Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.
Fairmount Santrol (NYSE:FMSA) completed a successful equity offering, raising $161 million in net proceeds (assuming the green shoe is exercised in full). As I argued in my note prior to the company's offering announcement, a public market equity raise was logical, inevitable and imminent.
The equity raise is without doubt a positive development for the stock, as it alleviates the most immediate liquidity concerns. Despite the 17.7% increase in the existing share count, in the aftermath the stock price recovered almost to the pre-offering level. However, the size of the offering was somewhat disappointing. The leverage issue remains unresolved and will require follow-up offerings, at least one of which is likely this year, in my opinion.
Pro forma for the offering, Fairmount Santrol's net debt remains above $900 million. The company is one of the industry's largest, diversified frac sand producers, and at the peak of the industry's last upcycle, its current debt burden would have appeared manageable. Indeed, the company Adjusted EBITDA averaged ~$315 million per year during the 2011-2013 period and peaked at $397 million in 2014. It is worth noting that maintenance capital in a frac sand operation is typically low, and free cash flow can represent a high percentage of the EBITDA generated. As a result, during an upcycle, a frac sand producer may appear to have high borrowing capacity. The implicit assumption, of course, is that the upcycle can last.
In a downcycle, the situation changes dramatically. Fairmount Santrol posted a near-breakeven EBITDA for the second quarter of this year, which leaves the company to a great degree at the mercy of its lenders. So far, the lenders have been highly supportive. As a result, Fairmount Santrol was able to avoid issuing equity during the worst part of the cyclical trough, coming to the market for critical equity funding after its stock price recovered more than six-fold from the lowest point it saw in January.
As I said, last week's $161 million equity raise improves the company's liquidity and improves the lenders' confidence in the credit. However, given that the timing of the cyclical recovery in the industry remains uncertain, Fairmount Santrol's balance sheet challenges are far from over. A case can be made that even in anticipation of a fairly robust cyclical recovery, the company's current debt level is uncomfortably high. Assuming a slow cyclical recovery or a substantial delay in the timing of the upcycle, the current debt level is outright dangerous.
While last week's equity offering could not resolve the leverage issue, I would argue nonetheless that it was critically important for the company and a big success, as the capital injection effectively stabilized the liquidity situation and paved the way for follow-up deleveraging steps on more favorable terms. The offering was very well timed, in my opinion.
What To Expect
Going from here, Fairmount Santrol has two potential alternatives:
- Arguably, the company now has some flexibility to wait before raising additional equity, in the hope of seeing an improvement in the market for frac sand. A stronger cash flow would reduce the amount of equity required to cure credit concerns, whereas the stock may move higher. This alternative is a risky gamble, however, as the downcycle in oil may persist, and the company may be forced to issue equity at much lower prices than in the latest offering.
- Alternatively, Fairmount Santrol may pursue an additional equity raise as quickly as the market may permit. While the timing may be unfavorable in terms of the current stock price, the trade-off is greater certainty of surviving the downcycle without distress.
The second alternative makes more sense, in my opinion, and is therefore more likely, with another equity offering possibly taking place in the Fall.
The View On The Frac Sand Cycle Drives The View On The Stock's Trajectory
Predicting the timing and shape of the upcycle for the frac sand sector is a non-trivial task, given the industry's current overcapacity and demand outlook being highly dependent of the price of oil. Fairmount Santrol is particularly exposed in this regard. Unlike U.S. Silica (NYSE:SLCA), which is essentially immune to the longevity of the downcycle, the significantly more levered Fairmount Santrol may not have the ability to wait for the arrival of the upcycle forever. I discuss the frac sand industry's outlook and fundamentals in greater detail in "Frac Sand Industry Fundamentals And Oil Macros."
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Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
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.