# ProFrac Holding Corp. (ACDC) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from ProFrac Holding Corp.'s 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1881487/000095017023010960/acdc-20221231.htm
Accession: 0000950170-23-010960
Filing date: 2023-03-30
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

Company profile: /company/ACDC/
All MD&A years: /company/ACDC/mda/
Next year: /company/ACDC/mda/fy2023/ (FY 2023)

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

The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included within “Item 8. Financial Statements and Supplementary Data.” In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect the Company’s plans, estimates, or beliefs. Actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report, including, without limitation, those described in the sections titled “Cautionary Note Regarding Forward-Looking Statements” and Part I, Item 1A “Risk Factors.”

Overview

We are a technology-focused, vertically integrated energy services company providing well stimulation services, proppants production and other complementary products and services to oil and gas companies engaged in E&P of unconventional oil and natural gas resources throughout the United States. Founded in 2016, ProFrac was built to be the go-to service provider for E&P companies’ most demanding hydraulic fracturing needs. On May 17, 2022, ProFrac Corp. completed its IPO of 16,000,000 shares of its Class A common stock, par value $0.01 per share, which is listed on the Nasdaq Global Select Market. Our business combines a young fleet of modern, technologically advanced pressure pumping equipment with vertically integrated proppant, chemicals and manufacturing, enabling us to deliver premium service quality while maintaining an advantaged cost structure. We believe the technical and operational capabilities of our fleets, as well as our internal frac sand production and equipment manufacturing capabilities uniquely position us to capitalize on the growing demand for well stimulation services to support the ongoing development of American oil and gas reserves. Additionally, we have a focused M&A strategy to acquire high-quality businesses at attractive valuations that increase our scale and expand our technological and supply chain competencies. Since the completion of our IPO, we have completed six acquisitions adding approximately 18.7 million tons of annual sand capacity and 13 frac fleets. These acquisitions provide us with an opportunity to generate attractive returns, when combined with our operational and commercial platform.

Our operations are focused on the most active unconventional regions in the United States, where we have cultivated deep and longstanding customer relationships with some of those regions’ leading E&P companies. We believe we are among the largest well stimulation services providers in the United States, with 42 active fleets as of January 3, 2023. We operate throughout nearly all major unconventional oil and gas basins in the United States and our scale and geographical footprint provide us with both operating leverage as well as exposure to a diversified customer and commodity mix.

Summary Financial Results

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Total revenue for the year ended December 31, 2022 was $2,425.6 million

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Net income for the year ended December 31, 2022 was $342.7 million

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Adjusted EBITDA (a non-GAAP measure defined below) for the year ended December 31, 2022 was $811.2 million

Our Predecessor and ProFrac Holding Corp.

Our predecessor consists of ProFrac LLC and its subsidiaries, Best Pump & Flow LP (“Best Flow”) and Alpine Silica, LLC (“Alpine”), (which we refer to as “ProFrac Predecessor”) on a consolidated basis. Historical periods for ProFrac Predecessor had been presented on a consolidated and combined basis given the common control ownership the Wilks Parties. On December 21, 2021, all of the then-outstanding membership interests in Best Flow and Alpine were contributed to ProFrac LLC in exchange for membership interests in ProFrac LLC. Unless otherwise indicated, the historical consolidated financial information included in this Annual Report presents the historical financial information of ProFrac Predecessor. Historical consolidated financial information is not indicative of the results that may be expected in any future periods.

2022 Significant Events

Initial Public Offering and Corporate Reorganization

On May 17, 2022, we consummated the IPO of 16,000,000 shares of our Class A Common Stock, at a public offering price of $18.00 per share. On June 6, 2022, the underwriters’ over-allotment option was partially exercised, resulting in a sale of an additional 2,228,153 shares of Class A Common Stock at a price of $18.00 per share. The IPO and exercise of the underwriters’ over-allotment option generated combined net proceeds of $301.7 million, after deducting underwriter discounts and commissions and estimated offering costs. In connection with our IPO, and the corporate reorganization (see “Note 1 – Organization and Description of Business” in the notes to our consolidated financial statements), we became a holding company.

After giving effect to the corporate reorganization and the IPO, ProFrac Holding Corp. directly and indirectly owned approximately 27.8% of ProFrac LLC, and the Unit Holders owned approximately 72.2% of ProFrac LLC and all of our Class B Common Stock.

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Acquisition of FTS International, Inc.

On March 4, 2022, ProFrac LLC acquired FTS International, Inc. (“FTSI”) for a purchase price of approximately $405.7 million, consisting of cash consideration of $332.8 million and certain equity interests in ProFrac LLC of $72.9 million (the “FTSI Acquisition”). Prior to the FTSI Acquisition, FTSI was one of the largest providers of hydraulic fracturing services in North America, with 1.3 million HHP as of December 31, 2021. FTSI averaged 13 active fleets in the fourth quarter of 2021, with operations in the Permian Basin, Eagle Ford Shale, Midcontinent, Haynesville Shale and Uinta Basin.

Consolidation of Flotek Industries, Inc.

Through a series of transactions in the first half of 2022, we entered into a supply agreement with Flotek Industries, Inc. (“Flotek”) to provide full downhole chemistry solutions for 30 of our hydraulic fracturing fleets for a period of ten years starting on April 1, 2022. In exchange for entry into the supply agreement, we received $60.0 million in principal amount of convertible notes, and we received the right to designate up to four out of seven directors to Flotek’s board of directors.

Because of our power to appoint directors to the board of directors of Flotek without a direct equity interest in Flotek, we determined that Flotek is a variable interest entity (“VIE”). We further determined that the Company is the primary beneficiary of the VIE, due to our ability to appoint a majority of directors to Flotek’s board of directors. As a result, subsequent to May 17, 2022, the date that Flotek shareholders approved the supply agreement, we have accounted for this transaction as a business combination using the acquisition method of accounting. Accordingly, Flotek’s financial statements have been included in our consolidated financial statements from May 17, 2022.

We believe our investment in and strategic relationship with Flotek demonstrates our commitment to our vertical integration strategy and provides greater control over our supply chain.

Acquisition of SP Silica of Monahans, LLC and SP Silica Sales, LLC

On July 25, 2022, we acquired 100% of the issued and outstanding membership interests of the West Texas subsidiaries of Signal Peak Silica, for a purchase price of $90.0 million in cash (the “Monahans Acquisition”). In connection with the closing of the Monahans Acquisition, we acquired an in-basin frac sand facility and related mining operations in the Permian Basin (the “Monahans Sand Mine”).

Acquisition of U.S. Well Services, Inc.

On November 1, 2022, we acquired U.S. Well Services, Inc. (“USWS”) for a total purchase consideration of $479.1 million, consisting of cash consideration of $195.9 million, issuance of 12.9 million shares of Class A Common Stock valued at $282.0 million, and issuance of Class A Common Stock warrants valued at $1.1 million (the “USWS Acquisition”).

Prior to the USWS Acquisition, USWS was a technology-driven oilfield service company focused on electric-powered pressure pumping services in the United States. The USWS fleets consist mostly of all-electric, mobile pressure pumping equipment and other auxiliary heavy equipment to perform stimulation services. The USWS Clean Fleet® electric fleets replace the traditional engines, transmissions, and radiators used in conventional diesel fleets with electric motors.

