FET - Forum Energy Technologies: International Market Growth And Deleveraging Despite Cost Hikes

2023-03-19 04:19:57 ET

Summary

• Forum Energy expects international offshore markets to drive growth in 2023.
• Rig reactivation in the offshore market can benefit its mud systems and tubular handling businesses.
• Supply chain disruption and higher freight expenses affected its operating margin adversely.
• Despite negative cash flows, deleveraging has decreased its risk level.

FET Is On A Consolidation Path

I discussed in my previous article how Forum Energy Technologies (FET) management is focused on pursuing markets where it can commercialize its products. Continuing with that strategy, it now focuses on introducing new techniques like hydraulic fracturing operations without requiring a traditional zipper manifold. While its growth in the US may stay muted in 2023, the international market can spearhead its growth, mainly offshore, where rig reactivations are picking up. The company's book-to-bill ratio has maintained steady health, which would complement its topline growth trajectory.

The debt-to-equity conversion strengthened the balance sheet and allayed some of the concerns arising from negative cash flows. However, maintaining a steady operating margin has challenged the company due to supply chain issues and commodity price inflation. The stock is trading at a discount to the past average. Investors may do well to "hold" the stock at this level.

Analyzing The Industry

The company expects equipment utilization and service intensity to remain high as crude oil demand steadies. A stable demand incentivizes the operators to commit investment for an extended period, especially in the international markets. In the US, however, the growth trajectory is non-linear, with the expectation of moderate growth in 2023.

Many of FET's customers face limited spare capacity in oilfield equipment. They are essentially spending on replacing older models with more efficient and advanced items. The US drilled well count increased by 25% in the past year until February. The DUC wells, which were once continuously falling, have reversed course, although it is still down by 7% over the previous year. The drilling and completion industry growth has decelerated precipitously over the past couple of months.

New Applications And Techniques

FET looks to gain attention in hydraulic frac operations through its recent innovations after gaining a foothold in the completion market through wireline, conventional and greaseless cables. Its FASTConnect System can perform fracking without a traditional zipper manifold. It helps increase the stages completed per day and reduces operating costs. It also improves the ESG quotient of a frac fleet by eliminating 18 million pounds of grease from well sites per year, per its estimates. The company estimates that the solution has a target market size of $300 million to $500 million. The company has also recently won an electrostatic desalter system award for a contract value of $25 million.

The international market is the current focus, mainly because it now accounts for 40%-50% of its total revenue. It has strategically selected its manufacturing and distribution hubs in various parts of the world to supply efficiently. FET also observes the offshore market keenly because rig reactivation here can benefit its drilling capital products for mud systems and tubular handling operations. In the long run, it plans to gain from higher demand for inspection ROVs and related products.

Q1 2023 Guidance

FET's book-to-bill ratio improved to 1.13x in Q4 2022 from 1.09x a year ago. So, with a slightly higher book-to-bill ratio, the management expects its Q1 2023 revenues to remain nearly unchanged (at the guidance midpoint) compared to Q4 2022. Adjusted EBITDA can inflate by 9% in Q1. Despite higher operating profit, the management expects free cash flow to remain negative in Q1.

What Are The Challenges?

The primary challenge for FET is the effect of the supply chain disruption that can reduce its operating margin. In Q4, it incurred higher freight expenses, impacting nearly all its operating segments. On top of it, the steel price inflation reduced the margin in its coiled tubing and production equipment product lines. The company operates in an environment where a lag exists between the receipt of orders and ultimate shipment, and therefore, a price hike cannot have any immediate offsetting effect. But, the steel and freight costs are expected to normalize, and so can push the operating margin up in 2023.

Segment Value Drivers In Q4

Drilling & Downhole segment : Revenues increased by 7% in Q4 2022 compared to Q3 2022 in this segment. Increased demand for drilling handling tools and capital equipment mix drove the topline in Q4. However, subsea project costs increased freight expenses, and an unfavorable product mix adversely affected the segment's operating profit. Quarter-over-quarter, the segment order increased by ~19%.

Completions segment : The revenue growth was mild (2.6% up quarter-over-quarter) in Q4. The growth came primarily from higher wireline revenue. However, an unfavorable sales mix increased project costs in coiled tubing, and higher freight costs dampened the operating profit in this segment.

Production segment : This segment witnessed higher revenues (by 5%) in Q4 compared to the previous quarter. Despite the moderate growth, an improved book-to-bill ratio following orders in surface processing equipment and technology will enhance revenue visibility in 2023.

Cash Flows And Debt

The company's cash flows went further into the negative territory (-$17 million) in FY 2022 versus a year ago. Although year-over-year revenues increased, a higher inventory led to a cash flow decline. The management expects a negative free cash flow of $20 million-$30 million in Q1 2023.

FET's liquidity stood at $207 million as of December 31, 2022, while its debt-to-equity was 0.78x. During Q4, it reduced debt by converting long-term debt to common stock. Due to reduced leverage, FET's credit rating was upgraded in Q4. Lower debt also decreased its annual cash interest payments by $11 million. With liquidity nearly matching the long-term debt, the financial risks are low.

Why Do I Downgrade FET?

Earlier in 2022, FET was still seeing a robust backlog, with orders coming primarily from production equipment bookings. This was because the oilfield services companies were replacing capital components with consumable items and investing in equipment upgrades. I expected the company's cash flows to turn around quickly, which prompted me to give a "buy" rating. I wrote :

Currently, the company's electric line cables used in zipper and simul-frac operations and drilling product lines offering mud pump consumables are in strong demand. Much of the order growth is owed to oilfield services companies' replacement of capital components with consumable items and investment in equipment upgrades and new builds.

Since then, the energy industry has stagnated while the completion activities have moderated in the background of geopolitical uncertainty worldwide. The supply chain issues hit the company's ability to service and lowered its margin. But its order book has remained strong. It has focused more on international operations and has set up manufacturing and distribution hubs worldwide to supply efficiently. Given the cross-current, I changed my call from a "buy" to a "hold."

Relative Valuation

FET's forward EV/Revenue multiple is not available. So, it is impossible to compare it with its peers (NINE, OIS, and PTEN). Its current EV/Revenue multiple (0.76x) is lower than its five-year average of 0.83. So, the stock is currently trading at a discount to its past average.

What's The Take On FET?

FET is diversifying into hydraulic frac operations, which includes innovations like FASTConnect System. The international market, which accounts for a significant part of its total revenue, is the current focus after strategically selecting its manufacturing and distribution hubs worldwide to supply efficiently. The company's order booking also did not slow down in Q4, leading to improved revenue visibility into 2023. So, the stock performed nearly in line with the VanEck Vectors Oil Services ETF ( OIH ) in the past year.

Its cash flows were negative in FY2022. The company significantly improved its balance sheet by deleveraging through debt-to-equity conversion. It also maintains liquidity sufficient to match total debt. Given the low relative valuation multiples, you may consider holding the stock at this level.

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