CARBO Ceramics Inc. (NYSE:CRR) is an oil & gas service company, focused on the manufacture and distribution of ceramic proppants for use by natural gas and oil well operators in the hydraulic fracturing process. Ceramic proppants are manufactured from aluminum ores, particularly bauxite. Selected market data for CRR is presented in the table below.
Source: Bloomberg, Independent Calculations
Hydraulic fracturing involves pumping liquids under extremely high pressure into an oil or gas well in order to fracture the rock formation and cause the release of hydrocarbons contained within. In order to ensure that the fracture stays open once it is formed, a small granular material known as proppant is pumped into the fracture. This creates a conductive channel, allowing for the free flow of hydrocarbons from the fracture, back to the well, and then to the surface for recovery. Proppants are a vital input in the hydraulic fracturing process.
At first glance, proppants seems like a near-commodity product. The small granular material looks unassuming and can even be substituted for sand in shallower fractures, however, when you pump proppant into a fracture, where pressures routinely exceed 10,000 psi, differences in quality become very apparent. These variations manifest themselves in oil & gas production rates, as well as the overall amount of oil & gas that can be recovered from a well. High-quality proppants, with uniform shapes and free from internal defects have been shown to dramatically increase production and total recovery.
Source: Investor presentation, based on a Bakken Operator's comparison between CRR proppant and lower-quality foreign imported proppant
There are 3 broad categories of proppant:
1) Sand. This is the least expensive proppant available; however it also has the most irregular shape and lowest strength.
2) Resin-Coated Sand. An intermediate product offering a balance between the properties of sand and ceramic.
3) Ceramic. A premium-grade product capable of withstanding the pressures from the deepest wells, it also offers the most uniform shape, thereby allowing the highest flow-rates. This proppant is the highest cost alternative.
CRR's business focus is at the premium end of the proppant range. They offer a diverse product line of 6 different ceramic proppants, each designed for differing reservoir conditions and/or operator preferences. They also began producing and selling Resin-Coated Sand (RCS) in 2010 in order to increase their market share.
Competition has risen in recent years due to the expiration of two key patents previously held by CRR, one in 2006 and the other in 2009. As a direct result of this, lower quality imported ceramics (particularly from China, Brazil and Russia) have become a major source of competition, leading to pricing pressure.
CRR is currently engaged in a technical marketing campaign, designed to educate E&P (Exploration & Production) operators on the advantages of using high-quality ceramic proppants, relative to the risks of lower-quality foreign imports. Along with lower performance and crushing due to internal defects, poor quality proppant can cause flow-back (where proppant spills out of the fracture), leading to well-bore cleanouts, delays, and possible equipment damage.
Source: Investor presentation
CRR recently completed development of a new proppant they named Kryptosphere, which sets an entirely new standard in conductivity and strength for ceramics (see below). It is capable of providing the highest conductivity of any proppant on the market and withstanding the pressures from the deepest wells. Kryptosphere is currently undergoing commercialization and CRR is examining the engineering implications of applying the necessary production technology to existing factories. Kryptosphere technology could eventually be applied to all of CRR's proppant production.
Patents on Kryptosphere and its manufacturing process are pending.
Source: Investor presentation
Scale-guard is an example of another innovation CRR has developed. Through a patented process, some proppant pellets are infused with substances which prevent the build-up of solids and precipitates in the well. These substances are released by the high pressure of the fracture and help ensure a steady flow of oil and gas for the life of the well.
The development of Kryptosphere and Scale-guard demonstrate that CRR is still several steps ahead of their competition when it comes to innovation and product quality. Product innovations such as these will give CRR more pricing power and market share.
OTHER BUSINESS SEGMENTS:
The majority of CRR's revenue (~90%) comes from the production and sale of proppants, however CRR also operates several subsidiaries related to the oil and gas industry:
- FracPro Software is the most widely used hydraulic fracturing simulation
- StrataGen is CRR's petroleum engineering and consulting division, which provides advice to operators on matters related to unconventional reservoirs.
- Falcon Technologies provides solutions for spill prevention & countermeasures, containment of hazardous materials.
Rather than being a major source of revenue, other segments serve more of a supplemental role to promote the sale of proppant via cross-selling. For example, FracPro simulation software includes features which model the increased production rates which can be achieved using CRR's proppants. StrataGen also positions CRR as an industry expert in petroleum engineering, boosting their credibility and reputation as a company.
