Carbo Ceramics (CRR): Is It Ever Okay for a Company to Have No Free Cash Flow?

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May 16, 2012
Someone who reads my articles asked me this question:

Hi Geoff,

A German blogger just posted about this site. It is a list of the most shorted stocks in the USA...

Iwassurprised that ITT Educational (ESI), Carbo Ceramics (CRR, Financial), and Boston Beer (SAM, Financial) are on this list...

ITT has some law problems.

SAM has a "high" P/E ratio but is high quality.

But I have a problem with Carbo. Carbo shows a high EPS but the cash flow is much lower most of the time, and is even negative in five years. This
makes me think of Enron. So do you have an idea why the cash flow at Carbo is much lower than earnings?

Kind regards,


It depends on what you mean by cash flow. There are really three or four cash flow measures to talk about. The most important one is Warren Buffett’s owner earnings. That is a more subjective measure though. So, I’m going to focus on three measures where we can agree on the actual numbers:


· Cash Flow From Operations

· Free Cash Flow

Let’s look at Carbo Ceramics (CRR) using each of them.

And let’s compare each of these to net income. That way we can see why EPS is so much higher than “cash flow.”

I’ll use 10-year cumulative numbers. So, that’s the ratio of 10 years (Year 1 + Year 2 + Year 3....+ Year 10) of net income and the same of EBITDA, cash flow from operations, etc.

The 10-year ratio of EBITDA to net income is 1.87. In other words, Carbo tends to have $1.87 in EBITDA for every $1 of net income. This is almost exactly normal. While I don’t have data on what constitutes a normal relationship between net income and EBITDA in the U.S. today – I can tell you I see plenty of good companies that turn every $1 of EBITDA into 50 to 55 cents of net income. That’s what CARBO is reporting. And that looks normal.

So that’s our first hint of why Carbo’s cash flow is so much lower than EPS. It’s something that earnings and EBITDA both fail to capture. They are losing cash somewhere else along the way.

Well the hunt for answers continues. Next up is cash flow from operations.

Cash flow from operations has totaled about $595 million over the last 10 years. That compares to $570 million in cumulative net income. That’s definitely close. Too close. Something is going on there.

And it suggests Carbo doesn’t produce a lot of free cash each year. If you don’t produce a lot of cash flow from operations relative to net income – there’s no way you can produce a lot of free cash flow relative to net income.

Now, free cash flow. When you said cash flow was sometimes negative – I think this is what you were talking about.

Over the last 10 years, Carbo has only produced $65 million in free cash flow. That’s only about 11% of what they reported in net income.

And, yes, it’s sometimes been negative. But, again, that’s free cash flow that’s been negative.

· EBITDA has never been negative

· Cash flow from operations has never been negative

· And net income has never been negative

Just free cash flow. This is a huge hint as to where Carbo is slipping up from earning money to actually delivering cash to shareholders.

Let’s look at what each of these numbers measure:

EBITDA measures the capitalization independent cash flow of the business. So it takes out interest and taxes. That doesn’t matter in Carbo’s case. The company tends not to borrow.

Okay. So what else does EBITDA do?

Well, it excludes spending on depreciation and amortization. That’s a meaningful expense at Carbo. Depreciation was about 6% of sales last year. Of course, depreciation only takes into account Carbo’s existing assets. Depreciation is an expense used to spread out the past cost of an asset providing benefits now. It doesn’t take into account spending today for benefits that won’t be realized until next year and beyond.

What else doesn’t EBITDA take into account?

Working capital changes.

A lot of folks forget about working capital changes. They’re important. And just looking at free cash flow without considering what’s going on with working capital can cause misunderstandings.

Sometimes a company produces a lot of free cash flow because – like Dun & Bradstreet (DNB, Financial) – it really doesn’t need working capital even when it grows say 3% a year or so. And some companies always need a ton of working capital like Lakeland (LAKE, Financial) or ADDvantage (AEY, Financial). How you feel about how those companies use working capital has a lot to do with whether or not you like those stocks long-term.

Then there are companies that have increased working capital very, very fast over the last decade or so – but they’ve also increased sales at a startling clip.

That’s Carbo.

Let’s look at where the difference between EBITDA and operating cash flow is coming from.

