Carbo Ceramics Analysis
Board: Value Hounds
Capacity growth now—building for the future
Carbo sells fracking proppant to oil & gas producers and brisk activity in E&P is critical to their success. The current low price/oversupply in natural gas has upset the flow of their business and the price is per share is dropping. Business is manufacturing and selling ceramic proppant and resin-coated sand for use primarily in fracking. Carbo also provides hydraulic fracture simulation software called FracPro and hydraulic fracture design, consulting and geotechnical monitoring services.
In October 2009, Falcon Technologies, a wholly owned subsidiary acquired most of BBL Falcon Industries-- supplier of spill prevention, containment and countermeasure systems.
During 2010, they began production of resin-coated ceramic (CARBOBOND LITE) and resin-coated sand (CARBOBOND RCS) proppants. Light resin coated ceramic proppant reduces flow back (it adheres and is a good option for slickwater operations) and resin-coated sand is one of the biggest selling proppants exceeding ceramic performance under some well conditions. Carbo’s move in to this high performance lower cost option is critical. Unfortunately, the slowing of production in natural gas has resulted in oversupply of sand, and their expansion of resin-coated sand is on hold temporarily. In the future, this should prove to be an excellent investment.
Expansion of capacity is critical to long-term growth. Carbo recently completed a fourth production line at its Toomsboro facility that increases ceramic production capacity by 250 million pounds annually and brings total ceramic capacity to 1.7 billion pounds per year.
Resin-coating expansion includes a second production line in New Iberia LA (400 million pounds) completed in Q1 2012 and a 600 million pound per year resin-coating facility is under construction in Marshfield, Wisconsin, but temporarily on hold. The sand processing plant in Marshfield became operational late in the second quarter of 2012 and is receiving Carbo’s own high quality northern white sand.
Carbo is building a new plant in Millen, Georgia at a targeted production capacity of up to 500 million pounds of ceramic proppant annually and a portion will begin production in 2013.
A little background on proppant and Carbo
[See Post for Tables]
Carbo made a 52-week high of $163 last August and it’s been downhill since then to $64 where it sits today.
It’s a good company that makes a useable product critical to the fracking process and in wells that require refracking. Carbo makes the proppants that hold fractures open and allow flow of hydrocarbons.
Hydraulic fracturing is the most widely used method of increasing production from oil and natural gas wells. It consists of pumping fluids down a natural gas or oil well at pressures sufficient to create fractures in the hydrocarbon-bearing rock formation. A granular material, proppant, is suspended and transported in the fluid and fills the fracture, “propping” it open once high-pressure pumping stops. The proppant-filled fracture creates a conductive channel through which the hydrocarbons flow more freely from the formation to the well and then to the surface.
There are three types of proppant in use:
2) resin coated sand
Sand is dirt cheap, resin coated sand is pricier and ceramic is the Lamborghini of proppants and the most expensive. According to Carbo, it can improve production by as much as 20% and can be worth the price.
The quest for improving proppants continues worldwide. The current proppant market is approximately 17 billion lb/year, and more than 99% of that supply is met with sand, resin-coated sands, and ceramic proppant. Numerous other materials injected into wells during the past 40 years have not reached more than 1% of the proppant market including foam and nanoparticles.
A typical hydro-fractured well uses between 300,000 and 500,000 lbs. of proppant.
The most expensive proppants are not necessarily the best. Depending on which papers and well tests you read, resin-coated sand may actually out perform the higher priced ceramic under certain conditions. One of the leaders in resin-coated sand, Momentive, has done extensive testing under downhole conditions of pressure, heat and wetness and concluded resin-coated sand outperforms ceramic proppants. They do admit that it has become increasingly difficult to determine if one proppant is superior to another under all well conditions and they may be interchangeable. Carbo offers a discount and a trial period of their product to producers and estimates a 50%-60% success rate signing accounts.
From Proppants Open Production Pathways by Don Lyle
CARBO senior staff engineer Terry Palisch said ceramic proppants were developed in the late 1970s when Claude Cooke with Exxon looked for a proppant stronger than sand. That led to the first bauxite ceramic proppant and its benefits of higher strength for deeper, hotter formations.
The development of intermediate and lightweight ceramics followed as the industry realized the benefits of a uniformly sized, spherically shaped, crush-resistant manmade proppants.
“The best way to identify the appropriate proppant is to determine the conductivity of the proppant under realistic conditions. The benefits of increasing the conductivity of the fracture (better production, higher EUR) can then be compared to the required investment, and the solution, which provides the greatest rate of return for your investment, will be preferred. We call this the Economic Conductivity proposal,” Palisch said.
