Carbo Ceramics: A Long Play On U.S. Drilling

Summary

• Proppant is an essential product to the essential oilfield development of fracking, which is here to stay.
• CRR sells a differentiated and IP protected product in a niche market it created and dominates.
• Low oil prices have lowered oilfield investment spending, pushing drillers away from more expensive and productive ceramic proppant toward commoditized sand proppant.
• CRR dominates its niche at the customer level, maintaining strong customer relationships and a preference for their product.
• This is a high risk/high reward turnaround opportunity.

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Carbo Ceramics (CRR) represents a pure play on U.S. fracking, and higher oil prices make the potential upside for this proppant manufacturer significant if they can capitalize on an increase in drilling in deepwater and high pressure wells. A recent run-up in price has squeezed the margin of error in valuation, but if ceramic proppant volumes can begin to recover I believe upside remains as CRR approaches breakeven EBITDA and positive free cash flow in the next year.

CRR manufactures and sells proppant, a bead-like product used in the hydraulic fracturing process to keep or prop open the induced fracture open and conduct oil and natural gas out of the well. Proppant is one the most significant and essential drivers of oilfield innovation today, allowing for horizontal drilling that can reach deepwater wells and tap the massive U.S. oil reserves of the shale revolution. CRR was incorporated in 1987 and IPOd in 1996 among the rise of fracking.

Proppant comes in multiple different forms, ranging from Northern white sand to forms of ceramic, each with varying degrees of conductivity and crush-resistance. Sand is the lowest quality form of the product, unable to withstand high pressure wells and having the lowest productivity, but it is also readily available and cheap to get, making it a commoditized and undifferentiated product that's far cheaper than its ceramic counterpart.

Source: Investor Presentation

In the chart above, you can see the varying types and qualities of proppant. At the bottom is basic sand, which has the least amount of conductivity and lowest pressure resistance, and at the top is Carbo's highest quality products that can be used in the highest pressure wells. From the perspective of drillers, your proppant purchase decision is going to be ROI-based, which means the price of oil will decide what they're willing to spend.

Higher oil prices make ceramic proppant worth the investment because of its ability to increase well productivity, increase the life of the well, and reach wells that are inherently more expensive to drill in. In high pressure wells like deepwater wells, ceramic proppant is an essential piece of the fracking process and a part of what makes them so expensive to drill in. Lower prices mean the opposite, as the extra upfront investment for ceramic is no longer worth it and expensive, high pressure wells stop production.

Source: Alliance Bernstein 2014

As seen in the above chart, the varying prices at which oil projects are profitable will drive drilling and investment decisions. At current oil prices with Brent crude over $70/bbl, U.S. oil projects, including non-shale projects, are profitable with 80% of tight oil capacity additions profitable between $50-$69/bbl according to an IHS study.

What this means for CRR is that they're a long play on drilling. CRR sells both sand and ceramic proppant and has exposure to U.S. drilling, primarily in the Permian basin area and the Gulf of Mexico. This drilling exposure, particularly in expensive high pressure wells and in the U.S., creates built-in leverage to the industry it operates in. As oil prices rise past the key breakeven points for U.S. projects, drilling activity that CRR is exposed to increases exponentially and the opposite is true for falling prices. This built in leverage in its commodity exposure can be seen below in the stock's performance over the last five years during the oil crash relative to oil and the rest of the oil industry.

Source: Investor Presentation

Source: Thompson Reuters Eikon

Because of the exponential effect oil prices have on drilling, CRR has been even more volatile than crude oil itself, with strong correlation.

Once trading at $168 a share CRR fell to nearly $5 following the oil crash as drilling activity slowed and oilfield companies looking to preserve themselves cut costs by switching to sand proppant. Carbo began producing and selling Northern white sand to meet the market demand and to maintain and develop customer relationships. Sand being far less profitable cut into CRR's top and bottom lines while the fixed costs of idling ceramic factories forced their gross margin negative. The company borrowed money and cut back capex to survive as revenues declined until the inflection point at the third quarter of 2016. Rising oil prices, diversification of CRR's marketing mix, and adjustments to lower production levels caused margins to begin to improve and revenue to once again grow.

In April 2017, billionaire oil entrepreneurs and investors, the Wilks Brothers, took a 10.3% stake in the company. They also paid off their Wells Fargo loans and replaced them with a $65mm personal loan at 9% with PIK accrual options. With significant stakes in both the debt and equity of the company, that's a massive vote of confidence from investors with decades of experience from within the industry. Their equity position puts them in the same shoes as shareholders while their debt position increases their incentive to help the company in its turnaround to profitability.

Source: Company Proxy Filings

Source: Investor Presentation

As seen in the first table above, the Wilks Brothers have continued to purchase CRR to add to their position, increasing it to 13.19% of outstanding shares at an average purchase price of between $12-$14/share. Management has also been buying up shares throughout the last year, with the CEO adding significantly to his position.

A return to $50/bbl oil

With oil once again over $50/bbl, and more recently over $70, U.S. shale projects are once again profitable and drilling activity is increasing in markets that CRR sells to. With more valuable oil comes a desire to extend the life of wells and their productivity; the investment in a product like ceramic proppant becomes worth it. Additionally, high cost wells like deepwater wells in the Gulf of Mexico where ceramic proppant is a necessity to operate become profitable. A restoration of deepwater drilling activity in this area would lead to a spike in demand for Carbo's flagship product, making CRR a clear long play on deepwater drilling and fracking

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Source: IEA

Following the oil crash, large oil and gas companies cut capex spending to preserve themselves which killed demand for premium products aimed at increasing production. With higher oil prices an increase in capex spending across the industry should be seen displaying the industry's willingness to invest in growth and productivity. According to the Oil & Gas Journal's latest annual capacity spending survey, oilfield capex spending is projected to increase 15% in 2018. As seen in the below chart, a natural gas well using CRR's product produced 20% more than one using just sand proppant.

Source: Investor Presentation

Valuation

To value CRR I attempted to predict a normalized year, post-transformation that management has said should be complete by 2021. I assumed that this first normalized year would occur in fiscal 2021.

Using the median EV/EBITDA of 8.1x for comparable proppant companies and my forecast 2021 EBITDA I reached an implied 2021 EV of just under $672 million. I believe the multiple of 8.1x is conservative for 2021 considering we are coming out of the bottom of the cycle. For a net debt estimation, I decided to be conservative and account for potential cash fluctuations. I used $50 million as a more conservative estimate as opposed to the current net debt balance of $27 million.

I then discounted the resulting implied equity value by the cost of equity resulting in a valuation of around $14.00/share, or a 22% premium over the current market price.

Risks

Clearly, there's significant risk inherent is a turnaround thesis on a company that recently touched the brink of bankruptcy in a presently depressed industry. CRR has extremely significant commodity exposure with a sort of leverage in its correlation to commodity prices. They also operate in a highly regulated industry with significant geopolitical risk, especially among the current uncertainty in Venezuela and Iran. CRR is also currently unprofitable and the investment thesis is centered on a turnaround; my bear case valuation without a recovery values CRR at $2.93/share.

Final Thoughts

Despite CRR's recent run-up in price from as low as $6.85 in mid-April to its current price of $11.19 on oil's fast-paced rise, it still seems to have some room to go from a valuation perspective. If deepwater activity resumes quickly, the upside could be significantly higher. I believe CRR could be worthy of a premium to other proppant companies in the future because of their dominance of single niche that's needed in high pressure wells that will soon, if not already, resume activity.

Disclosure: I am/we are long CRR. 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.