Proppant Industry Stress Test Part 1: U.S. Silica

Summary

• Q4 2019 revealed the depths of proppant pricing destruction and O&G segment contribution margin despair.
• The proppant industry isn’t dead.
• U.S. Silica remains a leader with free-cash-flow-positive operations.

Introduction

Amidst all the doom and gloom of the overall equity and bond markets, this article continues a set of informative pieces related to U.S. Silica (NYSE:SLCA) and contains information related to the O&G proppant space overall.

Please see my first article for a company overview and introduction to some key terms if you are unfamiliar with this industry or would simply like a refresher.

Several months ago, a frequent Seeking Alpha commenter posited that a series of “stress test” articles would help our online community better understand how companies that serve the proppant market might fare in the coming quarters and years. To that end, I will attempt to elucidate a stress test scenario for U.S. Silica and discuss the future of the company.

The remainder of this stress test series will review company fundamentals, performance and provide a viability prognosis of U.S. Silica's publicly-traded industry peers including Covia (CVIA), Hi-Crush (HCR), and Smart Sand (SND).

(U.S. Silica Logo, Trademark U.S. Silica)

Significant Updates From Q4 2019

U.S. Silica reported Q4 2019 earnings and provided their 2019 Annual Report a few days ago with nearly every metric down on a quarterly and/or annual basis. The fourth quarter of each year has proven to be seasonally slow for both the O&G and ISP segments across the industry, so those of you who follow this space were likely expecting mediocre numbers at best. As of December 31, 2019, U.S. Silica’s term loan due May 1, 2025 had $1.248B outstanding. Market interest rate decreases reduced the realized rate to 5.81% vs. 6.56% a year earlier. Should interest rates remain depressed, the company could realize an annual interest reduction benefit of approximately $9.3MM in 2020 vs. the year earlier period.

Disciplined capital spending of $20.455MM and a realized $52.3MM customer shortfall penalty (of $70.6MM total 2019 shortfall penalties) kept U.S. Silica cash flow positive for the quarter: EBDA + non-cash adjustments – capex = $6.658MM FCF. With 73,343 shares outstanding, the company’s newly reduced $0.02 quarterly dividend (to be paid April 3, 2020) will only cost another $1.467MM/quarter.

The company’s Annual Report and conference call with CEO Bryan Shinn and CFO Don Merril provide a wealth of information:

• Reiterated ~10% workforce reduction announced Q4 2019 estimated to save $20MM SG&A annually.
• Planned 2020 capex of $30MM to $40MM vs. $118MM in 2019.
• “Rightsizing” the business by exiting high-cost transload sites, renegotiating fees and rail rates, staggering railcar leases to roll off 1,100 in 2020 and another 900 in 2021.
  • Railcar reductions should provide a $2 to $2.5 contribution margin/ton benefit in 2020.
• Proppant pricing has improved since exiting Q4, up between $2 to $3 overall. Spot pricing in West Texas is 80% to 100% from $10 to $12/ton to $20+ ton.
  • Approximately 80% of 2020 sales are under contract.
  • A number of sand mines/producers have shuttered and/or reduced capacity/shown restraint with attempts to capture market share. Despite expected Q4 demand/completion slowdowns and E&Ps “working within their means,” supply/capacity reductions are finally evidencing a positive pricing impact.
• A survey by a “leading bank” showed that 48% of respondents prefer box proppant systems (like what SandBox uses) vs. 44% preferring silo proppant systems.
• Approximate 24% market share for SandBox, but significantly less growth in 2020 vs. the two prior years.
• SandBox load volumes were down 18% Q/Q due to significantly lower completion activity in Q4.
• The company is prioritizing profitable pricing vs. sales volume/market share gains and does not plan to return idled production to the market. Bryan Shinn predicts proppant sales between 13MM to 14MM tons in 2020. U.S. Silica sold 15.054MM tons and 14.242MM tons of proppant in 2019 and 2018, respectively.
• Akin to Q4 2018 end of year impairments of $291.899MM, the company took significant non-cash asset impairments to the tune of $363.847MM in 2019.
• Expectation of 5% industry proppant demand growth in 2020. NWS-specific demand expectation of 20MM to 25MM tons vs. 40MM to 50MM tons of active (non-idled) supply.
• ISP sales price increases up to 6%.

Key Metrics

Please see this article if you’d like to know more about the importance of EBDA and why adjusted EBITDA is not a trustworthy figure as it relates to U.S. Silica’s business.