Although these businesses do not generate substantial revenue for CRR, Falcon in particular could have some growth potential. As environmental considerations become more important for E&P Operators (especially after events such as the BP/Transocean Gulf oil spill), prevention measures will be valuable for public relations and avoiding lawsuits.
CAPITAL SPENDING PROJECTS:
Expanding capacity to meet anticipated demand is one of CRR's primarily objectives. Current facilities and their respective capacities are shown in the table below.
A major facility is under construction in Millen, GA. When completed, it will consist of 4 production lines, each producing 250 mm lbs. of ceramic proppant, for a total of 1000 mm lbs. of additional capacity. The first line will be operational by Q3 2014, with the second line expected around mid-2015.
A new RCS facility was also under development in Marshfield, Wisconsin, which would add 600 million lbs. of RCS capacity. However, construction was idled in late-2012 due to adverse RCS proppant market conditions.
Drilling activity has shifted towards tight oil plays in recent years due to persistently low natural gas prices. The lack of established infrastructure in these areas has led to an increase in distribution costs (and increased working capital requirements) for CRR, who often deliver on a just-in-time basis direct to drilling sites. To counteract rising costs, CRR is transitioning from a rolling stock (using railcars to store inventory), to constructing storage facilities on-site. Management expects the benefits from these investments to be evident by the second half of 2014.
CRR is planning to put Kryptosphere into commercial production by retrofitting one of their existing plants. This will initially provide around 250 mm lbs. of Kryptosphere capacity. Given the potential for Kryptosphere, CRR could eventually apply the technology to all of their existing facilities. The first retrofit is expected to be completed before the second Millen line in H2 2015.
The end-users of CRR's proppants are oil and gas well operators, however the majority of sales are made to pressure pumping service companies who are hired by well operators to drill and hydraulically fracture their wells. In particular, Halliburton Co. (NYSE:HAL) and Schlumberger Ltd. (NYSE:SLB) are very large accounts for CRR, together representing an average of 45-50% of CRR's revenue.
Such a strong concentration of buyers is a risk for CRR. Issues at either firm could have a significant impact on CRR's profitability. Examining the financial risk of SLB and HAL (see below) reveals that they are both in reasonably healthy financial shape, with good working capital management, moderate debt levels, and good interest coverage.
CRR has also maintained both accounts for upwards of 15 years without any significant issues, suggesting that they have a strong business relationship. Nevertheless, due to the importance of SLB and HAL, an investor in CRR will have to continue to monitor their financial health.
INDUSTRY ENVIRONMENT & OUTLOOK:
The primary driver of growth in the proppant industry has been the proliferation of horizontal drilling used in conjunction with hydraulic fracturing. Unconventional oil and gas plays typically involve low-permeability rock (in particular, shale), through which hydrocarbons slowly migrate over millions of years as they sink down towards traditional reservoirs (McKinsey, 2012). Horizontal drilling and hydraulic fracturing are currently the only economically viable methods for recovery of unconventional oil and gas, making proppant a vital input in a growing industry.
Horizontal drilling and hydraulic fracturing are likely to see strong growth in coming years as unconventional resources continue to undergo development. This will cause proppant demand to rise proportionately. According to EIA projections, US production of both oil and natural gas is expected to grow substantially from current levels.
Tight oil plays, which require the use of horizontal drilling & hydraulic fracturing, will be the primary contributor to growth in total US oil production. Production from tight oil is expected to rise sharply over the next few years, peaking in 2020 at 2.8 million barrels per day, before gradually declining and leveling off at around 2 million barrels per day by 2030 (see below). The decline will occur as development moves into lower-productivity areas, with lower initial production rates and flatter decline curves, according to the EIA's Annual Energy Outlook.
Data Source: Energy Information Administration
Production will fall after 2020 not as a result of fewer wells being drilled, but due to the development of less productive reserves. Because the decline will be due to less productive wells and not fewer wells being drilled, there will still be very strong demand for proppant. Demand for ceramics may even rise under such a scenario: as wells become less productive, E&P operators will search for ways to boost production and total recovery. Highly conductive ceramic proppants will be a good option for achieving that goal.
