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CARBO Ceramics Inc. (NYSE:CRR)

Q3 2010 Earnings Call

October 28, 2010 11:00 am ET

Executives

Gary Kolstad - CEO

Ernesto Bautista - CFO

Analysts

Max Barrett - Tudor, Pickering, Holt

Luke Lemoine - Capital One Southcoast

Blake Hutchinson - Howard Weil

Steve Ferazani - Sidoti & Company

Roger Reed - Natixis Bleichroeder

James Stone - Bearing Capital

Brian Uhlmer - Global Hunter

Operator

Hello, and welcome to today’s CARBO Ceramics third quarter 2010 earnings conference call. At this time, all participants are in listen-only mode. After management’s remarks, we will conduct a question-and-answer session and instructions will follow at that time. Please be advised, this call is being recorded today October 28, 2010, and your participation implies consent to our recording this call. If you do not agree to these terms, simply disconnect.

I would like to remind all participants that during the course of this conference call, the company will make statements that provide information other than historical information, and will include projections concerning the company’s future prospects, revenues, expenses or profits. These statements are considered forward-looking statements under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995 and are subject to risks and uncertainties that could cause actual results to differ materially from these projections.

These statements reflect the company’s beliefs based on current conditions, but are subject to certain risks and uncertainties that are detailed in the company’s press release and public filings.

Your host for today’s call is Mr. Gary Kolstad, President and Chief Executive Officer of CARBO Ceramics. Mr. Kolstad, please begin your call.

Gary Kolstad

Thank you, and thank all of you for joining us this morning. This morning we report third quarter revenues of 118.5 million along with net income of 20.2 million or $0.87 per share, an increase of 29% and 40% respectively from last year’s third quarter.

Global profit sales volume totaled 332 million pounds for the third quarter, representing a year-over-year increase of 12%. Our average selling price per pound increased modestly when compared to the second quarter of 2010.

The North American profit sales volume increased 16% year-over-year while international profit sales volume declined 6% compared to the same period last year. We continue to see robust activity levels across the major shale plays in North America, and as a result demand for our products remained strong as clients continue to benefit from the high conductivity of our ceramic profit, a key attribute in enhancing oil and gas production. Although we remain capacity constrained, our plants operate at high utilization levels during the quarter with quite a vital role and our ability to address our clients’ demands.

As some of you witnessed at our Analyst Day Tour in September, constructions on Toomsboro Line 3 is nearing the finish line, and we expect production to start in November. We are eager to bring on this additional capacity, also alleviate some of the capacity constraints that exist today. Construction on Toomsboro Line 4 is also progressing well and we expect production to commence during the second half of 2011. All told, we expect to add about 40% or 500 million pounds of production capacity over the next 12 months. Falcon Technologies continued its geographical expansion during the quarter with the opening of a Marcellus Shale offer.

During the third quarter, we also saw encouraging initial acceptance of CARBOBOND. This resin-coated ceramic proppant was successfully pumped in numerous wells during the quarter and continues to garner interests from clients.

Before I turn to our outlook, I’d like to highlight a few more financial metrics. As mentioned, we had a year-over-year revenue increase of 29%, our operating profit increased 45% due to increase in sales volume and average selling price. SG&A and other operating expenses expressed as a percentage of revenues declined to 11.3% of revenue for the third quarter of 2010, versus 11.8% of revenues for the third quarter of 2009. Net income for the third quarter of 2010 increased 40% compared to the third quarter of 2009.

Looking forward, we continue to see a strong environment for our business. Our low natural gas fundamentals remain weak, the shift in oilfield activity by our clients to oily liquids-rich plays is encouraging, and we anticipate the demand for our ceramic proppant will remain high.

As we look to the fourth quarter, we expect sales volume to be reduced quarter-over-quarter due to seasonality issues, especially surrounding the holidays. As in past years, we would expect to lose the equivalent of five days of sales. Additionally, we will incur certain costs associated with the startup of Line 3 in Toomsboro. We expect these costs will approximate $600,000 during the fourth quarter.

We continue to be optimistic about our long-term growth opportunities. Growing our productive capacity is a key initiative we have taken on, and at the end of 2010 we will have doubled our annual productive capacity over the last five years, going from 750 million pounds to 1.5 billion pounds. In 2011, we will add an additional 250 million pounds upon the completion of Line 4 at Toomsboro.

