10-K 1 ftk_10kx2016.htm 10-K Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2016
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                      to
Commission File Number 1-13270
 
floteka09.jpg
FLOTEK INDUSTRIES, INC.
(Exact name of registrant as specified in its charter)
 
 
 
 
 
Delaware
 
90-0023731
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
10603 W. Sam Houston Parkway N. #300
Houston, TX
 
77064
(Address of principal executive offices)
 
(Zip Code)
(713) 849-9911
(Registrant’s telephone number, including area code)
 
 
 
 
 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, $0.0001 par value
 
New York Stock Exchange, Inc.
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark:
•      if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No ý
•      if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No ý
•      whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨
•      whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨
•      if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
•      whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer ý Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨
•      whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No ý
The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2016 (based on the closing market price on the NYSE Composite Tape on June 30, 2016) was approximately $512,060,000. At January 31, 2017, there were 57,008,597 outstanding shares of the registrant’s common stock, $0.0001 par value.
DOCUMENTS INCORPORATED BY REFERENCE
The information required in Part III of the Annual Report on Form 10-K is incorporated by reference to the registrant’s definitive proxy statement to be filed pursuant to Regulation 14A for the registrant’s 2017 Annual Meeting of Stockholders.
 



TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


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FORWARD-LOOKING STATEMENTS
 
This Annual Report on Form 10-K (the “Annual Report”), and in particular, Part II, Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains “forward-looking statements” within the meaning of the safe harbor provisions, 15 U.S.C. § 78u-5, of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts but instead represent the Company’s current assumptions and beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside the Company’s control. The forward-looking statements contained in this Annual Report are based on information available as of the date of this Annual Report. The forward looking statements relate to future industry trends and economic conditions, forecast performance or results of current and future initiatives and the outcome of contingencies and other uncertainties that may have a significant impact on the Company’s business, future operating results and liquidity. These forward-looking statements generally are identified by words such as “anticipate,” “believe,” “estimate,” “continue,”“intend,” “expect,” “plan,” “forecast,” “project”
 
and similar expressions, or future-tense or conditional constructions such as “will,” “may,” “should,” “could” and “would,” or the negative thereof or other variations thereon or comparable terminology. The Company cautions that these statements are merely predictions and are not to be considered guarantees of future performance. Forward-looking statements are based upon current expectations and assumptions that are subject to risks and uncertainties that can cause actual results to differ materially from those projected, anticipated or implied. A detailed discussion of potential risks and uncertainties that could cause actual results and events to differ materially from forward-looking statements include, but are not limited to, those discussed in Part I, Item 1A – “Risk Factors” of this Annual Report and periodically in future reports filed with the Securities and Exchange Commission (the “SEC”).
The Company has no obligation to publicly update or revise any forward-looking statements, whether as a result of new information or future events, except as required by law.

 

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PART I
Item 1. Business.
General
Flotek Industries, Inc. (“Flotek” or the “Company”) is a global, diversified, technology-driven company that develops and supplies chemistry and services to the oil and gas industries, and high value compounds to companies that make cleaning products, cosmetics, food and beverages, and other products that are sold in consumer and industrial markets.
The Company was originally incorporated in the Province of British Columbia on May 17, 1985. In October 2001, the Company moved the corporate domicile to Delaware and effected a 120 to 1 reverse stock split by way of a reverse merger with CESI Chemical, Inc. (“CESI”). Since then, the Company has grown through a series of acquisitions and organic growth.
In December 2007, the Company’s common stock began trading on the New York Stock Exchange (“NYSE”) under the stock ticker symbol “FTK.” Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, (the “Exchange Act”) are posted to the Company’s website, www.flotekind.com, as soon as practicable subsequent to electronically filing or furnishing to the SEC. Information contained in the Company’s website is not to be considered as part of any regulatory filing. As used herein, “Flotek,” the “Company,” “we,” “our” and “us” refers to Flotek Industries, Inc. and/or the Company’s wholly owned subsidiaries. The use of these terms is not intended to connote any particular corporate status or relationship.
Recent Developments
During the fourth quarter of 2016, the Company initiated a strategic restructuring of its business to enable a greater focus on its core businesses in energy chemistry and consumer and industrial chemistry. The Company is executing a plan to sell or otherwise dispose of its Drilling Technologies and Production Technologies segments. An investment banking advisory services firm has been engaged and is actively marketing these segments. Effective December 31, 2016, the Company has classified the assets, liabilities, and results of operations for these two segments as “Discontinued Operations” for all periods presented.
In August 2016, the Company opened its new Global Research & Innovation Center. This state-of-the-art research facility fosters the development of next-generation innovative chemistries and permits expanded collaboration between clients, leaders from academia, and Company scientists. These collaborative opportunities are important and will distinguish the Company’s chemistry technologies and capability within the industry.
 
In July 2016, the Company acquired 100% of the stock and interests in International Polymerics, Inc. (“IPI”) and related entities for $7.9 million in cash consideration, net of cash acquired, and 247,764 shares of the Company’s common stock. IPI is a U.S. based manufacturer of high viscosity guar gum and guar slurry for the oil and gas industry with a wide selection of stimulation chemicals.
In January 2015, the Company acquired 100% of the assets of International Artificial Lift, LLC (“IAL”) for $1.3 million in cash consideration and 60,024 shares of the Company’s common stock. IAL specializes in the design, manufacturing and service of next-generation hydraulic pumping units that serve to increase and maximize production for oil and natural gas wells. The assets, liabilities, and results of operations of IAL are included in discontinued operations.
In April 2014, the Company acquired 100% of the membership interests in SiteLark, LLC (“SiteLark”) for $0.4 million in cash consideration and 5,327 shares of the Company’s common stock. SiteLark provides reservoir engineering and modeling services for a variety of hydrocarbon applications. Its services include proprietary software which assists engineers with reservoir simulation, reservoir engineering and waterflood optimization.
In January 2014, the Company acquired 100% of the membership interest in Eclipse IOR Services, LLC (“EOGA”), a leading Enhanced Oil Recovery (“EOR”) design and injection firm. The Company paid $5.3 million in cash consideration, net of cash received, and 94,354 shares of the Company’s Common Stock. EOGA’s enhanced oil recovery processes and its use of polymers to improve the performance of EOR projects has been combined with the Company’s existing EOR products and services.
Description of Operations and Segments
The Company’s continuing operations include two strategic business segments: Energy Chemistry Technologies and Consumer and Industrial Chemistry Technologies. The Drilling Technologies and Production Technologies segments are classified as discontinued operations.
The Company offers competitive products and services derived from technological advances, some of which are patented, that are responsive to industry demands in both domestic and international markets. Flotek operates and/or distributes its products in over 20 domestic and international markets.
Financial information about operating segments and geographic concentration is provided in Note 19 – “Segment and Geographic Information” in Part II, Item 8 – “Financial Statements and Supplementary Data” of this Annual Report.


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Information about the Company’s two continuing operating segments is below.
Energy Chemistry Technologies
The Energy Chemistry Technologies (“ECT”) segment designs, develops, manufactures, packages, and markets chemistries for use in oil and gas (“O&G”) well drilling, cementing, completion, and stimulation activities designed to maximize recovery in both new and mature fields. These specialty chemistries possess enhanced performance characteristics and are manufactured to withstand a broad range of downhole pressures, temperatures and other well-specific conditions to be compliant with customer specifications. This segment has technical services laboratories and a research and innovation laboratory that focus on design improvements, development and viability testing of new chemistry formulations, and continued enhancement of existing products. Chemistries branded Complex nano-Fluid® technologies (“CnF® products”) are patented both domestically and internationally and are proven strategically cost-effective performance additives within both oil and natural gas markets. The CnF® product mixtures are environmentally friendly, stable mixtures of plant derived oils, water, and surface active agents which organize molecules into nano structures. The combined advantage of solvents, surface active agents and water, and the resultant nano structures, improve well treatment results as compared to the independent use of solvents and surface active agents. CnF® products are composed of renewable, plant derived, cleaning ingredients and oils that are certified as biodegradable. CnF® chemistries help achieve improved operational and financial results for the Company’s customers in low permeability sand and shale reservoirs.
Consumer and Industrial Chemistry Technologies
The Consumer and Industrial Chemistry Technologies (“CICT”) segment sources citrus oil domestically and internationally and is one of the largest processors of citrus oils in the world. Products produced from processed citrus oil include (1) high value compounds used as additives by companies in the flavors and fragrances markets and (2) environmentally friendly chemistries for use in the oil & gas industry and numerous other industries around the world. The CICT segment designs, develops, and manufactures products that are sold to companies in the flavor and fragrance industries and specialty chemical industry. These technologies are used within food and beverage, fragrance, and household and industrial cleaning products industries.
Discontinued Operations
Drilling Technologies. The Drilling Technologies segment, reported as discontinued operations, provides downhole drilling tools for use in energy and mining activities. This segment assembles, rents, sells, inspects, and markets specialized equipment used in energy, mining, and industrial
 
drilling activities. Established tool rental operations are located throughout the United States (the “U.S.”) and in a number of international markets.
Production Technologies. The Production Technologies segment, reported as discontinued operations, provides pumping system components, electric submersible pumps (“ESPs”), gas separators, production valves, and complementary services. Through the Company’s acquisition of IAL, the Company provides a line of next generation hydraulic pumping units that serve to increase and maximize production for oil and natural gas wells.
Seasonality
Overall, operations are not significantly affected by seasonality. Certain working capital components build and recede throughout the year in conjunction with established purchasing and selling cycles that can impact operations and financial position. In particular, citrus oil inventories increase during the first and second quarters in-line with the citrus crop harvest and processing season. The performance of certain services within each of the Company’s segments can be susceptible to both weather and naturally occurring phenomena, including, but not limited to, the following:
the severity and duration of winter temperatures in North America, which impacts natural gas storage levels, drilling activity, and commodity prices;
the timing and duration of the Canadian spring thaw and resulting restrictions that impact activity levels;
the timing and impact of hurricanes upon coastal and offshore operations; and
adverse weather and disease can affect citrus crops in Florida and Brazil which can negatively impact the availability of citrus oils for the CICT business unit.
Product Demand and Marketing
Demand for the Company’s energy chemistry products and services is dependent on levels of conventional and non-conventional oil and natural gas well drilling and completion activity, both domestically and internationally. Products in both the Energy Chemistry Technologies and Consumer and Industrial Chemistry Technologies segments are marketed directly to customers through the Company’s direct sales force and through certain contractual agency arrangements. Established customer relationships provide repeat sales opportunities within all segments. While the Company’s primary marketing efforts remain focused in North America, a growing amount of resources and effort are focused on emerging international markets, especially in the Middle East and North Africa (“MENA”), Asia-Pacific, and South America. In addition to direct marketing and relationship development, the Company also markets products and services through the use of third party agents primarily in international markets.


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Customers
The Company’s customers primarily include major integrated oil and natural gas companies, oilfield service companies, independent oil and natural gas companies, pressure pumping service companies, international supply chain management companies, national and state-owned oil companies, household and commercial cleaning product companies, fragrance and cosmetic companies, and food manufacturing companies. In the two segments reported in continuing operations, the Company had two major customers for the year ended December 31, 2016, which accounted for 16% and 13% of consolidated revenue, three major customers for the year ended December 31, 2015, which accounted for 17%, 15%, and 11% of consolidated revenue, and one major customer for the year ended December 31, 2014, which accounted for 22% of consolidated revenue. In aggregate, the Company’s largest three customers collectively accounted for 36%, 43%, and 41% of consolidated revenue for the years ended December 31, 2016, 2015, and 2014, respectively.
Research and Innovation
The Company is engaged in research and innovation activities focused on the design of reservoir specific, customized chemistries in the Energy Chemistry Technologies segment and improvement of flavor and fragrance additives in the Consumer and Industrial Chemistry Technologies segment. In these two segments, for the years ended December 31, 2016, 2015, and 2014, the Company incurred $9.3 million, $6.7 million, and $4.8 million, respectively, of research and innovation expense. In 2016, research and innovation expense was approximately 3.5% of consolidated revenue. The Company expects that its 2017 research and innovation investment will increase in response to growth of the business.
Backlog
Due to the nature of the Company’s contractual customer relationships and the way they operate, the Company has historically not had significant backlog order activity.
Intellectual Property
The Company’s policy is to protect its intellectual property, both within and outside of the U.S. The Company considers patent protection for all products and methods deemed to have commercial significance and that may qualify for patent protection. The decision to pursue patent protection is dependent upon several factors, including whether patent protection can be obtained, cost-effectiveness, and alignment with operational and commercial interests. The Company believes its patent and trademark portfolio, combined with confidentiality agreements, trade secrets, proprietary designs, and manufacturing and operational expertise, are necessary and appropriate to protect its intellectual property and ensure continued strategic advantage. Within its continuing operations, the Company currently has 16 issued patents and over six dozen pending patent applications filed in the U.S.
 
and abroad on various chemical compositions and methods, and software methods. In addition, the Company currently has 59 registered trademarks and over three dozen pending trademark applications filed in the U.S. and abroad, covering a variety of its goods and services.
Competition
The ability to compete in the oilfield services industry and the consumer and industrial markets is dependent upon the Company’s ability to differentiate its products and services, provide superior quality and service, and maintain a competitive cost structure with sufficient raw material supplies. Activity levels in the oil field services industry are impacted by current and expected oil and natural gas prices, oil and natural gas drilling activity, production levels, and customer drilling and production designated capital spending. Domestic and international regions in which Flotek operates are highly competitive. The unpredictability of the energy industry and commodity price fluctuations create both increased risk and opportunity for the products and services of both the Company and its competitors.
Certain oil and natural gas service companies competing with the Company are larger and have access to more resources. Such competitors could be better situated to withstand industry downturns, compete on the basis of price, and acquire and develop new equipment and technologies, all of which could affect the Company’s revenue and profitability. Oil and natural gas service companies also compete for customers and strategic business opportunities. Thus, competition could have a detrimental impact upon the Company’s business.
The citrus-based terpene (d-limonene) is a major feedstock for many of the Company’s CnF® chemistries. In addition, the Company utilizes naturally derived terpenes from other sources and bio-based solvents from other natural sources when it determines the efficacy of such formulas is appropriate. The Company has the ability to purify these alternative solvents to ensure they meet Flotek’s rigorous environmental standards.
The Company’s Consumer and Industrial Chemistry Technologies segment faces competition from other citrus processors, flavor companies, and other solvent sources. Other terpenes and esters can provide an effective substitute to the Company’s citrus-based terpenes, although, without refinement and enhanced formulations efforts, are generally of lower quality. Such terpenes and esters can be cheaper than citrus terpenes, but, as noted above, can contain unfavorable characteristics and compounds that have varying degrees of toxicity and performance limitations. The Company’s chemistries are intended to replace these undesirable qualities. In addition, the segment’s flavor ingredients compete with synthetic and bio-engineered substitutes that are cheaper than natural flavors derived from citrus oils. These substitutes lack complexity and impact of the Company’s natural flavors and fragrances.


3


Raw Materials
Materials and components used in the Company’s servicing and manufacturing operations, as well as those purchased for sale, are generally available on the open market from multiple sources. Collection and transportation of raw materials to Company facilities, however, could be adversely affected by extreme weather conditions. Additionally, certain raw materials used by the chemistries segments are available from limited sources. Disruptions to suppliers could materially impact sales. The prices paid for raw materials vary based on energy, steel, citrus, guar, and other commodity price fluctuations, tariffs, duties on imported materials, foreign currency exchange rates, business cycle position, and global demand. Higher prices for chemistries, steel, citrus, guar, and other raw materials could adversely impact future sales and contract fulfillments.
The Company is diligent in its efforts to identify alternate suppliers, in its contingency planning for potential supply shortages and in its proactive efforts to reduce costs through competitive bidding practices. When able, the Company uses multiple suppliers, both domestically and internationally, to purchase raw materials on the open market.
Citrus greening disease has adversely affected the availability of citrus crops around the world, thereby negatively impacting the supply and increasing the price of citrus terpenes. The Company’s market position, inventory, and forward purchases helps ensure availability for its patented CnF® technologies, as well as its existing customer base within CICT. As mentioned previously, the Company has also developed new CnF® formulations utilizing alternative solvents. These new formulations not only diversify the Company’s dependence on citrus terpenes, but they also provide certain performance benefits necessary for specific customer and reservoir challenges.
Government Regulations
The Company is subject to federal, state, and local environmental, occupational safety, and health laws and regulations within the U.S. and other countries in which the Company does business. These laws and regulations strictly govern the manufacture, storage, transportation, sale, use, and disposal of chemistry products. The Company strives to ensure full compliance with all regulatory requirements and is unaware of any material instances of noncompliance.
The Company continually evaluates the environmental impact of its operations and attempts to identify potential liabilities and costs of any environmental remediation, litigation, or associated claims. Several products of the Energy Chemistry Technologies’ and Consumer and Industrial Chemistry Technologies’ segments are considered hazardous materials. In the event of a leak or spill in association with Company operations, the Company could be exposed to risk of material cost, net of insurance proceeds, to remediate any
 
contamination. No environmental claims are currently being litigated, and the Company does not expect that costs related to remediation requirements will have a significant adverse effect on the Company’s consolidated financial position or results of operations.
Employees
At December 31, 2016, the Company had 363 employees in its continuing operations and 154 employees in its discontinued operations segments, exclusive of existing worldwide agency relationships. None of the Company’s employees are covered by a collective bargaining agreement and labor relations are generally positive. Certain international locations have staffing or work arrangements that are contingent upon local work councils or other regulatory approvals.
Available Information and Website
The Company’s website is accessible at www.flotekind.com. Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available (see the “Investor Relations” section of the Company’s website), as soon as reasonably practicable, subsequent to electronically filing or otherwise providing reports to the SEC. Corporate governance materials, guidelines, by-laws, and code of business conduct and ethics are also available on the website. A copy of corporate governance materials is available upon written request to the Company.
All material filed with the SEC’s “Public Reference Room” at 100 F Street NE, Washington, DC 20549 is available to be read or copied. Information regarding the “Public Reference Room” can be obtained by contacting the SEC at 1-800-SEC-0330. Further, the SEC maintains the www.sec.gov website, which contains reports and other registrant information filed electronically with the SEC.
The 2016 Annual Chief Executive Officer Certification required by the NYSE was submitted on May 4, 2016. The certification was not qualified in any respect. Additionally, the Company has filed all principal executive officer and financial officer certifications as required under Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 with this Annual Report. Information with respect to the Company’s executive officers and directors is incorporated herein by reference to information to be included in the proxy statement for the Company’s 2017 Annual Meeting of Stockholders.
The Company has disclosed and will continue to disclose any changes or amendments to the Company’s code of business conduct and ethics as well as waivers to the code of ethics applicable to executive management by posting such changes or waivers on the Company’s website.



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Item 1A. Risk Factors.
The Company’s business, financial condition, results of operations, and cash flows are subject to various risks and uncertainties. Readers of this report should not consider any descriptions of these risk factors to be a complete set of all potential risks that could affect Flotek. These factors should be carefully considered together with the other information contained in this Report and the other reports and materials filed by the Company with the SEC. Further, many of these risks are interrelated and, as a result, the occurrence of certain risks could trigger and/or exacerbate other risks. Such a combination could materially increase the severity of the impact of these risks on our business, results of operations, financial condition, or liquidity.
This Annual Report contains “forward-looking statements,” as defined in the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements discuss Company prospects, expected revenue, expenses and profits, strategic and operational initiatives, and other activities. Forward-looking statements also contain suppositions regarding future oil and natural gas industry conditions, as well as market conditions impacting the consumer and industrial business, both domestically and internationally. The Company’s results could differ materially from those anticipated in the forward-looking statements as a result of a variety of factors, including risks described below and elsewhere. See “Forward-Looking Statements” at the beginning of this Annual Report.
Risks Related to the Company’s Business
The Company’s business is largely dependent upon domestic and international oil and natural gas industry spending, as well as consumer trends in the Company’s consumer and industrial business. Spending could be adversely affected by industry conditions, consumer trends or by new or increased governmental regulations, global economic conditions, the availability of credit, and lower oil and natural gas prices. All of these factors are beyond the Company’s control. The resulting reductions in customers’ expenditures could have a significant adverse effect on Company revenue, margins, and overall operating results.
The Company’s energy segment is dependent upon customers’ willingness to make operating and capital expenditures for exploration, development and production of oil and natural gas in both North American and global markets. Customers’ expectations of a decline in future oil and natural gas market prices could result in curtailed spending, thereby reducing demand for the Company’s products and services. Industry conditions are influenced by numerous factors over which the Company has no control, including the supply of and demand for oil and natural gas, domestic and international economic conditions, political instability in oil and natural gas producing countries and merger and divestiture activity among oil and natural gas producers and service companies.
 
