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Thesis

Emerge Energy Services is a high organic growth MLP trading at an outlier ~ 12.5% distribution yield based on next year’s production ramp as derived from Management’s recent Reg FD Disclosure.

We are recommending a long position in Emerge (EMES) at $31.83/unit. We believe that EMES should trade in line with its closest peer High Crush (HCLP) which trades at a 6% distribution yield while having less organic growth without unit dilution. Assuming a conservative 8% distribution yield and $3.97 of distribution power in 2014, EMES is worth $49.25/unit, which equates to over 50% upside excluding quarterly distributions.

Overview

Emerge Energy Services LP, incorporated on April 27, 2012, owns and operates a diversified portfolio of energy service assets. The Company operates in two segments, Sand, and Fuel Processing & Distribution. The Sand segment consists of mining and processing frac sand, a component used in hydraulic fracturing of oil and natural gas wells. The Company’s frac sand facilities are located in New Auburn, Wisconsin, Barron County, Wisconsin and Kosse, Texas. The Fuel Processing and Distribution segment consists of acquiring, processing and separating the transmix that results when multiple types of refined petroleum products are transported sequentially through a pipeline. The Company’s Fuel Processing and Distribution segment consists of its operations in the Dallas-Fort Worth metropolitan area and Birmingham, Alabama.

Reasons to Own

• No additional MLP unit sales necessary to get to the $4/unit distribution.
• Earn an ~10% yield while waiting for the linear growth in EPS per unit from $0.54 to $1.07 over the next 12 months.
• Barron’s mine output appears to be increasing faster than their S1 projections. If that’s the case, our projections could prove conservative. One of their competitors recently developed their sand mine in half the time originally projected. In our opinion, this is operationally achievable at Barron.
• Barron should have the ability to run at 90% of capacity including downtime similar to the New Auburn plant. Our analysis assumes Barron ramp up to capacity (~82%) by the 4th quarter of 2014.
• Barron’s operational costs today are ~$22 per ton and will decrease to ~$18-20 a ton by 2H of 2014. This will be achieved by internally operating their wholly owned wet facility that is currently being operated by a 3^rd party. Emerge will realize a 10-20% cost benefit once Barron’s wet facility is operational.
• Best white sand available (Illinois sand) in the United States
• Moratorium on new sand mine permits in Trempealeau and LaSalle County, the most active sand mine permitting counties in Wisconsin and Illinois. 
• Logistically favorable sand transport routes with two rail providers, Union Pacific & Canadian National offering ability for single line haul to most major shale plays.
• Currently, the majority of their customers are contracted at today’s spot prices. EMES doesn’t share the same risk profile as some of their competitors with legacy rolling contracts at ~$60/ton equivalent sand.
• Fuels business has hidden synergies. Spending ~$300k on new equipment for the business will generate $1-$2mm in EBITDA. Management is confident that there are multiple opportunities similar to the one stated above
• Relationships with their rail counterparties: They sell fuel to UNP which is their largest rail transportation provider. Overlapping business could prove useful in negotiating rail contracts.
• The General Partner (Insight Equity) owns the same units as all shareholders and don’t have Incentive Distribution Rights. We believe this alleviates any misalignment with EMES public shareholder base that would usually occur in a standard MLP structure.
• $36mm of undrawn revolver capacity for brownfield growth capex discussed above

 Regulation FD Disclosure

“On August 28, 2013, Rick Shearer and Robert Lane, Chief Executive Officer and Chief Financial Officer, respectively, of the general partner of Emerge Energy Services LP (the “Partnership”), made a presentation to certain financial institutions in connection with an event at the New York Stock Exchange. During the course of that presentation, Messrs. Shearer and Lane provided certain information about the Partnership that they mistakenly believed already had been made public. In particular, Messrs. Shearer and Lane discussed management’s belief that the previously disclosed strategies of the Partnership to increase revenues and lower costs could eventually result in an increase in distributable cash flow to $4.00 per unit annually. They also stated that management believes that current market prices for spot sales of 20/40 frac sand product may be stabilizing at around $56 to $60 per ton. Messrs. Shearer and Lane further expressed their belief that because of increasing upward demand pressures on product prices and additional customer contracts, the Partnership may not be able to extend the temporary preferred prices it currently offers to one of its largest customers beyond October 2013.”