Acquisition of Monarch Silica, LLC

On December 23, 2022, we completed the acquisition of the Eagle Ford sand mining operations of Monarch Silica, LLC, and related real estate property, for total purchase consideration of $175 million, consisting of cash consideration of $87.5 million and a secured note payable to the seller, Monarch Capital Holdings, LLC, for the remaining $87.5 million. A portion of the consideration is subject to certain customary post-closing adjustments.

Acquisition of REV Energy Holdings, LLC

On December 30, 2022, we acquired REV Energy Holdings, LLC (“REV”), a privately owned pressure pumping service provider with operations in the Rocky Mountains and Eagle Ford Shale. REV operates three premium frac fleets totaling 204,500 HHP. This acquisition expanded ProFrac’s presence in the Rocky Mountains and Eagle Ford Shale.

We acquired REV for a total purchase consideration of $140.0 million, consisting of (i) a number of shares of Class B Common Stock and Units, valued at $70.0 million, (ii) a secured note payable to BCKW LLC (REV sellers’ representative), with a principal amount of $39.0 million, (iii) approximately $5.5 million in debt assumption, and (iv) cash consideration of $25.5 million. A portion of the total purchase consideration is subject to certain customary post-closing adjustments. The agreement pursuant to which we acquired REV provides for up to $20.0 million of earn-out payments to sellers if certain EBITDA-based performance targets are achieved during 2023.

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Recent Developments

Acquisition of Producers Services Holdings LLC

On January 3, 2023, we acquired 100% of the issued and outstanding membership interest of Producers Service Holdings LLC, a Delaware limited liability company, an employee-owned pressure pumping services provider serving Appalachia and the Mid-Continent, for approximately $35.0 million of total transaction value, of which approximately half is payable in shares of Class A Common Stock, with the remainder consisting of cash and debt assumption. A portion of the cash consideration is subject to certain customary post-closing adjustments. Through this transaction, we have added three fleets, of which two are currently active, totaling 200,000 HHP as well as a 50,000 square foot manufacturing facility located near Zanesville, OH, through which we plan to expand our manufacturing footprint to support Northeast operations.

Acquisition of Performance Proppants

On February 24, 2023, we acquired 100% of the issued and outstanding membership interest in (i) Performance Proppants, LLC, a Texas limited liability company, (ii) Red River Land Holdings, LLC, a Louisiana limited liability company, (iii) Performance Royalty, LLC, a Louisiana limited liability company, (iv) Performance Proppants International, LLC, a Louisiana limited liability company, and (v) Sunny Point Aggregates, LLC, a Louisiana limited liability company (together, “Performance Proppants”) for an aggregate purchase price of $475.0 million, consisting of (x) $469.0 million in cash and (y) a number of shares of Class A Common Stock equal to $6.0 million. A portion of the cash consideration is subject to certain customary post-closing adjustments. Performance Proppants is a frac sand provider in the Haynesville basin.

See “Note 4 – Business Combinations and Asset Acquisition” and “Note 5 – Investments” in the notes to our consolidated financial statements for additional discussion related to all of our recent acquisitions and investments.

Overall Trends and Outlook

Industry Trends

Demand for well stimulation services and frac sand is primarily driven by the level of drilling and completion activity of E&P companies in the United States. Drilling and completion activity is driven by well profitability and returns, which are influenced by a number of factors, including domestic and international supply and demand for oil and gas and prices for oil and gas, as well as the perceived stability and sustainability of those prices over the longer term.

With the growth in oil and gas demand, E&P activity has increased across all major onshore oil and gas basins in the United States. According to the North American Rig Count reported by Baker Hughes Company (“Baker Hughes”), as of March 17, 2023, the number of active U.S. land drilling rigs increased 15% from March 2022 to March 2023 and 91% from March 2021 to March 2023. Rig activity in our primary areas of operation (Permian Basin, Eagle Ford, Haynesville, Appalachia and the Rockies) has increased substantially over that same period.

We anticipate that the following market dynamics and trends in our industry may benefit our operations and our ability to achieve our business objectives:

Adoption of dynamic gas blending (“DGB”) and electric fleets. E&P operators have increased their focus on improving their emissions profiles. Some of these operators have transitioned from legacy Tier II diesel frac fleets to greener, next-generation Tier IV DGB frac fleets and electric fleets, because Tier IV DGB fleets utilize gas (including natural gas, CNG, LNG, pipeline and field gas) as a cheaper, cleaner fuel source. Rystad Energy anticipates that by the end of 2026, over 70% of active frac fleet horsepower in North America will be utilizing natural gas capable or electric fleets, as compared to 21% in 2020. As a market leader in next-generation fleet technology, we believe we are well positioned to capture additional market share as the shift to cleaner DGB and electric fleets continues.

Obsolescence of significant hydraulic fracturing horsepower in the market. The U.S. frac market is currently facing a pivotal transition with significant fleet capacity nearing retirement due to obsolescence. Prolonged underinvestment, including during the COVID-19 induced industry downturn, has resulted in a deterioration of the condition of operable legacy fleets. Even prior to the recent downturn, substantial legacy capacity had reached the end of its useful life, according to Rystad Energy. Retirement of these fleets is expected to tighten marketed supply while demand growth continues, resulting in expected frac fleet utilization levels in excess of 80% sustained through 2026, according to Rystad Energy. We believe that our vertical integration and lower cost of capital resulting from in-house maintenance and manufacturing of our own frac equipment will allow us to respond to this demand as well as increase our ability to maintain both the condition and utilization rates of our fleets. Over the last several years, we have earned higher margins versus peers (as defined by Adjusted EBITDA margin) that rely on third parties for refurbishment and newbuild fleets at higher cost. Additionally, with 65%+ of active frac capacity among the top five players (according to Rystad Energy), we believe the industry will see increased pricing and efficiency moving forward.

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According to Rystad, frac fleets averaged ~48,000 HHP per fleet in 2015 and are expected to average ~58,000 HHP per fleet in 2024. We believe that this factor, which reduces the number of required frac fleets in the industry, in conjunction with attrition of older fleets and tight equipment supply, will improve pricing.

Tightening Frac Sand Market. Over the last three years, the growth in demand for frac sand for use in the hydraulic fracturing process has resulted in a significant increase in sand prices as well as constraints on supply availability. According to Rystad Energy, total U.S. frac sand demand is expected to grow by 17.6 million tons (14%) in 2023 compared to 2022) and reach 139 million tons. In 2023, the Permian Basin, Eagle Ford and Haynesville, where we currently operate 8 mines, are expected to collectively account for approximately 74% of the total U.S. demand, according to Rystad Energy. Current frac sand pricing is at its highest levels since 2017, with Permian free on board mine pricing reaching as high as $51/ton in the spot market in 2022, according to Rystad Energy. We believe our vertically integrated business model and recent sand mine investments (Lamesa, Monahans and Monarch), as well as our acquisition of Performance Proppants, position us to capitalize on this increased demand, insulate our operations from rising sand raw material costs and allow us to provide surety of supply to customers in an increasingly tight sand market.

Pivot to In-Basin Sand Supply. The frac sand market has undergone a transformation in recent years. Historically, sand was primarily supplied from sources out-of-basin. However, in recent years, producers have primarily sourced sand from in-basin suppliers due to logistical efficiencies and transportation cost savings.