Cash flow from others as shown on GuruFocus’s 10-year financials page for Carbo – I’ll use this as a proxy for working capital changes – was positive in only two years. And not by much. Usually, it’s been negative. Over the 10 years, that single line has added up to a negative $173 million. Wow.

Okay. Then there’s the difference between free cash flow and owner earnings. Owner earnings as you’ll remember is Warren Buffett’s calculation of what a business could pay out to owners in cash at the end of the year – if it stopped growing. But didn’t shrink. More on that later. For now, let’s look at the difference between Carbo’s depreciation and Carbo’s spending on property, plant and equipment.

Over the last 10 years, cap-ex has been: $546 million (or $425 million if you allow cap-ex to provide cash flow in certain years, this is a weird issue I don’t want to touch right now)

And over the last 10 years, depreciation has been: $201.52 million

That’s a big gap. We’ve got some combination of Carbo underreporting economic depreciation by anywhere from $225 million to $350 million or so – or we’ve got Carbo investing something like $225 million to $350 million in growth.

Which is it?

Let’s check the growth angle first.

Over the last 10 years, Carbo has grown total sales by just under 18% a year. Now, I happen to know their new product development record had not been so hot during the 1990s or earlier part of the 2000s. For about 15 years they spent on R&D without launching a single successful new product. Finally, they did have some product success but mostly just by providing options to customers that allowed for more of a tiering of Carbo products where you can use lower end stuff for your lower end applications. They’ve gone even more in this direction with their resin coated sand. Whether you want to call that a big R&D success or not – I don’t know – but I wouldn’t say technological breakthrough is what’s driving Carbo’s sales growth.

My point is – it’s not like they are Apple (AAPL) or something. They didn’t release some hit products and – zoom – sales shot up 18% a year. They probably gained market share with an existing product. In fact, that’s been pretty much Carbo’s whole history.

Carbo is really at its core a one trick pony. There’s nothing wrong with this. It’s better to know one great trick than 100 mediocre ones.

Carbo has differentiated the products a bit to give you this idea that there are all these different products. And they acquired some companies I rather they hadn’t bought.

That’s about it.

Basically, Carbo’s grown for like 30 years because the percentage of hydraulic fractures using a ceramic proppant has been going up, up, up. In the last 25 years, it’s probably quadrupled or quintupled or something. The percentage of hydraulic fractures using ceramic proppants was very deep in the single digits in terms of the number of hydraulic fractures in say 1987 or however far back you want to go. Now it’s a lot higher. So they’ve ridden that wave. You could say they created that wave. But that’s what they’ve done. They’ve manufactured a lot more little clay balls.

What does that take?

I’d love to tell you Carbo Ceramics has the economics of Coca-Cola’s syrup business or something. But it doesn’t. When Carbo grows – it has to invest in growth. It can’t outsource that growth to somebody else. They don’t just design stuff and outsource all the ugly manufacturing aspects to somebody else. They do the manufacturing. And the distributing.

I know this is a long quote. But I want you to read it. It paints a picture of Carbo’s business that will help you imagine how the company really works – and especially what it takes to expand:

“The Company maintains finished goods inventories at each of its manufacturing facilities and at remote stocking facilities. The North American remote stocking facilities consist of bulk storage silos with truck trailer loading facilities, as well as rail yards for direct transloading from rail car to tank trucks. International remote stocking sites are duty-free warehouses operated by independent owners. North American sites are typically supplied by rail, and international sites are typically supplied by container ship. In total, the Company leases approximately 2,000 rail cars for use in the distribution of its products and has contracted for the delivery of an additional 650 railcars by the end of 2012. The price of the Company’s products sold for delivery in the lower 48 United States and Canada includes just-in-time delivery of proppant to the operator’s well site, which eliminates the need for customers to maintain an inventory of ceramic proppant. The Company expands its distribution network as needed to support production capacity additions at the Company’s manufacturing facilities. During 2011, the Company expanded its distribution network. The expansion, which continues into 2012, includes rail car additions as well as increasing finished goods storage capacity at stocking locations in the key unconventional plays the Company serves.”