 Financials- link above will display model

S-1 Company Estimates

According to S-1 estimates from their IPO, the Company guided to $0.63, $0.71, $0.70 and $0.79 for Q213, Q313, Q413 and Q114 respectively. As indicated by Q2 results, the Barron & New Auburn facility was producing at 2.5mm tons per year, exceeding the 2 million tons per year run-rate projected in their prospectus for the 12 months ending March 31^st, 2014. Considering the linear production growth associated with sand mines, we would anticipate the Company’s growth to continue to outpace their S1 projections prospectively.

Sensitivity Analysis Q4 2013 Run-Rate

Assuming our base case scenario, on a run-rate basis, Emerge Energy should trade at $38.37/unit off based on our Q4 2013 projections. One could make a case for a tighter yield considering ~50% organic distribution growth opportunities in 2014 without the need for additional equity.

Sensitivity Analysis 2014 - link above will display model

Distribution

EMES distributed a dividend of $0.37 in Q2 due to the IPO of the company midway through the quarter, which is equivalent to $0.70 per common unit on a pro rata quarterly basis. We believe that the distribution will go from $0.37 to$1.07 per unit by Q4 2014. At that level, we anticipate north of a $4.20/unit distribution for 2015.

Emerge Energy Services vs High-Crush

• Emerge trades at a 5.1% distribution yield discount to Hi-Crush based on next year’s distribution power
• Emerge has distribution growth of 51.9%, vs Hi-Crush growth of 6.8% from 2013 to 2014.
• Emerge long-term contracts are +/- 5% of spot prices vs Hi-Crush’s which are above market
  • One would expect some of those legacy contracts to roll to new spot rates over time

Sand Segment Overview

Sand Market Dynamics

Advances in unconventional oil and natural gas extraction techniques, such as horizontal drilling and hydraulic fracturing, have allowed for significantly greater extraction of oil and natural gas trapped within unconventional resource basins such as shale rock. In the hydraulic fracturing process, granular material, called proppant, is suspended and transported in the fluid and fills the fracture, "propping" it open once high-pressure pumping stops, allowing for the hydrocarbons to flow freely to the wellhead. Frac sand represents the lowest cost and largest volume of proppant supplied to pressure pumping companies and operators. According to a report by the Freedonia Group dated March 1, 2012, which we refer to as the Freedonia Report, North American raw frac sand demand, by weight, grew 29% per year from 2006 to 2011 and is expected to grow 7.3% per year from 2011 to 2016.

Frac sand must meet stringent requirements for grain size, crush strength and sphericty in addition to several other important criteria as determined by the American Petroleum Institute, or API. Larger, coarser sand grains (such as 16/30, 20/40 and 30/50 mesh) are typically used in hydraulic fracturing processes targeting oil and liquids-rich natural gas recovery, while smaller, finer grains (such as 40/70 and higher mesh) are used primarily in dry natural gas drilling applications. Deposits of coarse sand that satisfy API standards are predominantly found in the upper Midwest, with the greatest concentration in the state of Wisconsin. Although the exploration and production industry is cyclical and oil prices have historically been volatile, we believe that many of the domestic oil and liquids-rich natural gas plays are economically attractive at prices substantially below the current prevailing prices for oil and liquids-rich natural gas. We believe this should provide continued and growing opportunities for drilling activity in oil and liquids-rich natural gas formations and continued growth in demand for coarser frac sands.

S1-Operations Summary

Summary of Key Strengths

Sand Segment

• Large reserve of high quality coarse frac sand

• Efficient logistics network

• Low cost operating structure

• Significant organic growth capacity

•Highly experienced management team

Supply/Demand

Global demand for silica sand is forecast to climb 4.4% annually through 2016, to 278 million metric tons, valued at ~$8.5 billion. Global demand is to total 278 million metric tons in 2016. Hydraulic fracturing (or fracking) is expected to represent by far the fastest growing market, spurred by a large increase in its use as a well stimulation technique, particularly in the US.

