Have you ever worked on a stock and came to the conclusion it could either double or go to zero? I have and I did again last week. In an effort to limit mistakes and maintain an attractive batting average, as an absolute return investor, I try to avoid coin flip investing. During my resent search for discounts in the energy sector, I discovered the industry was filled with potential coin flips. CARBO, the market leading ceramic proppant manufacturer in the oil and gas industry, is a good example.
What’s worse than being in a commodity business? Selling a commodity to a commodity business. While I’m certain CARBO would argue most of their products are proprietary, they compete with a commodity known as sand. As energy prices declined in 2014-2016, energy and production companies looked for ways to reduce finding and development expenditures. In their effort to lower costs, many energy companies increased the use of sand in their fracking process. Furthermore, less expensive imported proppants were also threatening market share. In effect, CARBO faced stiffer competition from lower cost providers at the same time energy exploration budgets were being slashed. It was a devastating combination.
Prior to the bust, oil was trading near $100/bl (2011-2014), with exploration and production companies focusing almost exclusively on production growth. As oil prices traded well above all-in costs, companies were willing to pay for higher-end proppants to maximize production. Elevated oil prices also made higher cost reserves at lower depths economical. This benefited CARBO as their proppants are more effective at lower depths (higher pressure) than sand and lower quality proppants.
As Wall Street flooded the energy industry with cheap capital, the race to grow production was on – CARBO’s business was booming. Due to surging demand, CARBO expanded capacity aggressively with capital expenditures far exceeding depreciation during the boom years. CARBO was a popular growth stock, reaching $180 in 2011! Earnings also peaked in 2011, with EPS reaching $5.62 (CARBO is a good example of investors confusing cyclical growth for sustainable growth). Currently trading at $7/share and losing money (-$3.29 EPS in 2016), CARBO has seen better days.
Fortunately for CARBO, revenue trends are beginning to recover. With capital budgets and rig counts in North America increasing, the demand for proppants is improving. Recent results from the major service providers (SLB, BHI, and HAL) and CARBO confirm this trend. The below quotes are from last quarter’s earnings reports and conference calls.
Halliburton (HAL): “North America activity increased rapidly during the first quarter, which was highlighted by our U.S. land revenue growth of nearly 30%, outperforming the sequential average U.S. land rig count growth of 27%.”
Baker Hughes (BHI): “The ramp-up in North America has been more robust than many had expected. Along with this growth, we’ve had to work through the challenge of supply chain tightness, with labor and materials cost inflation [would include proppants] impacting select product lines and basins.”
Schlumberger Limited (SLB): “The recovery will clearly be led by North America land, where investment levels are expected to increase by 50% in 2017, leading to a strong increase in activity and an overdue correction to service and product pricing.”
CARBO Ceramics (CRR): “Given the first quarter revenue and our outlook for the next couple of quarters, we believe our 2017 revenue will show strong double-digit growth of at least 40% increase over the 2016.”
With CARBO’s net assets selling significantly below replacement value and its business trends improving, why wouldn’t I consider buying the equity? Unfortunately, in my opinion, CARBO possesses both financial risk and operating risk (disqualifies CRR as an absolute return holding). With $56 million in cash and $109 million in net working capital, the company should have adequate liquidity this year. Furthermore, the majority of its $73 million in debt was recently refinanced out to 2022.
While CARBO should have sufficient liquidity for 2017, if its cash burn rate remains negative (possible if energy cap ex budgets are cut), liquidity and financial risk could increase and is a concern. The company burned $24 million in cash in Q1 2017 after a $13 million negative free cash flow drain in Q4 2016. As you can see, at current rates, it wouldn’t take long for CARBO to spend its remaining cash and run into liquidity issues. Fortunately, management expects the company’s cash burn rate to improve sequentially and exit 2017 at a neutral rate (we’ll know more next week when CARBO reports earnings).
Given CARBO’s balance sheet risk (liquidity relative to cash burn) combined with its extremely cyclical business, it’s not an appropriate investment for my absolute return portfolio. That said, I’ve been pondering if several energy stocks, such as CARBO, would be worthwhile “coin flip” speculations for option strategies – owning puts and calls. In effect, a position that would pay off if things go great or awful (I’m expecting one or the other for CARBO). I’m certainly not an option expert (I often get the idea right, but the timing wrong!), and it would clearly be a speculation, but I think it’s interesting to think about nonetheless. As a side note, you know your opportunity set is bad when you’re contemplating ways to profit from a coin flip!
In conclusion, my search for value in the small cap energy sector has generated several possible buy ideas. While I believe there are many energy companies selling at discounts to net asset values, most balance sheets appear ill-equipped to handle an extended period of depressed commodity prices. In other words, there is value in energy, but is there sufficient liquidity or time for that value to be realized? Until balance sheets improve, I expect to find more coin flips in the energy sector than investments that meet my buy criteria for cyclical businesses.