There are good reasons to think frack sand supplier U.S. Silica (NYSE: SLCA) and water technology specialist A.O. Smith (NYSE: AOS) could struggle to grow in the year and years ahead. The former's fate is linked to a commodity market with a volatile past, while the latter is facing obstacles in its most important growth market.
But investors with a long-term mindset who look below the surface will see reasons for optimism in each business. The changing dynamics of American shale energy and the forgotten slow-and-steady growth of the North American water heater market are likely to help U.S. Silica and A.O. Smith, respectively, continue to grow for the foreseeable future.
What happens when the supers move into the Permian?
To be blunt, U.S. Silica hasn't been a great stock to own in recent memory. The only time in the last five years investors could have purchased shares and be sitting on gains at current prices was...the last five months or so. But a closer look suggests the business is well positioned to deliver sustainable operations in good times and bad going forward. Given the shifting dynamics of American shale, there's potential for significant upside.
The business reported $392 million in adjusted EBITDA in 2018 (notably excluding roughly $282 million in asset impairment charges), which marked a healthy improvement from $307 million the year before. Perhaps a better sign of the strength of operations is the fact U.S. Silica generated a record $310 million in cash from operations last year.
The recent acquisition of industrial ceramic manufacturer EP Minerals looks like a stroke of genius in retrospect. Industrial sales volumes increased just 8% from 2017 to 2018, but average selling prices soared 66% in that span. That led to a 79% year-over-year increase in revenue for the industrial segment. The company's other subsidiary, SandBox Logistics, is also crushing its niche in last-mile deliveries of frack sand. U.S. Silica says the business has 24% market share based on throughput volumes.
Of course, the company's bread-and-butter business of frack sand deliveries is highly dependent on the pace of oil well completions, which have been subdued thanks to a lack of crude oil takeaway capacity, primarily in the Permian Basin. There are two reasons that could quickly change. First, a slew of major pipelines is starting up in 2019 and 2020 that can help relieve bottlenecks in the region.
Second, the supermajors are beginning to consolidate acreage in the Permian Basin. The scale they introduce could push production costs down to levels not seen outside Saudi Arabia. For instance, ExxonMobil thinks it can drive pumping costs to $15 per barrel and pull up 1 million barrels per day by 2024. That would allow production to proceed no matter the global benchmark prices -- and provide a huge boon for in-basin sand suppliers such as U.S. Silica.
Considering shares are trading at a low valuation relative to earnings today, when operations aren't firing on all cylinders, it doesn't seem Wall Street is taking the supermajor shift too seriously yet. Investors willing to factor it into their five-year forecasts could beat analysts to the punch.
A slowing Chinese economy can be navigated
A.O. Smith may be in the boring business of water heaters, but it has quietly been one of the best growth stocks on the market since it went all in on water technologies in 2011. The ascension has been powered by its dominant market share in China, where tens of millions of newly formed middle-class households purchased their first-ever water heaters. In contrast, the typically slower-growth North American market is primarily driven by slow-and-steady factors such as replacing older equipment.
Considering the Chinese market has driven the stock to incredible heights -- and deservedly so -- Wall Street has been freaking out over the impact of the country's economic slowdown on the business. Analysts aren't exactly wrong. A.O. Smith reported that North American market revenue outgrew its rest-of-world segment in 2018, and management expects sales in China to decline as much as 10% in 2019.
That creates one of the most significant hurdles for the business in recent memory, but operations will remain comfortably profitable. A.O. Smith generated 75% of total adjusted segment earnings from the North American market in 2018, thanks to bolstering its product lineup with some of the most energy-efficient water heaters and boilers on the market. It grew global annual water treatment sales to $400 million, compared to just $35 million seven years ago, and became the exclusive water-treatment products supplier to Lowe's.
The ability to leverage its leadership position and diversify revenue streams with new products provides a healthy cushion against a slowing Chinese economy. Reduced consumer spending in the country will still sting, to be sure, but A.O. Smith exited 2018 with $645 million in cash and a net cash position of $424 million. It generated $449 million in cash from operations last year, which marked a 38% increase year over year. It also reported record revenue and adjusted earnings.
In other words, investors with a long-term mindset could find the recent slide in shares to be a great opportunity. Then again, a long-term mindset isn't required to decisively label A.O. Smith as an attractively valued growth stock. Shares change hands at just 20 times trailing earnings and 17.4 times future earnings. By comparison, the S&P 500 trades at an average of 30 times cyclically adjusted earnings.
Investors willing to bet that management can navigate a slowing Chinese economy could see above-average returns in five or 10 years' time.
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