SND - Smart Sand

[AugustRain]

I originally wrote this in November so some of the details may be slightly off now as the stock price has gone up since then, however, I believe what I wrote still stands.

 

Company Overview

 

Smart Sand is a small fully integrated frac sand supplier and services company. The company is a low-cost supplier of Northern White frac sand, focusing mainly on the production of 100 and 40/70 mesh sand coming from their main facility in Oakdale, Wisconsin. The main facility is adjacent to two Class 1 railroads and can produce up to 5.5 million tons of frac sand annually. The company also operates a transloading terminal in Van Hook, North Dakota to service the Bakken, which contains their main customers. Smart Sand also offers portable wellsite proppant storage under the SmartSystems brand. Recently, the company purchased another facility in Utica which has the ability to produce 3.5 million tons.

 

Industry Overview

 

The frac sand industry has been a difficult one to operate in for the past several years. Two major problems occurred. The first was the discovery of regional sand in Texas. This meant that instead of sand needing to be shipped via rail thousands of KM, it could be shipped hundreds. This drastically reduced the cost of regional sand. Northern White frac sand, which mainly comes from Wisconsin, and was previously the main source for proppant sand, became a lot less desirable in the Permian because of this discovery. The second problem was that many of these Northern White frac sand producers suffered from the same problems as many oil and gas firms. They had burdened themselves with a lot of debt to expand as much as possible. This was done with the expectation that frac sand usage would increase year over year, but instead surplus of frac sand occurred. Most of the public frac sand companies are currently in bankruptcy, or look close to it. The pandemic was the final nail in the coffin for many of these companies that were barely hanging on. Already reduced frac sand prices from oversupply became lower, and fewer companies were continuing their fracking activity.

 

Luckily, the light at the end of the tunnel may be in view. Smart Sand and other frac sand companies have forecast increased sales next quarter. Smart Sand expects an increase in 15-20% in sales, as do many other companies. The low oil prices are shaking out the weak companies, and further consolidation is expected in both the oil and gas industry and the frac sand industry. Investors are hesitant to invest in the oil industry due to its history of value destruction. I believe because of this some of these oil companies may switch back to Northern White frac sand. Specifically, 100 mesh and/or 40/70 mesh sand. A report by Rystad Energy found that higher quality sand increased long-term well production and profit. The initial price of Northern White may be higher, but oil and gas companies may begin to switch to longer term value generation because of investor hesitance.

 

Smart Sand – A Survivor

 

Smart Sand is a low-cost producer that focuses on the production of fine mesh sand. 80% of their Oakdale facility reserves are this finer mesh sand. The company mainly serves the Bakken and Appalachian regions, which are less affected by the regional sand discovered in the Permian. The Bakken and Appalachian are more mountainous regions and the discovery of regional sand in these areas is unlikely. This is why Smart Sand has attempted to cater to these regions. The company has a number of competitive advantages for transporting their sand. The first is that their main facility is adjacent to two Class 1 railroads (Canadian Pacific and Union Pacific). This allows the company to negotiate reduced freight costs more easily. The company also began operating the Van Hook terminal in 2018 to gain a competitive advantage in servicing the Bakken. Finally, the company has unit train capability, which generally reduces freight time to about a third compared to other competitors.

 

The company also purchased a frac sand services company and rebranded as SmartSystems. The industry is quickly becoming oversupplied in this area, but the SmartSystems storage has been a source of profit for the company so far. The company’s SmartSystems design has a number of competitive advantages over silos, box design, or hybrid designs currently in use by other competitors. They allow for quick setup and takedown, dust control, direct to blender offload, and contain no moving parts, making them more reliable. Due to the company’s structure, mainly operating one facility, the company is easily able to ramp up or down production. Instead of attempting to produce as much frac sand as possible, the aim of the company has been to build up their main facility and delivery and wellsite solutions. This has led to very low leverage levels of approximately 0.2x net debt / TTM EBITDA.

 

I believe that Smart Sand is set to survive even if there is a limited switch back to finer mesh sand. As I will outline below, COVID19 has led to a number of opportunities for the company which should help strengthen their balance sheet and position in the frac sand market.

