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CARBO Ceramics Inc. (NYSE:CRR)

Q1 2008 Earnings Call Transcript

April 24, 2008 11:00 am ET

Executives

Gary Kolstad – President and CEO

Paul Vitek – CFO, SVP of Finance and Administration

Analysts

James West – Lehman Brothers

Roger Read – Natixis Bleichroeder

Scott Gill – Simmons

Steve Ferazani – Sidoti

Jeff Tillery – Tudor Pickering

Robert Christensen – Buckingham Research

Operator

Hello and welcome to today's CARBO Ceramics first quarter 2008 earnings conference call. 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 risk 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 filing.

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

Good morning and thanks everyone for joining us to discuss our first quarter results. This morning, we reported first quarter net income of $14.2 million or $0.58 per share, an increase of 7% from last year's first quarter. We had a very nice quarter with innovative product introductions, geographical expansion and solid execution by the team.

One of our primary objectives was to fill up our plant capacity up to our large capital investments over the past couple of years, and we have taken a major step towards that by accomplishing that with the introduction of CARBOHYDROPROP, our new lightweight ceramic proppant targeted for use in the growing market for slickwater fracturing. We achieved record quarterly revenues of $101.9 million, record quarterly proppant sales of 283 million pounds, and record revenues and operating profit from Pinnacle Technologies.

A few comments on the first quarter, both of our business segments continue to perform well. Our record proppant sales volume was the result of strong sales in North America and an increase in sales in Russia as we continue to ramp up production in our Russian manufacturing facility.

First quarter sales volume in North America increased 24% over last year's first quarter, led by strong sales of CARBOHYDROPROP. I would also add that the sales volume in North America increased year-over-year, even excluding those sales of HYDROPROP. In Canada, we are pleased with our performance as sales volume increased 2% compared to the first quarter of 2007, while the rig count in Canada was slightly down year-over-year.

Overseas, proppant sales volume grew 28% compared to the first quarter of 2007, led by our success in Russia. And Pinnacle Technologies continues to perform remarkably with revenues up 50% and pre-tax income up over three times compared to last year's first quarter.

Some regional comments, as I said before, proppant sales volume was very good in North America. In the U.S., we saw improved demand in some of our traditional markets for ceramic proppant, in particular Texas and the Rockies, and this demand is driven by the general strength in drilling activity that is resulting from higher than anticipated prices for natural gas in the U.S.

The introduction of CARBOHYDROPROP was also a significant factor contributing to sales volume growth in North America. CARBOHYDROPROP is a new lightweight ceramic proppant targeted for use in the growing market for slickwater fracturing. It provides E&P operators with higher conductivity, easier placement of proppant or the transportability of it, improved cleanup of the fracture and improved returns when compared with sand-based alternatives.

Notably, the product is also priced similar to the resin-coated sand that has been used in a number of slickwater fracture applications. Initial application of HYDROPROP has been in sandstone formations, primarily in East and West Texas that utilize slickwater fracturing. However, we have seen strong interest in this product in some of the emerging – in the deeper shale plays such as Fayetteville, Woodford, Marcellus, Barnett, Bakken and recent Muskwa in northern B.C. in Canada.

In international markets, the most significant development was the increase in our year-over-year revenue in Russia, and we continue to be pleased with our sales of our products and our plant performance there.

The average selling price of our ceramic proppant declined 5% from the previous year, primarily due to the lower selling price of HYDROPROP relative to our other products and also a shift in the mix of products sold. We had more EconoProp sales and less HSP sales.

As we've discussed previously, the introduction of HYDROPROP has the effect of decreasing margin percentages in the proppant business, but adds incremental earnings and cash flow. While the proppant business benefited from increased sales volume and revenue on lightweight proppants in North America and CARBOPROP in Russia, operating profit was impacted by higher fixed costs associated with the company's expanded manufacturing capacity. The increased cost included an increase of $1.8 million in depreciation and higher costs for factory administration compared to the previous year.

In addition, the company incurred about $500,000 of cost in the first quarter in connection with the idling of the New Iberia, Louisiana facility. Pinnacle Technologies continued its outstanding operating financial performance in the first quarter, with an increase of 50% in revenue and a tripling of net income before tax compared to the same period last year. Pinnacle continues to benefit from the increased level of drilling and complex resource plays in North America.

SG&A for the first quarter increased $1.7 million compared to last year, but declined from 11.3% to 11% of revenue. The net result of all these changes is that operating income increased $1.7 million in the first quarter as compared to the prior year.

