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Flotek Industries, Incorporated (NYSE:FTK ) has underperformed the market in the previous year but outperformed the market YTD. The outperformance is exclusively attributable to the 98% share price surge in response to the company's agreement with ProFrac Holdings ( PFHC), a vertically integrated energy company.

The deal may indeed prove to be a turning point for the company and may have a significant positive influence on the company and its stock's performance. Still, the recent surge has shot up the share price far quicker than the company's financials, leading to a significant premium on the stock's intrinsic value.

Additionally, after the maturity of the convertible notes issued by the company, the stock will be significantly diluted, weighing heavily on the EPS. Since there is no quantifiable evidence of improvement yet, only the most risk-tolerant investors would move forward with the investment.

I am reluctant to rate the company as a buy because it lacks reliable historical financial performance caused by core operational issues. Considering the imminent share dilution, Flotek needs to deal with these issues to improve shareholder confidence.

Flotek is a specialty green chemistry and data technology solution provider that helps its customers in industrial, commercial, and consumer markets to improve their ESG performance and operational goals. It operates through two segments:

The company will stop reporting on a segment basis in the upcoming quarterly reports and start reporting on a consolidated basis. In the wake of the recently closed PIPE deal, the company is undergoing major changes.

Flotek recently underwent a Private Investment in Public Equity (PIPE) deal in February 2022 to secure growth capital, raising $19 million in net cash proceeds by issuing 10% convertible notes with a maturity of one year.

Subsequently, the stock price almost doubled overnight pertaining to the news of contract expansion. Under the expansion, Flotek anticipates an increase in its backlog by over $2 billion over the next 10 years, including revenues of over $200 million in 2023.

Under the expanded contract, FTK has issued a further 10% convertible notes with a principal amount of $50 million and granted appointment rights to ProFrac, for four members on FTK's BOD out of seven. ProFrac would own up to approximately 48% of Flotek's common stock on an as-converted basis.

According to the agreement, ProFrac will be obligated to purchase a minimum supply greater of either a baseline determined by reference to ProFrac’s first 30 hydraulic fracturing fleets deployed or 70% of ProFrac’s requirements for ten years.

The company has failed to rebound after the pandemic with the rest of the market. Its revenue plunged from $119.4 million in 2019 to $53.1 million in 2020 and $43.3 million in 2021.

At first glance, the cost of revenue seems mismatched with revenue, accounting for a little over 103% of revenue in Q1 2022, 92.5% in 2021, and 154% in 2020, leading to volatile profit margins. However, a one-time gain of $7.6 million recorded in 2021 due to a contract termination resulted in a lower cost of revenue, meaning the higher cost of revenue is the norm.

The company's profitability is sub-par compared to its peers and has earned it the lowest, F, grade from Seeking Alpha's rating system.

The company's 5-year averages have been severely damaged because of the loss-making 2019 and 2020, but its revenue and gross margin have declined for almost a decade. If not for the $7.6 million adjustments in the previous year, it would have resulted in a gross loss of $4.2 million.

The company's loss from operations also paints a better picture in 2021 with a 78% improvement. However, this is due to the reduction of impairment charge from $81 million in 2020 to $8 million in 2021, which subsequently led to a 70% decrease in depreciation and amortization expense from about $3.4 million in 2020 to $1 million in 2021.

According to the company's most recent 10-K filing, the impairment charge was recorded in accordance with the following:

For the DA reporting unit, production growth is still anticipated to be lower in the near term as operators continue to show an abundance of fiscal discipline in development spending. Midstream thru-out volumes have remained well below capacity levels. While we are expecting production growth to increase, it is likely to do so at a more conservative pace.

The reduction of non-cash expenses doesn't really excite me right now because the company needs to get its cash situation under control. The company's annualized operating cash burn rate is unsustainable despite the addition of the recent growth capital.

The Q2 earnings report will show a surge in the company's cash balance as it has issued the $50 million convertible notes under the expanded agreement. Still, the levered FCF margin of almost -60% and sequential deterioration of the FCF per share make me doubtful of the company's cash conversion ability.

The company's balance sheet could do better, but it looks especially bad without a closer look because of the accumulated deficit and the convertible notes. The Altman Z score of negative 5.45 is heavily influenced by the accumulated deficit of over $319 million, and the leverage metrics highly pertain to the convertible notes.

With the upcoming inflow of around $50 million against further loan notes, I expect these metrics to worsen before they likely start getting better in 2023.

Since the company isn't reporting positive figures at the bottom line and the cash flows are also negative, we'll use its topline and balance sheet figures to value the company. It has contrasting forward and TTM-based metrics because of the PIPE deal.

The TTM P/S and EV-to-sales ratios of 1.9 and 2.3 are over 50% higher than the industry median. In contrast, forward P/S and EV-to-sales ratios of 0.65 and 0.74 are almost equally lower than the industry medians, exposing the post-agreement transformational line drawn by the company.

The company's P/B ratio of 6.8 is extremely higher than the industry median of 1.89, which is especially concerning because FTK has almost religiously deteriorated its book value since Q1 2019 from over $4 per share to $0.18 in the MRQ.

For a small-cap company like FTK, the risks and rewards are almost always higher than high-cap stocks, but an unreliable operational history, weak balance sheet, and a 680% premium on a declining book value make the stock too risky for me.

I would have rated the stock as a sell based on its current position, but because of the transformational deal, which may start delivering positive results in early 2023, I am neutral on the stock.

Opening a small position in anticipation of the potential upside by risk-tolerant investors may hold some water, but the stock's high volatility due to its low market cap and high risk, coupled with the overall market downturn, prophesize a bleak outlook.

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. Business relationship disclosure: This article was researched and written by Waleed M. Tariq.