Source Energy Services Ltd. may have thought it got its timing right as it scheduled an early-2017 initial public offering, planning to catch an upswing in sentiment in the sector. Alas, not so much: By the time it went public in April, it had to sharply cut its offering price to $10.50; the shares traded below $7 for the first time this week, making investors losers as well.
This sorry state for Source Energy's shares, however, may be an opportunity for those with the longer term in mind. Calgary-based Source Energy is Canada's entry in the surprisingly large category of publicly traded sellers of "proppants," or the sand and materials used in fracking. And there are three factors that could drive Source Energy's earnings up sharply in the next couple of years: More wells may be drilled; E&P (exploration and production) companies are using more proppants for every well; and the company is poised to continue taking share in the Canadian market.
This thesis also applies, in part, to some of Source Energy's U.S. peers, which have also become screaming bargains in a sector sell-off the last few weeks. Not all, however: Investing in proppants sellers these days is kind of like sifting through sand.
Source Energy's boosters say it has one of the most compelling theses around. The company originally started in the late 1990s purely as a transporter of fracking sand. In 2013, it became a miner, pulling Northern White sand (a high-quality sand for fracking) out of the ground in Wisconsin and shipping it primarily to well sites in the Western Canadian Sedimentary Basin.
"The key differentiator is [the company has the] largest and best positioned frac sand terminal network in the basin, in our view," writes Benjamin Owens of RBC Dominion Securities Inc., who has an outperform rating and $13 target price. Source owns six frac-sand terminals with three more scheduled to enter service by 2018, he says; the next closest competing supplier owns three terminals. "We think this footprint is what has enabled the company to become the largest sand supplier to the WCSB" and boost profits "by participating in the full spectrum of frac sand logistics from the mine to the wellsite."
Mr. Owens estimates Source Energy sold one-third of all frac sand consumed in Canada in 2016, up from 25 per cent in 2015 and 20 per cent in 2014. His forecast: 38-per-cent market share in 2018.
And that, most analysts believe, will be a big share of a growing pie.
Over the past several years, Canadian operators, particularly in Source Energy's core Northeast British Columbia/Northwest Alberta market, "have been rapidly increasing the amount of proppant and fluid pumped into a given well," writes Michael Mazar of BMO Nesbitt Burns Inc., who has an outperform rating and $14 target price on the stock. "Producers have discovered that there is a marked correlation between proppant loads and well economics, and have, accordingly, taken a 'bigger is better' approach to completion design."
In 2012, Mr. Mazar says, the average well in the Montney formation in Alberta and B.C. was completed with just over 900 tonnes of proppant; by 2016, that number had increased more than 150 per cent to nearly 2,300 tonnes. In the Duvernay formation in Alberta, average proppant for every well increased from about 1,000 tonnes to over 4,000 tonnes during the same period, he says. "While there will eventually be a point of diminishing returns and proppant intensity will level off, we would point out that the top-quartile operators in the Montney are using well above the average of the group, and we would expect some 'catch up' as other producers modernize the completion designs."
More demand? Higher prices. Analyst Jason Zhang of Cormark, in modelling earnings for Source Energy for 2017, plots prices of $130 a tonne and 1.65 million tonnes sold, generating earnings before interest, taxes, depreciation and amortization, or EBITDA, of $43.1-million. In 2018, he figures $150 for each of the 2.45 million tonnes sold, for EBITDA of $113.5-million.
That profit explosion means that Source Energy – and its U.S. peers – look very, very cheap on forward multiples. Mr. Zhang, who has a buy rating and $15 target price, figures that Source Energy now trades at 3.3 times 2018 EBITDA, versus an average of 4.4 times EBITDA for the U.S. group.
Will, or should, the discount persist? There are even bigger gains to be had if Source Energy can convince investors to eliminate the gap. Mr. Zhang suggests Source Energy deserves a "modest premium" to U.S. peers because any excess supply in the U.S. market is less likely to affect it, given its dominant position and distribution network in Canada. RBC's Mr. Owens, however, suggests Source Energy deserves a discount because it serves a single basin with a single product, lacking the customer and supply diversification of the U.S. companies.
Investors may choose to play the frac-sand thesis by buying some of the U.S. names. If so, the clear choices, according to research firm Morningstar, are Smart Sand Inc. and Hi-Crush Partners LP, both of which currently have the rare five-star designation from the firm (Source Energy is not rated by Morningstar). Smart Sand has ample sand reserves that investors are undervaluing, analyst Preston Caldwell argues, while Hi-Crush is attractive as the lowest-cost producer.
On the flip side, former industry darling Carbo Ceramics, profiled here nearly three years ago may never recover its lustre. As suggested by the name, Carbo's proppants are man-made ceramics, not sand. They improve well performance, it's generally agreed, but they're also more expensive than sand. And as E&P companies cut costs in the downturn, they moved away from Carbo's product, producing some ugly numbers for the company. The company watched its net income of $106-million on $646-million in sales in 2012 tumble to a net loss of $88-million on $105-million in sales over the past 12 months.
Morningstar puts four stars on Carbo, but analysts as a whole see Carbo's comeback much less certain. With Source Energy, Smart Sand and Hi-Crush available, the sector's investing landscape offers finer specimens for investors with true grit.