In non-operating results, the continued valid devaluation of the US dollar relative to the ruble, the Russian ruble, resulted in the company recognizing a net foreign currency gain of $1.5 million versus a gain of $0.5 million in the first quarter of 2007. Pre-tax net income for the first quarter increased $2.5 million compared to the first quarter of 2007, and the net income increased by $900,000 with a higher tax rate than was in Q1 2007, as 2007 income tax expense was reduced by adjustment for prior year's returns.

On technology highlights, we had a number of technical developments in the first quarter. We've already discussed CARBOHYDROPROP and its significance to our current performance and our future outlook. In addition to this development, we had a focused field trial that demonstrated the benefits of lightweight ceramics over sand-based proppants in the Rocky Mountain region and has resulted in increased utilization of CARBO EconoProp and tight gas completions in southwest Wyoming. We're starting to see the benefits of a field study published last November documenting the benefits of lightweight ceramics over sand in the Bakken formation in North Dakota.

Pinnacle began a long-term project with Imperial Oil in Calgary with a Web-based passive seismic management system for their Cold Lake Alberta heavy oil operations. Pinnacle utilized our new high-temperature microseismic equipment to successfully map fracture treatments in the Muskwa Shale for EOG and Apache in the Horn River Basin in Northeast British Columbia. And Pinnacle also performed the first tiltmeter fracture mapping job in Russia.

Our future outlook: Looking forward, 2008 is shaping up better than most in the industry expected three months ago. In the short-term, we're already seeing the impact of normal seasonal decline in Canada in the second quarter. The magnitude of this impact is that global proppant sales volumes may decline 10% to 15% from the first quarter, with a similar reduction in earnings. However, as we move into the second half of the year, we would expect to see an improved drilling environment in North America if gas prices remain high, as many now anticipate. This strength, combined with the anticipated strong demand for CARBOHYDROPROP, should be very positive for proppant sales demand.

Overseas, our outlook for drilling and fracturing activity remains optimistic based on the strong global demand, and global oil and gas reserves are increasingly difficult to find and develop, and this drives an increased demand for our products and services that enhance production and recovery rates. We have seen steady growth in Russia since the completion of our plant there last year and it is our expectation that continued growth and demand for proppants in Russia could utilize most of our capacity of 2008. While sales in Russia met our expectations in the first quarter, we are taking steps to improve production costs in our Russian plant, following stabilization of operations in this facility.

We have initiated the previously announced idling of production at our New Iberia, Louisiana facility and expect production there to be complete by late May. The idling of production in this facility will reduce our fixed production expenses. In the first quarter of 2008, we accrued approximately $500,000 in costs for curtailment activities and expect no further costs in the remainder of the year.

In our frac mapping business, we expect another strong year in 2008 based on the continued growth and activity in gas resource plays in the shale formations in North America and on international growth following the deployment of fracture mapping assets outside of North America. However, we also expect to see increased competition in frac mapping.

From a financial perspective, we expect continued revenue growth in 2008. Operating margins in the second quarter may be slightly lower than the first due to lower proppant sales volume expectations, because of my previous comments about Canada, but these margins should improve in the second half of the year. As I said earlier, one of our primary objectives was to fill up our plant capacity and we've taken a major step towards accomplishing that with the introduction of CARBOHYDROPROP. Our goal now is to improve operating margins in the remainder of the year and in order to accomplish that, we expect to reduce fixed costs by idling the production in New Iberia as previously announced and increase throughput in our newer manufacturing facilities in Toomsboro and Russia.

As oils and gas reservoirs become more complex and exploration and production companies seek a greater return on their investment, we believe our products and services will continue to be in high demand. We remain the technology leader in each of our business segments. We've completed a significant expansion of our proppant manufacturing capacity and are generating increasing cash flow, and have introduced another value-creating solution for oil and gas operators with the introduction of CARBOHYDROPROP.

This completes our prepared remarks and at this time, we will be happy to address any questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from James West with Lehman Brothers.

James West – Lehman Brothers

Hey, good morning, Gary.

Gary Kolstad

Good morning.

James West – Lehman Brothers

With the increased traction around the CARBOHYDROPROP technology, given that it sells at a lower price than some of the existing proppants, do you think that there's a chance that margins will continue to decline for several quarters before you're able to stabilize production and hold margins up?

Gary Kolstad

No, actually the opposite. We're ramping up our new line two in Toomsboro, so we will continue to see improved production output there. And no, we wouldn't expect that at all. As the volumes increase, we'd expect it to go the other way.

James West – Lehman Brothers

Okay, understood. And then, could you give us a sense of how much the increase in volumes sequentially came from the HYDROPROP?