The tables below summarize certain key metrics for the last 8 quarters and 5 annual periods. Note that service revenue and net income figures declined between Q1 and Q4 2019, reflecting the fact that SandBox’s service component provides only partial insulating effects to proppant pricing pressure.

O&G segment contribution margin (CM) is presented below. Q4 CM of $20.22/ton is grossly inflated due to a $52.3MM customer shortfall penalty benefit and the related lack of cost for proppant that was not delivered. Q4 net CM sans penalty benefit drops from $67.993MM to $15.693MM or $4.67/ton. 2019 annual CM of $248.594MM drops to $177.594MM or $11.80/ton after making the same adjustments for annual shortfall penalty benefits ($70.6MM). Such underwhelming quarterly CM is eerily reminiscent of 2016 and shockingly only 51.7% of the CM Hi-Crush reported in their earnings report last week.

One on hand, shortfall penalties are obviously a positive indication that U.S. Silica is able to enforce its contracts more reliably (or has superior contract language) than several years ago. On the contrary, U.S. Silica’s continued ability to operate and produce FCF is directly dependent on its contractual agreements. CFO Don Merill noted that “a little less than half” of the shortfall benefit from Q4 is a cash benefit. N.B. Total 2019 shortfall penalties are subject to ongoing discussions between U.S. Silica and its customers. In the year earlier period, customer shortfall penalties were just $1.6MM, so the annual penalties skyrocketed 4400% Y/Y. CEO Bryan Shinn downplayed that shock factor on the conference call.

ISP segment contribution margin is presented below.

The tables below display a majority of U.S. Silica’s future liabilities in the form of purchase commitments, lease liabilities, pension and post-retirement benefits. The importance of these liabilities cannot be understated for a company that generated just under $6MM in net 2019 FCF after dividends.

CEO commentary about “rightsizing” the business is evidenced if only slightly in the lease obligations and future purchase commitments as of December 31, 2019 compared to a year earlier. After adjusting for 2019 costs, future lease obligations have decreased by almost $22.8MM and minimum purchase commitments have actually increased by $3.3MM.

2019 Annual Report Figures

Compared With 2018 Annual Report Figures

Unfunded and underfunded pension and post-retirement benefits are projected to require $6.5MM from the company in 2020 (significantly more than prior years). While pension benefits have not been provided to new employees for about a decade or more (see Note R from the Annual Report), the pension liabilities for past and present qualifying employees remain a significant portion of FCF. The trust to pay post-retirement health benefits was depleted in 2017, so costs for these benefits come from available cash.

(Source for all preceding tables and graphs: SEC Filings and calculations by the author.)

2020 Financial Outlook, Stress Test

U.S. Silica is one of the largest players in the North American O&G proppant, North American O&G service and global ISP industries. Despite an excellent network of facilities and decades of operational experience, significant headwinds remain for U.S. Silica related to its O&G business.

Schlumberger (SLB) CEO Olivier Le Peuch recently stated his prediction for US shale growth slowing to between 600,000-700,000bpd in 2020 and only 200,000bpd in 2021. Oil prices are under pressure as OPEC+ struggles to curtail enough production to match the severe demand impacts especially related to reductions in air travel and shipping created by COVID-19. It seems like there is no shortage to the number of shoes that can drop and we’re all just waiting for the next one, but is the sky actually falling? Will U.S. Silica survive?

Stress Test Assumptions

• A market crash and/or global recession are immaterial to this analysis that seeks to understand the long-term viability of U.S. Silica’s business segments.
• Shale growth will slow, but SandBox will retain its existing 24% market share for the foreseeable future with little to no significant market share capture in the coming years.
• U.S. Silica will be able to successfully reduce additional lease commitments as stated.
• Regardless of WTI price per barrel, E&Ps will continue to complete significant amounts of unconventional wells and continue use increasing amounts of proppant. Given this, demand for both in-basin and NW sand will yield slow, stable growth on an annual basis.
• U.S. Silica will remain 80%+ contracted for proppant in 2020 and thereafter and will be able to effectively enforce its customer contracts.
• Proppant prices will remain somewhat depressed as compared to 2017 and 2018, but will recover to levels seen in early 2019. Rystad Energy’s proppant price forecast for 2020 minegate prices around $22 aligns with conference call comments from Bryan Shinn. Future pricing forecasts look relatively stable around the $20 mark.
  • Proppant supply and demand will remain more closely balanced due to discipline by proppant producers (public and private)
• U.S. Silica will retain a significant majority of its existing ISP customer base, acquire additional customers, increase product pricing and develop new and improved products that will significantly increase contribution margin over the next 3-5 years.
• Equity market sentiment notwithstanding, Q4 2019 was the worst-case scenario for unconventional production and related services in North America over the next 5-10 years.

