Cactus, Inc.: Form 10-Q for the period ended Sep 30, 2023

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, which are difficult to predict, including those described above in “Cautionary Note Regarding Forward-Looking Statements,” and in the risk factors included in “Part I, Item 1A. Risk Factors” in our 2022 Annual Report, in “Part II, Item 1A. Risk Factors” of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2023 and in “Part II, Item 1A. Risk Factors” of this Quarterly Report. 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

Cactus is an equipment solutions provider primarily for onshore oil and gas markets. Founded in 2011 by a management group that previously operated two of the largest wellhead providers at the time, Cactus has rapidly grown to be a leading provider of wellhead solutions to the U.S. onshore market. On February 28, 2023, Cactus acquired FlexSteel, which similarly grew from its founding in 2003 to its current status as a leading provider of spoolable pipe technologies primarily to the U.S. onshore market.

Including final adjustments for closing working capital, cash on hand and indebtedness as set forth in the merger agreement, we paid total cash consideration of approximately $621.5 million for the FlexSteel acquisition. Additionally, there is a potential future earn-out payment of up to $75 million to be paid no later than the third quarter of 2024 if certain revenue growth targets are met by FlexSteel. We believe this acquisition enhances our position as a premier manufacturer and provider of highly engineered equipment to the E&P industry and should provide meaningful growth potential. We further believe FlexSteel’s products are highly complementary to Cactus’ equipment as it expands our exposure to our customers’ operations from production trees to transportation of oil, gas and other liquids as well as to additional customers operating in the midstream area.

Demand for our products and services depends primarily upon oil and gas industry activity levels, including the number of active drilling rigs, the number of wells being drilled, the number of wells being completed, and the volume of newly producing wells, among other factors.

Revenues

Our revenues are derived from three sources: products, rentals, and field service and other. Product revenues are derived from the sale of wellhead systems, production trees and spoolable pipe and fittings. Rental revenues are primarily derived from the rental of equipment used during the completion process, the repair of such equipment and the rental of equipment or tools used to install wellhead equipment or spoolable pipe. Field service and other revenues are primarily earned when we provide installation and other field services for both product sales and equipment rental.

During the nine months ended September 30, 2023, we derived 74% of total revenues from the sale of our products, 10% of total revenues from rental and 16% of total revenues from field service and other. During the nine months ended September 30, 2022, we derived 65% of total revenues from the sale of our products, 15% of total revenues from rental and 20% of total revenues from field service and other. We have predominantly domestic operations with more limited operations in Australia, Canada, and the Middle East as well as sales in other international markets.

Following the acquisition of FlexSteel, we now operate in two business segments consisting of the Pressure Control segment and the Spoolable Technologies segment.

Pressure Control

The Pressure Control segment designs, manufactures, sells and rents a range of wellhead and pressure control equipment under the Cactus Wellhead brand. 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 equipment.

We operate through service centers in the United States, which are strategically located in the key oil and gas producing regions, and in Eastern Australia. These service centers support our field services and provide equipment assembly and repair services. We also provide rental and service operations in the Kingdom of Saudi Arabia. Pressure Control manufacturing and production facilities are located in Bossier City, Louisiana and Suzhou, China.

Demand for our product sales in the Pressure Control segment are driven primarily by the number of new wells drilled, as each new well requires a wellhead and, after the completion phase, a production tree. Demand for our rental items is driven primarily by the number of well completions as we rent frac trees to oil and gas operators to assist in hydraulic fracturing. Rental demand is also driven to a lesser extent by drilling activity as we rent tools used in the installation of wellheads. Field service and other revenues are closely correlated with revenues from product sales and rentals, as items sold or rented almost always have an associated service component.

Spoolable Technologies

The Spoolable Technologies segment designs, manufactures, and sells spoolable pipe and associated end fittings under the FlexSteel brand. Our customers use these products primarily as production, gathering and takeaway pipelines to transport oil, gas or other liquids. In addition, we also provide field services and rental items to assist our customers with the installation of these products. We support our field service operations through service centers and pipe yards located in oil and gas regions throughout the United States and Western Canada. Our manufacturing facility is located in Baytown, Texas.

