Description

If an aggregates business and a duopoly specialty chemical business got together and had a baby, they would create SLCA’s Industrial Sand (“ISP”) segment (assuming no double recessive genes!).  This segment is one of the more compelling businesses I have stumbled upon.  It is a hidden gem inside a stock that the entire investing universe still considers to be a frac sand company.  This is despite the fact that Frac Sand will likely only generate 1/3 of EBITDA in 2022 (with upside potential).  If I assume that the frac sand segment is worth 5x EBITDA, you are creating the incredibly attractive ISP business for 7.5x 22 EBITDA which is half the valuation of where aggregates trade and 12% ULFCF yield for the segment.  This despite far higher secular and cyclical growth than aggregates.  Further, the Frac Sand segment is one of the few E&P service providers that actually deserves a 5x EBITDA multiple because it extremely low cost position allows it to generate cash through all parts of the cycle.  Conversely, a pressure pumping stock trading at 3.5x EBITDA is grossly over-valued because it will take all FCF and reinvest it into maintenance capex until people stop drilling for oil.  In aggregate, the stock today trades at 7.4x 22 EBITDA with a 17% LFCF yield which is impossible cheap given that the ISP segment will be 2/3 of EBITDA.  As time goes on, ISP will dwarf frac sand…. new sellside coverage will start to cover the name and massive FCF generation will quickly deleverage the company… creating a tremendous IRR. 

U.S. Silica (“SLCA”) operates sand mines and diatomaceous earth mines that serve a variety of end markets.  SLCA operates two segments.  1) Frac sand to E&Ps.  2) Industrial sand and diatomaceous earth which serves the solar panel, windfarm, biodiesel, glass and dozens of other industries. 

SLCA is well-known as a leader in the supply of commodity sand for hydraulic fracturing in O&G.  Investors and the sellside know this company to be a frac sand producer which is a miserable industry.  However, SLCA’s management team had the foresight to only develop the lowest cost mines.  As a result, SLCA’s frac sand segment generated cash during the 2020 oil rig crash and is poised to improve as the rig count recovers. 

The North American oil and gas industry has entered a new paradigm forced upon them by two growing realizations.  1)  most O&G drilling destroys capital  2)  oil and gas may enter secular decline in the coming 5-30 years.  As such, E&P investors are reluctant to have all their cash reinvested into the ground and “get paid” in oil production in the future.  Investors want cash now to compensate them for terminal value risk.  As a result, this is the first surge in oil prices which hasn’t seen a frenzied response to drill more by the industry.   Nonetheless, the frac crew and rig count is powering upwards as the more efficient operators have found a way to drill more from existing cashflow – buttressed by higher oil prices.  Provided the oil price stays in the $65/bbl range, I suspect that we continue to see an upward trajectory to the rig and frac crew counts which converts into frac sand demand.  This will modestly improve this segment.  We could reach a point where the only remaining idle mines are high cost – forcing frac sand prices higher to drive re-openings but this might be 2+ years away.  These assets are very low cost and attractive over the cycle.  I suspect Frac Sand will generate $70-90mm of EBITDA annually over the next two years which converts to a reasonable amount of FCF due to capex of $15-20mm.  I apply 5-6x EBITDA to the segment to arrive at a valuation of $350-$540mm which aggregates to a big snooze for this stock which could be highly conservative given their FCF thru the cycle and upside potential should oil prices remain firm.  I suspect management would sell this if they could get $500mm+ at some point in this upcycle which would be positive because it would reveal the ISP … where the real juice is …

SLCA’s industrial and specialty sand (“ISP”) segment mines specialty sand for solar panel glass, fiber-glass for windfarm blades, golf courses, commodity glass and dozens of applications.  Industrial sand is a national oligopoly with the historically irrational Covia with the two parties controlling 85% market share.  Covia filed for bankruptcy and is now controlled by a Golden Gate Capital and a new CEO.  Legend would have it that in the past the CFO would push the CEO to raise price due to his understanding of their pricing power but the CEO refused.  Our conversations with Covia suggest they are well aware of the highly concentrated industrial make-up.  This is further buttressed by the fact that industrial sand is far more specialized than aggregates.  The sand can vary due to iron or other mineral content to whether its homogenously shaped or heterogeneously – which matters to the buyers.  Further, the sand is bulky creating local monopolies too.

In addition, a large portion of profits comes from diatomaceous earth (“DE”) mines.  DE is a highly specialized formation of fossilized hard-shelled snails.  Deposits are extremely rare and concentrated in North America.  DE operates as a national oligopoly w Imersys.  DE end markets include specialty filtration, metal polishes, insecticides, absorbents (kitty litter) and many others.  The DE component for ISP was bought by SLCA in 2018 for 12.5x $60mm of EBITDA.  I suspect the DE EBITDA has grown substantially since then.  

