Is Fairmount Santrol Holdings Inc. a Buy?

Most mining industries remove materials from deep underground and bring them to the surface, where the raw product can find more valuable uses. But the flow of materials works in the opposite direction in the frack sand industry. Sand is mined from surface deposits then pumped miles underground to wedge open microscopic cracks in rock that allow oil and gas liquids to flow back to the wellhead.

It's not the only thing that's backwards about the frack sand industry. Right now, most sand miners can't seem to do enough to impress Wall Street and lift their valuations. Fairmount Santrol Holdings (NYSE: FMSA) has fared a bit better than some of its peers, but it's all relative. The company's shares are still down 12% year to date despite an 80% leap in revenue from 2016 to 2017.

Are there good reasons to stay away from the stock as Wall Street suggests, or is Fairmount Santrol a buy?

By the numbers

Fairmount Santrol rode industrywide trends in 2017 to deliver a solid year-over-year improvement. For example, the average rig count in the United States soared from 400 in 2016 to 740 in 2017.

Additionally, more oil and gas customers want to source their frack sand "in-basin" to cut down on logistics costs, which can account for over 70% of the delivered cost per ton. Last year, the company generated 74% of all revenue from in-basin sales after acquiring mines closer to customers and investing in its terminal network. It definitely translated into much-improved performance.

The business also benefited from trends some of its peers couldn't capitalize on. While the majority of proppants consumed are raw frack sand (minimally processed sand), a small percentage of proppants are coated with special resins or processed in large kilns to increase their durability and create a more uniform grain size. Resin-coated proppants are more expensive, and are therefore only used in special cases, which means they'll likely never be a great product to base an entire business upon (see: struggles at CARBO Ceramics). Some frack sand suppliers don't even waste their time on the niche market.

That said, these specialty sands are finding more and more applications as shale drilling techniques evolve. Fairmount Santrol reported a 111% increase in resin-coated proppant sales volume in 2017 compared to the prior year. That's not insignificant due to the portfolio's higher margins compared to raw frack sand, but value-added proppant sales only accounted for 8% of total volume sold last year. It's a solid "nice to have" nonetheless.

Speaking of nice-to-haves, Wall Street and investors are eagerly awaiting the start-up of a key growth project in the Permian Basin and the pending merger with Unimin, which would create a sand mining Goliath overnight.

Looking ahead

Last summer Fairmount Santrol entered a lease agreement for sand mining rights in Kermit, Texas, which is located within an approximately 50-mile radius of 80% of all activity in the Permian Basin. The move follows peer Hi-Crush Partners LP, which reached full operations at its own Kermit mine in October 2017. By comparison, Farimount's mine is expected to begin operations in the second quarter of 2018 and churn out 3 million tons per year at full tilt.

Snagging mining rights in the Permian Basin is a big deal, but it's dwarfed by the importance of the pending merger.

In December 2017, Fairmount Santrol confirmed rumors swirling around the industry by announcing that it had agreed to merge with SCR-Sibelco NV subsidiary Unimin. The combined company would immediately become one of the largest frack sand and industrial sand companies in the world, boasting the following resume:

• Over 45 million tons of sand processing capacity and another 3 million tons of resin-coating capacity.
• Revenue of $2 billion and adjusted EBITDA of $400 million for the year ended September 2017. Since frack sand demand is expected to grow, these totals likely would be significantly higher in 2018.
• An industrial segment that generated 45% of profits and frack sand segment that generated 55% of profits in the year ended September 2017. While these would also change in 2018 and favor frack sand even more heavily, the new company would be much less dependent on oil and gas customers than many of its peers.

Fairmount Santrol shareholders will receive $170 million in cash payments (a windfall of about $0.74 per share) and a 30% stake in the new company, which would list shares under a new ticker on the NYSE. The merger still needs to pass regulatory approval, but assuming that happens, there's no doubt the new company would become an intriguing investment opportunity for energy investors.

Wall Street is wrong about this energy stock

While Mr. Market has been neglecting all stocks tied to the frack sand industry, opportunistic investors could find several intriguing targets for their portfolios. A few management teams appeared to have learned some hard lessons during the last downturn, and Fairmount Santrol would be included on that list. The company has made smart investments aimed at creating long-term shareholder value, such as the Kermit mine, and has worked to further diversify the business by merging with Unimin. Considering the operational improvements made in 2017, expectations for further improvements in 2018, and the fact that shares are trading lower now than when the merger was announced, investors should consider this stock a buy.

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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.