The price for oil and natural gas is subject to a variety of factors, including, but not limited to:
global demand for energy as a result of population growth, economic development, and general economic and business conditions;
the ability of the Organization of Petroleum Exporting Countries (“OPEC”) to set and maintain production levels and the impact of non-OPEC producers on global supply;
availability and quantity of natural gas storage;
import and export volumes and pricing of liquefied natural gas;
pipeline capacity to critical markets;
political and economic uncertainty and socio-political unrest;
cost of exploration, production and transport of oil and natural gas;
technological advances impacting energy production and consumption; and
weather conditions.
The volatility of oil and natural gas prices and the consequential effect on exploration and production activity could adversely impact the activity levels of the Company’s customers.
One indicator of drilling and production spending is drilling activity as measured by rig count, which the Company actively monitors to gauge market conditions and forecast product and service demand. A reduction in drilling activity could cause a decline in the demand for, or negatively affect the price of, some of the Company’s products and services. Domestic demand for oil and natural gas could also be uniquely affected by public attitude regarding drilling in environmentally sensitive areas, vehicle emissions and other environmental standards, alternative fuels, taxation of oil and gas, perception of “excess profits” of oil and gas companies, and anticipated changes in governmental regulation and policy.
Volatile economic conditions could weaken customer exploration and production expenditures, causing reduced demand for the Company’s products and services and a significant adverse effect on the Company’s operating results. It is difficult to predict the pace of industry growth, the direction of oil and natural gas prices, the direction and magnitude of economic activity, and to what extent these conditions could affect the Company. However, reduced cash flow and capital availability could adversely impact the financial condition of the Company’s customers, which could result in customer project modifications, delays or cancellations, general business disruptions, and delay in, or nonpayment of, amounts that are owed to the Company. This could cause a negative impact on the Company’s results of operations and cash flows.


5


The Company’s consumer and industrial business is dependent on consumer demand for environmentally preferred solvents, as well as flavors and fragrances that are based on the unique attributes of citrus oils. Synthetic and bio-derived chemicals compete with the Company’s line of naturally derived products and could affect future demand.
Furthermore, if certain of the Company’s suppliers were to experience significant cash flow constraints or become insolvent as a result of such conditions, a reduction or interruption in supplies or a significant increase in the price of supplies could occur, adversely impacting the Company’s results of operations and cash flows.
The Company’s inability to develop and/or introduce new products or differentiate existing products could have an adverse effect on its ability to be responsive to customers’ needs and could result in a loss of customers, as well as adversely affecting the Company’s future success and profitability.
The oil and natural gas industry is characterized by technological advancements that have historically resulted in, and will likely continue to result in, substantial improvements in the scope and quality of oilfield chemistries and their function and performance. Consequently, the Company’s future success is dependent, in part, upon the Company’s continued ability to timely develop innovative products and services. Increasingly sophisticated customer needs and the ability to anticipate and respond to technological and operational advances in the oil and natural gas industry is critical. If the Company fails to successfully develop and introduce innovative products and services that appeal to customers, or if existing or new market competitors develop superior products and services, the Company’s revenue and profitability could deteriorate.
Consumer and industrial chemistry markets that purchase the Company’s citrus-based products are largely influenced by consumer preference and regulatory requirements. While citrus-based beverage flavorings, retail cleaning products, and fine fragrances perpetually rank high in consumer surveys, the Company’s continued success requires new product innovation to keep pace with consumer trends and regulatory issues.  If the Company fails to provide innovative products and services to its customers or to introduce performance products that comply with new environmental regulations, the Company’s financial performance could be impacted.
Increased competition could exert downward pressure on prices charged for the Company’s products and services.
The Company operates in a competitive environment characterized by large and small competitors. Competitors with greater resources and lower cost structures or who are trying to gain market share may be successful in providing competing products and services to the Company’s customers at lower prices than the Company currently charges. This may require the Company to lower its prices, resulting in an adverse impact on revenues, margins, and operating results.
 
If the Company is unable to adequately protect intellectual property rights or is found to infringe upon the intellectual property rights of others, the Company’s business is likely to be adversely affected.
The Company relies on a combination of patents, trademarks, copyrights, trade secrets, non-disclosure agreements, and other security measures to establish and protect the Company’s intellectual property rights. Although the Company believes that existing measures are reasonably adequate to protect intellectual property rights, there is no assurance that the measures taken will prevent misappropriation of proprietary information or dissuade others from independent development of similar products or services. Moreover, there is no assurance that the Company will be able to prevent competitors from copying, reverse engineering, modifying, or otherwise obtaining and/or using the Company’s technology and proprietary rights to create competitive products or services. The Company may not be able to enforce intellectual property rights outside of the U.S. Additionally, the laws of certain countries in which the Company’s products and services are manufactured or marketed may not protect the Company’s proprietary rights to the same extent as do the laws of the U.S. Furthermore, other third parties may infringe, challenge, invalidate, or circumvent the Company’s patents, trademarks, copyrights and trade secrets. In each case, the Company’s ability to compete could be significantly impaired.
A portion of the Company’s products and services are without patent protection. The issuance of a patent does not guarantee validity or enforceability. The Company’s patents may not necessarily be valid or enforceable against third parties. The issuance of a patent does not guarantee that the Company has the right to use the patented invention. Third parties may have blocking patents that could be used to prevent the Company from marketing the Company’s own patented products and services and utilizing the Company’s patented technology.
The Company is exposed and, in the future, may be exposed to allegations of patent and other intellectual property infringement from others. The Company may allege infringement of its patents and other intellectual property rights against others. Under either scenario, the Company could become involved in costly litigation or other legal proceedings regarding its patent or other intellectual property rights, from both an enforcement and defensive standpoint. Even if the Company chooses to enforce its patent or other intellectual property rights against a third party, there may be risk that the Company’s patent or other intellectual property rights become invalidated or otherwise unenforceable through legal proceedings. If intellectual property infringement claims are asserted against the Company, the Company could defend itself from such assertions or could seek to obtain a license under the third party’s intellectual property rights in order to mitigate exposure. In the event the Company cannot obtain a license, third parties could file lawsuits or other legal proceedings against the Company, seeking damages (including treble damages) or an injunction against the manufacture, use, sale, offer for sale, or importation of the


6


Company’s products and services. These could result in the Company having to discontinue the use, manufacture, and sale of certain products and services, increase the cost of selling certain products and services, or result in damage to the Company’s reputation. An award of damages, including material royalty payments, or the entry of an injunction order against the use, manufacture, and sale of any of the Company’s products and services found to be infringing, could have an adverse effect on the Company’s results of operations and ability to compete.
The loss of key customers could have an adverse impact on the Company’s results of operations and could result in a decline in the Company’s revenue.
The Company has critical customer relationships which are dependent upon production and development activity related to a handful of customers. In the two segments reported in continuing operations, revenue derived from the Company’s three largest customers as a percentage of consolidated revenue for the years ended December 31, 2016, 2015, and 2014, totaled 36%, 43%, and 41%, respectively. Customer relationships are historically governed by purchase orders or other short-term contractual obligations as opposed to long-term contracts. The loss of one or more key customers could have an adverse effect on the Company’s results of operations and could result in a decline in the Company’s revenue.
Loss of key suppliers, the inability to secure raw materials on a timely basis, or the Company’s inability to pass commodity price increases on to customers could have an adverse effect on the Company’s ability to service customer’s needs and could result in a loss of customers.
Materials used in servicing and manufacturing operations as well as those purchased for sale are generally available on the open market from multiple sources. Acquisition costs and transportation of raw materials to Company facilities have historically been impacted by extreme weather conditions. Certain raw materials used by the Energy Chemistry Technologies and the Consumer and Industrial Chemistry Technologies segments are available only from limited sources; accordingly, any disruptions to critical suppliers’ operations could adversely impact the Company’s operations. Prices paid for raw materials could be affected by energy, steel and other commodity prices; weather and disease associated with the Company’s crop dependent raw materials, specifically citrus greening; tariffs and duties on imported materials; foreign currency exchange rates; and phases of the general business cycle and global demand. The Energy Chemistry Technologies and the Consumer and Industrial Chemistry Technologies segments secure short and long term supply agreements for critical raw materials from both domestic and international vendors. The Drilling Technologies and Production Technologies segments, reported as discontinued operations at December 31, 2016, purchase critical raw materials on the open market and, where able, from multiple suppliers, both domestically and internationally.
 
The prices of key raw materials including citrus terpenes and natural polymers (guar) are subject to market fluctuations which at times can be significant and unpredictable. The Company may be unable to pass along price increases to its customers, which could result in an adverse impact on margins and operating profits. The Company currently uses purchasing strategies designed, where possible, to align the timing of customer demand with supply commitments. However, the Company currently does not hedge commodity prices, and there is no guarantee that the Company’s purchasing strategies will prevent cost increases from resulting in adverse impacts on margins and operating profits.
If the Company loses the services of key members of management, the Company may not be able to manage operations and implement growth strategies.
The Company depends on the continued service of the Chief Executive Officer and President, the Chief Financial Officer, the Executive Vice President, Operations, the Executive Vice President, Research and Development, and other key members of the executive management team, who possess significant expertise and knowledge of the Company’s business and industry. Furthermore, the Chief Executive Officer and President serves as Chairman of the Board of Directors. The Company has entered into employment agreements with all of these key members; however, at December 31, 2016, the Company only carries key man life insurance for the Chief Executive Officer and the Executive Vice President of Operations. Any loss or interruption of the services of key members of the Company’s management could significantly reduce the Company’s ability to manage operations effectively and implement strategic business initiatives. On November 2, 2016, Robert M. Schmitz notified the Company of his decision to retire as the Company’s Executive Vice President and Chief Financial Officer effective in the first quarter of 2017. The Company can provide no assurance that appropriate replacements for key positions could be found should the need arise.
Failure to maintain effective disclosure controls and procedures and internal controls over financial reporting could have an adverse effect on the Company’s operations and the trading price of the Company’s common stock.
Effective internal controls are necessary for the Company to provide reliable financial reports, effectively prevent fraud and operate successfully as a public company. If the Company cannot provide reliable financial reports or effectively prevent fraud, the Company’s reputation and operating results could be harmed. If the Company is unable to maintain effective disclosure controls and procedures and internal controls over financial reporting, the Company may not be able to provide reliable financial reports, which in turn could affect the Company’s operating results or cause the Company to fail to meet its reporting obligations. Ineffective internal controls could also cause investors to lose confidence in reported financial information, which could negatively affect the trading price of the Company’s common stock, limit the ability


7


of the Company to access capital markets in the future, and require additional costs to improve internal control systems and procedures.
Network disruptions, security threats and activity related to global cyber-crime pose risks to our key operational, reporting and communication systems.
The Company relies on access to information systems for its operations. Failures of or interference with access to these systems, such as network communications disruptions, could have an adverse effect on our ability to conduct operations or directly impact consolidated reporting. Security breaches pose a risk to confidential data and intellectual property, which could result in damages to our competitiveness and reputation. The Company has policies and procedures in place, including system monitoring and data back-up processes, to prevent or mitigate the effects of these potential disruptions or breaches. However, there can be no assurance that existing or emerging threats will not have an adverse impact on our systems or communications networks.
The Company may pursue strategic acquisitions, joint ventures, and strategic divestitures, which could have an adverse impact on the Company’s business.
The Company’s past and potential future acquisitions, joint ventures, and divestitures involve risks that could adversely affect the Company’s business. Negotiations of potential acquisitions, joint ventures, or other strategic relationships, integration of newly acquired businesses, and/or sales of existing businesses could be time consuming and divert management’s attention from other business concerns. Acquisitions and joint ventures could also expose the Company to unforeseen liabilities or risks associated with new markets or businesses. Unforeseen operational difficulties related to acquisitions and joint ventures could result in diminished financial performance or require a disproportionate amount of the Company’s management’s attention and resources. Additionally, acquisitions could result in the commitment of capital resources without the realization of anticipated returns. Divestitures could result in the loss of future earnings without adequate compensation and the loss of unrealized strategic opportunities.
If the Company does not manage the potential difficulties associated with expansion successfully, the Company’s operating results could be adversely affected.
The Company has grown over the last several years through internal growth, strategic alliances, and strategic business and asset acquisitions. The Company believes future success will depend, in part, on the Company’s ability to adapt to market opportunities and changes, to successfully integrate the operations of any businesses acquired, expansion of existing product and service lines, and potentially expand into new product and service areas in which the Company may not have prior experience. Factors that could result in strategic business difficulties include, but are not limited to: 
 
failure to effectively integrate acquisitions, joint ventures or strategic alliances;
failure to effectively plan for risks associated with expansion into areas in which management lacks prior experience;
lack of experienced management personnel;
increased administrative burdens;
lack of customer retention;
technological obsolescence; and
infrastructure, technological, communication and logistical problems associated with large, expansive operations.
If the Company fails to manage potential difficulties successfully, the Company’s operating results could be adversely impacted.
We may be exposed to liabilities or losses from operations that we have or will discontinue or otherwise sell, including our Drilling Technologies and Production Technologies segments.
During the fourth quarter of 2016, the Company initiated a strategic restructuring under which the Company plans to sell or otherwise dispose its Drilling Technologies and Production Technologies segments. Effective December 31, 2016, the Company has classified the assets, liabilities, and results of operations for these two segments as “Discontinued Operations” for all periods presented. We intend to sell as a going-concern or otherwise dispose of the two segments by the end of 2017; however, we cannot assure that we will complete a transaction under terms favorable to the Company, or even at all. Similarly, we may incur unanticipated additional costs in connection with the sale or disposition of the Drilling Technologies and Production Technologies segments. If we are not able to sell or dispose of the two segments on terms favorable to the Company, our business, prospects, financial condition or operating results could be harmed.
The Company’s ability to grow and compete could be adversely affected if adequate capital is not available.
The ability of the Company to grow and be competitive in the market place is dependent on the availability of adequate capital. Access to capital is dependent, in large part, on the Company’s cash flows and the availability of and access to equity and debt financing. The Company’s term and revolving loan agreements require approval and place limits on certain capital transactions and various business acquisitions and combinations. The Company cannot guarantee that cash flows will be sufficient, or that the Company will continue to be able to obtain equity or debt financing on acceptable terms, or at all. As a result, the Company may not be able to finance strategic growth plans, take advantage of business opportunities, or to respond to competitive pressures.


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The Company’s revolving credit facility and term loan have variable interest rates that could increase.
At December 31, 2016, the Company had a $55.2 million revolving credit facility commitment subject to collateral availability limits. The interest rate on advances under the revolving credit facility varies based on the level of borrowing. Rates range (a) between PNC Bank’s base lending rate plus 1.5% to 2.0% or (b) between the London Interbank Offered Rate (LIBOR) plus 2.5% to 3.0%. The Company is required to pay a monthly facility fee of 0.25% per annum, on any unused amount under the commitment based on daily averages. The current credit facility remains in effect until May 10, 2020.
The amount the Company borrowed under a term loan was reset to $10.0 million effective as of September 30, 2016. The interest rate on the term loan varies based on the fixed charge coverage ratio. Rates range (a) between PNC Bank’s base lending rate plus 2.25% to 2.75% or (b) between the London Interbank Lending Rate (LIBOR) plus 3.25% to 3.75%.
There can be no assurance that the revolving credit facility and the term loan will not experience significant interest rate increases.
Failure to collect for goods and services sold to key customers could have an adverse effect on the Company’s financial results, liquidity and cash flows.
The Company performs credit analysis on potential customers; however, credit analysis does not provide full assurance that customers will be willing and/or able to pay for goods and services purchased from the Company. Furthermore, collectability of international sales can be subject to the laws of foreign countries, which may provide more limited protection to the Company in the event of a dispute over payment. Because sales to domestic and international customers are generally made on an unsecured basis, there can be no assurance of collectability. If one or more major customers are unwilling or unable to pay its debts to the Company, it could have an adverse effect of the Company’s financial results, liquidity and cash flows.
Unforeseen contingencies such as litigation could adversely affect the Company’s financial condition.
The Company is, and from time to time may become, a party to legal proceedings incidental to the Company’s business involving alleged injuries arising from the use of Company products, exposure to hazardous substances, patent infringement, employment matters, commercial disputes, and shareholder lawsuits. The defense of these lawsuits may require significant expenses, divert management’s attention, and may require the Company to pay damages that could adversely affect the Company’s financial condition. In addition, any insurance or indemnification rights that the Company may have may be insufficient or unavailable to protect against potential loss exposures.
 