As we look beyond 2011, we will continue to evaluate capacity additions to better serve our end marks. Another area of growth will come from the Falcon Technology business as we see a sustained focus on environmental stewardship by our clients. We are optimistic about the growth prospects for this business and continue to identify and evaluate other key geographic regions for expansion.

On the technology front, I am pleased to announce our new Houston Technology Center; it was completed during the quarter. This new center will centralize our R&D efforts and support clients’ future growth by reducing the time from concept to commercialization of our new products. It will also allow better collaboration with our clients.

We continue to maintain a debt-free balance sheet leaving us a strong financial position. At the moment we are finding ample opportunities to advance organically. However, our current financial position also affords us the flexibility for the right opportunity present itself to grow the acquisitions.

This completes our prepared remarks and this time we are happy to address any questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions). Our first question comes from Max Barrett at Tudor, Pickering, Holt.

Max Barrett - Tudor, Pickering, Holt

You mentioned modest price increases in Q3. How should we think about price in Q4?

Gary Kolstad

Well, we above 1.5% in Q3 and for the fourth quarter we would expect any price increase to be minimal, very similar comment that we made after the Q2 earnings.

Max Barrett - Tudor, Pickering, Holt

Okay, and then we continue to hear anecdotes in certain areas like the Bakken of spot pricing for ceramics being roughly doubled to cover the sales prices, so Pressure and Pump are obviously marking up the product. How does CARBO approach this issue as it's, obviously, not healthy for demand?

Gary Kolstad

Well we can only control our business. I think we are fairly transparent on that and we tend to take a very long-term look at this. I think you have to acknowledge that the current conditions in natural gas or less than $4 and we have 500,000 million pounds coming online. So, we will worry about our business and not necessarily try and interfere with the other. It’s the E&P and service company to work out that.

In regards to slowing demand we are not seeing that.

Max Barrett - Tudor, Pickering, Holt

And then last question from me. How much of your volumes are under pricing agreements or contracts, where they've been negotiated directly with E&P?

Gary Kolstad

First of all, we don’t negotiate that, we sell through the service companies. We will sell to any Pressure Pumping business. Secondly, our contractual makeup goes from completely spot to the long-term agreements we don’t say which clients those are set up with but we have a variety of contracts.

Operator

The next question comes from Luke Lemoine of Capital One Southcoast.

Luke Lemoine - Capital One Southcoast

I'm just trying to dig into the 3Q volumes a little more. If we excluded the seasonality in 4Q, would 3Q run rate and volumes be sustainable from your current group line capacity; or that, kind of, extra 30 million above your stated capacity of 300 million pounds in 3Q, should we really consider that coming from inventory?

Gary Kolstad

Well, I think so first of all, I probably need to start the statement that by you know that we like to be conservative literally in all parts of our business. So, our stated global capacity or nameplate is 1.2 billion and while I casually say that we basically produce a 100 million a month, 1.25 billion equates to about 105 million a month.

Then you have to factor into the fact that sometimes the mix of the products that we make lightweight versus heavyweight in other words. We can get an even higher efficiency out there. So, the 100 million is what we like to say because when we have as many lines as we do around the global we sometimes could ask the question do you have plan maintenance coming and with that many lines it usually doesn’t impact us too much in any given quarter.

But we like to use the 100 million just as a conservative approach. The reality is we are the 105 plus when everything goes good and when it goes really good like it did in Q3 of this year, we can go above that.

Luke Lemoine - Capital One Southcoast

Okay. And then, on Line three, when it comes on in November, do you already have a significant portion of this plan dedicated to certain customers for a set period?

Gary Kolstad

I think we will not have any problem moving that out.

Operator

The next question comes from Blake Hutchinson at Howard Weil.

Blake Hutchinson - Howard Weil

Just kind of thinking about Toomsboro 3 and then how it will affect the overall pricing and margin as we get to kind of full production, maybe thinking about, kind of, first quarter, second quarter of next year. You've commented in the past that the lighter end of the product spectrum will get you a lower price point but higher margin. Should we expect that as that Toomsboro 3 ramps up that maybe you will get the mixed causes flat to maybe even down pricing? But there is a tradeoff of maybe even materially improved margins?