(Source: 1yr graph of FRED PPI for Hydraulic Fracturing Sand)

(Source: 1yr graph of FRED PPI for Industrial Sand)

Given all the above assumptions, U.S. Silica should not only survive, but eventually thrive in the coming years as its ISP business expands. Q4 2019 margins for proppant were meager at best and growth in the O&G segment (both for proppant supply and services) is over for a while, but that severe contraction is balanced by:

1. A massive $20MM annual reduction in SG&A costs.
2. Reductions in legacy railcar lease expenses (up to $2.50 CM/ton benefit in 2020).
3. Proppant supply rationalization (mine closures, idling capacity and valuing profitability over market capture) should help curtail pricing pressure.
4. Favorable interest rates for the term loan (potential $9.3MM interest expense benefit).
5. Responsible levels of capex ($30MM to $40MM) directed toward the profitable ISP segment.

The company is likely to continue retiring relatively minimal levels of long-term loan debt. If the pattern of $22MM of debt principal repayment from 2019 continues through the end of 2024, the term loan balance should reflect $1.138B around the time of potential refinancing.

Q4 2019 was the stress test for U.S. Silica and it managed to remain FCF positive. Let’s use the stressed third and fourth quarters of 2019 as a barometer for the worst-case future quarters and see how the company might perform given the aforementioned reductions:

• Assume O&G CM of $13/ton (like Q3 ‘19).
  • Assume 14MM tons of proppant sales based on comments from the CEO, even though this is a reduction from prior years.
• Assume ISP CM of $46.50 (no improvement, even though improvement seems likely).
  • Assume 3.7MM tons of ISP sales (a slight reduction from 2019).

With the above assumptions, total 2020 CM would be $354MM ($182MM O&G + $172MM ISP). That can be compared to 2019 CM of $426.8MM.

Net profit from sales before cash expenses is the critical figure that shines a light on the bottom-line dollar value of annual CM. 2019 net profit from sales (defined as revenue minus cost of sales) was $341.184MM (79.9% of CM). Assume the aforementioned lower sales volumes that prioritize profit, reduced underlying sales costs and ~200% higher pension and post-retirement benefits yield 80% net sales profit ($283.2MM) as a % of CM in 2020 (nearly the same % as 2019 and 2018).

2019 SG&A costs were $150.848MM, so reducing those per commentary reveals $131MM annual 2020 SG&A. 2019 interest expense was $95.472MM. Lower interest rates could mean a reduction to $86.2MM in 2020. Combined SG&A and interest expenses in 2020 would total $217.2MM yielding a net cash of $66MM or $0.90/share before spending $35MM on capex and $5.868MM on dividends. The net FCF after all of those costs is $25.132MM or $0.34/share.

Remember that the aforementioned figures are non-GAAP and intentionally omit non-cash items like depreciation, depletion & amortization, stock-based incentive compensation and non-cash goodwill/impairment charges, the former two of which will likely total at least $195MM in 2020. GAAP earnings will undoubtedly be negative, but the company will be cash-flow positive.

Valuation

How do we value U.S. Silica’s 73.343MM common shares? Since GAAP earnings are negative and adjusted EBITDA figures are inaccurate measurements, let’s use P/FCF.

Actual FCF (after all actual expenses have been paid) is $25.132MM. Dividing today’s market cap of $348.4MM (share price $4.75) into actual FCF yields of P/FCF multiple of 13.86. Using the more generous $66MM FCF figure before capex and dividends reveals a P/FCF of 5.28 which seems to be clear value territory according to a variety of standards. P/FCF figures do not necessarily indicate shares are “cheap” due to a number of macro and other factors, but it is somewhat reassuring to understand why U.S. Silica may have traded in the $5 range for the last few months.

Conclusion

Long-term investors will eventually be rewarded by U.S. Silica. The company has leaders in place that understand the industry and how to maintain both dominant and cash-flow-positive operations even under extreme pressure.

If you’ve enjoyed this article, please consider clicking the “Like” button below. I hope you will tune into forthcoming “stress test” articles to see how other companies in the proppant and ISP space will fare. Covia, Hi-Crush, and Smart Sand are all on the list.

Analyst’s Disclosure: I am/we are long SLCA, HCR, CVIA. 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.

The author may frequently trade both equities and options in the energy sector long and short.