Cactus, Inc.: Form 10-Q for the period ended Jun 30, 2020

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 Cactus, Inc. (“Cactus Inc.”) and its consolidated subsidiaries, unless we state otherwise or the context otherwise requires. 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.

We operate in one business segment. 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 six months ended June 30, 2020, we derived 58% of total revenues from the sale of our products, 22% of total revenues from rental and 20% of total revenues from field service and other. In the six months ended June 30, 2019, we derived 55% of total revenues from the sale of our products, 24% of total revenues from rental and 21% of total revenues from field service and other. We have predominantly U.S. operations, with a small amount of sales being generated in Australia.

Market Factors

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, the level of well remediation activity, 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.

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, at some time after completion, the installation of an associated production tree. We measure our product sales activity levels against our competitors by the number of rigs that we are supporting on a monthly basis, as it is correlated to wells drilled. Each active drilling rig produces different levels of revenue based on the customer’s drilling plan, which includes factors such as the number of wells drilled per pad, the time taken to drill each well, the number and size of casing strings, the working pressure, material selection and the complexity of the wellhead system chosen by the customer and the rate at which production trees are eventually deployed. All of these factors may be influenced by the oil and gas region in which our customer is operating. While these factors may lead to differing revenues per rig, we have historically been able to broadly forecast our product needs and anticipated revenue levels based on general trends in a given region and with a specific customer. 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 but can be delayed due to such factors as takeaway capacity, storage capacity and budget constraints.

Field 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 field service and other revenues generated.

Recent Developments and Trends

In March 2020, COVID-19 continued spreading worldwide and was declared a pandemic by the World Health Organization. The combination of travel restrictions, school and business closures and stay-at-home orders worldwide resulted in a severe decline in the demand for oil. Oil prices declined sharply in April 2020, with West Texas Intermediate (WTI) prices trading at negative levels for a brief period. Although oil prices have recovered from their lows in April to over $40 a barrel in July, demand for oil remains severely depressed and our customer activity levels have dropped significantly as capital expenditure budgets have been cut drastically this year. This has resulted in reduced demand for our products and services. As COVID-19 continues to spread rapidly throughout the U.S. as well as other countries, demand for oil and natural gas products may not improve significantly in the near term.

Evidence of the industry downturn can be seen in the decline in U.S. onshore rig counts throughout 2020. At the end of 2019, the U.S. onshore rig count as reported by Baker Hughes was 781 rigs. The weekly average U.S. onshore rig count dropped to 378 rigs for the three months ended June 30, 2020. This is compared to 963 rigs for the comparable period in 2019. As of July 24, 2020, the U.S. onshore rig count was 239.

We believe we are well positioned to successfully navigate the industry downturn even though the duration and extent remains unknown at this time. We are continuing to actively review all opportunities to reduce costs and capital deployed and believe we will be able to manage our expenses and capital expenditures relative to market conditions. To date, we have implemented certain workforce, wage and capital expenditure reductions beginning as early as March 2020. As of June 30, 2020, we have reduced our worldwide workforce by approximately 50%. Total annualized cost savings on the headcount and wage reductions and other payroll-related measures are estimated to be approximately $85 million. Additionally, our required capital expenditures have historically tended to be lower than most other oilfield service providers due to the asset-lite nature of our business model. As of June 30, 2020 we had no long-term debt and over $270 million of cash. We also believe that the operating environment following the industry downturn may prove more favorable for companies that are financially well positioned.

Tariffs

On March 26, 2020, the U.S. Trade Representative (“USTR”) announced certain exclusion requests related to tariffs on our Chinese imports under Section 301 of the Trade Act of 1974 (“Section 301”). Not all of our products with Section 301 tariffs were included under this exclusion. The tariff exemption applies to covered products exported from China to the United States from September 24, 2018 until August 7, 2020. The tariff rate on the covered products was 10% beginning in September 2018 and raised to 25% in June 2019. In April 2020, we completed filing post summary corrections and protests in order to request refunds back to 2018 for tariffs paid on the now excluded products. To date, we have recognized $7.7 million in refunds, inclusive of $0.2 million in interest, and applied those amounts against inventory and cost of goods sold based on whether the costs had been recognized in our statements of income or remained in inventory pending sale. The post summary correction and protest filings are subject to review and approval; therefore, we are not recognizing the refunds until we have confirmation of the refund amounts paid. As of June 30, 2020, we have approximately $6.3 million in refunds pending that will be recognized as credits to cost of sales if and when received. We are unable to predict when that will occur. Although we feel our requests for refunds are supportable, we cannot be sure they will not be challenged by the government. The tariff suspension currently remains in effect until August 7, 2020. At this time, we do not know if the exclusions will be extended.

