Two billion dollars of its market value has evaporated. Its stock now trades for a quarter of where it was last summer. Of its shares that trade freely, 39% are sold short. Is investors' disgust for Carbo Ceramics (NYSE:CRR) deserved?

Sand in the gears
Carbo Ceramics sells sand. Well, fancy sand. Hydraulic fracturing -- the controversial method of extracting oil and natural gas from otherwise impenetrable reserves -- relies on pumping material into the ground at high pressures to break up rock. Typically, that material is sand.

Carbo Ceramics has created a special kind of sand. Its resin- or ceramic-coated sand allows drillers to get more oil or gas out of their wells. And because fewer tons of fancy sand is required to complete a project, the wear and tear on drillers' equipment is reduced. The downside? Although sand is ridiculously cheap, Carbo's fancy sand is not.

What bearish investors see
Will oil prices hovering below $50, fewer wells are being drilled. Demand for sand of any variety falls with drilling activity. But if volumes are collapsing, it isn't showing up in Carbo Ceramics' top line. Revenue declined a measly 2.8% in 2014. The recently ended fourth quarter -- certainly the worst oil services environment in years -- actually grew over the fourth quarter in 2013. 

The story unfolds as you move from revenue to profits. Despite higher revenue, operating profit tumbled 28% in the fourth quarter. The culprit is aggressive cost cutting on the part of drillers. Fighting to stave off their own shrinking profits, drillers are hunting for every avenue to cut costs. Never mind that Carbo's fancy sand is economically superior to basic sand -- it needs to go.

TypeQ4 2013 (Millions of Pounds)Q4 2014 (Millions of Pounds)
Ceramic 409 409
Resin Coated Sand 89 35
Northern White Sand 51 413

Source: Company press release.

Volumes for fancy sand -- the ceramic and resin varieties -- have collectively fallen, while basic Northern White sand has exploded. Unfortunately for Carbo, the margin difference between fancy and basic sand is enormous. The company has seen a precipitous fall in margins as a result.

Source: Capital IQ.

As a manufacturer, Carbo has only limited ability to scale back its ongoing expenses to reflect volume changes. It costs roughly the same to run factories and pay employees regardless of the price its products fetch. That can spell trouble when demand suddenly shifts from high- to low-margin products.

But is it really that bad?
Let's look on the bright side. Carbo's balance sheet is reasonably strong. Net debt rounds to zero, so at least the company doesn't risk breaking a debt covenant or struggling to meet interest payments. Both are becoming problematic for others in the industry.

Though margins have fallen sharply, Carbo is still profitable, though barely. More importantly, cash flow has remained decent. We don't yet have the figure for the fourth quarter, but in Q3 Carbo generated $39 million in cash. Carbo has spent over $100 million annually reinvesting in the business. In last week's conference call, CEO Gary Kolstad and CFO Ernesto Bautista hinted that only $30 million to $40 million is required to maintain operations. That's how much cash the company generated in its third quarter.

After falling 75%, Carbo's stock is trading for tangible book value. Sure, Carbo is tied up with fancy sand that might be held at prices that are now too high. But inventory constitutes just 15% of Carbo's assets, so overvalued sand would inflate book value only minimally. 

An inflection point
This cheap of a valuation is unusual for a company that continues to generate a meaningful stream of cash. Even more unusual is the continued sky-high short interest in the stock. A third of shares have been shorted. Of the 85% of the shares that are freely traded (15% are held by management and board members), nearly 40% are held short.  These figures earn Carbo Ceramic the title of "Most Shorted Energy Stock."

It would be injudicious to argue that those currently short Carbo Ceramics haven't considered the stock's merits. Depending on when these investors entered their positions, they've been quite right on the stock and could be sitting on a tidy little profit to prove it. But shorting Carbo Ceramics' stock 50% or 75% ago involved a different thesis than it does today. No stock is a buy (or a short) at just any price. At some point, the valuation catches up with the stock's fundamentals. Carbo has been a great short, but we may be reaching that inflection point.