Gary Kolstad

Well it’s a perceptive question and one that others should listen to because that’s fairly true. In our conservative fashion we would say we would not expect any deterioration margins. But its really true and its one of the things that people struggle with kind of figure out the pricing. But yes, lower pricing products don’t necessarily have lower margins and we would expect very good financial performance as we had in Toomsboro line 3 and 4.

Blake Hutchinson - Howard Weil

And kind of following on with that, I know you don't necessarily broadcast it, but this would be about the time of year I think you would be locking in the cost of your major raw material in terms of natural gas. I mean, would you caution us in assuming that, you know, prices or costs for 2011 would be materially below what we saw for 2010 in that regard, given the strip?

Gary Kolstad

Yes. The end of the year doesn’t play any factor with us at all. We look much longer term than one year. So, as a general statement, a lot of our plants in the US, we own the reserves in the ground, so you don’t see much of a change. On the natural gas front we’ve got a little different strategy today than we did years ago and so we are farther out, let’s say. So, I wouldn’t expect a material change or an inflationary pressure as we move into 2011.

Sometimes we will see inflationary pressure brought on, the diesel fuel is real high or something like that, right, and our trucking chargers and various things like that, but in terms of natural gas or raw materials, domestically no. Those are decently set. Overseas plants can sometime see increases in some of those countries in which they are in, are seeing some inflationary pressure.

Blake Hutchinson - Howard Weil

And then, I guess finally, the North American market has been so healthy. I don't think we are paying much attention to the international market. I mean if we look at your international sales trends, are those reflective of the actual market or are you at the point where you are kind of allocating away from international markets, or whatever color you can give to the health of major international markets, would be helpful as well?

Gary Kolstad

Well, it’s reflective of where we move proppant for sure, but counter to that, we are seeing some places where we are seeing nice growth and we have some strategic objectives in a few countries and we are seeing some of those play out very well. So, I think it’s a combination of both, but at the end of the day, capacity restraints are driving the majority of that.

Blake Hutchinson - Howard Weil

So, it will be safe to assume that given capacity, you're saying you're probably not fully addressing the international markets that you could, and ergo the growth trends we see from your business internationally are not necessarily reflective of the market itself.

Gary Kolstad

That is correct.

Operator

The next question comes from Steve Ferazani with Sidoti & Company.

Steve Ferazani - Sidoti & Company

I wanted to ask about the resin-coated ceramics, utilization at that plant and whether you had a full quarter of sales with the resin-coated ceramics already?

Gary Kolstad

Yes, it’s full utilized by any stretch of imagination. We are very excited the growing client list and the number of jobs we are putting in the ground and the fact that the geographical places we are going continues to increase. But we are adding staff to get more and more crews and get the plant working more and more. The efficiency is coming along extremely well. And so, I’d say we are very pleased. I might mention, we still have a little bit of a bottle-neck. I wish we had extra ceramic proppant, let’s say to feed the plant, but we worked those balances. But overall, we are very pleased with the way it’s going, but you are not seeing that. You did not see those results in Q3.

Steve Ferazani - Sidoti & Company

So, in terms of the fact that you did have the stronger gross margin that probably was not yet impacted by the resin-coated ceramics?

Gary Kolstad

Not yet, Steve. No. That wasn’t what drilled the quarter.

Steve Ferazani - Sidoti & Company

Also, I'm a little bit surprised given just the demand you are supplied, your demand for the proppant, demand for frac equipment, that you are indicating a seasonal slowdown. Is that just sort of your conservative approach, or what do you think the likelihood we don't see it this year?

Gary Kolstad

Well, it’s a combination of our conservative approach of course, but it’s also a history lesson. And I remember, at this time last year I said the exact same thing and I think a lot of people didn’t want to believe it and sure enough it happened. It happens every year. December is always the month and so I think nothing changes that way, that’s the oilfield. The other thing I think that people need to take into account and it won’t just affect us, today, the service industry ourselves, we have let’s say a larger percentage working up in Montana, North Dakota, in that whole exciting Bakken Play, and growing up in that country, I know what winter does up there. So, I think you are going to see days up there but may surprise people with being shut down due to cold weather.

