Smart Sand, Inc. Q2 FY2023 Earnings Call

Good morning and thank you for joining us for Smart Sand's second quarter 2023 earnings call. On the call today we have, Chuck Young, Founder and Chief Executive Officer; Lee Beckelman, Chief Financial Officer; and John Young, Chief Operating Officer. Before we begin, I would like to remind all participants that our comments made today will include forward-looking statements, which are subject to certain risks and uncertainties that could cause actual results or events to materially differ from those anticipated. For a complete discussion of such risks and uncertainties, please refer to the company's press release and our documents on file with the SEC. Smart Sand disclaims any intention or obligation to update or revise any financial projections or forward-looking statements whether because of new information, future events or otherwise. This conference call contains time-sensitive information and is accurate only as of the live broadcast today, August 9, 2023. Additionally, we will refer to the non-GAAP financial measures of contribution margin, adjusted EBITDA, and free cash flow during this call. These measures, when used in combination with our GAAP results, provide us and our investors with useful information to better understand our business. Please refer to our most recent press release or our public filings for our reconciliations of gross profit to contribution margin, net income to adjusted EBITDA, and cash flow provided by operating activities to free cash flow. I would now like to turn the call over to our CEO, Chuck Young.

Thanks Chris, and good morning. Smart Sand delivered another quarter of strong operating and financial results. In the second quarter, we sold approximately 1.1 million tons, we generated $19 million in contribution margin and $11.4 million in adjusted EBITDA in the quarter, both solid improvements over second quarter 2022 results and first quarter 2023 results. Additionally, in the first half of the year, we generated approximately $12 million in free cash flow, including approximately $11 million in the quarter. We expect to remain free cash flow positive for 2023. In the quarter, we paid down approximately $13 million in debt. We are committed to maintaining our strong balance sheet that will allow us to continue to successfully manage the operating cycles in the oil and gas industry. Our focused business strategy of providing high-quality Northern White sand in an efficient and sustainable fashion to our customers throughout North America continues to deliver strong financial results and long-term value for our shareholders. We could not have achieved these results without the dedication and hard work of our employees. I want to thank our employees for their efforts and continued commitment to Smart Sand. In the second quarter, we saw continued strong demand for Northern White frac sand. Activity in the Bakken increased substantially from the first quarter. We currently expect to see strong demand in this basin through the end of the third quarter. Typically, the second and third quarters of the year are the strongest demand periods for sand in the Bakken, as most producers plan the majority of their completion activity in the summer months. We currently expect activity to moderate in the fourth quarter due to normal seasonal slow down and completion activity in this basin. With our Van Hook terminal in North Dakota, we believe we have the most efficient movement of Northern White frac sand into the Bakken, which allows us to continue to be a market leader in this key Northern White market. As we highlighted on our first quarter call, activity did moderate in the Marcellus in the second quarter due to lower gas prices, with sales volume into this basin still at healthy levels. Tons sold in the Marcellus were lower than the first quarter; shipments were slightly higher than the same period a year ago. Currently, we expect activity in the Marcellus to be lower in the third quarter, where we're seeing signs that sales volumes in the Marcellus should pick up in the fourth quarter. We believe long-term natural gas fundamentals are strong and completion activity in Marcellus will grow over time. We are currently expanding our Waynesburg terminal in Southwestern Pennsylvania to allow us to take advantage of the expected increased activity in the Marcellus in the future and to increase our market share in this key Northern White market. This expansion is expected to be completed before year-end. Our Blair facility in Wisconsin is operational and we made our first shipments into Canada this quarter. While still a small portion of our overall sales, we expect sales volumes to continue to grow in this market. With Blair being directly on the CN rail line, we are well positioned to compete in the Canadian frac sand market. We currently expect sales volumes into Canada to be 10% to 15% of tons sold in the second half of this year. Our focus on cost-effective, efficient and sustainable delivery of frac sand from the mine to the well site has established Smart Sand as a market leader of frac sand in the Bakken and Marcellus markets. We believe the Blair facility now provides us an opportunity to become a market leader of Northern White sand in the Canadian market as well. We believe