Energy Technologies Forum: Operating Leverage (NYSE: FET)
FET focuses on key objectives
Increased demand for drilling and completion equipment has prompted Forum Energy Technologies (NYSE: FET) to profit from sales of short-cycle products, including artificial lift products, new well completions and well workovers. He improved his operating leverage remarkably over the past year, thereby reducing the cost structure. In the medium term, the company will increase its share of activity in the control of methane emissions, the use and storage of carbon and offshore wind.
However, lower order backlog in the Drilling & Downhole and Completion segments hurt the near-term revenue outlook. In addition, supply chain constraints may reduce operating margin expansion. It has enough cash on the balance sheet, and in the event of converting convertible debt into equity, the balance sheet would deleverage significantly. I think this will reduce concerns about negative cash flow, and investors can hold the stock expecting slightly positive returns over the medium term.
In my previous article, I discussed FET’s business portfolio in more detail here. The company is subtly placed in the oil service industry so that it is somewhat insulated from sudden changes in industry drivers. Its sand management systems help operate electric submersible pumps efficiently. Its ROVs help operate offshore support vessels. Its high-strength tubing and grease-free cable allow drillers to complete more steps per month.
In addition to the legacy energy service model, it focuses on methane emissions control, carbon use and storage, and offshore wind. Although decarbonization is only a small part of its total revenue, the contribution is expected to grow as new technologies come to market and demand grows. Thus, it is partially isolated from the demand for services induced by energy prices.
Restructuring of costs and benefits of new products
The second key aspect of FET is the organizational restructuring and its portfolio optimization strategy. Profitability can be observed from the decrease in the cost structure. U.S. onshore rig count increased 14% in Q1 2022 compared to Q4 2021. With current rig count comparable to 2020, its profitability over the in fiscal 2021 exceeded fiscal 2020 by $40 million due to better operating leverage. However, it faces challenges related to supply chain delays and input price inflation. Additionally, to mitigate delivery delays, the company has taken on additional air freight and other shipping charges. These factors reduced its fourth quarter 2021 EBITDA by $4 million.
Some of the key additions to FET’s repertoire in the fourth quarter were Hawker Well Works and Reach Production Solutions. The acquisition of Reach has helped consolidate compression technology, which can extend to applications in artificial lift and emissions control. It strengthened its drilling investment product offering by adding products from Hawker, expanding the customer base and increasing operational efficiency. Acquired for $5.7 million, the acquisition is expected to add $2 million to EBITDA in 2022.
Guidance for the first quarter and fiscal year 2022
Supply chain disruption, commodity price inflation, rising wages, and last mile trucking issues can slightly slow the company’s revenue generation. Nevertheless, this will have a deeper impact on EBITDA in the first quarter. As such, management expects its first quarter revenue to grow 8% (at the midpoint of the forecast) from the fourth quarter of 2021. Adjusted EBITDA, however, may contract in the first quarter.
In fiscal 2022, logistical delays due to supply chain issues and other SG&A cost increases will continue. So, FET will try to mitigate this by raising prices. In addition, it builds up inventories of key products, which can increase costs in the short term. However, as we move forward, it may reduce the overall cost structure (assuming cost inflation continues) and improve profitability. Thus, in fiscal year 2022, management expects EBITDA to reach $50-60 million, which is 175% higher than in fiscal year 2021.
Fourth quarter segment value drivers
Drilling and downhole segment: Drilling & Downhole segment revenue increased 5.2% in Q4 2021 compared to Q3 2021, although operating margin declined. The main reason for the improved performance was higher sales of artificial mining products, the completion of new wells and well workovers, as well as the acceleration in international spending. Quarter-over-quarter, the segment’s order was down 27%.
Achievements Segment: The surge in sales of coiled tubing and stimulation products following the recovery of well completions activity in North America in recent quarters is reflected in the growth in revenues of the Completions segment (up 2.6 % from quarter to quarter). Additionally, during the quarter, the company introduced Enviro-Lite cables, which reduced the cost of upgrading customers’ corded units. However, the segment’s order fell sharply in the fourth quarter (~11% decline), which could lead to lower product delivery in the coming months.
Manufacturing segment: This segment experienced the highest revenue growth (8.4%) in Q4 compared to the previous quarter. The introduction of new products, including the marketing of vapor recovery units at the well site and storage facilities, helped gain market share. The order book swelled (+40.5%) during this period.
Cash flow and debt refinancing
Forum’s cash flow from operations (or CFO) turned negative (-$15.8 million) in fiscal 2021. In the first quarter, it plans to build inventory to ease channel constraints supply and make other necessary payments. Although year-over-year revenues remained stable, unfavorable changes in working capital contributed to the decline. Thus, the cash outflow may exceed the current level and the free cash flow may deteriorate further.
FET’s liquidity was $174 million as of December 31, 2021. Its leverage ratio was 0.71x as of that date. Investors may note that about half of its total debt ($232 million) is convertible into equity. Management also believes that a conversion is plausible given the current state of the industry, which can significantly reduce the balance sheet and increase the value of the company.
Forecast based on linear regression
Based on a regression equation between key industry indicators (crude oil prices, U.S. completion wells, and wells drilled) and reported FET revenues over the past seven years and previous four quarters, revenues are expected to remain stable over the next 12 months (or NTM 2022). The growth rate may accelerate in NTM 2023 but may decline sharply the following year.
Based on the regression model using projected revenue, I expect the company’s EBITDA to remain negative and deteriorate in NTM 2022. It may, however, recover in NTM 2023.
Target price and relative valuation
I calculated the EV using the EV/Revenue multiple of FET. The return potential using the forward EV/Income multiple (0.60x) is lower (17% upside) than the returns expected by analysts on the sell side (~33% upside) of the stock.
FET’s current EV/Revenue multiple (0.68x) versus the contraction of the forward EV/Revenue multiple implies an increase in revenue over the next four quarters. The contraction is less pronounced than the average fall of its peers (NINE, OIS and PTEN). This usually results in a lower EV/Income multiple than peers. The stock’s current EV/Revenue multiple is lower than that of its peers. It is therefore reasonably valued compared to its peers at the current level.
None of the analysts on the sell side rated FET “Buy”, while one rated it “Hold”. Additionally, none of the sell-side analysts noted a “sell”. The consensus target price is $30, which gives a yield of 34% at the current price. I think the stock price has a reasonable upside in the short term.
What is the take on FET?
Following the sharp rise in energy prices and other energy indicators, there is an increased demand for drilling and completion equipment. Thus, it now sells higher volumes of artificial lift products, new well completions and well workovers. International spending has also accelerated. One of the company’s main goals of late has been to focus on improving operating leverage and reducing the cost structure. Due to higher efficiency, its profit margin is better than comparable industry conditions a few years ago.
However, FET’s near-term outlook for drilling and downhole has deteriorated with a book-to-bill ratio of 0.9x. In addition, supply chain constraints may reduce operating margin expansion. Negative cash flow was a concern in fiscal 2021. As such, the stock has underperformed the VanEck Vectors Oil Services (OIH) ETF over the past year. However, since part of its debt is convertible into equity, it can deleverage the balance sheet considerably and increase the value of the company in the months to come. Investors can expect modest returns if they decide to hold the stock for the medium term.