U.S. Silica Holdings: Turning The Corner
- The company turned in some better-than-expected results for Q-1 and the stock popped 21% in a single day.
- We think as the crude market realities reassert themselves in the coming week, a lot of this gain will be lost.
- If it trades back below $2.00, we could get interested.
- This idea was discussed in more depth with members of my private investing community, The Daily Drilling Report. Get started today »
I've been writing so many strategy pieces recently that there hasn't been time to write much on what most of you are interested in - stock picks that can make you some money. So at least for now, we will rectify that with this article on a sand player.
I last wrote on this company last fall with a fairly positive review, although I suggested then that buyers wait for a better price. I had dabbled in another player earlier, Hi-Crush, Inc. (HCR), and managed to escape its implosion with most of my capital intact. That left me a little gun-shy in this sector and I wisely sat on the sidelines as these companies continued to implode. Some are no longer with us, but U.S. Silica Holdings (NYSE:SLCA) remains, and I think it will survive the shale train wreck on the horizon.
When the company released earnings the other day, the market was impressed with a -$.03 beat on a consensus loss of -$.43 per share and rewarded it with a 21% one-day jump. One day moves like this are rarely sticky these days, given all the negative stuff coming out of the Permian, but let's see what it has to say.
I am a potential buyer, but as before - not at today's price. I think SLCA has a turnaround story, but it could be one that takes some time to play out. I'll set a buy target a little later, when I close out the article.
Note: This article came out in early March in the Daily Drilling report.
In this article we will summarize the state of the proppant industry and give some reasons why we think SLCA holds the dominant position that it does. Finally we will set a buy target and a time horizon for capital appreciation.
The Proppant Business
Proppants are used in the fracking of oil and gas wells to provide a conductive pathway back to the well bore for hydrocarbons trapped in "tight" reservoirs. As is well known by now, over the last 15 years hydro-fracking technology has changed the landscape of oil production, with the U.S. going from being one of the world's leading importers of oil to a leading exporter. Wow!
Just looking at the chart above you would think that proppants are a great business to be in. Once upon a time you would have been right; for the last couple of years though, it's been a train wreck as companies shifted to cheaper local sand sometimes called Texas Red. Texas Red is the absolute antithesis of what should be pumped in a frac pack, but it's cheap, and cheap rules these days.
Below is a table taken from SLCA's website with properties of several of its sand grades.
Probably the strongest attributes of the sands described above are the Krumbein shape factors and the crush resistance (higher numbers are better). Close behind that would be the acid solubility (lower numbers are better).
I am not going to go into a long dissertation right now about engineering properties of frac sand. I will say that shape factors have a big influence on...wait, you tell me. Come on, if you read my articles you should know the answer here. Got it yet?
Absolutely right, permeability. And why do we pump a frac at all?
Same answer...mostly. To increase the "Connected" permeability back to the well bore. So more perm is better than less perm, right. Yes, of course!
Ok, class is over for now. Let's get into why I have a long-term bullish thesis for SLCA.
Fracking will remain a force for a long time
I probably need to reinforce this point given the tone of my last few articles. I've thought a shake-out was coming in shale for a long time, and tried to high grade my portfolio. (I should have tried harder as everything I own in the energy space has been decimated since the turn of the year).
Shake-out simply means marginal operators are going to fall by the way. I have put together a list of attributes I think survivors are going to need to stay afloat.
- Great rock
- Logistically advantaged
- High technology
- Low costs of production
- Economy of scale
To these we should probably add manageable debt loads. This is going to become an issue at current prices if they hang around too long.
So shale production will remain an important source of production for the U.S. It just will not be at current levels. There are too many players and the market must consolidate. Not every name with which you are familiar will be around six months from now in the frac sand space. I think U.S. Silica Holdings has a better-than-average shot at being one of the survivors.
U.S. Silica...Best house in a bad neighborhood
So we are bottom fishing here. To be interested in SLCA, you've got to buy into the sector rotation thesis - every dog has his day, more or less. You've to believe that these guys will have a market six months down the road like I do.
If you're not making much money, you've got to cut costs. It looks like the company is doing the hard work to reduce cash burn as the industry struggles. Bryan Shinn, SLCA's CEO, comments:
Drawing on our roots and continuous improvement and lean manufacturing, our operations teams are pursuing approximately $25 million in additional plant cost savings and supplier contract renegotiations. In addition, we've taken significant actions to reduce G&A expenses.
Over the last five months, we've eliminated approximately 250 positions across the company and reduced other costs, resulting in an expected 40% decrease in our SG&A run rate going forward. We're sad to lose so many of our valued colleagues, but took this difficult step for the overall health of the company.
I am not going to do a deep dive on SLCA's current financials except the impact to liquidity and debt. Pretty much everything else is useless given the decline in the market since the company reported. Instead most of what I discuss regarding the company will be focused on the attributes that will help it survive the next six months.
Debt - The company has long-term debt of $1.247 bn. The bulk of this is in a term loan with a maturity in May 2025, giving it some running room. One issue it may have to grapple with is the leverage ratio of 3.75:1. It isn't in compliance here by a long shot and doesn't have a short-term path to regaining it. Let's assume bond holders will be patient on this issue.