Gary Kolstad

I don't know if we're going to spell it out that completely, but what I will say is that our volume increased without HYDROPROP considered in there. It's been very successful and it's penetrated the market for sand-based proppant and it did generate a good portion of the growth. However, we did see our other product lines, especially in North America, outpace the growth in the rig count and we saw significant growth in Russia as well. So on balance, it helped but everything else is growing as well.

James West – Lehman Brothers

Okay, understood. Then on the international side of the business, in the last conference call, you had mentioned some price competition in select markets. You didn't mention that this time. Has that gone away?

Gary Kolstad

Well, there's still pressure from some countries in the eastern hemisphere, but it's primarily coming from lower quality, lower priced products from China. That really hasn't changed since the last quarter so, no, we didn't feel it was anything that was important.

James West – Lehman Brothers

Okay, great. Thanks, Gary.

Operator

Our next question comes from the line of Roger Read with Natixis Bleichroeder.

Roger Read – Natixis Bleichroeder

Good morning.

Gary Kolstad

Good morning.

Roger Read – Natixis Bleichroeder

A quick question, I guess kind of following up on James' deal [ph] there, maybe try to get you to give us a little more color on the volume side. If you're looking sequentially fourth quarter to first quarter in Russia, I kind of understand the year-over-year improvement, but how did that plant sort of operate? I mean you had the agreement for roughly 50% of the capacity under a frame agreement. Are we selling up to that? Are we selling beyond that? Can you kind of maybe give us some more color on that portion?

Gary Kolstad

Yes. We're doing better than what you just stated. There's a very strong interest in our products in Russia and operationally, the plant is in line with our expectations and doing extremely well. As I mentioned earlier, we're pretty confident we're going to lower operational costs here as we move forward. But, no, it's doing better than what you implied. We've tried to kind of keep actual numbers out of there for competitive reasons, but we are very pleased with Russia.

Roger Read – Natixis Bleichroeder

Understand. But, for forecasting, we're always trying to get specific numbers as you know.

Gary Kolstad

I know. But I mentioned that, as the year rolls on, we'll probably be consuming that plant if that helps.

Roger Read – Natixis Bleichroeder

Okay. That is helpful. In terms of ramping up sales of HYDROPROP, are there any, other than just as you're ramping up Toomsboro two, are there any other sort of constraints you're seeing out there? I mean, we've heard on the, at least the high strength proppant issues, you've gone – trouble in the back half of last year with some of the raw materials, also costs on railcars and so forth and clearly natural gas is a lot higher. Can you, in terms of your commentary on margins going up in the back half of the year as utilization of the manufacturing capacity goes up, could you kind of walk us through how you're set up on the cost side?

Gary Kolstad

Yes. Some things are very good and will improve and some of the other ones you mentioned will put pressure on us. I would say from a distribution standpoint, we're by far the largest player, and we have a very well defined distribution system in North America and we actually, in the particular comment like you mentioned on the railcars, we've actually lowered our price on those. So we have some things that are working very well and the higher throughput and output we have in Toomsboro, of course, our margins improve because we get to spread the fixed costs, i.e., depreciation, out better. So we'll see some positive things. Paul, I don't know if you want to make a comment about the high-strength raw material issue or not but I would say, on balance, it'll be more favorable to us.

Paul Vitek

Yes. Roger, I would add that with respect to HYDROPROP, keep in mind that that is a lightweight product that's manufactured primarily at our plant in Toomsboro, Georgia, which is where we have a 20-plus year supply of lightweight raw materials. So we're in pretty good shape with respect to our cost structure on that product. Your comment regarding the high strengths, we are still working off some of the inventories we had – raw material inventories we had for our high-strength products in last year. We really haven't seen the impact on manufacturing costs in that product that we referenced in our last quarterly call, but we expect we'll start to see that kind of late second quarter and into the second half of the year.

Roger Read – Natixis Bleichroeder

Okay. Thank you.

Operator

Our next question comes from the line of Scott Gill with Simmons.

Scott Gill – Simmons

Yes, good morning.

Gary Kolstad

Good morning.

Scott Gill – Simmons

Could you give us some feel for kind of what percentage of the ultra-light profit now makes up of your volume?

Gary Kolstad

I think we're going to stay away from the breakout since we haven't broke out the four products before.

Scott Gill – Simmons

But you haven't [ph] done it recently anyway.

Gary Kolstad

Yes, recently. I can say this, it's not the fifth largest selling proppant we have, if that helps. We've really had a lot of success with it and it was really a targeted market approach. It's really going well and we're pushing the system to get more of it, let's say.

Scott Gill – Simmons

Okay. And we're hearing a lot from the pressure pumpers about the shortages of sand. Are you seeing any benefit that might not otherwise be there because sand is in pretty short supply that people are going to your product as a substitute?

