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Summary

  • Based on its recent contract with Liberty Oilfield Services and continuation of existing contracts, HCLP is well positioned to continue taking advantage of a shifting energy market.
  • As a necessary component of fracking, HCLP has attractive growth potential parallel to that of the industry as shown by U.S. Energy Information Administration projections.
  • The firm has strong fundamentals as well as a sound business model that will remain effective for the discussed time horizon.

Aside from exceptions like the Carnegie Steel Company, most businesses have not perfected vertical integration. Companies involved with fracking, or hydraulic fracturing, are not exceptions. When I first became familiar with this technique, I immediately looked to the products necessary for the livelihood of fracking - at least in the near-term. Conclusion: fracking requires special sand. Special sand comes from Hi-Crush Partners LP (NYSE:HCLP).

Because information on fracking and HCLP is easily accessible, I will provide only the essential information necessitated by this article. As a producer and supplier of monocrystalline sand, HCLP offers the proppant used to boost retrieval rates of hydrocarbons from wells containing oil and natural gas. While Northern White sand is not as sexy as Amazon's new Fire Phone, it is simple and profitable.

Future of Fracking

(click to enlarge) Source: U.S. Energy Information Administration, Annual Energy Outlook 2013 Early Release

As one can see in the graph above, shale gas - associated with fracking - is projected to roughly double and comprise about half of the U.S. dry natural gas production by 2040. Not only that, shale production from the U.S. has increasingly grown in international market share and is anticipated to make up about 9% of the global supply. It is safe to say that fracking has and will continue to have a vast playground.

Business Model

Not only does HCLP own and operate its proprietary sand reserves as well as excavation and processing facilities, it also controls a facility with integrated rail structure so as to smooth the product delivery process which generally results in the absence of shipping costs.

Data from the United States Geological Survey Minerals Yearbook, Silica, 2011 shows that frac sand production increased ~250% from 2009 to 2011. HCLP has logically planned accordingly so as to best milk the gains from this trend. According to management's guidance, HCLP is expanding its reserve base and improving processing capacity through acreage acquisitions and storage silos, respectively.

HCLP Fundamentals

The great thing about HCLP is that the share price will not fluctuate just because an extreme environmentalist creates a petition against fracking. This is because HCLP has sound fundamentals as shown below.

In order to forecast HCLP's revenue, I created a projection model based on real GDP growth, shale gas production, number of contracts, revenue per contract, total contractual revenue and frac sand market share to arrive at total revenue. As for the number of contracts, I took into account the recent announcement of the five-year contract with Liberty Oilfield Services and grew it at a conservative 5%. Prior to that, HCLP had four existing contracts.

The U.S. Energy Information Administration (U.S.EIA) takes the AEO2014 Reference Case results which state that there will be a 56% increase in total natural gas production and a 13% increase in shale gas share of that total from 2012 to 2040. I was then able to back out the average growth rate given total natural gas production and the percentage of that total in shale gas and consequently project the change in shale gas production.

I found the change in revenue per contract using a multi-variable regression comprised of change in GDP and change in total shale gas production. While the EIA states that the price differential between crude oil and natural gas affects the latter's production and use, I assumed that increased proppant revenue due to increased natural gas demand would be mostly offset by decreased proppant revenue due to decreased oil demand as HCLP provides frac sand to both oil and natural gas wells. If necessary, these price differentials can be found by taking WTI crude oil futures and comparing them to natural gas futures. I then took into account the loss of market share to competitors like CARBO Ceramics Inc. (NYSE:CRR) and U.S. Silica Holdings (NYSE:SLCA) and their proppants using information provided by Industrial Minerals.

(click to enlarge) Source: Proprietary Model

(click to enlarge) Source: Proprietary Model

As shown above, HCLP's gross margins, ROA, operating ratio, revenue growth and EBITDA growth are healthy and reasonable for a young, but maturing company.

Valuation

As of June 23rd 2:48PM, HCLP has a share price of $56.75. Under the aforementioned conditions, discount rate range and exit EV/EBITDA multiple range, I believe that HCLP's fair value is between $63.06 and $72.60 per share. This valuation range represents an 11.1% to 27.9% premium over the current price.

*Note on discount rates and exit multiples: the 8.5-9.5% discount rate is conservative given Aswath Damodaran suggested the cost of equity for HCLP is ~8.31%. In regards to exit multiples, I used HCLP's closest competitors' data to generate a reasonable range.

(click to enlarge) Source: Proprietary Model

(click to enlarge) Source: Proprietary Model

Recommendation:

Although HCLP is trading near its 52 week range, I still believe that now is a good entry point when considering macro factors such as the overall growth of the industry. Those interested in holding positions in HCLP should have a medium time horizon. Although unlikely, investors should exit said positions if alternative proppants retain market share considerably quicker than expected and/or laws severely limit or ban fracking within the U.S.

Source: Hi-Crush Partners LP Is To Fracking As Knife Is To Chef