Natural gas developments also represent a large source of on-going demand for proppants. Unlike tight oil, natural gas production is expected to grow steadily into 2040 (see below), creating another growing source of demand for proppants.
Data Source: Energy Information Administration
International opportunities are even more exciting. The EIA estimates that global unconventional oil and gas reserves are more than triple those of the US and Canada, creating a potentially huge source of proppant demand, especially for companies such as CRR who already have an international presence, and have accrued an in-depth understanding of proppant manufacturing and fracture engineering.
The timeline for development of international resources remains uncertain though. Horizontal drilling and hydraulic fracturing are relatively new processes, with somewhat unknown environmental effects. The primary concern is the potential contamination of ground water and aquifers as a result of the drilling and fracturing process. Other concerns include land degradation, air pollution, and water-use sustainability. According to consulting and research firm McKinsey, this has caused many countries to take a wait-and-see approach, as they watch developments in the US before making their own decisions.
Nevertheless, as more environmental research is conducted and improvements are made to the process, international development of unconventional plays should proceed. International sales currently account for around 20% of CRR's total revenue, leaving room for growth when these resources are developed.
REVENUE, EARNINGS, AND DIVIDENDS:
Revenue growth has been strong over the past 10 years, growing at a CAGR of 16.34%. Diluted EPS grew at a slightly slower rate of 14.22%, owing to a deterioration of margins due to competition, pricing pressure, and increased distribution costs in recent years.
Important to note is the resilience of both CRR's earnings and revenue. Despite large declines in oil & gas drilling activity from 2008 to 2009, CRR's revenue only fell by 11.8%. After adjusting 2008 net income for a one-time gain, earnings only fell by 12.1%. The similar, shallow declines in revenue and net income imply that CRR's margins are able to withstand economic volatility quite well.
CRR pays a quarterly dividend which has grown steadily at a CAGR of 15.2% and has never been cut. Despite the growth, the payout ratio has remained low, averaging 21.6% of earnings and sitting at 30.8% in 2013. A low payout means that dividends are very sustainable at their current level.
A low payout also creates the possibility for stronger dividend growth (via a rising payout) once major expansion projects are completed. However, I doubt the payout ratio will rise substantially in the near future since CRR remains focused on expanding capacity for the forseeable future.
I think CRR's 2013 earnings (EPS of 3.67) were abnormally low due to pressure on gross margins, leading to a jump in payout %. Similarly, 2011 earnings (EPS of 5.62) were abnormally high, creating a big drop in payout %.
CAPITAL STRUCTURE & LIQUIDITY:
Liquidity is very strong. CRR's current ratio is 5.75 and has averaged 5.3 over the last 7 years, even their quick ratio (calculated using only Cash and A/R) is 3.5 and has historically averaged 2.9. Cash reserves also typically exceed Capital Expenditures in any given year. One could make the argument that CRR carries a bit too much cash, especially considering that cash rates are virtually zero. They could safely accelerate their pace of reinvestment slightly. That being said, too much cash is preferable to too little cash, and it gives management the flexibility to respond quickly to future investment opportunities.
CRR has no debt in its capital structure; however they do have $120 million in operating leases related to railcars used to distribute proppant. Treating the present value of these obligations as a capital lease gives CRR a Debt-to-Assets ratio of 9.4%, which is still small. Low debt and very strong liquidity significantly reduce the financial risk associated with CRR (the risk of default or funding problems).
Cash Flow relative to Reinvestment has averaged 1.44, indicating that CRR has been able to fund their capital budget out of cash flow generated by their existing business. The volatility of Operating Cash Flow to Reinvestment is due to working capital fluctuations which net out over multiple periods (ex. Accounts Receivable which are uncollected at the end of the period would be reported as a reduction to Operating Cash Flow but may be collected soon after). Looking at the average level of the ratio filters out the noise.
CRR's ability to fund expansions out of their Cash reserves and Operating Cash Flow limits the risk of dilution via equity issuance and the need for debt financing.
Working capital management has been relatively stable over the past 7 years, with the exception of inventory. Inventory investment has increased substantially, as a doubling of Days-Inventory-on-Hand shows. Finished Goods Inventory relative to Revenue has also more than doubled over the period. Due to the distribution challenges involved with tight oil plays, CRR has needed a much larger inventory investment in order to support their sales. The costs related to storing and transporting more inventory is one of that factors that has caused gross margins to fall.