Steve Ferazani - Sidoti & Company

Last one from me and maybe this is for Ernesto. I'm just trying to think about what Line 3 is going to do to depreciation next year, and can you give us a sense on that, or even just the cost and timeline for depreciating it?

Ernesto Bautista

I think we would start appreciation in 4Q on a run rate basis. It’s something approximating $300,000.

Steve Ferazani - Sidoti & Company

Per quarter?

Ernesto Bautista

Per quarter. I’m so sorry. It’s per month, correct.

Operator

Your next question comes from Roger Read at Natixis Bleichroeder.

Roger Read - Natixis Bleichroeder

Again, we end up with more things going on than we can handle in a short amount of time, but if this has been asked and answered, I apologize. But specifically on volumes, fairly consistently here, several quarters you've outperformed what nameplate capacity is. I understand in Q1, you know, you had a large volume of inventory built up. Is that what we are still seeing, you know, less so in Q2 and more so in Q3, you’re selling at a volume or are you able to run above nameplate capacity on a more consistent basis than, maybe, you previously thought?

Gary Kolstad

Roger, I actually did answer that before so I might give you a quick summary of that. Conservatively, we always tell you a 100 million a month, the reality is the name plate are 1.25 billion which equates to 105 million a month. When we have the mix split that favors light weights we actually can go beyond that. So what you got to see this quarter was a combination of us, our plans working extremely well and our folks doing an incredible job. The mix working well and one of the reasons we like to just use that 100 million term is that with the amount global lines we have around the world, we are always doing plant maintenance or types of maintenance.

So we like to be conservative and say 100.

Roger Read - Natixis Bleichroeder

I understand under-promise and over-deliver is always a good strategy to pursue, and 100 is a nice round number as well. And then my other question, just looking at the balance sheet, cash drew down a bunch in the quarter, I didn't know if that was just an accounting thing they went into long-term assets, or was there kind of enhanced spending on Line 3 during the third quarter?

Ernesto Bautista

That’s right, Roger we are turning it up a bit if you will on the completion of Line 3 as well as spending on Line 4.

Operator

Your next question is from James Stone at Bearing Capital.

James Stone - Bearing Capital

A follow-up to that question on the balance sheet. Ernesto, you did have a $30 million plus Q to Q build in other current assets, and I'm just wondering if you can give us some details as to how much of that was receivables and how much of that was inventory? And then on the inventory side, how that may have broken down between finished foods and raw materials?

Ernesto Bautista

Sure, James. So, we did see a growth in inventories that’s a big of a driver. The breakdown you could see that there was a larger growth in raw materials as we continue to add as we have historically and in addition to that from a finished goods standpoint, we also had a bit of an increase there on a sequential basis as well from a standpoint it will something approximately $3 million say in finished goods. From a receivable standpoint, there was also a bit of growth we did see a small increase quarter on quarter as well.

Gary Kolstad

On other current liabilities we have the construction in progress too.

Ernesto Bautista

Right, from a working capital standpoint that’s right. Because of the acceleration in paying anyway were and billing that were seasoned with recurring at a quicker rate for Line 3 and 4.

James Stone - Bearing Capital

I guess I'm just a little surprised to hear that you had any finished goods inventory build on a sequential basis, just given the high level of volumes that you had in the quarter, and even if you ran, you know, Gary at 105 million a month, you'd still only have gotten the 315 million and you sold at 330 million. So I'm trying to understand that difference between everything runs great, and we still get an extra 15 million pounds and we built finished goods inventory.

Gary Kolstad

Yes. The biggest part of that was the work in progress right on the line from the balance sheet you are seeing there.

James Stone - Bearing Capital

What section is this? Is it finished goods or is it work-in-process?

Gary Kolstad

The nested yield.

James Stone - Bearing Capital

I thought Ernesto said 3 million of finished goods?

Gary Kolstad

Right and that was $3 million and you have to take into consideration is evaluation of that from a pound basis, it may not be as much as you are thinking only because a lot of that also includes CARBOBOND and CARBOBOND is going, it is building and did though as of quarter end and that valuation of that is going to be higher than typical uncoated ceramics. So we are building inventories of resin coated ceramic and trying to it up to distribution point.

Operator

(Operator Instructions). Our next question comes from Brian Uhlmer at Global Hunter.