 

COVID19 and Resulting Opportunities

 

The COVID19 pandemic has put a strain on Smart Sand, however, it has led to some major opportunities for the company. Due to Smart Sand’s low debt levels (Total debt of $34M), which is quite spread out, their annual payments for debt are approximately $6.5-7M annually. Lease liabilities are approximately $10.5M in 2021 and decrease each year thereafter. Total lease liabilities are $33.8M. Due to these low debt levels, Smart Sand has ample room to navigate throughout this period of decreased oil prices. It also has put the company in a position to benefit to a bargain purchase which I will outline below. The company recently purchased Eagle Oil and Gas Proppants Holdings LLC, a subsidiary of Eagle Materials Inc. for $2 million in stock. The deal allowed them to purchase two frac sands facilities, although, the only one I will discuss in detail is the Utica facility which can produce 3.5 million tons of frac sand annually, and has access to a class 1 railroad (BNSF). The second facility in New Auburn, Wisconsin will likely remain closed for the foreseeable future unless frac sand prices increase. As part of the deal, Smart Sand also entered into a loan agreement with Eagle Materials, whereby the company could draw up to $5M from Eagle Materials for up to 3 years. Smart Sand recorded this as a bargain purchase of $40M.

 

I view this acquisition as an opportunistic purchase by Smart Sand. The proppant business was a small part of Eagle Materials business and they were likely looking to sell the business for awhile to focus their attention on other aspects of their business. The majority of frac sand companies were in no position to buy these assets, particularly during a pandemic and the historic drops in oil prices. The majority of frac sand companies have facilities idled or closed down due to over-expanding as well. Closing down the facility would have cost Eagle Materials in terms of remediation costs, layoffs, etc. This gave the perfect opportunity for Smart Sand to expand their business for practically no cost and allowed Eagle Materials to exit a business that was not part of their long-term plans. Smart Sand has said that it is expecting to open up the Utica plant by the end of the quarter. Management has stated that the opening of the facility will have little impact on this quarter’s results, but there are a few key benefits from obtaining this facility. Access to the BNSF railroad allows the company to negotiate between 3 Class 1 railroads. The new facility will also likely come with new relationships with other customers, and better allow Smart Sand to become the main supplier for a few big companies under long-term take or pay agreements.

 

Management has not ruled out further acquisitions, but I am not expecting much unless a great deal comes their way. They believe further consolidation in the industry is needed and will occur, and I believe they are in one of the best positions to take advantage of this due to their conservative balance sheet, and their history of strategic acquisitions. Given the companies history, acquisitions that may burden the company with too much debt are unlikely.

 

Consolidations within the Oil and Gas Industry

 

We are starting to see further consolidation within oil and natural gas producers. EQT, one of Smart Sand’s largest buyers, and a company which Smart Sand has a good relationship with is one example. With further consolidation, it is likely that these oil and gas companies will want to consolidate their suppliers as well, and I believe Smart Sand is in a good position for this consolidation. On the latest conference call, management appeared optimistic about further business with EQT as well. With access to 3 class 1 railroads allowing them to negotiate reduced freight costs, supplying finer mesh sand, and good relationships with some of their largest customers, they are well positioned to take advantage while most of their public frac sand competitors are going through bankruptcy. The increase from 5.5M tons to 9M tons of frac sand sold may also help the company cement itself as a reliable and quick frac sand supplier. The company also has the undeveloped Hixton site and the New Auburn facility which they acquired from Eagle Materials, but I do not expect either of these to be running in the near future.

 

Litigation

 

Smart Sand’s accounts receivable is quite unusual. Their accounts receivable is currently at $66M, the majority of which ($55M) is from one company (US Well Services) which Smart Sand is currently in litigation against. Given that Smart Sand has a market cap of $66M at the time of writing, it is quite the interesting situation. This revenue is from shortfall amounts that Smart Sand states US Well Services owes the company. I view this as a heads you win, tails you don’t lose situation. I am not convinced that Smart Sand can win the lawsuit, and even if they do, I am skeptical that US Well Services can pay this amount. Litigation can have unexpected outcomes, so I tend to worst case scenario. Settlement is an option, and has been done before between Smart Sand and Schlumberger. I believe the market is discounting any of this shortfall revenue being collected, however, even a small percentage of the $55M could significantly boost the company and its stock price. If the company cannot retrieve any of the $55M, I do not believe it will impact the stock price in any significant way in the long run.

 

Management

I believe Smart Sand’s management is one of the best in the frac sand industry. They focused on high quality frac sand production earlier than most and in an environment where most companies were trying to produce as much frac sand as possible. The company focused on expanding their main facility, allowing them to easily ramp up or down production depending on the climate, and it has consistently maintained a very low debt load. Management is almost honest to a fault, essentially broadcasting that they had an acquisition in mind during the quarterly conference call before the acquisition was announced. The CEO is the founder of the company, and including their private equity partner (Clearlake Capital Partners), Smart Sand insiders own over 50% of outstanding shares.