Northern White sand is undeniably a superior proppant to regional sand alternatives. While our primary focus will continue to be on growing our market share in primary Northern White markets, we believe Northern White sand leads to better long-term well results and E&P companies in the Permian and the Eagle Ford and other markets that have regional sand can improve their long-term well performance by using Northern White sand in their well completion designs. We commissioned a white paper that you can read on our website to build on a study done by Rystad Energy, a leading energy consulting firm that evaluated well results in the Delaware and Midland Basin since 2018, comparing the performance of wells completed with Northern White sand to wells completed with regional sand. The results of these studies are striking. They clearly demonstrate the potential for producers to achieve improved well results using Northern White sand as the proppant in their completion designs. By choosing Northern White sand versus regional sand, producers have the potential to significantly improve long-term well results, which should lead to higher production, higher free cash flow, and ultimately lower capital spending over time, as producers will have to drill fewer wells to deliver the same or higher production levels. Also, regional sand supply in the Permian Basin is potentially facing a threat as the Dunes Sagebrush Lizard is now scheduled to be listed as an endangered species in the next 12 to 18 months. This listing could impact sand mining operations and supply that is based in the Permian, which could lead to increased demand for Northern White sand in this basin. It is too early to tell how significant an impact the listing of the Dunes Sagebrush Lizard may have on regional sand mines in the Permian or potential increased demand for Northern White sand. But this is something we are keeping a close watch on. To be clear, Smart Sand does not have to sell sand into the operating basins of the Southwestern United States that are currently primarily supplied by regional sand to be successful. As demonstrated by our strong financial results, we will continue to deliver solid operating and financial performance by serving the current key Northern White markets. However, we believe we can deliver high-quality Northern White sand sufficiently and sustainably into the Permian and Eagle Ford basins, in particular, which can be a win-win for Smart Sand and E&Ps. We can expand sales volume into these markets and E&Ps can benefit from better long-term well results, which should lead them to be able to generate higher free cash flow, as they generate more production from every well they drill. While our frac sand sales remain strong, we are continuing to look to grow our other business lines. The performance of SmartSystems last mile offering continues to improve. We added our SmartPath technology to our service offering, which allows us to handle greater volumes of sand at the well site, while reducing our ongoing maintenance requirements. We operated two SmartSystems fleets with our SmartPath system in the second quarter and saw a substantial improvement in our operating results due to lower maintenance costs. Additionally, with the new valve technology, our SmartSystems can support higher volumes directly into the blender of the pressure pumping equipment leading to more efficient last mile delivery for producers and pressure pumpers compared to other sand delivery options at the well site. We are investing in additional smart belts to add to our existing fleet to further extend these savings. We expect to have nine fully functional SmartSystems with this new technology available to serve the market starting in 2024. We expect to see continued improvement in the operational profitability of our last-mile offering going forward. Our Industrial Product Solutions business also continues to grow. Industrial Product Solutions sales volume this quarter increased 70% over first quarter results and represented approximately 5% of our overall sales volume in the quarter. We are investing in cooling and blending capabilities at our Utica, Illinois facility, which should allow us to market more aggressively to the foundry markets and other industrial applications. This investment is expected to be completed by year-end. We expect sales volumes to be in the 5% range, or better, for the remainder of 2024 and grow from there. We're committed to the Industrial Product Solutions market to help diversify our business beyond oil and gas and to more effectively utilize our asset base. We are taking the time to build this business for long-term success. As always, we will continue to keep our eye on the future. We are focused on generating higher returns from our existing quality asset base and logistics capabilities while maintaining prudent leverage levels that allow us to successfully manage our business through the operating cycles in the oil and gas industry. Our goal is to consistently deliver free cash flow and to be a market leader of delivering high-quality Northern White sand to frac and industrial sand markets. And we will always keep our employees and shareholders' interests in mind in everything we do. And with that, I'll turn the call over to our CFO, Lee Beckelman.