Proppant performance can be enhanced by additional elements. For example, CARBOTAG is a traceable proppant that, if it comes back up the well bore, can be analyzed to identify a well (offshore) or completions (onshore multistage fractures) that failed. CARBONRT is a newly introduced non-radioactive tracer that can help measure fracture height and proppant location. CARBOBond is a curable resin that can be applied to any of the company’s proppants to eliminate proppant production in reservoirs prone to flowback of frac sand.
One thing that is agreed on is that fracking works and resin-coated sand and ceramic outperform sand by a wide margin under pressure and heat. Operators balance the cost of the treatment with the expected increased recovery. Ceramic proppants on average cost 25% more than resin-coated sand.
In 2011, Carbo sold 1.605 billion pounds of proppants and capacity is 1.735 billion not including resin at New Iberia that came online Q 2012. The new Millen plant will allow for an additional 500 million pounds of ceramic proppant. The Marshfield facility will produce 600 million pounds of resin-coated sand.
In the first half of 2012, Carbo proppant volume was 807 million pounds. If sales slow in the back half, they will not be at full capacity and volume potentially may come in below 2011 levels. He market appears to be pricing Carbo for a poor H2. Utilization including the new capacity is going to look considerably worse than 2011 and I expect the margins to reflect the lack of leverage across these new fixed costs.
In 2011, there was a move away from dry gas basins to wet gas and oil fields. The supply chain was transitioned impacting sales volume and costs. Carbo shifted its product to the liquid-rich basins. Volume year-over-year was down in the US but international volume increased. Part of the US decline was disruption of the supply chain, but some volume was lost to decreased rig activity.
Gas rig count was 877 at the end of July 2011 and was 505 at the end of July 2012.
Oil rigs were up to 1,416 in July 2012 compared to 1,025 in 2011. The loss in gas rigs has been more than offset by oil, but it has cost Carbo volume and revenue getting the supply chain rerouted to the new fields.
Carbo was not running at capacity in Q1 and inventories were high requiring reduction. The CEO would not comment on utilization but would only say the plants were running. Apparently, fields are awash in resin coated sand and Carbo has put its Marshfield facility (that will expand its own resin coated sand production} on hold. They are slowing construction and throttling down capex on the project. It does suggest oversupply of proppants in the field at least for resin coated sand and likely for ceramic as well. Carbo continues to bring its inventory levels down.
CEO Gary Kolstad
We are very prudently reducing down our inventories there as well. So we do a balancing act of reducing down inventories on that and increasing the consumption of our plant produced products.
Compounding Carbo’s troubles was an influx of ceramic proppant from China. When there is oversupply and competition, pricing leverage disappears and Carbo was not able to raise prices and is in fact lowering them.
So, directionally we're saying the pricing is directionally lower and we think it's very prudent to say that. I also put in the caveat as I mentioned couple of time now that we will be doing field trials and we have a history on what those do and they always work out long term for us. It's a right thing to do, but we offer an economic benefit at the time of execution on those, and then when we're done with them, we go back to, let's say our normal pricing.
The quarter was good with increased revenue and earnings per share. In spite of that the company continues to lag the sector as competition from China, volume declines and margin erosion concerns overshadow its recent performance.
Revenue in Q2 was $177.6 million -— analysts were expecting $162.7 million. Net sales increased 19% over Q2 2011 revenue of $149.7 million. EPS were $1.38 beating analyst estimates of $1.31. EPS were 7.0% higher than the $1.29 in 2011. In response to great earnings but a downbeat outlook, Carbo shares are down almost 20% in a little under two weeks.
The second quarter continued to see oversupply in proppants largely courtesy of the Chinese who are flooding the market with cheaper ceramic product. Carbo adamantly maintains that the quality is inferior and producers are tending to come back to Carbo ceramics.
Natural gas production has been reduced and the sales volume for proppants was only rescued by the switch to liquid basins especially Bakken and Eagle Ford. Volume managed a 17% increase in North America and a 20% increase in volume internationally.
They continue to be challenged by supply chain logistics and higher costs in the second quarter. The disruption raised distribution costs and eroded margins by 1.5%. That will continue for 2012.
Average pricing for proppant declined 4% in Q2 with 1% of that due to discounted field-testing. The biggest part of the decline came in the last part of the quarter. Oversupply is a big part of the problem with the flood of ceramic product from China, but there is also a surplus of resin-coated sand. Carbo’s Marshfield resin-coated sand plant is still on hold.
They began lowering inventories in Q1 and will continue to let them shrink. Margins are not going to improve in the second half. The slowing demand and highly competitive environment coupled with contracting margins has sent the price per share down by nearly 60% this year.
