A stake in the fast growing U.S. natural gas market might be tough to swallow for some investors - at least those with an aversion to environmental liability. Reaching U.S. natural gas reserves requires the implementation of an increasingly controversial extraction method - hydraulic fracturing or fracking. I believe Carbo Ceramics (CRR) is an alternative vehicle to play the growth in natural gas - without the potential environmental liability that may be building for oil and gas producers.
First a bit of background on hydraulic fracturing and then my case for Carbo Ceramics.
Fracking in Simple Terms
On the simplest terms hydraulic fracturing involves pumping large quantities of water and proppants underground to pry apart the rock and release gas deposits. Proppant is a fancy word to describe sand or other materials that is taken by the water stream deep underground to create a pumping pathway from where the gas is trapped back up to the surface. Fracturing increases the volume of natural gas that can be recovered from a targeted geological formation.
As you can imagine it is not that easy pumping sand anywhere even with a lot of water, so gas drillers and the pressure pumping services they hire to help them out use chemicals in the mix: 1) biocides to cut down on bacteria in the water, 2) friction reducers to make the water mixture flow more smoothly and 3) other chemicals to deal with temperature changes and other practical issues.
Those chemicals are at the heart of the objections to the practice of hydraulic fracturing. Hydrochloric acid and ethylene glycol (anti-freeze) are two of the chemicals used in fracking mixtures. It does not take a degree in chemistry to realize water supplies underground and animal feed supplies above ground could be in jeopardy if things do not go as planned.
The practice has engendered a spate of state legislation to bring transparency to fracking and in particular to the chemicals. Although we have not seen it on balance sheets yet, this probably spells higher future liability on the part of those running the fracking operation.
Investing Without Environmental Liability for Fracking
It is not possible to invest in the oil and gas industry without taking a stake in hydraulic fracturing and the potential liability an accident could entail. An estimated nine out of ten natural gas wells in North America involve the practice. Halliburton Energy Services and Schumberger Ltd. are the two largest pressure pumping service providers. They are likely just as culpable in the event of an accident and so investors can cross these companies off the list too. The chemicals are commodities supplied by a large group of specialty chemical suppliers. There is limited play in this group on the natural gas industry growth.
A Case for Carbo Ceramics
By process of elimination we have arrived at the suppliers of the proppants as a means to play the growth in the domestic natural gas industry without the liability related to the nastier side of fracturing.
The list of proppant suppliers to the oil and gas industry is surprisingly short. Carbo Ceramics, Inc. (CRR) is the world's largest supplier of ceramic proppant and has a decent offering of sand proppants as well. Carbo competes with Saint-Gobain Proppants, a division of Saint-Gobain of France, and Grupo Curimbaba of Brazil, both of which have ceramic proppants on the market. There are also a number of smaller suppliers of sand proppants, most of which also in the U.S. market. There are also a few suppliers in Russia and China, all of which appear to address only their respective domestic markets.
It is hard to find a flaw in Carbo's financial profile. Sales increased 32.3% in 2011 compared to the prior year, largely on the expansion of oil and gas drilling in the U.S. and Canada. Profit margins are expanding - net margin was 20.8% in 2011 compared to 16.6% in the previous year. Carbo managed to turn 17.8% of revenue into cash in 2011, which is one of the reasons the company had free cash flow of $14.8 million.
With all that free cash pouring in from operations, it is not surprising that the company's balance sheet is cash-heavy and debt-free. Cash totaled $41.3 million at the end of December 2011. The company even managed to condense its financing interval by speeding up collections on its own accounts receivable while taking advantage of more credit with suppliers.
A company with such impressive financial strength must be over priced - right? Here the analysis becomes a bit more subjective. There are only four analysts following the company, but if you accept their word for Carbo's future, expect 35% growth in earnings over the next five years. The consensus among the four is $6.41 in earnings per share on $721.3 million in sales in 2012, followed by another sharp increase in earnings in 2013 to $8.47 EPS on $927.1 million in revenue.
CRR shares are trading at 18.8 times trailing earnings but only 12.5 times the 2012 consensus. Those multiples look quite compelling against a growth rate in the mid-30s. However, I might not be so generous as to apply the growth rate as a proxy earnings multiple to value CRR. The list of competitors is not likely to remain short for very long. That means some of the cash must be used for developing new products to maintain market leadership. Margins might be compressed as new entrants use lower prices to capture market share. In my view, a multiple of 20 times forward earnings seems more prudent. This would put Carbo's price multiple at a premium to the broader industry multiple of 16.6 times earnings, but I believe that is justifiable given its market leadership position.
A multiple of 20.0 times the consensus estimate suggests a target price of $128 - implying potential price appreciation of 22%. My price target looks conservative against the consensus target of $132.50. However, the very wide range of price target contributions to the consensus - from $92.00 to $192.00 - suggests someone's analysis is shaky. I will leave it up to the reader to decide who that might be.
Disclaimer: Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.