Gary Kolstad

We've certainly had some communication, in particular probably in reference to – yesterday is what you're probably referencing. But, keep in mind that CARBOHYDROPROP, the one product it really displaces is resin-coated sands.

Scott Gill – Simmons

Right.

Gary Kolstad

And so just with its conductivity and everything, it's just a no-brainer that way. But, I assume we're benefiting some, but that's not really our target market.

Scott Gill – Simmons

Okay. And Gary, as you look out for the balance of the year, US volume continues to be very impressive. Do you think we sustain those year-over-year growth rates as this year progresses?

Gary Kolstad

Growth rates, you mean this quarter versus last year's Q1?

Scott Gill – Simmons

Yes. You had 30%. I'm just...

Gary Kolstad

I think you may actually have to start thinking in terms of our manufacturing capacity might be what you need to start factoring in.

Scott Gill – Simmons

Okay. And I guess my last question then on price, where do we stand on pricing initiatives, particularly in the US market now?

Gary Kolstad

We're holding steady on price. We haven't seen the deterioration on price. The mix of our products this quarter is what caused the 5% drop. Our standard products that we've had in place have been steady.

Scott Gill – Simmons

I guess I was more curious from the standpoint, clearly, natural gas is a part of your cost of goods sold and with rising natural gas prices, if you're going to push some of that on to your customer?

Gary Kolstad

Well, we certainly expect that the inflation side of the commodities will probably mean that pricing will likely improve as opposed to soften.

Scott Gill – Simmons

Okay. Thank you very much.

Operator

Our next question comes from the line of Steve Ferazani with Sidoti.

Steve Ferazani – Sidoti

Good morning. I wanted to get a little bit into capacity issues. If you did 283 million pounds this quarter as drilling activity picks up in the second half, then how quickly do you think you're going to run into capacity constraints?

Gary Kolstad

I hope as soon as we can, Steve. The one nice thing about this call is I haven't got asked when are you going to sell out that capacity, which has been the common question.

Steve Ferazani – Sidoti

Right.

Gary Kolstad

Seven quarters. So, no, these are discussions that are ongoing right now and it will be sooner than later.

Steve Ferazani – Sidoti

I mean is New Iberia, just that's done, the more likely thing would be to start a new line in Toomsboro or what's the chance of bringing New Iberia back on line?

Gary Kolstad

Well, the industry just has a heck of a demand for lightweights and with our product innovation on CARBOHYDROPROP, it has opened up a whole new field of demand. So, no, we would much more lean towards adding another line in Toomsboro, which is why we designed that facility that way and it's just such a highly efficient, high-quality operation that that'll be where we go.

Steve Ferazani – Sidoti

What's the timetable from when you make that decision because this is a little different than the second line, right? It's like starting a second plant again or is there a call it [ph] sort of...

Gary Kolstad

No, no. It's a bolt-on one more time.

Steve Ferazani – Sidoti

Okay.

Gary Kolstad

So we designed that to go to four lines at the minimum, so a good estimate is 15 months.

Steve Ferazani – Sidoti

15 months. Okay. And then just the last question was a little bit on the – have you locked in a long-term supplier with the bauxite or where does that stand now?

Gary Kolstad

We have not, Steve. We're continuing to evaluate alternatives there. As I've said before, what we'd like to do is develop a long-term source that's similar to the long-term supply situation we have with our lightweights and we are evaluating a couple of deposits outside of the US and would hope to have a decision made by the end of this year. We do have firm supplies of products, so availability is not an issue, but we'd like to lock in a situation that lowers our cost long-term.

Steve Ferazani – Sidoti

Are you seeing significant fluctuations in prices? Is that a big issue in terms of preventing the volatility, or can you give a little color on that?

Gary Kolstad

We clearly have seen quite a bit of volatility both on the underlying commodity price and the ocean freight over the course of the last year to year-and-a-half. Now, that has not continued to accelerate, so some of that volatility has gone away. But, obviously, we don't want that exposure long-term.

Steve Ferazani – Sidoti

Okay. Appreciate the answers.

Operator

Our next question comes from the line of Jeff Tillery with Tudor Pickering.

Jeff Tillery – Tudor Pickering

Hi. Good morning.

Gary Kolstad

Good morning.

Jeff Tillery – Tudor Pickering

Could you talk a little bit, just qualitatively, about the uptake in HYDROPROP? Did it surprise you what the demand was this quarter and just talk a little bit qualitatively about kind of how things played out relative to what you thought coming into the year.

Gary Kolstad

Well, we had our hopes. We designed the product for market need and it absolutely exceeded our expectations.