 

Clearlake Capital Partners selling out is a concern, but not one I view as likely anytime soon or at these prices. The company is also very much a family run operation with relatives of the CEO working in management positions. This is not something you would typically like to see, but I have no reason to doubt their effectiveness in their roles at this time.

 

Company Valuation

 

By almost every metric Smart Sand is undervalued. Pre-pandemic, the company had cash flow per share of $1.48 which is almost what the company’s stock is currently priced at. I believe it’s safe to say that the market expects very little in the future from this company, but the company has shown that it has the ability to survive, at least so far. Despite the pandemic, Smart Sand has been able to produce $22M cash flow from operations this year. The company was cash flow negative from operations for the most recent quarter, however, on the conference call they mentioned that they received more orders in September this year, so cash flow may be increased in the next quarter. The company is also expecting an increase of 15-20% in sales next quarter, and while their revenue is still drastically below pre-pandemic levels, it looks like the worst may be behind them. Next quarter I would expect the company will be back to cash flow positive and should be able to continue to service debt.

 

I expect the company to continue to grow in the long-term, albeit likely at a slower rate than they have so far. If we look at the last few years since the company IPO’d, the company has increased their book value from $2.63 a share in 2016 to $7.04 a share now. Cash flow per share has also increased each year, from $0.44 a share in 2016 to $1.48 a share in 2019 (I have excluded 2020 from the cashflow due to the pandemic, however, as mentioned they remain cash flow positive this year). While the other frac sand producers were destroying shareholder value, Smart Sand has quietly built up while keeping a manageable level of debt. The company has maintained a very conservative balance sheet throughout their history.

 

Risks

 

This is a small company and comes with many risks, not only due to its small size, but primarily due to the industry it is in. There has been a switch to cheaper regional sand, which has been hurting them for years. The cost of entry into the industry is quite low, which has resulted in many new entrants into the frac sand mining business. You can see the resulting bankruptcies with Carbo Ceramics, Hi-Crush, and Covia. US Silica has managed to stave off bankruptcy, however, it still has quite high debt.

 

Smart Sand has a small handful of customers which result in the majority of its business, and it mainly sells to the Bakken and Appalachian basins, which typically have higher breakeven costs. These companies may be hit harder and come back slower than oil producers in Texas, hurting Smart Sand's sales.

 

The switch to regional sand may increase at a faster rate, which will hinder Smart Sand's sales to a greater degree, even if the Bakken and Appalachia will likely remain reliant on Northern White sand for the foreseeable future. While there is some evidence that higher quality sand increases production and longevity of wells, companies may prefer to switch to cheaper regional sand to show investors decreased well costs.

 

Catalysts

 

Smart Sand recovers in part or in full the $55M from US Well Services.

 

Further consolidation within the frac sand industry and oil and gas industry.

 

New customer relationships due to Eagle Proppants acquisition / Surprise earnings from the new facility.

 

Oil price recovery.

[Nelg]

Thanks for the write-up. I was smart enough to look at this last fall, but not smart enough to buy it. The numbers looked compelling to me and as you mentioned the balance sheet is reasonably strong, but I didn't buy it because it was my understanding (which was apparently incorrect, based on your write-up) that they sold mostly to the Permian, and I was worried about what the regional Permian sand would do to their economics.

 

Can you expand on exactly why they are the low-cost supplier using any available data/numbers you have, and/or how you're thinking about competing suppliers in their market?

[AugustRain]

You are correct that they service the Permian as well. I don't believe they release numbers on each basin, though their top three are Appalachian basin, Bakken, and Eagle Ford / Permian. In the last few years I believe they have focused more on the Bakken and Appalachia, though the reduction in sales from Texas has certainly hurt them, along with most of the industry.

 

They have a few advantages that put them ahead of the competition in terms of lower costs. For their main facility, which has a capacity of 5.5M tons annually, the Canadian Pacific line runs through their property, and the Union Pacific is a few KM's away, I believe. This gives them an advantage in terms of cost of transporting the sand to the railway infrastructure, since the distance is so low. It also allows them to negotiate between the two railways, since they have two options instead of only one. As far as I'm aware this is a bit of a special circumstance. They are simply in a good location. With their newest acquisition of the Eagle Proppants mine, they added an additional 1.6M tons of production for essentially free. A big selling point is that it is close to a terminal with access to BNSF, which gives them a third railway to negotiate with (along with more options for clients and being closer to the Appalachian basin).

 

The second advantage is that a number of operators built out rather than up. They built numerous facilities which tended to have lower annual capacity. This makes it difficult to ramp production up and down and lately has meant a lot of plants are either idled, not working at capacity, or shutdown. Smart Sand went the other direction and built up their one main facility, allowing for higher annual production. This allows for a quick ramp up or down of production compared to peers and is simply more cost effective in terms of personnel, maintenance, etc.