By the way, they’re always expanding. If you go back and read old earnings call transcripts, old 10-Ks, etc. it’s just expand, expand, expand. And all the sales growth – and the headaches – that comes along with that.

This is the polar opposite of something like DNB. Carbo grows and invests everything it earns in that growth. DNB doesn’t grow. And it doesn’t need to invest a penny in its core operations.

If you noticed, Carbo is talking about having 2,650 rail cars in 2012. This gives you some idea of the logistics of this business. Just one other imagine I’d like to paint: their production capacity is about 2.1 billion pounds of product. While the cost of their product is small relative to the economic investment their customers have made in the wells – it’s not like this is an asset light business. There are a lot of physical assets involved in the business. Physical assets that have to be expanded. So expansion costs Carbo a lot of money.

Also, Carbo has ownership rights in Georgia clay – kaolin if you want to be fancy about it – that should last 15 years. Remember, this is supposed to be a ceramic company. Not a clay company. This is like an airline buying an oil refinery. Also, it’s obvious from some of the things Carbo says in its filings that it has some facilities located where they are in part because of raw material availability.

Again, I think it’s important to consider the scale here. For example, Carbo owns “4,000 acres of land and leasehold interests” near plants in Georgia and Alabama. That’s a lot of property. And they’ve got another 500 acres up in Wisconsin. So right there you have rights in 4,500 acres of property that they have just as a source of raw materials.

Does this explain the cap-ex?

I think so.

Net PP&E – which means net of accumulated depreciation – rose from $112 million in 2002 to $411 million today. So, that’s a $300 million increase in property. Sounds awful. But that’s only about a 14% a year increase in property versus an 18% a year increase in sales. I’m not saying I like property increasing that fast. But I’m saying it makes sense when you’re not an asset light business and you are growing sales in the high teens each year.

What about working capital?

That’s where cash flow from operations falls short.

Inventory has increased 24% a year over the last 10 years. Receivables have increased 17% a year. Sales – remember – have increased 18% a year. I’m just spewing compound rates here, so be careful – compound rates depend a lot on the start and end numbers. And Carbo ran into a big logistical problem recently. They couldn’t move some stuff by rail that they wanted to.

Let’s recap the cash drain for Carbo’s growth.

The increase in inventories over 10 years has been: $116 million

The increase in receivables over 10 years has been $89 million

And the increase in property has been: $299 million

So that’s additional investment in inventory, receivables, and property of: $504 million

Over half a billion dollars. What you’re doing with that money is that you’re taking your winnings from one bet and you’re immediately betting it on the next hand. You aren’t taking it home. So the question is whether the return on that investment is:

· High enough

· Reliable enough

Is it high enough?

Yes. Carbo doesn’t use leverage. By any measure I can come up with its unleveraged returns are lovely. This is a good business. You can do the math for yourself. You’ve seen other articles where I look at returns on investment and especially unleveraged returns on tangible net assets. You can check those numbers for Carbo. But I’m telling you now – they’ll look good. And they’ve gotten better over time – not worse.

So return on investment is high enough.

But is it reliable enough?

This one’s tougher. If Carbo was the only player in the industry – if they had some way to keep other competitors out, I’d say yes. Mostly because I think the inherent characteristics of the business – the value of what you are giving customers versus the cost of providing that service – is really, really good. I think it’s inherently a business with a lot of pricing power between the seller of the proppant and the user of the proppant.

But how much pricing power would Coke have if you’re willing to switch to Pepsi if they undercut Coke on price by just a penny?

I mean, even if you were theoretically willing to pay $10 for a can of cola – if Coke and Pepsi are both right there in front of you and Pepsi is priced at $1.50 a can and you have no allegiance to Coke, well Coke isn’t going to get your $10 are they?

That’s the problem we have here. And it’s compounded by growth. There is no unique distribution here. You are moving things by rail. Anyone can do that.

Carbo certainly does not have the marketing advantages that someone else you mentioned – Boston Beer (SAM) – has. Boston Beer has a way of selling the product that is better than other craft brewers can do. Because they have a better sales force.

And because of the number of accounts they have to call on. Over half of Boston Beer’s business is away from home. And then over half of that away from home business is actually selling to some pretty small businesses.

