EMERGE ENERGY SERVICES LP EMES
September 24, 2014 - 6:06pm EST by
nychrg
2014 2015
Price: 116.77 EPS $3.11 $8.81
Shares Out. (in M): 24 P/E 37.6x 13.3x
Market Cap (in $M): 2,802 P/FCF 26.0x 11.3x
Net Debt (in $M): 162 EBIT 83 220
TEV ($): 2,964 TEV/EBIT 35.7x 13.5x

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  • MLP
  • Network effects
  • Potential Future Acquisitions
  • Potential Merger
  • Negative Sentiment
  • Oil and Gas
  • Energy services

Description

 
Introduction

We are posting a timely investment idea to take advantage of the recent, unserved sell-off in the stock. We are reccommeding Emerge Energy (EMES) as a compelling long and believe the stock is well positioned to generate 50%+ upside returns in the coming 12-18 months.

The stock has upcoming catalysts, and many of its risks (discussed below) are hedgeable.

EMES is an MLP poised to grow their annual dividend from about $4 in 2014 to $10.35  in ’15 and $12.50 in ’16. Company description follows but as a large supplier of sand sold into fracking, EMES is endowed with a high quality sand resource base, a nationwide logistics footprint, and long term contracts with creditworthy customers like Schlumberger (~38% of EMES's sales), Baker Hughes, Halliburton etc. The company is poised to reap the benefits of a significant capacity investment (already funded) which will increase their 2015 production by 2x (over 2014/early 2015) all of which is already spoken for via long term contracts. The expansion should drive dividend growth of more than 100% in the coming year. Industry demand for sand is robust and growing (and set to remain strong for an extended period of time) due to numerous secular tailwinds described in more detail below.

Our variant perspective is that first movers (like EMES) that possess a national distribution footprint benefit from a network effect that new entrants and small producers will be unable to attain. As such, we expect EMES and other large incumbents to grow market share and strengthen their network effect in the coming years. Furthermore, EMES, an MLP with a low cost of capital, will be able to further expand via M&A if they choose to do so. Our estimates do not factor in potential M&A although it remains an upside call option to this story. A further benefit of EMES’ MLP structure is that the GP owner received no IDR’s and hence no further dilution going forward. Another potential call option in our valuation (with potential to the upside) are price increases on sand due to potential near and intermediate term shortages.

Finally we like that 100% of free cash flow gets paid out in dividends and that based on our estimates, the company would return to us almost $25 in dividends over the next 24 months. We were previously paired with a short on CRR (well written thesis on VIC) but have since covered the short after it imploded. We see the shift from ceramics to sand as benefitting EMES and would look to pair up against CRR should it rebound.  

 

The Opportunity

Despite strong and improving fundamentals, we believe that the stock has recently fallen dramatically due to: a) Momentum/beta sell-off in September, b) Rate fears hitting MLPs, c) Poor energy sentiment, d) Competitor IPO being launched a couple of days ago and e) Fears of the sponsor selling stock in the next 12 months. We believe that commodity prices would have to fall dramatically (oil below $75 and gas below $3) for demand destruction to threaten EMES’ contracted tonnages for ’15 and ’16; further this commodity risk is hedge-able. We expect rates to stay in a reasonable range during our investable time period although rates are also hedge able. We see the energy sentiment related sell-off as an opportunity since frack sand producers are benefitting from secular growth drivers and should remain insulated from operating volatility as long as energy prices remain within our expected range. The competitor's IPO will increase capacity for publicly traded frac sand market cap which is supply that will have to be absorbed but we think this short term negative is offset by the spot light highlighted by the roadshow and new coverage which will likely tout the strength of this niche sub-sector.

Finally, a recent WSJ article enabled the equity sponsor to take a victory lap and all but announced a secondary (or two) in the coming year (http://online.wsj.com/articles/small-firm-strikes-it-rich-with-fracking-sand-1410801465). Our view is that the sponsor originally invested hoping to sell sand to golf courses and ended up, due to the fracking transformation, with a goldmine. To their credit the sponsor executed exceedingly well and has generated an embarrassment of riches. We credit them with installing a management team with strong execution skills but we are not looking at their exit as timing the top of the cycle and recognize as private equity they need to monetize for various reasons, such as to raise their next fund or pay their investors dividends. 