Trends in E&P Operations. There are several trends within the E&P space which we believe will have a positive impact on our operations moving forward. First, E&P companies are drilling longer laterals. According to Enverus, average lateral length has increased from 5,511 feet in 2013 to 9,240 feet in 2022. Increased drilling time increases the number of frac stages and pump hours required to frac a well. We expect to see higher fleet utilization due to these factors in the future. However, even as lateral lengths have been increasing, there has been a decrease in well performance. E&P well productivity per lateral foot has fallen as operators have been forced to drill more Tier II and Tier III inventory. According to Enverus, in 2022, cumulative oil production per 1,000 feet was ~5% lower through 3 months of production and ~4% lower through 6 months of production relative to 2021. We believe this trend will provide a catalyst to our operations as E&P companies will be forced to drill more to maintain production, requiring more rigs and frac crews which we believe will improve fleet utilization and pricing.

Investor and regulator focus on ESG. The energy industry is undergoing a significant change of operating practices, with industry participants becoming increasingly focused on environmental and social considerations. Companies are experiencing market pressure to implement ESG initiatives, particularly related to environmental sustainability via a reduction of GHG emissions. We believe that state and federal governments are likely to implement increased measures to regulate GHG emissions, increasing pressure on, or requiring, E&P companies to decrease their emissions footprint. Additional ESG topics, such as human rights, supply chain management, water usage, natural capital and biodiversity, among others, are also receiving increased attention, and there may be increasing pressure on our customers to take actions to address these topics as well.

We believe our investment in greener, next-generation fleet technology places us at the forefront of the industry’s move towards a cleaner and more sustainable future and enables us to meet growing customer demand for ESG-sensitive operations.

We believe we are well positioned to capitalize on the continued demand for next generation frac fleets and in-basin frac sand. Our business, which combines a young fleet of modern, technologically advanced pressure pumping equipment with vertically integrated proppant, chemicals and manufacturing, has been purpose-built to capture maximum customer demand across the spectrum of completions operations. Our focus on next-generation fleet technology positions us to serve the growing demand for emissions-friendly solutions while also offering our customers significant fuel cost savings. At the same time, our focus on strategic in-basin sand mine acquisitions allows us to provide surety of supply in an increasingly tight sand market and realize additional margin uplift through our integrated frac service offering.

General Trends

Drilling and completion activities for oil and gas are heavily influenced by oil and gas prices. In 2022, geopolitical tensions in Eastern Europe related to Russia’s invasion of Ukraine have resulted in significant supply disruptions as a broad coalition of countries have responded with sanctions and/or import bans associated with Russian oil and natural gas. This has resulted in significant tightening in the market as reflected by higher commodity prices, with oil and gas prices reaching decade highs. As a result of the FTSI acquisition, our operations have diversified exposure to both natural gas and oil producing areas. Natural gas and oil prices have increased substantially compared to year-end 2020 prices and have also surpassed year-end 2019 (pre-COVID-19) levels.

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While commodity prices have returned to and exceeded pre-pandemic levels, the pandemic led to supply chain disruptions worldwide. Tariffs, access to employees, increased shipping rates and raw material shortages are impacting markets. Our supply chain is either vertically integrated or predominantly U.S. based, reducing our exposure to global disruptions and allowing us to continue to maintain attractive margins. As our operations are predominantly U.S. based, we have no direct exposure to Russia and Ukraine. We have realized indirect impacts that may have occurred as a result of the crisis, such as increases in the costs of certain raw materials and components we purchase for use in our manufacturing processes. However, given the inflationary climate in the United States and globally, we are unable to determine the extent to which such increased commodity prices are the result of the crisis in Ukraine or a result of other factors. Despite these increases, we have experienced improved results of operations due to increased utilization of our fleets and increased prices for our products and services which have permitted us to maintain and increase our margins notwithstanding such cost increases.

The oil and gas industry is currently undergoing significant realignment of operating practices with a focus on reducing impacts to the environment. Many E&P companies are implementing carbon tracking and reduction initiatives and are expecting oilfield service providers to deliver products and services that utilize the most advanced and environmentally friendly technologies. We believe that companies in the pressure pumping industry with the most technologically advanced fleets and lowest carbon footprint will likely see significant growth in market share at the expense of companies with less advanced equipment. We have embraced tangible initiatives that help to protect the environment and improve our environment and communities making it part of our organizational culture since early in the life of the company. We have and intend to continue to invest in a number of industry leading advanced technologies that reduce carbon emissions while increasing profitability. We are currently upgrading approximately ten engines per month from Tier II to Tier IV DGB. In November 2022 we fully deployed our first electric fleet and have four additional electric fleets under construction, which will bring our total electric fleets to 12 fleets. We believe that these initiatives and commitment to lower emissions will help us lead the energy transition of the frac industry towards cleaner and sustainable business.

How We Generate Revenue

We operate three business segments: stimulation services, proppant production, and manufacturing. Business activities that are not separately reportable, which only included Flotek, are classified in the other category.

Stimulation Services. We own and operate a fleet of mobile hydraulic fracturing units and other auxiliary equipment that generates revenue by providing stimulation services to our customers. We also provide personnel and services that are tailored to meet each of our customers’ needs. We generally do not have long-term written contractual arrangements with our customers other than standard master service agreements, which include general contractual terms between our customers and us. We charge our customers on a per-job basis, in which we set pricing terms after receiving full specifications for the requested job, including the lateral length of the customer’s wellbore, the number of frac stages per well, the amount of proppant employed and other specifications of the job. Well stimulation contains complementary services that we often provide to our customers, including sand and associated logistics, chemicals and fuel.

Proppant Production. We generate revenue by providing proppant to oilfield service providers and E&P companies. We either own or lease, and operate the Monarch Sand Mine in the Eagle Ford basin, and the Monahans Sand Mine, Kermit Sand Mine and Lamesa Sand Mine in the Permian basin and we charge our customers on a per ton of proppant basis at current market prices. We do not have long-term contractual arrangements with our customers with fixed pricing. For the years ended December 31, 2022, 2021 and 2020, intersegment revenues for the proppant production segment were 62%, 40% and 20%, respectively.

Manufacturing. We primarily generate revenue through sales of highly engineered, tight tolerance machined, assembled, and factory tested products such as high horsepower pumps, valves, piping, swivels, large-bore manifold systems, seats, and fluid ends. As of December 31, 2022, we operate facilities in Cisco, Aledo and Fort Worth, Texas, including an ISO 9001 2015 certified OEM manufacturing facility, in which we manufacture and refurbish many of the components used by our fleets, including pumps, fluid ends, power ends, flow iron and other consumables and an engine and transmission rebuild facility that is licensed to provide warranty repairs on our transmissions. Additionally, we provide iron inspection, iron recertification, pump refurbishment, fluid end refurbishment, pump function testing, paint, scrap, and lube system change services. We charge our customers for equipment based on a per-order basis, in which we set pricing terms after receiving full specifications for the requested equipment. We charge our customers for our services based on the parts and labor incurred. For the years ended December 31, 2022, 2021 and 2020, intersegment revenues for the manufacturing segment were 92%, 90% and 97%, respectively.

