March 28, 2014 - 3:07pm EST by
2014 2015
Price: 135.50 EPS $3.67 $4.40
Shares Out. (in M): 23 P/E 36.9x 30.8x
Market Cap (in $M): 3,130 P/FCF 0.0x 0.0x
Net Debt (in $M): -90 EBIT 125 156
TEV (in $M): 3,040 TEV/EBIT 24.3x 19.5x
Borrow Cost: NA

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  • Pricing Pressure
  • Oil and Gas
  • Low Barriers to Entry
  • Competitive Threats
  • Oil Price Exposure


Investment Thesis – CARBO Ceramics common stock is a short because:

¦ High returns and no barriers to entry are causing rapid supply increases in CARBO’s market

¦ This increased supply will soon cause prices to fall as lower-cost domestic supply replaces higher-cost imports

¦ Even if prices do not fall CARBO is overvalued


Business Overview

CARBO is the world’s largest producer of ceramic proppant used in hydraulic fracking of oil and gas wells. As the company’s 10-k explains “The hydraulic fracturing process consists of pumping fluids down a natural gas or oil well at pressures sufficient to create fractures in the hydrocarbon-bearing rock formation. A granular material, called proppant, is suspended and transported in the fluid and fills the fracture, “propping” it open once high-pressure pumping stops. The proppant-filled fracture creates a conductive channel through which the hydrocarbons can flow more freely from the formation to the well and then to the surface”. Sand accounts for about 89% of all proppants used, with resin-coated sand at 7% and Ceramic proppant at only 4%.  Ceramic is by far the most expensive option costing 6-9x more than sand, but can provide better returns to drillers in certain geologies.

Excess Returns are Available to Market Entrants with No Barriers to Entry

There are no barriers to entry into the ceramic proppant market. Indeed, two new companies (Shamrock Proppants and CoorsTek) will begin producing this year.  The required raw materials (Kaolin or Bauxite) are widely available and the manufacturing / distribution process is rather simple.  A ceramic proppant plant takes about 1.5-2 years to build and costs approximately $0.33/lb of capacity.  Using current pricing and cost data yields an all-in after-tax return of approximately 16-28% as shown below.

Figure 1: Ceramic Proppant Economics

Project Assumptions   Unlevered Returns   Levered Returns
Plant size (mm lbs.) 500         Cost of project debt 5.0%
Capital expenditure per pound $0.33   Gross margin 55   Debt to total cap 50.0%
Total capex 165   G&A (5% of sales) 8      
Working capital (25% of sales) 40   Pre -tax profit 47   Pre -tax profit 47
Total investment ($mm) $205   Taxes (32%) 15   Interest 4
      Net income 32   Taxes (32%) 14
Revenue per lb. $0.32         Net income 29
Cost per lb (including maint capex) $0.21   Unlevered ROI 16%      
            Levered ROE 28%


Prices are Currently Set by High-Cost Chinese Imports

As in all commodity markets, prices for ceramic proppant are set by the high-cost producer which in this case is imports from China.  Ceramic proppant manufacturing involves little labor, but requires natural gas as a feedstock. Since the U.S. has much lower natural gas prices than China, Chinese and U.S. producers have very similar production costs.  However, shipping from China to the U.S. costs about $0.09 - $0.10/lb. so the delivered cost for Chinese producers is much higher.

It should not be surprising that the difference in Chinese producers’ costs relative to U.S. producers is almost exactly equal to CRR’s gross margin. Since there is significant excess capacity in China, Chinese producers are willing to ship to the U.S. at minimal profit.  Thus, the market price is about equal to Chinese’s producers’ costs as that is the lowest price required for Chinese firms to supply the market. Since CRR’s cost are about $0.10/lb. lower than the delivered cost for Chinese producers it is also about $0.10/lb. lower than the market price and that is CRR’s gross margin.


Rapidly Increasing Supply Will Soon Displace Imports

Basic economic theory contends it is impossible to sustain excess profits without barriers to entry because firms will increase supply in order to capture any excess profits thus driving down prices. This is exactly what is happing in CRR’s market. Since a ceramic proppant plant takes about 1.5-2 years to build, we have a fairly good idea of how much industry supply will be increasing in the next couple of years.  As shown if figure 2 below, domestic capacity is expected to increase over 60% in the next two years. Even assuming healthy demand growth of 11% annually, this supply growth will soon eliminate the need for imports into the U.S.  As such, the high-cost supplier will no longer be Chinese imports and the new high-cost supplier in the market will have a much lower marginal cost. This will cause prices to fall substantially impacting CRR’s profits. 