 

Background Information

Emerge Energy Services, LP (EMES) is a Delaware Limited Partnership formed in 2012, which became a publicly traded partnership on May 14th 2013. The company’s operations are split between two segments:

1.       Sand Segment (“Super Silica Sands LLC”): Mining, processing and distributing high quality, “northern white” fracking sands, a key input for the hydraulic fracturing of oil and gas wells.

2.       Fuel Segment (“Direct Fuels”, “Allied Energy Company”): Fuel processing and distribution. The company processes transmix, distributes refined motor fuels and renewable fuels, operates bulk motor fuel storage terminals and provides other complementary services

By and large, the fuel segment provides the bulk of EMES’s revenues, even though the sand segment makes up a majority of EMES’s EBITDA (and is key to EMES’s growth going forward):

 

2011

2012

2013

 

1Q'14

2Q'14

Adjusted EBITDA

9.3

38.6

85.2

 

28

30.1

% YoY

 

316%

121%

     

Sand

3.9

33.8

66.6

 

22.2

23.2

Fuel

5.4

4.9

23.1

 

7.6

9.8

Corporate

 

-0.1

-4.5

 

-1.8

-2.8

 

2011

2012

2013

 

1Q'14

2Q'14

% of EBITDA

           

Sand

42%

87%

74%

 

75%

70%

Fuel

58%

13%

26%

 

25%

30%

% of Revenues

           

Sand

7%

11%

19%

 

23%

26%

Fuel

93%

89%

81%

 

77%

74%

 

EMES’s sponsor is Insight Equity, which owns 30% of EMES’s Common Units. Unlike other publicly traded MLPs, EMES has a simplified MLP structure: All units are common units (including the Sponsor’s stake), there are no Incentive Distribution Rights, and no Minimum Quarterly Distribution. We like that the sponsor has aligned its financial interests alongside with common unit holders like ourselves. EMES pays out 100% of its available cash to common unitholders.

Our Perspective, Why we like EMES:

We believe that EMES is well-positioned to double its dividend payment out to common unitholders by 2015, due to strong secular demand tailwinds and supply constraints that will help grow EBITDA. The company’s common unitholder friendly policies will see growing distributable cash flow into the future.

Sand Segment

The frac sands business is in the midst of a robust, multi-year growth trajectory. E&P operators have been seeking to optimize well results, and newly introduced fracking technologies have resulted in E&P operators using significantly more frac sand/well (as much as 10x historical amounts in the ultra-deep Utica wells). In addition, the trend has been moving towards using more frac sand vs. ceramic proppants due to frac sand’s cheaper pricing. The demand for sand has increased over the years, from 150,000lbs per frac stage to as much as 500,000 lbs per frac stage. Meanwhile, the number of frac stages per well has increased from an average of ~10 stages to ~25 stages per well. As such, the demand for sand on a per well basis has increased from ~1.5M lbs/well to as high as 10-12.5M lbs/well. The average amount of sand used per well is thought to be still around 3.5M lbs/well, but that figure continues to increase, setting the stage for demand to grow at around 25-30% YoY (according to Goldman Sachs, Morgan Stanley, as well as management forecasts from the frac sand companies).

Currently, EMES’s dry plants have a total capacity of 4.4M tons, and the company is on track to introduce an additional 5.0M tons of capacity by 2015 (2.5M in 4Q’14 and 2.5M in 1Q’15). The company has also indicated plans to increase capacity by another 2.5M tons, bringing the total capacity to ~11-12M tons in the near future (we think by 2016/2017).

EMES also has a very strong transportation and logistics network, which is a key ingredient to the company’s success as it allows the company to serve its customers near the wellhead. EMES has 13 transload facilities across North America: 3 in Western Canadian Sedimentary Baasin, 5 serving the Texas area basin, 4 in the Marcellus/Utica, and 1 serving the Bakken. In addition, the company is negotiating for further leasing and contracting of additional transload facilities to set up a “store-front” for its clients, something that we see major frac sand suppliers do, as they are increasingly tasked with the assignment of handling all logistics from the mine to the wellhead.  

In sum, we think that EMES’s Sand Segment is poised to grow volumes sold through capacity expansions, which together with strong pricing, will drive multi-year growth in EBITDA and distributable cash flow to shareholders.

