FTSI‘s Upside Is Limited
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 the stock price to exhibit positive momentum in the short term. How the company handles the pressure on margin will decide how it performs in the medium term.
The excess supply of frac equipment in the market has put substantial pressure on the pricing of the OFS companies, particularly the pressure pumpers. The company’s frac fleet is likely to fall further in Q3, given the lack of demand in the market. Also, despite the de-leveraging process, erratic cash flow, and a high debt-to-equity ratio can be a recipe for further trouble in the current energy market scenario. Despite the adverse developments, the share repurchase program, initiated in May, reflects the company’s belief in improving the stock price.
Frac Stages Start To Improve
In recent times, the two focus areas for FTSI include developing the fluids-end business and improving blenders. Over the past years, it made changes to the fluids-end, which allowed for more efficient flow to improve metallurgy. Alongside, it made improvements in sleeve technology, which helped reduce fluid end expense per pumping hour by 25% in the past two years. During the same period, trading pressure increased by 15%, thus improving efficiency. The company has also upgraded missiles using the vibration sensor data, which reduced the risks of capitation in the pressure pumps used for hydraulic fracturing.
In the use of information technology, the company aims to equip at least one fleet in 2019 with software, which will automatically take action unless manually intervened. The use of automation is expected to result in a better quality of stages completed.
FTSI’s strategy has undergone a strategic shift, given the upstream companies’ E&P budget pruning. While the company earlier preferred dedicated frac agreements, it now looks to strike transactions at the market price with the mid and large-cap E&P companies. The strategy has its advantages and disadvantages. A dedicated arrangement typically means a stable relationship rather than changing the drilling plans based on the volatile spot market rates. A specialized plan would typically encompass 12 months. The new method, on the other hand, enables it to earn high margins when the demand-supply balance becomes tighter. In the new environment, FTSI can generate significant cash flows that can be used to repay a substantial amount of debt.
The dual-threat of lower pressure pumping demand due to less-than-expected improvement in completions activity and an oversupply of fracking equipment has resulted in fleet reductions. The E&P companies’ capex budget cut aggravated the threats. Plus, higher efficiencies in completions job that have been achieved over the years have also softened demand. The competitive bidding in the spot market, especially from the smaller players, has maintained the pressure on the margin. As a result of the sluggish demand, the company is likely to stack two-to-three more rigs in Q3, which will affect its top-line adversely.
Of the 20 fleets that are in operations, nine are in the Delaware Basin, one is in the Midland Basin, three are in South Texas, three are in the Northeast, three are in Mid-Con, and one is in East Texas. The U.S. rig count has declined by ~4% by the end of August compared to a month ago. The softness in the spot price remains one of the primary concerns for FTSI. The current weakness in the price, led by upstream companies’ capital discipline, will likely resume activity in Q1 2020. At that point, the demand and supply balance in the fracking market will return, and the company might see an improvement in pricing.
The Recent Performance Drivers
In Q2 2019, FTS International’s top line was resilient (1% up) compared to Q1 2019. Year over year, however, revenues declined sharply, by 54%. Although volume was higher in Q2 over Q1, lower pricing could not attribute much to the profitability. The company’s bottom line did turn to a profit from a net loss in Q1. In Q1, charges related to supply commitments and asset impairments reduced net income.
FTSI increased the completed stages by ~7% in Q2 2019 compared to Q1 2019. On top of that, there were higher active fleets, averaging 21 in Q2 compared to 20 in Q1. Compared to Q2 2017, it pumped 16% longer stages and 12% more hours per day in Q2 2019. Despite the improvement in the metrics, the annualized adjusted EBITDA per average active fleet remained nearly unchanged in Q2.
In this context, it would be noteworthy to discuss on the sand supply commitments. These are the payments FTSI makes to the sand suppliers when its purchase falls short of the minimum purchase guarantees. Over the past couple of years, an increasing number of the company’s customers have been sourcing own sand from mines closer to their operating areas. As a result, the company recorded $56.7 million charges in FY2019 so far. In May 2019, it amended the most significant supply contract to reduce the total remaining annual commitment from $47.9 million to $21.0 million from 2019 through 2024. Following the restructuring, it recorded a supply commitment charge of $55.0 million in 1H 2019 and will incur $55 million charges in aggregate (or $11 million annually) from 2019 through 2024. The payments, however, be accelerated. Overall, the supply commitment charge will be much lower compared to the previous years and will improve the company’s margin. In another step to restructure the business, FTSI will discontinue its underperforming wireline operations. While an impairment charge was deducted in Q2, the proceeds from the sale will add to the cash in the coming quarters.
Looking at the industry indicators, it becomes apparent why the metrics have not been consistent. While the average crude oil price increased by 8.5% in Q2 over the previous quarter, it has declined by 7% in Q3 so far. In short, the crude oil price has been volatile since the latter half of 2018. On top of that, the industry witnessed tightness in the upstream customers’ budget and a slowdown in the completions activity. So, a reduction in pricing and pressure pumping activity caused a lower profit margin for FTSI. The fall in the DUC wells in the past four months until July points to the further slowdown in the completions activity.
