Cactus, Inc.: Form 10-Q for the period ended Mar 31, 2019

Except as otherwise indicated or required by the context, all references in this Quarterly Report to the “Company,” “Cactus,” “we,” “us” and “our” refer to (i) Cactus, Inc. (“Cactus Inc.”) and its consolidated subsidiaries (including Cactus LLC) following the completion of our initial public offering on February 12, 2018 (our “IPO”), unless we state otherwise or the context otherwise requires and (ii) Cactus Wellhead, LLC (“Cactus LLC”) and its consolidated subsidiaries prior to the completion of our IPO. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and related notes. The following discussion contains “forward-looking statements” that reflect our plans, estimates, beliefs and expected performance. Our actual results may differ materially from those anticipated as discussed in these forward-looking statements as a result of a variety of risks and uncertainties, including those described above in “Cautionary Note Regarding Forward-Looking Statements” and included elsewhere in this Quarterly Report, all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forward-looking events discussed may not occur. We assume no obligation to update any of these forward-looking statements except as otherwise required by law.

Executive Summary

We design, manufacture, sell and rent a range of highly engineered wellhead and pressure control equipment. Our products are sold and rented principally for onshore unconventional oil and gas wells and are utilized during the drilling, completion and production phases of our customers’ wells. In addition, we provide field services for all of our products and rental items to assist with the installation, maintenance and handling of the wellhead and pressure control equipment.

We operate through service centers in the United States, which are strategically located in the key oil and gas producing regions, including the Permian, SCOOP/STACK, Marcellus, Utica, Eagle Ford, Bakken, among other active oil and gas regions in the United States, and in Eastern Australia. These service centers support our field services and provide equipment assembly and repair services. Our manufacturing and production facilities are located in Bossier City, Louisiana and Suzhou, China.

Our revenues are derived from three sources: products, rentals, and field service and other. Product revenues are primarily derived from the sale of wellhead systems and production trees. Rental revenues are primarily derived from the rental and associated repair of equipment used for well control during the completion process as well as the rental of drilling tools. Field service and other revenues are primarily earned when we provide installation and other field services for both product sales and equipment rental. Additionally, other revenues are derived from providing repair and reconditioning services to customers that have previously installed our products on their wellsite. Items sold or rented generally have an associated service component. As a result, there is some level of correlation between field service and other revenues and revenues from product sales and rentals.

In the three months ended March 31, 2019, we derived 55% of our total revenues from the sale of our products, 24% of our total revenues from rental and 21% of our total revenues from field service and other. In the three months ended March 31, 2018, we derived 51% of our total revenues from the sale of our products, 25% of our total revenues from rental and 24% of our total revenues from field service and other. We have predominantly domestic operations, with 99% of our total sales for the three months ended March 31, 2019 and 2018, respectively, earned from U.S. operations.

Market Factors and Trends

Demand for our products and services depends primarily upon the general level of activity in the oil and gas industry, including the number of drilling rigs in operation, the number of oil and gas wells being drilled, the depth and drilling conditions of these wells, the number of well completions and associated frac crews operating, the level of well remediation activity, and the volume of production and the corresponding capital spending by oil and natural gas companies. Oil and gas activity is in turn heavily influenced by, among other factors, oil and gas prices locally and worldwide, which have historically been volatile.

Oil supply markets tightened in 2017 and through the third quarter of 2018, driving 2018 average West Texas Intermediate (“WTI”) crude oil prices higher. However, during the fourth quarter of 2018, crude oil prices declined following concerns over slowing worldwide demand and the granting of waivers to several purchasers of Iranian oil. In response, many of the larger publicly traded exploration and production (“E&P”) companies announced plans to reduce their capital budgets year-over-year for 2019 which may reduce the amount of planned drilling and completion activity in 2019. Despite a return to more balanced global oil markets and higher crude prices thus far in 2019, E&P companies may be reluctant to increase capital spending plans. We are well positioned to respond to increased demand for our products and rental equipment but are also prepared to pull back and react to weaker customer demand.

For the three months ended March 31, 2019, the weekly average U.S. onshore rig count as reported by Baker Hughes was 1,021 rigs. The weekly average U.S. onshore rig counts for the full year 2018 and 2017 were 1,011 rigs and 853 rigs, respectively. The U.S. onshore rig count as of March 31, 2019 was 981, below the year-to-date average of 1,021. To the extent the rig count remains at levels below year-to-date 2019 and 2018 levels, there may be reduced demand for our products and services. However, given the recovery in crude oil prices thus far in 2019, drilling activity declines are generally expected to moderate and potentially increase modestly later in 2019.