The Company’s current insurance policies may not adequately protect the Company’s business from all potential risks.
The Company’s operations are subject to risks inherent in the oil and natural gas industry, such as, but not limited to, accidents, blowouts, explosions, fires, severe weather, oil and chemical spills, and other hazards. These conditions can result in personal injury or loss of life, damage to property, equipment and the environment, as well as suspension of customers’ oil and gas operations. These events could result in damages requiring costly repairs, the interruption of Company business, including the loss of revenue and profits, and/or the Company being named as a defendant in lawsuits asserting large claims. The Company maintains insurance coverage it believes is adequate and customary to the oil and natural gas services industry to mitigate liabilities associated with these potential hazards. The Company does not have insurance against all foreseeable risks. Consequently, losses and liabilities arising from uninsured or underinsured events could have an adverse effect on the Company’s business, financial condition, and results of operations.
Regulatory pressures, environmental activism, and legislation could result in reduced demand for the Company’s products and services, increase the Company’s costs, and adversely affect the Company’s business, financial condition, and results of operations.
Regulations restricting volatile organic compounds (“VOC”) exist in many states and/or communities which limit demand for certain products. Although citrus oil is considered a VOC, its health, safety, and environmental profile is preferred over other solvents (e.g., BTEX), which is currently creating new market opportunities around the world. Changes in the perception of citrus oils as a preferred VOC, increased consumer activism against hydraulic fracturing or other regulatory or legislative actions by governments could potentially result in materially reduced demand for the Company’s products and services and could adversely affect the Company’s business, financial condition, and results of operations.
The Company is subject to complex foreign, federal, state and local environmental, health and safety laws and regulations, which expose the Company to liabilities that could adversely affect the Company’s business, financial condition, and results of operations.
The Company’s operations are subject to foreign, federal, state, and local laws and regulations related to, among other things, the protection of natural resources, injury, health and safety considerations, waste management, and transportation of waste and other hazardous materials. The Company’s operations expose the Company to risks of environmental liability that could result in fines, penalties, remediation, property damage, and personal injury liability. In order to remain compliant with laws and regulations, the Company maintains permits, authorizations and certificates as required


9


from regulatory authorities. Sanctions for noncompliance with such laws and regulations could include assessment of administrative, civil and criminal penalties, revocation of permits, and issuance of corrective action orders.
The Company could incur substantial costs to ensure compliance with existing and future laws and regulations. Laws protecting the environment have generally become more stringent and are expected to continue to evolve and become more complex and restrictive into the future. Failure to comply with applicable laws and regulations could result in material expense associated with future environmental compliance and remediation. The Company’s costs of compliance could also increase if existing laws and regulations are amended or reinterpreted. Such amendments or reinterpretations of existing laws or regulations, or the adoption of new laws or regulations, could curtail exploratory or developmental drilling for, and production of, oil and natural gas which, in turn, could limit demand for the Company’s products and services. Some environmental laws and regulations could also impose joint and strict liability, meaning that the Company could be exposed in certain situations to increased liabilities as a result of the Company’s conduct that was lawful at the time it occurred or conduct of, or conditions caused by, prior operators or other third parties. Remediation expense and other damages arising as a result of such laws and regulations could be substantial and have a material adverse effect on the Company’s financial condition and results of operations.
Material levels of the Company’s revenue are derived from customers engaged in hydraulic fracturing services, a process that creates fractures extending from the well bore through the rock formation to enable natural gas or oil to flow more easily through the rock pores to a production well. Some states have adopted regulations which require operators to publicly disclose certain non-proprietary information. These regulations could require the reporting and public disclosure of the Company’s proprietary chemistry formulas. The adoption of any future federal or state laws or local requirements, or the implementation of regulations imposing reporting obligations on, or otherwise limiting, the hydraulic fracturing process, could increase the difficulty of oil and natural gas well production activity and could have an adverse effect on the Company’s future results of operations.
Regulation of greenhouse gases and/or climate change could have a negative impact on the Company’s business.
Certain scientific studies have suggested that emissions of certain gases, commonly referred to as “greenhouse gases,” which include carbon dioxide, methane, and other volatile organic compounds, may be contributory to the warming effect of the Earth’s atmosphere and other climatic changes. In response to such studies, the issue of climate change and the effect of greenhouse gas emissions, in particular emissions from fossil fuels, is attracting increasing worldwide attention. For example, the Paris Agreement was signed in 2016, which sets forth a global framework to address climate change. Legislation and regulatory initiatives at the regional, state, and local level have been considered and in some cases adopted
 
in an effort to reduce greenhouse gases. Some states have individually or in regional cooperation imposed restrictions on greenhouse gas emissions under various policies and approaches, including establishing a cap on emissions, requiring efficiency measures, or providing incentives for pollution reduction, use of renewable energy sources, or use of replacement fuels with lower carbon content. In addition, the Environmental Protection Agency, the Bureau of Land Management, and some states have issued regulations that impose certain standards in an effort to limit greenhouse gas emissions from oil and gas exploration and production operations.
Existing or future laws, regulations, treaties, or international agreements related to greenhouse gases, climate change, and indoor air quality, including energy conservation or alternative energy incentives, could have a negative impact on the Company’s operations, if regulations resulted in a reduction in worldwide demand for oil, natural gas, and citrus oils. Other results could be increased compliance costs and additional operating restrictions, each of which could have a negative impact on the Company’s operations.
Changes in regulatory compliance obligations of critical suppliers may adversely impact our operations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), signed into law on July 21, 2010, includes Section 1502, which required the Securities and Exchange Commission to adopt additional disclosure requirements related to certain minerals sourced from the Democratic Republic of Congo and surrounding countries, or “conflict minerals,” for which such conflict minerals are necessary to the functionality of a product manufactured, or contracted to be manufactured, by an SEC-reporting company. The metals covered by these rules include tin, tantalum, tungsten and gold. The Company and Company suppliers use some of these materials in their production processes.
In 2014, the Company established management systems and processes and completed due diligence in compliance with the requirements of Section 1502. Future requirements for conducting Conflict Minerals due diligence may result in significant increased costs to the Company. Furthermore, failure of key suppliers to provide evidence of conflict free materials could impact the Company’s ability to acquire key raw materials and/or result in higher costs for those raw materials.
The Company and the Company’s customers are subject to risks associated with doing business outside of the U.S., including political risk, foreign exchange risk and other uncertainties.
Revenue from the sale of products to customers outside the U.S. has been steadily increasing. The Company and its customers are subject to risks inherent in doing business outside of the U.S., including, but not limited to:
governmental instability;
corruption;


10


war and other international conflicts;
civil and labor disturbances;
requirements of local ownership;
cartel behavior;
partial or total expropriation or nationalization;
currency devaluation; and
foreign laws and policies, each of which can limit the movement of assets or funds or result in the deprivation of contractual rights or appropriation of property without fair compensation.
Collections and recovery of rental tools from international customers and agents could also prove difficult due to inherent uncertainties in foreign law and judicial procedures. The Company could experience significant difficulty with collections or recovery due to the political or judicial climate in foreign countries where Company operations occur or in which the Company’s products are used.
The Company’s international operations must be compliant with the Foreign Corrupt Practices Act (the “FCPA”) and other applicable U.S. laws. The Company could become liable under these laws for actions taken by employees or agents. Compliance with international laws and regulations could become more complex and expensive thereby creating increased risk as the Company’s international business portfolio grows. Further, the U.S. periodically enacts laws and imposes regulations prohibiting or restricting trade with certain nations. The U.S. government could also change these laws or enact new laws that could restrict or prohibit the Company from doing business in identified foreign countries. The Company conducts, and will continue to conduct business in currencies other than the U.S. dollar. Historically, the Company has not hedged against foreign currency fluctuations. Accordingly, the Company’s profitability could be affected by fluctuations in foreign exchange rates.
The Company has no control over, and can provide no assurances that future laws and regulations will not materially impact the Company’s ability to conduct international business.
The Company’s tax returns are subject to audit by tax authorities. Taxing authorities may make claims for back taxes, interest, and penalties.
The Company is subject to income, property, excise, employment, and other taxes in the U.S. and a variety of other jurisdictions around the world. Tax rules and regulations in the U.S. and around the world are complex and subject to interpretation. From time to time, taxing authorities conduct audits of the Company’s tax filings and may make claims for increased taxes and, in some cases, assess interest and penalties. The assessments for back taxes, interest, and penalties could be significant. If the Company is unsuccessful in contesting these claims, the resulting payments could result in a drain on the Company’s capital resources and liquidity.
 
Risks Related to the Company’s Industries
General economic declines (recessions), limits to credit availability, and industry specific factors could have an adverse effect on energy industry activity, demand for flavor and fragrance products, and the Company’s citrus based solvents resulting in lower demand for the Company’s products and services.
Worldwide economic uncertainty can reduce the availability of liquidity and credit markets to fund the continuation and expansion of industrial business operations worldwide. The shortage of liquidity and credit combined with pressure on worldwide equity markets could continue to impact the worldwide economic climate. Unrest in the Middle East or other regions of the world may also impact demand for the Company’s products and services both domestically and internationally.
Demand for the Company’s energy segments’ products and services is dependent on oil and natural gas industry activity and expenditure levels that are directly affected by trends in oil and natural gas prices. Demand for the Company’s energy products and services is particularly sensitive to levels of exploration, development, and production activity of, and the corresponding capital spending by, oil and natural gas companies, including national oil companies. One indication of drilling and production activity and spending is rig count, which the Company monitors to gauge market conditions. Any prolonged reduction in oil and natural gas prices or drop in rig count could depress current levels of exploration, development, and production activity. Perceptions of longer-term lower oil and natural gas prices by oil and natural gas companies could similarly reduce or defer major expenditures given the long-term nature of many large-scale development projects. Lower levels of activity could result in a corresponding decline in the demand for the Company’s oil and natural gas well products and services, which could have a material adverse effect on the Company’s revenue and profitability.
The Company’s consumer and industrial customers would be adversely affected if economic activity decreased dramatically. One of the Company’s primary products, d-limonene, is often used to replace less desirable solvents in numerous consumer and industrial applications and is often more expensive than other materials. As economic activity decreases, consumer and industrial companies not only consume less solvent, they also may relax their environmental preferences and purchase cheaper solvents. Demand for the Company’s flavor and fragrance ingredients could be negatively impacted as a result of a decline in demand for consumer based products containing these ingredients. The Company’s revenue and profitability could be negatively impacted if demand for these products softens because of weak economic activity. Furthermore, the segment is a critical supplier of unique flavor and fragrance additives from citrus for use in major retail beverages and fragrances. Reformulations away from natural citrus ingredients by these


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major retail branded products would adversely affect the segment.
Events in global credit markets can significantly impact the availability of credit and associated financing costs for many of the Company’s customers. Many of the Company’s customers finance their drilling and production programs through third-party lenders or public debt offerings. Lack of available credit or increased costs of borrowing could cause customers to reduce spending on drilling programs, thereby reducing demand and potentially resulting in lower prices for the Company’s products and services. Also, the credit and economic environment could significantly impact the financial condition of some customers over a prolonged period, leading to business disruptions and restricted ability to pay for the Company’s products and services. The Company’s forward-looking statements assume that the Company’s lenders, insurers, and other financial institutions will be able to fulfill their obligations under various credit agreements, insurance policies, and contracts. If any of the Company’s significant lenders, insurers and others are unable to perform under such agreements, and if the Company was unable to find suitable replacements at a reasonable cost, the Company’s results of operations, liquidity, and cash flows could be adversely impacted.
A continuing period of depressed oil and natural gas prices could result in further reductions in demand for the Company’s products and services and adversely affect the Company’s business, financial condition, and results of operations.
The markets for oil and natural gas have historically been volatile. Such volatility in oil and natural gas prices, or the perception by the Company’s customers of unpredictability in oil and natural gas prices, could adversely affect spending. The oil and natural gas markets may be volatile in the future. The demand for the Company’s products and services is, in large part, driven by general levels of exploration and production spending and drilling activity by its customers. Continued weakness in oil and natural gas prices has caused a decline in exploration and drilling activities, as compared to prior peak periods, and a continuing weakness in oil and gas prices or further decreases could cause further declines in exploration and production activities. This, in turn, could result in lower demand in the future for the Company’s products and services and could result in lower prices for the Company’s products and services. Further declines in oil or natural gas prices could adversely affect the Company’s business, financial condition, and results of operations.
New and existing competitors within the Company’s industries could have an adverse effect on results of operations.
The oil and natural gas industry is highly competitive. The Company’s principal competitors include numerous small companies capable of competing effectively in the Company’s markets on a local basis, as well as a number of large companies that possess substantially greater financial and
 
other resources than does the Company. Larger competitors may be able to devote greater resources to developing, promoting and selling products and services. The Company may also face increased competition due to the entry of new competitors including current suppliers that decide to sell their products and services directly to the Company’s customers. As a result of this competition, the Company could experience lower sales or greater operating costs, which could have an adverse effect on the Company’s margins and results of operations.
The Company’s industry has a high rate of employee turnover. Difficulty attracting or retaining personnel or agents could adversely affect the Company’s business.
The Company operates in an industry that has historically been highly competitive in securing qualified personnel with the required technical skills and experience. The Company’s services require skilled personnel able to perform physically demanding work. Due to industry volatility, the demanding nature of the work, and the need for industry specific knowledge and technical skills, current employees could choose to pursue employment opportunities outside the Company that offer a more desirable work environment and/or higher compensation than is offered by the Company. As a result of these competitive labor conditions, the Company may not be able to find qualified labor, which could limit the Company’s growth. In addition, the cost of attracting and retaining qualified personnel has increased over the past several years due to competitive pressures. In order to attract and retain qualified personnel, the Company may be required to offer increased wages and benefits. If the Company is unable to increase the prices of products and services to compensate for increases in compensation, or is unable to attract and retain qualified personnel, operating results could be adversely affected.
Severe weather could have an adverse impact on the Company’s business.
The Company’s business could be materially and adversely affected by severe weather conditions. Hurricanes, tropical storms, flash floods, blizzards, cold weather and other severe weather conditions could result in curtailment of services, damage to equipment and facilities, interruption in transportation of products and materials, and loss of productivity. If the Company’s customers are unable to operate or are required to reduce operations due to severe weather conditions, and as a result curtail purchases of the Company’s products and services, the Company’s business could be adversely affected.
A terrorist attack or armed conflict could harm the Company’s business.
Terrorist activities, anti-terrorist efforts, and other armed conflicts involving the U.S. could adversely affect the U.S. and global economies and could prevent the Company from meeting financial and other obligations. The Company could experience loss of business, delays or defaults in payments


12


from payors, or disruptions of fuel supplies and markets if pipelines, production facilities, processing plants, or refineries are direct targets or indirect casualties of an act of terror or war. Such activities could reduce the overall demand for oil and natural gas which, in turn, could also reduce the demand for the Company’s products and services. Terrorist activities and the threat of potential terrorist activities and any resulting economic downturn could adversely affect the Company’s results of operations, impair the ability to raise capital, or otherwise adversely impact the Company’s ability to realize certain business strategies.
Risks Related to the Company’s Securities
The market price of the Company’s common stock has been and may continue to be volatile.
The market price of the Company’s common stock has historically been subject to significant fluctuations. The following factors, among others, could cause the price of the Company’s common stock to fluctuate significantly due to:
variations in the Company’s quarterly results of operations;
changes in market valuations of companies in the Company’s industry;
fluctuations in stock market prices and volume;
fluctuations in oil and natural gas prices;
issuances of common stock or other securities in the future;
additions or departures of key personnel;
announcements by the Company or the Company’s competitors of new business, acquisitions, or joint ventures; and
negative statements made by external parties, about the Company’s business, in public forums.
The stock market has experienced significant price and volume fluctuations in recent years that have affected the price of common stock of companies within many industries including the oil and natural gas industry. The price of the Company’s common stock could fluctuate based upon factors that have little to do with the Company’s operational performance, and these fluctuations could materially reduce the Company’s stock price. The Company could be a defendant in a legal case related to a significant loss of value for the shareholders. This could be expensive and divert management’s attention and Company resources, as well as have an adverse effect on the Company’s business, financial condition, and results of operations.
An active market for the Company’s common stock may not continue to exist or may not continue to exist at current trading levels.
Trading volume for the Company’s common stock historically has been very volatile when compared to companies with larger market capitalizations. The Company cannot presume that an active trading market for the Company’s common stock
 
will continue or be sustained. Sales of a significant number of shares of the Company’s common stock in the public market could lower the market price of the Company’s stock.
The Company has no plans to pay dividends on the Company’s common stock, and, therefore, investors will have to look to stock appreciation for return on investments.
The Company does not anticipate paying any cash dividends on the Company’s common stock within the foreseeable future. The Company currently intends to retain all future earnings to fund the development and growth of the Company’s business and to meet current debt obligations. Any payment of future dividends will be at the discretion of the Company’s board of directors and will depend, among other things, on the Company’s earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends, and other considerations deemed relevant by the board of directors. Additionally, the Company’s current credit facility restricts the payment of dividends without the prior written consent of the lenders. Investors must rely on sales of common stock held after price appreciation, which may never occur, in order to realize a return on their investment.
Certain anti-takeover provisions of the Company’s charter documents and applicable Delaware law could discourage or prevent others from acquiring the Company, which may adversely affect the market price of the Company’s common stock.
The Company’s certificate of incorporation and bylaws contain provisions that:
permit the Company to issue, without stockholder approval, up to 100,000 shares of preferred stock, in one or more series and, with respect to each series, to fix the designation, powers, preferences and rights of the shares of the series;
prohibit stockholders from calling special meetings;
limit the ability of stockholders to act by written consent;
prohibit cumulative voting; and
require advance notice for stockholder proposals and nominations for election to the board of directors to be acted upon at meetings of stockholders.
In addition, Section 203 of the Delaware General Corporation Law limits business combinations with owners of more than 15% of the Company’s stock without the approval of the board of directors. Aforementioned provisions and other similar provisions make it more difficult for a third party to acquire the Company exclusive of negotiation. The Company’s board of directors could choose not to negotiate with an acquirer deemed not beneficial to or synergistic with the Company’s strategic outlook. If an acquirer were discouraged from offering to acquire the Company or prevented from successfully completing a hostile acquisition by these anti-takeover measures, stockholders could lose the opportunity to sell their shares at a favorable price.


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Future issuance of additional shares of common stock could cause dilution of ownership interests and adversely affect the Company’s stock price.
The Company is currently authorized to issue up to 80,000,000 shares of common stock. The Company may, in the future, issue previously authorized and unissued shares of common stock, which would result in the dilution of current stockholders ownership interests. Additional shares are subject to issuance through various equity compensation plans or through the exercise of currently outstanding options. The potential issuance of additional shares of common stock may create downward pressure on the trading price of the Company’s common stock. The Company may also issue additional shares of common stock or other securities that are convertible into or exercisable for common stock in order to raise capital or effectuate other business purposes. Future sales of substantial amounts of common stock, or the perception that sales could occur, could have an adverse effect on the price of the Company’s common stock.
The Company may issue shares of preferred stock or debt securities with greater rights than the Company’s common stock.
Subject to the rules of the NYSE, the Company’s certificate of incorporation authorizes the board of directors to issue one or more additional series of preferred stock and to set the terms of the issuance without seeking approval from holders of common stock. Currently, there are 100,000 preferred shares authorized, with no shares currently outstanding. Any preferred stock that is issued may rank senior to common stock in terms of dividends, priority and liquidation premiums, and may have greater voting rights than holders of common stock.
 
The Company’s ability to use net operating loss carryforwards and tax attribute carryforwards to offset future taxable income may be limited as a result of transactions involving the Company’s common stock.
Under section 382 of the Internal Revenue Code of 1986, as amended, a corporation that undergoes an “ownership change” is subject to limitations on the Company’s ability to utilize pre-change net operating losses (“NOLs”), and certain other tax attributes to offset future taxable income. In general, an ownership change occurs if the aggregate stock ownership of certain stockholders increases by more than 50 percentage points over such stockholders’ lowest percentage ownership during the testing period (generally three years). An ownership change could limit the Company’s ability to utilize existing NOLs and tax attribute carryforwards for taxable years including or following an identified “ownership change.” Transactions involving the Company’s common stock, even those outside the Company’s control, such as purchases or sales by investors, within the testing period could result in an “ownership change.” Limitations imposed on the ability to use NOLs and tax credits to offset future taxable income could require the Company to pay U.S. federal income taxes in excess of that which would otherwise be required if such limitations were not in effect. Net operating losses and tax attributes could expire unused, in each instance reducing or eliminating the benefit of the NOLs and tax attributes. Similar rules and limitations may apply for state income tax purposes.
Disclaimer of Obligation to Update
Except as required by applicable law or regulation, the Company assumes no obligation (and specifically disclaims any such obligation) to update these risk factors or any other forward-looking statement contained in this Annual Report to reflect actual results, changes in assumptions or other factors affecting such forward-looking statements.


Item 1B. Unresolved Staff Comments.
Not applicable.

Item 2. Properties.
At December 31, 2016, the Company operated 32 manufacturing, warehouse, and research facilities in 12 U.S. states and one research facility in Calgary, Alberta. The Company owns 16 of these facilities and the remainder are
 
leased with lease terms that expire from 2017 through 2031. In addition, the Company’s corporate office is a leased facility located in Houston, Texas. The following table sets forth facility locations:


14


Segment
Owned/Leased
Location
Energy Chemistry
    Technologies
Owned
Carthage, Texas
 
Owned
Dalton, Georgia
 
Owned
Healdton, Oklahoma
 
Owned
Marlow, Oklahoma
 
Owned
Monahans, Texas
 
Owned
Waller, Texas
 
Leased
Calgary, Alberta
 
Leased
Houston, Texas
 
Leased
Hurst, Texas
 
Leased
Natoma, Kansas
 
Leased
Plano, Texas
 
Leased
Raceland, Louisiana
 
Leased
The Woodlands, Texas
Consumer and
Industrial
Chemistry
Technologies
Owned
Winter Haven, Florida
Discontinued Operations
Drilling
Technologies
Owned
Evanston, Wyoming
 
Owned
Houston, Texas
 
Segment
Owned/Leased
Location
Discontinued Operations
Drilling
Technologies
Owned
Midland, Texas
 
Owned
Oklahoma City, Oklahoma
 
Owned
Robstown, Texas
 
Owned
Vernal, Utah
 
Leased
Bossier City, Louisiana
 
Leased
Grand Prairie, Texas
 
Leased
New Iberia, Louisiana
 
Leased
Odessa, Texas
 
Leased
Pittsburgh, Pennsylvania
 
Leased
Wysox, Pennsylvania
Production
Technologies
Owned
Dickinson, North Dakota
 
Owned
Gillette, Wyoming
 
Owned
Vernal, Utah
 
Leased
Boyd, Texas
 
Leased
Denver, Colorado
 
Leased
Farmington, New Mexico
The Company considers owned and leased facilities to be in good condition and suitable for the conduct of business.