ISP competes on the basis of scarcity, high regulatory barriers to entry, intellectual property, local and national oligopolies.  ISP’s products are often akin to chemicals in that they are “low-cost/high value.”  In many cases, ISP’s products under-go lengthy qualifying processes and are “spec’d” into the product, greatly limiting a customer’s ability to switch supplier.  Volumes and pricing dipped modestly during 2020.  Given the catastrophic decline in the economy, the results point to considerable resiliency in the mid to high EBITDA margin territory.  Further, volumes in 1Q-21 have already eclipsed 1q-20 and point to secular growth.  Management has spent a tremendous amount of time and resources developing new products which they believe can drive secular growth; adding $90mm of contribution margin by 2024 (estimate $180mm in 2021) and possibly doubling contribution margin by 2026. https://ussilica.gcs-web.com/static-files/6e3b94f9-1f0b-4b32-b4ed-4d217cb721df

Further, this segment has considerable pricing power that the management team is flexing.  All sales pass-through transportation costs immediately and the company has pushed three 15% price increases on uncontracted volumes THIS YEAR.  We believe that the volumetric recovery, transportation cost pass through, price increases and modest cost inflation will spring this segment back to 2018-2019 contribution margin peak (or higher) in 2022.  After which, the volumes will continue to grow at robust levels while management continues to flex pricing.  All of these extremely favorable aspects seem largely lost on the sell-side which obsesses over the frac sand segment despite representing well less than 25% of the value of the company.  The ISP segment has the following unique attributes.

-          SLCA’s ISP mines/quarries are subject to local regulations which limit the expansion of capacity.  The bulkier industrial sands must meet specific grades and can-not travel far due to the high freight costs.  Even the sand in golf sand traps meet a specialty grade.

-          Diatomaceous earths (DE) are extremely rare mineral deposits and SLCA shares a national oligopoly

-          SLCA has found ways to meaningfully enhance the characteristics of its DE and sand deposits, adding material value for niche applications ranging from blood filters, biodiesel filters, cool roof granules,  white kitchen counters and various other applications

-          Many of its end products are going into high growth industries such as biodiesel, solar panels, windfarms and new technologies for cool roofs

In 2018, the ISP segment generated 24-25% EBITDA margins.  I see it likely eclipsing this in 2022 for the following reason.  As I mentioned, secular growth of end markets in renewables and the development of new products will drive a volumetric recovery that is both cyclical and secular.  SLCA has undergone a tremendous cost restructuring as its leverage nearly killed it in 2020.  Management had a near-bk experience and cut costs hard.  Coming out of it, the management team seems to understand that frac sand may not recapture its prior glory.  To dig itself out of their leverage, they have attached their horses to the ISP segment and will need to be lean.  However, I also suspect that the new-found emphasis has led them to realize that their ISP segment has real pricing power and past-efforts may not have optimized pricing.  As such, 2022 should see materially higher volumes than 2018 from secular and cyclical growth with new high margin products, a lower cost structure and a management team bent on optimizing price to help drive deleveraging.

What is this sector worth?  I see a lot of similarities to the aggregates industry including EBITDA margins but in many ways I would argue the business is superior.  SLCA has local and national monopolies but many of the products are hard to replace and fall into the “low cost/high value” category.  Further, it has secular demand growth in the highly attractive renewable sector.  That said, they bought DE unit for 12.5x and I am not sure you can attribute more than 12x to this sector with the frac sand attached to it.  As such, I assign 10-12x $160mm of 22 EBITDA – which they might be able to beat - $1.6-$1.8bn.

This combines to a TEV of $1,950-$2,460mm with upside risk.  After the settlement cash and 21 FCF, this translates into a stock price target of $15-20/share – offering 50-100% upside.  I suspect the trajectory at the ISP segment becomes more obvious as the year goes on.  As such, these are year-end targets.  It is worth noting that the company just settled a dispute for $1.75/share of value (mostly cash) on a broken contract.  As such at $10.3/share today, it is trading more like $8.5/share versus a high point on the year of $14.91 – offering 70% upside to get back to its $14.91 high + $1.75/share of settlement.  There may be more settlements in the works which could present as margin expansion in 22 as re-struck contracts compensate SLCA for the loss. 

Risks:

1)      Sell-side is bearish on the name because they only really understand the frac sand segment – which isn’t great.  Further, O&G customers don't care.

2)      The frac sand recovery has clearly “plateau’d” for now which may limit the upside revisions to estimates

3)    Stock is correlated with OIH

Limited investor attention.  we are small firm and were able to secure a call with mgmt almost immediately after 2Q.

Catalyst

Not a ton of obvious catalysts other than it is absurdly cheap.