Emerge Energy's Sell-Off Was Overdone, Shares Are A Buy

Summary

• Emerge Energy reported a strong quarter, despite transitory issues weighing partially on earnings.
• Emerge’s share price consequently plummeted, but for reasons that are inconsistent with other frac sand company’s reports. Hence, construction, completion, and dividend delays can't be the culprit behind the selling, and are actually a good thing for the industry.
• All delays in the events stated above are pointing, instead, to a fracking boom in 2019, especially in the 2H, where most current pipeline projects and regional mine builds are scheduled to be finished.
• I attribute the sell-off to profit taking from the recent run-up, and consider the drop in share prices as an opportunity to add to long positions.

When Covia Holdings (CVIA) reported delays in construction of their regional sand mine in Texas, the stock didn’t plummet nearly 20% like Emerge Energy's (NYSE:EMES) did on its last earnings announcement. Halliburton (HAL), however, cited takeaway issues as delaying completions activity, and saw its stock drop precipitously in similar fashion; so, maybe the delayed completions activity bear argument holds some weight.

Except, why do investors feel that delayed construction and completions activity are a bad thing for services companies like Emerge? Sure, even better earnings get delayed a quarter or two, but not through any wrong doing of the company. Rather, completions are slowing because the fracking industry is TOO strong, and volumes are bottlenecking major oil & gas supply hubs.

Construction of frac sand plants, as well as completion activity, is being delayed due to exhausted labor forces being stretched too thin, and heavy frac sand construction overwhelming supply chains. This is a good problem to have for investors, ultimately, assuming that companies execute on their plans, which Emerge said it is doing.

So, Emerge Energy’s sell-off was unwarranted for three reasons:

• Construction delays at their San Antonio plant have been widely foreshadowed by the industry, and are actually exacerbating shortages of frac sand (which is good for pricing).

The two month construction delay has pushed down our timeline. We still expect San Antonio to drive a substantial improvement for the second half of the year, and margin should expand materially in the fourth quarter with San Antonio achieving full utilization post NSR permit upgrade.

• The dividend not being reinstated (which some investors thought could have been the culprit behind the sell-off) was no surprise, and not even possible in 2018. Fortunately, the dividend is still on track to be reinstated in early 2019, which is going along just as the company planned.

The board of directors of our general partner elected not to make a distribution for the quarter. Also, as previously disclosed, we are restricted into our current credit agreements from paying distributions in 2018.

• Also, delays in completions due to strength, rather than weakness, is a positive for the industry, not a negative. Increased earnings and pricing are only temporarily delayed.

As a result, these three events are offering investors a chance to add to Emerge Energy and other frac sand positions on the dip before the 2019 shale boom that surely awaits.

Emerge Showing Pattern Of Increased Revenues

Emerge Energy reported a solid quarter, despite the transitory issues stated above. Revenues were $101.84 million, which grew 23% year-over-year, and adjusted EBITDA came in at $23.4 million. Revenues have also been on a linear trajectory for more than four straight quarters (seen below), implying that there's a trend of higher revenues to come.Source: E*TRADE

The company obviously had to lower guidance as a result of the delays, but now this provides a lower bar for Emerge to beat on its next earnings date. Also, with delays expected to continue due to a shortage of labor seen in the frac sand industry, barriers to entry will remain elevated, and pricing should stay flat to slightly up.

Let’s Get Pricing Out Of The Way

Pricing did increase 2% in the second quarter, but should flatten out over the coming months as more NW sand gets displaced by regional sand, and gets re-routed to other growing basins outside of the Permian. These developments are nothing new, and have also been widely predicted by frac sand companies, who have said all along that 100 mesh pricing would suffer for miners higher on the cost curve, and would be displaced by regional volumes in Texas.

This event was bound to happen as regional sand came online, and is more of a positive than a negative because companies would rather sell more volumes at a lower price, than less volumes at a higher price (Wal-Mart model). More sand is also good for the industry as it allows more fracking to take place, which, in turn, demands more sand and different grades for the job. More basins are opening up in Utah, Wyoming, and Canada, and EMES is already re-routing NW volumes to those regions (proven by their new terminal in Canada, and transload site in Utah).

We continue to see frequent requests for Northern White 30-50 and 40-70 even in the markets where in-basin sand consumption has become more prevalent. Nonetheless there are signs that 100 mesh is becoming over supplied in West Texas freeing up the Northern product to move to these other basins.

As long as all of Emerge’s NW and local volumes are spoken for, which they are, the company will continue to leverage earnings through having full utilization of their facilities, while reducing fixed costs.

Also, future pricing must not really be an issue, since no other frac sand companies fell much in sympathy from Emerge’s conference call. Actually, by virtue of all recent price action displayed by public frac sand company's stocks, the reasons for the drop in Emerge cannot be attributed to delays in construction, completions, or signs of declining prices, since other frac sand companies did not fall the same way, on the same news.

Analyst Consensus

Analysts agree that EMES share prices should be higher, as the low target of $7.00, and high target of $9 are, both, above current levels. Source: E*TRADE

I still believe the high target of $9 is modest, at best, since earnings are set to increase substantially and consistently in the coming quarters. Its IPO price, alone, is higher than the stock's current price, and that public offering was done with less assets then, than Emerge has now. Even during a downturn, Emerge's contracts will be more enforceable, which should provide the cushion needed to ride out any possible downturn in the future.

Conclusion

To summarize, investors familiar with the frac sand space know why these silica companies could be potential home-runs, and core holdings for a lifetime, even, as this is brand-new industry that has not found its true pricing yet.

Sure, the stock is not even close to its IPO price. But, whatever happened to assigning forward discounts and premium multiples to growing energy stocks? It seems like any other stock these days can get a rally, even with companies gushing money like Tesla (TSLA). Heck, even Big Foot's stock is flying now, BigFoot Projects Investments (OTCPK:BGFT).

So, these prices for frac sand companies are certainly laughable, if nothing else, since companies with losses or no chance of winning fly to the moon, while EMES suffers due to widely known construction delays, completion delays (which is a good problem, in the end), no dividend payment, and raised pricing on NW volumes (2%).

Meanwhile, revenues and net income continue to climb for Emerge, with no end in sight, due to insatiable demand for short cycle investing by E&Ps, and contracts that are now enforceable by frac sand companies. As a result, investors should buy Emerge Energy, once the dust swirling around the stock settles, and go long with a growing shale industry that is set to boom in 2019 and beyond.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long EMES, HCLP. 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.