Item 3. Legal Proceedings.
Class Action Litigation
In November 2015, four putative securities class action lawsuits were filed in the United States District Court for the Southern District of Texas against the Company and certain of its officers. The lawsuits have been consolidated into a single case, and an amended complaint has been filed. The amended complaint asserts that the Company made false and/or misleading statements, as well as failed to disclose material adverse facts about the Company’s business, operations, and prospects. The complaint seeks an award of damages in an unspecified amount on behalf of a putative class consisting of persons who purchased the Company’s common stock between October 23, 2014 and November 9, 2015, inclusive.
In January 2016, three derivative lawsuits were filed, two in the District Court of Harris County, Texas (which have since been consolidated into one case), and one in the United States District Court for the Southern District of Texas, on behalf of the Company against certain of its officers and its current
 
directors. The lawsuits allege violations of law, breaches of fiduciary duty, and unjust enrichment against the defendants.
The Company believes the class action lawsuit and the derivative lawsuits are without merit, and it intends to vigorously defend against all claims asserted. Discovery has not yet commenced. At this time, the Company is unable to reasonably estimate the outcome of this litigation.
In addition, the U.S. Securities and Exchange Commission has opened an inquiry related to similar issues to those raised in the above-described litigation.
Other Litigation
The Company is subject to routine litigation and other claims that arise in the normal course of business. Management is not aware of any pending or threatened lawsuits or proceedings that are expected to have a material effect on the Company’s financial position, results of operations or liquidity.


Item 4. Mine Safety Disclosures.
Not applicable.



15


PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.


The Company’s common stock began trading on the NYSE on December 27, 2007 under the stock ticker symbol “FTK.” As of the close of business on January 31, 2017, there were 57,008,597 shares of common stock outstanding held by approximately 12,800 holders of record. The Company’s closing sale price of the common stock on the NYSE on January 31, 2017 was $10.57. The Company has never
 
declared or paid cash dividends on common stock. While the Company regularly assesses the dividend policy, the Company has no current plans to declare dividends on its common stock and intends to continue to use earnings and other cash in the maintenance and expansion of its business. Further, the Company’s credit facility contains provisions that limit its ability to pay cash dividends on its common stock.


The following table sets forth, on a per share basis for the periods indicated, the high and low closing sales prices of common stock as reported by the NYSE. These prices do not include retail mark-ups, mark-downs or commissions.
Fiscal quarter ended:
 
2016
 
2015
High
 
Low
 
High
 
Low
March 31,
 
$11.11
 
$5.52
 
$18.76
 
$14.35
June 30,
 
$13.82
 
$6.73
 
$18.87
 
$11.27
September 30,
 
$16.60
 
$12.88
 
$20.70
 
$11.62
December 31,
 
$14.84
 
$8.96
 
$20.98
 
$8.72


16


Stock Performance Graph
 
The performance graph below illustrates a five year comparison of cumulative total returns based on an initial investment of $100 in the Company’s common stock, as compared with the Russell 2000 Index and the Philadelphia Oil Services Index for the period beginning December 31, 2011 through December 31, 2016. The performance graph assumes $100 invested on December 31, 2011 in each of the Company’s common stock, the Russell 2000 Index, and the Philadelphia Oil Service Index and that all dividends were reinvested.
 

The following graph should not be deemed to be filed as part of this Annual Report, does not constitute soliciting material, and should not be deemed filed or incorporated by reference into any other filing of the Company under the Securities Act of 1933, as amended, or the Exchange Act, as amended, except to the extent the Company specifically incorporates the graph by reference.

ftk_10kx2016xchart-51625a02.jpg
  
 
December 31,
  
 
2011
 
2012
 
2013
 
2014
 
2015
 
2016
Flotek Industries, Inc.
 
$
100

 
$
122

 
$
202

 
$
188

 
$
115

 
$
94

Russell 2000 Index
 
$
100

 
$
115

 
$
157

 
$
163

 
$
153

 
$
183

Philadelphia Oil Service Index (OSX)
 
$
100

 
$
102

 
$
130

 
$
97

 
$
73

 
$
85



17


Securities Authorized for Issuance Under Equity Compensation Plans
Equity compensation plan information relating to equity securities authorized for issuance under individual compensation agreements at December 31, 2016 is as follows:
Plan Category
 
Number of Securities to be
Issued Upon Exercise of
Outstanding Options,
Warrants and Rights(1)
 
Weighted-Average Exercise
Price of Outstanding
Options, Warrants and Rights(2)
 
Number of Securities
Remaining Available for
Future Issuance Under
Equity Compensation Plans
(Excluding Securities
Reflected in Column(a))
  
 
(a)
 
(b)
 
(c)
Equity compensation plans approved by security holders
 
2,114,923

 
$
8.87

 
1,787,860

Equity compensation plans not approved by security holders
 

 
$

 

Total
 
2,114,923

 
$
8.87

 
1,787,860

(1)
Includes shares for outstanding stock options (663,288 shares), restricted stock awards (683,242 shares), and restricted stock unit share equivalents (768,393 shares).
(2)
The weighted-average exercise price is for outstanding stock options only and does not include outstanding restricted stock awards or restricted stock unit share equivalents that have no exercise price.

Issuer Purchases of Equity Securities
In November 2012, the Company’s Board of Directors authorized the repurchase of up to $25 million of the Company’s common stock. Repurchases may be made in open market or privately negotiated transactions. Through December 31, 2016, the Company has repurchased $20.1 million of its common stock under this repurchase program and $4.9 million may yet be used to purchase shares.
In June 2015, the Company’s Board of Directors authorized the repurchase of up to an additional $50.0 million of the Company’s common stock. Repurchases may be made in open market or privately negotiated transactions. Through December 31, 2016, the Company has not repurchased any of its common stock under this authorization and $50.0 million may yet be used to purchase shares.
Repurchases of the Company’s equity securities during the three months ended December 31, 2016 are as follows:
 
 
Total Number
of Shares
Purchased (1)
 
Average Price
Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
 
Maximum Dollar Value
of Shares that May Yet be
Purchased Under the
Plans or Programs (2)
October 1 to October 31, 2016
 
1,078

 
$
14.54

 

 
$
54,907,862

November 1 to November 30, 2016
 

 
$

 

 
$
54,907,862

December 1 to December 31, 2016
 
147,009

 
$
9.57

 

 
$
54,907,862

Total
 
148,087

 
$
9.61

 

 


(1)
The Company purchases shares of its common stock (a) to satisfy tax withholding requirements and payment remittance obligations related to period vesting of restricted shares and exercise of non-qualified stock options, (b) to satisfy payments required for common stock upon the exercise of stock options, and (c) as part of a publicly announced repurchase program on the open market.
(2)
A covenant under the Company’s Credit Facility limits the amount that may be used to repurchase the Company’s common stock. At December 31, 2016, this covenant limits additional share repurchases to $4.9 million.



18


Item 6. Selected Financial Data.
The following table sets forth certain selected historical financial data and should be read in conjunction with Part II, Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8 – “Financial Statements and Supplementary Data” of this Annual Report. The selected operating and financial position data as of and for each of the five years presented has been derived from audited consolidated Company financial statements, some of which appear elsewhere in this Annual Report. Financial data has been adjusted for discontinued operations, as indicated.
During the fourth quarter of 2016, the Company initiated a strategic restructuring of its business to enable a greater focus on its core businesses in energy chemistry and consumer and industrial chemistry. The Drilling Technologies and Production Technologies segments will be sold or otherwise disposed of and have been classified as “Discontinued Operations” for all periods presented because of this strategic shift in operations and the major effect it will have on operations and financial results.
 
During 2016 and 2015, the Company made one small acquisition each year, and in 2014, the Company made two small acquisitions. Insignificant non-recurring charges were incurred related to these acquisitions. The net income and non-recurring charges related to these acquisitions do not materially affect comparability.
Impairments recognized in 2016 and 2015 relate to the Drilling Technologies and Production Technologies segments and, therefore, are included in discontinued operations.
During 2013, the Company acquired Florida Chemical Company, Inc. for purchase consideration of $106.4 million.
During 2012, the Company recorded a reduction in the valuation allowance for deferred tax assets of $16.5 million and incurred losses on the extinguishment of debt of $7.3 million. Additionally, during 2012, the Company recorded $2.6 million of income for the change in the fair value of its warrant liability.


 
As of and for the year ended December 31,
 
2016
 
2015
 
2014
 
2013
 
2012
 
(in thousands, except per share data)
Operating Data
 
 
 
 
 
 
 
 
 
Revenue (1)
$
262,832

 
$
269,966

 
$
319,852

 
$
243,860

 
$
183,962

Income (loss) from operations (1)
(7,304
)
 
12,278

 
58,619

 
37,360

 
32,945

 
 
 
 
 
 
 
 
 
 
Income from continuing operations (1)
$
1,907

 
$
7,158

 
$
39,622

 
$
22,376

 
$
14,114

Income (loss) from discontinued operations, net of tax
(51,037
)
 
(20,620
)
 
13,981

 
13,802

 
35,677

Net (loss) income
$
(49,130
)
 
$
(13,462
)
 
$
53,603

 
$
36,178

 
$
49,791

 
 
 
 
 
 
 
 
 
 
(1) Amounts exclude impact of discontinued operations.
 
 
 
 
 
 
 
 
 
 
Per Share Data
 
 
 
 
 
 
 
 
 
Basic earnings (loss) per share:
 
 
 
 
 
 
 
 
 
Continuing operations
$
0.03

 
$
0.13

 
$
0.73

 
$
0.44

 
$
0.29

Discontinued operations, net of tax
(0.91
)
 
(0.38
)
 
0.26

 
0.27

 
0.74

Basic earnings (loss) per share
$
(0.88
)
 
$
(0.25
)
 
$
0.99

 
$
0.71

 
$
1.03

Diluted earnings (loss) per share:
 
 
 
 
 
 
 
 
 
Continuing operations
$
0.03

 
$
0.13

 
$
0.71

 
$
0.42

 
$
0.28

Discontinued operations, net of tax
(0.91
)
 
(0.37
)
 
0.25

 
0.26

 
0.70

Diluted earnings (loss) per share
$
(0.88
)
 
$
(0.24
)
 
$
0.96

 
$
0.68

 
$
0.98

 
 
 
 
 
 
 
 
 
 
Financial Position Data
 
 
 
 
 
 
 
 
 
Total assets
$
386,588

 
$
403,090

 
$
423,276

 
$
375,581

 
$
219,867

Convertible senior notes, long-term debt, and capital
     lease obligations, less discount and current portion
7,833

 
18,255

 
25,398

 
35,690

 
22,455

Stockholders’ equity
287,343

 
293,651

 
306,003

 
249,752

 
154,730



19


Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the related Notes to the Consolidated Financial Statements included elsewhere in this Annual Report. The following information contains forward-looking statements, which are subject to risks and uncertainties. Should one or more of these risks or uncertainties materialize, actual results could differ from those expressed or implied by the forward-looking statements. See “Forward-Looking Statements” at the beginning of this Annual Report.
Basis of Presentation
During the fourth quarter of 2016, the Company classified the Drilling Technologies and Production Technologies segments as held for sale based on management’s intention to sell these businesses. The Company’s historical financial statements have been revised to present the operating results of the Drilling Technologies and Production Technologies segments as discontinued operations. The results of operations of Drilling Technologies and Production Technologies are presented as “Loss from discontinued operations” in the statement of operations and the related cash flows of these segments has been reclassified to discontinued operations for all periods presented. The assets and liabilities of the Drilling Technologies and Production Technologies segments have been reclassified to “Assets held for sale” and “Liabilities held for sale”, respectively, in the consolidated balance sheets for all periods presented.
Results of operations of the Drilling Technologies and Production Technologies segments for the years ended December 31, 2016, 2015, and 2014 are discussed below.
Executive Summary
Flotek is a global, diversified, technology-driven company that develops and supplies chemistry and services to the oil and gas industries, and high value compounds to companies that make cleaning products, cosmetics, food and beverages, and other products that are sold in consumer and industrial markets.
The Company’s oilfield business includes specialty chemistries and logistics. Flotek’s technologies enable its customers in pursuing improved efficiencies in the drilling and completion of their wells. The Company also provides automated bulk material handling, loading facilities, and blending capabilities. The Company sources citrus oil domestically and internationally and is one of the largest processors of citrus oil in the world. Products produced from processed citrus oil include (1) high value compounds used as additives by companies in the flavors and fragrances markets and (2) environmentally friendly chemistries for use in numerous industries around the world, including the oil and gas (“O&G”) industry.
 
Flotek operates in over 20 domestic and international markets. Customers include major integrated O&G companies, oilfield services companies, independent O&G companies, pressure-pumping service companies, national and state-owned oil companies, and international supply chain management companies. The Company also serves customers who purchase non-energy-related citrus oil and related products, including household and commercial cleaning product companies, fragrance and cosmetic companies, and food manufacturing companies.
Continuing Operations
The operations of the Company are categorized into two reportable segments: Energy Chemistry Technologies and Consumer and Industrial Chemistry Technologies.
Energy Chemistry Technologies designs, develops, manufactures, packages, and markets specialty chemistries used in O&G well drilling, cementing, completion, and stimulation. These technologies developed by Flotek’s Research and Innovation team enable customers to pursue improved efficiencies in the drilling and completion of wells.
Consumer and Industrial Chemistry Technologies designs, develops, and manufactures products that are sold to companies in the flavor and fragrance industries and specialty chemical industry. These technologies are used by beverage and food companies, fragrance companies, and companies providing household and industrial cleaning products.
Discontinued Operations
The Drilling Technologies and Production Technologies segments are classified as discontinued operations.
Drilling Technologies assembles, rents, sells, inspects, and markets downhole drilling equipment used in energy, mining, and industrial drilling activities.
Production Technologies assembles and markets production-related equipment, including pumping system components, electric submersible pumps (“ESP”), gas separators, valves, and services that support natural gas and oil production activities.
Market Conditions
The Company’s success is sensitive to a number of factors, which include, but are not limited to, drilling and well completion activity, customer demand for its advanced technology products, market prices for raw materials, and governmental actions.
Drilling and well completion activity levels are influenced by a number of factors, including the number of rigs in operation and the geographical areas of rig activity. Additional factors


20


that influence the level of drilling and well completion activity include:
Historical, current, and anticipated future O&G prices,
Federal, state, and local governmental actions that may encourage or discourage drilling activity,
Customers’ strategies relative to capital funds allocations,
Weather conditions, and
Technological changes to drilling and completion methods and economics.
Historical North American drilling activity is reflected in “TABLE A” on the following page.
Customers’ demand for advanced technology products and services provided by the Company are dependent on their recognition of the value of:
Chemistries that improve the economics of their O&G operations,
 
Chemistries that meet the need of consumer product markets, and
Chemistries that are economically viable, socially responsible, and ecologically sound.
Market prices for commodities, including citrus oils and guar, can be influenced by:
Historical, current, and anticipated future production levels of the global citrus (primarily orange) and guar crop,
Weather related risks,
Health and condition of citrus trees and guar plants (e.g., disease and pests), and
International competition and pricing pressures resulting from natural and artificial pricing influences.
Governmental actions may restrict the future use of hazardous chemistries, including, but not limited to, the following industrial applications:
O&G drilling and completion operations,
O&G production operations, and
Non-O&G industrial solvents.


TABLE A
2016
 
2015
 
2014
 
2016 vs. 2015 % Change
 
2015 vs. 2014 % Change
Average North American Active Drilling Rigs
 
 
 
 
 
 
 
 
 
United States
509

 
978

 
1,862

 
(48.0
)%
 
(47.5
)%
Canada
130

 
192

 
379

 
(32.3
)%
 
(49.3
)%
Total
639

 
1,170

 
2,241

 
(45.4
)%
 
(47.8
)%
Average U.S. Active Drilling Rigs by Type
 
 
 
 
 
 
 
 
 
Vertical
60

 
139

 
376

 
(56.8
)%
 
(63.0
)%
Horizontal
400

 
744

 
1,275

 
(46.2
)%
 
(41.6
)%
Directional
49

 
95

 
211

 
(48.4
)%
 
(55.0
)%
Total
509

 
978

 
1,862

 
(48.0
)%
 
(47.5
)%
Average North American Drilling Rigs by Product
 
 
 
 
 
 
 
 
 
Oil
471

 
835

 
1,745

 
(43.6
)%
 
(52.1
)%
Natural Gas
168

 
335

 
496

 
(49.9
)%
 
(32.5
)%
Total
639

 
1,170

 
2,241

 
(45.4
)%
 
(47.8
)%
Source: Rig count: Baker Hughes, Inc. (www.bakerhughes.com); Rig counts are the annual average of the reported weekly rig count activity.

21


ftk_10kx2016xchart-51944a02.jpgftk_10kx2016xchart-53665a02.jpg

During the year ended 2016, North American drilling activity saw a significant decline compared to 2015 and 2014, but started to recover during the second half of the year. Total average North American active drilling rig count in 2016 decreased by 45.4% from 2015 and 47.8% from 2014 to 2015. Average North American oil drilling rig activity decreased by 43.6% in 2016 compared to 2015, and 52.1% from 2014 to 2015. Average North American natural gas drilling rig count decreased by 49.9% in 2016 compared to 2015, and 32.5% from 2014 to 2015.
Average U.S. rig activity decreased by 48.0% in 2016 compared to 2015, and 47.5% from 2014 to 2015. Average Canadian rig count in 2016 decreased by 32.3% from 2015, and 49.3% from 2014 to 2015.
According to data collected by the U.S. Energy Information Administration (“EIA”), completions in the seven most prolific areas in the lower 48 states decreased 43.0% in 2016 compared to 2015 and 38.1% from 2014 to 2015.
Outlook for 2017
After a continuous decline in North American drilling rig activity beginning in mid-2014, the market began to gradually recover in the second quarter of 2016. Although a continuing recovery appears to be underway, the level of drilling and completion activity is still depressed compared to historical levels. Assuming the price for crude oil remains relatively stable and regulatory impediments are reduced, the Company expects North American oilfield activity to improve modestly throughout 2017.
During 2016, the Company continued to successfully promote the efficacy of its CnF® chemistries resulting in a 14.7% increase in CnF® sales volumes compared to 2015, despite a
 
45.4% decline in North American general oilfield activity. Although quarter to quarter performance may vary, the Company expects its Energy Chemistry Technologies sales to outperform market activity metrics over time by continuing to demonstrate the efficacy of its CnF® chemistries through comparative analysis of wells with and without CnF® chemistries, field validation results conducted by E&P companies, and the continuation of its direct-to-operator sales program known as the Flotek Store™. Whether operators purchase directly from Flotek or continue to purchase from oilfield distribution and service companies, E&P operators are benefiting from increased price transparency and a more direct relationship with Flotek’s technical expertise and supply chain.
In July 2016, the Company acquired 100% of the stock and interests in International Polymerics, Inc. (“IPI”) and related entities, a U.S. based manufacturer of high viscosity guar gum and guar slurry. The IPI business is being integrated into the Company’s Energy Chemistry Technologies segment as an important part of the Company’s expanding line of polymer based chemistries.
The Company’s success in promoting its patented and proprietary chemistries is supported through its industry leading research and innovation staff who provide customer responsive product innovation, as well as development of new products which are expected to expand the Company’s future product lines. During the third quarter of 2016, the Company completed its new Global Research & Innovation Center in Houston. This state-of-the-art facility allows for the development of next-generation innovative energy chemistries, as well as expanded collaboration between clients, leaders from academia, and Company scientists. These collaborative opportunities are an important and distinguishing capability within the industry.


