U.S. Silica's Questionable Capital Allocation Is Cause For Concern

| About: U.S. Silica (SLCA)

Summary

U.S. Silica is using recently raised cash to expand the business.

While the bolt-on deal looks attractive based on relative multiples, I have real concerns about capital allocation.

The company sold a lot of shares recently at discounted prices. This is more evidence management has a questionable capital allocation track record.

Given the uncertainty, renewed usage of leverage and high valuations in relation to potential earnings, I remain very cautious on the shares.

U.S. Silica Holdings (SLCA) announced a sizable acquisition of a Silica mine. The timing of the bolt-on deal might come somewhat as a surprise given that the maker of Silica faces harsh times amidst the slump in the energy sector. The deal triggers my curiosity into the business, its industry, and prospects going forwards.

U.S. Silica turns out to be a classical boom-bust case as demand for Silica has boomed amidst the US shale energy revolution. This resulted in shares increasing by a factor of 5 times between 2012 and 2014, before collapsing in 2015 and early this year. While shares have seen a decent recovery in recent months, I am not at all inclined to buy into this story. Poor timing of buybacks and share issues as well as high multiples based on "average" earnings, makes me very cautious.

Debut In 2012

U.S. Silica made its public debut in 2012, when the 111 year old firm traded in the high-teens. Shares actually fell towards the $10 mark during that year but the energy revolution in the US triggered a huge rally in 2013 and 2014. Shares actually ended up trading in their $70s by the summer of 2014.

Following the sequential bust in the energy sector, shares have retreated all the way to the mid-teens in 2015 and early 2016. Following the recent rally in oil prices shares have recovered to current levels in the mid-thirties.

Back in 2012, U.S. Silica sold 7.2 million tons of Silica, a 14% increase compared to the year before. The prices of Silica moved up spectacularly that year, fueling a 50% increase in revenues to $442 million. This means that prices improved to $61 per ton, up from $47 in 2011.

Part of the price increase resulted from the growing demand from the oil and gas industry, in which Silica is used to improve oil extraction with horizontal drilling. Revenues from oil & gas segment rose from merely $70 million in 2010 to $243 million in 2012. The boom resulted in a huge boost to margins, with segment margins coming in at an unprecedented 58% of sales.

Silica is also used by glass manufacturers, building products, chemicals and fillers. Those businesses are pretty much established, generating sales of $198 million in 2012, accompanied by segment margins of 27%. With the vast majority of mines being owned, proven reserves totaled 176 million tons of Silica, sufficient to cover the 2012 production levels for 25 years to come.

What Has Happened Ever Since?

Back in 2012, U.S. Silica was a rapidly growing business with a net debt load of $200 million, for a 1.3 times leverage ratio. The company was incredibly profitable, reporting net earnings of $80 million on sales of $442 million. With earnings per share coming in at $1.50 per share, the valuation was not demanding given that shares traded in a $10-$20 range that year.

The growing demand resulted in huge investments being made by the company. Capital spending totaled $105 million in 2012, exceeding depreciation charges by a factor of 4 times. These investments and continued alongside the oil boom resulted in sales doubling to $877 million in 2014. Adjusted EBITDA improved to $246 million as earnings amounted to $121 million. With volumes increasing to 10.9 million tons, it is clear that pricing has been a key driver behind the reported growth as prices averaged at $80 per ton in 2014.

Essentially all the growth has come from the oil & gas business with revenues of that segment improving to $663 million in 2014, as the general industrial applications saw sales improve slightly to $214 million.

The strong profits in 2013 and 2014 allowed the company to reduce net debt from $200 million in 2012 to roughly $150 million by 2014, although that excludes pension related obligations of $60 million. A lot of capital was tied up in the growth process as well. Capital spending came in at $150 million for 2013 and 2014, complemented by a $100 million acquisition.

The Inevitable Bust

Rapid growth in the period 2012-2014 attracted many investors into the shares. While earnings peaked at +$2 per share in 2014, shares have risen to $70. That suggests that the earnings multiple rose from merely 10 times in 2012 to more than 30 times by 2014. Not just earnings growth, but also valuation multiple inflation has been a key driver behind the insane momentum leading up to the summer of 2014.

Following the collapse in oil prices since 2014, and the huge fall in capital spending, shares of U.S. Silica have fallen 80% from their highs in the time span of just 12-18 months.