The key market factors impacting our product sales are the number of wells drilled and placed on production, as each well requires an individual wellhead assembly, and after completion, the installation of an associated production tree. We measure our product sales activity levels versus our competitors by the number of rigs that we are supporting on a monthly basis as a proxy for wells drilled. While numerous factors may lead to differing revenues per rig, we are able to broadly forecast our product needs and anticipated revenue levels based on general trends in a given region and with specific customers. Increases in horizontal wells drilled as a percentage of total wells drilled, the shift towards pad drilling, and an increase in the number of wells drilled per rig are all favorable trends that we believe enhance the demand for our products relative to the active rig count.

Our rental revenues are primarily dependent on the number of wells completed (i.e., hydraulically fractured), the number of wells on a well pad and the number of fracture stages per well. Well completion activity generally follows the level of drilling activity. We believe that the current number of drilled but uncompleted wells (“DUCs”), particularly resulting from near-term takeaway issues that are likely to be resolved later this year, could ultimately provide additional opportunities although we recognize that not all DUCs will be completed and that certain customers may elect to maintain an increased inventory of DUCs to provide production flexibility.

Service and other revenues are closely correlated to revenues from product sales and rentals, as items sold or rented almost always have an associated service component. Therefore, the market factors and trends of product sales and rental revenues similarly impact the associated levels of service and other revenues generated.

Our business experiences some seasonality during the fourth quarter due to holidays and customers managing their budgets as the year concludes. This can lead to lower activity in our three revenue categories as well as lower margins, particularly in field services due to reduced labor utilization.

Recent Developments

Reference is made to the disclosure in our Annual Report on Form 10-K for the year ended December 31, 2018 (our “2018 Annual Report”) under the headings “Part I. Item 1.—Business—Costs of Conducting our Business—Impact of Section 301 of the Trade Act of 1974 (“Section 301”)” and “Item 1.A. Risk Factors—The outcome of final actions under Section 301 of the Trade Act of 1974 may adversely affect our business.” During the week of May 5, 2019, President Trump and the U.S. Trade Representative indicated that tariffs on $200 billion of products imported from China would be raised from 10% to 25% effective on May 10, 2019 unless a trade agreement is reached.

Consolidated Results of Operations

Three Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018

The following table presents summary consolidated operating results for the periods indicated:

(in thousands)

Revenues

Product revenue for the three months ended March 31, 2019 was $86.6 million, an increase of $27.7 million, or 47%, from $58.9 million for the three months ended March 31, 2018. The increase was primarily attributable to increased sales of wellhead and production related equipment due to our increased market share and greater drilling activity from customers. The quarterly average U.S. onshore rig count increased 8% to 1,021 rigs for the three months ended March 31, 2019 compared to 948 rigs for the same period in 2018. Additionally, the number of rigs followed by Cactus increased 19% to 297 rigs during the first quarter 2019 compared to 250 rigs for the first quarter 2018. The term “rigs followed” represents the approximate number of active U.S. onshore drilling rigs to which we were the primary provider of wellhead products and corresponding services during drilling.

Rental revenue for the three months ended March 31, 2019 was $38.5 million, an increase of $9.4 million, or 32%, from $29.1 million for the three months ended March 31, 2018. The increase was primarily attributable to increased investment in our rental fleet that enabled us to take advantage of greater completion activity from customers.

Field service and other revenue for the three months ended March 31, 2019 was $33.7 million, an increase of $6.7 million, or 25%, from $27.0 million for the three months ended March 31, 2018. The increase was primarily attributable to the higher demand for these services following the increase in our product and rental revenue, as field service is closely correlated with these activities.

Costs and expenses

Cost of product revenue for the three months ended March 31, 2019 was $53.0 million, an increase of $16.0 million, or 43%, from $37.1 million for the three months ended March 31, 2018. The increase was largely attributable to an increase in product sales volume driven by higher demand for our products.

Cost of rental revenue for the three months ended March 31, 2019 was $17.8 million, an increase of $5.6 million, or 46%, from $12.2 million for the three months ended March 31, 2018. The increase was largely attributable to higher depreciation expense on a larger rental fleet, increased repair costs associated with a larger and more active rental fleet, and an increase in costs associated with the deployment of assets into the field.

