Summary
- U.S. Silica Holdings, Inc. is the leader in the frac sand business and has good long-term prospects.
- The current downturn is making U.S. Silica Holdings shares cheaper.
- In this article, we discuss reasons why we are waiting to dip our toes in U.S. Silica Holdings stock.
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Introduction
The last timeI covered U.S. Silica Holdings, Inc. (NYSE:SLCA), I rated it a hold. At nearly $18 a share, I thought perhaps it was a little too far out over its skis. I was right and wrong at the same time. I had correctly judged that gravity might slow SLCA's rise - not necessarily any problem with the company, as we all know what happened in June to the oil price. (WTI dropped from $120 in early June to $76 in late September in case you've been hibernating.)
Price chart for SLCA(Seeking Alpha)
On reflection, at $11.50, I was probably guilty of reading too much into management's comments about signing take or pay contracts with operators and contribution margins rising toward $40 per ton. I am guilty of getting out my Rockwell handheld calculator (big green numbersand little rubber feet.), and having fun with numbers. I did in this case and came up with $15.00 as a possible entry point. I own my mistakes, and boy....I blew that one.
Now we will take a fresh look at U.S. Silica Holdings, Inc. to see if there is an investment case near current prices. The professional analyst cadre rate the company as a Hold, with price targets that range from$13.50 to $24.00, which would conceptually make it a buy if they are half right.
In this article, we will take another look at their business to see where and if we might take a stake in the company. It should be noted that I've writtenseven prior articles on SLCA, and they should be reviewed for deep background on the company.
The business case for SLCA
There is no substantial oil or gas production from shale reservoirs without fracture stimulation. A trip back to 2008 validates this notion, as at the dawn of the shale age, U.S. land production was around a million barrels a day. Shale fracking requires large amounts of water and sand to achieve the results necessary for fractured wells to payout. Currently, the trend in shale drilling favors increased use of sand, with longer laterals and higher sand concentration per foot of interval. It all adds up to a robust demand for SLCA's products as far as the eye can see.
As drilling has recovered over the past year and half service and commodity suppliers, companies like U.S. Silica Holdings, Inc. have been able to reflate revenues and margins to profitable levels. In the Q3 2022 call, CEO Bryan Shinn made some bullish commentary that followed the tone of his Q1 2022 remarks regarding take or pay contracts and contribution margins exceeding $20 per ton, and put forward a very constructive outlook for 2023.
We believe that a combination of constructive, crude oil pricing and strong sand profit customer contract coverage and mix coupled with higher sandbox margins will continue to generate significant free cash flow from operations in 2023 and help further strengthen ourbalance sheet.
SLCA has also been developing an industrial market for its products. The volumes are lower than the frac market, but margins are higher. Shinn was more reserved in his commentary for this market in Q3, noting the concerns about the general economy:
Turning to our industrial and specialty product segments, we are continuing to carefully evaluate a variety of factors to develop our 2023 outlook. Currently our base case 2023 forecast is for increased sales volumes with improving margins. We have not yet seen meaningful indications of potential recessionary impacts, but obviously there's a lot of noise in the market right now.
We will focus our analysis on the frac market, as it carries the company.
The macro environment for OFS companies
Things haven't developed in this segment quite the way I thought they might at the turn of the year. You may recall I put out some bullish articles on the drillers. They were based on some input I had received from an industry consultant, and the robust comments made by the companies in their Q3 2022 calls.Hereandhereare links to the articles on Helmerich & Payne (HP) and Patterson-UTI Energy (PTEN). Both are about 20% below where I picked them to go higher. What's going on?
Two things really. First, therig count has flatlined, actually dropping a dozen rigs since the turn of the year standing at 760 now. We were supposed to grow past 800, and reach possibly the 850 level this year. It could still happen, there's a lot of time left in the year, but the trend is not our friend in this regard. It's much the same story for frac spreads, which peaked at 300 in November of last year, dropped to 250 in the depths of winter and have only rebounded to the 272 level thus far in 2023.
There are a number of "villains" responsible for this state of affairs, pick one or five that resonate with you - a 30% drop in oil prices, an 80% drop in gas prices, worries about the Fed crashing the economy-with the resulting dollar strength, SPR releases, massive inventory builds, a warm winter...Putin threatening nuclear annihilation... I could go on, but you get my drift here. For the oil bulls, there has not been a single thing that's bolstered the case recently, with the possible exception of China pivoting on its Covid lockdown stance. And, even the "sugar-high" of China's economic activity resuming has been buffered over the past few weeks, with WTI hanging out in the upper $70's.
Bottom line, we need for a strong price signal from the market to invest further in second tier OFS companies at current levels, particularly ones with the "warts" (debt-bombs) that are hidden in SLCA's balance sheet. That could come as I expect later this year, when shale production begins to bend the curve, or from improvement in any of the areas I've mentioned above.
Q3 2022 Financials
While revenues grew smartly to $418 mm in the quarter, about a 9% increase QoQ, operating cash flow dropped ~25% to $66 mm. This was the result of a working capital build for contracts and costs associated with a loan repurchase. The company had $267 mm of cash on the books, leaving net-debt at $819 mm. The oil field contribution margin grew to $24.38 per ton, with ~3.5 mm tons delivered during the quarter. On an annualized basis, that's 14 mm tons and near the company's stated ceiling of 14.5 mm tons.
Guidance in the call was bullish for Q4 2022. Brian Shinn, CEO commented on expectations for the rest of the year and into 2023-
We've already got 85% to 90% of our capacity sold for 2023 and pushing upwards of 70% under contract for 2024. we had a lot of pricing tailwinds in Q3 and I think you can expect to see some of those embedded in future contracts. Obviously, as we're signing contracts over the next couple of quarters and extending contracts prices in some of those older contracts will be updated.
With that commentary as a framework, we can probably project cash flow rebounding toward the mid-$80 mm area for Q4 2022 (expected 2/24pre-market).
Risks
As noted, the rig count that drives North American oilfield activity has weakened, and could weaken still further. The market has yet to react to the current train-wreck in gas prices. Sooner or later, the high cost drillers are going to have to lay down some rigs. Both the Permian and the Haynesville are adding gas into the market as forecast by the DPR. Together they are expected to add ~210 mscf/d in March. As noted in prior articles, we are swimming gas right now, and is the primary reason for the collapse in prices. Unless gas prices rebound in the next few weeks-not anything I am predicting, some gas rigs are going stacked.
Your takeaway
SLCA stock is trading at 5.3X forward OCF, so is not expensive at current prices. Since I don't see a short term catalyst for the shares and am concerned about further downside as discussed, I would pick an entry point well below current levels, sub-$10.00 to price in the risk of dead money, or worse.
If that opportunity presents itself, it would probably be worthwhile to dip your toes in U.S. Silica Holdings, Inc. If we do bend the curve on shale production, either through declines in the rig count, or in combination with lower quality rock being drilled, leading to increases in sand intensity, shares of U.S. Silica Holdings, Inc. could pop higher.
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