Expect A Revenue Squeeze For FET
Forum Energy Technologies (FET) serves the drilling, subsea, completions, production and infrastructure business in the energy sector. Following the reduction in the upstream capex, the demand from capital equipment is slated to fall in 2019, which has reduced the company’s orders in Q1. I expect FET’s stock price to remain depressed in the short-term. However, if the crude oil price steadies at the current level, it can lead to improved upstream activity, which can increase the returns from this stock in the medium-to-long term.
FET aims to increase the marketing of the consumable products including flow iron and coiled tubing outside of North America, particularly in the Middle East, to drive growth in FY2019. Artificial lift products, frac trailers, and related power pump equipment are also likely to drive sales in the coming quarters. The company is working on reducing its inventory to streamline working capital management. With a heavy debt burden falling in 2021, it might need to improve FCF consistently to avoid financial risks in the medium-term.
Gazing Through The Current State Of Affairs
Forum Energy Technologies’ strategy is going through a shift in 2019. While it efficiently managed the well-cycles in the past through maintaining a balance between consumables and capital equipment, the upstream capex decline in 2019 has tilted the balance. Due to the reduction in the estimated capex, we notice a shift in demand from capital equipment to the consumable and replacement products. The company’s management believes that it has an advantage over its peers in the consumable products area, particularly in pressure pumping equipment making. In this category, higher-margin flow iron and consumable products are replacing the lower orders for power-ends intervention products. The other category where the company expects demand to escalate is the completions product category including coil pressure control equipment, tubing, and coiled line pipe, and wireline cable. Outside of North America, these products can see increased demand from international customers.
Given the demand pattern, I will now discuss FET’s recent product developments and technological innovation. In Q1 2019, it introduced 15000 PSI hydraulic latch assembly. On the high-pressure zipper frac wells, the latch system lets users use it remotely during hydraulic fracturing operations. In 2018, the company introduced the 10000 PSI version, and this year, it has added the 15000 PSI version to the customers for higher pressure wells.
In coiled tubing, FET has added DURACOIL and 130-grade coil tubing which improve the longevity of the coil for high-pressure horizontal wells. For midstream line pipe applications, it has introduced an abrasion-resistant overcoat for the coils line pipe.
The other achievement for the company was the rapid growth of its international sales. In Q1 2019, international sales amounted to $150 million, or 55% of the quarterly revenues. International business was boosted in recent times through the shipments of casing hardware products to Latin America and Asia and a significant order for subsea coiled line pipe into the Middle East. Historically, coiled tubing accounted for 30% of the company’s total international orders. On top of that, the company found customer inquiry for subsea ROVs, artificial lift products, capital equipment for land rigs, and drill pipe handling tools in its international operations. The company’s artificial lift products have been centered on the ESP (electrical submersible pump) completions. It was able to increase artificial lift market share in North America and the Permian basin in the past few years. Because these products are fitted with protection equipment, which acts as a safety measure, they are increasingly considered as a preferred choice for many large international operators.
In this context, I will discuss the sales trend for a couple of FET’s key products. The company’s valves business, which depends on infrastructure spending by the midstream and downstream sectors, did not have a good quarter. Sales fell in Q1 because the PVF distributors in North America and the Middle East drove down their working capital, and hence, generated lower demand. It might take a few quarters for FET to improve market share in this business. The other critical determinant for the company’s sales is the outlook for frac pump orders in 2019. The company sees increasing demand for a newer generation of power-ends both 2,500 and 3,000 horsepower. Accordingly, the company’s frac trailers and related power pump equipment sales are likely to increase.
Analyzing The Segment Value Drivers
Drilling & Downhole segment: Given the abovementioned trends in the industry, let us now look at FET’s performance and value drivers in each of its operating segments. In the Drilling & Downhole segment, revenues decreased by 3% in Q1 2019 compared to Q4 2018, although it did improve over a year ago (11.4% up). The U.S rig count declined by 7% during Q1, while the international rig count remained nearly unchanged compared to a quarter ago. The company also saw lower revenue recognition of subsea projects, which pulled revenues down. However, improved sales of artificial lift products partially offset the downward pressure. The segment outlook also seems less bright if we take into account the change in order growth. From Q4 2018 to Q1 2019, the segment order declined by 8%, leaving a book-to-bill ratio of 0.95. A book-to-bill ratio of greater than one indicates an improvement in market demand, while a ratio of less than one suggests a falling demand
Completions segment: Here, revenues remained nearly unchanged compared to a quarter ago, although it increased by 11.7% compared to a year ago. The revenue addition from the delivery of Coiled Tubing line pipe project to a customer in the Middle East was mitigated by lower sales of stimulation and intervention equipment. However, a higher mix of high-margin pressure pumping consumables and Coiled Tubing products benefited the segment adjusted EBITDA margin. The segment order weakened in Q1 (24% down), which once again puts a question mark on the future revenue generation capability. The segment book-to-bill ratio was 0.85 in Q1 2019.