While ramping production capacity entails some hurdles (capital, permitting, securing machinery and equipment) all of which require expertise and foresight, all these can be overcome in 6 - 12 months. The significant bottleneck remains distribution and logistics, which are poised to remain bottlenecks for the foreseeable future. As sand is a bulk commodity, the entire sand supply chain, from covered hopper availability, to railroad service, to transload facility capacity, to last mile distribution capacity is woefully unprepared for the current (and future) growth in demand for sand at fracking sites. As described above, some wells are now talking more than 10x the quantity of sand relative to a few years ago due to various drilling enhancements (described below), and in smaller part due to a shift away from ceramic to sand. Further, up and coming basins like the Utica are taking significantly more sand due to their geology. There are anecdotal reports of some deep wells in the Utica wells taking a unit train of sand per well, or 100 train loads per well.  

Strong Secular Demand Tailwinds

Advancements in drilling technologies have resulted in an exponential increase in the demand for fracking sands, best represented by:

Proppant Demand =

Horizontal Rig Count × Wells/Rig × Lateral Length × Stages/Lateral × Proppant/Stage

 

As E&P operators opt to pump longer lateral lengths, more stages per lateral, and use more proppant (sand) per stage, we see that demand for fracking sands is poised to grow dramatically. Anecdotally, in 2013, lowest-quartile operators pumped ~500 tons of sand per well, and a year later, these operators have pumped 44% more fracking sands per well. Leading edge E&P operators have been seen pumping up to 8,000 - 10,000 tons of sand-- a whole unit train (100 rail cars) full of them!

According to data from FracFocus.com, the median operator used ~1,300 tons of sand/well in April 2013, and that has increased to ~1,800tons of sand/well in March 2014, representing a ~35-40% YoY increase in the amount of frac sand used/well. Using statistics from operators in the lowest quartile, the amount of frac sand used per well has increased by 44% YoY between the same time period.

The top 10 sand intensive operators account for ~19% of total wells, based on estimates made by Morgan Stanley and FracFocus. As such, there is still room for larger market penetration of high-frac-sand usage across wells and basins.

Credible industry estimates suggest frac sand demand could double in 2016 vs. 2013, driven by the multiplier effect of: increase in horizontal rig counts, well counts, frac stages and sand usage/stage.

Relevant WSJ article describing the forecast for frac sands up till 2015:

Forecast for frac sand through 2015

Compelling Economics for Increased Frack Sands Usage

Using more sand/well:

From SM Energy’s 2Q’14 earnings presentation: Increased sand/well produced an average well rate of return of 40%, making the economics highly compelling for the driller.

SM Energy 2Q'14 Earnings Presentation

     
 

Old

New

% Change

Avg. Lateral Length (ft)

5,008

5,176

3.4%

Avg. Sand / Lateral Foot (lbs)

1,128

2,025

79.5%

Sand/Well (tons)

2,825

5,241

85.5%

Avg. Cost ($mm)

7

7

1.6%

Rate of Return Increase: 40%

     
 

This has resulted for a “mad-dash” for frac sands, and we have seen that prices for frac sands have increased by ~20-30% in the spot market at various intervals. Oil companies’ seemingly insatiable appetite has generated renewed interest in second-tier deposits of lower-quality brown sand from places like Texas and Arkansas.

Shifting from ceramics to sand:

Rosetta Resources:

John D. Clayton: “If you strictly kept the proppant amount the same at about 270,000lbs/well and went from ceramic to sand, we’re saving close to $900,000 per well (that’s ~14% of cost savings based on ~$6.25M/well)... But our plans going forward are to move to sand…” “(And in the Eagle Ford) We’re going to go to 100% sand, and we’re going to increase the sand amount to try to catch up to the amount of conductivity that ceramic gave us. So we’re going to go to 100% sand”

Strong Barriers to Entry, Supply Contraints

1.       Good quality sand located near rail lines are difficult to find/mine

2.       Permitting is increasingly difficult to complete

According to an article put out by the WSJ, the dozens of new sand-mine permits (and even if a new mine is permitted, one would have to get it close enough to the rail lines to make it economical) have “triggered a massive public backlash about the truck traffic, dust and breathing problems these operations can create. Now many state and county-level officials are trying to slow the sector’s expansion” http://online.wsj.com/articles/demand-for-sand-takes-off-thanks-to-fracking-1407193760

3.       A huge supply constraint: Access to Rail roads, rail cars and logistics

It can take anywhere from 25 rail cars to transport enough sand to frack one well, and up to a unit train (100 rail cars) for a deep Utica well. Increasingly, as operators are experimenting with sand volumes closer to that which requires a unit train to transport, a huge bottleneck to the process is the lack of availability of railcar and railroad capacity to deal with the increased traffic volume. Currently, the backlog for a covered hopper (used to transport grain/sand) is 2-3 years.