22


The outlook for the Company’s consumer and industrial chemistries will be driven by the availability and demand for citrus oils, industrial solvents, and flavor and fragrance ingredients. Although current inventory and crop expectations are sufficient to meet the Company’s needs to supply its flavor and fragrance business, as well as both internal and external industrial markets, the market supply of citrus oils has declined in recent years due to the reduction in citrus crops caused by the citrus greening disease. This reduced supply has resulted in higher citrus oil prices and increased price volatility. The Company expects terpene prices to remain elevated for the foreseeable future. However, the Company expects its strong market position to enable it to maintain a stable supply of citrus oils for internal use and external sales. The Company expects to manage the impact of increasing terpene costs through the development of new product formulations and pricing strategies.
During the fourth quarter 2016, the Company implemented a strategic restructuring of its business to enable a greater focus on its core businesses in energy chemistry and consumer and industrial chemistry. The Company initiated a process to market for sale its Drilling Technologies and Production Technologies segments and has identified potential buyers. Marketing efforts are ongoing to ensure the completion of these sales during 2017.
 
Capital expenditures for continuing operations, exclusive of acquisitions, totaled $14.0 million in 2016, inclusive of $6.3 million for the completion of its Global Research & Innovation Center. The Company expects capital spending to be between $15 million and $20 million in 2017. The Company will remain nimble in its core capital expenditure plans, adjusting as market conditions warrant.
Changes to geopolitical, global economic, and industry trends could have an impact, either positive or negative, on the Company’s business. In the event of significant adverse changes to the demand for oil and gas production and/or the market price for oil and gas, the market conditions affecting the Company could change rapidly and materially. Should such adverse changes to market conditions occur, management believes the Company has access to adequate liquidity to withstand the impact of such changes while continuing to make strategic capital investments and acquisitions, if opportunities arise. In addition, management believes the Company is well-positioned to take advantage of significant increases in demand for its products should market conditions improve dramatically in the near term.


Results of Continuing Operations (in thousands): 
 
Year ended December 31,
 
2016
 
2015
 
2014
Revenue
$
262,832

 
$
269,966

 
$
319,852

Cost of revenue
172,154

 
173,660

 
189,088

Gross profit
90,678

 
96,306

 
130,764

Gross margin %
34.5
 %
 
35.7
%
 
40.9
%
Selling, general and administrative costs
80,150

 
70,276

 
61,236

Selling, general and administrative costs %
30.5
 %
 
26.0
%
 
19.1
%
Depreciation and amortization
8,530

 
7,108

 
6,141

Research and innovation costs
9,320

 
6,657

 
4,787

Gain on disposal of long-lived assets
(18
)
 
(13
)
 
(19
)
(Loss) income from operations
(7,304
)
 
12,278

 
58,619

Operating margin %
(2.8
)%
 
4.5
%
 
18.3
%
Gain on legal settlement
12,730

 

 

Interest and other expense, net
(2,282
)
 
(1,644
)
 
(1,749
)
Income before income taxes
3,144

 
10,634

 
56,870

Income tax expense
(1,237
)
 
(3,476
)
 
(17,248
)
Income from continuing operations
1,907

 
7,158

 
39,622

(Loss) income from discontinued operations, net of tax
(51,037
)
 
(20,620
)
 
13,981

Net (loss) income
$
(49,130
)
 
$
(13,462
)
 
$
53,603




23


Results for 2016 compared to 2015—Consolidated
Consolidated revenue for the year ended December 31, 2016, decreased $7.1 million, or 2.6%, from 2015. The decrease in revenue was due to an 11.9% decline in Energy Chemistry Technologies revenue driven by reduced oilfield market activity. This was partially offset by a 32.3% increase in Consumer and Industrial Chemistry Technologies revenue primarily related to increased citrus terpene prices.
Consolidated gross profit for the year ended December 31, 2016, decreased $5.6 million, or 5.8%, from 2015. Gross margin as a percentage of revenue decreased to 34.5% for the year ended December 31, 2016, from 35.7% in 2015, primarily attributable to increased inventory cost and direct costs associated with manufacturing in the Consumer and Industrial Chemistry Technologies segment, partially offset by higher volumes of all CnF® products sold in Energy Chemistry Technologies.
Selling, general and administrative (“SG&A”) expenses are not directly attributable to products sold or services provided. SG&A costs as a percentage of revenue rose from 26.0% to 30.5% for the year ended December 31, 2016, compared to 2015, as SG&A costs grew while revenues declined. SG&A costs increased $9.9 million, or 14.1%, for the year ended December 31, 2016, from 2015, primarily due to higher professional and legal fees and increased head count in the Energy Chemistry Technologies sales and support staff for new business lines.
Depreciation and amortization expense not included in gross profit for the year ended December 31, 2016, increased by $1.4 million, or 20.0%, from 2015. This increase was primarily attributable to the completion and equipping of the Global Research & Innovation Center in August 2016, along with other improvements to manufacturing facilities.
Research and Innovation (“R&I”) expense for the year ended December 31, 2016, increased $2.7 million, or 40.0%, from 2015. The increase in R&I is primarily attributable to Flotek’s commitment to remaining responsive to customer needs, increased demand, continued growth of our existing product lines, and the development of new chemistries which are expected to expand the Company’s intellectual property portfolio.
In December 2016, the Company recognized a gain of $12.7 million from a legal settlement related to disgorgement of potential short-swing trading profits from a stockholder.
Interest and other expense increased $0.6 million for the year ended December 31, 2016, compared to 2015, primarily due to the interest rate increases on the term loan and revolving credit facility effective March 31, 2016, and September 30, 2016, associated with the credit facility amendments.
The Company recorded an income tax provision of $1.2 million, yielding an effective tax provision rate of 39.3%, for the year ended December 31, 2016, compared to an income
 
tax provision of $3.5 million, yielding an effective tax provision rate of 32.7%, in 2015.
The Company implemented a strategic restructuring of its business to enable a greater focus on its core businesses in energy chemistry and consumer and industrial chemistry. The Company initiated a process to market for sale the Drilling Technologies and Production Technologies segments and has identified potential buyers. Marketing efforts are ongoing to ensure the completion of these sales during 2017. The Company recorded a net loss from discontinued operations of $51.0 million in 2016 for the classification of the Drilling Technologies and Production Technologies segments as held for sale.
Results for 2015 compared to 2014—Consolidated
Consolidated revenue for the year ended December 31, 2015, decreased $49.9 million, or 15.6%, from 2014. The decrease in revenue was primarily due to the drop in oilfield market activity as indicated by the 47.8% decrease in the average North American active rig count from 2014 to 2015. This resulted in the Energy Chemistry Technologies segment experiencing a decline in revenues due to the development of lower price point products and pricing related to strategic customer relationships for CnF® sales and reduced customer demand for non-CnF products. This was partially offset by increased revenue in the Consumer and Industrial Chemistry Technologies segment due to increased citrus pricing.
Consolidated gross profit for the year ended December 31, 2015, decreased $34.5 million, or 26.4%, from 2014. Gross margin as a percentage of revenue decreased to 35.7% for the year ended December 31, 2015, from 40.9% in 2014, primarily attributable to incentive pricing structures in Energy Chemistry Technologies.
Selling, general and administrative (“SG&A”) expenses are not directly attributable to products sold or services provided. SG&A costs as a percentage of revenue rose from 19.1% to 26.0% for the year ended December 31, 2015, compared to 2014, as SG&A costs grew while revenues declined. SG&A costs increased $9.0 million, or 14.8%, for the year ended December 31, 2015, from 2014, primarily due to higher stock
compensation expense and professional fees, increased head
count in the Energy Chemistry Technologies sales staff, increased bad debt expense, and a civil penalty related to an environmental matter assessed in the first quarter of 2015, partially offset by cost reduction actions taken throughout 2015.
Depreciation and amortization expense not included in gross profit for the year ended December 31, 2015, increased by $1.0 million, or 15.7%, from 2014. This increase was primarily attributable to the depreciation of improvements to facilities and equipment that were added during the later portion of 2014.
Research and Innovation (“R&I”) expense for the year ended December 31, 2015, increased $1.9 million, or 39.1%, from


24


2014. The increase in R&I is primarily attributable to Flotek’s commitment to remaining responsive to customer needs, increased demand and continued growth of our existing chemistry product lines and the new Houston R&I facility.
Interest and other expense decreased $0.1 million, or 6.0%, for the year ended December 31, 2015, compared to 2014.
 
The Company recorded an income tax provision of $3.5 million, yielding an effective tax provision rate of 32.7%, for the year ended December 31, 2015, compared to an income tax provision of $17.2 million, yielding an effective tax provision rate of 30.3%, in 2014.

Results by Segment

Energy Chemistry Technologies
 
 
 
 
 
(dollars in thousands)
Year ended December 31,
 
2016
 
2015
 
2014
Revenue
$
188,233

 
$
213,592

 
$
268,761

Gross profit
$
74,592

 
$
81,935

 
$
117,867

Gross margin %
39.6
%
 
38.4
%
 
43.9
%
Income from operations
$
29,014

 
$
43,902

 
$
84,846

Operating margin %
15.4
%
 
20.6
%
 
31.6
%

Results for 2016 compared to 2015—Energy Chemistry Technologies
Energy Chemistry Technologies revenue for the year ended December 31, 2016, decreased $25.4 million, or 11.9%, from 2015, compared to a 45.4% decline in market activity as measured by average North American rig count. Flotek’s Energy Chemistry Technologies segment outperformed these market indicators by continuing to aggressively promote the benefits of its CnF® chemistries. CnF® sales volumes increased 14.7% (revenues increased 11.6%) year over year. Non-CnF revenues declined approximately 40.8% due to reduced customer demand resulting from oilfield market conditions.
Sequentially, quarterly revenues increased 22.5% primarily from a 12.4% increase in CnF® volumes (21.4% increase CnF® in revenues). The Company initiated a significant new contract with a large operator and had increased sales to several operators and service companies.
Energy Chemistry Technologies gross profit for the year ended December 31, 2016, decreased $7.3 million, or 9.0%, from 2015, primarily due to the decline in revenue. Gross margin as a percentage of revenue for the year ended December 31, 2016, increased to 39.6%, compared to 38.4% in 2015. The increase in gross margin over the period is primarily due to higher sales volumes of all CnF® products.
Sequentially, margins in the fourth quarter 2016 were lower by 4.1% resulting from higher freight costs and field service costs associated with the startup of the new Prescriptive Chemistry Management™ (“PCM™”) service line, increased citrus terpene costs, and product mix.
Income from operations for the Energy Chemistry Technologies segment decreased $14.9 million, or 33.9%, for
 
the year ended December 31, 2016, compared to 2015. This decrease is primarily attributable to the decrease in gross profit, increased costs associated with sales and marketing efforts in pursuit of growth opportunities, and increased costs associated with the Company’s continued commitment to its research and innovation efforts within Energy Chemistry Technologies.
Results for 2015 compared to 2014—Energy Chemistry Technologies
Energy Chemistry Technologies revenue for the year ended December 31, 2015, decreased $55.2 million, or 20.5%, from 2014, compared to a 47.8% decline in market activity as measured by average North American rig count. Flotek’s Energy Chemistry Technologies segment outperformed these market indicators by continuing to aggressively promote the benefits of CnF® chemistries. CnF® sales volumes increased 18.0% year over year. This success was achieved by demonstrating the efficacy of its CnF® chemistries through comparative analysis of wells with and without CnF® chemistries, field validation results conducted by E&P companies, and introduction of its direct-to-operator sales program known as the Flotek Store™. Whether operators purchase directly from Flotek or continue to purchase from oilfield distribution and service companies, E&P operators are benefiting from increased price transparency and a more direct relationship with Flotek’s technical expertise and supply chain. CnF® revenues declined 8% year over year due to the development of lower price point products and pricing related to strategic customer relationships. Non-CnF revenues declined approximately 32% due to reduced customer demand resulting from oilfield market conditions, partially offset by a strategic supply arrangement with a large service company.
Energy Chemistry Technologies gross profit for the year ended December 31, 2015, decreased $35.9 million, or 30.5%, from


25


2014, primarily due to the decrease in product sales revenue. Gross margin as a percentage of revenue for the year ended December 31, 2015, decreased to 38.4%, compared to 43.9% in 2014. The decline in gross margin as a percentage of revenue over the period is primarily due to new incentive pricing structures associated with new strategic relationships, partially offset by proportionately higher sales of higher margin CnF® products.
 
Income from operations for the Energy Chemistry Technologies segment decreased $40.9 million, or 48.3%, for the year ended December 31, 2015, compared to 2014. This decrease is primarily attributable to the decrease in gross profit, increased costs associated with sales and marketing efforts in pursuit of growth opportunities, and increased costs associated with the Company’s continued commitment to its research and innovation efforts within Energy Chemistry Technologies.


Consumer and Industrial Chemistry Technologies
 
 
 
 
 
 
(dollars in thousands)
 
Year ended December 31,
 
 
2016
 
2015
 
2014
Revenue
 
$
74,599

 
$
56,374

 
$
51,091

Gross profit
 
$
16,086

 
$
14,371

 
$
12,897

Gross margin %
 
21.6
%
 
25.5
%
 
25.2
%
Income from operations
 
$
9,664

 
$
8,742

 
$
6,558

Operating margin %
 
13.0
%
 
15.5
%
 
12.8
%

Results for 2016 compared to 2015—Consumer and Industrial Chemistry Technologies
CICT revenue for the year ended December 31, 2016, increased $18.2 million, or 32.3%, from 2015. This increase is due to higher terpene prices associated with limited availability of citrus oils globally and volume increases in the Flavor and Fragrance product line.
CICT gross profit for the year ended December 31, 2016, increased $1.7 million, or 11.9%, from 2015. Average product margins decreased 3.5% on product mix and increased raw material cost. Gross margin as a percentage of revenue decreased to 21.6% for the year ended December 31, 2016, compared to 25.5% for 2015, due to lower average product margins and higher direct costs associated with manufacturing.
Income from operations for the CICT segment increased $0.9 million, or 10.5%, for the year ended December 31, 2016, from 2015, primarily due to increased sales, partially offset by increased raw material cost and higher operating expenses associated with growth in the segment’s Flavor activities.
 
Results for 2015 compared to 2014—Consumer and Industrial Chemistry Technologies
CICT revenue for the year ended December 31, 2015, increased $5.3 million, or 10.3%, from 2014. Although global availability of citrus oil was down in 2015, the Company was able to pass along the resulting price increases to its customers producing higher revenue for the period.
CICT gross profit for the year ended December 31, 2015, increased $1.5 million, or 11.4%, from 2014, primarily driven by increased terpene prices and reduced freight expense between the two periods. Gross margin as a percentage of revenue increased slightly to 25.5% for the year ended December 31, 2015, compared to 25.2% for 2014, due to higher terpene margins, partially offset by lower flavor and fragrance margins due to product mix.
Income from operations for the CICT segment increased $2.2 million, or 33.3%, for the year ended December 31, 2015, from 2014, primarily due to the increased margins and a reduction in indirect salaries and benefits.


Discontinued Operations
During the fourth quarter of 2016, the Company classified the Drilling Technologies and Production Technologies segments as held for sale based on management’s intention to sell these businesses. The Company’s historical financial statements
 
have been revised to present the operating results of the Drilling Technologies and Production Technologies segments as discontinued operations.


26



Drilling Technologies
 
 
 
 
 
 
(dollars in thousands)
 
Year ended December 31,
 
 
2016
 
2015
 
2014
Revenue
 
$
27,627

 
$
52,112

 
$
113,302

Gross profit
 
$
8,961

 
$
16,702

 
$
45,651

Gross margin %
 
32.4
 %
 
32.1
 %
 
40.3
%
(Loss) income from operations
 
$
(44,521
)
 
$
(27,340
)
 
$
19,022

(Loss) income from operations - excluding impairment
 
$
(7,999
)
 
$
(7,772
)
 
$
19,022

Operating margin % - excluding impairment
 
(29.0
)%
 
(14.9
)%
 
16.8
%

Results for 2016 compared to 2015—Drilling Technologies
Drilling Technologies revenue for the year ended December 31, 2016, decreased $24.5 million, or 47.0%, from 2015. The revenue decline was primarily related to the decrease in drilling rig activity and significant pricing pressure during the year. Revenue improved 5.6% for the quarter ended December 31, 2016, compared to the quarter ended September 30, 2016, as market conditions continue to improve.
Drilling Technologies gross profit for the year ended December 31, 2016, decreased $7.7 million, or 46.3%, from 2015, in line with the decline in revenue. The impact of lower revenue was offset by lower direct operating costs resulting from a 46.1% reduction in headcount, decreased depreciation expense, and lower material and freight costs. These cost reductions allowed margins as a percentage of revenue to increase slightly to 32.4% in 2016 from 32.1% in 2015.
During the first quarter of 2016, as a result of the sequential decline in segment revenue and expectations for future drilling activity, the Company determined the carrying amount of certain long-lived assets exceeded their respective fair values and that some inventory was either not usable in future operations or the carrying value exceeded its market value. As a result, an impairment charge of $36.5 million was recorded to reflect the reduced value of inventory and long-lived assets in the Drilling Technologies segment.
Drilling Technologies loss from operations for the year ended December 31, 2016, increased by $17.2 million from 2015, primarily resulting from first quarter 2016 impairment charges. Loss from operations, excluding the impairment, for the year ended December 31, 2016, increased by $0.2 million from 2015, primarily due to reductions in revenue and pricing pressure that resulted in customer price concessions. These volume decreases were offset by a 27.5% reduction in sales
 
and administrative cost reductions throughout the year, including employee related expenses and reduced travel costs.
Results for 2015 compared to 2014—Drilling Technologies
Drilling Technologies revenue for the year ended December 31, 2015, decreased $61.2 million, or 54.0%, from 2014, due to a 64.0% decrease in domestic revenue primarily from lower activity levels and significant pricing reductions partially offset by an increase in Teledrift International revenue.
Drilling Technologies gross profit for the year ended December 31, 2015, decreased $28.9 million, or 63.4%, from 2014. Gross margin as a percentage of revenue decreased to 32.1%, compared to 40.3% in 2014. This was primarily due to pricing decreases, partially offset by a 38% reduction in direct costs including personnel and freight costs.
During the second quarter of 2015, as a result of decreased rig activity and its impact on management’s expectations for future market activity, the Company refocused the Drilling Technologies segment to businesses and markets that have the best opportunity for profitable growth in the future. As a result, an impairment charge of $19.6 million was recorded to reflect the reduced value of inventory and rental equipment associated with product lines and markets the Company exited.
Drilling Technologies income (loss) from operations for the year ended December 31, 2015, decreased by $46.4 million from 2014, primarily resulting from the second quarter impairment charge and margin decreases. Income (loss) from operations, excluding the impairment, for the year ended December 31, 2015, decreased by $26.8 million from 2014, primarily due to lower margins, partially offset by a 6.5% decrease in SG&A costs in 2015, including lower personnel and travel costs.