Demand for our product sales in the Spoolable Technologies segment are driven primarily by the number of wells being placed into production after the completions phase as customers use our spoolable pipe and associated fittings to bring wells more rapidly onto production. Rental and field service and other revenues are closely correlated with revenues from product sales, as items sold usually have an associated rental and service component.

Recent Developments and Trends

FlexSteel Acquisition

As previously discussed, we completed the acquisition of FlexSteel on February 28, 2023. The results of operations of FlexSteel have been reflected in our accompanying condensed consolidated financial statements from the closing date of the acquisition through September 30, 2023. See Note 2 to the unaudited condensed consolidated financial statements for additional information related to the acquisition.

Oil and Natural Gas Prices

The following table summarizes average oil and natural gas prices in North America over the indicated periods as well as industry activity levels as reflected by the average number of active onshore drilling rigs during the same periods.

(1) EIA Cushing, OK WTI (“West Texas Intermediate”) spot price.

(2) EIA Henry Hub Natural Gas spot price per million British Thermal Unit (“MMBtu”).

(3) Baker Hughes.

As expected, drilling and completion activity levels declined in the third quarter of 2023. The average number of U.S. land drilling rigs decreased by 17% from the fourth quarter of 2022 with most of the reductions occurring in the third quarter of 2023. Oil prices rose 12% in the third quarter compared to the second quarter of 2023 as global oil demand remained strong and concerns regarding tightening supply emerged due to continued OPEC+ production cuts. The recent conflict in the Middle East has resulted in some volatility in oil prices due to concerns regarding the potential impact on global oil supplies. Natural gas prices have also risen since the second quarter of 2023 primarily due to declining drilling activity and moderating storage surplus.

Barring any significant developments in the Middle East, we believe oil and natural gas activity levels in the fourth quarter of 2023 will display a modest recovery compared with the third quarter.

Critical Accounting Policies and Estimates

A discussion of our critical accounting policies and estimates is contained in our 2022 Annual Report on Form 10-K. There have not been any changes in our critical accounting policies since December 31, 2022 other than the following additional critical accounting estimate.

Determination of Fair Value in Business Combinations

Accounting for the acquisition of a business requires the allocation of the purchase price to the various assets acquired and liabilities assumed at their respective fair values. The determination of fair value requires the use of significant estimates and assumptions, and in making these determinations, management uses all available information. If necessary, we have up to one year after the acquisition closing date to finalize these fair value determinations under the applicable GAAP. For tangible and identifiable intangible assets acquired in a business combination, the determination of fair value utilizes several valuation methodologies including discounted cash flows which has assumptions with respect to the timing and amount of future revenue and expenses associated with an asset. The assumptions made in performing these valuations include, but are not limited to, discount rates, future revenues and operating costs, projections of capital costs, and other assumptions believed to be consistent with those used by principal market participants. Due to the specialized nature of these calculations, we engage third-party specialists to assist management in evaluating our assumptions as well as appropriately measuring the fair value of assets acquired and liabilities assumed.

Consolidated Results of Operations

The following discussions relating to significant line items from our condensed consolidated statements of income are based on available information and represent our analysis of significant changes or events that impact the comparability of reported amounts. Where appropriate, we have identified specific events and changes that affect comparability or trends and, where reasonably practicable, have quantified the impact of such items.

