On the face of it, CARBO Ceramics Inc. (NYSE:CRR) is a wonderful business with tremendous growth prospects. For the moment, Carbo’s business will remain wonderful and its high growth rate will likely continue for at least a few more years.
In fact, shareholders will probably be rewarded for owning the company with share price appreciation exceeding that of the S&P 500 over the next few years.
Unfortunately, the company has a fatal flaw that will eventually cause it to fall flat on its face and leave long-term shareholders with sub-par returns.
Carbo has grown at an extremely high rate over the last two decades. Demand for its main product — a high-quality ceramic proppant used to enhance hydraulic fractures — has skyrocketed as fracking has taken the oil and gas industry by storm.
From 2003 through 2011, Carbo grew pre-tax income at an annualized rate of 17.3% before a slowdown in drilling caused a decline in 2012. In addition, Carbo earns really high margins — since 2002, the company has averaged a 26% pre-tax margin.
High margins are a testament to the products’ pricing power. High-quality proppant is just a small part of the total cost of a well, but it is responsible for a disproportionate percentage increase in profitability of a well. As a result, Carbo can charge a little more and its customers will not run and switch to a lower-grade proppant.
As a result of pricing power, Carbo has been able to produce earnings that it can then re-invest back into the business to produce more profits and continue the growth story.
As I said in the introduction, I believe owners of Carbo may continue to be rewarded by share price appreciation for at least a few more years. But when they sell — possibly at a massive profit — they will be selling to a greater fool. Here’s why:
Carbo re-invests all of its cash into its business — a business that earns high margins and really high returns on investment. This is something shareholders should normally want — a dividend or share repurchases do not make sens when a company can compound the money at a high rate by re-investing in the business.
Unfortunately, the music will eventually stop and Carbo shareholders will end up owning a company that reinvested all of its excess cash into a business with declining ROI. This is because Carbo lacks a durable competitiveadvantage.
Companies that lack durable competitive advantages cannot sustain outsized returns on investment. Carbo’s only competitive advantage at the moment is that it sells the best proppant on the market. But high ROI attracts competitors, and competition is the enemy of moatless companies.
Carbo is only one of many companies in the proppant business. It manufactures a high-quality proppant that can be closely replicated by competitors. As fracking continues to grow in popularity, a flood of proppants will eventually hit the market to take advantage of the enormous growth in the industry and the outsized returns. But competition always lowers returns — and it will lower Carbo’s as well.
Could Happen Sooner
I think Carbo still has some room to run. I do not think shareholders will be punished in the short term. But here are some reasons why pain could lay just a year or two away for shareholders:
Halliburton Company (NYSE:HAL) has significant exposure to the North American market — which has been great for Carbo. Unfortunately, it is focusing its expansion efforts on international markets — India and China in particular — where Carbo’s competitors can more easily supply the company with proppant.
Although Halliburton Company (NYSE:HAL) has a fortress balance sheet and generates lots of cash flow, a catastrophic deterioration of its business would mean big trouble for Carbo.
But Schlumberger Limited. (NYSE:SLB) is the real short-term threat to Carbo’s business. The company’s HiWAY fracking technique reduces the need for proppant by up to 40%. The technology is being deployed in a growing number of North American fracking operations and poses a major threat to proppant demand.
Sometimes it is difficult to imagine that a company growing as quickly and as profitably as Carbo will suddenly fall off a cliff. Sometimes, even if you believe that it will eventually fall off a cliff, it is difficult to pass up the opportunity for short-term profits. Some people have had success trading in and out of stocks at the right time, but it is not something that usually works over long periods of time.
If you want to make a lot of money over the course of a long investing career, stick to buying great businesses with durable competitive advantages. It’s not the only way to compound your wealth at a high rate — but it’s the surest way.
The article Fatal Flaw Will Sink Long-Term Owners of This Stock originally appeared on Fool.com and is written by Ted Cooper.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.