27



Production Technologies
 
 
 
 
 
 
(dollars in thousands)
 
Year ended December 31,
 
 
2016
 
2015
 
2014
Revenue
 
$
8,292

 
$
12,281

 
$
16,003

Gross profit
 
$
411

 
$
2,101

 
$
6,544

Gross margin %
 
5.0
 %
 
17.1
 %
 
40.9
%
(Loss) income from operations
 
$
(8,815
)
 
$
(4,111
)
 
$
3,246

(Loss) income from operations - excluding impairment
 
$
(4,902
)
 
$
(3,307
)
 
$
3,246

Operating margin % - excluding impairment
 
(59.1
)%
 
(26.9
)%
 
20.3
%

Results for 2016 compared to 2015—Production Technologies
Revenue for the Production Technologies segment for the year ended December 31, 2016, decreased by $4.0 million, or 32.5%, from 2015, primarily due to decreased sales of rod pump equipment and older technology ESP equipment. Sequentially, revenue increased by 5.3% in the fourth quarter 2016, compared to third quarter 2016.
Production Technologies gross profit decreased by $1.7 million for the year ended December 31, 2016, compared to 2015. Gross margin as a percentage of revenue decreased to 5.0% for the year ended December 31, 2016, compared to 17.1% in 2015, primarily due to declining sales volumes and product pricing pressure throughout 2016. Sequentially, quarterly gross margins are improving, increasing 4.4% on increased revenue and improved pricing.
As a result of the introduction of newer and proprietary technology, as well as lower demand for older technologies, the Company evaluated its Production Technologies inventory for impairment leading to the recording of an impairment charge of $3.9 million for inventory in the first quarter of 2016.
Loss from operations increased by $4.7 million for the year ended December 31, 2016, from 2015. Loss from operations, excluding the impairment, increased by $1.6 million for the year ended December 31, 2016, from 2015. These increased losses are primarily due to lower revenue volume and lower margins due to pricing pressure. SG&A costs have decreased by 8.8% year over year due to reduced employment costs and decreased travel costs, partially offsetting the impact of the decreased revenue.
 
Results for 2015 compared to 2014—Production Technologies
Revenue for the Production Technologies segment for the year ended December 31, 2015, decreased by $3.7 million, or 23.3%, from 2014, as sales of international Petrovalve® tools and domestic lifting units decreased by $4.8 million, or 96.4%,
in 2015 offset by a slight increase of $0.9 million, or 8.2%, increase in rod pump equipment sales.
Production Technologies gross profit decreased by $4.4 million, or 67.9%, for the year ended December 31, 2015, compared to 2014. Gross margin as a percentage of revenue decreased to 17.1% for the year ended December 31, 2015, compared to 40.9% in 2014, primarily due to decreased high margin international Petrovalve® sales.
As a result of the shift in focus towards oil production markets and away from CBM markets, the Company evaluated its CBM inventory during the second quarter of 2015. This evaluation led to the recording of an impairment of $0.8 million in CBM inventory in the second quarter of 2015.
Income (loss) from operations decreased by $7.4 million for the year ended December 31, 2015 from 2014. Income (loss) from operations, excluding the impairment, decreased by $6.6 million for the year ended December 31, 2015 from 2014. These decreases are primarily due to the decreased international Petrovalve® margins and higher SG&A expenses
attributable to employee-related expenses as the segment continues to refocus and reposition for growth in the market.


Capital Resources and Liquidity
Overview
The Company’s ongoing capital requirements arise from the Company’s need to service debt, acquire and maintain equipment, fund working capital requirements, and when the opportunities arise, to make strategic acquisitions and repurchase Company stock. During 2016, the Company
 
funded capital requirements primarily with operating cash flows, debt financing, and the issuance of company stock.
The Company’s primary source of debt financing is its Credit Facility with PNC Bank. This Credit Facility contains provisions for a revolving credit facility and a term loan secured by substantially all of the Company’s domestic and


28


Canadian real and personal property, including accounts receivable, inventory, land, buildings, equipment, and other intangible assets. As of December 31, 2016, the Company had $38.6 million in outstanding borrowings under the revolving debt portion of the Credit Facility and $9.8 million outstanding under the term loan. Effective September 30, 2016, the Company entered into a Sixth Amendment to the Credit Facility which extends the facility term to May 10, 2020, modifies certain covenants and restrictions, and reestablishes a fixed charge coverage ratio for March 31, 2017 and leverage ratio for June 30, 2017. Significant terms of the Credit Facility are discussed in Note 12 – “Long-Term Debt and Credit Facility” in Part II, Item 8 – “Financial Statements and Supplementary Data” of this Annual Report.
At December 31, 2016, the Company remained compliant with the continued listing standards of the NYSE.
Cash and cash equivalents totaled $4.8 million at December 31, 2016. During 2016, the Company received proceeds of $30.1 million, net of issuance costs, from the private placement of 2.5 million common shares, which was used to pay down outstanding borrowings under the revolving
 
credit facility and to purchase IPI. The Company generated $2.1 million of cash inflows from continuing operations (net of $6.1 million expended in working capital). Offsetting these cash inflows, the Company paid $7.9 million associated with the purchase of 100% of the stock and interests in IPI, used $14.0 million for capital expenditures, used $2.1 million for repayments of debt, net of borrowings, and $2.4 million for purchases of treasury stock for tax withholding purposes related to the vesting of restricted stock awards and the exercise of non-qualified stock options.
Liquidity
The Company plans to spend between $15 million and $20 million for committed and planned capital expenditures in 2017. During 2017, the Company plans to use internally generated funds and, if necessary, borrowings under the revolving line of credit to fund operations and capital expenditures and make required payments on the term loan. Any excess cash generated may be used to pay down the level of debt or be retained for future use. The Company does not anticipate repurchasing any shares under its share repurchase programs in the near future.


Net Debt
Net debt represents total debt less cash and cash equivalents and combines the Company’s indebtedness and the cash and cash equivalents that could be used to repay that debt. Components of net debt are as follows (in thousands):
 
December 31, 2016
 
December 31, 2015
Cash and cash equivalents
$
4,823

 
$
2,208

Current portion of long-term debt
(40,566
)
 
(32,291
)
Long-term debt, less current portion
(7,833
)
 
(18,255
)
Net debt
$
(43,576
)
 
$
(48,338
)

Cash Flows
Cash flow metrics from the consolidated statements of cash flows are as follows (in thousands):
  
Year ended December 31,
  
2016
 
2015
 
2014
Net cash provided by operating activities
$
2,054

 
$
25,472

 
$
42,644

Net cash used in investing activities
(22,281
)
 
(17,005
)
 
(15,660
)
Net cash provided by (used in) financing activities
22,851

 
(7,349
)
 
(28,440
)
Net cash flows used in discontinued operations
(6
)
 

 

Effect of changes in exchange rates on cash and cash equivalents
(3
)
 
(176
)
 
(8
)
Net increase (decrease) in cash and cash equivalents
$
2,615

 
$
942

 
$
(1,464
)

Operating Activities
During 2016, 2015, and 2014, cash from operating activities totaled $2.1 million, $25.5 million, and $42.6 million, respectively. Consolidated net income for 2016 totaled $1.9
 
million, compared to consolidated net income of $7.2 million and $39.6 million for 2015 and 2014, respectively.
Net non-cash contributions to net income in 2016, totaled $6.3 million. Contributory non-cash items consisted primarily of


29


$10.9 million for depreciation and amortization expense, $12.1 million for stock compensation expense, $2.5 million for reduction in incremental tax benefit related to share-based awards, and $0.6 million for provisions related to accounts receivables, partially offset by $19.7 million for changes to deferred income taxes.
Net non-cash contributions to net income in 2015, totaled $13.3 million. Contributory non-cash items consisted primarily of $9.1 million for depreciation and amortization expense, $13.1 million for stock compensation expense, and $0.4 million for provisions related to accounts receivables, partially offset by $7.9 million for changes to deferred income taxes and $1.3 million for excess tax benefit related to share-based awards.
Net non-cash contributions to net income in 2014, totaled $15.4 million. Contributory non-cash items consisted primarily of $8.1 million for depreciation and amortization expense, $9.1 million for stock compensation expense, and $1.5 million for changes to deferred income taxes, partially offset by $3.4 million for excess tax benefit related to share-based awards.
During 2016, changes in working capital used $6.1 million in cash, primarily resulting from increasing accounts receivables, inventories, income taxes receivable, and other current assets by $40.8 million and decreasing income taxes payable by $2.0 million, partially offset by increasing accounts payable and accrued liabilities by $36.6 million.
During 2015, changes in working capital provided $3.4 million in cash, primarily resulting from decreasing accounts receivable and other current assets by $13.8 million and increasing accrued liabilities, income taxes payable, and interest payable by $11.8 million, partially offset by increasing inventories and income taxes receivable by $14.6 million and decreasing accounts payable by $7.7 million.
During 2014, changes in working capital used $13.7 million in cash, primarily resulting from increasing accounts receivables, inventories, and other current assets by $44.5 million, partially offset by increasing accounts payable, accrued liabilities, and income taxes payable by $30.8 million.
Investing Activities
Net cash used in investing activities was $22.3 million during 2016. Cash used in investing activities primarily included $14.0 million for capital expenditures, $7.9 million associated with the purchase of 100% of the stock and interests of IPI, and $0.6 million for the purchase of patents and intangible assets.
Net cash used in investing activities was $17.0 million during 2015. Cash used in investing activities primarily included $16.4 million for capital expenditures and $0.6 million for the purchase of patents and intangible assets.
Net cash used in investing activities was $15.7 million during 2014. Cash used in investing activities primarily included $9.3
 
million for capital expenditures, $5.7 million associated with the purchase of Eclipse IOR Services, LLC and SiteLark, LLC, and $0.7 million for the purchase of patents and intangible assets, partially offset by $0.1 million of proceeds received from the sale of fixed assets.
Financing Activities
During 2016, net cash generated through financing activities was $22.9 million. Cash generated through financing activities was primarily due to receiving $30.9 million in proceeds from the sale of common stock, inclusive of $30.1 million, net of issuance costs, from the private placement of 2.5 million common shares on July 27, 2016. Cash generated through financing activities was partially offset by using $2.1 million for repayments of debt, net of borrowings, reductions in tax benefit related to stock-based compensation of $2.5 million, purchases of treasury stock for tax withholding purposes related to the vesting of restricted stock awards and the exercise of non-qualified stock options of $2.4 million, and payments of debt issuance costs of $1.2 million.
During 2015, net cash used in financing activities was $7.3 million. Cash used in financing activities was primarily due to $6.3 million for purchases of treasury stock for tax withholding purposes related to the vesting of restricted stock awards and the exercise of non-qualified stock options, and $9.7 million for the repurchase of common stock. Cash used in financing activities was partially offset by receiving $6.5 million for borrowings of debt, net of repayments, proceeds from the excess tax benefit related to stock-based compensation of $1.3 million, and proceeds from the sale of common stock of $0.9 million.
During 2014, net cash used in financing activities was $28.4 million. Cash used in financing activities was primarily due to $18.1 million for repayments of debt, net of borrowings, $6.3 million for purchases of treasury stock for tax withholding purposes related to the vesting of restricted stock awards and the exercise of non-qualified stock options, and $10.4 million for the repurchase of common stock. Cash used in financing activities was partially offset by proceeds from the excess tax benefit related to stock-based compensation of $3.4 million, proceeds from exercise of stock options and warrants of $2.0 million, and proceeds from the sale of common stock of $0.9 million.
Off-Balance Sheet Arrangements
There have been no transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose entities” (“SPEs”), established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2016, the Company was not involved in any unconsolidated SPEs.
The Company has not made any guarantees to customers or vendors nor does the Company have any off-balance sheet


30


arrangements or commitments that have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, change in financial condition, revenue, expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.
Contractual Obligations
Cash flows from operations are dependent on a variety of factors, including fluctuations in operating results, accounts
 
receivable collections, inventory management, and the timing of payments for goods and services. Correspondingly, the impact of contractual obligations on the Company’s liquidity and capital resources in future periods is analyzed in conjunction with such factors.
Material contractual obligations consist of repayment of amounts borrowed under the Company’s Credit Facility and payment of operating lease obligations.


Contractual obligations at December 31, 2016 are as follows (in thousands):
 
Payments Due by Period
 
Total
 
Less than 1 year
 
1 - 3 years
 
3 -5 years
 
More than
5 years
Term loan
$
9,833

 
$
2,000

 
$
4,000

 
$
3,833

 
$

Estimated interest expense on term loan (1)
1,468

 
587

 
780

 
101

 

Borrowings under revolving credit facility (2)
38,566

 
38,566

 

 

 

Operating lease obligations
23,965

 
2,750

 
4,723

 
3,996

 
12,496

Total
$
73,832

 
$
43,903

 
$
9,503

 
$
7,930

 
$
12,496

(1)
Interest expense amounts assume interest rates on this variable rate obligation remain unchanged from December 31, 2016 rates. The weighted-average interest rate was 4.55% at December 31, 2016.
(2)
The borrowing is classified as current debt. The weighted-average interest rate was 3.92% at December 31, 2016.

Critical Accounting Policies and Estimates
The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Preparation of these statements requires management to make judgments, estimates and assumptions that affect the amounts of assets and liabilities in the financial statements and revenue and expenses during the reporting period. Significant accounting policies are described in Note 2 – “Summary of Significant Accounting Policies” in Part II, Item 8 – “Financial Statements and Supplementary Data” of this Annual Report. The Company believes the following accounting policies are critical due to the significant, subjective, and complex judgments and estimates required when preparing the consolidated financial statements. The Company regularly reviews judgments, assumptions, and estimates to the critical accounting policies.
Basis of Presentation
During the fourth quarter of 2016, the Company classified the Drilling Technologies and Production Technologies reportable segments’ operations as held for sale based on management’s intention to sell these businesses. The operating results of these segments have been reported as discontinued operations in the consolidated financial statements. Amounts previously reported have been reclassified to conform to this presentation to allow for meaningful comparison of continuing operations.
 
Revenue Recognition
Revenue for product sales and services is recognized when all of the following criteria have been met: (a) persuasive evidence of an arrangement exists, (b) products are shipped or services rendered to the customer and all significant risks and rewards of ownership have passed to the customer, (c) the price to the customer is fixed and determinable, and (d) collectability is reasonably assured. The Company’s products and services are sold based on a purchase order and/or contract and have fixed or determinable prices. There is typically no right of return or any significant post-delivery obligations. Probability of collection is assessed on a customer-by-customer basis.
Revenue and associated accounts receivable in the Energy Chemistry Technologies, Consumer and Industrial Chemistry Technologies, Drilling Technologies, and Production Technologies segments are recorded at the agreed price when the aforementioned conditions are met. Generally, a signed proof of obligation is obtained from the customer (delivery ticket or field bill for usage). Deposits and other funds received in advance of delivery are deferred until the transfer of ownership is complete.
For certain contracts related to the EOGA division and the Logistics division of the Energy Chemistry Technologies segment, the Company recognizes revenue under the percentage-of-completion method of accounting, measured


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by the percentage of costs incurred to date proportionate to the total estimated costs of completion. This calculated percentage is applied to the total estimated revenue at completion to calculate revenue earned to date. Contract costs include all direct labor and material costs, as well as indirect costs related to manufacturing and construction operations. General and administrative costs are charged to expense as incurred. Changes in job performance metrics and estimated profitability, including those arising from contract bonus and penalty provisions and final contract settlements, may periodically result in revisions to revenue and expenses and are recognized in the period in which such revisions become probable. Known or anticipated losses on contracts are recognized when such amounts become probable and estimable.
Within the Drilling Technologies segment, revenue is recognized upon receipt of a signed and dated field billing ticket from the customer. Customers are charged contractually agreed amounts for oilfield rental equipment damaged or lost-in-hole (“LIH”). LIH proceeds are recognized as revenue and the associated carrying value is charged to cost of sales.
Revenue for equipment sold by the Production Technologies segment is recorded net of any credit issued for return of an item for refurbishment under the equipment exchange program.
Sales tax collected from customers is not included in revenue but rather is accrued as a liability for future remittance to the respective taxing authorities.
Allowance for Doubtful Accounts
The Company performs ongoing credit evaluations of customers and grants credit based upon historical payment history, financial condition, and industry expectations, as available. Determination of the collectability of amounts due from customers requires the Company to use estimates and make judgments regarding future events and trends, including monitoring customers’ payment history and current credit worthiness, in order to determine that collectability is reasonably assured. The Company also considers the overall business climate in which its customers operate.
These uncertainties require the Company to make frequent judgments and estimates regarding a customers’ ability to pay amounts due in order to assess and quantify an appropriate allowance for doubtful accounts. The primary factors used to quantify the allowance are customer delinquency, bankruptcy, and the Company’s estimate of its ability to collect outstanding receivables based on the number of days a receivable has been outstanding.
The majority of the Company’s customers operate in the energy industry. The cyclical nature of the industry may affect customers’ operating performance and cash flows, which could impact the Company’s ability to collect on these obligations. Additionally, some customers are located in
 
international areas that are inherently subject to risks of economic, political, and civil instability.
The Company continues to monitor the economic climate in which its customers operate and the aging of its accounts receivable. The allowance for doubtful accounts is based on the aging of accounts and an individual assessment of each invoice. At December 31, 2016, the allowance was 1.4% of gross accounts receivable, compared to an allowance of 2.0% a year earlier. While credit losses have historically been within expectations and the provisions established, should actual write-offs differ from estimates, revisions to the allowance would be required.
Inventory Reserves
Inventories consist of raw materials, work-in-process, and finished goods and are stated at the lower of cost or market, using the weighted-average cost method. Finished goods inventories include raw materials, direct labor, and production overhead. The Company’s inventory reserve represents the excess of the inventory carrying value over the amount expected to be realized from the ultimate sale or other disposal of the inventory.
The Company regularly reviews inventory quantities on hand and records provisions or impairments for excess or obsolete inventory based on the Company’s forecast of product demand, historical usage of inventory on hand, market conditions, production and procurement requirements, and technological developments. Significant or unanticipated changes in market conditions or Company forecasts could affect the amount and timing of provisions for excess and obsolete inventory and inventory impairments.
Significant changes have not been made in the methodology used to estimate the reserve for excess and obsolete inventory or impairments during the past three years. Specific assumptions are updated at the date of each evaluation to consider Company experience and current industry trends. Significant judgment is required to predict the potential impact which the current business climate and evolving market conditions could have on the Company’s assumptions. Changes which may occur in the energy industry are hard to predict, and they may occur rapidly. To the extent that changes in market conditions result in adjustments to management assumptions, impairment losses could be realized in future periods.
At December 31, 2016 and 2015, the Company recorded an impairment for all inventory items identified as excess and obsolete inventory.
Business Combinations
The Company allocates the fair value of purchase consideration to the assets acquired, liabilities assumed, and any non-controlling interests in the acquired entity generally based on their fair values at the acquisition date. The excess of the fair value of purchase consideration over the fair value


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of these assets acquired, liabilities assumed, and any non-controlling interests in the acquired entity is recorded as goodwill. The primary items that generate goodwill include the value of the synergies between the acquired company and Flotek and the value of the acquired assembled workforce. Acquisition-related expenses are recognized separately from the business acquisition and are recognized as expenses as incurred.
The purchase price allocation process requires management to make significant estimates and assumptions at the acquisition date with respect to the fair value of:
intangible assets acquired from the acquiree;
tax assets and liabilities assumed from the acquiree;
stock awards assumed from the acquiree that are included in the purchase price; and
pre-acquisition obligations and contingencies assumed from the acquiree.
Although the Company believes the assumptions and estimates it has made in the past have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain.
Goodwill
Goodwill is not subject to amortization, but is tested for impairment annually during the fourth quarter, or more frequently if an event occurs or circumstances change that would indicate a potential impairment. These circumstances may include, but are not limited to, a significant adverse change in the business climate, unanticipated competition, or a change in projected operations or results of a reporting unit. Goodwill is tested for impairment at a reporting unit level. At December 31, 2016, four reporting units have a goodwill balance. Energy Chemistry Technologies and Consumer and Industrial Chemistry Technologies are reporting units in continuing operations and Teledrift and Production Technologies are reporting units in discontinued operations.
During the annual testing, the Company assesses whether a goodwill impairment exists using both qualitative and quantitative assessments. The qualitative assessment involves determining whether events or circumstances exist that indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If, based on this qualitative assessment, it is determined that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, the Company does not perform a quantitative assessment.
If the qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying amount or if the Company elects not to perform a qualitative assessment, a quantitative assessment or two-step impairment test is performed to determine whether goodwill impairment exists at the reporting unit.
 