Brian Uhlmer - Global Hunter

That was a good segue to start talking about CARBOBOND. I'm just curious on a few things on that. Number one, what the capacity is for that? Second part, what kind of pricing premium you get for CARBOBOND, and I know you're going to give a dollar-figure, but on a percentage basis? And number three is, if you can pass through all the additional costs and there's incremental margin on top of those additional costs? So you actually get better margins by selling CARBOBOND? And then, finally, you said you got positive feedback from your customers. What basins were those in and what was the feedback? What specifically can you point to what people are liking about that product?

Gary Kolstad

So first of all, the plant in New Iberia is kind of a name plate of a 100 million pounds per year and efficiencies going to drive that of course higher and lower. Secondly, yes it does have incremental value and the margins when we sell CARBOBOND we will be lets say attractive or incremental compared to just selling the substrate.

Brian Uhlmer - Global Hunter Securities

And then on the customer feedback?

Gary Kolstad

And on the feedback we have done quite a few jobs originally its East Texas to South Texas and Mexico. The purpose for resin coating ceramic is strictly for fall back purposely and the measurement of that is are you getting any proppant flowing back in the well bar and I have to tell you we are extremely pleased with the result so far and its really been good.

Brian Uhlmer - Global Hunter Securities

So it makes you clean out quicker and easier?

Gary Kolstad

Yes. We just don’t have flow back into the well bar which has to be cleaned out and or erodes the surface equipment.

Brian Uhlmer - Global Hunter Securities

Right. So your measure of payback is based on by limiting that. That's how your E&P guy can calculate payback and thus pay a premium?

Gary Kolstad

Yes and also you don’t have to choke the well back in from and higher rates etcetera.

Brian Uhlmer - Global Hunter Securities

Okay, and moving on to your NRT, I was just curious. We had talked about that the last few quarters, and how are sales going with that? What type of volumes are we talking? Is it still minimal in terms of 1 million pounds, or higher than that? And what geographies are you placing those into?

Gary Kolstad

Yes those will be minimal that’s more of a niche product to be honest and the markets literally would be around the globe. I think I had mentioned on the last call that in some countries around the world they won’t allow radioactive tracers and things like that. So, the overseas market might actually be at least as attractive as domestic market. But it will not be a volume nature of that will approach CARBOBOND?

Brian Uhlmer - Global Hunter Securities

Okay. That makes sense. And finally, can you tell us on a percentage basis, what kind of contribution Falcon had this quarter? And you've given a projection of decent growth in that segment, and breaking, 20 plus million to have 20% growth in that segment. Are you still on track, and how are you feeling about that acquisition?

Gary Kolstad

That’s good for Q2 we told you that ’09 was about 19 million and we told you to model 25 million for 2010 and I think what we will do is we all give you an update at the end of the year on how that 25 million turned out was that conservative or whatever. And as far as we obviously don’t tell the financials on it but we do say that if margins don’t approach the proppant business. So we are investing a lot of money we are extremely excited about this, we spend a lot of R&D building a SMC a surface-mounted containment system and we have a few of those jobs going on in Marcella’s right now. The environmental push there and the location logistics and difficulty of that and so we are still very excited about the business but it’s still a young business such as service business and we will expand it.

Operator

At this time, there appear to be no further questions. Mr. Kolstad I will turn the call back to you for closing remarks.

Gary Kolstad

Thank you and thank you everybody for joining us this morning. A couple of summary points, the natural gas fundamentals remained pretty weak but our outlook on oil is a lot of more constructive and we think that any declines in our products due to the lower natural gas activity that will likely come will be largely offset by the increased activity in the oil and liquid rich plate.

And the fourth quarter as we mentioned as we have seen in recent years, we expect sales volumes to be down quarter-over-quarter due to seasonality issues and looking beyond the next quarter we continue to differentiate our products offerings and build upon the success we’ve had and we will keep growing the business.

So we are very optimistic about Toomsboro Line 3 and Line 4 and what that will mean to the market and we educate our clients on the benefits of economic conductivity. And then finally, I would like to thank our employees that they did a great job this quarter and running the plants and everything kind of clicks. So thank you all and we will see you next quarter.

Operator

This concludes today conference thank you for attending. You may now disconnect.

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