Thanks, Chuck. Now I'll go through some of the highlights of the second quarter. We sold 1.1 million tons in the second quarter of 2023, which is relatively consistent with first quarter sales volumes of 1.2 million tons. Total revenues for the second quarter of 2023 were $74.8 million compared to $82.4 million in the first quarter of 2023. Total revenues were slightly lower in the second quarter of 2023, primarily due to lower tons sold and contractual shortfall revenue recognized in the first quarter of 2023. Our cost of sales for the quarter were $62.1 million, compared to $70.7 million last quarter. The decrease was primarily due to lower seasonal production costs. Production costs are typically lower in the second and third quarters of the year as we build inventory over the warmer months to support sales demand later in the year as we enter the winter months. Additionally, we had lower freight expenses sequentially due to a shift in our in-basin sales mix. Total operating expenses decreased to $9.6 million in the second quarter compared to $13.2 million in the first quarter of 2023, due primarily to a $1.9 million net loss on disposal of fixed assets included in the previous quarter as well as year-end 2022 bonuses that were paid in the first quarter of 2023. For the second quarter of 2023, the contribution margin was $19 million and adjusted EBITDA was $11.4 million compared to first quarter contribution margin of $17.8 million and adjusted EBITDA of $8.4 million. The increase in the contribution margin was due primarily to lower production costs and improved margins for our SmartSystems fleets. Adjusted EBITDA was higher sequentially due to the higher contribution margin and lower operating expenses. For the second quarter of 2023, contribution margin per ton was $17.57 per ton compared to $14.89 per ton in the first quarter of 2023. For the second quarter of 2023, we generated $16.1 million in net cash provided by operating activities leading to $10.8 million of free cash flow after we spent $5.2 million on capital expenditures. Year-to-date through the end of June, we have generated $11.9 million in free cash flow. We ended the second quarter with no outstanding borrowings on our credit facility. We had approximately $5.5 million in cash and cash equivalents at the end of the second quarter. Between cash and availability from our credit facility, we currently have available liquidity in excess of $24 million. Currently, we expect sales volumes to be in the $1 million to $1.2 million range in the third quarter. We believe third quarter contribution margin per ton will remain in the mid-double-digit range of $14 to $17 per ton consistent with the last three quarters. Shortfall revenue in the third quarter will be similar to the first quarter shortfall revenue. The majority of the reported shortfall revenue being recorded in 2023 is related to one contract that recognizes shortfall revenue in the first and third quarter of each year. This contract expires in the third quarter this year. We still expect capital expenditures for the year to be in the $20 million to $25 million range, which includes the capital expenditures related to the start-up of the Blair facility, which is now operational, as well as the expansion of the Waynesburg terminal and investment in the cooling and blending capabilities at Utica, that Chuck mentioned in his comments. We still expect free cash flow to be positive for the year. This concludes our prepared comments, and we will now open the call up for questions.

We will now begin the question-and-answer session. Our first question comes from Patrick Ouellette of Stifel. Please go ahead.

Hi, this is Pat on for Stephen Gengaro today. Thanks for taking the financial questions.

How you doing?

So, could you give us an update on industry supply and demand for frac sand? And what it looks like specifically for Northern White? And maybe, how you expect demand to play out in the second half of the year and into 2024?

Yes. So, as Chuck had kind of said in his comments, we expect some moderation in demand in the fourth quarter. It's hard to say what that's going to be. The fourth quarter is always kind of a little bit of a shot in the dark at this time of the year. But certainly, the fundamentals look good on Northern White right now. The market has been relatively in supply and demand balance. And so, we think that it's promising for the rest of this year from a volume perspective. And we also think that Canada is going to be a nice bright spot for us, kind of going into the third and fourth quarters this year.

Great. Okay. Thanks. And then just building off talking about Canada. Regarding gross profit you noted improvements sequentially based on sales mix of the basins you were delivering to. So, is any of that margin improvement coming from the deliveries to Canada?

Well, again, as we highlighted in our press release and comments, part of the margin improvement was lower production costs in the second quarter, because we capitalize inventory costs and typically we have lower production costs in the second and third quarters. Then we'll see a little higher in the fourth and the first quarter as we draw down inventory. So that was basically a driver of that. Pricing was relatively flat in the second quarter versus the first quarter. In Canada, we do expect that to help overall sales, but most of our sales in Canada right now are on an FOB mine basis. So that actually will lead our pricing to be a little lower on an average sales price even though we'll have less freight expense associated with that. So the margins in Canada right now seem to be fairly similar to what we're seeing in the US.

Okay. Great. That's very helpful. I'll turn it back.