So when I say anything about marketing at Boston Beer people always fixate on the Sam Adams brand. It’s good to have that brand. But marketing isn’t a synonym for ads.

A strong brand is good. Having that sign out there and people recognize it is helpful. I’d rather own shares of a company where you can put their beer out there and people have seen the logo before. But to think that the words “Samuel Adams” is all there is – no – it’s the sales force. It’s how the product is sold. It’s where the product is consumed. It’s how annoying it is to have to duplicate that from scratch even when you’ve got a killer new product.

And, most importantly, it’s the combination of a nice marketing ability with a product whose image is something the guys with the best marketing capabilities (the giant beer companies) can’t easily match. On the one side of Boston Beer you have really little guys who have the right image – but now they’ve got to get it into restaurants and stores and such. And then you’ve got the big guys on the other side. Who could distribute the stuff. They’d do a great job. But they need to distribute it while basically hiding who they are. Because they have the wrong corporate image for the product. They need to disassociate it from their other products.


You’ve got nothing like that at Carbo. You don’t have distribution advantages like at Boston Beer. This is something you can move by rail. Ultimately, it feels a lot like a manufacturing business where the overall supply and demand of the industry is very important. And that’s not a recipe for as reliable long-term results in terms of return on investment.

What’s nice about Boston Beer is that ultimately it’s a Peter Lynch stock. It has grown quickly in an industry that isn’t growing at all. That’s something you want to look for.

Carbo Ceramics is different. It’s a fast growing business – yes. But it’s a fast growing business in a fast growing industry. That’s the worst kind. You want a fast growing business in a slow growing industry.

Otherwise, you attract attention.

A fast growing business in a fast growing industry is going to face more competition every year.

Ceramic proppant has grown quickly. And everybody has heard about hydraulic fracturing – so I won’t even go there. But the perception is that those things have grown alarmingly fast.

And I wouldn’t disagree with that. For me, the fast growth of Carbo Ceramics is problematic. Because growing assets that fast is not usually good. Asset growth is something you want to watch out for. I don’t like looking at stocks that have grown all sorts of assets by 15% to 25% a year. Unless you can insulate yourself entirely from competition that kind of asset growth is going to end badly.

So that would be my concern with Carbo. Which is different from the concern you have. Totally different. You said it reminds you of Enron. I wouldn’t worry about that. In fact, I wouldn’t worry about the past or present at all with Carbo. I think the past and present look lovely. All I’d worry about it being too much of a growing commodity business in the future. That too much new investment would be made too fast.

Now, the product itself is not very commodity like in terms of prices. Commodities rarely have the kind of psychological advantages this particular product has. As I said about Carbo before, it’s a pixie dust business. You don’t want to bet against a pixie dust business normally. Because something where sprinkling a relatively low cost item on your relatively high cost item causes a big improvement in that expensive item – that’s a recipe for long-term pricing power.

Again, when I say a pixie dust business I want you to think of BASF’s slogan: “At BASF, we don’t make a lot of the products you buy. We make a lot of the products you buy better.”

That’s a pixie dust business.

If you can choose between owning Sanderson Farms (SAFM) and McCormick (MKC, Financial) – pick McCormick. Spice is just a better product than chicken. Well, ceramic proppant is a really, really good product. It’s the spice of the oil industry.

But McCormick isn’t just any spice company. They’ve been around for like 130 years or something now. They’ve got like 40% or more of the spice aisle in your local supermarket.

Their position in the industry is much more settled than Carbo’s position. And Carbo is in a fast growing industry. Spice is not a fast growing industry. So McCormick and Carbo are similar in terms of some of the inherent advantages of the product as a product – they’re both selling pixie dust. But one company is very settled with a very clear future. The other is less settled. Carbo’s industry is less settled.

So, Carbo is selling the spice of the oil business. Which I love.

But growth attracts competition. And that is the danger here. Especially if you have too much growth in hydraulic fracturing. I’m less concerned about too much growth in ceramics vs. other proppants. That attracts competition. But it’s less likely to cause too much capacity to be built too fast and then have several years of excess capacity. Because I don’t think that once market share is taken by ceramics it will be given back over time. I think that’s sustainable.

I don’t know enough to know how much hydraulic fracturing is sustainable.