Q3 2019 Guidance
FTSI plans to exit Q3 with 17 or 18 active fleets due to customers dropping fleets. The adjusted EBITDA per fleet is expected to be $7 million to $8 million, which would be ~6% lower than Q2. The fall in the EBITDA is due to the expected decline in pricing.
Deleveraging Is The Key
FTSI has continued to de-leverage in FY2019. In 1H 2019, it repaid $31 million of debt, while the sale of its interest in SinoFTS JV will bring down debt by a further $33 million in Q3. The company expects to reduce net debt by over $100 million in 2019. Earlier, in FY2018, it repaid $625 million, which more than halved its total debt.
Despite the de-leveraging, FTSI’s debt-to-equity stands at 8.1x due to low shareholders’ equity. The company’s accumulated loss over the past years until FY2017 has resulted in such a small equity base. Superior Energy Services (SPN) has similar leverage (7.1x), while Helmerich & Payne (HP) has much lower leverage (0.12x, respectively).
FTSI’s liquidity (borrowings available under the revolving credit facility and cash & equivalents) totaled $274 million as of June 30. Approximately $300 million of its 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.
In May 2019, FTSI initiated a $100 million share buyback program, which will be completed in the next 12 months. From April through June, it repurchased 761 thousand shares at an average price of $6.11. Currently, the stock is trading at a 59% discount to the average repurchase price. So, at this level, the stock price presents an opportunity for a buyback. Earlier, the company revealed an inclination to replace its debt reduction program with the repurchase program.
In 1H 2019, FTSI’s cash flow from operations (or CFO) was $47.3 million, which was a 73% decrease compared to a year ago, due primarily to the fall in revenues in the past year. The 1H 2019 cash flows would have been higher had the company not levied a provision for supply commitment charges. The company needs to maintain consistency in its cash flows in the medium-to-long-term to meet debt repayments. Else, if the energy market environment deteriorates, its leveraged balance sheet can spin out of control. Even bankruptcy is not out of the reckoning.
What Does The Relative Valuation Imply?
FTSI is currently trading at an EV-to-adjusted EBITDA multiple of ~4.5x. Based on sell-side analysts’ estimates, the forward EV/EBITDA multiple is slightly higher, which implies a marginally lower adjusted EBITDA in the next four quarters. The stock is currently trading in line with its past five-quarter average of 4.5x.
FTSI’s forward EV/EBITDA multiple expansion versus the current multiple is significantly less steep than peers because the sell-side analysts expect the company’s EBITDA to fall less sharply than peers. This typically results in higher current EV/EBITDA multiple compared to peers. The company’s EV/EBITDA multiple is lower than its peers’ (RES, SPN, and HP) average of 4.6x. So, the stock can be relatively undervalued at the current level. I have used estimates provided by Seeking Alpha in this analysis.
According to data provided by Seeking Alpha, three analysts rated FTSI a “buy” in September (includes “outperform”), while ten recommended a “hold.” None of the sell-side analysts rated a “sell.” The consensus target price is $4.57, which at the current price yields ~46% returns.
According to Seeking Alpha’s Quant Rating, the stock receives a “Very Bearish” rating. It scores poorly on growth, momentum, and EPS revisions, but has high-to-moderate ratings on profitability and value. Not only are FTSI’s year-over-year revenue growth rate lower than peers, but also it has been inconsistent over the past several quarters. So, I think Seeking Alpha’s low rating on growth is justified. The company’s EBITDA has been consistent over the past quarters except in Q2 when it incurred negative EBITDA. So, I think Seeking Alpha’s moderate rating on profitability is on target. I also think the low rating on EPS revision is also right, given that its earnings missed analysts’ estimates in three out of the past four quarters. I think its relative valuation multiple is above-par, as I discussed earlier in the article, and so, I would rate its value similar to Seeking Alpha.
What’s The Take On FTSI?
Given the lack of demand in the market, the company’s frac fleet is likely to reduce in Q3. Also, the pricing for fracking services will remain under pressure due to the oversupply of frac equipment in the market, particularly in the pressure pumping market. FTSI’s recent drop in cash flow and a high debt-to-equity ratio can be a recipe for further trouble in the current energy market scenario.
The supply attrition in the OFS equipment market and efficiency enhancement will eventually lead to an improvement in pricing. To its credit, the company continued to improve efficiency through higher completed stages and more hours per day. In May, the management initiated a share repurchase program, which reflects its belief in seeing a higher stock price. Going forward, it might want to maintain consistency in its cash flows to avoid further strains on the balance sheet. I do not expect FTSI’s stock price to exhibit positive momentum in the short term. How the company handles the pressure on margin will decide how it performs in the medium-term.
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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.