3 Reasons to Sell CARBO Ceramics

I recently laid out several reasons that investors should consider CARBO Ceramics (NYSE: CRR  ) , which makes high-quality ceramic proppants for use in the oil and gas drilling industry. The advancement and wide-scale deployment of extraction and recovery technologies in the last decade has resulted in an explosion of tight oil and gas wells. How important are the company's products?

Anywhere from 3 million to 5 million pounds of proppant could be used in a typical 20-stage well, which represents about 5% of a well's total cost. Better yet, as hydrocarbon producers drill deeper wells demand for higher quality ceramic proppants increases. No one is disputing the growth that lies ahead for the industry. However, investors would be wise to acknowledge some of the risks and challenges facing the company. Here are the three reasons to remain cautious about CARBO Ceramics.   

1. Overexposed to market uncertainty
There are several red flags filed under this tag that could spell disaster for CARBO. In 2011 the company generated $625.7 million in total revenue, but 92.3% of that came from ceramic proppant sales. Furthermore, 48% of total revenue came from just two customers: Halliburton (NYSE: HAL  ) and Schlumberger (NYSE: SLB  ) . You can see that any prolonged slowdown in the drilling industry or an unforeseen change in relationships with its major customers would be detrimental to the company.  

Investors may point to the fact that revenue has grown at a CAGR of 23.6% since 2009 as a sign that the company's overexposure is not a major issue. It is possible to grow with a limited number of customers, especially given the strong outlook for ceramic proppants in coming years as wells go deeper and deeper into the Earth's crust. Is the company making a major push to decrease its dependency on its top two customers?

History suggests that management is aware of its overdependence and is steering business to other customers. For instance, the company's top two customers accounted for 62% of revenue in 2009 and 52.5% in 2010. The drop is an encouraging sign, but 48% is still much too high.

2. Rising costs
In 2012 cost of revenue grew 16% compared to 2011, while revenue grew just 3%. That is not a very good ratio given a mere 7% increase in production volumes. Consider that a 22% year-over-year increase in cost of revenue in 2011 was offset by a 32% increase in revenue. Although this may be deemed an unfortunate derivative of the short-term trend in reduced drilling activity, I don't think investors should dismiss it completely. What gives?

While the company owns mineral rights to hundreds of acres rich in kaolin and bauxite-the raw material for ceramic products-the assets are classified as the long-term variety, which means they weren't used in 2012. Most of the company's raw materials are sourced from suppliers close to its Georgia production facility, but that doesn't insulate CARBO from price increases on the open market. Shipping proppant from Georgia to shale plays in the Bakken and Eagle Ford regions can also negatively impact costs, although the company is opening a new distribution center in the Bakken this year. 

Increased production costs will continue to negatively affect income for 2013. Analysts currently expect EPS to fall from $4.59 in 2012 to just $4.34 in 2013, but then return with a bang in 2014 to $5.64 as drilling picks up again (note: prediction). There are a lot of pages on the calendar between now and then, but CARBO remains confident in its long-term growth strategy. The company managed to hike its dividend 13% for shareholders in 2012 – the 12th consecutive year of dividend growth.

3. Large and innovative competition
CARBO has experienced tremendous growth in the last decade, but the company's market cap is still just $2 billion. That pales in comparison to larger companies in the ceramic proppant market. Baker Hughes (NYSE: BHI  ) generated $10.26 billion in North American revenue for its oilfield services segment. Granted, not all of that can be credited to ceramic proppants alone, but the company's wide range of services for all aspects of the drilling process makes it a one-stop shop for customers.

High quality competition also poses direct threats to CARBO's business. For instance, Schlumberger offers the HiWAY Flow-Channel Hydraulic Fracturing System that dramatically improves a well's porosity – thus allowing better flow for hydrocarbons. The company's website claims that its system also reduces proppant use by up to 40% in a single well, and has offset 1.2 billion pounds of proppant since 2010.

Hopefully, you can see that the innovative technology provided by Schlumberger smacks CARBO with the ultimate double whammy. One of its two largest customers wields a technology that reduces the need for its best-selling product. Ouch.

Foolish bottom line
This is not a comprehensive list of the risks facing CARBO Ceramics, nor does it necessarily offset the growing number of reasons that support the case for continues growth. We Fools simply believe that investors need to consider both the risk and reward sides of each investment, while also knowing which information to look for when researching a potential investment.

Domestic oil and gas service companies have taken a hit due to a slowdown in the natural gas drilling boom of the last couple of years. As this market looks to rebound, investors would be wise to consider Halliburton, one of the top companies in the business and one of those most in tune with the domestic market. To access The Motley Fool's new premium research report on this industry stalwart, simply click here now and learn everything you need to know about how Halliburton is positioning itself both at home and abroad.


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