The shale drilling production technique known as hydraulic fracturing, or fracking, has altered the landscape of the global energy industry in general and U.S. energy industry in particular. The process involves injecting liquids under high pressure into a hole drilled horizontally through a tight shale formation for the purpose of creating fractures in the shale. Specialized sand is injected with the liquid to keep those cracks open and allow the trapped gas and oil to flow through the cracks into the drill hole where it can then be brought to the surface. Without the sand to hold the cracks open, fracking does not work and U.S. Silica Holdings (NYSE:SLCA) is one of the leading suppliers of this highly sought and critical product. A business that supplies an irreplaceable product to a critical industry and trades at a bargain price is an opportunity shrewd investors cannot afford to miss.
As a value investor, I am always seeking businesses that supply products and services that are crucial to our survival or maintaining our standard of living because it makes them necessary. In a capital intensive industry such as horizontal drilling and hydraulic fracturing where a single hole can cost hundreds of thousands of dollars, once you have a proven product that performs well in the process, there is very little incentive to change suppliers. U.S. Silica has the proven product and that status provides them with a highly effective moat of protection around their fracking sand business.
Why U.S. Silica?
Silica is used in products such as glass containers, structural fiberglass, fiberglass insulation, automotive, commercial and residential glass panels, solar panels and on and on. Some of these products are simply commodity applications subject to low-margins based on the lowest price available in the market. Others, however, are quite specialized and offer high margins and customers who are resistant to move away from a proven supplier with a proven product. Think of it this way. As a purchasing agent for manufacturer of touch screens, are you going to risk your job by changing suppliers of the specialty silica used in the manufacturing process just because a different, but unproven, supplier can save you a few cents per pound? There is no personal downside risk by staying with the existing source but a problem with a new supplier that you selected could cost you your job. Are you willing to take that chance? Entrenched and proven suppliers have a huge advantage in any type of specialty application and purchasing managers are loathe to shoulder the risk of a problem caused by a decision to move away from a proven source.
Many of these products are simply standard silica based products with very little proprietary advantage to distinguish them from the same products produced by competitors. They are as Warren Buffett describes them "subject to the lowest price available anywhere in the world". It would be a mistake, however, to take Mr. Buffett's statement and jump to a conclusion that commodity style products do not offer any benefit to a business that can produce them in conjunction with lines of specialty products using the same general facilities, materials and administrative structures.
Why The Commodity Products Are Important To U.S. Silica
Many investors and analysts look down their collective noses with disdain at commodity type products as being difficult low margin products with no real value to a company. What that line of thinking fails to consider is the spreading effect the production of these commodity products can have on the overall fixed costs required to run a business. For example, if a business is selling $5 million dollars of products and increases it sales to $10 million of similar products, in most cases, the purchasing department does not double in size, the orders they place simply get larger, they do not add another General Manager or President, those positions simply lead a larger business, extra shifts can be added in its factories. The so-called fixed costs of the business tend to collapse as a percentage of the overall cost of sales as volumes increase. This added absorption of fixed costs is the hidden value of having a strong and viable line of commodity style products to compliment the specialty group.
The sand used in the hydraulic fracturing process is quite a special product and not just any sand can be used. However, no matter how solid and necessary and single product or market might be, any business with one product for a single market would have to be considered a high-risk proposition. But investors will be overlooking a plethora of product offerings if they leap to that conclusion. Even though fracking sand is its largest and most profitable product, U.S. Silica's Industrial & Specialty Products business segment offers more than 200 products to its customers.
This wide base of product offerings spread between high-volume commodity offerings and very specialized high-margin products positions U.S. Silica quite uniquely and advantageously as a business. The production of the specialized products lessens the need for maintaining the margin levels that would normally be necessary for the commodity style products to survive as a stand-alone business and the production of commodity style products disperses the fixed costs of operations across a broader product base and provides U.S. Silica with a competitive advantage in the specialty products side of the business by lower those average costs/unit.