Three Months Ended September 30, 2023 Compared to Three Months Ended June 30, 2023

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

(in thousands)

21

Pressure Control. Pressure Control revenue for the third quarter of 2023 was $182.5 million, a decrease of $16.7 million, or 8.4%, from $199.1 million for the second quarter of 2023 primarily due to decreased sales of wellhead and production related equipment and related field services resulting from reduced activity offset slightly by higher rental revenues. Pressure Control operating income of $47.8 million for the third quarter of 2023 decreased $6.7 million, or 12.3% from the second quarter of 2023. The decreased revenues and associated gross margins related to equipment sales and field services were offset by higher gross margins associated with rentals driven by higher revenue and lower depreciation expense on our rental fleet. Selling, general and administrative expenses (“SG&A”) decreased approximately $2.0 million from the second quarter primarily due to lower bad debt expense, professional fees, stock-based compensation expense and annual incentive bonus accruals.

Spoolable Technologies. Spoolable Technologies revenue for the third quarter of 2023 was $105.4 million, a decrease of $1.3 million from the second quarter of 2023. Total operating income for Spoolable Technologies for the third quarter of 2023 was $39.8 million compared to an operating loss of $6.0 million for the second quarter of 2023. The improvement in operating income was mainly due to recognition of a gain of $5.1 million for the change in fair value of the earn-out payment for the FlexSteel acquisition in the third quarter compared to an $18.1 million loss in the second quarter. Additional increases in operating income from the second quarter were due to a $19.3 million decrease in inventory step-up expense and a $4.7 million reduction in intangible amortization expense.

Interest expense, net. Interest expense, net was $1.4 million for the third quarter of 2023 compared to $5.9 million for the second quarter of 2023. The decrease in interest expense from the second quarter was the result of our repayment of $55.0 million under the Amended ABL Credit Facility in July 2023, reducing our total bank debt outstanding to zero.

Other income, net. Other income, net of $0.3 million for the third quarter of 2023 represented non-cash adjustments for the revaluation of the liability related to the tax receivable agreement as a result of changes to the state tax rate.

Income tax expense. Income tax expense for the third quarter of 2023 was $18.5 million compared to $10.1 million for the second quarter of 2023. The increase in income tax expense from the second quarter was primarily due to an increase in operating income quarter over quarter. Cactus Inc. is only subject to federal and state income tax on its share of income from Cactus Companies. Income allocated to the non-controlling interest is only taxable to the non-controlling interest.

Nine Months Ended September 30, 2023 Compared to Nine Months Ended September 30, 2022

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

(in thousands)

22

Pressure Control. Pressure Control revenue was $576.3 million for the first nine months of 2023, an increase of $75.7 million, or 15.1%, from $500.6 million for the first nine months of 2022. This was primarily due to higher sales of wellhead and production related equipment resulting from higher drilling and completion activity by our customers. In addition, increased rental of drilling and completion equipment and field service associated with product and rental revenues increased as a result of the abovementioned activity. Operating income of $151.8 million in the first nine months of 2023 increased $25.3 million, or 20.0%, from $126.5 million in the first nine months of 2022. The increase was primarily attributable to higher gross margins during the period due to the increased volume partially offset by higher SG&A expenses. The increase in SG&A expenses primarily related to $11.9 million of professional fees and expenses incurred in 2023 associated with the FlexSteel acquisition, higher bad debt expense and higher stock-based compensation expense.

Spoolable Technologies. Spoolable Technologies revenue of $245.8 million and operating income of $34.0 million represents FlexSteel results generated from February 28, 2023, the date of acquisition, through September 30, 2023. The results for Spoolable Technologies included approximately $13.1 million of expense related to the change in fair value of the estimated earn-out payment for the FlexSteel acquisition, $23.5 million of inventory step-up expense and $16.3 million of intangible amortization expense as well as depreciation expense of $9.9 million primarily associated with the step-up of fixed assets in connection with accounting for the purchased assets at fair value in conjunction with purchase accounting.

Interest income (expense), net. Interest expense, net was $6.3 million for the first nine months of 2023 compared to $1.3 million of interest income, net for the nine months ended September 30, 2022. Interest expense in 2023 primarily related to borrowings outstanding through July 2023 under the Amended ABL Credit Facility.

Other income, net. Other income, net for 2023 and 2022 primarily related to non-cash adjustments for the revaluation of the liability related to the tax receivable agreement as a result of changes to the state tax rate.