Next question comes from Jim Barrett of Barrett Investments. Please go ahead.

Good morning, everyone. Maybe for you your current level of capital spending for this year is that the new normal given the addition of Blair and growth plans for SmartSystems, or do you expect spending to subside on 2024 and 2025?

Well, this year we're expecting to spend about $20 million to $25 million, which includes specific growth initiatives at Blair, the expansion of Waynesburg as we highlighted, as well as the IPS expansion. So every year we evaluate, but I can say generally that our maintenance tie-up and efficiency capital is probably going to be typically in the $10 million to $15 million a year. And then depending on growth initiatives we might see another $5 million to $10 million. So I think we'll continue to range under our current operating structure with our three mines and probably a $15 million to $25 million CapEx per year depending on growth initiatives each year.

On a separate note can you tell us how much of your volumes currently are under long-term contracts?

Well, roughly today about 50% of our volumes are under some term portion of contracts that goes. Our contract structure today goes anywhere from kind of 6 months to 18 months for maybe half of those volumes and we do have a few long-term contracts that go out multiyear.

I see. And Chuck, could you tell us who your sand competitors are in the Canadian market to service those customers? Also, can you provide an overview of the competitive landscape up there?

Yeah. So basically, the Canadian market for the most part we see it's Canadian National originations. So, Source Badger companies like that are existing companies. But we see that market and the activity that's going on with the E&Ps there. It looks to be very, very strong. The pipeline infrastructure is being put in place and we're feeling really good about that market.

Okay. Good. My last question is about the white paper on your website that showcased the advantages of using Northern White sand in markets like the Permian and Eagle Ford. Have you received any feedback from customers in Texas regarding this? Is it generating additional interest, or are you still in the early stages of educating customers about the differences between the various types of sands?

Yes. I think in general right now you're seeing a lot of the E&Ps really looking at their production and their wells in the Permian and looking for ways to impact that. So we definitely think it's on the radar. Additionally, the Dunes Sagebrush Lizard issue has a way of not only impacting sand mining down in the Permian Basin, but also could have potential impact on people in their acreage holdings on drilling down there. So I think in general there's kind of a concern on what's going on down there. Again, we're not spending capital on this right now down there, but we are very much watching this.

Okay. Well, thank you both very much.

Thank you.

Thank you.

The next question comes from Jonathan Catlin of Catlin Capital Management. Please go ahead.

Hi. Good morning, John and congratulations on a terrific quarter. I have two questions. You mentioned that you expect to be cash flow positive for the year, and it seems you are already significantly cash flow positive. Does that imply that we will see negative cash flow in the second half? My second question is more general. This quarter's performance appears to have exceeded analyst estimates of a loss, as you recorded a substantial gain. It looks like your business is evolving and moving into more profitable market areas. Could you provide some insights into which markets are showing better profitability and how sustainable that trend is?

I'll address the first question. We have experienced strong free cash flow in the first half of the year, but we might see slightly higher capital expenditures in the second half. We spent around $9.2 million in the first half and anticipate $20 million to $25 million as we finish the projects mentioned by Chuck. Therefore, we could see an increase in capital expenditures in the latter half of the year. Typically, we will accumulate a bit more working capital for inventory in the third quarter, which should decrease somewhat in the fourth quarter. Consequently, I do not expect our free cash flow to be as positive in the second half, but I do foresee generating some positive free cash flow during that time, leading to strong overall free cash flow for the full year. Regarding markets, John and Chuck can elaborate, but we believe our logistics advantages and investments in the Van Hook and Waynesburg terminals position us as market leaders in the Bakken and Marcellus regions. We are confident we can achieve similar success in Canada. Our real growth potential lies in expanding our market share in the Marcellus and Bakken due to our low-cost production and efficient transport, provided that the railroads remain reliable partners and we extend this model into Canada. While we do not discuss profitability by basin individually, we still see favorable long-term prospects in all three basins. Although it represents a small part of our business, our SmartSystems are gaining traction as we enhance their operational efficiencies, and we expect them to contribute positively to the overall margin moving forward. We are also making progress in Industrial Product Solutions, which accounted for 5% of our sales this quarter, showing substantial improvement from the previous quarter. We view both areas as additive to our frac sand business, which should help us maintain positive growth going forward.