Earnings quality is high, with Cash Flow to EBIT averaging over 1, meaning that CRR's management team has not been manipulating reported earnings.
When profit fell in 2009, it was mainly due to falling sales (asset turnover fell to 0.67) and falling leverage. In 2013, margin compression has been much more to blame for the drop in profitability (EBIT margin of 18.7% compared to an average over 25%). Margins are currently the lowest they have been for CRR during the past 10 years. This is due to 3 factors: 1) pricing pressure due to competition 2) increased distribution costs and 3) the addition of lower-margin RCS.
CRR has historically not had any debt in their capital structure and because they are generating enough cash flow to fund their current expansion plans, Financial Leverage and Interest Burden are unlikely to change. Tax Burden should also be fairly stable at around 65% (marginal tax rate of 35%).
Asset turnover will be driven by Sales Volume and ASPs. Kryptosphere has the potential to boost asset turnover by increasing sales through higher ASPs. RCS, despite being lower-margin, should help drive sales by capturing market share among cost-focused operators (particularly in natural gas plays, where low prices have forced operators to minimize costs).
With pricing expected to remain flat through 2014, margin improvement over the near term will have to come from cost reduction. Pay close attention to gross margins through 2014 to gauge the effectiveness of CRR's distribution initiatives. Kryptosphere's effect on margins will depend on its cost of production, which management has yet to determine. Considering its proprietary nature though, I think it's reasonable to expect it will generate higher margins.
As I said earlier, it looks like 2011 profits were abnormally high for CRR and that 2013 is abnormally low. However, margins will have to show signs of improvement over the next 1-2 years for this theory to be proven true. Gross margins are the most important profitability driver to watch over the next several quarters.
I decided that using a DCF was the most versatile way of valuing CRR, and I made the following assumptions in building the model. Keep in mind that it both assumes flat prices and understates the potential effect of Kryptosphere (since it's an early introduction and I think it's premature to make major assumptions about it).
- Revenue is projected based on historical volume expansion, current expansion plans for the Millen line, and assuming flat prices.
- CapEx is assumed to coincide with expansion plans and taper off to a maintenance level towards the end of the forecast period.
- Depreciation is also assumed to rise with CapEx, since a growing asset base will require increasing depreciation expense.
- Due to the higher inventory costs that CRR has encountered recently, Working Capital investment is based on requirements over the last 3 years.
- CRR has shown a positive trend towards operating leverage over the last 10 years. SGA expenses have decreased from 14% of revenue down to 10%, which shows that CRR has become more and more efficient in generating earnings per dollar of SGA expense. This trend was assumed to continue, but at a much slower pace (there's a limit to how low SGA expenses can go without impairing the firm).
- CRR's effective tax rate is assumed to hold constant at 35% (however this could fall if international operations are expanded).
- I viewed 2013's gross margins as abnormally low and assumed they would recover to a historical average over the forecast period. Note: if 2013's margins are the new norm, CRR is worth much less than the value shown in the model.
The matrix at the bottom shows the current value of CRR assuming various discount and growth rates. Given the long-term growth that is expected in the horizontal drilling/hydraulic fracturing industry (domestically, and especially internationally), I think it is reasonable to assume CRR can achieve a long-run nominal growth rate of 4-5%. Based on the model, this means that CRR shares are priced to grow at 10% per year. At that rate of compounding, CRR would reclaim its all-time high and hit 190 per share within 5 years. Based on forecast earnings for that year, it would then be trading at a PE of 17.8x (down from the 33.17x it trades at currently). It looks as though the PE will drop to a more normal range as CRR grows.
Investment Drivers & Conclusion:
- Growth in the hydraulic fracturing industry. CRR will benefit from the level of activity in the drilling sector. As the development of unconventional oil and gas resources in the US grows, the demand for proppant will grow substantially from current levels. Additionally, international opportunities are have the potential to be very significant, with EIA estimates projecting global unconventional reserves at more than 3 times those of the US.