If quantitative impairment testing is performed, the Company uses a two-step process. The first step is to compare the estimated fair value of each reporting unit which has goodwill to its carrying amount, including goodwill. To determine fair value estimates, the Company uses the income approach based on discounted cash flow analyses, combined, when appropriate, with a market-based approach. The market-based approach considers valuation comparisons of recent public sale transactions of similar businesses and earnings multiples of publicly traded businesses operating in industries consistent with the reporting unit. If the fair value of a reporting unit is less than its carrying value, the second step of the impairment test is performed to determine the amount of impairment, if any. The second step compares the implied fair value of the reporting unit goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit’s goodwill exceeds its implied value, an impairment loss is recognized in an amount equal to that excess.
The Company determines fair value using widely accepted valuation techniques, including discounted cash flows and market multiples analyses, and through use of independent fixed asset valuation firms, as appropriate. These types of analyses contain uncertainties, as they require management to make assumptions and to apply judgments regarding industry economic factors and the profitability of future business strategies. The Company’s policy is to conduct impairment testing based on current business strategies, taking into consideration current industry and economic conditions as well as the Company’s future expectations. Key assumptions used in the discounted cash flow valuation model include, among others, discount rates, growth rates, cash flow projections, and terminal value rates. Discount rates and cash flow projections are the most sensitive and susceptible to change as they require significant management judgment. Discount rates are determined using a weighted average cost of capital (“WACC”). The WACC considers market and industry data, as well as Company-specific risk factors for each reporting unit in determining the appropriate discount rate to be used. The discount rate utilized for each reporting unit is indicative of the return an investor would expect to receive for investing in a similar business. Management uses industry considerations and Company-specific historical and projected results to develop cash flow projections for each reporting unit. Additionally, if appropriate, as part of the market-based approach, the Company utilizes market data from publicly traded entities whose businesses operate in industries comparable to the Company’s reporting units, adjusted for certain factors that increase comparability.
During annual goodwill impairment testing in 2016, 2015, and 2014, the Company first assessed qualitative factors to determine whether it was necessary to perform the two-step goodwill impairment test. Based on its qualitative assessment, the Company concluded there was no indication of impairment of goodwill as of the fourth quarter of 2014 and therefore no further testing was required.


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As of the fourth quarter of 2016, the Company concluded it was not more likely than not that there was an impairment of goodwill for the Consumer and Industrial Chemistry Technologies or Energy Chemistry Technologies reporting units based on the assessment of qualitative factors. The Consumer and Industrial Chemistry Technologies reporting unit has outpaced prior years revenues and maintained strong margins. The Energy Chemistry Technologies reporting unit saw revenue reduced by 12% versus 2015 as market activity fell 43% from 2015 to 2016. However, the segment continued to produce strong margins.
The Company was not able to conclude that it was not more likely than not that the estimated fair value of the Teledrift and Production Technologies reporting units exceeded the carrying value of the respective reporting units. Therefore, the Company performed a Step 1 impairment test for each of these reporting units. The results of the Step 1 test indicated that the estimated fair values of the two reporting units exceeded the carrying value of their respective reporting units by approximately $13.2 million and $6.7 million respectively, or an excess of 34% and 44%, respectively, over the carrying value. Therefore, no further testing was required for these two reporting units. To evaluate the sensitivity of the fair value calculations of the Teledrift and Production Technologies reporting units, the Company applied a hypothetical 10% unfavorable change in the weighted average cost of capital, which would have reduced the estimated fair value of the Teledrift and Production Technologies reporting units by approximately $5.3 million and $4.2 million, respectively. These sensitivity analyses were not indicative of an impairment for the Teledrift or Production Technologies reporting units.
As of the third quarter of 2016, the Company concluded it was not more likely than not that there was an impairment of goodwill for the Consumer and Industrial Chemistry Technologies reporting unit, the Energy Chemistry Technologies reporting unit, and the Teledrift reporting unit based on the assessment of qualitative factors. The Consumer and Industrial Chemistry Technologies reporting unit has seen increased revenues in 2016 compared to 2015 and has maintained margins in the range seen from 2014 through 2015. The Energy Chemistry Technologies reporting unit had an 11% decrease in revenue versus the 27% decline in market activity for the first quarter of 2016 compared to the fourth quarter of 2015, a 3% decrease in revenue versus the 35% decline in market activity for the second quarter of 2016 compared to the first quarter of 2016, and a 4% increase in revenue versus the 28% increase in market activity for the third quarter of 2016 compared to the second quarter of 2016, but continues to maintain gross margins. The Teledrift reporting unit, having passed the Step 1 impairment tests in the previous two quarters, had the highest revenue quarter for 2016 and improved margins. Teledrift revenue for the third quarter of 2016 increased 37% versus the second quarter of 2016 and improved gross margins by 8.4%.
 
For the first quarter of 2016, the Company was not able to conclude that it was not more likely than not that the estimated fair value of the Production Technologies and Teledrift reporting units exceeded the carrying value of the respective reporting units. Therefore, the Company performed a Step 1 impairment test for each of these reporting units. The results of the Step 1 test indicated that the estimated fair values of the Production Technologies and the Teledrift reporting units exceeded the carrying value of their respective reporting units by approximately $34.9 million and $2.1 million, respectively, or an excess of 153% and 5%, respectively, over the carrying value. Therefore, no further testing was required for these two reporting units.
Again, for the second quarter of 2016, the Company was not able to conclude that it was not more likely than not that the estimated fair value of the Production Technologies and Teledrift reporting units exceeded the carrying value of the respective reporting units. Therefore, the Company performed a Step 1 impairment test for each of these reporting units. The results of the Step 1 test indicated that the estimated fair values of the Production Technologies and the Teledrift reporting units exceeded the carrying value of their respective reporting units by approximately $17.1 million and $2.2 million, respectively, or an excess of 77% and 6%, respectively, over the carrying value. Therefore, no further testing was required for these two reporting units.
Once again, for the third quarter of 2016, the Company was not able to conclude that it was not more likely than not that the estimated fair value of the Production Technologies reporting unit exceeded the carrying value of the reporting unit. Therefore, the Company performed a Step 1 impairment test for this reporting unit. The results of the Step 1 test indicated that the estimated fair value of the Production Technologies reporting unit exceeded the carrying value of the reporting unit by approximately $8.1 million, or an excess of 36.9% over the carrying value. Therefore, no further testing was required for this reporting unit.
Key assumptions and estimates were based on experience of the Company’s management, experience with past recessions within the oil and gas industry (specifically the 2008/2009 recession), and internal as well as published external perspectives of recovery timing. Key assumptions used in the discounted cash flow analysis included:
U.S. rig count bottoms during 2016 and begins to recover to average 532 rigs for the last two quarters of 2016. Average Rig count climbs to 725 in 2017, 880 in 2018, and 920 in 2019, and grows by 50 rigs annually for 2020 through 2023, and then holds flat through 2026;
International revenue grows 3% annually;
Domestic rental revenue per rig and total domestic revenue per rig dip to lows seen during the 2008/2009 downturn through 2017 and then slowly return to the lower end of the ranges seen between 2012 and 2014;


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International indirect expenses remain 3.5% of total international revenue;
Domestic indirect expense percentages slowly return to historical levels;
Margins stay in the lower portion of historical ranges;
Working capital ratios remain consistent; and
Risk premium related to foreign country security and government stability.
Some of the factors that affected the change in results of the Step 1 impairment test from the fourth quarter of 2015 to the fourth quarter of 2016 included:
Impairment testing of long-lived assets excluding goodwill resulted in a reduction to the balance sheet of $14.3 million for the Teledrift reporting unit in the first quarter of 2016.
Impairment of inventory resulted in a reduction to the balance sheet of $1.3 million for the Teledrift reporting unit and $3.9 million for the Production Technologies reporting unit in the first quarter of 2016.
Cost reduction initiatives during the first half of 2016 reduced direct and indirect expenses for the Drilling Technologies segment.
Due to the surplus of rental tools and the low levels of drilling rig activity, capital expenditures for new rental tools will be minimal through 2019 in the Teledrift reporting unit.
Based on the Company’s fourth quarter 2016 testing of goodwill for impairment at each reporting unit, no impairments were recorded.
The business of the Drilling Technologies segment is closely aligned with the drilling rig count and the U.S. drilling rig count declined approximately 55% during the first and second quarters of 2015. Revenue of the Drilling Technologies segment declined over 30% compared to the fourth quarter of 2014, although the segment’s gross margin was rising moderately. The drop off in business resulting from declines in oil prices and the active drilling rig count was an event or circumstance that caused the Company to test its recorded goodwill in the Teledrift reporting unit within the Drilling Technologies segment (deterioration in the operating environment and overall financial performance of the reporting unit) during the second quarter of 2015. In addition, the Company took a look at its business to ascertain whether there were operating changes that needed to be made.
Impairment of goodwill was not tested for other reporting units during the second quarter of 2015 as revenue and margins in the Energy Chemistry Technologies and the Consumer and Industrial Chemistry Technologies reporting units had been increasing. Goodwill of $1.7 million in the Production Technologies reporting unit resulted from a 2015 acquisition which provided an avenue for new products and additional revenue.
 
Goodwill of $15.3 million in the Teledrift reporting unit was tested for impairment during the second quarter of 2015. The primary technique utilized to estimate the fair value of the Teledrift reporting unit was a discounted cash flow analysis. Discounted cash flow analysis requires the Company to make various judgments, estimates and assumptions about future revenue, margins, growth rates, capital expenditures, working capital and discount rates. The first step in the impairment testing process compared the estimated fair value of the reporting unit to its carrying amount, including goodwill. The analysis indicated a fair value in excess of the carrying amount by approximately 97% for the Teledrift reporting unit. Because the fair value of the reporting unit exceeded its carrying amount, the second step of the goodwill impairment test was not necessary.
As of the fourth quarter of 2015, the Company concluded it was not more likely than not that there was an impairment of goodwill for the Consumer and Industrial Chemistry Technologies reporting unit based on the assessment of qualitative factors. The Consumer and Industrial Chemistry Technologies reporting unit has seen increased revenues in 2015 compared to 2014 and has maintained gross margins.
However, the Company was not able to conclude that it was not more likely than not that the estimated fair value of the Energy Chemistry Technologies, Teledrift, and Production Technologies reporting units exceeded the carrying value of the respective reporting units. Therefore, the Company performed a Step 1 impairment test for each of these reporting units. The results of the Step 1 test indicated that the estimated fair values of the Energy Chemistry Technologies and Production Technologies reporting units exceeded the carrying value of their respective reporting units by approximately $217.3 million and $35.8 million respectively, or an excess of 156% and 141%, respectively, over the carrying value. Therefore, no further testing was required for these two reporting units. To evaluate the sensitivity of the fair value calculations of the Energy Chemistry Technologies and Production Technologies reporting units, the Company applied a hypothetical 10% unfavorable change in the weighted average cost of capital, which would have reduced the estimated fair value of the Energy Chemistry Technologies and Production Technologies reporting units by approximately $44.0 million and $8.6 million, respectively. These sensitivity analyses were not indicative of an impairment for the Energy Chemistry Technologies or Production Technologies reporting units.
The Step 1 impairment test for the Teledrift reporting unit indicated that the estimated fair value of the reporting unit was less than the carrying value by approximately $1.4 million; therefore, the Company performed a Step 2 impairment test with the assistance of a third party valuation firm. The results of the Step 2 impairment test indicated that the implied fair value of goodwill exceeded the carrying value of the goodwill for the Teledrift reporting unit by approximately $2.0 million, or an excess of 15% over the carrying value. To evaluate the sensitivity of the fair value calculation for the Teledrift


35


reporting unit, the Company applied a hypothetical 10% unfavorable change in the weighted average cost of capital, which would have reduced the estimated fair value of goodwill by approximately $0.7 million which was not indicative of an impairment of goodwill.
Key assumptions and estimates were based on experience of the Company’s management, experience with past recessions within the oil and gas industry (specifically the 2008/2009 recession), and internal as well as published external perspectives of recovery timing. Key assumptions used in the discounted cash flow analysis included:
US rig count bottoms at year end around 700 rigs in 2015 to average 983 rigs for 2015. Rig count climbs to 875 in 2016, continues to 1,000 rigs in 2017 and grows 5% annually for 2018 through 2020, and then grows 7% annually through 2025;
International revenue grows 3% annually;
Domestic rental revenue per rig and total domestic revenue per rig dip to lows seen during the 2008/2009 downturn through 2017 and then slowly return to the lower end of the previous three year range;
International indirect expenses remain 3.5% of total international revenue;
Domestic indirect expense percentages slowly return to historical levels;
Margins stay in historical ranges;
Working capital ratios remain consistent; and
Risk premium related to foreign country security and government stability.
Some of the factors that affected the change in results of the Step 1 impairment test from the second quarter of 2015 to the fourth quarter of 2015 included:
Crude oil prices had rallied during the second quarter to average $59.82 per barrel in June 2015 versus the January 2015 average of $47.22 per barrel, but subsequently fell during the third and fourth quarters to average $37.19 per barrel in December 2015,
The dramatic decline in US rig activity had leveled off during June 2015 after having declined 53.3% from the rig activity level as of December 31, 2014, only to decrease another 18.7% in the second half of 2015 to end the year with an outright drop in rig activity of 62.1%.
The weighted average cost of capital increased from 14.1% in the second quarter of 2015 to 19.1% in the fourth quarter of 2015 as the significance of the international portion of the reporting unit grew, resulting in a higher risk premium associated with international activity.
There are significant inherent uncertainties and judgments involved in estimating fair value. A further extension or deepening of the industry downturn could have a negative impact on the cash flow analysis.
 
The Company cannot predict the occurrence of events or circumstances that could adversely affect the fair value of goodwill. Such events may include, but are not limited to, deterioration of the economic environment, increases in the Company’s weighted average cost of capital, material negative changes in relationships with significant customers, reductions in valuations of other public companies in the Company’s industry, or strategic decisions made in response to economic and competitive conditions. If actual results are not consistent with the Company’s current estimates and assumptions, impairment of goodwill could be required.
Based on the Company’s fourth quarter 2015 testing of goodwill for impairment at each reporting unit, no impairments were recorded.
Long-Lived Assets Other than Goodwill
Long-lived assets other than goodwill consist of property and equipment and intangible assets that have determinable and indefinite lives. The Company makes judgments and estimates regarding the carrying value of these assets, including amounts to be capitalized, depreciation and amortization methods to be applied, estimated useful lives, and possible impairments. Property and equipment and intangible assets with determinable lives are tested for impairment whenever events or changes in circumstances indicate the carrying value of the asset may not be recoverable.
For property and equipment, events or circumstances indicating possible impairment may include a significant decrease in market value or a significant change in the business climate. An impairment loss is recognized when the carrying amount of an asset exceeds the estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss is the excess of the asset’s carrying value over its fair value. Fair value is generally determined using an appraisal by an independent valuation firm or by using a discounted cash flow analysis.
For intangible assets with definite lives, events or circumstances indicating possible impairment may include an adverse change in the extent or manner in which the asset is being used or a change in the assessment of future operations. The Company assesses the recoverability of the carrying amount by preparing estimates of future revenue, margins, and cash flows. If the sum of expected future cash flows (undiscounted and without interest charges) is less than the carrying amount, an impairment loss is recognized. The impairment loss recognized is the amount by which the carrying amount exceeds the fair value. Fair value of these assets may be determined by a variety of methodologies, including discounted cash flows.
Intangible assets with indefinite lives are not subject to amortization, but are tested for impairment annually during the fourth quarter, or more frequently if an event occurs or circumstances change that would indicate a potential impairment. These circumstances may include, but are not


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limited to, a significant adverse change in the business climate, unanticipated competition, or a change in projected operations or results of a reporting unit.
The Company assesses whether an indefinite lived intangible impairment exists using both qualitative and quantitative assessments. The qualitative assessment involves determining whether events or circumstances exist that indicate it is more likely than not that the fair value of the indefinite lived intangible is less than its carrying amount. If, based on this qualitative assessment, it is determined that it is not more likely than not that the fair value of the indefinite lived intangible is less than its carrying amount, the Company does not perform a quantitative assessment.
If the qualitative assessment indicates that it is more likely than not that the indefinite-lived intangible asset is impaired or if the Company elects to not perform a qualitative assessment, the Company then performs the quantitative impairment test. The quantitative impairment test for an indefinite-lived intangible asset consists of a comparison of the fair value of the asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Fair value of these assets may be determined by a variety of methodologies, including discounted cash flows.
The development of future net undiscounted cash flow projections requires management projections of future sales and profitability trends and the estimation of remaining useful lives of assets. These projections are consistent with those projections the Company uses to internally manage operations. When potential impairment is identified, a discounted cash flow valuation model similar to that used to value goodwill at the reporting unit level, incorporating discount rates commensurate with risks associated with each asset, is used to determine the fair value of the asset in order to measure potential impairment. Discount rates are determined by using a WACC. Estimated revenue and WACC assumptions are the most sensitive and susceptible to change in the long-lived asset analysis as they require significant management judgment. The Company believes the assumptions used are reflective of what a market participant would have used in calculating fair value.
Valuation methodologies utilized to evaluate long-lived assets other than goodwill for impairment were consistent with prior periods. Specific assumptions discussed above are updated at each test date to consider current industry and Company-specific risk factors from the perspective of a market participant. The current business climate is subject to evolving market conditions and requires significant management judgment to interpret the potential impact to the Company’s assumptions. To the extent that changes in the current business climate result in adjustments to management projections, impairment losses may be recognized in future periods.
The domestic drilling industry has continued to deteriorate since the end of 2015 to levels not seen since April 1999. As the business of the Drilling Technologies segment is closely
 
aligned with the drilling rig count and average U.S. drilling rig count declined 27% during the first quarter of 2016, the drop off in rig count led to a decline in revenue and gross profit of 37% and 69%, respectively, from the fourth quarter of 2015 for the Drilling Technologies segment. As a result of the continued drop in rig count and the significant decline in operations in the first quarter of 2016, the Company concluded these were events or circumstances that caused the Company to test its long-lived assets for impairment within the segment.
During the three months ended March 31, 2016, the Company completed testing for impairment of long-lived assets within the Drilling Technologies segment for four asset groups:
Downhole Tools - primarily used in the vertical drilling market;
International Drill Pipe - primarily used in foreign mining operations;
Teledrift Domestic - primarily associated with the Measurement While Drilling (“MWD”) market in the U.S.; and
Teledrift International - primarily associated with the MWD market in international markets.
Impairment indicators affected both asset groups that are tied directly to the domestic drilling market. While impairment indicators are not present for the International Drill Pipe or Teledrift International asset groups, the Company performed recoverability tests for all four asset groups.
The recoverability test indicated that the undiscounted estimated cash flows of the International Drill Pipe and Teledrift International asset groups exceeded the carrying value of their respective asset groups by approximately $2.6 million and $64.1 million, respectively, or an excess of 98% and 906%, respectively. However, the undiscounted estimated cash flows of the Downhole Tools and Teledrift Domestic asset groups did not exceed the carrying value of their respective asset groups, and therefore, the Company performed a discounted cash flow analysis on each asset group to determine the fair values.
Since the assets in the asset groups are not highly specialized, the Company assumed the current use of each asset would be a similar use as if the assets were sold. As such, the cash flow used in the recoverability test is the same cash flow used to create the discounted cash flow for fair value analysis. This testing indicated that the carrying value of the Downhole Tools and Teledrift Domestic asset groups exceeded the fair value by $9.6 million and $14.3 million, respectively, or an excess of 69% and 56%, respectively. As a result, a combined impairment loss for these two asset groups of $23.9 million was recognized during the three months ended March 31, 2016.
Additionally, the business of the Production Technologies segment incurred similar declines with revenue and gross profit, falling approximately 30% and 42%, respectively. Therefore, the Company completed testing for impairment of long-lived assets within the Production Technologies