Income tax expense. Income tax expense for the first nine months of 2023 was $30.6 million compared to $23.5 million for the first nine months of 2022. Income tax expense for 2023 included an approximately $38.3 million expense associated with current income offset by a $12.1 million benefit associated with the release of our valuation allowance previously provided for our investment in Cactus Companies based on the determination that the deferred tax asset was realizable due to our ability to generate sufficient taxable income of the appropriate type. Additionally, we recognized $4.3 million of expense associated with the revaluation of our deferred tax asset as a result of a change in our forecasted state tax rate, $0.5 million of expense related to the finalization of our 2022 tax returns and a $0.4 million benefit associated with permanent differences related to equity compensation. Income tax expense for 2022 included approximately $26.3 million expense associated with current income offset by a $1.7 million benefit associated with permanent differences related to equity compensation and a $1.2 million tax benefit associated with the partial valuation allowance release in conjunction with CW Unit redemptions during 2022. Partial valuation releases occur in conjunction with redemptions of CW Units (or CC Units, in the case of redemptions after the CC Reorganization) as a portion of Cactus Inc.’s deferred tax assets from its investment in Cactus LLC (or, after the CC Reorganization, its investment in Cactus Companies) becomes realizable.

Liquidity and Capital Resources

At September 30, 2023, we had $63.7 million of cash and cash equivalents. Our primary sources of liquidity and capital resources are cash on hand, cash flows generated by operating activities and borrowings under our Amended ABL Credit Facility (as defined in Note 7 in the notes to the unaudited condensed consolidated financial statements). Depending upon market conditions and other factors, we may also have the ability to issue additional equity and debt if needed. As of September 30, 2023, we had $222.9 million of available borrowing capacity under our Amended ABL Credit Facility with no outstanding borrowings and $1.5 million in letters of credit outstanding. We were in compliance with the covenants of the Amended ABL Credit Facility as of September 30, 2023.

In June 2023, our board of directors authorized the Company to repurchase shares of its Class A common stock for an aggregate purchase price of up to $150 million. Under our share repurchase program, shares may be repurchased from time to time in open market transactions or block trades, in privately negotiated transactions or any other method permitted under U.S. securities laws, rules and regulations. The repurchase program does not obligate the Company to purchase any particular amount of shares, and the repurchase program may be suspended or discontinued at any time at the Company’s discretion.

We believe that our existing cash on hand, cash generated from operations and available borrowings under our Amended ABL Credit Facility will be sufficient for at least the next 12 months to meet working capital requirements, debt service obligations, anticipated capital expenditures, repurchases of shares of our Class A common stock, expected TRA liability payments, anticipated tax liabilities and dividends to holders of our Class A common stock as well as pro rata cash distributions to holders of CC Units other than Cactus Inc.

We currently estimate our net capital expenditures for the year ending December 31, 2023 will range from $35 million to $40 million. In the Pressure Control segment, capital expenditures are primarily related to rental fleet investments, the March 2023 purchase of our previously leased branch facility in Odessa, Texas, international expansion, diversification of our low cost supply chain and development of a recently-leased research and development facility in Houston, Texas. In the Spoolable Technologies segment, capital expenditures are primarily related to manufacturing plant enhancements and additional deployment equipment to facilitate installation of recent product introductions.

Our ability to satisfy our long-term liquidity requirements, including cash requirements to fund income tax liabilities and the TRA liability at Cactus Inc. along with associated distributions to holders of CC Units relating to their ownership of Cactus Companies, depends on our future operating performance, which is affected by, and subject to, 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. We will not be able to predict or control many of these factors, such as economic conditions in the markets where we operate and competitive pressures. If necessary, we could choose to further reduce our spending on capital expenditures and operating expenses to ensure we operate within the cash flow generated from our operations.

