Value investing legend Warren Buffett (Trades, Portfolio) says to “be fearful when others are greedy and greedy when others are fearful. Resource investing legend Rick Rule likes to say that, when it comes to commodity investing, you are either a contrarian or you are broke. The recent collapse in oil prices present us with an exceptional opportunity to combine that valuable advice and be a greedy contrarian investor today while buying the deeply undervalued and misunderstood shares of U.S. Silca Holdings (SLCA, Financial).
Why does this opportunity exist?
I doubt there is even a casual follower of current events in the United States who has not heard of hydraulic fracturing, commonly referred to as “fracking,” and the effect that process has had on the energy industry in the United States. This process has unleashed such a massive amount of oil and gas from our onshore shale formations that it has caused a sudden collapse in the global price of oil. The huge volumes of natural gas being produced from these shale formations have driven the price of natural gas from a high of around $13/mmBTU in the summer of 2006 to under $4.00/mmBTU today.
And oil prices have followed suit from their all-time high over $140/bbl. that was reached in the spring of 2009 as shown in the chart below.
When value investors are seeking ideas and inspiration, we tend to look to the words of wisdom from some of the modern day wizards of the technique. Warren Buffett (Trades, Portfolio) is obviously the best-known value investor of our time, and he likes to tell others to “be fearful when others are greedy and greedy when others are fearful.”
Investors in the oil and gas sector are fearful, and they are selling anything that has any association with this industry as fast as they can and not the least bit concerned about asking questions as to why. Clearly others are fearful right now and clearly it takes a true contrarian to buy into this sector at this time.
One of the premiere suppliers of products and services to the shale oil and gas industry is U.S. Silica Holdings. They supply the specialized sand used in the process of hydraulic fracturing to hold open the fractures created in the shale stone that allow the oil and gas to flow through the cracks and become a recoverable resource. Just as the two charts above has illustrated, the chart below of U.S. Silica’s share price shows it has not been spared by the carnage in the industry either.
From a 12-month high of just over $73 in September of 2014, the shares plummeted 69% to a low of $22.71 on December 16. But I believe the market has grossly misjudged U.S. Silica and presented us with a spectacular opportunity for huge gains if we choose to act before this error is recognized and corrected.
What has the market overlooked?
In my view, there are several valuation errors the market appears to have made in regard to U.S. Silica. First of all, I believe the selloff in the stock is overblown. Hydraulic fracturing is the reason we are seeing such low prices for oil and gas and SLCA is a key player in making that process work effectively. Second, the collapse in global oil prices was accelerated by the recent announcement from OPEC that they would not be reducing oil production to support higher oil prices.
This decision from OPEC has nothing to do with any desire to aid global consumers or help economic growth around the world. It is a good, old-fashioned price war designed to price their competition out of business. They no longer control the world’s oil supply and a decision by them to cut production today would simply prop up prices for their competitors in the US who would continue to produce at increasing levels. They are hoping that lower prices will put their competitors out of business and hand control of the world energy markets back to them on a silver platter. In simple terms, they are engaged in predatory pricing practices. In the U.S., this practice could constitute a violation of law; but OPEC doesn’t operate under U.S. law and they are not going to give up their stranglehold on the global oil market without a fight.
However, oil and gas production from fracking continues to grow in the U.S., and I don’t think this Genie is going back into the bottle anytime soon. Therefore, the businesses that supply critical products and services to the fracking business will be with us as well.
But U.S. Silica is far more than just a supplier of sand to the oil and gas industry. It supplies silica products across a range of growing industries in the United States and North America including glass, chemical, foundry, building products, fillers and extenders and industrial filtration and treatment.
One reasons these industries are now growing in the U.S. is that they are energy intensive and energy has become cheap in the U.S.; particularly natural gas. Natural gas is the preferred fuel source for power in plants in most of the U.S. based industries listed above because it is readily available, cheap and clean; it is also one of their largest costs of manufacturing. While the price in the U.S. is currently below $4/mmBTU for natural gas, it is three to four times that level on the world market as shown below.
So U.S. Silica produces fracking sand that drives the price of domestic natural gas down far below the global market price and attracts customers for all of their other products to the U.S. and increases sales for U.S. Silica across its other product lines.
The market is treating the stock of U.S. Silica as if it were nothing more than a supplier of fracking sand to the oil and gas industry, but it is much more than that and the cheap domestic prices for natural gas in the United States are drawing new customers for U.S. Silica to our shores from overseas.
When the market mistakes U.S. Silica for a one-trick pony supplying sand to the fracking industry, it is making a serious miscalculation and creating a massive opportunity for those who know how to recognize the real value of the overall business by looking beyond the headlines.
How large is the opportunity?
As oil prices crashed recently, shares of U.S. Silica fell from a high of $73.43 in September to a low of $22.71 on December 16; a stunning decline of 69% in less than 4 months! However, between December 16 and 19, the share then bounced 25% higher to close on Friday at $28.41/share. Could the market be recognizing the error it has made in valuing the business? How large an error has it made?
SLCA is expected to produce earnings per share of $2.45 in 2014 based on the average estimates of the 11 analysts providing guidance. The overall range of the estimates is from $2.28 to $2.55/share. This means that the company is currently priced at only 11.56 times current year earnings. For 2015, there are 15 analysts providing earnings estimates with an average of $3.06/share. This creates a forward P/E ratio of a mere 9.28 times 2015 earnings. In a broad market where the average P/E is currently over 17 times earnings, this business appears to be priced at about half of its fair value considering the broad range of industries in which its products provide a critical component and the anticipated domestic growth for those industires.
But SLCA’s numbers look even more attractive when compared to the expectations analysts have for the long-term earnings growth rate over the next 5 years which is a stellar 40% annualized rate. If this projection is off by 50% and the earnings only grow at 20%/year, this stock should be trading for at least $60/share simple to be at a price to earnings growth (PEG) multiple of 1. For a business projected to grow this quickly, I normally assign a PEG multiple of 1.5 which would produce a fair value estimate of around $90/share or about 200% above the current price.
What is the near-term catalyst that could ignite the shares?
To begin with, a simple, basic analysis of the stock price should attract a new wave of value investors, and we may have already seen the beginning of that with the recent four-day bounce of 25%. As we move into next year and the analysts’ earnings projections do not fall by a significant amount, the share price should begin to move higher fairly quickly. As a value-oriented investor, I actually prefer share prices to remain depressed well below my fair value estimate for an extended time as it gives me a broader opportunity to build a large position. I fear the extreme and obvious undervaluation of this business will not allow it to stay this cheap for long.
As the figures above reveal, this stock still has exceptional upside potential even after a 25% bounce from its low. The price chart provided above also clearly displays the current valuation of the business related to it historic levels and it is far closer to the low end of it normal P/E range than it is to the high end of that range. It is also worth noting that the shares bounced hard after touching the low end of that range at $22.71 on the 16th.
Based on this analysis and the recent and historic valuations of this business, it appears to me that the downside risk is about 25%, to the approximate level of the recent low, and the upside potential is about 300% to $90/share that would price it at a PEG ratio of 1.5 of the long-term earnings growth rate currently projected by the analysts providing guidance, if those estimates are 50% too high! That produces a reward to risk ratio of 12:1. This is what I call a slam dunk. Buy it now before it runs even higher.