Figure 2: Domestic Ceramic Proppant Supply-Demand Forecast

2013 Ending U.S. Capacity   U.S. Supply Increase 2014-2015
CRR 1550   CRR 500      
Saint-Gobain 565   Imerys 450   2015E ending capacity 3,755
Imerys 220   Shamrock 120   2015E assumed  demand (2) 3,739
Current supply 2,335   CoorsTek 150   Import requirements (16)
Imports 800   Saint-Gobain 200      
Total demand (1) 3,035   Total increase 1,420      
(1) Does not add up because assumes new Saint-Gobain unit did not produce at capacity    
(2) Assumes demand grows 11%/yr based on conversations with industry sources      


Replacement Cost Analysis Supports Thesis

As shown in figure 3 below, the market currently values CRR at approximately 2.5x replacement cost. Economic theory requires that in the absence of barriers to entry, the value of a business’s normalized earnings should equal its replacement cost.  Since there are indeed no barriers to entry here, the fact that CRR trades well in excess of replacement cost supports the view that the company is over-valued.


Figure 3: CRR Replacement Cost

  Volume (mm lbs) Unit cost Replacement cost
2014E year end ceramic capacity 2,000 $0.33 660
Coated sand capacity 400 $0.11 44
Regular sand capacity 650 $0.02 15
Other assets (transportation)     100
Intangible assets (1yr of G&A)     65
Net working capital (incld cash)     304
Total     1,188
Per share     $51.43


Even if Prices Do Not Fall, CARBO is Overvalued

Lets assume that I’m wrong and prices for CRR’s product never fall while CRR is able to expand indefinitely at currently available returns. In this case, CARBO would be worth the perpetuity value of the company’s current earnings plus the value created by all growth in the future. As shown in figure 4 below, even if you assume CRR is able to invest $50mm of equity per year (about equal to 250mm lbs. of capacity) at 28% levered ROEs, CRR’s equity is only worth about $105/share – well below the current market price.

Figure 4: CRR is Overvalued Even if Prices Do Not Fall

      Equity investment per year 50
2014E EBITDA 208   Net value created by 1yr investment  (28% levered ROE) 71
- Maint capex 50   Total value of growth option (9% cost of capital) 786
- Taxes (32%) 50      
NOPAT 107   + excess cash 90
Perpetuity value of current business (9% cost of capital & 2% growth) 1,532   Total equity value 2,408
      Per share $104



Increases to Chinese Producers’ Costs – As discussed earlier, market prices for ceramic proppant in the U.S. are currently set by Chinese producers’ costs. As such, anything that increases these costs but does not impact CRR (such as Bauxite prices, freight rates from China, Chinese natural gas prices, etc.) would increase market prices and thus CRR’s profitability.  However, this impact would only effect the market until Chinese imports are displaced. Since we only expect the U.S. to import ceramic proppant from China for the next couple years, the long-term impact from an increase in Chinese producers’ cost would be minimal.

Greater-than-Expected Demand Growth – Demand ultimately depends on several factors such as commodity prices, shale formations and drilling techniques that cannot be estimated with high conviction. As such, it is possible demand grows materially faster than anticipated. However, even if demand grows at 20% per year in 2014 and 2015 (nearly double our estimate of 11% growth) the level of imports in to the U.S. would still fall. Thus, even in this case it is unlikely prices would actually increase. Furthermore, faster demand growth does not refute the thesis; it merely would take longer to play out. Therefore I view this risk as acceptable.

Project Completions – There is no guarantee that the planned supply increases will ever be completed, as even in-construction developments can always be stopped. However, the only plausible reason for this expanded capacity not to materialize would be a change in the underlying economics of the industry. If industry economics deteriorate fast enough to kill expansion projects, CRR’ business will be similarly impacted, and the short position will profit even faster.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


Lower proppant prices and lower earnings
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