Costs of Conducting Our Business

The principal costs of products and services involved in operating our business are expendables, personnel, equipment repairs and maintenance and fuel. Our fixed costs are relatively low and a large portion of the costs described below are only incurred as we perform jobs for our customers.

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Expendables. Expendables used in our stimulation services business are the largest expenses incurred, and include the fuel, product and freight costs associated with proppant, chemicals and other consumables. Fuel is consumed both in the operation and movement of our hydraulic fracturing fleets and other equipment. In our proppant production business, fuel to run equipment is one of our major expenses. These costs comprise a substantial variable component of our service costs, particularly with respect to the quantity and quality of sand demanded when providing hydraulic fracturing services.

Raw Materials. Our manufacturing segment relies on various raw materials, specifically various grades of steel and other raw metals, and electricity.

Direct Labor Costs. Payroll and benefit expenses directly related to the delivery of our products and services are included in our operating costs.

Other Direct Costs. We incur other expenses related to our products and service offerings, including the costs of repairs and maintenance, general supplies, equipment rental and other miscellaneous operating expenses. Capital expenditures to upgrade or extend the useful life of equipment are not included in other direct costs.

How We Evaluate Our Operations

Our management uses a variety of financial and operating metrics to evaluate and analyze the performance of our business, including Adjusted EBITDA.

Note Regarding Non-GAAP Financial Measures

Adjusted EBITDA is not a financial measure presented in accordance with generally accepted accounting principles in the United States (“GAAP”) and should not be considered as a substitute for net income, net loss, operating loss or any other performance measure derived in accordance with GAAP or as an alternative to net cash provided by operating activities as a measure of our profitability or liquidity. Adjusted EBITDA is a supplemental measure utilized by our management and other users of our financial statements such as investors, commercial banks, research analysts and others, to assess our financial performance because it allows us to compare our operating performance on a consistent basis across periods by removing the effects of our capital structure (such as varying levels of interest expense), asset base (such as depreciation and amortization) and items outside the control of our management team (such as income tax rates).

We view Adjusted EBITDA as an important indicator of performance. We define Adjusted EBITDA as our net income (loss), before (i) interest expense, net, (ii) income tax expense, (iii) depreciation, depletion and amortization, (iv) loss on disposal of assets, (v) stock-based compensation, and (vi) other unusual or non-recurring charges, such as costs related to our initial public offering, non-recurring supply commitment charges, certain credit losses, loss on extinguishment of debt and gain on investments.

We believe that our presentation of Adjusted EBITDA will provide useful information to investors in assessing our financial condition and results of operations. Net income (loss) is the GAAP measure most directly comparable to Adjusted EBITDA. Adjusted EBITDA should not be considered as an alternative to net income (loss). Adjusted EBITDA has important limitations as an analytical tool because it excludes some but not all items that affect the most directly comparable GAAP financial measure. You should not consider Adjusted EBITDA in isolation or as a substitute for an analysis of our results as reported under GAAP. Because Adjusted EBITDA may be defined differently by other companies in our industry, our definition of this non-GAAP financial measure may not be comparable to similarly titled measures of other companies, thereby diminishing its utility.

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The following table presents a reconciliation of Adjusted EBITDA from net income (loss), our most directly comparable financial measure calculated and presented in accordance with GAAP:

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Factors Affecting The Comparability of Our Financial Results

Our future results of operations may not be comparable to our historical results of operations for the reasons described below:

Recent Acquisitions

We have grown recently through strategic acquisitions and investments, including through our recently completed acquisitions of FTSI, West Munger, Monahans, USWS, Monarch, REV, Producers, Performance Proppants and our consolidation of Flotek. These acquisitions are not reflected in our historical results of operations for the period prior to the closing of each such acquisition and our future results will differ as a result.

In addition, in connection with our acquisitions, we have recorded the acquired assets and liabilities at fair value on the date of acquisition, which has impacted deferred revenue and deferred costs balances and increased revenue and expenses from that which would have otherwise been recognized in subsequent periods. We also recorded identifiable intangible assets that are amortized over their useful lives, increasing expenses from that which would otherwise have been recognized.

Public Company Expenses

We expect to incur additional recurring administrative expenses as a result of becoming a publicly traded corporation that we have not previously incurred, including costs associated with compliance under the Exchange Act, annual and quarterly reports to shareholders, transfer agent fees, audit fees, incremental director and officer liability insurance costs, SOX compliance readiness, and director and officer compensation. We additionally expect to incur approximately $3 million in incremental, non-recurring costs related to our transition to a publicly traded corporation.

Income Taxes

ProFrac Holding Corp. is a corporation and will be subject to U.S. federal, state and local income taxes. Although the ProFrac Predecessor entities are subject to franchise tax in the State of Texas, they have historically been treated as pass-through entities for U.S. federal and other state and local income tax purposes and as such were not subject to U.S. federal income taxes or other state or local income taxes. Rather, the tax liability with respect to the taxable income of the ProFrac Predecessor entities was passed through to their owners. Accordingly, prior to the March 2022 acquisition of FTSI, a corporation subject to U.S. federal and state income tax, the financial data attributable to ProFrac Predecessor contains no provision for U.S. federal income taxes or income taxes in any state or locality (other than franchise tax in the State of Texas). Subsequent to the acquisition of FTSI in March 2022, the financial data of the ProFrac Predecessor does contain both U.S. federal and state income taxes. We estimate that we will be subject to U.S. federal and state taxes at a blended statutory rate of approximately 24% of pre-tax earnings. Additionally, with the acquisition of EKU, the Company is subject to certain foreign taxes, which were immaterial for the year ended December 31, 2022.

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Effective March 4, 2022 we account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled pursuant to the provisions of Accounting Standards Codification (“ASC”) 740, Income Taxes. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in earnings in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts more likely than not to be realized.

We recorded a valuation allowance on substantially all of our net deferred tax assets based on our assessment that it is more likely than not that the deferred tax assets will not be realized. Flotek net deferred tax assets also have a full valuation allowance with the exception of $0.4 million. A change in these assumptions could cause a decrease to the valuation allowance, which could materially impact our results of operations.

Results of Operations

Year Ended December 31, 2022

Revenues

Total revenues for the year ended December 31, 2022 was $2,425.6 million an increase of $1,657.2 million and $1,877.9 million from the same periods in 2021 and 2020, respectively. The increase was primarily attributable to an increase in customer activity for our stimulation services, and an increase in active fleets, pumping hours and pricing. Additionally, the acquisitions of FTSI and USWS during the year contributed to the increase in revenues.

The following table summarizes our reportable segment revenues and certain operating statistics:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Revenues:"],["Stimulation Services","","$","2,348.7","","","$","745.4","","","$","538.3"],["Proppant Production","","","90.0","","","","27.2","","","","10.2"],["Manufacturing","","","166.7","","","","76.4","","","","46.2"],["Other","","","111.8","","","","-","","","","-"],["Eliminations","","","(291.6",")","","","(80.6",")","","","(47.0",")"],["Total revenues","","$","2,425.6","","","$","768.4","","","$","547.7"],["Operating Statistics:"],["Active fleets (1)","","","38.0","","","","14.0","","","","11.0"],["Baker Hughes Domestic Average Rig Count\u2014Onshore (2)","","","660.0","","","","430.0","","","","385.0"],["Average oil price (per barrel) (3)","","$","94.79","","","$","67.99","","","$","39.23"],["Average natural gas price (per thousand cubic feet) (4)","","$","6.67","","","$","4.06","","","$","2.11"]]
[[/GREPCENT_TABLE]]

(1)
Active fleets is the average number of fleets operating in the period.