 

The competitors mostly have the disadvantages as I stated above. They built out their capacity via more mines rather than building up in anticipation of ever increasing proppant demand. Most of this was funded through massive amounts of debt. You have a few private companies that still sell Northern White sand and a few public companies: US Silica - large but saddled with a large amount of debt. They are also not a pure play and are more diversified. You also have SHLE, though again they have 3 main facilities, if I'm remembering correctly, all with fairly low annual production capacity which barely rivals SND's main facility, and they have approximately $200M debt, which compared to SND, is about 4x higher.

 

The regional mines in Texas are definitely hurting them. The Texas mines can compete in terms of fine mesh, which is in demand right now. If there is a company in Texas that wants the finer mesh and high crush strength though, going back to Northern White is likely the best option. They will not be able to compete with regional mines in Texas if the companies demand the not so fine mesh sand or that drill shallow wells. I don't believe they need to compete in Texas to survive, though if there is a gradual shift back to finer sand, I certainly wouldn't be upset. With all that said, there is some high mesh sand with decent crush strength that is produced in Texas (See Black Mountain Sand). It can be difficult to get a clear picture of these companies since they are mostly private. Though typically the selling point of Northern White is a higher crush depth than Texas sands, so it can be used in deeper wells. For shallow wells, Texas 100 mesh or 40\70 is a better option, or at least is competitive with Northern White. If the well is say 10,000 ft deep, Northern White would likely win out. At the end of the day it comes down to whether the transport costs are worth the extra production in the Permian. In some cases it may very well be, in other cases, it isn't. Whether the companies follow this, or say go with the cheaper sand for better initial results with regard to cost of production while sacrificing long term gain, I can't say.

 

For the Bakken and Appalachia, they simply don't have sand in the region. They can get sand supplied from Wisconsin, or a few places in Canada, I believe. It simply makes sense to stick with Northern White for these basins. I believe that for these basins, SND is better positioned to grow than many of their rivals due to the lower costs associated with these two facilities, the quality of their location, particularly their main facility, and simply having little debt. I think Eagle Proppants is an example of this. Eagle Materials does not focus on proppant supply. I suspect they wanted to get rid of their facilities to focus on their main business, but there were simply no buyers. They took what they could get from SND because shutting down the facility would have been more costly to shareholders and they weren't likely to get a good deal anytime soon.

 

I don't have any numbers in front of me at the moment. I could likely get back to you on that. Honestly, the fact that they don't have a crushing amount of debt makes them lower cost than their competitors. Everything else I said is just a bonus. US Silica and SHLE would be a good comparison. The other major competitors are going through chapter 11 at the moment. They may come back with less debt, but I am not as confident in their leadership as I would be with SND, nor do they have the benefit of lower costs of production that come from having one main facility.

[Anglozurich]

Thanks for the write up. I looked at this last year and did not see a problem with the litigation. Like you say, write it off. I had a problem with the, quite frankly, enormous levels of capex from 2017 to 2019 to the extent the company didnt make any FCF. How do you get comfortable with forward capex and the general capital intensity of this business?

[AugustRain]

2017 and 2018 was when they were expanding their main facility to 5.5M tons. In 2017, approximately $49M related to capital expenditures was increasing their main facility from 3.3M tons to 5.5M tons. In 2018 they acquired a proppant storage company which they renamed SmartSystems. This is for wellsite proppant storage. The industry has quite a few options here, so the purchase of this company was likely to keep them competitive in the market. With that said the SmartSystems segment seems to be performing quite well for them, so they may continue to expand this in the future. The cost of purchasing Quickthree (now Smartsystems) was $30M. They also acquired the rights to operate the Van Hook Terminal for increased access to the Bakken region. The cost of this was $15.5M. The rest of the capital expenditures in 2018 would have been associated with finishing up the expansion to 5.5M tons capability at their main facility.

 

2019 was mostly expanding the SmartSystems and improvements at the Van Hook terminal.

 

In the future you may have further capital expenditures regarding further expansion of the SmartSystems segment. The company has also mentioned potentially increasing the main facility to 9M tons annually, though I am not sure if that is still in the cards at the point. They have also talked about further consolidation in the industry, which may have an impact, but it is difficult to say what will happen with the industry.

 

The company was free cash flow positive in 2019 and 2020. I do not see any reason why they would not be in the future.

 

In general it is a more capital intensive business, but the company seems to have fairly healthy margins even considering the market environment for sand in the last few years.