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5 Things Emerge Energy Services Management Thinks You Should Know

Even though volumes and revenue have grown quickly over the past couple of quarters at Emerge Energy Services (NYSE: EMES), it has yet to translate into any bottom-line result. That may be frustrating for any investor that has hung on throughout the oil and gas downturn, but management thinks that investors' patience will be well rewarded in the coming quarters.

Here are several quotes from Emerge's most recent conference call that show how management is approaching this recent upswing in frack sand and the challenges it might face in the coming quarters in funding that plan. 

Image source: Getty Images.

Market looks good for the first time in a while

Based on the initial statement from Emerge Chairman Ted Beneski, you wouldn't think that oil and gas prices were much higher than the $45-$50 a barrel we have seen recently. Thanks to lower breakeven costs for shale drilling, frack sand producers seem to be in hog heaven right now.

After speaking with you all about 2 weeks ago, regarding our exciting acquisition of Osburn Materials, based outside of San Antonio, Texas, we are now pleased to announce that Emerge Energy has reached a critical inflection point with our positive Q1 results. Volume and prices increased dramatically, reflecting the severe tightening of supply and demand in the frac sand industry, and we achieved breakeven adjusted EBITDA during the quarter for the first time since Q4 of 2015. All of our mines and plants are now running near full utilization, and we are seeing prices increase further in the second quarter.

This outlook is in line with what its peers were saying in their respective conference calls. The market for frack sand is in much better shape than it has been in a while, and those idle facilities are up and running again. Start-up costs were high throughout the industry, so don't be surprised if margins improve in the coming quarters. 

Sand supplies are smaller than what the numbers say 

Another interesting wrinkle in this story is that Wall Street may be underestimating how much sand is out there. According to CEO Richard Shearer, there is a difference between the amount of sand that one would assume is available and what is actually available. Much has to do with the total amount of sand a facility mines and the amount of sand that meets oil and gas producers' specifications.

Note that the terms 30/50 and 20/40 in this quote refer to mesh sizes. This is a way the industry measures the fineness of sand. The larger the number, the finer that sand is. These two mesh sizes are considered a coarser sand that is less popular among producers.

We echoed the comments of our peers that the industry is still experiencing a tight level of supply, despite the recent capacity expansions announcements made by us and some of our competitors. We remain sold out of the fine mesh products, and we are starting to see better movement of our coarser grade products, especially 30/50 and even a good portion of our 20/40 product. One of our peers has articulated why the industry supply number must be adjusted to reflect real operating conditions or effective capacity rather than relying upon the nameplate figures. This is a very important point, especially in an environment where the fine mesh sands are in higher demand than the coarser products. As such, you should haircut the nameplate figures by at least 10% to 20% to account for the grade imbalance, and also factor in another 10% for more plant downtime and maintenance to arrive at a plant's realistic output.

If only one company was to say this, then investors might scoff at this statement. On the surface, it looks like a way to make a business look more valuable than it is. Emerge isn't the only company saying this, though, so this is probably something to consider. 

Expanding operations

The fact that demand is robust and that the supply situation is much tighter than it appears on the surface is why Emerge is looking to increase its production capacity rather fast. Right now, Emerge has a couple of expansion efforts in the works, the largest of which is its San Antonio-based Osborne facility. According to Shearer, the company's expansion plans could be big.

Since the announcement was made 2 weeks ago, we have started to market the product and we are receiving strong interest from current and potential new customers. We are close to achieving the Phase 1 expansion of 24/7 operations, and remain on target for Phase 2 completion by Q4 of this year. Phase 1 and Phase 2 expansions will allow us to sell more than 60,000 tons per month of frac sand. The Phase 3 expansion will add another 3 million tons per year in San Antonio by mid-2018.

Our other imminent expansion plan is at our Kosse, Texas site. We are evaluating our options to debottleneck the plant and increase the capacity above 600,000 tons per year. Our ability to finance this project will be an important factor, either internally or through an external source such as a customer. This Kosse expansion will add another 35,000 tons to 40,000 tons per month of capacity.

Just to give an idea of scale for this plan, Emerge's first-quarter production is equivalent to an annual run rate of 5 million tons per year. If the company can deliver on these expansion plans and demand for frack sand remains strong, then Emerge will grow by a significant amount. 

Diving into delivery

Something else that Emerge's peers have been working on for some time are sand logistics and last-mile delivery options. These kinds of offerings make it easier to retain customers since they don't have to worry as much about logistics and sourcing sand. Not to be left behind, Shearer said that the company wants to offer something similar soon. 

[W]e continued to assess our position on a last mile solution. As a reminder, we are providing this through third parties rather than through our own equipment or brand, but there could be an opportunity to expand further into this segment. We will keep studying the different concepts out in the market and will look to consider partnerships that benefit both parties. Last mile services are very much in our business strategy going forward.

The two largest companies in the industry right now -- U.S. Silica Holdings and Hi-Crush Partners -- have seen success with their own respective last-mile delivery options. While it might make sense for Emerge to develop its own by buying some third-party logistics company, it might make more sense to team up with one of these other companies. 

Still tight on cash

So here's the crux for Emerge right now. Even though it has a lot of plans for expansion, it doesn't really have the balance sheet to take on these projects. CFO Deborah Deibert laid out the situation.

We generated a distributable cash flow deficit of $4.3 million for the 3 months ended March 31, 2017, and the Board of Directors of our general partner elected not to make a distribution for the quarter. We are also restricted under our credit agreement from paying distributions at this time. Our capital expenditures for the quarter were $1.4 million, which includes $900,000 of maintenance capital. As we previously reported, we continue to operate on a significant reduced capital expenditure budget and are including only those projects in 2017 that are necessary for our current operations and/or for which we are contractually obligated. We previously reported that our total capital expenditures for 2017 would be around $5 million. But the addition of the San Antonio plant Phase 2 expansion adds almost $3 million to our full year target, which is in accordance with our current covenants. If the market continues to improve, we will seek permission from our lenders to increase the limits.

Any investor who watched Emerge's rise and fall during the first shale boom has to be a little wary about these expansion plans. Management overestimated the need for sand and was spending a significant amount of money on development when the price crash hit. As a variable-rate master limited partnership, the company was paying out all available cash at the end of each quarter and not reserving any for growth. This, in turn, led to an overlevered company that is still under restrictions from creditors related to capital spending and paying distributions. In fact, it had to issue second lien debt to get this Osborne deal done. Second lien notes are never something you want to see a company do. 

Perhaps the market will remain healthy for sand and Emerge will be able to pay off these high-interest debts and start paying distributions to shareholders. Until that happens, however, it may be worth watching this stock rather than jumping in.

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Tyler Crowe has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.