its peers Superior Energy Services (SPN) and Helmerich & Payne (HP) have much lower leverage (2.0x and 0.11x, respectively). RPC, Inc. (RES) has no debt.

FTSI’s liquidity (borrowings available under the revolving credit facility and cash & equivalents) totaled $384 million as of December 31. Approximately, $300 million of FTSI’s debt repayment obligation lies in the next one-to-three years, while $498 million is due to be repaid in the next three-to-five years.

FTSI’s cash flows

In FY2018, FTSI’s cash flow from operations (or CFO) was $385 million, which more than doubled since FY2017. On top of a mild increase in revenues in the past year, FTSI’s CFO improved due to significantly lower accounts receivable in FY2018. The company’s free cash flow was $284 million in FY2018. FTSI needs to maintain consistency in its cash flows in the medium-to-long-term to meet debt repayments. Otherwise, its de-leveraging process would come to a halt, which can increase financial risks if the crude oil price crashes and the energy market environment deteriorates.

What does FTSI’s relative valuation say?

FTSI is currently trading at an EV-to-adjusted EBITDA multiple of ~3.2x. Based on sell-side analysts’ estimates in the next four quarters, as pulled from Thomson Reuters, FTSI’s forward EV/EBITDA multiple is higher, which implies lower adjusted EBITDA in the next four quarters. FTSI is currently trading at a discount to its past four-quarter average.

FTSI’s forward EV/EBITDA multiple expansion versus the current multiple is significantly higher than the rise in the peers’ average, which typically reflects in lower current EV/EBITDA multiple compared to the peers. FTSI’s TTM EV/EBITDA multiple is lower than its peers’ (RES, SPN, and HP) average of 6.5x.

Analysts’ rating on FTSI

According to data provided by Seeking Alpha, seven analysts rated FTSI a “buy” in March (includes strong buys), while five recommended a “hold.” None of the sell-side analysts rated FTSI a “sell.” The analysts’ consensus target price for FTSI is $11.3, which at FTSI’s current price yields ~24% returns.

What’s the take on FTSI?

The completion activity slowdown coupled with infrastructure issues in some of the key unconventional resource shales in Q4 of 2018 has led to a steep fall in FTS International’s stock price. Sans growth, FTSI is looking for ways to reduce costs to save its margin. The lack of hydraulic fracturing activity growth and an excess supply of frac equipment in the market have put substantial pressure on the pricing. The company has already reduced its fleet size in response to the completions activity slowdown. To counter the headwinds, FTSI relies on its strong in-house manufacturing to minimize some of its operating costs.

FTSI’s difficulty is underlined by the fact that a majority of its asset base lies in the Permian, which was central to the infrastructure bottleneck issue. So FTSI is slowly shifting its asset base to the Northeast region, where growth is expected to recover. Also, the current industry headwinds are not expected to continue for long. In the latter part of this year, as the infrastructure bottleneck issues are resolved, the U.S. E&P industry should regain its momentum, thus bailing out shale frackers like FTSI. The company, despite the de-leveraging process, still has a high debt-to-equity ratio. The company might want to maintain consistency in its cash flows, going forward. I do not expect FTSI’s stock price to show positive momentum in the short-term.

Disclosure: I/we 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.