Carbo Ceramics Killed Earnings, Still Poised For Growth

Nov.25.13 | About: CARBO Ceramics (CRR)

I began following Carbo Ceramics (NYSE:CRR) a few months ago, initially giving the stock an intrinsic valuation of $129.25 -- a 23.5% upside from its price on Oct. 16, about a week before it released earnings. Carbo is an oil servicing company headquartered in Houston, Texas, that was founded in 1987. In terms of market capitalization, Carbo is worth about $2.8B. In the past year the stock has ranged between $62.11 and $132.55, currently trading around $120.22.

My original investment thesis was that Carbo is the world's largest supplier of fracking proppant. Shale and deepwater drilling are currently growing more rapidly than in the past, which provides an opportunity for Carbo to expand due to the increased need for drilling materials. Yes, Carbo does have a number of peers that think they can do the same thing. However, lately Carbo has made large investments in research and development. Even with this, it's still are showing strong cash flows and also have no long-term debt. Before its earnings release, Carbo looked like the perfect value play to me. After its earnings release, Carbo caught up to my relative valuation of $129.25, even passing that price at one point before settling in the low $120s. Although still undervalued in my opinion, Carbo is setting itself up for growth in the short and long run, all while maintaining no debt.

Just to start from the beginning, proppant is the granular material in the fluid that fills the fracture and "props" the fracture open once the high pressure pumping is completed. This creates a channel through which the hydrocarbons flow to the surface. To the average investor, this means nothing, but is crucial to understanding how Carbo makes its money. The proppant industry is very heavily leveraged toward drilling activity in America. At this moment, there are 1,736 different rigs that are drilling wells throughout America. Something interesting -- despite not being very relevant for now -- is that the Energy Information Administration predicts that the U.S. will be completely energy-independent by the year 2035. This could very well happen. A number of people did not think electric cars would ever make it, and as long as Tesla (NASDAQ:TSLA) cars stop combusting they will be proven wrong. Carbo supplies three of the three different types of proppants currently used in wells in the U.S.: sand, resin coated sand, and ceramic proppant.

Carbo Ceramics has four different segments of its business, four different ways of making money: proppant, consulting, software, and environmental protection products. It goes without saying that the proppant business is the largest, as Carbo is the largest supplier of proppant in the world. The software that Carbo produces is the top-selling and most used software within the oil and gas sector. Its software is favored compared to that of its competitors because it calculates, in real time, any problems when fracking a well. The consulting and environmental segments are profitable, although it is not as large of a percentage of revenue as the proppant or software segments are.

Carbo's margins have remained strong quarter after quarter. The following are margins as of Q3 2013:

  • Gross Margin: 36.6%
  • Operating Margin: 24.6%
  • Profit Margin: 16.4%

The numbers show that Carbo is profitable, but how? Carbo provides various ancillary services, which are required while drilling and fracking a well. Its largest margins are from the money it earns by providing proppant for newly fracked wells. Revenue from the sale of fracking software, consulting services, and environmental protection products also boost its margins despite consulting and environmental protection products being small percentages of total revenue as stated before.

As I said before, I like that Carbo is debt-free (debt to equity: 0.00). Carbo also has a current ratio of approximately 9.00, meaning it is more than capable of quickly paying off short-term liabilities or debt. Also, with a quick ratio of 5.40, Carbo has a fairly strong ability to pay off that short-term debt with its current liquid assets. A couple more crucial ratios toward Carbo's long-term success are its return on equity and return on assets (14.86% and 13.1%, respectively). Both are increasing Q/Q and Y/Y, meaning Carbo is profitable in terms of shareholder's equity and its current assets. Lastly, Carbo has a fixed asset utilization rate of 24.85%. Carbo has a large investment in research and development as stated previously, therefore this ratio demonstrates how well Carbo is utilizing its fixed assets and investments.

Like I said earlier, I valued Carbo at $129.25 a little over a week before its earnings report on Oct. 31. Analysts were expecting net income of $0.83 per share with a total revenue of about $161M. It reported an earnings of $1.31 per share on a revenue of $201.5M. That was significantly higher than expected, sending the stock price up to its peak of $132.55. This peak was higher than my intrinsic valuation, but it has come down from this peak to $122.19, a couple of percent below my original valuation. To me, this means that it is still undervalued, but at this point Carbo is turning into more of a growth play than a value play (despite still being slightly undervalued). I would look for $130.00-plus sometime soon, then Carbo will be trading at book value but still poised for future growth.

In terms of future growth, proppant demand growth is expected to grow to over 100B pounds per year by the year 2017. The current demand is only at 60B pounds per year. That said, Carbo reported in its guidance than ceramic proppant volume was up over 41.0% last quarter alone, all while proppant prices remained relatively stable. Domestic drilling is expected to increase as well, as noted by the Energy Information Administration. This will open up a number of new opportunities for Carbo to grow domestically. Carbo is advancing faster and more efficiently than its competitors as well. It recently developed a new proppant that will have the ability to double the amount of recoverable oil from deepwater wells. Finally, in terms of long-term and future growth, Carbo has increased its proppant capacity by over 60.0% in the past five years alone, significantly better than its peer average.


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Even though on a valuation basis Carbo is not the cheapest as compared to its competitors, it has the largest market share in the world with respect to proppant as the world's largest supplier in the basic materials oil and gas sector. To sum up the key advantages of Carbo in the long run, most importantly it has no debt. Carbo is expanding domestically, while maintaining its long-term debt (current ratio: 9.00+). Domestic drilling is expected to greatly increase over the next 10 years, and the U.S. will be energy-independent by 2035. Demand for proppants is expected to double over the next five years, and since Carbo is the world's leading provider in proppants, it will capitalize on this opportunity. Carbo's proppants are by far the best and most efficient in the industry and sector. Various oil and gas companies have been changing over to Carbo's proppants as opposed to low-quality Chinese proppants, increasing its market share even more.

With these advantages come certain risks as well. Carbo is heavily leveraged toward oil and natural gas drilling. Fluctuations in crude and natural gas futures could influence a fraction of Carbo's business. Various fracking legislatures could put more regulations on proppants and fracking, although the majority of these legislatures would not greatly affect Carbo. The majority of Carbo's revenue comes from proppant sales and fracking software sales, so this puts them at some risk -- although it is only a small risk in the big picture, as they are necessary segments of its business. New entrants into the market could reduce Carbo's market share, but these new entrants would take years to development a product as efficient as that of Carbo. But that's still something to consider in the long run. The thing to keep in mind is that these are small risks when compared to the company's advantages.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CRR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.