Jeff Tillery – Tudor Pickering

That's helpful. Could you talk a little bit about Pinnacle and what sort of capacity or growth limitations you see on that side? Is there anything on the people side that concerns you in terms of its ability to sustain kind of the growth pace that it's been on of late?

Gary Kolstad

Well, the people is probably a much more limiting factor than us building tools and everything. Yes, I would categorize the people as the thing that holds us back. On the very good side, the E&P operators, because of our just overwhelming experience and leading technology, they trust us, so what's happening is that they're taking us everywhere they're going, so all the new shales, they're bringing us into them.

Jeff Tillery – Tudor Pickering

And maybe Paul could talk a little bit about natural gas and what your position is on hedging in the next couple of quarters and how you see that impacting margins as the year plays out.

Paul Vitek

Yes. At the moment, we've said in the past that our goal is to be about 70% covered for the forward 12 months. We're a little shy of that right now, probably closer to 50%, so we do have some exposure in the second half of the year. But, we will continue our past practice of being in the market on regular intervals to dollar cost average those purchases and look for opportunities to accelerate our purchasing activity when prices soften.

Jeff Tillery – Tudor Pickering

And the hedge price that you guys have, say for the second quarter, how would that compare to what you realized in the first quarter from a cost standpoint?

Paul Vitek

It'll be slightly higher, but not significantly.

Jeff Tillery – Tudor Pickering

Any significant impact we'd see will be kind of Q3, Q4 of this year?

Paul Vitek

That's correct.

Jeff Tillery – Tudor Pickering

Okay. Thank you.

Operator

(Operator instructions) Our next question comes from the line of Robert Christensen with Buckingham Research.

Robert Christensen – Buckingham Research

What are the differences between HYDROPROP and lightweight in terms of its benefits and carry or whatever, strength?

Gary Kolstad

Well, it has the benefits of ceramics, first of all, the strength and the conductivity of magnitudes of twice of what resin-coated sand is. The thing that's different about it is that it is a lighter weight than our EconoProp and we have changed the transportability, altering the mesh size and some other things. And so, it really fits that slickwater market very well. We kind of engineered it by a combination of raw material sources that we have and then just the process of making it.

Robert Christensen – Buckingham Research

How much more expensive is it than the resin-coated sand?

Gary Kolstad

I think what we've consistently said, and it was part of our targeted marketing campaign, was that it is priced similar to resin-coated sand. So it made the interim – the decision point for the E&P operator very easy. If you can get twice the conductivity for a similar cost, you get the great economics of increased production and quite honestly, probably increased ultimate recovery in the wells.

Robert Christensen – Buckingham Research

Could you say how many frac jobs and shales it has been applied to yet, assuming the nation drills maybe 20,000 shale wells a year at the moment. I'm just guessing, I mean.

Gary Kolstad

I probably don't have that information.

Robert Christensen – Buckingham Research

Is it a hundred wells? Is it a couple hundred wells? 'Cause it's a relatively new product, right?

Gary Kolstad

I would probably say, on my earlier comment, I said it was much more in the sandstones because that is where we'd first targeted it. So, I'm probably going to say, we're – and that has been enormously successful. So we're probably 90% in the sandstone, in slickwater sandstones, but we are seeing a lot of interest in the shales, as I previously mentioned as well.

Robert Christensen – Buckingham Research

One final, if I may. How many different shale plays – I mean there's so many out there, but would you say you're in two, three, five, has it been used in so far?

Gary Kolstad

Yes. Probably three is a good number.

Robert Christensen – Buckingham Research

Very good. Thank you very much for your help.

Gary Kolstad

Thank you.

Operator

At this time, there appear to be no more questions. Mr. Kolstad, I'll turn the call back over to you for closing remarks.

Gary Kolstad

Thank you and thank you, everyone, again for joining us this morning. Just a couple of key points to close on. It's our expectation and more importantly, the expectation of our customers that North America drilling activity should improve in the second half of this year. CARBOHYDROPROP is creating value for those customers in reservoirs that hadn't previously used ceramic proppants. And with this new product, we're growing the market for ceramic proppant, which has always been our long-term strategy and we're growing it against lower-conductivity sand-based proppants. This, of course, has the benefit of more fully utilizing our manufacturing capacity, which was our other main goal.

So, having accomplished the objective of improving capacity utilization, we'll now look to improve operating margins. We'll continue to focus on R&D activities to identify and develop more value-creating products and services. And finally, we have the financial flexibility to respond to opportunities. We intend to grow our business organically and are looking for complementary acquisitions. Have a good day, and we look forward to seeing you next quarter.

Operator

This concludes today's conference call. You may now disconnect.

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