The 27% fall in 2015 sales is not even that shocking, with revenues being down by $233 million on an absolute basis. The trouble is that a high cost base has hurt margins to a great extent, with operating profits falling by $150 million to just $27 million. This is very disappointing as average selling prices still came in at a respectable $64 per ton.

Worse, trends were accelerating towards the downside as fourth quarter sales for 2015 fell to just $136 million, resulting in operating losses of $12 million and adjusted EBITDA of just $10 million. While the company held $300 million in cash and equivalents, providing it with much needed liquidity, the company did operate with a net debt load of $190 million.

The first quarter performance was even worse with sales falling to $122 million. The lack of earnings and turmoil forced the company to make a painful decision by offering new shares. U.S. Silica sold 10 million shares for a combined $186 million, reducing the net debt load to merely $20 million, thereby eliminating the debt overhang.

The modest quarterly losses of $10 million should be supported by operating cash flows as a near standstill in capital spending generates sufficient cash with depreciation charges running at nearly $60 million a year. The offering was very painful as the company has actually been buying back shares in 2014 at peak prices, creating real red flags in my opinion. These poor timing efforts tell me that management has little visibility into the future and value of the business.

Spending Money Again?

Following the questionable transactions in its own stock, U.S. Silica is already using the proceeds from the offering during this spring. Remember that those shares were sold at levels in the high-teens, creating roughly 20% dilution for shareholders at the time.

U.S. Silica announced a $210 million purchase of the NBR Sand Unit. With little over half this purchase price being paid for in cash, the company is already moving back into debt with a current net debt load of roughly $150 million. The $90 million stock component will result in another 2.5 million shares being offered, diluting the shareholder base to more than 65 million shares. At $35 per share, equity is hereby valued at $2.3 billion, or the entire business at nearly $2.5 billion.

With the purchase, U.S. Silica will acquire a Texas mine with the capacity to sell two million tons of frac sand to nearby oil and gas wells, increasing the reliance on the energy business. Unfortunately the company does not specify the current production rate. Management did say that it expects the deal to add $0.20 to $0.30 per share to 2017s earnings per share.

It should be said that the 2 million tons capacity is equivalent to roughly 20% of U.S. Silica's own production reported for 2015. The $210 million deal tag is equivalent to less than 10% of the enterprise valuation of the company, while it can boost production by 20% if it is fully used. The other good news is that parts of Texas allow for low cost oil production.

That being said, leverage incurred creates some real risks if the recovery in the energy sector is not keeping up pace, potentially resulting in further dilution down the road. Remember that the current net debt load stands at $150 million and that the company continues to post losses.

Not Appealing, Despite Relative Financial Strength

I typically avoid commodity related plays, certainly if they do not have good management and a strong balance sheet. Given the capital allocation decisions of the past I am not willing to give management the benefit of the doubt here.

While U.S. Silica has the potential to be very profitable, as it has been in the past, the issue is that it is very hard for management to act counter cyclically. This is not just the case with capital spending and the timing of acquisitions, but applies to share buybacks as well, as has painfully been the case for its shareholders.

The fact that the company is taking on debt already, and still has a relative expensive cost structure, are causes for concern. Remember that in 2012 the company still posted earnings of $80 million on sales of $442 million. The current run rate in terms of sales is similar, but now the company has been posted operating losses, suggesting that the cost base has increased significantly as well during the boom times.

If we for simplicity assume that structural operating profitability is seen around a generous 15-20% of sales on "sustainable" revenues of $500-$700 million, operating profits could come in anywhere between $75 and $140 million. After applying a $10 million interest bill and a 35% tax rate, earnings could come in an anywhere between $40-$80 million. That translates into earnings of just $0.60 to $1.20 per share given the dilution incurred in recent times. The volatility of the business, leverage incurred, and very high valuation multiples based on these projected earnings, makes shares not very attractive in my eyes. This makes it easy for me to avoid the shares, even after the recent run upwards.

If we assume that a new energy boom could result in revenues of a billion and operating earnings of $250 million per annum, after-tax earnings could come in at $150 million, or at $2.00-$2.50 per share. That implies that current levels already factor in a 15 times earnings multiple in a rosy scenario. This is pretty rich given the uncertainty faced by the business, making it easy to avoid even if relative good times could return.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.