Emerge Energy Services: Economic Factors Indicate Deep Value
Summary
- Economic factors should push EMES over $10/share short term.
- $120 million adjusted EBITDA and $60 million Net Income guidance for 2018.
- Price is suppressed trading at a P/E of just 3.
- Price/ton and demand are both on the rise.
Now that we have all had some time to take in the earnings call for Emerge Energy Services (NYSE:EMES), I believe it is the perfect time to add some clarity to the 2017 annual performance, including Q4 as well as the future outlook described in the call. These are exciting times for this company, and I would even go as far as to say this is the best position the company has been in since the drastic oil decline that began in June of 2014. If you have not listened to the earnings call yet, you definitely need to (download here). EMES posted Q4 revenue of $103.14 million, missing estimates by $11.25 million and EPS of $0.18/share missing estimates by $0.11. Although the company missed on top and bottom line, Q4 represents the second consecutive profitable quarter for the company.
Looking Back on 2017 and Q4
For those that listened and reviewed the transcripts there were two very clear explanations to the management provided. The first reason for earnings miss was due to the "widely documented service issues from the Class 1 railroads impacted" which directly impacted the company's ability to ship their hottest selling product, Northern White frac sand. The second reason provided was extreme winter weather, on top of the holidays, affected the ability to complete frac jobs. So, if we examine both of these factors that impacted the EPS negatively, one common denominator can be derived: both factors were out of the control of management. It is an important point to denote because an earnings miss of $0.11 for a company this size could easily be misconstrued. However, in the next breath of the earnings call Chairman Ted Beneski is very deliberate in citing that the "small decline in volumes is by no means a reflection of any market softness". Not only did he immediately disprove the theory that market was softening and that management's estimations from prior in the year were irresponsible, but he doubled down by touting the true demand for frac sand remaining strong, specifically telling shareholders EMES expects substantial volume growth for 2018. The more important factor, in my own opinion, that contributed to the earnings miss was the logistical issues with the Class 1 railroads. If you recall, these issues were directly mentioned in the Q3 earnings call, where CEO, Rick Shearer said they were monitoring the situation for potential impacts and were taking measures to mitigate these risks. The measures included were re-routing shipments and placing previously stored railcars back into service. In this earnings call, Rick Shearer dove into more detail on the company's mitigation tactics. Due to the Canadian National Railway taking a large hit from severe weather in January, EMES rerouted what they described as "major tons" to other railroad logistics companies, including Union Pacific and BNSF. The company recognizing shipping could vastly impact their top and bottom lines for the quarter and all of 2017 took mitigation a step further by establishing a new origin point with BNSF in October, of which they are currently discussing an expansion for. Although railroad outlets have advised the company that service should improve as we head into Q2, EMES has deployed all 181 stored railcars to get ahead of any further impacts to shipping in an effort to meet the needs of clients whom are anticipating increased production due to the bullish global outlook for oil in 2018. Management's proactive measures to the risk and continued communication throughout the process with the railroad outlets were largely overlooked by the market, as was the forward looking guidance for 2018 that was given.
What to Expect Moving Forward
Some readers and investors may have a hard time discerning why I am writing a positive article on the company's outlook after an earnings and revenue miss. This is because the real value is in the detail of the earnings call the company provides. Some positive items to take away that I feel are very important to the valuation are focused on the microeconomics of the business and the macroeconomics of the industry. For starters, it was denoted in the Q3 earnings call that price increases of $2-$3/ton were likely to occur in Q4, but management surprisingly said price increases actually exceeded their expectations for the quarter. In addition, they expect price increases for Q1 to rise an additional 3-5% and also noted Q2 negotiations have indicated increases of 5-10%. Management did state that they expect prices to hold steady to these levels for the most part in the second half of 2018 due to additional supply being available to clients through new producers. These increases are extremely bullish for the company and will directly and positively impact EMES on top and bottom lines. Furthermore, demand for 2018 is to exceed 100 million tons, with expected 2019 growth demand of 10%-15%.
Interestingly enough, many of you are aware of the acquisition of the San Antonio mine and the company's work towards bringing that mine to full production during Q2 of 2018. Fortunately, management was able to refinance their existing revolving debt, reducing their commitment to just $75 million from $180 million. In addition, a new second term loan was established in the amount of $215 million. The refinancing the company concluded allowed them to substantially pay down their debt, gave EMES the flexibility they needed to finish the San Antonio mine on time and under budget by early May. San Antonio is uniquely positioned to benefit from clients in the Eagleford basin. Noting that Rick Shearer alluded to a ramp up time for other mines in the company's history of just two weeks, it's safe to conclude that the mine will be at full production allowed by their current permits by the end of Q2 or beginning of Q3 at the latest. It is worth mentioning that the current permit restricts the mine to a limit of 2.4 million tons of annual capacity. The company has stated that they intend to file the NSR permit in the coming weeks, which given approval from the Texas State regulatory body, would bump up the maximum capacity to 4 million tons of annual capacity, increasing San Antonio production by 67% if operating at max capacity. Including production of the 2.4 million tons of annual capacity for San Antonio, management gave forward guidance for 2018 of $120 million adjusted EBITDA and $60 million Net Income, but were sure to state that they believe these numbers can be exceeded if rail service improves quickly and permitting is expeditious for the San Antonio mine.
My belief is that at a minimum, the economics of the company position in the market drive this above $10/share as stated in my previous article for the short term. In the longer term, I remain in agreement with the thoughts of fellow SA contributor, Paul Lebo, of an expected 12 to 15 times P/E ratio, specifically calling out the correlation to the price of crude oil and the increased demand by shale producers in the United States.
Risks Moving Forward
There are risks moving forward for EMES, but I believe the company has the ability to overcome them given their position. The largest risk in the short term is the logistics interruptions EMES faces. Although railroad outlets have indicated improving service during Q2, it still poses as a threat for the first part of the year. The other major risk is the permitting process for the NS permit EMES needs to be able to operate a full capacity for San Antonio. Company has stated that private consultants, specializing in this permitting process have indicated that it could be 6-12 months depending on the public comment period. Rick Shearer does hope to capitalize on the mine's 80 year history in the area (previously owned by Osborn Materials), particularly with locals who could stand to benefit from employment as well as other benefits from the company's production. Lastly, I could not write this article in good faith if I did not at least mention the debt position the company faces. I do not consider this a major risk at this point, with the macro- and microeconomic factors being so favorable, but the company is still restricted from issuing any distributions by their debt covenants currently in place. I actually look at this as a positive factor because it forces the company to be more structured with their financing and cash flow in the short- and mid-term. If the company was able to distribute cash to shareholders, I would fear that it would be prematurely as they are still spending significant dollars on the San Antonio mine construction and continuing to pay down debt.
Conclusion
In conclusion, I am highly bullish on EMES and have great confidence that management is working hard to show this company is worth more than a P/E ratio of just 3. The company is in the very beginning stages of hitting its stride during this bullish cycle for oil, the primary driver for frac sand stocks. The economics show that there is a shortage of frac sand that could negatively impact the shale production in the United States per author Nick Cunningham. Subsequently, frac sand prices are increasing and EMES in increasing production to meet these demands. Higher production equals higher revenue and price increases correlate to better margins. Adding to this that despite some concerns about debt, management is and expects to remain in compliance with their debt covenants. I am confident management can execute the plan the laid before us, and will deliver results that substantially increase shareholder value long term
This article was written by
Analyst’s Disclosure: I am/we are long EMES. 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.
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