(2)
Average onshore U.S. rig count published by Baker Hughes.

(3)
Average West TX Intermediate Spot Price published by EIA.

(4)
Average Henry Hub Natural Gas Spot Price published by EIA.

Revenues—Stimulation Services. Stimulation services revenues for the year ended December 31, 2022 increased $1,603.3 million, or 215%, and $1,810.4 million, or 336%, respectively from the same periods in 2021 and 2020. The increase was primarily attributable to an increase in customer activity for our stimulation services, and an increase in active fleets, pumping hours and pricing. Additionally, FTSI and USWS contributed revenue to this segment from their acquisition dates.

Revenues—Proppant Production. Proppant production revenues for the year ended December 31, 2022 increased $62.8 million, or 231%, and $79.8 million, or 782%, respectively from the same periods in 2021 and 2020. The increase was primarily attributable to an increase in proppant production and pricing resulting from increased proppant demand primarily in the Permian basin. Additionally, Monahans contributed revenue to this segment from its acquisition date.

Revenues—Manufacturing. Manufacturing revenues for the year ended December 31, 2022 increased $90.3 million, or 118%, and $120.5 million, or 261%, respectively from the same periods in 2021 and 2020. The increase was primarily attributable to increased activity in our stimulation services segment.

Revenues—Other. Other revenues for the year ended December 31, 2022 was $111.8 million, which represents the revenue from Flotek.

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Cost of Revenues

The following table summarizes our cost of revenues by segment:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Cost of revenues, exclusive of depreciation, depletion, and amortization:"],["Stimulation Services","","$","1,433.6","","","$","570.8","","","$","427.5"],["Proppant Production","","","40.5","","","","14.1","","","","6.1"],["Manufacturing","","","137.5","","","","65.8","","","","40.4"],["Other","","","118.4","","","","-","","","","-"],["Eliminations","","","(291.3",")","","","(80.6",")","","","(47.0",")"],["Total cost of revenues, exclusive of depreciation, depletion, and amortization","","$","1,438.7","","","$","570.1","","","$","427.0"]]
[[/GREPCENT_TABLE]]

Total cost of revenues, exclusive of depreciation, depletion, and amortization for the year ended December 31, 2022 was $1,438.7 million an increase of $868.6 million and $1,011.7 million from the same periods in 2021 and 2020, respectively. The increase was primarily attributable to an increase in customer activity for our stimulation services. Additionally, the acquisitions of FTSI and USWS during the year contributed to the increase in cost of revenues.

Cost of Revenues, Exclusive of Depreciation, Depletion, and Amortization—Stimulation Services. Stimulation services cost of revenues for the year ended December 31, 2022 increased $862.8 million, or 151%, and $1,006.1 million, or 235%, respectively from the same periods in 2021 and 2020. The increase was primarily due to an increase in customer activity levels and increased prices for proppant and chemicals used in the fracturing process. Additionally, FTSI and USWS contributed cost to this segment from their acquisition dates.

Cost of Revenues, Exclusive of Depreciation, Depletion, and Amortization—Proppant Production. Proppant production cost of revenues for the year ended December 31, 2022 increased $26.4 million, or 187%, and $34.4 million, or 564%, respectively from the same periods in 2021 and 2020. The increase was primarily attributable to an increase in proppant production to meet increased customer demand. Additionally, Monahans contributed costs to this segment from its acquisition date.

Cost of Revenues, Exclusive of Depreciation, Depletion, and Amortization—Manufacturing. Manufacturing cost of revenues for the year ended December 31, 2022 increased $71.7 million, or 109%, and $97.1 million, or 240%, respectively from the same periods in 2021 and 2020. The increase was primarily attributable to increased activity in our stimulation services segment as well as higher prices for the cost of raw materials.

Cost of Revenues, Exclusive of Depreciation, Depletion, and Amortization—Other. Other cost of revenues for the year ended December 31, 2022 was $118.4 million, which represents the revenue from Flotek.

Selling, General and Administrative

The following table summarizes our selling, general and administrative expenses:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Selling, general and administrative:"],["Selling, general and administrative, excluding stock-based compensation","","$","175.7","","","$","64.2","","","$","48.2"],["Stock-based compensation related to deemed contributions","","","59.3","","","","-","","","","-"],["Stock-based compensation","","","8.1","","","","-","","","","-"],["Total selling, general and administrative","","$","243.1","","","$","64.2","","","$","48.2"]]
[[/GREPCENT_TABLE]]

Selling, general and administrative expenses for the year ended December 31, 2022 was $243.1 million an increase of $178.9 million and $194.9 million from the same periods in 2021 and 2020, respectively.

The increase was primarily due to increased headcount, incentive compensation and non-labor costs associated with our increased activity levels and 2022 acquisitions. The increase was also due to stock-based compensation expense in 2022, primarily related to expense associated with certain deemed shareholder contributions. See “Note 10 – Stock-based Compensation” in the notes to our consolidated financial statements for more information on our stock-based compensation.

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Depreciation, Depletion, and Amortization

The following table summarizes our depreciation, depletion, and amortization:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Depreciation, Depletion, and Amortization"],["Depreciation","","$","261.2","","","$","139.9","","","$","150.6"],["Amortization","","","5.6","","","","0.6","","","","-"],["Depletion","","","0.5","","","","0.2","","","","0.1"],["Total selling, general and administrative","","$","267.3","","","$","140.7","","","$","150.7"]]
[[/GREPCENT_TABLE]]

Depreciation, depletion, and amortization for the year ended December 31, 2022 was $267.3 million compared to $140.7 million and $150.7 million for the same periods in 2021 and 2020, respectively. The increase was primarily due to increased capital expenditure in 2022 and the depreciation related to the assets acquired from FTSI and USWS acquisition.

Acquisition Related Expenses

Acquisition related expenses for the year ended December 31, 2022 was $48.8 million compared to zero for the same periods in 2021 and 2020, respectively. These costs related to our acquisition and integration activities in 2022.

Other Operating Expenses, Net

The following table summarizes our other operating expenses, net:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Loss on disposal of assets, net","","$","2.1","","","$","9.8","","","$","8.4"],["Accruals for legal contingencies","","","11.3","","","","-","","","","-"],["Provision for credit losses, net of recoveries","","","1.9","","","","(1.2",")","","","2.8"],["Loss on foreign currency transactions","","","-","","","","0.2","","","","-"],["Reorganization costs","","","-","","","","2.1","","","","-"],["Severance charges","","","-","","","","0.5","","","","-"],["Supply commitment charges","","","-","","","","-","","","","5.6"],["Total","","$","15.3","","","$","11.4","","","$","16.8"]]
[[/GREPCENT_TABLE]]

Loss on disposal of assets, net consists of gains or losses on excess property, early equipment failures, and other asset dispositions.

Accruals for legal contingencies represent estimates for significant loss contingencies with regards to certain vendor disputes and litigation matters. See “Note 13 - Commitments and Contingencies” in the notes to the consolidated financial statements for discussion of significant litigation matters.