EMES has a rail-fleet of 4,700 cars, and is expected to reach 6,400 by 2016 and thus will have enough rail cars to deal with increased capacity coming online). In addition, EMES’s new transload facilities will allow it to get onto 4 Class 1 railroads.

Increasingly, the industry’s dynamics have evolved into one so that customers are expecting the sand provider to execute on all logistic requirements. Formerly, 75% of sales would occur at the mines, and 25% near the wellhead, but that has now changed to the other way around: ~75% near the wellhead and 25% at the mine. Hence, the prevalent trend is toward scale as a critical requirement and therefore the big guys get bigger, and the smaller sand producers increasingly lose out, or get bought out by the larger producers. Participants across the supply chain, such as the railroads, railcar manufacturers and leasing companies, and large pressure pumpers, seek to align with those that possess a national footprint and who can provide scale. 


EMES Specific: Contracted Volumes provide for Limited Downside

Currently, EMES has ~7.4M tons of sand volumes under long term contracts. To refresh, EMES had 4.4M tons of capacity as of 4Q’13, and is bringing an additional 2.5M tons at the end of this year as well as an additional 2.5M tons in early 2015. Triangulating the numbers, we estimate that EMES has contracted roughly 95-100% of expected 2015E sales, and 88% of 2016E sales. We are attracted to the contracted nature of the business and to the implied dividends ~ $10 in ’15 and $12.50 in ’16 so long as EMES can execute on the contracts. Further, we continue to see contracts for tonnage in out years, providing some comfort that the dividends are sustainable beyond 2016. We also note that pricing has only recently begun to move off its long term level and hence new contracts are likely to show some upside in pricing along with built-in PPI / cost+ / pricing escalators.

Customer Concentration

Schlumberger represents EMES’s largest customer, ~38% of its sales. 11 customers make up >90% of total sales of the company. Increasingly, we believe that the large customers would prefer to deal with less suppliers with sufficient scale to deal with not only delivering signficant volumes of sand on time, but also with increasingly complex logistical demands (larger customers can have greater bargaining power with railroads, railcar manufacturers, transload leasing companies, trucking companies etc).

Additional Upside

We have also been told that when market pricing is strong, EMES is able to capture ~20% of the pricing upside even if the sands are being contracted with long term contracts. In addition, the company also is able to capture spot market pricing (increased as much as 20-30% this year) for volumes that aren’t on contract.

Fuel Segment

EMES’s fuel segment provides transmix refining, terminalling, whole distribution and biodiesel refinery services.

Our initial analyses tells us that it is a rather stable business as EMES’s transmix facilities are located along major pipelines, and its revenues are derived from a diverse mix of stable margin and fixed-fee activities. The company has guided to a “floor” of $20M of EBITDA from this segment per year, although we note that the company’s 1Q’14 and 2Q’14 fuel segment EBITDA has an annualized value of ~$35M. For the sake of posting this write up in a timely manner, because we do not expect fuel to be a key driver of the stock, we are limiting the discussion here and focus on the the sand segment instead, as it is the growth driver of the business and the stock.

Turning it into Numbers

Calculating dividend/share:

FCF RECONCILIATION / DIVIDEND

2011

2012

2013

2014E

2015E

2016E

Adj. EBITDA

9.3

38.6

85.2

118.5

260.8

314.9

Minus: Cash Interest

3

11

11

8

8

8

Minus: Cash taxes

0

0

0

0

0

0

Minus: Maintenance Cap ex

0.97

2.52

2.39

2.5

3.92

4.23

FCF, Dividend to be paid

4.8

24.9

71.6

107.8

248.7

302.5

Dividend/share

   

$2.98

$4.49

$10.35

$12.59

Dividend Yield

0.2%

0.9%

2.6%

3.8%

8.9%

10.8%

Income Statement

EMES

           
 

2011

2012

2013

2014E

2015E

2016E

Revenues

377

624

873

1,123

1,454

1,565

% YoY

 

65%

40%

29%

30%

8%

Sand

28

67

168

284

615

726

Fuel

349

557

705

839

839

839

COGS

360

575

768

976

1143

1194

Gross Profit

18

49

105

146

310

372

Gross Margin

5%

8%

12%

13%

21%

24%

Depreciation, depletion & Amortization

7

9

21

29

46

52

SG&A

9

10

27

34

45

48

IPO related costs

   