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segment. The recoverability test indicated that the undiscounted estimated cash flows for the segment exceeded the carrying value of assets by $3.0 million, or an excess of 23%. As a result, no impairment of long-lived assets was recognized for the Production Technologies segment.
During the second quarter of 2016, the average U.S. drilling rig count fell 23% versus the first quarter of 2016. The Drilling Technologies segment held revenue relatively flat and improved margins when comparing the second and first quarters of 2016. As such, the Company determined that testing for impairment of long-lived assets was not warranted for the segment.
However, the Production Technologies segment results showed a decline in revenue of 8% and continuing negative margins when comparing the second and first quarters of 2016. Therefore, the Company completed testing for impairment of long-lived assets within the Production Technologies segment. The recoverability test indicated that the undiscounted estimated cash flows for the segment exceeded the carrying value of assets by $4.4 million, or an excess of 34%. As a result, no impairment of long-lived assets was recognized for the Production Technologies segment.
During the third quarter of 2016, the average U.S. drilling rig count rose 14% versus the second quarter of 2016. The Drilling Technologies segment revenue increased 13% and improved margins when comparing the third and second quarters of 2016, while the Production Technologies segment results showed an increase in revenue of 15% and improved margins when comparing the third and second quarters of 2016. As such, the Company determined that testing for impairment of long-lived assets was not warranted for either segment.
During the fourth quarter of 2016, the average U.S. drilling rig count rose 23% versus the third quarter of 2016. The Drilling Technologies segment revenue increased 6% and showed slightly lower margins when compared to the third quarter of 2016 but still exceeded second quarter 2016 margins. The Production Technologies segment results showed an increase in revenue of 5% and improved margins when comparing the fourth and third quarters of 2016. As such, the Company determined that testing for impairment of long-lived assets was not warranted for either segment.
Key assumptions and estimates used in performing these recoverability tests were based on experience of the Company’s management, experience with past oil and gas industry downturns and recoveries, and internal, as well as published external, perspectives of recovery timing. Key assumptions used in the recoverability test included:
Rental tools are the primary cash generating assets for each group;
Remaining estimated useful life for each group was determined to be 7 years;
Carrying amount of the asset group is the net book value of the assets as of March 31, 2016, for first
 
quarter testing and June 30, 2016, for second quarter testing;
Estimates of future cash flows for the group assumed the sale of the group at the end of the remaining useful life of the primary asset; and
Since the Downhole Tools asset group includes product sales in the cash flow analysis, a portion of the inventory was included in the carrying amount of the asset group. The remaining portion of the inventory is normally utilized to repair and fabricate rental tools and is included in cost of goods sold.
During the second quarter of 2015, as a result of decreased rig activity and its impact on management’s expectations for future market activity, the Company refocused the Drilling Technologies segment to businesses and markets that have the best opportunity for profitable growth in the future.  Additionally, the Company shifted the focus of the Production Technologies segment towards oil production markets and away from the less opportunistic CBM markets. As a result of these changes in focus and projected declines in asset utilization, the Company recorded impairment charges for inventory ($18.0 million) and rental equipment ($2.3 million) in the second quarter of 2015. Additionally, an assessment was made regarding possible impairment of property and equipment for (a) the Drilling Technologies asset group and (b) the Production Technologies asset group.
An analysis of the Drilling Technologies asset group showed that discounted future cash flows exceeded the carrying amount of this asset group. In addition, projected future cash flows considering only rental tools would exceed the carrying amount of this asset group in approximately six years. These preliminary analyses clearly indicated that the carrying amount of property and equipment would be recoverable and therefore, the Company did not perform an undiscounted future cash flow analysis for this asset group.
An analysis of the Production Technologies asset group showed that projected future cash flows from two recently introduced products significantly exceeded the carrying amount of this asset group. This preliminary analysis clearly indicated that the carrying amount of property and equipment would be recoverable and therefore, the Company did not perform a more complete analysis of undiscounted future cash flows for this asset group.
There are significant inherent uncertainties and judgments involved in estimating fair value. A further extension or deepening of the industry downturn could have a negative impact on the cash flow analysis.
The Company cannot predict the occurrence of events or circumstances that could adversely affect the fair value of the asset (asset group). Such events may include, but are not limited to, deterioration of the economic environment, increases in the Company’s weighted average cost of capital, material negative changes in relationships with significant customers, reductions in valuations of other public companies


38


in the Company’s industry, or strategic decisions made in response to economic and competitive conditions. If actual results are not consistent with the Company’s current estimates and assumptions, additional impairment of long-lived assets could be required.
In 2016, 2015, and 2014, while testing annual indefinite lived intangible assets for impairment, the Company first assessed qualitative factors to determine whether it was necessary to perform the impairment test. Based on its qualitative assessment, the Company concluded there was no indication of the need for an impairment of indefinite lived intangibles, and therefore no further testing was required.
No impairment was recorded for property and equipment and intangible assets with determinable or indefinite lives during 2014.
Fair Value Measurements
Fair value is defined as the amount that would be received for the sale of an asset or paid for the transfer of a liability in an orderly transaction between unrelated third party market participants at the measurement date. In determination of fair value measurements for assets and liabilities, the Company considers the principal, or most advantageous, market and assumptions that market participants would use when pricing the asset or liability. The Company categorizes financial assets and liabilities using a three-tiered fair value hierarchy, based upon the nature of the inputs used in the determination of fair value. Inputs refer broadly to the assumptions that market participants would use in pricing an asset or liability and may be observable or unobservable. Significant judgments and estimates are required, particularly when inputs are based on pricing for similar assets or liabilities, pricing in non-active markets, or when unobservable inputs are required.
Income Taxes
The Company’s tax provision is subject to judgments and estimates necessitated by the complexity of existing regulatory tax statutes and the effect of these upon the Company due to operations in multiple tax jurisdictions. Income tax expense is based on taxable income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which the Company operates. The Company’s income tax expense will fluctuate from year to year as the amount of pretax income fluctuates. Changes in tax laws and the Company’s profitability within and across the jurisdictions may impact the Company’s tax liability. While the annual tax provision is based on the best information available to the Company at the time of preparation, several years may elapse before the ultimate tax liabilities are determined.
The Company uses the liability method in accounting for income taxes. Deferred tax assets and liabilities are recognized for temporary differences between financial statement carrying amounts and the tax bases of assets and liabilities and are measured using the tax rates expected to be in effect when the differences reverse. Deferred tax assets are
 
also recognized for operating loss and tax credit carry forwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is used to reduce deferred tax assets when uncertainty exists regarding their realization.
A valuation allowance is recorded to reduce previously recorded tax assets when it becomes more likely than not such assets will not be realized. The Company evaluates, at least annually, net operating loss carry forwards and other net deferred tax assets and considers all available evidence, both positive and negative, to determine whether a valuation allowance is necessary relative to net operating loss carry forwards and other net deferred tax assets. In making this determination, the Company considers cumulative losses in recent years as significant negative evidence. The Company considers recent years to mean the current year plus the two preceding years. The Company considers the recent cumulative income or loss position of its filings groups as objectively verifiable evidence for the projection of future income, which consists primarily of determining the average of the pre-tax income of the current and prior two years after adjusting for certain items not indicative of future performance. Based on this analysis, the Company determines whether a valuation allowance is necessary.
The Company periodically identifies and evaluates uncertain tax positions. This process considers the amounts and probability of various outcomes that could be realized upon final settlement. Liabilities for uncertain tax positions are based on a two-step process. The actual benefits ultimately realized may differ from the Company’s estimates. Changes in facts, circumstances, and new information may require a change in recognition and measurement estimates for certain individual tax positions. Any changes in estimates are recorded in results of operations in the period in which the change occurs. At December 31, 2016, the Company performed an evaluation of its various tax positions and concluded that it did not have significant uncertain tax positions requiring disclosure. The Company’s policy is to record interest and penalties related to income tax matters as income tax expense.
Share-Based Compensation
The Company has stock-based incentive plans which are authorized to issue stock options, restricted stock, and other incentive awards. Stock-based compensation expense for stock options and restricted stock is determined based upon estimated grant-date fair value. This fair value for the stock options is calculated using the Black-Scholes option-pricing model and is recognized as expense over the requisite service period. The option-pricing model requires the input of highly subjective assumptions, including expected stock price volatility and expected option life. For all stock-based incentive plans, the Company estimates an expected forfeiture rate and recognizes expense only for those shares expected to vest. The estimated forfeiture rate is based on historical experience. To the extent actual forfeiture rates differ from the


39


estimate, stock-based compensation expense is adjusted accordingly.
Loss Contingencies
The Company is subject to a variety of loss contingencies that could arise during the Company’s conduct of business. Management considers the likelihood of a loss or impairment of an asset or the incurrence of a liability, as well as the Company’s ability to reasonably estimate the amount of loss, in determining potential loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount
 
of loss can be reasonably estimated. Accruals for loss contingencies have not been recorded during the past three years. The Company regularly evaluates current information available to determine whether such accruals should be made or adjusted.
Recent Accounting Pronouncements
Recent accounting pronouncements which may impact the Company are described in Note 2 – “Summary of Significant Accounting Policies” in Part II, Item 8 – “Financial Statements and Supplementary Data” of this Annual Report.


Item 7A. Quantitative and Qualitative Disclosures About Market Risk.


The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, and commodity prices. Market risk is measured as the potential negative impact on earnings, cash flows, or fair values resulting from a hypothetical change in interest rates, commodity prices, or foreign currency exchange rates over the next year. The Company manages exposure to market risks at the corporate level. The portfolio of interest-sensitive assets and liabilities is monitored and adjusted to provide liquidity necessary to satisfy anticipated short-term needs. The Company’s risk management policies allow the use of specified financial instruments for hedging purposes only. Speculation on interest rates or foreign currency rates is not permitted. The Company does not consider any of these risk management activities to be material.
Interest Rate Risk
The Company is exposed to the impact of interest rate changes on any outstanding indebtedness under the revolving credit facility agreement and the term loan agreement both of which have a variable interest rate. The interest rate on advances under the revolving credit facility varies based on the level of borrowing under the revolving credit facility. Rates range (a) between PNC Bank’s base lending rate plus 1.5% to 2.0% or (b) between the London Interbank Offered Rate (LIBOR) plus 2.5% to 3.0%. PNC Bank’s base lending rate was 3.75% at December 31, 2016, and would have permitted borrowing at rates ranging between 5.25% and 5.75%. The Company is required to pay a monthly facility fee of 0.25% on any unused amount under the commitment based on daily averages. At December 31, 2016, $38.6 million was outstanding under the revolving credit facility, with $5.6 million borrowed as base rate loans at an interest rate of 5.75% and $33.0 million borrowed as LIBOR loans at an interest rate of 3.62%.
The amount borrowed under the term loan was reset to $10.0 million as of September 30, 2016. Monthly principal payments of $0.2 million are required. The unpaid balance of the term loan is due May 10, 2020. The interest rate on the term loan varies based on the fixed charge coverage ratio. Rates range (a) between PNC Bank’s base lending rate plus
 
2.25% to 2.75% or (b) between LIBOR plus 3.25% to 3.75%. At December 31, 2016, $9.8 million was outstanding under the term loan, with $0.8 million borrowed as base rate loans at an interest rate of 6.50% and $9.0 million borrowed as LIBOR loans at an interest rate of 4.37%.
Foreign Currency Exchange Risk
The Company presently has limited exposure to foreign currency risk. During 2016, approximately 1.9% of revenue was demarcated in non-U.S. dollar currencies and virtually all assets and liabilities of the Company are denominated in U.S. dollars. However, as the Company expands its international operations, non-U.S. denominated activity is likely to increase. The Company has historically performed no swaps and no foreign currency hedges. The Company may utilize swaps or foreign currency hedges in the future.
Commodity Risk
The Company is one of the largest processors of citrus oils in the world and, therefore, has a commodity risk inherent in orange harvests. In recent years, citrus greening has disrupted citrus fruit production in Florida and Brazil which caused raw material feedstock cost to increase. The Company believes that adequate global supply is available to meet the Company’s needs and the needs of general chemistry markets at this time. The Company primarily relies upon diverse, long-term strategic supply relationships to meet its raw material needs which are expected to remain in place for the foreseeable future. Price increases have been passed along to the Company’s customers. The Company presently does not have any futures contracts and it does not plan to utilize these in the foreseeable future.
The Company purchased IPI in July 2016, an importer and processor of guar splits into fast hydrating guar powder at its facility in Dalton, Georgia. Guar powder is used as a gelling agent for fluid systems in the completion of oil and gas wells. Guar seed is largely produced in India and Pakistan and has inherent commodity risk associated with agricultural crops and geopolitical uncertainty. In recent years, the price of guar


40


has been disrupted by weak demand in the oil and gas industry, causing prices to decline significantly from peak industry activity in 2012. The Company believes its inventory and supply agreements are well positioned  to meet market needs at this time.  The Company primarily relies upon long-term strategic supply relationships to meet its raw material needs
 
which are expected to remain in place for the foreseeable future.  Although there are international, publically traded exchanges for guar seed, the Company presently does not have any futures contracts and it does not plan to utilize these in the foreseeable future.



41


Item 8.  Financial Statements and Supplementary Data.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Stockholders
Flotek Industries, Inc.
We have audited Flotek Industries, Inc.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Flotek Industries, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded International Polymerics, Inc. from its assessment of internal control over financial reporting as of December 31, 2016, because it was acquired by the Company in a purchase business combination in the third quarter of 2016. We have also excluded International Polymerics, Inc. from our audit of internal control over financial reporting. International Polymerics, Inc. is a wholly owned subsidiary whose total assets and net income represent approximately 4% and 2%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2016.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Flotek Industries, Inc. maintained in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2016, and our report dated February 8, 2017 expressed an unqualified opinion.



/s/ HEIN & ASSOCIATES LLP
Houston, Texas
February 8, 2017


42


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Stockholders
Flotek Industries, Inc.
We have audited the accompanying consolidated balance sheets of Flotek Industries, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Flotek Industries, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Flotek Industries, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated February 8, 2017 expressed an unqualified opinion on the effectiveness of Flotek Industries, Inc.’s internal control over financial reporting.



/s/ HEIN & ASSOCIATES LLP
Houston, Texas
February 8, 2017




43


FLOTEK INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 
December 31,
 
2016
 
2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
4,823

 
$
2,208

Accounts receivable, net of allowance for doubtful accounts of $664 and
    $709 at December 31, 2016 and 2015, respectively
47,152

 
35,511

Inventories
58,283

 
50,870

Deferred tax assets, net
52

 
2,649

Income taxes receivable
12,752

 
4,700

Assets held for sale
43,900

 
48,855

Other current assets
21,708

 
6,949

Total current assets
188,670

 
151,742

Property and equipment, net
74,691

 
60,006

Goodwill
56,660

 
55,798

Deferred tax assets, net
16,215

 
17,229

Other intangible assets, net
50,352

 
51,198

Assets held for sale

 
67,117

TOTAL ASSETS
$
386,588

 
$
403,090

LIABILITIES AND EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
29,960

 
$
17,221

Accrued liabilities
12,170

 
10,480

Income taxes payable

 
2,263

Interest payable
24

 
111

Liabilities held for sale
4,961

 
4,637

Current portion of long-term debt
40,566

 
32,291

Deferred tax liabilities, net
3,373

 

Total current liabilities
91,054

 
67,003

Long-term debt, less current portion
7,833

 
18,255

Deferred tax liabilities, net

 
23,823

Total liabilities
98,887

 
109,081

Commitments and contingencies

 

Equity:
 
 
 
Cumulative convertible preferred stock, $0.0001 par value, 100,000 shares
    authorized; no shares issued and outstanding

 

Common stock, $0.0001 par value, 80,000,000 shares authorized; 59,684,669
    shares issued and 56,972,580 shares outstanding at December 31, 2016;
    56,220,214 shares issued and 53,536,101 shares outstanding at
    December 31, 2015
6

 
6

Additional paid-in capital
318,392

 
273,451

Accumulated other comprehensive income (loss)
(956
)
 
(1,237
)
Retained earnings (accumulated deficit)
(9,830
)
 
39,300

Treasury stock, at cost; 2,028,847 and 1,784,897 shares at December 31, 2016
    and 2015, respectively
(20,269
)
 
(17,869
)
Flotek Industries, Inc. stockholders’ equity
287,343

 
293,651

Noncontrolling interests
358

 
358

Total equity
287,701

 
294,009

TOTAL LIABILITIES AND EQUITY
$
386,588

 
$
403,090

See accompanying Notes to Consolidated Financial Statements.

44


FLOTEK INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
 
 
Year ended December 31,
 
2016
 
2015
 
2014
Revenue
$
262,832

 
$
269,966

 
$
319,852

Cost of revenue
172,154

 
173,660

 
189,088

Gross profit
90,678

 
96,306

 
130,764

Expenses:
 
 
 
 
 
Selling, general and administrative
80,150

 
70,276

 
61,236

Depreciation and amortization
8,530

 
7,108

 
6,141

Research and development
9,320

 
6,657

 
4,787

Gain on disposal of long-lived assets
(18
)
 
(13
)
 
(19
)
Total expenses
97,982

 
84,028

 
72,145

(Loss) income from operations
(7,304
)
 
12,278

 
58,619

Other income (expense):
 
 
 
 
 
Interest expense
(1,979
)
 
(1,521
)
 
(1,373
)
Gain on legal settlement
12,730

 

 

Other (expense) income, net
(303
)
 
(123
)
 
(376
)
Total other income (expense)
10,448

 
(1,644
)
 
(1,749
)
Income before income taxes
3,144

 
10,634

 
56,870

Income tax expense
(1,237
)
 
(3,476
)
 
(17,248
)
Income from continuing operations
1,907

 
7,158

 
39,622

(Loss) income from discontinued operations, net of tax
(51,037
)
 
(20,620
)
 
13,981

Net (loss) income
$
(49,130
)
 
$
(13,462
)
 
$
53,603

 
 
 
 
 
 
Basic earnings (loss) per common share:
 
 
 
 
 
Continuing operations
$
0.03

 
$
0.13

 
$
0.73

Discontinued operations, net of tax
(0.91
)
 
(0.38
)
 
0.26

Basic earnings (loss) per common share
$
(0.88
)
 
$
(0.25
)
 
$
0.99

Diluted earnings (loss) per common share:
 
 
 
 
 
Continuing operations
$
0.03

 
$
0.13

 
$
0.71

Discontinued operations, net of tax
(0.91
)
 
(0.37
)
 
0.25

Diluted earnings (loss) per common share
$
(0.88
)
 
$
(0.24
)
 
$
0.96

Weighted average common shares:
 
 
 
 
 
Weighted average common shares used in computing basic earnings (loss) per common share
56,087

 
54,459

 
54,511

Weighted average common shares used in computing diluted earnings (loss) per common share
56,350

 
54,992

 
55,526

See accompanying Notes to Consolidated Financial Statements.



45


FLOTEK INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)

 
Year ended December 31,
 
2016
 
2015
 
2014
Income from continuing operations
$
1,907

 
$
7,158

 
$
39,622

(Loss) income from discontinued operations, net of tax
(51,037
)
 
(20,620
)
 
13,981

Net (loss) income
(49,130
)
 
(13,462
)
 
53,603

Other comprehensive income (loss):
 
 
 
 
 
Foreign currency translation adjustment
281

 
(735
)
 
(143
)
Comprehensive (loss) income
$
(48,849
)
 
$
(14,197
)
 
$
53,460


See accompanying Notes to Consolidated Financial Statements.



46



FLOTEK INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF EQUITY
(in thousands)
 
Common Stock
 
Treasury Stock
 
Additional
Paid-in
Capital
 
Accumulated
Other Comprehensive
Income (Loss)
 
Retained Earnings
(Accumulated
Deficit)
 
Non-controlling Interests
 
Total Equity
 
Shares Issued
 
Par Value
 
Shares
 
Cost
 
Balance, December 31, 2013
58,266

 
$
6

 
5,394

 
$
(15,176
)
 
$
266,122

 
$
(359
)
 
$
(841
)
 
$

 
$
249,752

Net income

 

 

 

 

 

 
53,603

 

 
53,603

Foreign currency translation adjustment

 

 

 

 

 
(143
)