Carbo Ceramics (CRR), at Thursday's closing price of 34.99, provides an interesting combination of value and volatility: with no debt and a TTM P/E of 13.2, it also sports an implied volatility of 69.6% and a short interest equal to 29.7% of the float. Based on its sound fundamentals, a risk tolerant value investor can reap good returns by using the covered combination strategy: buying the shares and selling strangles.
Overview – Carbo is in the Oil & Gas Equipment and Supplies sector. The company manufactures and sells ceramic proppants, used in the hydro-fracturing of oil and gas wells, and also provides services and software related to hydro-fracturing. An increasing proportion of new natural gas production is derived from shale plays, where the use of hydro-fracturing is required. Ceramic proppants are technically superior to the alternatives - sand and resin coated sand - due to their more uniform size and greater strength and heat resistance. The company believes that it is the largest producer of ceramic proppants worldwide.
Three large customers – BJ Services (BJS), Halliburton (HAL) and Schlumberger (SLB) accounted for 78% of sales in 2008.
Industry Context – Natural gas is currently trading at depressed prices based on over-supply. Active rig counts have declined precipitously, reducing demand for hydro-fracturing and proppants. In their last conference call, Carbo suggested that sales volumes could be expected to decline at about half the rate of decline in rig counts. The company has been discounting their product, and pushing lower-cost, lower strength versions as a superior substitute for sand in lower depth wells where sand is more frequently used.
Many industry observers, myself included, believe that the relatively rapid fall-off in production from new shale wells, as compared to conventional wells, will make the cycle self-correcting. It is difficult to predict when this will occur – most of the company management I have listened to on conference calls thinks the current situation will extend at least through the end of 2009. I did a fairly long analysis of the industry in connection with my writeup on BJS and will not repeat it here.
Long-term natural gas will be big: the supply is abundant; it's in the US of A, not Iraq, Iran or Nigeria; it burns clean compared to coal; it's lower cost than oil; it is continuous as compared to wind and solar which are intermittent, it stores easily underground, compared to wind and solar which must be used as produced. Infrastructure in the form of new pipelines has been sprouting rapidly. Most of the new natural gas being discovered is in shale formations: shale requires hydro-fracturing and ceramic is the best proppant.
Finally, the product is better than sand. From the last conference call (see full transcript):
We have an incredibly tight pressure reservoir down there that we are poking a hole in and everything else. But when you look at the Haynesville, there is a couple of factors there and we are not going to go into individual clients. We value the confidentiality of our E&P clients and we just wont go there. But from a technical standpoint, you know, you have these high temperatures which of course sand doesn't like. And you have these closure stresses that go beyond what sand or resin-coated sand are capable of handling.
So these closure stresses are sitting it [down there] 10,000 and in some cases, probably running up around 12,000 or 13,000 PSI. So what happens as we drain these wells and the bottom hole pressure goes down, the closure stress continues to increase and ultimately you crush it. You combine that with the temperature problem that sand doesn't like, where we run 315, in some cases we have heard 360, 370 Fahrenheit, it just doesn't work. Okay.
Now, as far as a trend for CARBO, once again we are not going to be too open on that since we are the only public company. But I can say, Q2 was very pleased, our Q1 was very pleasing for us in the trends we see happening there, both in the number of clients, and the volume is very favorable in our opinion.
Balance Sheet – a primary attraction here is the strength of the balance sheet. As of the end of the first quarter, current assets were 237 million as against current liabilities of 30 million. There was no long term debt and cash and equivalents stood at 94.6 million, or 4.06 per share.
Deployment of Capital – past performance has been superb. The company has a ten year history of meeting its capex requirements from cash flow, without incurring any long term debt. Timing of acquisitions and divestitures has been adroit. From the announcement of their sale of assets from their Pinnacle Technologies subsidiary:
The fracture and reservoir diagnostics business has been a high growth business for us, and we believe the future potential of this business is reflected in the value we received for these assets. In addition to the sale of assets, we have executed a multi-year proppant supply agreement with Halliburton that is intended to support our plans to continue to expand the production and use of our superior quality ceramic proppant worldwide. This transaction monetizes the value of a high growth business we acquired a little over six years ago and eliminates a conflict with our valued ceramic proppant customers. Equally important, we are retaining the highly respected software and consulting businesses. These two businesses are highly complementary to the ceramic proppant business, share the same client base and taken together, form an important piece of the global fracturing marketplace.