11

     

Impairment charges

1

         

EBIT

1

29

47

83

220

272

Interest expense

3

11

11

8

8

8

Loss (gain) on extinguishment of debt

0

0

1

     

Gain on extinguishment of trade payable

-1

         

Other

0

1

-1

     

EBT

-1

17

36

75

212

263

Provision for taxes

0

0

0

     

Net Income (loss)

-1

17

35

75

212

263

Less Predecessor Income before May'13

   

13

     

Net income ex. Predecessor

   

22

     

DEPS

   

$0.92

$3.11

$8.81

$10.97

Shares, diluted

   

24.02

24.02

24.02

24.02

Segment Information and Financials

Drivers of Sand Segment Volume/Pricing

2011

2012

2013

2014E

2015E

2016E

Volume (tons, M)

0.4

1.2

2.7

4.0

7.5

8.4

% YoY

 

220%

117%

49%

89%

12%

Utilization (of 8.8M total)

     

45%

85%

95%

Implied Blended Price ($/ton)

$74

$55

$63

$71.59

$82.17

$86.88

% YoY

 

-26%

16%

13%

15%

6%

Roll-Off / New-Contracts

           

% of legacy volume rolling off contracts

     

10%

10%

10%

Legacy volume rolling off contract

     

0.27

0.4

0.75

New Pricing

     

$82

$90

$100

% YoY

     

30%

10%

10%

Legacy Revenue - Rolled Off

     

22

36

74

             

New Capacity

     

1.31

3.52

0.88

New Capacity ASP

     

$82

$90

$100

New Capacity Revenue

     

108

319

88

             

% legacy volume contracted

     

90%

90%

90%

Legacy volume- contracted

     

2.39

3.56

6.73

Legacy ASP- Contracted

     

$64.55

$73.03

$83.82

% YoY (CPI/PPI escalations)

     

2%

2%

2%

Contracted legacy revenue

     

154

260

564


Sand Segment

2011

2012

2013

2014E

2015E

2016E

Total revenues

28

67

168

284

615

726

COGS

20

27

91

171

332

382

COGS/ton

$52.05

$22.43

$34.48

$43.10

$44.40

$45.73

% YoY

 

-57%

54%

25%

3%

3%

Gross Profit

8

39

76

113

283

344

Gross Margin

29%

59%

46%

40%

46%

47%

Gross Profit/Ton

$21.72

$32.15

$28.80

$28.49

$37.78

$41.15

D&A

4

6

10

17

34

40

SG&A

5

6

11

17

37

44

Impairment of assets

1

         

EBIT

-2

27

55

79

212

260

Adjusted EBITDA

4

34

67

96

246

300

Adjusted EBITDA margin

14%

51%

40%

34%

40%

41%

Adjusted EBITDA YoY growth

 

770%

97%

44%

156%

22%

             

EBITDA/Ton

$10.17

$27.65

$25.13

$24.19

$32.84

$35.94

% YoY

 

172%

-9%

-4%

36%

9%


Fuel Segment

2011

2012

2013

2014

2015

2016

Total revenues

349

557

705

839

839

839

Revs growth assumption

 

60%

27%

     

COGS

340

548

676

805

811

811

Gross Margin

3%

2%

4%

4.00%

3.30%

3.30%

D&A

3

3

10

12

12

12

SG&A

4

5

6

5

5

5

EBIT

3

2

13

16

11

11

Adjusted EBITDA

5

5

23

28

23

23

Adjusted EBITDA margin

2%

1%

3%

3%

3%

3%

Capital Structure:

EMES Capital Structure

 

($M)

 

$350M Revolving Credit Facility (L+ ~263bps ) of 06/27/19

170

Other Long-Term Debt, Capital Lease

3.4

Total Debt

173

Cash

12

Net Debt

162

   

Shares

24

Price

$117

Market cap

2,802

   

Enterprise Value

2,964

Valuation

 

Using a 6% dividend yield on the $10.35 projected dividend for 2015, (which is in line with the Alerian MLP index), EMES’ 2015E price would be $183, a 57% upside from today’s closing price of ~$117.

