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Three Red Flags at CARBO Ceramics Inc. (CRR)

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For investors looking for an unobvious investment in natural gas CARBO Ceramics Inc. (NYSE:CRR) certainly fits the bill. The company is the world’s largest manufacturer of ceramic proppants — tiny beads that get pumped into a new oil or gas well to keep fractures open and hydrocarbons flowing. The company’s products enable drillers to maximize the amount of oil and gas ultimately recovered from a well, which has sent revenues soaring 36% since 2010.

CARBO Ceramics Inc.

Not everything is coming up roses for CARBO Ceramics Inc. (NYSE:CRR), however: The slowdown in drilling in 2012 led to flat year-over-year revenue growth, a 19% drop in net income, and a declining share price. The company’s stock has been beaten down in recent months, perhaps because investors are worried about these red flags.

1. Cheaper competition
Sand. There is really nothing novel about it in most cases and it requires minimal processing on its way from mine to customer. That is exactly why the drilling industry has embraced it as a low-cost proppant. Hi-Crush Partners LP (NYSE:HCLP) and U.S. Silica Holdings Inc (NYSE:SLCA) are two of the larger players that pose a threat to CARBO Ceramics Inc. (NYSE:CRR)’s higher-end products. The three have had mixed results over the last year, but keep in mind that Hi-Crush Partners LP (NYSE:HCLP) will be more volatile as a master limited partnership.

CRR Chart

CRR data by YCharts

CARBO Ceramics Inc. (NYSE:CRR) has worked feverishly to convince drillers that ceramic proppants offer better quality and therefore better returns. Ceramics are much stronger than sand and can therefore withstand the high temperatures and pressures of deep fractured wells. Consider that the more uniform size and shape of ceramic proppants allows for better flow from a well when compared to cheaper sand proppants — even in shallower wells where ceramic proppants are often overlooked.

Source: CARBO Ceramics

The campaign has worked to some degree. The problem is that each well is evaluated on a case-by-case basis that includes factors such as geography, geology, and reserves. In some cases, ceramic proppants offer only marginal economics and recovery rates compared to cheaper sands — effectively negating CARBO Ceramics Inc. (NYSE:CRR)’s selling point.

If that wasn’t bad enough, the company is also facing increasing competition from abroad. A number of Chinese companies have flooded the domestic market with cheap ceramic proppants. CARBO is again championing its higher-quality products, but it has to be careful not to tip-off its customers to other ceramic proppant manufacturers moving to America for its vast raw materials and drilling potential. The company responded to cheaper competition and lower drilling by lowering average proppant prices to just $0.34 per pound last year compared to $0.36 per pound in 2011.

2. Overdependence
Investors should always be cautious of companies that are overexposed to customers, production facilities, and markets. That makes two strikes for CARBO Ceramics Inc. (NYSE:CRR). In 2011, the company generated 92.3% of total revenue from sales of ceramic proppants (the company did not distinguish revenue sources in 2012). Quickly growing environmental services and software businesses won’t be coming to the rescue anytime soon.

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