EMES produces about 2 million tons per year (~20% of U.S. demand and 16.7% of world demand).

EMES’s Wisconsin mines contain deposits of nearly 30% 40 mesh or coarser substrate which in comparison to other Ottawa white deposits is 5% greater. The Barron’s reserves are comprised of more than 60% 50 mesh and coarser substrate. This gives EMES a cost advantage as other competitors tend to have to mine more of their resources for the same amount of the desired mesh size.  EMES also maintains the advantage of being connected to single rail routes which provide a cost saving of $15 per ton. EMES has in place long term contracts with the Railways which are currently priced at a discount and provide a major cost saving for the customer. This in addition to maintaining a higher quality product makes EMES one of the most efficient and in demand Sand miners.

Market Pricing

There are only three types of Proppants to choose from Frac sand, resin coated sand, and ceramic. Typical frac sand sells in the range of $30-$100 per ton, while resin coated and ceramic sell for $500 to $700 per ton. The world consumed ~31.8 million tons in 2012, ~25.7 million tons of it was consumed by the U.S.

Sands are described and priced according to Coarseness, Crush Resistance, Conductivity, Acid Solubility, Purity and Turbidity, and Roundness.

The Northern white sand has superior coarseness and conductivity. Its crush resistant properties allow it to be used in deeper wells relative to other deposits such as those of Arkansas, Texas and other Southern US locations.

Operations

Frac sand operation is EMES’s largest segment by adjusted EBITDA, contributing ~$33.8M with ~ 65% margins, and contributing to ~40% of total Revenue. EMES ‘s Frac sand operation operates under the subsidiary Superior Silica Sands. SSS mines and processes Frac sands in Barron and New Auburn, WI, and in Kosse, TX. The Wisconsin plants produces 16/30, 20/40, and 30/50 mesh Northern White sands which is desirable for oil and liquids rich gas drilling. The Kosse plant produces 100 mesh sand, which is primarily used for dry gas drilling.

Fuel Processing & Distribution Segment Overview

The fuel processing and distribution segment is the second largest business segment contributing ~$17mm of EBITDA, at a 27% margin. This business segment is composed of two sub companies Direct Fuels and Allied Energy Corporation. The transmix business generates 63% of supply under exclusive sale agreements with an average duration of 17 months.

The Fuel Processing part of the business (also known as transmix) deals with the process of separating mixed fuels and petroleum products that have blended due to multiple fuel transportation through the pipelines. EMES’s fuel processing and distribution facilities are located in Dallas-Fort Worth and in Birmingham Alabama.

Each transmix facility tends to act like a localized monopoly due to their being only about 19 transmix facilities in the US. These transmix facilities are commonly located at termination points of major pipelines. The average operating profit of handling this transmix is about $0.20/gallon which in 2012 EMES processed 637 Million gallons of. The margins of the transmix business are superintended by the cost of transporting transmix by truck to the nearest transmix facility.

Bearish arguments

• Customer Concentration
  • The largest two customers contribute to 83% of Revenues in the Frac Sand segment
  • The top 5 customer contribute 52% of Transmix revenues
  • Contracting risk
    • EMES has contracts for 31% of the Barron facility
    • Headline risk from hydraulic fracturing
      • Negative press/new technology
      • Interest rates rise
        • Ability to access debt markets
        • Trade off to treasury resulting in lower valuation yields
        • Cyclical Nature
          • A slowdown in oil and gas exploration and rig count
          • Commodity risk/sand oversupply
          • Operational risk due to weather

• Barron plant ramp-up of sand production
• Wet Plant added in 1H 2014
• Operational synergies
• Estimated expansion of Fuels business (Birmingham) to process volumes of 3,000 per day which could add $4MM+ to EMES’s annual EBITDA
• Visible Distribution growth over the next 4 quarters.