2015E Price Targets

       
 

ASP % increase in Sand Spot

     

Yield:

5%

10%

15%

20%

5%

$195

$207

$220

$232

6%

$162

$173

$183

$193

7%

$139

$148

$157

$166

8%

$122

$129

$137

$145

         

% Upside to today's closing price

$116.77

     

At Yield:

       

5%

67%

77%

88%

99%

6%

39%

48%

57%

66%

7%

19%

27%

34%

42%

8%

4%

11%

18%

24%


2016E Price Targets

       
 

ASP % increase in Sand Spot

     

Yield:

5%

10%

15%

20%

5%

$229

$252

$275

$299

6%

$191

$210

$229

$249

7%

$164

$180

$196

$213

8%

$143

$157

$172

$187

         

% Upside to today's closing price

$116.77

     

At Yield:

       

5%

96%

116%

136%

156%

6%

64%

80%

96%

113%

7%

40%

54%

68%

83%

8%

23%

35%

47%

60%


Conclusion:

The North American land market is undergoing a significant transformation with enhanced drilling technologies driving significant demand growth for frac sand. Simultaeously, the bulk commodity nature of sand is leading to significant and pervasive supply chain bottlenecks which will not be cured in the next couple of years. Large incumbent producers like EMES, that possess a national logistics footprint are reaping the benefit of increasing sales volume and price increases. Going forward we expect their national logics network to provide a sustainable moat during the ’14-’16+ grow ramp leading to significant dividend increases, market share growth, and equity appreciation. As the industry grows and matures we expect to see consolidation led by incumbents like EMES who possess a low cost of capital and strong relationships with both customers and logistics partners like railroads and rail car manufacturers.

 

Risks:

Risks to our thesis include a significant (>20%) fall in oil, gas or liquids prices (could be hedged — short pressure pumpers or the commodity) , a significant rise in rates hurting yield focused MLPslike EMES (could be hedged — short IYR, AMLP, or rates), the development of substitute for sand, and new regulations adverse to fracking (could be hedged — short pressure pumpers). 

 

Relevant news articles / Investor links:

http://online.wsj.com/news/articles/SB10001424052702304868404579194250973656942

http://online.wsj.com/articles/demand-for-sand-takes-off-thanks-to-fracking-1407193760

http://online.wsj.com/articles/small-firm-strikes-it-rich-with-fracking-sand-1410801465

http://ir.emergelp.com/phoenix.zhtml?c=251428&p=irol-presentations

 
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.

Catalyst

1. Realization of the market that pressure pumpers / E&P operators are increasingly moving towards frac sands as their preferred choice of fracking proppants
2. The addition of new capacity coming online and the proper execution of that new capacity coming alone
3. Increase in demand for frac sands due to the convergence of frac sand usage towards median/leading-edge operators' level of frac sand usage/well
4. Increasing dividend payments due to growing EBITDA
5. New capacity expansion announcements
6. Announcements about the increase in pricing
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    Description

     
    Introduction

    We are posting a timely investment idea to take advantage of the recent, unserved sell-off in the stock. We are reccommeding Emerge Energy (EMES) as a compelling long and believe the stock is well positioned to generate 50%+ upside returns in the coming 12-18 months.

    The stock has upcoming catalysts, and many of its risks (discussed below) are hedgeable.

    EMES is an MLP poised to grow their annual dividend from about $4 in 2014 to $10.35  in ’15 and $12.50 in ’16. Company description follows but as a large supplier of sand sold into fracking, EMES is endowed with a high quality sand resource base, a nationwide logistics footprint, and long term contracts with creditworthy customers like Schlumberger (~38% of EMES's sales), Baker Hughes, Halliburton etc. The company is poised to reap the benefits of a significant capacity investment (already funded) which will increase their 2015 production by 2x (over 2014/early 2015) all of which is already spoken for via long term contracts. The expansion should drive dividend growth of more than 100% in the coming year. Industry demand for sand is robust and growing (and set to remain strong for an extended period of time) due to numerous secular tailwinds described in more detail below.

    Our variant perspective is that first movers (like EMES) that possess a national distribution footprint benefit from a network effect that new entrants and small producers will be unable to attain. As such, we expect EMES and other large incumbents to grow market share and strengthen their network effect in the coming years. Furthermore, EMES, an MLP with a low cost of capital, will be able to further expand via M&A if they choose to do so. Our estimates do not factor in potential M&A although it remains an upside call option to this story. A further benefit of EMES’ MLP structure is that the GP owner received no IDR’s and hence no further dilution going forward. Another potential call option in our valuation (with potential to the upside) are price increases on sand due to potential near and intermediate term shortages.