- CRR must maintain their quality standards and innovation initiatives. Quality and innovation are the backbone of CRR's competitive strategy. CRR's business model is built on offering superior results compared to other proppants. If E&P operators are going to spend more on CRR's proppant, the benefits must be clearly evident in production and EUR (Estimated Ultimate Recovery) results. CRR must maintain their manufacturing standards and continue to invest in R&D. Kryptosphere and Scale-Guard infused proppant are examples of recent innovations and show that CRR's R&D spending is continuing to provide results.
- Investing to expand capacity ahead of long-term demand. With the industry expected to experience substantial growth (and more potential internationally), CRR will need to continue to expand capacity to meet future demand and drive growth. Long lead times for opening new facilities (due to permitting and construction) make it important for management anticipate demand rather than react to it. That said, over-expansion would be equally bad, leading to excess capacity and carrying costs. This is a balancing act for CRR's management team.
- Controlling costs by streamlining their supply chain. Cost pressures have caused a drop in profitability in recent years (particularly in 2013). Some elements, such as prices, are largely out of CRR's control, making it all the more important for them to control costs in areas where they have the power to do so. Improving their supply chain to overcome distributional challenges will help CRR to both improve profitability and supply customers more effectively.
- Will E&P Operators substitute regular ceramics (particularly foreign imports) for Kryptosphere in average-depth wells? There's no doubt that Kryptosphere gives CRR a dominant presence in the deep-well, high-pressure niche. But if it yields high enough production benefits in shallower wells, it could become the new de facto standard for proppants in all wells. If so, CRR has a very valuable product which could insulate it from competition, increase market share, and increase ASPs. Pay close attention to Kryptosphere's market acceptance, what type of wells it is being used in, and what kind of results E&Ps are getting.
THE BOTTOM LINE:
Competition will continue to cause pricing pressures in the proppant market, however this is not as big of a problem as some pundits would make it out to be. Industry demand will grow substantially, with many domestic and international expansion options. CRR is also investing to increase their capacity and meet future demand. This will enable revenue growth even absent price increases. Furthermore, innovations such as Kryptosphere have the potential to give CRR much more pricing power than they have now.
As the industry matures over the next several decades, two things will happen:
Firstly, increasingly complex fracs will be developed (with higher pressures and lower conductivity). These will require more specialized proppants, which CRR has already begun to develop. They have a big lead over their competition in this category.
Secondly, as rich plays become scarcer and production rates fall, well-operators will look for ways to increase recovery from their wells.
Think of this as being similar to the growing focus on fuel-economy in the automobile market over the past decade. As gas prices rose, consumers have increasingly come to prefer cars that offer better mileage. When a resource becomes scarcer, we look for ways to conserve it. The same will hold true for E&P operators. As wells become less productive, they will look for ways to maximize the amount of resources recovered. Under such a scenario, sand, resin-coated sand, and low-quality ceramic proppants would see a material decline in favor of high-quality ceramics, which increase recovery.
The biggest risk facing CRR is a material decline in horizontal drilling and hydraulic fracturing. There are two major reasons why this could happen:
1) Persistently low oil & gas prices cause a decline in drilling activity
2) Environmental concerns surrounding horizontal drilling and fracturing lead to increased government regulation
The difference between the two is that low oil & gas prices would ultimately be temporary, whereas environmental regulation would more permanently affect the industry. A 2011 EPA study linked hydraulic fracturing to ground water contamination; however the study requires additional review and relates only to one specific instance. EPA research is on-going. Pending the findings of this research, increased government regulation could reduce the attractiveness of horizontal drilling and fracturing. The results of continued environmental research will also affect the pace at which international drilling opportunities develop.
On a technological basis, CRR has taken a big step ahead of their competition with the development of Kryptosphere. If competitors were having difficulty matching CRR's quality before, it will be even more difficult now, especially if CRR is able to secure patents on the product and manufacturing process (patents for both have been filed, but not yet granted).
Overall, CRR is a good way to play the shale oil and gas boom. The abundance of oil & gas supply from unconventional sources will put a ceiling on commodity price increases, which will limit the upside for E&Ps. On the other hand, service companies like CRR benefit from the overall level of activity in the industry, which will increase on a more stable trajectory as the US moves towards energy independence.
Watch for signs that management is able to alleviate some of the cost pressure on gross margins and how E&Ps respond to Kryptosphere. These will be the most important near-term developments.