Forum Energy: International Market Growth and Deleveraging Despite Cost Increases (NYSE:FET)

FET is headed for consolidation

I discussed in my previous article how Forum Energy Technologies (NYSE:FET) management is focused on pursuing markets where it can commercialize its products. In continuation of that strategy, the focus is now on introducing new techniques such as hydraulic fracturing operations without requiring a traditional zipper manifold. While growth in the US may remain subdued in 2023, the international market may lead growth, mainly offshore where rig reactivation is underway. The company’s book-to-invoice ratio has maintained stable health, which would complement its top-line growth trajectory.

The debt-to-equity conversion strengthened the balance sheet and alleviated some of the concerns arising from negative cash flows. But maintaining a stable operating margin has challenged the company due to supply chain issues and commodity price inflation. The stock is traded at a discount compared to previous averages. Investors can do that good to “hold” the stock at this level.

Analysis of the industry

The company expects equipment utilization and service intensity to remain high as demand for crude oil increases. A stable demand encourages the operators to invest for a longer period, especially in the international markets. In the US, however, the growth path is non-linear, with expectations of moderate growth in 2023.

Many of FET’s customers face limited spare capacity in oilfield equipment. They essentially spend on replacing older models with more efficient and advanced items. The number of wells drilled in the US rose 25% in the past year through February. DUC wells, once in steady decline, have reversed course, although it is still down 7% year over year. Growth in the drilling and completions industry has slowed sharply over the past few months.

New applications and techniques

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

The international market is the current focus, primarily because it now accounts for 40%-50% of its total revenue. It has strategically selected its manufacturing and distribution centers in different parts of the world to deliver efficiently. FET is also keenly watching the offshore market because rig reactivation here could benefit its drilling capital products for mud systems and pipe 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, management expects its Q1 2023 revenue to remain almost flat (at the guidance midpoint) compared to Q4 2022. Adjusted EBITDA could grow by 9% in Q1 . Despite higher operating profit, the management expects the free cash flow to remain negative in the 1st quarter.

What are the challenges?

The primary challenge for FET is the effect of the supply chain disruption that could reduce its operating margin. In Q4, it incurred higher freight costs, which affected almost all of its operating segments. On top of that, steel price inflation reduced margins in its coiled pipe and production equipment product lines. The company operates in an environment where there is a delay between the receipt of orders and the final shipment, and therefore a price increase may not have an immediate offsetting effect. But steel and freight costs are expected to normalize, and may therefore push up the operating margin in 2023.

Segment value drivers in Q4

Drilling and borehole segment: Revenue increased by 7% in Q4 2022 compared to Q3 2022 in this segment. Increased demand for drill handling tools and capital equipment mix drove the top line in Q4. However, subsea project costs increased freight costs and an unfavorable product mix negatively impacted the segment’s operating results. Quarter-over-quarter, segment orders increased ~19%.

Closing segment: Revenue growth was mild (up 2.6% quarter-on-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 operating results in this segment.

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

Cash flow and debt

The company’s cash flow moved further into negative territory (-$17 million) in FY 2022 compared to a year ago. Although revenue increased year-over-year, higher inventory led to a decrease in cash flow. Management expects negative free cash flow of $20 million-$30 million in Q1 2023.

FET’s liquidity stood at $207 million per December 31, 2022, while its debt to equity was 0.78x. During the 4th quarter, it reduced debt by converting long-term debt into common stock. Due to reduced leverage, FET’s credit rating was upgraded in the 4th quarter. Lower debt also reduced its annual cash interest payments by $11 million. With liquidity almost equal to the long-term debt, the financial risks are low.

Why am I downgrading FET?

Earlier in 2022, FET still experienced a robust backlog, with orders primarily coming from production equipment bookings. This was due to oilfield service companies replacing capital components with consumables and investing in equipment upgrades. I expected the company’s cash flow to turn around quickly, prompting me to give a “buy” rating. I wrote:

Currently, the company’s electrical cables used in zip and simul-frac operations and drilling product lines that offer mud pump consumables are in high demand. Much of the order growth is due to oilfield service companies replacing capital components with consumables and investing in equipment upgrades and new construction.

Since then, the energy industry has stagnated, while completion activities have moderated amid geopolitical uncertainty worldwide. The supply chain problems hit the company’s ability to service and lowered its margin. But the order book remains strong. It has focused more on international operations and has established manufacturing and distribution hubs worldwide to deliver 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 is the position on FET?

FET is diversifying into hydraulic frac operations, which includes innovations such as the FASTConnect System. The international market, which accounts for a significant portion of its total revenue, is the current focus after strategically choosing its manufacturing and distribution hubs across the world to deliver efficiently. The company’s backlog also didn’t slow in Q4, leading to improved revenue visibility into 2023. So the stock performed almost in line with the VanEck Vectors Oil Services ETF (OIH) over 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 sufficient liquidity to match total debt. Given the low relative valuation multiples, you might consider holding the stock at this level.