    Finally we like that 100% of free cash flow gets paid out in dividends and that based on our estimates, the company would return to us almost $25 in dividends over the next 24 months. We were previously paired with a short on CRR (well written thesis on VIC) but have since covered the short after it imploded. We see the shift from ceramics to sand as benefitting EMES and would look to pair up against CRR should it rebound.  

     

    The Opportunity

    Despite strong and improving fundamentals, we believe that the stock has recently fallen dramatically due to: a) Momentum/beta sell-off in September, b) Rate fears hitting MLPs, c) Poor energy sentiment, d) Competitor IPO being launched a couple of days ago and e) Fears of the sponsor selling stock in the next 12 months. We believe that commodity prices would have to fall dramatically (oil below $75 and gas below $3) for demand destruction to threaten EMES’ contracted tonnages for ’15 and ’16; further this commodity risk is hedge-able. We expect rates to stay in a reasonable range during our investable time period although rates are also hedge able. We see the energy sentiment related sell-off as an opportunity since frack sand producers are benefitting from secular growth drivers and should remain insulated from operating volatility as long as energy prices remain within our expected range. The competitor's IPO will increase capacity for publicly traded frac sand market cap which is supply that will have to be absorbed but we think this short term negative is offset by the spot light highlighted by the roadshow and new coverage which will likely tout the strength of this niche sub-sector.

    Finally, a recent WSJ article enabled the equity sponsor to take a victory lap and all but announced a secondary (or two) in the coming year (http://online.wsj.com/articles/small-firm-strikes-it-rich-with-fracking-sand-1410801465). Our view is that the sponsor originally invested hoping to sell sand to golf courses and ended up, due to the fracking transformation, with a goldmine. To their credit the sponsor executed exceedingly well and has generated an embarrassment of riches. We credit them with installing a management team with strong execution skills but we are not looking at their exit as timing the top of the cycle and recognize as private equity they need to monetize for various reasons, such as to raise their next fund or pay their investors dividends. 

     

    Background Information

    Emerge Energy Services, LP (EMES) is a Delaware Limited Partnership formed in 2012, which became a publicly traded partnership on May 14th 2013. The company’s operations are split between two segments:

    1.       Sand Segment (“Super Silica Sands LLC”): Mining, processing and distributing high quality, “northern white” fracking sands, a key input for the hydraulic fracturing of oil and gas wells.

    2.       Fuel Segment (“Direct Fuels”, “Allied Energy Company”): Fuel processing and distribution. The company processes transmix, distributes refined motor fuels and renewable fuels, operates bulk motor fuel storage terminals and provides other complementary services

    By and large, the fuel segment provides the bulk of EMES’s revenues, even though the sand segment makes up a majority of EMES’s EBITDA (and is key to EMES’s growth going forward):

     

    2011

    2012

    2013

     

    1Q'14

    2Q'14

    Adjusted EBITDA

    9.3

    38.6

    85.2

     

    28

    30.1

    % YoY

     

    316%

    121%

         

    Sand

    3.9

    33.8

    66.6

     

    22.2

    23.2

    Fuel

    5.4

    4.9

    23.1

     

    7.6

    9.8

    Corporate

     

    -0.1

    -4.5

     

    -1.8

    -2.8

     

    2011

    2012

    2013

     

    1Q'14

    2Q'14

    % of EBITDA

               

    Sand

    42%

    87%

    74%

     

    75%

    70%

    Fuel

    58%

    13%

    26%

     

    25%

    30%

    % of Revenues

               

    Sand

    7%

    11%

    19%

     

    23%

    26%

    Fuel

    93%

    89%

    81%

     

    77%

    74%

     

    EMES’s sponsor is Insight Equity, which owns 30% of EMES’s Common Units. Unlike other publicly traded MLPs, EMES has a simplified MLP structure: All units are common units (including the Sponsor’s stake), there are no Incentive Distribution Rights, and no Minimum Quarterly Distribution. We like that the sponsor has aligned its financial interests alongside with common unit holders like ourselves. EMES pays out 100% of its available cash to common unitholders.

    Our Perspective, Why we like EMES:

    We believe that EMES is well-positioned to double its dividend payment out to common unitholders by 2015, due to strong secular demand tailwinds and supply constraints that will help grow EBITDA. The company’s common unitholder friendly policies will see growing distributable cash flow into the future.

