Description

U.S. Silica (NYSE:SLCA): SHORT

What long-term contracts?  This is sand, right?

Summary Financials – Base Case:

Business Description:

U.S. Silica Holdings (SLCA) engages in the mining, processing, and sale of commercial silica in the United States. It operates in two segments, Oil & Gas Proppants and Industrial & Specialty Products.  SLCA offers whole grain commercial silica products to be used as fracturing sand in connection with oil and natural gas recovery, as well as in various size distributions, grain shapes, and chemical purity levels for manufacturing glass products.  SLCA generated 55% of revenues and 72% of Gross Contribution Profit from the sale of fracking sand in the Oil & Gas Segment during 2012.

Investment Thesis:

SLCA is a SHORT because:

• SLCA is generating “Cyclical Peak” earnings driven by legacy contracts that are priced significantly above market while supply continues to ramp and spot prices continue to decline
• Over the next 12 to 36 months, as the sand market continues to become oversupplied, these contracts will be replaced with shorter term contracts (2 years vs. 3 years) with fewer restrictions that are at significantly lower prices
• Given the high fixed cost nature of the sand mining business, even a 10% decline in sand prices would result in 30+% decline in EPS.  Furthermore, even today, product costs per ton are rising faster than prices per ton based on existing long-term contracts 
• More normalized prices, ~10-20% below current levels, would cause EPS to decline to $1.10 to $1.50 per share vs. consensus estimates of $2+ per share.  This suggests ~40% downside in the stock price from current levels

How this plays out:

• As contracts roll over new pricing terms will be set below historical levels and contract terms will become more flexible thus allowing customers to walk away from contracts when spot prices decline below contracted prices.  At the same time, supply will continue to ramp causing spot prices to continue to decline. Combined, this will cause average realized prices per ton to decline while costs per ton continue to rise or remain at elevated levels; thus resulting in a non-linear decline in profitability compared to current levels.

Bull Thesis:

• SLCA will likely benefit from increasing demand due to the bifurcation of footage drilled vs. rig count growth
• SLCA is expanding capacity.  SLCA announced Sparta Phase 2 bringing another ~800k tons of high quality frac sand online by YE 2013
• During 4Q12 SLCA extended its average contract maturity into 2015 from 2014 prior.
• SLCA continues to entrench itself with customers by moving up in the supply chain with transloads, partnering with railroads, and expanding ability to be a low-cost provider in all major basins.

Our View:

• SLCA will benefit from increasing demand however it is not the only one to do so and it operates in a fragment cyclical industry where many established and new players are expanding capacity as well.  Based on the 2012 U.S. Geological Survey 28% more companies had 37% more operations supplying frac sand in 2012 vs. 2011.  Based on our analysis there are ~100 facilities just in Wisconsin ~50% of which are operating and the remaining ~50% are in development.  While demand is expected to grow ~8% on average per year, supply is expected to grow at a faster pace.  Moreover, the continued decline in spot prices throughout 2012 and into 2013 indicates that the market is already over supplied.  Industry experts and customer indicate that the oversupply situation will likely get worse.
• Although, it seems that SLCA has extended its average contract maturity from 2014 to 2015, customers indicate that the new contract terms are at lower prices (~30+% lower) compared to peak pricing of historical contracts and for a shorter duration with the ability of the customers to walk away from the contracts if spot prices drop below contract prices for a period of greater than 30-60 days.  Moreover, legacy contracts were struck at peak pricing in ~2010/2011.  When these prices normalize profitability levels are likely to deteriorate.
• SLCA is not the only company creating transload facilities.  Based on our conversations with industry experts and customers, competitors have been following suit.  Customers indicate that there is no sustainable competitive in the sand business – it all comes down to the price.  Furthermore, the rising production cost per ton, which are rising faster than average prices per ton, indicate that the lower cost advantage is hurt by the expanding distribution network.  Margins for SLCA peaked in Q112 and since have gradually declined while it has built out its transload network.
• The fracking industry is moving from experimental drilling towards production drilling where the focus has shifted from maximizing well yield to optimizing costs.  In addition, pressure pumpers, SLCA’s customers are facing trough level margins.  As such, SLCA customers are now making a concerted effort to bring down their supply chain costs.  Our conversations with industry experts also indicates that Schlumberger (SLB) is also testing new methods of fracking that enables the usage of cheaper/lower quality sand while achieving relatively similar results.  Greater development and adoption of such methods would materially increase supply of available sand and would negatively impact the current advantages that the providers of high quality white sand like SLCA currently enjoy.  We have also seen this transition before where the sand usage today displaced the usage of more expensive ceramics in years past.  Lastly, the recent Q113 results showed initial evidence supporting our assumption that customers are increasing usage of cheaper, lower quality sand at the expense of higher priced higher quality sand

Pre-Mortem:

• Rising natural gas prices and oil prices leads to an expansion in E&P drilling budget thus leading to a higher than expected increase in sand demand while current long-term contracts maintain near-term profitability
• Environmental regulations cause a marked decrease in oncoming supply of sand

Sign-Posts:

• Margins peaked in Q112 and since then have been declining
• Baker Hughes walked away from a binding contract with hi-crush in Fall 2012
• SLCA had 9 customers under long-term contracts in 2012 and now has only 8.  This combined with our customer conversations that indicate the contracts are getting shorter, more flexible and are being struck are lower prices suggests that the market is in oversupply and the bargaining power has shifted back to the customers
• Average oil and gas proppant pricing cracked in Q113 results due to mix shift to cheaper sand
• Continued insider sales despite the recent futile promotional efforts by management to pump up the stock

Timeline – Key events:

• Earnings Calls

KEY METRICS:

Unit Economics are cracking

Notes:

• Sales are primarily a function of the price per ton realized and the volumes sold. In some instances, SLCA includes a charge for transportation services.  SLCA primarily sells its products under short-term price agreements.  However, the company has 8 take-or-pay supply agreements with customers in the Oil & Gas Proppant segment with initial terms expiring between 2013 and 2016.  The contracts provide for a volume and pricing commitment.  Prices under these agreements are generally fixed and subject to upward adjustment in response to certain cost increases. As a result, during periods of rapid price growth, our realized prices may grow more slowly than those of competitors, and during periods of price decline, our realized prices may outperform industry averages. Collectively, sales to customers with supply agreements (oil & gas segment) accounted for 31%, 17% and 18% of our total sales in 2012, 2011 and 2010, respectively.  That said 70-80% of SLCA’s oil & gas volumes are under long term contracts in 2012 and in 2013 with expiration ranging from 2013 to 2016.  SLCA’s weighted average contract terms end in mid-2015 (as of Q412) - SLCA 10K/Q and earnings transcripts

Catalyst