Consolidated Results of Operations

Three Months Ended June 30, 2020 Compared to Three Months Ended June 30, 2019

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

(in thousands)

Revenues

Product revenue was $40.9 million in the second quarter of 2020 compared to $94.5 million in the second quarter of 2019. The decrease of $53.6 million from 2019 was the result of lower sales of wellhead and production related equipment primarily due to lower drilling and completion activity in 2020 by our customers.

Rental revenue of $11.5 million in the second quarter of 2020 decreased $28.0 million, or 71%, from $39.6 million in the second quarter of 2019. The decrease was primarily due to reduced completion activity by our customers in 2020.

Field service and other revenue was $14.1 million in the second quarter of 2020, a decrease of $20.3 million, or 59%, from $34.4 million in the second quarter of 2019. The decrease was due to lower customer activity related to the overall industry downturn, resulting in lower billable hours and ancillary services.

Costs and expenses

Cost of product revenue for the second quarter of 2020 was $26.0 million, a decrease of $31.6 million, or 55%, from $57.5 million for the second quarter of 2019. The decrease was largely attributable to a reduction in product sales but was also due to approximately $3.1 million in credits related to tariff refunds recorded during the second quarter of 2020.

Cost of rental revenue of $10.7 million for the second quarter of 2020 decreased $8.8 million, or 45%, from $19.5 million for the second quarter of 2019. The decrease was primarily attributable to lower repair costs, scrap and rework expense and branch expenses. Rental cost of sales in the second quarter of 2020 also included approximately $0.3 million in credits related to tariff refunds recorded during the quarter. These decreases in cost were partially offset by an increase in depreciation expense on a larger rental fleet.

Cost of field service and other revenue was $11.5 million for the second quarter of 2020, a decrease of $15.3 million, or 57%, from $26.8 million for the second quarter of 2019. The decrease was mainly related to lower payroll costs associated with fewer field and branch personnel in addition to gains from sales of field service vehicles of $1.6 million.

Selling, general and administrative expenses for the second quarter of 2020 was $8.7 million compared to $13.3 million for the second quarter of 2019. The $4.6 million decrease was largely attributable to lower personnel costs including annual incentive bonus accruals as a result of headcount and salary reductions implemented during the quarter, lower professional fees and reduced travel and entertainment costs. These cost savings were partially offset by slightly higher stock-based compensation expense.

Severance expense for the second quarter of 2020 of $0.9 million represents severance benefits associated with headcount reductions of approximately 300 associates announced during the quarter.

Interest income, net. Interest income for the second quarter of 2020 was $0.2 million compared to $0.1 million for the second quarter of 2019. The increase in interest income from 2019 was primarily due to $0.2 million of interest income recognized on tariff refunds.

Other income. Other income for the second quarter of 2020 of $1.3 million related to a non-cash adjustment for the revaluation of the liability related to the tax receivable agreement.

Income tax expense. Cactus Inc. is subject to U.S. federal and state income taxes on its share of income of Cactus LLC. Income tax expense for the second quarter of 2020 was $1.3 million (12.6% effective tax rate) compared to $10.8 million (20.9% effective tax rate) for the second quarter of 2019. The second quarter of 2019 included additional tax expense of $4.0

million related to a valuation allowance increase. Our effective tax rate for the second quarter of 2020 is lower than the federal statutory rate of 21% primarily due to the Company amending its 2018 tax return to claim a more favorable foreign tax credit position and the fact that Cactus Inc. is only subject to federal and state income tax on its share of income from Cactus LLC. Income allocated to the non-controlling interest is not subject to U.S. federal or state tax.

Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019

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

(in thousands)

Revenues

Product revenue for the six months ended June 30, 2020 was $127.9 million, a decrease of $53.2 million, or 29.4%, from $181.1 million for the six months ended June 30, 2019. The decrease was primarily due to lower sales of wellhead and production related equipment primarily resulting from lower drilling and completion activity by our customers in the second quarter of 2020.

Rental revenue for the six months ended June 30, 2020 was $47.7 million, a decrease of $30.4 million, or 39%, from $78.1 million for the six months ended June 30, 2019. The decrease was primarily due to reduced completion activity by our customers in the second quarter of 2020.

Field service and other revenue for the six months ended June 30, 2020 was $45.1 million, a decrease of $23.1 million, or 34%, from $68.2 million for the six months ended June 30, 2019. The decrease was due to lower customer activity in the second quarter of 2020 related to the overall industry downturn, resulting in lower billable hours and ancillary services.

Costs and expenses

Cost of product revenue for the six months ended June 30, 2020 was $82.1 million, a decrease of $28.4 million, or 26%, from $110.5 million for the six months ended June 30, 2019. The decrease was attributable to a reduction in product sales in the second quarter of 2020 but was also due to approximately $3.1 million in credits related to tariff refunds recorded.

Cost of rental revenue for the six months ended June 30, 2020 was $30.0 million, a decrease of $7.2 million, or 19%, from $37.2 million for the six months ended June 30, 2019. The decrease was primarily attributable to lower repair costs but also due to lower branch expenses. Rental cost of sales in 2020 also included approximately $0.3 million in credits related to tariff refunds recorded during the second quarter. These decreases were partially offset by an increase in depreciation expense on a larger rental fleet during 2020 and slightly higher scrap and rework expenses.