    Sand Segment

    The frac sands business is in the midst of a robust, multi-year growth trajectory. E&P operators have been seeking to optimize well results, and newly introduced fracking technologies have resulted in E&P operators using significantly more frac sand/well (as much as 10x historical amounts in the ultra-deep Utica wells). In addition, the trend has been moving towards using more frac sand vs. ceramic proppants due to frac sand’s cheaper pricing. The demand for sand has increased over the years, from 150,000lbs per frac stage to as much as 500,000 lbs per frac stage. Meanwhile, the number of frac stages per well has increased from an average of ~10 stages to ~25 stages per well. As such, the demand for sand on a per well basis has increased from ~1.5M lbs/well to as high as 10-12.5M lbs/well. The average amount of sand used per well is thought to be still around 3.5M lbs/well, but that figure continues to increase, setting the stage for demand to grow at around 25-30% YoY (according to Goldman Sachs, Morgan Stanley, as well as management forecasts from the frac sand companies).

    Currently, EMES’s dry plants have a total capacity of 4.4M tons, and the company is on track to introduce an additional 5.0M tons of capacity by 2015 (2.5M in 4Q’14 and 2.5M in 1Q’15). The company has also indicated plans to increase capacity by another 2.5M tons, bringing the total capacity to ~11-12M tons in the near future (we think by 2016/2017).

    EMES also has a very strong transportation and logistics network, which is a key ingredient to the company’s success as it allows the company to serve its customers near the wellhead. EMES has 13 transload facilities across North America: 3 in Western Canadian Sedimentary Baasin, 5 serving the Texas area basin, 4 in the Marcellus/Utica, and 1 serving the Bakken. In addition, the company is negotiating for further leasing and contracting of additional transload facilities to set up a “store-front” for its clients, something that we see major frac sand suppliers do, as they are increasingly tasked with the assignment of handling all logistics from the mine to the wellhead.  

    In sum, we think that EMES’s Sand Segment is poised to grow volumes sold through capacity expansions, which together with strong pricing, will drive multi-year growth in EBITDA and distributable cash flow to shareholders.

    While ramping production capacity entails some hurdles (capital, permitting, securing machinery and equipment) all of which require expertise and foresight, all these can be overcome in 6 - 12 months. The significant bottleneck remains distribution and logistics, which are poised to remain bottlenecks for the foreseeable future. As sand is a bulk commodity, the entire sand supply chain, from covered hopper availability, to railroad service, to transload facility capacity, to last mile distribution capacity is woefully unprepared for the current (and future) growth in demand for sand at fracking sites. As described above, some wells are now talking more than 10x the quantity of sand relative to a few years ago due to various drilling enhancements (described below), and in smaller part due to a shift away from ceramic to sand. Further, up and coming basins like the Utica are taking significantly more sand due to their geology. There are anecdotal reports of some deep wells in the Utica wells taking a unit train of sand per well, or 100 train loads per well.  

    Strong Secular Demand Tailwinds

    Advancements in drilling technologies have resulted in an exponential increase in the demand for fracking sands, best represented by:

    Proppant Demand =

    Horizontal Rig Count × Wells/Rig × Lateral Length × Stages/Lateral × Proppant/Stage

     

    As E&P operators opt to pump longer lateral lengths, more stages per lateral, and use more proppant (sand) per stage, we see that demand for fracking sands is poised to grow dramatically. Anecdotally, in 2013, lowest-quartile operators pumped ~500 tons of sand per well, and a year later, these operators have pumped 44% more fracking sands per well. Leading edge E&P operators have been seen pumping up to 8,000 - 10,000 tons of sand-- a whole unit train (100 rail cars) full of them!

    According to data from FracFocus.com, the median operator used ~1,300 tons of sand/well in April 2013, and that has increased to ~1,800tons of sand/well in March 2014, representing a ~35-40% YoY increase in the amount of frac sand used/well. Using statistics from operators in the lowest quartile, the amount of frac sand used per well has increased by 44% YoY between the same time period.

    The top 10 sand intensive operators account for ~19% of total wells, based on estimates made by Morgan Stanley and FracFocus. As such, there is still room for larger market penetration of high-frac-sand usage across wells and basins.

    Credible industry estimates suggest frac sand demand could double in 2016 vs. 2013, driven by the multiplier effect of: increase in horizontal rig counts, well counts, frac stages and sand usage/stage.

    Relevant WSJ article describing the forecast for frac sands up till 2015: