The Saving Grace For Emerge Energy's Bull Thesis

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About: Emerge Energy Services LP (EMES), Includes: CVIA, HCLP, SOI
by: Todd Akin
Summary

Emerge Energy is redefining their company with new last-mile capabilities.

Contracts should now be based on the total suite of services offered by frac sand players like Emerge, instead of being based predominantly on frac sand pricing.

Emerge has an asset light strategy with their last-mile option, however, which may place them at an advantage over HCLP in certain regards.

As a result, the recent weakness in Emerge Energy's share price still offers significant value, especially under $5.

Emerge Energy (EMES) has seen its stock price climb back in recent weeks as the overall market, and oil, begins to find its footing again. There hasn't been much to report on frac sand names lately, except that business has slowed from delays in completions due to E&Ps awaiting new takeaway capacity.

However, certain dynamics are shifting for the frac sand industry, namely in that pricing per ton of sand should be less of a factor, as new contracts based on bundling services redefine earnings for frac sand players.

We recently discussed this bundling theme with Hi-Crush Partners (HCLP), yet Emerge has similar capabilities, as well as one more advantage working in its favor: the ability to go asset light with last-mile. These dynamics are reshaping the way Emerge generates revenues, should provide more stability and transparency to future earnings, and should move the stock price significantly as it market cap is now a fraction of where it was only a year ago.

Therefore, the weakness in its stock price offers significant value at current levels, and, as a result, I am gaining more conviction in owning frac sand players like Emerge. Let's discuss this game-changing topic more in detail below.

The Frac Sand Bull Thesis Did Change, For The Better

The frac sand bull thesis is still alive and well. However, it will take considerable time to see a meaningful recovery in frac sand pricing in 2019 due to the variance in pace of completions by E&Ps.

One thing that did change in frac sand player's favors, however, was OSHA regulations requiring sand to be covered for the last-mile. Who would of ever thought that this would end up being the saving grace for frac sand players and Emerge?

So, investors who are long the stock for the original bull thesis should remain long, but should also look to the future for the new dynamics unfolding in the last-mile department that will have drastic impacts on frac sand player's revenues.

We discussed that HCLP is taking market share from competitors due to the superior last-mile option that they employ. They should use the abundant volumes of sand present with lower pricing to their advantage, and flip the polarity of the bear's oversupply thesis in order to transmute their company into something greater.

By simply having a home for their sand volumes through the last-mile now, they can gain more fixed cost absorption again and fully utilize their assets while, at the same time, charging a premium for their upgraded suite of services.

This way, even if in-basin pricing for frac sand stays in the low $30s from any future slowdown in completions or added supply, the premium added for the larger transport network of the publicly traded frac sand players (unit-rail capability), as well as last-mile services, should allow contracts to always stay in the $50s to $70s (assuming transport costs fall in the range of $20 to $50 using truck or rail, respectively).

Because sand has to be covered now from OSHA, and has to be transported at the lowest cost possible, E&Ps will need to purchase sand from someone who has sufficient last-mile abilities, and cannot break a contract now just because they found cheaper sand.

So, with contracts being priced for the all-inclusive package Emerge can offer, frac sand prices become less of a factor. In my opinion, contracts should remain indexed to frac sand prices during periods of tight supply to benefit from higher prices, but keep a minimum floor in the $50s to $70s in order to make enough profit and sustain the industry.

The Advantage Emerge Has Over Hi-Crush In Last-Mile

At first thought, owning their own last-mile ability seems like an advantage for HCLP over EMES. After all, when HCLP can make over $1 million EBITDA per container, and charge more for their complete suite of services now, how could Emerge be in a better position?

The answer is simple. Emerge has always elected to go with an asset light strategy throughout the years, which has benefited them through downturns when overhead costs pile up. Last-mile is no different.

Emerge Energy's partnerships with Solaris (SOI) are a match made in heaven for both companies. Solaris gets business it would have never had, and Emerge can win customers over from competitors who don't have the same last-mile capabilities. This partnership ensures a home for Emerge Energy's volumes, and allows for premiums to be added to contract prices, all at a minimal expense for Emerge.

While Hi-Crush has to compete with new market entrants, train completion crews for their last-mile division, fabricate new equipment, and maintain it, Emerge simply has to make a phone call to one of the many new last-mile providers popping up (around 35 according to Covia's (CVIA) call) who are all fighting for market share.

They would love to join forces with a player like EMES who has quality sand in top, in-basin locations for E&Ps (Eagle Ford and Oklahoma). Risk-wise, if a downturn comes in oil & gas again, it costs Emerge nothing for their last-mile partnerships, unlike with Hi-Crush.

Conclusion

Emerge Energy should be valued differently for their full suite of frac sand services that they can now provide E&Ps. Because of this new ability of Emerge, worries of frac sand pricing volatility should become a thing of the past, since contract structures will be determined by the value of services offered, instead.

Now, if frac sand pricing rises, it should only act as a tailwind for Emerge Energy's stock price and benefit investors. On the flip side, if prices fall, contract pricing should find a floor anyway around the $50s to $70s based on the premium services offered. This would ensure steady revenues and visibility, even during a downturn, which is why EMES deserves to be trading higher.

So, not only does the old bull thesis stand for frac sand, as volumes and pricing should rise again in the back half of 2019 once completions resume, but now sand companies should be completely revalued based on the stability of revenues that their new generation contracts will provide.

Even if frac sand pricing stays in the $30s, premium services added in should allow Emerge to keep contracts prices elevated, while focusing less on frac sand pricing (except on managing mining costs and margins).

As a result, the recent weakness in Emerge Energy's share prices is offering investors a chance to pick up shares of a misunderstood company with a depressed market cap who, by all accounts, should be able to generate steady cash flow on new contracts tied to bundling last-mile in the future. Any higher sand pricing resulting from tightness in supply would just be icing on the cake for EMES.

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.