Cash Flows

Nine Months Ended September 30, 2023 Compared to Nine Months Ended September 30, 2022

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

(in thousands)

Net cash provided by operating activities was $248.6 million and $78.6 million for the nine months ended September 30, 2023 and 2022, respectively. Operating cash flows for 2023 increased due to higher income and a decrease in cash outflows associated with working capital, largely related to decreased purchases of Pressure Control inventories as well as higher collections on receivable balances. These increases in operating cash flows were slightly offset by $15.7 million of additional income tax payments, higher TRA payments of $15.2 million and $4.3 million of additional interest paid in 2023 compared to 2022.

Net cash used in investing activities was $645.2 million and $19.5 million for the nine months ended September 30, 2023 and 2022, respectively. The increase was primarily due to cash paid to acquire FlexSteel for $621.5 million less $5.3 million in cash acquired. Additionally, our capital expenditures increased approximately $12.2 million primarily due to the $7.0 million purchase of a previously leased facility and Pressure Control rental fleet additions and enhancements. Capital expenditures for the Spoolable segment have been modest since the acquisition, totaling approximately $1.1 million through September 30, 2023. Other movements in our investing activities were related to the increase in proceeds from sales of assets of approximately $2.6 million from 2022.

Net cash provided by financing activities was $116.7 million for the nine months ended September 30, 2023 as compared to net cash used in financing activities of $37.2 million for the nine months ended September 30, 2022. The increase in net cash provided by financing activities was primarily related to certain financing activities in 2023 associated with the FlexSteel acquisition. We received approximately $169.9 million of proceeds, net of issuance costs, from issuing shares of our Class A common stock during 2023. Additionally, we received $155.0 million from total borrowings under our Amended ABL Credit Facility of which all $155.0 million has been repaid. Increased payments of $6.7 million in debt issuance costs, increased distributions to members of $5.9 million, higher dividend payments of approximately $2.3 million and $1.1 million of additional payments on finance leases partially offset the aforementioned cash inflows associated with the equity financing activities during 2023.

For quantitative and qualitative disclosures about market risk, see Part II, Item 7A., “Quantitative and Qualitative Disclosures about Market Risk,” in our 2022 Annual Report. Our exposure to market risk has not changed materially since December 31, 2022, other than with regard to interest rate risk as described in “Part I, Item 3. Quantitative and Qualitative Disclosures About Market Risk” of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2023.

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 September 30, 2023 at the reasonable assurance level.

As disclosed in Note 2 to the unaudited condensed consolidated financial statements, we acquired FlexSteel on February 28, 2023 and accounted for this acquisition as a business combination. FlexSteel’s total revenues constituted approximately 30% of our total consolidated revenues for the first nine months of 2023. FlexSteel’s total assets constituted approximately 51% of our total consolidated assets as of September 30, 2023. We excluded FlexSteel’s disclosure controls and procedures that are subsumed by its internal control over financial reporting from the scope of management's assessment of the effectiveness of our disclosure controls and procedures. This exclusion is in accordance with the SEC staff’s general guidance that an assessment of a recently acquired business may be omitted from the scope of management’s assessment of internal controls over financial reporting for one year following the acquisition. We are in the process of implementing financial reporting controls and procedures at FlexSteel as part of our ongoing integration activities.

Changes in Internal Control over Financial Reporting

Except as described above, there were no changes in our internal control over financial reporting that occurred during the third quarter of 2023 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 2022 Annual Report, and under “Part II, Item 1A. Risk Factors” in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2023, 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. In addition to what was previously disclosed in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2023, there have been no material changes in our risk factors from those described in our 2022 Annual Report or our other Securities and Exchange Commission filings except as follows:

Recent conflict in the Middle East may adversely affect our business and results of operations.

Recent conflict in the Middle East has resulted in some volatility in oil prices due to concerns regarding the conflict’s impact on global oil supplies. Continued conflict or an expanded or increased level of conflict could further impact oil prices and drilling activity globally or have adverse effects on global macroeconomic conditions generally, which could have a negative impact on our business and results of operations.