Meet the rocket ship named CARBO Ceramics (NYSE:CRR). After being left for dead by Mr. Market in the last several months, the company reminded investors of its existence by beating Wall Street on both the top and bottom lines. There may be several good reasons to keep the world's largest supplier of ceramic proppants -- the tiny beads pumped into hydrocarbon wells to keep gas and oil flowing to the surface -- on your investing radar. However, there are several serious threats to the company's business even with the upbeat second quarter.
Shares popped because expectations were so low: Analysts had called for earnings of just $0.67 per share on revenue of $146 million. The company lifted the curtain to reveal earnings of $0.71 per share on revenue of $153.7 million. That may have walloped Wall Street, but revenue fell 13% and operating profit fell 49% compared to last year's second quarter.
Profits were affected by slow drilling activity, less than optimal utilization of production facilities for resin-coated sand, increased production of lower-cost sand-based products, and a lower average selling price for ceramic proppants -- a trend that has crept up on the industry for several years now. Interestingly, research and development into commercializing its new proppant technology slashed an impressive $0.08 per share off earnings. If the company's reportedly best-in-class ultra-deepwater proppant under development can impress enough drillers, the market opportunity could be huge.
The truth is that 2013 was penciled in as a poor year for CARBO from the start thanks to a challenging drilling environment and falling well totals. So if the company can manage to float through this year without scraping bottom, what can it do in 2014 and 2015 when drilling activity is expected to increase? That's the question being asked by investors right now, who seem to like the answer.
CARBO is still very dependent on ceramic proppant sales, but it does wield a portfolio of quickly growing services. The company's Fracpro fracture design software and environmental business, Falcon Technologies, witnessed increases in client base and revenue. StrataGen consulting is also looking to grow domestically. However, it appears that the quickest and largest growth will come from resin-coated-sand proppants -- a 600 million pound per year facility is waiting for market conditions to improve before being completed. Unfortunately, the market remains oversupplied and an official completion date cannot be set just yet.
Perhaps the best news was that one of the biggest risks to the company's business may be subsiding. Sales of low-cost, low-quality ceramic proppants have been pouring into domestic energy plays from China. CARBO has worked feverishly to educate drillers on the dangers of such proppants in recent quarters and announced that "inventories appear to be shrinking". That could lead to increasing market share for the company when drilling activity picks up.
The facts certainly support CARBO's claims. Consider the following image, which shows CARBO's ceramic proppant on the left and a low-quality Chinese ceramic proppant on the right taken from a well in Bakken.
The uniform size and shape of the proppant on the left allows for much better hydrocarbon flow in a well, whereas the irregular shape of the proppant on the right will reduce flow and decrease the economics of a well. Additionally, low-quality Chinese proppants are not as strong, which causes them to crumble into fine particles that clog wells.
Foolish bottom line
All in all, I think the future remains bright for CARBO if it can continue to improve its distribution and logistics network to cut transportation costs and, of course, if drilling activity increases in the years ahead. More efficient operations should be the priority of management right now, since efficiency will help the company withstand future market downturns in a more profitable way. Offshoot businesses -- such as Fracpro and Falcon -- are important, but remain too small to make much of a difference to the overall business. If you are interested in learning more about the world's leading ceramic proppant producer, you will want to start here.