Ultimately, demand for Carbo’s product is based on something – oil and gas production – that is way outside my circle of competence. And that’s where I’d be worried.

The long-term risk with any company that reinvests as heavily as Carbo does comes from the fact that you absolutely need the company to keep earning good returns in future periods. You aren’t betting on what the company’s ROI is today. You’re betting on what it will be in 15 years.

Why is that the bet?

Because Carbo reinvests really every penny they earn. So, it is a constant betting of your winnings on yet another hand.

If you have a really good business with a durable competitive advantage – that’s what you want. That’s actually much better than not being able to reinvest the money. You want a high ROI business to keep investing everything it can in the business. Over and over. Betting one hand after the next after the next.

So there’s nothing wrong with their cash flow in the past. It’s fine. If the future ROI is fine.

But how do you know what the future ROI will be?

In Carbo’s case – because of how good the economics inherent to the product are – it’s just a matter of competition.

· Will they be competitive?

· Will competitors over expand?

· And do they have a moat?

I know those aren’t the questions you asked. But they’re key. You may have started by asking about fraud – I assume that’s what you meant when you mentioned Enron – but really it’s not about fraud it’s about reinvesting as far as the eye can see.

When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future. And you need to be comfortable with that when you buy CRR.

As far as why people are shorting it – I don’t short stocks, so I’m not the person to ask about that. And there are lots of dumb longs and lots of dumb shorts.

One blog I really like is Distressed Debt Investing. There's a post over there that talks about shorting. You should read it.

I lost money when I was long Barnes & Noble (BKS, Financial). But if you shorted the stock when I bought it – you would’ve lost more than 25% by now, and a lot of time (when the market was rising), and shorting isn’t free. So, it would’ve gone very, very badly for you unless you really had the timing right.

Actually, if you literally shorted it when I went long you'd also have the issue of a couple dividend payments too. When you factor in dividends, I lost a tiny amount on BKS. But the opportunity cost was big. And the risks taken were very, very big. So it was a terrible long. But, it also might not have been as good a short as you'd think - unless you timed it right (the same could be said of the long, at one point you could've made 50% buying when I did and selling at the right time, needless to say I didn't time that right).

My point is just that people are making a bet either way. And they could be right or wrong. If you wanted to bet against hydraulic fracturing – you might short Carbo.

To be honest, if I had to short something, I’d rather short Barnes & Noble than Carbo Ceramics. Because BKS had a worse balance sheet. They’ve got technological obsolescence. And the inherent economics of their business – retail – frankly suck. They just managed to out compete everybody else and become the low cost operator. But that was in a different environment. They are not well adapted to the present. Of course, most of their competition – almost all of it – has already been annihilated. But there isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one.

I said Carbo’s product itself has some similarities to something like McCormick. And that’s true. And I wouldn’t short a stock that sells a product like that at any price.

There are a lot of very price competitive businesses out there. I’m not sure why you would want to short something where the economics of the product are so good. I would not short a great brand.

If you want to short something, short something with:

· A product that has inherently poor economics

· A bad balance sheet

· And deteriorating competitiveness

I’d also rather it be in an industry with a high mortality rate.

I think shorting things like Carbo and Boston Beer is a mistake. First of all, they’re definitely not going to zero. They may be overpriced. But there is a huge risk they can work through being overpriced over time.

But, I think a lot of people are much more short-term oriented than that. So, if you’re shorting the stock for this quarter – well, then that’s a whole different story. I don’t know how to think something like that through.

You probably start with a top down conviction about hydraulic fracturing or something. And then you say, well, it would make sense if Carbo dropped to a normal P/E for the market (that’s quite conceivable). And if you shorted it a while back then maybe you saw a lot of upside just from the possibility of a one-time multiple contraction.

I don’t know if as many people would short the stock if they had to stay short for three or five or ten years. I think, if you made people stay short a stock for five or ten years, you’d have a different set of stocks up there on that list.

Some of them would be up there either way. But I can also see three or four stocks where I think very few people would be willing to short the stock if they had to stay short for five years.

But if you’re buying the stock – even if you don’t intend to stick around for the next decade – the expected ROI in a decade really does matter. When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out.

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