Cost of field service and other revenue for the six months ended June 30, 2020 was $35.3 million, a decrease of $18.4 million, or 34%, from $53.7 million for the six months ended June 30, 2019. The decrease was mainly related to lower payroll costs associated with fewer field and branch personnel as well as gains from sales of field service vehicles of $1.9 million.

Selling, general and administrative expense for the six months ended June 30, 2020 was $22.4 million, a decrease of $3.6 million, or 14%, from $25.9 million for the six months ended June 30, 2019. The decrease was primarily due to lower personnel costs related to headcount and salary reductions in the second quarter of 2020 including annual incentive bonus accruals and a reduction in professional fees. These reductions were partially offset by increases in stock-based compensation expense, credit loss reserves and foreign currency losses during 2020.

Severance expense for the six months ended June 30, 2020 of $1.9 million was due to severance benefits associated with headcount reductions in 2020.

Interest income, net. Interest income for the six months ended June 30, 2020 was $0.6 million, compared to $0.1 million for the six months ended June 30, 2019. The change is primarily due to higher interest income due to the Company’s higher cash balance as well as interest income recognized on tariff refunds.

Other income (expense), net. Other income for the six months ended June 30, 2020 of $1.3 million represents a non-cash adjustment for the revaluation of the liability related to the tax receivable agreement during the second quarter. Other expense for the six months ended June 30, 2019 of $1.0 million related to offering expenses associated with a secondary offering in March 2019 of our Class A common stock.

Income tax expense. Cactus Inc. is subject to U.S. federal and state income taxes on its share of income of Cactus LLC. Income tax expense for the six months ended June 30, 2020 was $8.8 million (17.3% effective tax rate) compared to $9.8 million (9.9% effective tax rate) for the six months ended June 30, 2019. Tax expense for the six months ended June 30, 2019 was net of a $4.2 million tax benefit related to the release of our valuation allowance in conjunction with the redemptions of CW Units and the March 2019 Secondary Offering, as a portion of our deferred tax asset for our investment in Cactus LLC became realizable. Our effective tax rate is lower than the federal statutory rate of 21% primarily due to the fact that Cactus Inc. is only subject to federal and state income tax on its share of income from Cactus LLC. Income allocated to the non-controlling interest is not subject to U.S. federal or state tax.

Liquidity and Capital Resources

At June 30, 2020, we had $270.7 million of cash and cash equivalents, no borrowings outstanding under our ABL Credit Facility and $45.8 million of available borrowing capacity. See Note 6 of the Notes to Condensed Consolidated Financial Statements. We were in compliance with the covenants of the ABL Credit Facility as of June 30, 2020.

Our primary sources of liquidity and capital resources are cash on hand, cash flows generated by operating activities and, if necessary, 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.

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.

For the six months ended June 30, 2020, net capital expenditures totaled $16.6 million, which were primarily related to rental fleet investments planned prior to the downturn. We currently estimate our net capital expenditures for the year ending December 31, 2020 will range from $20 million to $25 million. 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 for at least the next 12 months to meet working capital requirements, anticipated capital expenditures, expected TRA liability payments, anticipated tax liabilities and dividends to holders of our Class A common stock. In addition, we believe we will be able to fund pro rata cash distributions to holders of CW Units (other than Cactus Inc.) resulting from the requirement to make TRA liability payments, tax liabilities and dividends from Cactus Inc.

Cash Flows

Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019

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

(in thousands)

Net cash provided by operating activities was $102.5 million and $98.3 million for the six months ended June 30, 2020 and 2019, respectively. Operating cash flows for 2020 increased from 2019 primarily due to a decrease in net working capital use.

Net cash used in investing activities was $16.6 million and $28.7 million for the six months ended June 30, 2020 and 2019, respectively. The decrease was primarily due to lower capital expenditures associated with our rental fleet in 2020 due to reductions in purchases as a result of the current industry environment.

Net cash used in financing activities was $17.9 million and $9.1 million for the six months ended June 30, 2020 and 2019, respectively. The increase was attributable to $8.6 million in dividend payments to holders of Class A common stock in 2020 and an increase of $0.9 million in Cactus LLC member distributions, partially offset by a $0.5 million reduction in payments on finance leases.

Off-Balance Sheet Arrangements

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 2019 Annual Report. Our exposure to market risk has not changed materially since December 31, 2019.

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 effective as of June 30, 2020 at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the second quarter of 2020 that have materially affected, or are 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 2019 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. Except as previously disclosed in our Quarterly Report on Form 10-Q for the period ended March 31, 2020, there have been no material changes in our risk factors from those described in our 2019 Annual Report or our other Securities and Exchange Commission filings.