The proceeds of the sale sit on the balance sheet and are available to fund capex, share repurchases, or acquisitions. The multi-year supply agreement with a major customer seems well-timed also, not to mention the conflict reduction.
Buybacks – the company has a repurchase authorization and through the end of the first quarter had repurchased 1.5 million shares at an average cost of 37.54, reducing shares outstanding by approximately 5%. Noting that there is no long-term debt and the average purchase price is less than my estimate of their value, the buybacks seem prudent and have increased the value of the remaining shares.
Valuation – for a stock in a cyclical industry, a long term average of earnings is useful. Leaving out the gain on the sale of Pinnacle's discontinued operations, 5 year average EPS by year end should be about 2.14. Applying a multiple of 20 (less than historical average, and typical for high quality) I get a value of 43 per share, to which I would add 6 for the excess of current assets over current liabilities, arriving at a target of 49 within two years. The shares have traded as high as 62.57 within the past 52 weeks.
Patent Expiration – from the latest 10-K:
The Company owns six U.S. patents, three Russian patents, and one Singapore patent. One of the Company’s U.S. patents relates to the CARBOLITE® and CARBOECONOPROP® products and will expire in 2009...
The Company believes that, although patent rights held by the Company and certain of its competitors are barriers to entry, the “know-how” and trade secrets necessary to efficiently manufacture a product of consistently high quality may ultimately prove a more difficult barrier to overcome.
I subscribe to the idea that process improvements and trade-craft, the accumulated experience gained over years of production, constitutes an ongoing advantage.
Competition – again from the 10-K:
The Company’s largest worldwide proppant competitor is Saint-Gobain Proppants (“Saint-Gobain”). Saint-Gobain Proppants is a division of Compagnie de Saint-Gobain, a large French glass and materials company. Saint-Gobain manufactures a variety of high-strength and intermediate strength ceramic proppants that it markets in competition with each of the Company’s products. Saint-Gobain’s primary manufacturing facility is located in Fort Smith, Arkansas. Saint-Gobain also manufactures ceramic proppant in China and Venezuela. Mineracao Curimbaba (“Curimbaba”), based in Brazil, manufactures high-strength and intermediate strength ceramic proppants that it markets in competition with each of the Company’s products.
There are two major manufacturers of ceramic proppant in Russia. Borovichi Refractory Plant (“Borovichi”) located in Borovichi, Russia, and FORES Refractory Plant (“FORES”) located in Ekaterinburg, Russia. While the Company has limited information about Borovichi and FORES, the Company believes that each of these companies primarily manufactures intermediate strength ceramic proppants and markets their products principally within Russia. The Company also believes that these companies have added manufacturing capacity in recent years and now provide a majority of the ceramic proppant used in Russia. The Company is also aware of an increasing number of manufacturers in China. Two of the largest are Yixing Orient Petroleum Proppant Company, Ltd. and GuiZhou LinHai New Material Company, Ltd. Each of these companies produces intermediate strength ceramic proppants that are marketed primarily in China.
Carbo as discussed is well capitalized and effectively managed: they are a capable competitor, the largest player in a profitable industry.
Short Interest – stands at 29.7%, and would constitute a reservation. Whatever these people are thinking, it is not about the balance sheet and it is only partly about natural gas. I checked short interest on other oil services players and didn't find anything comparable. I personally would not short CRR for the fact the balance sheet is impeccable and the company is small enough to be an acquisition target. To each his own.
Options Strategy – an investment along the following lines might be considered:
Buy 100 CRR @ 34.99
Sell to open 1 CRRLH, CRR Dec09 40 Call @ 2.90
Sell to open 1 CRRXF, CRR Dec09 30 Put @ 3.00
The share price is Thursday's close, the options are mid bid/ask rounded down. If the shares are called away, this yields 70% annualized. If the price is unchanged at expiration, the static return is 38%. If assigned on the puts, the average cost of 200 shares would be 29.55, fairly close to the 52 week low of 26.33. The dividend is .68, yielding 2.3% on the average price if assigned.
There isn't an awful lot of open interest on the options and the bid/ask is relatively wide. The stock fluctuates quite a bit, my guess would be that it is being program traded based on natural gas. It might be possible to leg into the combination at an advantage. Position size could be held small: if assigned it might be nice to have room to repeat the maneuver.
Disclosure: Long CRR shares, short a strangle. Long BJS, no position HAL or SLB.
