3 Red Flags at CARBO Ceramics

For investors looking for an unobvious investment in natural gas CARBO Ceramics (NYSE: CRR  ) certainly fits the bill. The company is the world's largest manufacturer of ceramic proppants -- tiny beads that get pumped into a new oil or gas well to keep fractures open and hydrocarbons flowing. The company's products enable drillers to maximize the amount of oil and gas ultimately recovered from a well, which has sent revenues soaring 36% since 2010.

Not everything is coming up roses for CARBO, however: The slowdown in drilling in 2012 led to flat year-over-year revenue growth, a 19% drop in net income, and a declining share price. The company's stock has been beaten down in recent months, perhaps because investors are worried about these red flags.

1. Cheaper competition
Sand. There is really nothing novel about it in most cases and it requires minimal processing on its way from mine to customer. That is exactly why the drilling industry has embraced it as a low-cost proppant. Hi-Crush Partners (NYSE: HCLP  ) and U.S. Silica Holdings (NYSE: SLCA  ) are two of the larger players that pose a threat to CARBO's higher-end products. The three have had mixed results over the last year, but keep in mind that Hi-Crush will be more volatile as a master limited partnership.

CRR Chart

CRR data by YCharts

CARBO has worked feverishly to convince drillers that ceramic proppants offer better quality and therefore better returns. Ceramics are much stronger than sand and can therefore withstand the high temperatures and pressures of deep fractured wells. Consider that the more uniform size and shape of ceramic proppants allows for better flow from a well when compared to cheaper sand proppants -- even in shallower wells where ceramic proppants are often overlooked.

Source: CARBO Ceramics

The campaign has worked to some degree. The problem is that each well is evaluated on a case-by-case basis that includes factors such as geography, geology, and reserves. In some cases, ceramic proppants offer only marginal economics and recovery rates compared to cheaper sands -- effectively negating CARBO's selling point.

If that wasn't bad enough, the company is also facing increasing competition from abroad. A number of Chinese companies have flooded the domestic market with cheap ceramic proppants. CARBO is again championing its higher-quality products, but it has to be careful not to tip-off its customers to other ceramic proppant manufacturers moving to America for its vast raw materials and drilling potential. The company responded to cheaper competition and lower drilling by lowering average proppant prices to just $0.34 per pound last year compared to $0.36 per pound in 2011. 

2. Overdependence
Investors should always be cautious of companies that are overexposed to customers, production facilities, and markets. That makes two strikes for CARBO. In 2011, the company generated 92.3% of total revenue from sales of ceramic proppants (the company did not distinguish revenue sources in 2012). Quickly growing environmental services and software businesses won't be coming to the rescue anytime soon.

Another strike is the company's dependence on its two top customers, which made up 35.2% and 13.7% of total revenue. A little detective work shows that these customers are energy giants Halliburton (NYSE: HAL  ) and Schlumberger (NYSE: SLB  ) , listed in no particular order. The good news is that neither Halliburton nor Schlumberger will be ceasing their energy operations anytime soon. As two of the leading fracking companies in the United States, both maximize their profits and reserves by utilizing ceramic proppants from CARBO. The bad news is they may not be as dependent on CARBO as CARBO is on them. 

3. Raw material costs
Ceramic proppants may provide enhanced recovery and economic profiles compared to sand or resin-coated proppants, but those advantages are facing pressure from raw material prices. The process starts with an alumina containing ore such as bauxite or kaolin, which is mined and then transformed into tiny beads. CARBO purchases the majority of its kaolin at market prices via supply contracts. One problem: kaolin prices are extremely volatile. Consider that the average price per ton in 2000 was just $63, but tipped the scales at $121 just three years later. In fact, the doubling in price came despite falling consumption and exports!

Source: United States Geological Survey

A quickly growing proppant industry has drastically increased demand for kaolin. When demand increases, prices are never far behind. And in a strange catch-22 for CARBO, increasing natural gas prices could also lead to stagnant or declining margins. The natural gas industry is cheering for higher natural gas prices for better economics. While that would lead to an increase in drilling activity and more business for CARBO, the company's manufacturing costs (it uses natural gas to create its products) would eat away at margins.

Foolish bottom line
These are just three of the risks facing CARBO Ceramics. While they may not override the growth potential behind the company, all investors should give them serious thought. This is especially true of the firm's overdependence on one line of products and two customers. Still, it could behoove you to invest in unobvious derivatives of the natural gas boom. CARBO offers just the opportunity.

In the meantime, if you're on the lookout for high-yielding stocks, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.

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