Interest Expense, Net

Interest expense, net for the year ended December 31, 2022 was $59.5 million compared to $25.8 million and $23.3 million for the same periods in 2021 and 2020, respectively. The increase in interest expense, net was attributable to our increased debt balances, and higher average interest rates in 2022. See “Note 6 – Debt” in the notes to our consolidated financial statements for additional discussion related to our debt.

Loss on Extinguishment of Debt

As a result of debt refinancing transactions and debt repayments in 2022, we recognized a loss on extinguishment of debt for the year ended December 31, 2022 of $17.6 million compared to $0.5 million and zero for the same periods in 2021 and 2020, respectively.

Other (Expense) Income, Net

For the year ended December 31, 2022, we recognized unrealized gains of $16.5 million related to the change in fair value of the Flotek Convertible Notes before we obtained control of Flotek and our investment in BPC.

Income Tax (Expense) Benefit

Income tax expense for the year ended December 31, 2022 was $9.1 million compared to income tax benefit of $0.2 million and income tax expense of $0.5 million for the same periods in 2021 and 2020, respectively. The increase in 2022 income tax expense is due to the Company’s corporate reorganization to a taxable entity subsequent to the IPO.

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Year Ended December 31, 2021

For a discussion of our Predecessor’s results of operations for the year ended December 31, 2021, please refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations of ProFrac in the Amendment No. 1 to the Registration Statement on Form S-4 filed by the Issuer on September 22, 2022 (Registration Statement No. 333-267168).

Liquidity and Capital Resources

Sources of Liquidity

Historically, our primary sources of liquidity and capital resources have been borrowings under our credit facilities, cash flows from our operations and capital contributions from our shareholders. We expect that our primary uses of capital will be to continue to fund our operations, support organic and strategic growth opportunities and satisfy future debt payments.

Due to our determination that Flotek is a VIE of which the Company is the primary beneficiary, Flotek’s financial statements have been included in our consolidated financial statements from May 17, 2022. However, we do not have the ability to access or use Flotek’s cash or liquidity in our operations and, accordingly, have excluded Flotek’s cash and other sources of liquidity from the following discussion of our liquidity and capital resources. Refer to “Note 4 – Business Combinations and Asset Acquisition” in the notes to our consolidated financial statements for additional discussion related to the acquisition of Flotek.

At December 31, 2022, we had $22.8 million of cash and cash equivalents, excluding Flotek, and $35.2 million available for borrowings under our revolving credit facility which resulted in a total liquidity position of $58.0 million. Refer to “Note 6 – Debt” in the notes to our consolidated financial statements for more information regarding our revolving credit facility.

In February 2023, our revolving credit facility was amended to increase the maximum availability to $400.0 million in connection with our acquisition of Performance Proppants. Refer to “Note 18 – Subsequent Events” in the notes to our consolidated financial statements for more information regarding the acquisition of Performance Proppants.

At February 28, 2023, we had $78.7 million of cash and cash equivalents, excluding Flotek, and $72.3 million available for borrowings under our revolving credit facility which resulted in a total liquidity position of $151.0 million.

We believe that our cash and cash equivalents, cash provided by operations, and the availability under our revolving credit facility will be sufficient to fund our capital expenditures, satisfy our obligations, and remain in compliance with our existing debt covenants for at least the next 12 months. If we pursue additional acquisitions during 2023 we will likely need to raise additional debt and/or equity financing to fund them.

Financing of Potential Acquisitions

Our growth strategy includes potential acquisitions and other strategic transactions, and from time to time we enter into non-binding letters of intent to make investments or acquisitions. These letters of intent may provide for purchase consideration including cash, notes payable by us, equity of ProFrac, or some combination, the use of which could impact our liquidity needs. These potential transactions are subject to the completion of satisfactory due diligence, the negotiation and resolution of significant business and legal issues, the negotiation, documentation and completion of mutually satisfactory definitive agreements among the parties, the consent of our lenders, our ability to finance any cash payment at closing, and approval of the ProFrac board of directors. We cannot guarantee that any such potential transaction would be completed on acceptable terms, if at all.

Flotek Liquidity

In Flotek’s Form 10-K filed on March 23, 2023, Flotek concluded that there was substantial doubt about its ability to continue as a going concern due to limited sources of liquidity. Flotek is evaluating strategies to obtain additional funding to improve its liquidity position and believes it will be able to continue to fund its operations. We believe that substantial doubt about Flotek’s ability to continue as a going concern does not materially adversely affect our business, financial condition or results of operations as we do not guarantee any Flotek liabilities and we have access to other chemical suppliers.

Working Capital

Our working capital was $197.3 million and $5.0 million as of December 31, 2022 and 2021, respectively. The $192.3 million increase in working capital was primarily due to higher activity levels and our business combinations in 2022.

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Cash Flows

The following table provides a summary of our cash flows:

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Net cash provided by (used in):"],["Operating activities","","$","415.2","","","$","43.9","","","$","45.1"],["Investing activities","","","(1,028.6",")","","","(78.4",")","","","(44.6",")"],["Financing activities","","","645.9","","","","36.9","","","","(15.3",")"],["Net change in cash, cash equivalents, and restricted cash","","$","32.5","","","$","2.4","","","$","(14.8",")"]]
[[/GREPCENT_TABLE]]

Operating Activities. Net cash provided by operating activities was $415.2 million, $43.9 million and $45.1 million for the years ended December 31, 2022, 2021 and 2020, respectively. The increase was primarily due to higher activity levels and profitability, offset by working capital increases in 2022.

Investing Activities. Net cash used in investing activities was $1,028.6 million, $78.4 million and $44.6 million for the years ended December 31, 2022, 2021 and 2020, respectively. The increase was primarily due to $640.7 in net cash paid for acquisitions and higher capital expenditures of $268.8 million related to dual fuel engine upgrades, engine standby controller installations, and our electric frac fleet build program. These uses of cash were partially offset by cash proceeds from the FTSI Sale Leaseback of real property.

Financing Activities. Net cash provided by financing activities was $645.9 million and $36.9 million for the years ended December 31, 2022 and 2021, respectively, compared to net cash used in financing activities of $15.3 million for the year ended December 31, 2020. The increase in cash provided by financing activities was due to proceeds from the issuance of long-term debt associated with refinancing transactions related to the FTSI acquisition, proceeds from upsizing the 2022 ABL Credit Facility, and proceeds from our IPO. These proceeds were offset by debt repayments.