Inventory management and its impact on cash flow from operations
[See Post for Tables]
YOY is year-over-year
Days in inventory is down by nearly a week sequentially and inventory levels have decreased 5% from Q1 2012. Cash flow from operations continues to be less than one as working capital accounts negatively effect cash flow.
This quote from the CEO warns of a grim the second half. Costs for distribution will be high, pricing will continue to be subject to competition and price per pound may decline, and volume is likely to decrease.
As we noted previously, 2012 will have its share of challenges due to the shift in activity away from natural gas basins towards the liquids-rich basins in North America. We expect to see a very volatile, competitive environment in the second half of 2012 due to three main reasons: the continued oversupplied proppant market, low natural gas price, volatile NGL and oil prices and a continuation of higher distribution costs.
As we look at H2, we’re going to continue to see an oversupplied proppant market. We are going to continue to see the commodity prices, natural gas, NGLs, oil, those – that volatility and low natural gas.
We are going to continue to have higher distribution costs and so all those three things are going to put pressure on pricing, and pricing is what kind of dictates our volumes, how much we participate in it. So we’ll see a lot of volatility in volumes.
Volume was declining in June and Q2 ended with lower sales.
I like Carbo for the future—not so much now, but now is when the price is getting interesting. Ceramic/resin coated ceramic is a well-designed proppant whose high strength under high pressure and heat allow increased conductivity and improved estimated ultimate recovery. The expense is a consideration and resin coated sand can perform just as well at 3/4 the cost. For that reason, Carbo’s move in to high quality Northern White resin coated sand is a sound addition to the ceramic business and should help them compete against the major sand producers like Momentive (not publicly traded).
Carbo has business relationships with some of the biggest service companies—Schlumberger and Halliburton. Two customers account for 48% of revenue.
Halliburton is suffering from the same US slowing in natural gas E&P and that does blow back on to its suppliers including Carbo. Both SLB and HAL have recovered from 52-week lows but are well off a multi-year peak in July 2011. As the entire oil services sector continues a recovery, Carbo should see some benefit. We are not nearly there yet if second half guidance is any guide. Carbo continues to hover near its 52-week low.
Cash flow, cash, debt & dividends
The company does not have any debt on the balance sheet. There is $116 million in off balance sheet leases that are largely for rail equipment. Building the business has been done with cash from operations. During years that free cash flow was negative, Carbo consumed cash.
Carbo has paid a dividend for years and when cash flow is negative, it is paid from cash on hand without taking on debt. They have returned value to shareholders through steadily rising dividends even though the yield is low. Far more important has been the share price appreciation that has outperformed the S&P:
Most of that price appreciation was in 2010-2011 coinciding with an unprecedented increase in fracking activity. If oil and gas production never recovers, if emerging economies continue to struggle and fail to grow and if fracking as a the method of choice for extraction from shale falls out of favor or is legislated into extinction, then Carbo will never be worth much. That’s a lot of ifs that taken altogether look unsustainably pessimistic, but that’s about what the market is pricing Carbo for these days.
I put together a simple two-stage discounted cash flow. The discount/cost of equity was difficult. Normally the calculation involves risk free rate and market risk premium. Risk free rate is matched to the years of high growth—-I use 10 years. The 10-year treasury is yielding 1.58% and that makes the cost of equity unnaturally low. I went ahead and used it with a market risk premium of 5.5% and a beta of 1.23. I usually set the beta to one but with the risk free rate low, that gives some weight to the risk of the equity. The cost of equity is 8.8%.
The value of Carbo with zero growth over 10 years and zero terminal growth is $62. The 5-year historical growth rate of operating income is 21%. The market is not expecting much. High returns and a positive spread
For a stock with zero prospects, Carbo is managing to create value. The return on invested income has been improving over the past 5 years along with growth in revenue and operating income. Carbo is impressively debt free and cash flow from operations has steadily increased.
The weighted cost of capital using the same risk free rate, beta and market risk premium is 8.1%. The spread between the 2011 ROIC of 20% and cost of capital of 8.1% is widely positive.
Carbo is priced for a disappointing back half of 2012. Management is not disputing the negatives and in fact is underlining them and warning analysts 2012 could get ugly. Margins will be down, volume volatile and lower and pricing is expected to decline. There may be no hurry to buy Carbo, but keep it near the top of stocks to watch. Timing the bottom could prove to be difficult. Carbo’s products have a proven track record and good news should send the price per share up quickly—it tends to make big moves. http://finance.yahoo.com/q/bc?s=CRR&t=1y&l=on&z=...
• Return of high E&P activity
• New resin-coated sand capacity to broaden proppant catalog
• Increased capacity overall
• Draining away of oversupply in the sector and taking share away from Chinese competition
• Higher margins as pricing power returns and distribution back to gas fields normalizes
• Raise the dividend again following historical trends