Playing in 'Frac Sand'

 | Jul 09, 2013 | 11:00 AM EDT
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One of the beneficiaries of the explosion in domestic oil and gas production over the past half dozen years has been the suppliers of the materials needed for hydraulic fracking.

Fracking is the core technology which has unlocked the huge amount of increase of oil and gas supplies in the United States over the past half-decade. One of the materials used in the fracking process is "frac sand," which is different types of specialized sand compositions. These are used as a core ingredient for the proppant utilized to unlock energy deposits from rock.

Frac sand is heavy and has large transportation costs. It is important to have material sources close to transportation hubs and drilling sites in order to maintain profitability. The industry's business model is similar to owning quarries close to construction projects. The sector has seen tremendous growth over the last few years. Let's take a look at two of the larger players in the space.

US Silica (SLCA) is the second largest company in the sector. Approximately 60% of its output is used in the "fracking" industry. One of the core strengths of U.S. Silica is that its 15 facilities are close to most of the core shale regions in the Mid-Continent (Bakken), Texas (Eagle Ford and Permian) and the East Coast (Marcellus) and to transportation hubs.

The company has doubled revenues and tripled earnings before interest, taxes, depreciation and amortization over the last three years. Despite this growth, SLCA goes for just 10x 2014's projected earnings and the stock sports a minuscule five- year projected price-earnings-to-growth ratio (.46) as well. Revenues are tracking to grow over 80% this fiscal year and analysts project around 20% sales gains in FY2014 as new facilities come online. The shares also provide a 2.4% dividend yield.

The stock has bounced off a recent low of $20 a share and is just under $22 a share. This is a battleground stock. Analysts have a median price target of $27 a share on SLCA, with Jefferies reiterating its "buy" rating recently. S.A.C. Capital also has an over two million share stake.

However, it is also a heavily-shorted stock with a massive short interest. Shorts believe the company will not be able to maintain margins as new supply comes on line. For this reason I am long SLCA via slightly out-of-the-money long dated bull call spreads.

Hi-Crush Partners (HCLP) produces a wide range of frac sands for use in all major U.S. shale basins. It is organized as a master limited partnership.  It has one of the few integrated rail infrastructures at its core facility in the region (Wisconsin). One of the most attractive features of HCLP is its low cost of capital due to the MLP structure as well as its over 8% distribution yield.

HCLP is expected to grow revenues at better than a 50%  compound annual growth rate over the next two fiscal years and it sports a minute five-year projected price-to-earnings growth ration (.20). It also sells for less than 8x projected 2014's earnings. The company recently acquired a frac-sand distributor that gives it new customer relationships in the Marcellus and Utica shale regions. It is projected to be accretive to earnings as well.

The company is the low-cost producer in its core producing region. It also locks in customers with fixed price volume contracts that currently have an average maturity of just less than three years -- which mitigates commodity price risk.

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