Description

US Silica (SLCA)                                               May 1, 2012

Authors Background:

A professional investor with over 35 years of experience.  In the past managed billions of dollars in mutual fund assets, but today focuses on personal investments.

Brief Company Description:

US Silica is the #2 producer of “frac sand or proppant” for the energy industry which will contribute 75% of profits in 2012. This pure white quartz sand has unique properties compared to conventional brown sand. At depths of 1 or 2 miles underground the frac sand is not crushed and is not melted by the high temperatures.  These traits allow for more oil and gas to be recovered from the wells. This quartz sand is also only found in the Midwest in states such as Wisconsin.

Investment Thesis:

US Silica just went public in February 2012 at $17. Golden Gate Capital, the private equity firm that controls US Silica intentionally priced the IPO below fair market value to enhance their ability to sell the remainder of their holdings at a later date.

The investment bankers have also poorly forecast profits for 2012 and 2013. Industry sources suggest that US Silica will be able to raise prices in excess of 50% for their whole grain silica in 2012 and boost production volume by 63%. The combination of these factors leads to potential 2012 EPS of $1.80 which is 25% above the investment bankers estimates. 

Even if you ignore this $1.80 EPS estimate and use consensus EPS estimates of $1.44,  US Silica is still trading at a 2012 12.6x P/E. This is a 15% P/E discount to its closest public peer Carbo Ceramics which trades at 14.8x 2012 EPS.  The valuation for Carbo Ceramics is also depressed as its 1 year forward P/E in the past 5 years has exceeded 19x. This margin of safety in valuation and fundamentals makes an investment loss in US Silica unlikely.

The upside case for US Silica is easily +100-200% in the next year. A forward 12x P/E on $2.50 EPS in 2013  leads to a $30 stock price, while an 18x P/E leads to a $45 stock price relative to $18 today.

The company will report March 2012 financial results on May 8th.  That should be a stock catalyst as guidance is raised for 2012.

Value Proposition For Customers:

Frac sand in an oil or gas well allows the driller to immediately recover 5-10% more oil and gas. As a result the frac sand pays for itself in the first year of oil and gas production.  The return on investment over the life of an oil well easily exceeds 100%.

A Mature Industry Finds New Demand That Drives Rapid Growth

The silica or sand market has existed for decades as an ingredient for the production of glass or specialty coatings.  The emergence of the shale oil and gas industry created a new end market that has grown from zero to 50% of industry demand in a few years.

A Sustained Product Shortage Gives The Industry Pricing Power

Demand from the shale industry has been growing over 30%/year as frac sand or proppant consumed per well kept rising  proportionately with the length of horizontal wells being drilled.  Industry supply has failed to keep pace with demand as it takes at least 3 years to receive permits and construct  a new frac sand facility.  As a result silica prices have increased annually at an average 9% rate for the past 10 years. Even after these prices increases white sand of a 20/40 mess variety is still priced at three cents per pound.

EOG Resources is a large buyer of frac sand or proppant for their shale well drilling efforts. On a recent conference call their CEO Mark Papa made the following comments about the frac sand market. “There has been a sand shortage in the United States. Those who have sand or access to sand can pretty much charge what they want for that sand. “   Nevertheless frac sand still represents under 5% of the total cost of most horizontal shale oil and gas wells.

US Silica Will Be Growing Its Share of Industry Profits

The IPO of US Silica has coincided with the company adding 63% to its frac sand production capacity in the December 2011 quarter. They are also raising prices in excess of 50% in 2012 as some long-term contracts that had below market pricing are re-priced.

High Return On Equity Business That Continues To Improve

After-tax return on equity for US Silica was approximately 50% in 2011 with historical shareholders equity figures impacted by the past leveraged buy-out.  The good news is that new plants being opened in 2011-2013 are forecast to achieve returns on equity well above 100%.

Risks:

Trouble At Carbo Ceramic Might Suggest Weakening Demand For US Silica

Carbo Ceramics missed their EPS forecasts for the December 2011  and March 2012 quarters as drilling in the Haynesville basin collapsed due to low natural gas prices.  Carbo produces “ceramic proppant” that is priced ten-fold above the white quartz sand sold by US Silica. This high end niche represents only 10% of the proppant industry and is used in the deepest wells where US Silica products are not consumed. On the April 26th Carbo quarterly call the company acknowledged that there is a shortage of white quartz sand that US Silica sells while Carbo’s ceramic market has excess supply.

Collapse In Oil Prices in 2008 Did Lead To Reduced Drilling and Reduced Demand For Frac Sand

US Silica’s end markets are cyclical. A global recession would harm unit demand and potentially lead to temporary price discounting.  In 2009 after oil prices fell 75% from their peak, demand for frac sand declined by -18% in 2009. In 2010 frac sand demand rose +125%. If you believe that oil prices are going to collapse than you should not invest in US Silica. WTI prices above $80/barrel will be sufficient to pay for most existing drilling budgets at oil exploration companies.

Catalyst