Cost of field service and other revenue for the three months ended March 31, 2019 was $26.9 million, an increase of $5.4 million, or 25%, from $21.5 million for the three months ended March 31, 2018. The increase was largely attributable to higher payroll costs due to additional field personnel and higher volume driven operating costs.

Selling, general and administrative expense for the three months ended March 31, 2019 was $12.7 million, an increase of $3.6 million, or 39%, from $9.1 million for the three months ended March 31, 2018. The increase was largely attributable to higher payroll and incentive compensation costs associated with our overall growth as well as higher stock-based compensation expenses related to equity awards and other costs associated with being a public company.

Interest income (expense), net. Interest income, net for the three months ended March 31, 2019 was less than $0.1 million, compared to interest expense, net of $2.9 million for the three months ended March 31, 2018. The change is primarily due to the repayment of our previous term loan in mid-February 2018 in conjunction with our IPO.

Other income (expense), net. Other expense, net for the three months ended March 31, 2019 relates to $1.0 million in offering expenses associated with the secondary offering of our Class A common stock in March 2019 by certain selling stockholders. This compares to a $4.3 million loss on early extinguishment of debt for the three months ended March 31, 2018, recorded in conjunction with the repayment of our previous term loan with a portion of the net proceeds from our IPO. See Note 1 of the Notes to Condensed Consolidated Financial Statements for further details of the March 2019 Secondary Offering.

Income tax expense, (benefit). Cactus Inc. is subject to federal as well as state income tax on its share of income of Cactus LLC. Our operations prior to our IPO were not subject to U.S. federal income tax at an entity level. Income tax benefit for the three months ended March 31, 2019 was $1.0 million compared to an income tax expense of $1.7 million (5.9% effective tax rate) for the three months ended March 31, 2018. The overall tax benefit recorded during the three months ended March 31, 2019 is due to the release of $8.2 million of our valuation allowance in conjunction with the March 2019 Secondary Offering as a portion of our deferred tax asset for our investment in Cactus LLC became realizable. In addition to the partial release of our valuation allowance, our effective tax rate is lower than the federal statutory rate of 21% as Cactus Inc. is only subject to federal and state income tax on its share of income of Cactus LLC. As of March 31, 2019, Cactus Inc. owned 61.8% of Cactus LLC compared to 35.3% as of March 31, 2018.

Liquidity and Capital Resources

Our ability to satisfy our liquidity requirements, including cash distributions to the holders of units representing limited liability company interests in Cactus LLC (“CW Units”) to fund their respective income tax liabilities relating to their share of the income of Cactus LLC and to fund liabilities related to the tax receivable agreement (the “TRA”), that we entered into with certain current or past direct and indirect owners of Cactus LLC (the “TRA Holders”), depends on our future operating performance, which is affected by prevailing economic conditions, market conditions in the E&P industry, availability and cost of raw materials, and financial, business and other factors, many of which are beyond our control.

At March 31, 2019 and December 31, 2018, we had $88.1 million and $70.8 million, respectively, of cash and cash equivalents. At March 31, 2019, we had no borrowings outstanding under the ABL Credit Facility and we had $75.0 million of available borrowing capacity under our ABL Credit Facility. See Note 5 of the Notes to Condensed Consolidated Financial Statements. We were in compliance with the covenants of the ABL Credit Facility as of March 31, 2019.

We expect that our primary sources of liquidity and capital resources will be cash flows generated by operating activities and borrowings under our ABL Credit Facility. Depending upon market conditions and other factors, we may also have the ability to issue additional equity and debt if needed.

We currently estimate our net capital expenditures for the year ending December 31, 2019 will range from $60 million to $65 million, excluding acquisitions, mostly related to rental fleet investments. We continuously evaluate our capital expenditures, and the amount we ultimately spend will depend on a number of factors, including, among other things, demand for rental assets, available capacity in existing locations, prevailing economic conditions, market conditions in the E&P industry, customers’ forecasts, demand and volatility and company initiatives.

We believe that our existing cash on hand, cash generated from operations and available borrowings under our ABL Credit Facility will be sufficient to meet working capital requirements, anticipated capital expenditures, expected cash distributions to holders of CW Units, expected TRA liability payments and anticipated tax liabilities for at least the next 12 months.