Production segment: In this segment, revenue increased marginally in Q1 compared to Q4, but declined by 5% versus a year ago. Improved demand for the company’s high-margin upstream and midstream valves not only increased revenues, it helped expand the segment EBITDA margin as well. The segment revenue outlook is more favorable because orders increased by 5.7% in Q1 compared to a quarter ago. The segment book-to-bill ratio was 0.87 in Q1.
Outlook And Cost Minimization
A couple of new orders are lately changing FET’s perspective. Early in Q2, it received a large subsea capital equipment order for a defense contractor. It also received orders for three Perry XLX-C work-class ROVs (remotely operated vehicle systems) to be delivered in Q4 2019 and early 2020.
Overall, the company’s management does not expect revenues to change much in Q2 2019 compared to Q1. There has been downward pressure on the company’s capital equipment backlog as was noticed in Q1. On the other hand, positive drivers are a higher demand for consumable products and increased international activity. The company also aims to increase EBITDA on a year-over-year basis. To this extent, it has undertaken various cost reduction measures. To reduce its overhead costs, it exited the Houston distribution facility and relocated finished goods to the U.S. based manufacturing plants. The exercise will help minimize rent and personal expenses and reduce inventory. To reduce inventory, FET is also trying to foster partnerships with key vendors and increase sales of older inventories. As a result, net inventory decreased successively in Q4 2018 and Q1 2019. Lower inventory is expected to add to the company’s free cash flow in FY2019.
Regarding inventory reduction, the company commented the following in the Q1 earnings call:
We have excess inventory that we can work down and I think we’ve got the programs in place to do that. And so I think those are going to be the two big drivers, cash flow from operations, converting EBITDA to cash, and then working down the inventory balance. And I think that’s not just a onetime thing, but that’s going to be a continuing source of cash for quite a few quarters here.
Free Cash Flow And Debt Level
In Q1 2019, FET’s cash flow from operations (or CFO) turned positive, which was an improvement over the negative CFO in Q1 2018. Higher revenues in Q1 2019 and an improvement in working capital led to the rise in CFO. Due to the increase in CFO, its free cash flow (or FCF) also turned positive in Q1 2019 compared to a negative FCF a year ago. In FY2019, the company expects capex to decrease by ~17% compared to FY2018.
One of the FET’s goals is to achieve higher free cash flow generation in 2H 2019 through a reduction in inventory, which the company can use to reduce debt and improve liquidity. I have already discussed that earlier in the article.
The company’s long-term debt amounted to $488 million as of March 31. Its liquidity (borrowings under a revolver plus cash & equivalents) as of March 31 was approximately $224 million. Its debt-to-equity was 0.41x as of March 31, which was lower than Superior Energy Services’ (SPN) 3.0x as of March 31. However, some of its other peers like C&J Energy Services, Inc. (CJ) and Dril-Quip, Inc. (DRQ) have not debt. While the company has ~$53 million debt repayment in FY2019, the majority of its debt repayment obligations lies in 2121 ($554 million). Between the current free cash flow generation rate and liquidity, the company needs to increase free cash flow significantly to avoid the risks of debt default in the medium-term, unless it refinances the debt.
What Does The Relative Valuation Say?
Forum Energy Technologies is currently trading at an EV-to-adjusted EBITDA multiple of 22.6x. Based on sell-side analysts’ EBITDA estimates, the forward EV/EBITDA multiple is 9.9x. Between FY2013 and FY2018, FET’s average EV/EBITDA multiple was 10.7x. So, the stock is currently trading at a steep premium to its past average.
FET’s forward EV-to-EBITDA multiple contraction versus its adjusted trailing 12-month EV/EBITDA is steeper than the industry peers’ average multiple compression because the sell-side analysts expect the EBITDA to improve more sharply compared to the peers in the next four quarters. This would typically result in a higher current EV/EBITDA multiple compared to the peers’ average. Its EV/EBITDA multiple is significantly higher than its peers’ (SPN, CJ) average of 4.0x. (I have not considered DRQ’s extremely high current EV/EBITDA multiple coming off of a low EBITDA). I have used estimates provided by Thomson Reuters in this analysis.
According to data provided by Seeking Alpha, six sell-side analysts rated FET a “buy” in May (includes strong buys), while eight of them rated it a “hold”. None of the sell-side analysts rated a “sell”. The consensus target price is $6.98, which at the current price yields a 35% return.
What’s The Take On FET?
FET’s new order squeezed in Q1 2019 compared to Q4, with a book-to-bill ratio of less than one, which indicates deterioration in market demand. Following the reduction in the upstream capex, the demand from capital equipment is slated to fall in 2019.
On the other hand, FET increasingly looks to market flow iron and consumable products and coiled tubing products outside of North America, particularly in the Middle East, to drive growth in FY2019. FET’s artificial lift and well intervention products can also stimulate growth.
FET will work on reducing its inventory to streamline working capital management. But, the company has a relatively heavy debt burden in 2021. It might need to improve FCF consistently to service debt and meet its contractual obligations.
Given the top line pressure, I expect FET’s stock price to remain depressed in the short-term. However, its margin can improve due to an improved product mix and various cost reduction initiatives. If the crude oil price steadies at the current level, it can lead to enhanced upstream activity, which can increase the returns from this stock.
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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.