Costs - It is taking steps to right size the company; cutting railcars loose - 1,100 this year, 900 the next. Cutting overhead by 10%. Taking charges for idle mines, and reducing capex YoY by 50%.
Liquidity - The company has $143.7 mm in cash and equivalents and $70.5 mm of borrowing on its revolver - although it should be noted that access to the revolver may be restricted due to its leverage ratio. This is down a good bit from Q-4 2019 structural problems in its core frac sand business. We'll mark this one as problematic if the recovery takes longer than a few months. Still this position is enviable compared to its peers in the frac sand market.
It will also be getting a substantial payout from the CARES Act. Don Merrill, CFO, comments:
We have identified a refund of $16 million of alternative minimum tax credits and $39 million related to net operating loss carrybacks attributable to the CARES Act provision that we expect to recover in 2020. This $55 million of cash will certainly help support our cash flow goals for 2020.
In short cash on hand and proceeds mentioned from the CARES Act will supply any liquidity requirements I can foresee until its core business ticks up.
Contribution margin improvement was another bright spot here, improving from cost reductions and plant closures.
Market share and cost position
On the good side, SLCA holds a commanding portion of the total market with a share estimated at 24%. After a drop off in this quarter and the next and assuming some sanity returns to the oil market, SLCA has the potential to return to growth, and perhaps share expansion. It's hard to imagine that all of its key competitors - Smart Sand (SND), Covia (CVIA), Hi-Crush - are going to be around for the rebound.
With a dozen locations spread across the Permian, it is fair to say the that SLCA has a competitive price position. Much of the final cost lies in the transport to an operator's location, so much so that this is a big factor in a client contracting with a particular company.
SLCA has developed a last mile distribution system called SandBox, which has netted it some new key accounts in the last quarter. I don't view this as a huge differentiator. It would be more noteworthy if it didn't have a last mile solution. Suffice it to say that it meets client requirements as noted in the call.
We invested in next-generation's equipment for SandBox, expanding box payloads and offering customers a new gravity fed stand that is quieter, required less maintenance and is less expensive to make, and we signed several new long-term contracts with blue-chip customers in our energy segment which will provide a springboard for growth going forward.
One point worth making is that this last mile solution adds to handling efficiency between the mine and the well site. This has the potential to reduce cost and proven execution skills could also be a factor in contract awards.
You will remember the term I've used, "Factory-ization." Equipment like SandBox helps make that a reality.
Investments SLCA has made gaining inroads to non-oil and gas sector businesses started paying off in a big way for it in 2019.
To start with, it's diversified in a big way, producing diatomaceous earth, specialty clays and perlite. These are all higher-margin offerings with different end users and demand drivers compared to some of the silica products.
In 2019, the industrial segment accounted for nearly half of the total contribution margin dollars, even after backing out the one-time customer shortfall penalty from 4Q 2019. In 2020, the company expects the ISP division revenues to constitute about 70% of its contribution margin dollars.
In 2020, the company expects that more than 40% of its contribution margin will come from non-sand products. I would say just in the nick of time when the U.S. shale market is collapsing, and other frac sand peers are just covering their heads hoping the roof doesn't fall directly on them.
Let's face it, the frac market is under tremendous pressure right now, and no one really knows the outcome. If things do not begin to improve materially by early next year, the current cash hoard could be gone, leaving the company between the rock and a hard place.
Investing in SLCA is no place for the rent money. It's a high risk microcap in a declining market.
Let's do some back-of-the-envelope math. Right now, there are about 9 mm bopd being produced in U.S shale, although as we've said in other articles - this is declining rapidly. But we have to use some figures and there are some data we have. So, if each well starts out making 750 bbl a day, then 12,000 wells are producing this oil. Take a 60 percent decline rate in the first year for these wells, and you've got to drill 7,200 new wells a year just to stay even. If each well takes 20 mm pounds of sand, then we are going to need 64 mm met-tons of sand to frac those wells.
That tracks with SLCA's estimate of 13-14 mm met-tons for 2020 at a 25% market share...pre OPEC+ meltdown. It's early days yet in the oil meltdown post OPEC+'s demise, but let's take a third off that for a further activity decline, and then add in an increase in market share from competitors dropping out...leaving me guessing it will probably sell at least half of its original 13-14 mm met-tons in 2020. Perhaps more as less stable competitors are unable to stay afloat. This is a really good time to have its liquidity position.
The point of this exercise, which probably has only a mild correlation to the real market as it is now declining rapidly, was to show there will be a frac sand market in 2020. Given that I think SLCA is a good way to play this market. When I originally wrote this article, SLCA was trading at $1.25 a share. I wasn't quite ready to bite and advised waiting until it got closer to a buck. Now with the break above $2.00, I am still skeptical and will wait for a retrenchment to ~$1.50/share. From this level, and a bottoming in the shale market later this year, I can see this stock doubling to ~$3.00/share this year, and again from there in 2021.
This article was written by
I am an oilfield veteran of 38+ years. Retired from Schlumberger since 2015. My background is drilling and completion fluids. I have authored a number of technical papers on completion topics. I have worked around the world- Brazil, Russia, Scotland, and the Far East. I still maintain a training and consulting practice and am always willing to help people who want to learn.
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