Yes. And the only thing I'd add to that is that over the years we've made some investments – capital investments and operational efficiency at our mine sites. And those are starting to pay some dividends. So that's certainly something that's providing a little bit of tailwind on operating results here. So hopefully that continues. We think that these investments that have been made are something that we've been looking at doing and we're seeing some advantage from them.

Thank you very much. That’s very helpful.

Thank you.

Next question comes from Stephen Gengaro of Stifel. Please go ahead.

Thanks. Good morning, gentlemen.

Good morning, Steve.

I was wondering – so we hear a lot or a lot – we definitely heard about spot pricing softness in Texas. And I was curious, given the different supply-demand drivers for Northern White and the destinations for your product, what are you seeing in sort of the spot market? And how does that kind of impact any existing contracts?

Yes. So obviously, we keep an eye on what's happening down in Texas, and there has been some moderation in the pricing there, not entirely sure what’s driving that. I think there's a lot of supply down there and any hiccups in demand can impact that market pretty dramatically. In Northern White, in certain cases, we see pricing moderating depending on grade of sand grain and those types of things. But it's hard to pin down exactly an individual market and if something is softening. We keep a close eye on it. We work closely with our customers. We work closely with the railroads to make sure that we're continuing to offer a competitive product in there. But given that Northern White has been in relative supply and demand balance over, call it, since the downturn of COVID, and some of the mines are no longer in existence, we've seen that supply-demand equation remain in balance. And so I don't know, Stephen, if that continues. I haven't heard of any additional supply coming onboard or coming online in Northern White to any great degree. So any kind of demand upset, either on the upside or the downside, has the potential to affect that. But mostly what we see when prices are moderating there is more seasonality or rigs moving and things like that. But right now it seems like the market is in relative balance.

Great. Thank you. And then one other for me. Have you seen much change? And you might have mentioned this I got cut off, but you see much change on the cost side as far as – I know you've done a lot of work and done a good job managing the cost side. But on the – basically based on the COGS line, has there been any positive movements we should be thinking about as we go forward from here?

Well, I think as we highlighted and John talked about earlier, we have made investments to improve our efficiency, particularly around mining at our Oakdale facility and we're actually just starting those processes. So we would expect that to really start helping margins and costs as we go into 2024. And again, that's also driven by higher volumes. To the extent we get higher volumes and increase our utilization, we do have kind of high fixed operating leverage. So as we can sell more volumes and spread our fixed costs, that helps drive our costs per ton down as well. So assuming we can maintain or increase our volumes and keep improving our mining efficiencies in particular on these new initiatives, I would expect to help on a cost-per-ton basis and bring down our costs going into 2024.

Thank you. And if I could just slip one more in. When we think about the kind of evolution of frac sand demand or usage per stage, that's obviously improved over the years. Where does that stand now? Is it stabilizing? Do you still see modest growth? How should we think about that?

I believe we are witnessing growth. The hydraulic fracturing stages are getting longer, and operators are looking to pump more sand per stage and do so at a faster pace. When we consider this growth and the quantities of sand we are injecting into the wells across various basins, it really comes down to logistical costs, which we frequently discuss during these calls. It’s essential to ensure a reliable and sustainable delivery of sand in the necessary quantities down the well. This involves considering the entire process from the mine to the wellsite. We have introduced new Smart Belt technology for our wellsite solutions, which was largely driven by the need to inject large amounts of sand quickly. We are confident in our approach and our capacity to support these longer laterals. We possess a substantial reserve base of over 500 million tons of sand and an annual production capacity of around 10 million tons. Additionally, we have the right mix of materials needed for fine grain sand applications, along with the logistics infrastructure in place, including rail, to effectively deliver this sand to the market.

Yeah. We put our system, our last-mile system, up against anybody's system on how much sand can be pumped down a hole a day. And I think that people are starting to really recognize that.

Okay. Great. Thank you for all the detail, John.

Thanks, Stephen.

This concludes our question-and-answer session. I would like to turn the conference back over to Chuck Young for any closing remarks.

Thanks for joining us on our second quarter call. Look forward to speaking to you again in November.

Conference has now concluded. Thank you for attending today's presentation and you may now disconnect.