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EMES: Frac Sand Rising

 

Oct. 2, 2017 3:20 PM ET
Paul Lebo, CFA
Long/short equity, Deep Value, value, hedge fund manager
 
(220 followers)

Summary

Emerge Energy Services LP is a potential multibagger at current prices between $8 and $9 a share.
 

Increased production capacity from the recent Osburn Materials acquisition and 24/7 production will help meet increasing demand for frac sand.
 

Although creditors and high debt continue to inhibit EMES’ ability to invest in its business, EMES is positively correlated with the price of crude oil and will see elevated demand.
 

By Nic Harvey and Paul Lebo, CFA

 

Emerge Energy Services LP (NYSE:EMES) primarily mines, produces and distributes silica sand, which is a crucial component of the hydraulic fracking process. EMES is positioned to service customers throughout the United States and Canada and is headquartered in Fort Worth, Texas with primary sand operations residing in Texas and Wisconsin.

EMES is currently trading at $8.05, a far cry from all-time-highs of over $145 per share nearly three years ago. At the time, the price of WTI Crude Oil was floating between the $90-$100 per barrel range. Consequently, as the price of crude has fallen over the last three years, the price of EMES has also suffered as demand for frac sand has diminished.
 

The acquisition of Osburn Materials located near San Antonio, which was completed in April 2017 for $20 million, will increase the annual production of EMES by 43% from 6.9mm tpy to 9.9mm tpy and will also increase reserves by 77% from 104.0mm tons to 184.0mm tons.

The acquisition will diversify EMES reserves from 26% local/74% northern white to 58% local/42% northern white and production from 9% local/91% northern white to 36% local/64% northern white. This is important because local and regional sands are approximately 30–35% of the frac sand market. The Osburn facility is strategically located in Texas as the delivered cost of sand to Eagle Ford Basin will be lowest in the country and the delivered cost to Permian Basin will be competitive with Brady, TX sites and lower than most midwestern plants. Frac sand demand in the Eagle Ford Basin, which reached a high of 15 mm tons in 2014 and declined to 7 mm tons in 2016, is expected to increase to 12 mm tons in 2017 and 17 mm tons in 2018. The acquisition will position EMES to take advantage of growth in Eagle Ford Basin. By mid-2018, EMES expects that it can increase Osburn production capacity 10x from 300,000 tpy to 3,000,000 tpy with its plant expansion plan. The acquisition will also allow EMES to enter other sectors of the frac sand market (construction, foundry, and sports sand) as Osburn currently does not sell any of its 400k tpy into the energy sector.
 

Between 2012 and 2014, EMES was able to increase revenue 5x from 67 million to 342 million as a result of a strong oil industry. This resulted in operating income increasing from 27 million to 93 million and an EPS high of $3.54 in 2014. However, as the oil industry weakened, revenue decreased to 128 million in 2016 resulting in an operating loss of 90 million. As the oil industry strengthens again, EMES believes it can drive a 200 million EBITDA increase by year end 2018 from negative 50 million in 2016 to 150 million. In order to accomplish this goal, the company expects to increase sales volumes from 2.2 million tpy to 8 million tpy. This growth will be driven as a direct result of an increasing demand for frac sand through year-end 2018 due to increased rig count and increases in drilling efficiencies. The consensus among Wall Street analysts is that the demand for frac sand will increase from 39 (tons in mm’s) to 83 (tons in mm’s) in 2017 and further increase to 112 (tons in mm’s) in 2018. The same analysts contribute this growth to growth in average proppant per Horizontal Well from 4.3 (tons in 000s) in 2016 to 6.7 (tons in 000s) in 2018.
 

Through the first half of 2017 EMES has increased revenue 3x from 54 million in the first half 2016 to 158 million in the first half 2017. The increase in revenue was due entirely to organic growth, with the company citing improved conditions in the frac sand market (rising demand and higher prices). In contrast, none of the revenue increase was tied to the Osburn acquisition, as the acquired operations did not come online for frac sand production until July 2017. While EMES is not profitable yet, management successfully slashed its first-half operating loss from 53 million to 9 million in the first half 2017.
 

Going forward, economic and geopolitical factors are expected to continue exerting upward pressure on the price of oil. Global demand is expected to rise while supply will continue to dwindle, increasing the likelihood that oil will remain above the $50 per barrel ceiling. Given the positive outlook for oil prices and growth of the fracking industry, experts believe higher rig counts and greater efficiencies in the drilling processes will propel demand for North American frac sand to 112 million tons in 2018, which far exceeds historical peak levels of 53 million tons set in 2014 (representing a 21% CAGR). As oil rises over the next one to two years, EMES is well-positioned to take advantage of appreciating oil prices and greater demand for frac sand.

