Much digital ink has already been spilt regarding the risk low oil prices pose to frac-sand stocks such as Fairmont Santrol (NYSE: FMSA).
But there are several company-specific threats that don't directly tie into crude prices that I think investors in this company need to be aware of. Let's take a look at what they are, but more importantly, whether this is one frac-sand stock worth buying at today's cheap share price or whether long-term investors should look elsewhere to profit from oil's inevitable, though unpredictable, recovery.
Ability to cut costs is limited
One of the main priorities of any oil-related stock during an oil crash is to conserve cash by cutting expenses. Doing so maximizes the chances of surviving the downturn and potentially opens up the possibility of acquiring distressed competitors to grow market share once crude prices recover.
While Fairmont has been thus far successful in cutting costs -- its last quarter's selling, administrative, and general costs are down 30% year over year -- there are limits to how much cost-cutting the company can do.
That's because of two main things. First, Fairmont is one of the world's largest frac-sand suppliers, with 13.4 million tons of annual capacity, 2.7 million of which is higher-margin resin-coated frac sand.
In its last quarter, total sand sales were 2.2 million tons, meaning the company is using only 66% of its overall capacity. The company has shut down, idled, and reduced production at several of its facilities already. However, if Fairmont wants to maintain market share once oil prices recover, it will have to pay to maintain its existing capacity to a certain degree, which limits its ability to cut costs beyond a certain level.
In addition, Fairmont has certain contractual obligations that will have to be met, even if overall demand is still low because of weak oil prices. For instance, over the next three years Fairmont has $466 million in purchase and leasing agreements it needs to honor, including 3,174 rail cars it needs to buy in 2016 and 2017.
In total, Fairmont has $915 million in contractual obligations coming up over the next three years, including $349 million in long-term debt payments.
Highly leveraged balance sheet means potential liquidity crunch
Fairmont holds $1.23 billion in long-term debt, giving it a total debt-to-EBITDA or leverage ratio of 3.79.
Under the terms of its current $125 million credit revolver -- of which it's able to borrow $113.5 million -- should the leverage ratio exceed 4.75 then its ability to draw on its revolver will drop to 25%. Based on its current letters of credit, Fairmont's ability to access this liquidity would be limited to around $25 million.
Management has said that should current market conditions continue, before the end of 2015 it expects its leverage ratio to exceed 4.75. However, Fairmont is confident that its combined $200 million in cash on hand plus the decreased credit limit should supply enough liquidity to get it through mid-2016. Of course, should oil prices remain low for several years, then Fairmont may find itself in a financial pickle given its contractual obligation unless it can roll over some of its debt that is due in 2017. However, since no one can predict how long low oil prices will last, there's a risk that creditors may not want to lend it the necessary cash, except perhaps at distressed -- that is, high-interest -- terms.
High dependence on two largest customers
Despite having around 80 customers for its proppant division, Fairmont is becoming increasingly dependent on its two largest clients, Halliburton and FTS International, the largest private well completion company in North America.
In fact, between 2013 and the first half of 2015, the percentage of total sales derived from these two customers rose from 30% to 43%.
The risk here is that these oil-service stocks, which are facing mounting pressure from oil producers to lower prices, will be able to leverage their importance to Fairmont to force the company to lower its frac-sand prices -- thus reducing margins even further.
Bottom line: Fairmont is likely to survive the oil crash, but be aware of the risks
Despite the risks, it appears that Fairmont Santrol will survive the oil crash provided it doesn't last for a very, very long time. Whether investors should choose Fairmont over some of its less leveraged competitors -- many of which are paying handsome dividends -- is another story.
If you're already an investor in Fairmont, I wouldn't necessarily advise selling at these undervalued prices. However, if you're looking to invest fresh money into frac-sand stocks, I would recommend looking elsewhere.