Hi-Crush Partners LP: A Shale-Based Income and Growth Play

One of the biggest growth opportunities in this market has been the surge in North American oil production thanks to horizontal drilling for shale oil. The obvious way to participate is to buy upstream oil companies that have big shale exposure, such as EOG Resources (NYSE: EOG  ) (NYSE: EOG  ) (NYSE: EOG  ) or Continental Resources (NYSE: CLR  ) (NYSE: CLR  ) (NYSE: CLR  ) . There is, however, a more focused way to take advantage of the "shale revolution," and that is by investing in companies that produce and deliver the necessary ingredient for horizontal drilling: frac sand.

You might think that such a readily available commodity wouldn't be so profitable. However, the amount and regularity in which drillers need the sand makes it so. Frac sand is used as a proppant, and it is an essential ingredient in 'propping' open fractured shale rock so that oil and gas migrates to the wellhead.

As well laterals become longer and "stages" are added, more proppant is needed in order to fracture the rock. So, demand for proppant is not only a function of wells drilled, but is also increased by longer well laterals, where increased pressure is needed. Frac sand is a leveraged play.

Hi-Crush Partners (NYSE: HCLP  ) (NYSE: HCLP  ) (NYSE: HCLP  ) is the fifth-largest producer in this space and is one of the only master limited partnerships in the industry. Last year, Hi Crush's distributable cash flow increased from $48 million in 2012 to $68 million in 2013, sporting a high growth rate of 40%.

Revenue skyrocketed 87% in 2013 on both higher volume and better pricing. According to management, this trend shows no sign of stopping in a nascent industry, which is both growing and consolidating. Like most MLPs, Hi Crush offers a nice yield -- just over 5%.

Growth story

Source: Courtesy of Hi-Crush Partners Investor Relations.

The graph illustrates the long-term growth opportunity Hi-Crush offers. Use of frac sand is projected to more than double in the ten years between 2012 and 2022. Over that same time period, the price of frac sand is expected to increase to $80 per ton. Supply cost, at the same time, is falling. With production costs around $12, and cost per ton around $60, Hi-Crush has some fantastic and improving margins.

Acquisitions continue to be an option, too. E&P operators in shale areas are increasingly looking for "one-stop shopping," in both frac sand production and distribution. Last year, Hi-Crush made a transformative acquisition of Utica shale-based sand distributor D&I, thereby making Hi-Crush an integrated provider of not only frac sand production but also delivery.

Financials
Total debt sits at a reasonable two times distributable cash flow, but almost all of that debt is in a revolving credit line. The average rate, while low right now, is variable. The partnership's finances are acutely affected by interest rates.

Of the company's $68 million in distributable cash flow, $63.6 million was paid last year (based on today's share count). That leaves a coverage ratio of only 1.069 times -- pretty thin when considering that the company's borrowings come from a variable-rate revolver. This is one risk that Hi-Crush carries.

Regarding the distribution, Hi-Crush's goal is to raise it by low single-digits each year. As a growth company, most incremental cash flow will go to further capital expenditures.

Valuation and conclusion
In valuing it by price-to-distributable cash flow, or DCF, Hi-Crush looks pretty expensive at just under 19 times. But looking at Hi-Crush as a growth company, which it most certainly is, this partnership still looks like a tremendous deal despite its run-up over the last year. With 40% DCF growth, Hi Crush has a PEG ratio equivalent of under 0.5 times, which makes the partnership a great deal.

In the long run, I believe that the shale revolution in the United States is here to stay and that rig counts will continue to grow through the decade. Therefore, I believe Hi-Crush is still a good buy, for those willing to hold it for multiple years.

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