Debt Obligations

The following table summarizes our outstanding indebtedness as of December 31, 2022:

[[GREPCENT_TABLE]]
[["","","2023","","","2024","","","2025","","","2026","","","2027","","","Thereafter","","","Total"],["2022 ABL Credit Facility","","$","-","","","$","-","","","$","-","","","$","-","","","$","234.3","","","$","-","","","$","234.3"],["2022 Term Loan Credit Facility","","","26.0","","","","26.0","","","","467.2","","","","-","","","","-","","","","-","","","","519.2"],["First Financial loan","","","16.6","","","","-","","","","-","","","","-","","","","-","","","","-","","","","16.6"],["REV Note (1)","","","24.2","","","","8.5","","","","6.3","","","","-","","","","-","","","","-","","","","39.0"],["Monarch Note","","","32.8","","","","54.7","","","","-","","","","-","","","","-","","","","-","","","","87.5"],["Finance Lease Liabilities","","","2.5","","","","2.5","","","","2.1","","","","1.3","","","","0.9","","","","-","","","","9.3"],["Flotek Convertible Notes","","","12.7","","","","-","","","","-","","","","-","","","","-","","","","-","","","","12.7"],["Equify Note (1)","","","5.0","","","","5.0","","","","5.0","","","","5.0","","","","3.8","","","","-","","","","23.8"],["Equipment Financings","","","3.6","","","","1.5","","","","-","","","","-","","","","-","","","","-","","","","5.1"],["Other","","","4.2","","","","5.7","","","","1.4","","","","0.1","","","","0.1","","","","0.4","","","","11.9"],["Total","","$","127.6","","","$","103.9","","","$","482.0","","","$","6.4","","","$","239.1","","","$","0.4","","","$","959.4"]]
[[/GREPCENT_TABLE]]

(1) Related party debt agreements.

See “Note 6 – Debt” and “Note 7 - Leases” in the notes to our consolidated financial statements for the discussion of our various debt agreements and operating and capital leases, respectively.

On December 30, 2022, the 2022 Term Loan Credit Facility was amended to provide the option to request borrowings of delayed draw term loans, in an aggregate principal amount not to exceed $150 million, $80 million of which was borrowed on January 4, 2023 and the remaining $70 million of which was borrowed on January 20, 2023. On February 1, 2023, the 2022 Term Loan Credit Facility was amended to increase the size of the 2022 Term Loan Credit Facility by $170 million. On February 23, 2023, the 2022 Term Loan Credit Facility was further amended to provide for more flexibility in certain debt financings, the addition of a most favored nation adjustment to the 2022 Term Loan Credit Facility in the event that any obligor enters into certain debt financings, and permit our acquisition of Performance Proppants (see below). The outstanding principal balance of the 2022 Term Loan Credit Facility after these amendments and borrowings was $839.2 million.

In January and February 2023, we repaid all amounts outstanding under the 2022 ABL Credit Facility with the proceeds from the additional borrowings under the 2022 Term Loan Credit Facility discussed above. On February 23, 2023 the 2022 ABL Credit Facility was amended to, among other things, provide for more flexibility in debt financing, increase the maximum availability to $400.0 million, and permit our acquisition of Performance Proppants (see below). In February 2023, we borrowed $317.0 million to help fund the acquisition of Performance Proppants and for other general corporate purposes.

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Purchase Commitments

We have purchase agreements and orders placed for hydraulic fracturing equipment related to the buildout of our Nyx Clean Fleets®. As of December 31, 2022, we have purchase commitments of $21.0 million due in the next twelve months under these agreements and purchase orders.

Capital Expenditures

During the years ended December 31, 2022, 2021 and 2020, our capital expenditures were $356.2 million, $87.4 million and $48.0 million, respectively. The primary drivers of the increase were increased maintenance capital expenditures for our larger fleet, building electric-powered hydraulic fracturing fleets, engine upgrades as part of our ESG focus, and the construction of our Lamesa sand mine.

For 2023, we expect capital expenditures to be in line with 2022, excluding the effect of acquisitions. We have budgeted approximately 15% of this amount to complete the construction of four electric-powered fleets. We also expect to allocate roughly 30% of our 2023 capital expenditure budget to complete engine upgrades and other growth initiatives, as well as another 15% for various initiatives in our proppant production and manufacturing segments. The remainder of the 2023 capital expenditure budget will be used to fund maintenance capital expenditures, estimated to be $3.0 million to $3.5 million per fleet per year.

We continually evaluate our capital expenditures and the amount that we ultimately spend will depend on a number of factors, including customer demand for new fleets and expected industry activity levels. We believe we will be able to fund our 2023 capital program from cash flows from operations.

Tax Receivable Agreement

On May 17, 2022, in connection with its IPO, the Issuer entered into a tax receivable agreement (the “TRA”) with certain of Unit holders of ProFrac LLC (the “TRA Holders”). The TRA generally provides for the payment by the Issuer to each TRA Holder of 85% of the net cash savings, if any, in U.S. federal, state and local income tax and franchise tax (computed using simplifying assumptions to address the impact of state and local taxes) actually realized (or deemed to have been realized in certain circumstances) as a result of (i) certain increases in tax basis that occur as a result of the Issuer’s acquisition (or deemed acquisition for U.S. federal income tax purposes) of all or a portion of such TRA Holder’s Units of ProFrac LLC in connection with the IPO or pursuant to an exercise of the Redemption Right (as defined in the TRA) or the Call Right (as defined in the TRA) and (ii) imputed interest deemed to be paid by us as a result of, and additional tax basis arising from, any payments made under the TRA. The Issuer depends on ProFrac LLC to make distributions to us in an amount sufficient to cover its obligations under the TRA.

Payments will generally be made under the TRA as the Issuer realizes actual cash tax savings from the tax benefits covered by the TRA. However, if there is a Change of Control of the Issuer (as defined in the TRA), or the TRA otherwise terminates early, the Issuer’s obligations under the TRA would accelerate and the present value of the anticipated future payments to be made by it under the TRA (determined by applying a discount rate) would become immediately due and payable. Any such payment is expected to be substantial. See the discussion in Item 9B of this Annual Report for additional information.

Off-Balance Sheet Arrangements

From time-to-time, we enter into off-balance sheet arrangements and transactions that can give rise to off-balance sheet obligations. As of December 31, 2022 and 2021, the off-balance sheet arrangements and transactions that we have entered into include undrawn letters of credit. We do not believe that these arrangements are reasonably likely to materially affect our liquidity or availability of, or requirements for, capital resources.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally acceptable in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the consolidated financial statements and the reported revenues and expenses during the reporting periods. We evaluate these estimates and assumptions on an ongoing basis and base our estimates on historical experience, current conditions and various other assumptions that we believe to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities as well as identifying and assessing the accounting treatment with respect to commitments and contingencies. Our actual results may materially differ from these estimates.

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Listed below are the accounting policies that we believe are critical to our consolidated financial statements due to the degree of uncertainty regarding the estimates or assumptions involved, and that we believe are critical to the understanding of our operations. See “Note 2 - Summary of Significant Accounting Policies” in the notes to our consolidated financial statements for additional information on all our significant accounting policies.

Property, Plant and Equipment

Our property and equipment are recorded at cost, less accumulated depreciation.

Upon sale or retirement of property and equipment, the cost and related accumulated depreciation are removed from the consolidated balance sheet and the net amount, less proceeds from disposal, is recognized as a gain or loss in earnings.

The estimated useful lives and salvage values of property and equipment is subject to key assumptions such as maintenance, utilization and job variation. Unanticipated future changes in these assumptions could negatively or positively impact our net income. The determination of the appropriate useful life of our property and equipment requires significant judgment resulting from the demanding operating environments in which we conduct our business as well as the significant volatility and demand fluctuations we have seen in our industry in recent years. A significant change in our established useful lives could cause depreciation expenses to fluctuate materially.

Business Combinations

Business combinations are accounted for under the acquisition method of accounting. Under this method, the assets acquired and liabilities assumed are recognized at their respective fair values as of the date of acquisition. The excess, if any, of the acquisition price over the fair values of the assets acquired and liabilities assumed is recorded as goodwill. For significant acquisitions, we utilize third-party appraisal firms to assist us in determining the fair values for certain assets acquired and liabilities assumed. The measurement of these fair values requires us to make significant estimates and assumptions which are inherently uncertain.