Despite a challenging 2016, the company has demonstrated strength in 2017 through its acquisition of Osburn Materials, growing market awareness with new products, regaining market share and improving profitability. In the company’s Q2 earnings call, management reaffirmed it was delivering significant pricing improvements and operating its northern plants at full utilization. Given the production limits with existing capacity, the company is focused on integration and expansion of its newly acquired San Antonio, Texas site (related to Osburn Materials transaction). The San Antonio site, which is strategically located in the second most active shale play, will further support the diversification of EMES' product portfolio and help the company realize greater cost efficiencies with direct access to four Class One rail lines that can reach all major basins in North America on single hauls. It is worth noting that the plant commenced Phase 1 of frac sand production at the end of July and now aims to double frac capacity in Phase 2 to 600,000 tons per year with minimal required capital. Phase 3 will be the full-scale commercial frac sand plant implementation and is expected to be completed by early Q2 of 2018 with production goals of over 3 million tons per year.
 

Given the cyclicality of the oil and drilling industry, the company is focused on market trends such as customer profit intensity, amount of sand used per horizontal well, and is proactively positioning its business to better endure industry downturns. In response, the company is moving forward with two revolutionary technologies that start commercialization in 2018. SandMaxx, a unique patented self-suspending technology contacts more fissures during the completion process, releasing a higher amount of hydrocarbons compared to completions using raw frac sand. The expected incremental hydrocarbon recovery in a well has the potential to drive significant margin premium versus raw sand. The company also is preparing for new OHSA regulations beginning in June that will lower current permissible exposure to respirable silica by 50% by releasing a dustless proppant called SandGuard that prevents harmful silica dust from being released into the air. Use of this technology is intended to ultimately eliminate the need for expensive mechanical dust control systems. The company also leases its sites to retain valuable flexibility when customer activity moves within and between certain basins. Finally, EMES is capitalizing on the current period’s tight supply of fine grade sands by securing take or pay contracts with key customers. With over 60% of 2017 projected volume under take or pay contracts, these agreements contain significant penalties for shortfall quantities, which will help bolster financials whenever the next downturn may occur.
 

Currently, EMES is trading at a P/E of five times earnings, which is substantially lower than other industry competitors, even at these depressed oil prices. For the reasons expressed in this article, we view EMES as a multibagger and conservatively expect the EMES stock price to trade at levels of 12 to 15 times earnings, with potential for greater returns positively correlated with increased oil production.
 

There are always risks to consider with a company so closely tied to the oil and drilling industry. It is also worth highlighting that short-term pressures, such as Hurricane Harvey, have the potential to put upward pressure on the dilapidated stock price of EMES. When affected producers who were forced to cut back or even abandon production operations entirely due to Hurricane Harvey recover, we anticipate an uptick in demand for the silica sand that EMES produces. Likewise, the rising tensions between the United States and North Korea (and its allies China and Russia) have the capacity to affect crude prices due to the large volume of oil traded between the countries. Additionally, the massive debt EMES currently has on its balance sheet overshadows equity by a multiple of 3.5 and is alarming to an extent, when not accounting for other business factors. These factors include the aggressive business expansion by CEO Richard Shearer and team to meet increasing demand for mesh sands (primarily the operations in San Antonio, Texas from the recent Osburn Materials acquisition). Also to be taken into account, is the real industry supply number, which is 10% to 20% less than current reported figures as noted in the article 5 Things Emerge Energy Services Management Thinks You Should Know.

 

While the amount of long-term debt is considered risky, management has taken steps to lower its debt burden and improve liquidity. During the fiscal year 2016, EMES was able to reduce its long-term debt balance by 56% (from $295 million to $134 million) by divesting its Fuel business and selling 3.4 million shares @ $10.00 per share. Management also refinanced senior debt further improving liquidity. When debt is compared to market value of equity, debt is currently 38% of the capital structure. As of the end of second quarter 2017, the long-term debt is $170 million, the current market cap is $276 million. By reducing its ABL balance, the company freed up liquidity enabling it to finance the San Antonio transaction without diluting shareholder value.
 

The share price for EMES hovering in the $8 to $9 range is extremely attractive but, at the very least, worth tracking in the coming weeks for those with debt concerns for the company. However, if oil continues to climb as expected, this will result in an increase in production, subsequent rise in EMES shares, and continued upward pressure from increased production capacity.
 

By Nic Harvey and Paul Lebo, CFA

Disclosure: I am/we are long EMES.

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.