An Ancillary Energy Play Could Be a Bargain

 | Dec 28, 2012 | 11:00 AM EST  | Comments
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A 13G filed with the Securities and Exchange Commission has disclosed that Ardsley Partners now owns 715,000 shares of Hi-Crush Partners (HCLP), a provider of "frac sand" that is used as an ingredient in frac fluids that in turn are being used to extract unconventional oil and gas.

Hi-Crush went public in mid-August, and it's down about 25% from its levels shortly after the IPO. Most of that decline came on Nov. 13, after the company announced that Baker Hughes (BHI) was canceling a supply agreement. Our database of 13F filings doesn't show Ardsley as having owned any shares in Hi-Crush at the beginning of October, so it's possible that the fund believes that the market overreacted to that announcement and has been moving into the stock.

Hi-Crush's market capitalization is about $420 million, but on average, more than 200,000 shares have been traded per day in the last three months, and the current market price is $15.30. So there should be enough dollar volume for most investors.

Hi-Crush filed a 10-Q for the third quarter of 2012, though the accounting is complicated, as the company went public halfway through that quarter. If we total the company's revenue from July 1 through Sept. 30, it was a little over $25 million -- more than triple the sales from the same period in 2011. Hi-Crush reported very high margins, at about 72% during the period that it was a public company, which resulted in earnings of $9.1 million. This figure, which, again, was for half of the third quarter, was more than double what the company had earned during the third quarter of 2011. It also comes out to $0.33 per share, which annualized would be $2.64 and would imply a P/E multiple of 6. Of course, such a short period is sensitive to random variation as well as any seasonal effects.

The company has a limited number of customers -- four, according to the 10-Q -- and so the loss of Baker Hughes could pose a problem. Frac sand is currently in very high demand as drilling activity remains strong in the onshore U.S., and many of the drillers' techniques call for "re-fracking" wells over time to generate more product, so even if prices and rig count fall, demand would be somewhat protected. Hi-Crush reports that it is discussing agreements with both current customers that may wish to expand their purchases and new customers that may need additional frac sand or are looking for alternative sources. However, we'd assume, out of conservatism if nothing else, that Baker Hughes knows what is it doing, and that even if Hi-Crush does find sufficient demand, it will be on poorer terms.

Still, Hi-Crush offers exposure to an attractive industry, and the financials look good. Analysts expect $2.21 per share of earnings in 2013, which would make for a forward P/E of 7. The stock also distributes cash to shareholders, through a formula disclosed in the company's partnership agreement. The distribution for last quarter, paid on Oct. 31, was $0.237 per share, and according to the 10-Q, this was a pro-rated figure for the quarter. In other words, it applied to only the half of the quarter that Hi-Crush was public. If we annualize that payment, we get $1.90 in distributions for a year, or a yield of 12.7%.

As we have mentioned, the period covered in the half-quarter that Hi-Crush has been public is likely not representative, but even the one payment that has actually been made for one-eighth of the company's year is 1.6% of the current stock price. As a result, even if actual payments are only 2 to 3 times that figure, the stock likely deserves consideration from income investors as well.

We like Hi-Crush's industry, and a number of metrics are very attractive, including the forward earnings multiple and the broad range of potential dividend yields. The Baker Hughes development is, of course, a red flag that could cause problems at the company, but we believe it may be worth it to determine in better detail how much of an impact there might actually be. The market may in fact have overreacted and left an intriguing value opportunity.

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