I'll admit it. I am late to the party. I worked in the refining business, yet I didn't see the powerful market forces that were driving profits at Tesoro
Around the same time, in 2002, I was interested in a small company called CARBO Ceramics. It was profitable and paid a dividend, but the price-to-earnings ratio (P/E) was about 30. I thought it was a little too expensive and stopped paying attention. Since then, shares have more than tripled. Looking into the business in detail, there is a good reason for the increase, and CARBO may only be getting started.
CARBO Ceramics claims to have about a 50% share of the ceramic proppant market. Proppants are solid particles used to open fractures in oil and gas wells, allowing the hydrocarbons to flow more freely. Key customers are oilfield services companies like Schlumberger
Getting deeper into the business, I've found that CARBO Ceramics shares many of the characteristics that distinguish companies chosen as Motley Fool Hidden Gems picks. For example:
- Founders with large personal stakes.
- Financial statements that are easy to read.
- A solid asset base with little or no debt.
- Price ratios that significantly undershoot growth rates of free cash flow (FCF).
- Dominant positioning in a profitable niche.
- Plenty of room to grow.
CARBO Ceramics is rock solid when it comes to nearly all of these qualities. Management owns more than 15% of the shares outstanding. The financial statements are simple as pie (mmm.pie) to read. The company has $73 million in cash and cash equivalents, as well as no debt. It controls the largest stake of a profitable niche (ceramic proppants) within the oil and gas production business. It also has plenty of room to grow.
The growth will come from at least three avenues.
First, even with huge growth in the past decade, ceramic proppants still only represent 17% of the proppants used worldwide. As oil and gas companies seek to expand production at existing wells, the percentage of ceramic proppants will continue to increase.
Second, in 2002, CARBO purchased Pinnacle Technologies, which makes the most widely used fracture simulation software in the world. Only a small fraction of wells use hydraulic fracture mapping technology, providing a huge expansion opportunity for this business segment, which is currently showing 50% revenue growth.
Finally, CARBO will continue to ride the wave of expanded hydrocarbon production worldwide. To meet the growing demand, CARBO is expanding capacity by building new plants in Georgia (U.S.) and Russia, and it expanded capacity at its plant in China just last year.
The only question remains whether or not the current price offers a discount relative to free cash flow growth. Here, we take a tumble, as CARBO's recent building spree has sent its normally positive free cash flow into the negative column for the first half of this year. The P/E ratio remains above 30, and one would be hard pressed to consider CARBO a value stock.
Of course, I came to the same conclusion three years ago. This time, I won't stop paying attention -- there is just too much to like about CARBO. Once the new factories are online and the increased capital spending is complete, CARBO will return to being a cash-generating machine. Share count has increased at less than 2% a year for the past five years. Even as a very small company, CARBO initiated dividends in 1996 and has increased the dividend in each of the past four years. It is the dominant player in a growing industry, and at a market cap of just $1.5 billion, I believe it has plenty of growth remaining.
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