Adjustments to the fair values of assets acquired and liabilities assumed are made until we obtain all relevant information regarding the facts and circumstances that existed as of the acquisition date (the “measurement period”), not to exceed one year from the date of the acquisition. We recognize measurement-period adjustments in the period in which we determine the amounts, including the effect on earnings of any amounts we would have recorded in previous periods if the accounting had been completed at the acquisition date.

The estimation of net assets acquired in business combinations requires significant judgment in determination of the fair value of the assets and liabilities acquired. Our fair value estimates require us to use significant observable and unobservable inputs. The estimates of fair value are also subject to significant variability, are sensitive to changes in market conditions, and are reasonably likely to change in the future. A significant change in the observable and unobservable inputs and determination of fair value of the assets and liabilities acquired could significantly impact our consolidated financial statements.

Tax Receivable Agreement

In connection with our IPO, ProFrac Corp. entered into a tax receivable agreement (the “TRA”) with certain Unit holders (the “TRA Holders”). The TRA generally provides for payment by ProFrac Corp. to the TRA Holders of 85% of the net cash savings, if any, in U.S. federal, state and local income tax and franchise tax (computed using simplifying assumptions to address the impact of state and local taxes) that ProFrac Corp. actually realizes (or is deemed to realize in certain circumstances) as a result of (i) certain increases in tax basis that occur as a result of ProFrac Corp.’s acquisition (or deemed acquisition for U.S. federal income tax purposes) of all or a portion of such TRA Holder’s Units in connection with the IPO or the exercise of the Redemption Right (as defined in the TRA) or the Call Right (as defined in the TRA), and (ii) imputed interest deemed to be paid by ProFrac Corp. as a result of, and additional tax basis arising from, any payments ProFrac Corp. makes under the TRA. ProFrac Corp. will be dependent on ProFrac LLC to make distributions to ProFrac Corp. in an amount sufficient to cover ProFrac Corp.’s obligations under the TRA. ProFrac Corp. will retain the benefit of the remaining 15% of any actual net cash tax savings. The payment obligations under the TRA are ProFrac Corp.’s obligations and not obligations of ProFrac LLC, and we expect that the payments required to be made under the TRA could be substantial.

The term of the TRA commenced upon the completion of the IPO and will continue until all tax benefits that are subject to the TRA have been utilized or expired, unless we experience a Change of Control (as defined in the TRA, which includes certain mergers, asset sales, or other forms of business combinations) or the TRA otherwise terminates early (at our election or as a result of our breach or the commencement of bankruptcy or similar proceedings by or against us) and ProFrac Corp. makes the termination payments specified in the TRA in connection with such Change of Control or other early termination. In the event that the TRA is not terminated, the payments under the TRA could commence in 2023 and will continue for 15 years after the date of the last redemption of the Units.

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Payments will generally be made under the TRA as we realize actual cash tax savings from the tax benefits covered by the TRA. However, if we experience a Change of Control or the TRA otherwise terminates early, ProFrac Corp.’s obligations under the TRA would accelerate and ProFrac Corp. would be required to make an immediate payment equal to the present value of the anticipated future payments to be made by it under the TRA. For example, if a Change of Control or other early termination event had occurred on December 31, 2022, we estimate the payment could have ranged up to more than $475 million. There can be no assurance that we will be able to satisfy our obligations under the TRA.

Estimating the amount and timing of payments that may become due under the TRA is by its nature imprecise. For purposes of the TRA, net cash tax savings generally are calculated by comparing ProFrac Corp.’s actual tax liability (determined by using the actual applicable U.S. federal income tax rate and an assumed combined state and local income and franchise tax rate) to the amount ProFrac Corp. would have been required to pay had it not been able to utilize any of the tax benefits subject to the TRA. The actual increases in tax basis covered by the TRA, as well as the amount and timing of any payments under the TRA, will vary depending on a number of factors, including the timing of any redemption of Units, the price of ProFrac Corp.’s Class A Common Stock at the time of each redemption, the extent to which such redemptions are taxable transactions, the amount of the redeeming Unit holder’s tax basis in its Units at the time of the relevant redemption, the depreciation and amortization periods that apply to the increase in tax basis, the amount and timing of taxable income we generate in the future, the U.S. federal income tax rates then applicable, and the portion of ProFrac Corp.’s payments under the TRA that constitute imputed interest or give rise to depreciable or amortizable tax basis.

We account for amounts payable under the TRA when we determine that a liability is probable and the amount is reasonably estimable.

Income Taxes

Before May 17, 2022, the ProFrac Predecessor entities were organized as limited liability companies or a limited partnership and were treated as either a disregarded entity or a partnership for U.S. federal income tax purposes, whereby the ordinary business income or loss and certain deductions were passed-through and reported on the members’ income tax returns. As such, the Company was not required to account for U.S. federal income taxes in the consolidated financial statements. Certain state income-based taxes are imposed on the Company which are reflected as income tax expense or benefit in historical periods.

In connection with the IPO in May 2022, the Company reorganized and ProFrac LLC became partially owned by ProFrac Corp., a U.S. Internal Revenue Code Subchapter C corporation (“C-Corporation”). ProFrac Corp. is a taxable entity and is required to account for income taxes under the asset and liability method for periods subsequent to May 17, 2022.

Income taxes are accounted for using the asset and liability method. Deferred taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. We recognize future tax benefits to the extent that such benefits are more likely than not to be realized.

We record a valuation allowance to reduce the value of a deferred tax asset if based on the consideration of all available evidence, it is more likely than not that all or some portion of the deferred tax asset will not be realized. Significant weight is given to evidence that can be objectively verified. We evaluate our deferred income taxes at each reporting date to determine if a valuation allowance is required by considering all available evidence, including historical and projected taxable income and tax planning strategies. We will adjust a previously established valuation allowance if we change our assessment of the amount of deferred income tax asset that is more likely than not to be realized.

An estimate of whether a valuation allowance is necessary and the related amount of the valuation allowance contain uncertainties because it requires us to apply judgment to all positive and negative evidence available to us. When considering the likelihood of whether a deferred tax asset will be available to offset future taxable income, we assess, among other things, our historical and projected income or loss. When performing this assessment, we must consider the cyclical nature of our business. Our business is heavily influenced by current and expected prices for oil and natural gas. These prices are outside of our control and a downturn in the market can result in periods of significant losses for us, which could prevent the realization of a deferred tax asset. We therefore must consider the future possibility of an industry downturn and the severity of its effect on our business when considering all positive and negative evidence related to the realization of our deferred tax assets. Although we believe that our judgments and estimates are reasonable, an adjustment to a valuation allowance in a given period may require a material adjustment in a future period if our assumptions regarding our future taxable income are proven inaccurate due to an industry downturn.

Recent Accounting Pronouncements

See “Note 2 – Summary of Significant Accounting Policies” in the notes to our consolidated financial statements for further discussion regarding recently issued accounting standards.

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Related Party Transactions

See “Note 16 – Related Party Transactions” in the notes to our consolidated financial statements for further discussion regarding related party transactions.