Cash Flows

Three Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018

The following table summarizes our cash flows for the periods indicated:

(in thousands)

Net cash provided by operating activities was $34.2 million and $38.6 million for the three months ended March 31, 2019 and 2018, respectively. The primary reasons for the change were the $22.0 million increase in net income, offset by a $4.5 million decrease in non-cash items and a $21.8 million increase in net working capital use due to the increase in business activity during the first quarter 2019.

Net cash used in investing activities was $13.8 million and $15.7 million for the three months ended March 31, 2019 and 2018, respectively. The primary reasons for the decrease was slightly lower capital expenditures during the first quarter 2019 in addition to higher proceeds primarily from the sale of certain rental equipment and vehicles.

Net cash used in financing activities of $3.6 million for the three months ended March 31, 2019 consists of $1.5 million used to repurchase stock, $0.2 million in Cactus LLC member distributions and $1.8 million related to the principal payments on our finance leases. Net cash used in financing activities of $22.6 million for the three months ended March 31, 2018 was primarily related to the receipt of $469.6 million of net proceeds from our IPO, offset by (i) a $248.5 million repayment of the borrowings outstanding under our previous term loan and (ii) $216.4 million in redemptions of CW Units from certain direct and indirect owners of Cactus LLC in connection with our IPO. Additionally, we made a $26.0 million distribution to owners prior to our IPO to provide funds to pay their federal and state liabilities associated with taxable income recognized by them in the period prior to the completion of our IPO as a result of their ownership in Cactus LLC.

Tax Receivable Agreement

In connection with our IPO, we entered into the TRA, which generally provides for the payment by Cactus Inc. to the TRA Holders of 85% of the net cash savings, if any, in U.S. federal, state and local income tax or franchise tax that Cactus Inc. actually realizes or is deemed to realize in certain circumstances. Cactus Inc. will retain the benefit of the remaining 15% of these net cash savings. To the extent Cactus LLC has available cash, we intend to cause Cactus LLC to make generally pro rata distributions to its unitholders, including us, in an amount at least sufficient to allow us to pay our taxes and to make payments under the TRA.

Assuming no material changes in the relevant tax law, we expect that if the TRA were terminated as of March 31, 2019, the estimated termination payments, based on the assumptions discussed in Note 2 of the Notes to Condensed Consolidated Financial Statements, would be approximately $342 million, calculated using a discount rate equal to one-year LIBOR plus 150 basis points, applied against an undiscounted liability of $471 million. A 10% increase in the price of our Class A common stock at March 31, 2019 would have increased the discounted liability by $16 million to $358 million (an undiscounted increase of $25 million to $496 million), and likewise, a 10% decrease in the price of our Class

A common stock at March 31, 2019 would have decreased the discounted liability by $17 million to $325 million (an undiscounted decrease of $25 million to $446 million).

Contractual Obligations

A summary of our contractual obligations as of March 31, 2019 is provided in the following table:

(in thousands)

(1) Operating lease obligations relate to real estate and equipment.

(2) Finance lease obligations relate to vehicles used in our business.

(3) Represents obligations by Cactus to make payments under the TRA. The amount and timing of payments is subject to change.

Off-Balance Sheet Arrangements

Currently, we do not have off-balance sheet arrangements.

For quantitative and qualitative disclosures about market risk, see Part II, Item 7A., “Quantitative and Qualitative Disclosures about Market Risk,” in our 2018 Annual Report. Our exposure to market risk has not changed materially since December 31, 2018.

Evaluation of Disclosure Controls and Procedures

In accordance with Exchange Act Rules 13a-15 and 15d-15, we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the period covered by this report. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Based upon that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were not effective as of March 31, 2019 due to a previously disclosed material weakness in internal control over financial reporting. This material weakness was identified and discussed in “Part II – Item 9A - Controls and Procedures” of our 2018 Annual Report.

Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during the first quarter of 2019 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

In addition to the information set forth in this Quarterly Report, you should carefully consider the risk factors and other cautionary statements described under the heading “Item 1A. Risk Factors” included in our 2018 Annual Report and the risk factors and other cautionary statements contained in our other filings with the Securities and Exchange Commission, which could materially affect our business, results of operations, financial condition or cash flows. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, results of operations, financial condition or cash flows. There have been no material changes in our risk factors from those described in our 2018 Annual Report or our other Securities and Exchange Commission filings.