This is a lesson I learned firsthand in 1996 when working on a turnaround project in Echuca, Victoria. I was about to fire a customer whose product had a slightly negative gross margin; until the financial manager and I looked at the impact that the lost production hours would have on the fixed costs applied to our remaining products. I was absolutely stunned to find it was more profitable for the overall business to keep producing a product that sold at a slight loss than it was to stop making it because of the fixed cost absorption the production of that product contributed. Even after I saw the numbers and calculated them myself, it was hard to believe; but, it was true.
Production of commodity products with stable demand can also be useful when mixed with the production of custom products to "smooth" production demand and provide needed work for highly skilled employees during periods of slack demand for the specialty lines. In virtually any industry, there are almost always key employees that you will not get to return if you lay them off and it is crucial to have a profitable way to retain them even if not in the optimum role. The commodity product of U.S. Silica fill these roles and also contribute to the bottom line on their own.
What Is The Past Performance And Current Value?
For the second quarter this year, SLCA reported earnings of $0.55/share versus $0.38/share for the same quarter last year and beat analysts' expectations of $0.46 by 19.5%. In just the last 90 days, the consensus earnings estimates for 2014 and 2015 have increased by 9.18% and 13.3% respectively. And the positive news gets even better. The 2015 earnings estimate of $3.32/share represents an increase of 54.67% above the $2.14/share currently projected for this year and the P/E ratio is only 18.24 times 2015's projected earnings. The P/E based on 2015 projected earnings is one third of the projected year over year growth rate. Furthermore, that 18.24 P/E would allow for an increase in the share price of 27.7% just to reach a one times multiple to its projected 5-year forward growth rate of 23.3%.
While past results do not always indicate future success, they do provide a history and track record that creates a view as to the capabilities of the people responsible for the day to day operation of a business. At the end of 2009, shareholder equity in U.S. Silica equaled $127 million; by the end of 2013 it had risen to $309.3 million. This represents an annualized return on equity of 24.9% over the past 4 years. These are truly impressive results and certainly make the current valuation understandable and even compelling.
And The Future Opportunity?
Based upon the current fundamentals of the company and the strong and growing demand for its primary product, it is hard to imagine that this business should not trade at a minimum of a multiple of 1 times its 4-year average return on equity (24.9%) multiplied by next year's projected earnings of $3.32. This calculation produces a current estimated fair value of $82.67/share based upon a reasonably conservative valuation metric. This valuation implies an increase in the share price of 36.5% from the current price of $60.56 just to reach current fair value with the additional potential to achieve annualized returns equal to the forward growth rate of the earnings.
For those investors who also like to include a more aggressive estimate of value as part of their investment consideration, one common methodology is to apply an earnings multiple of 1 to the projected 1-year forward earnings growth rate of the business to the current year's earnings. This calculation results in an equation of 2015 projected earnings of $3.32, divided by 2014 projected earnings of $2.14 multiplied by the 2014 projected earnings. The projected 54.67% year over year growth rate times the $2.14/share current year earnings produces an optimistic valuation of $116.99/share which implies a potential upside for the stock of 93% from the current share price.
Final Thoughts And Actionable Conclusions
While there is always risk involved in any investment, buying shares of businesses that supply critical products to critical industries is always a great way to mitigate risks. We don't need every business involved in producing our crucial energy needs to succeed for this business to prosper; we just need for the shale deposit oil and gas industry to survive. It is difficult to imagine how to reduce risk much further than that.
If the management team is only capable of maintaining the kind of performance over the next five years that they have delivered over the past four, this stock should rise at a pace at least in line with the future earnings growth rate, currently projected to be 23% annualized. In addition, even on a relatively conservative estimate of the current fair value, the stock has an immediate upside potential of 36.5%.
If the business continues to perform as it has and begins to attract a serious momentum following, then the real potential exists for explosive gains going forward. Either way it turns out, prudent investors have the opportunity now to energize their portfolios with U.S. Silica Holdings and should act now to buy the shares and receive the big gains yet to come over the next several years.
Disclosure: The author is long SLCA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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