Emerge Energy Follow-Up Report: Has The Bear Case Gotten Stronger?

11/25/2015 at 12:45 PM

With oil crashing 8% for the biggest weekly loss in eight months, we are impressed with EMES stock price resilience. It is holding above $5 per share, quite a bit above its low of $3.78 on October 27th. Looking at the company again to see if we missed anything, we are as confident as ever with our bearish thesis.

The main reason for this, is EMES fuel segment is now in big trouble. And right when they’re negotiating with their lenders! Can’t be good.

EMES is known as one of the major frac sand sellers in the US. But its bigger business is its fuel segment. As shown below, its fuel segment generates almost twice the revenues of its sand segment.

From the comments section of a recent Seeking Alpha article on EMES, User 3636401, who appears to be very knowledgeable on the company, commented:

I see EMES as three parts: sand, fuel and rail cars. Each part has a capital expenditure or investment as well as a replacement cost. EMES has too much capital tied up in rail cars.

 

When I studied the fuel segment profit contribution component, and cross referenced it to the quarterly slope of RBOB, the effect was dramatic. Fuel segment would add up to $0.65 per share EPS per quarter when RBOB was increasing, and would cause an EPS loss in quarters when RBOB was in decline. I have been curious why EMES cannot or does not hedge to smooth out the fuel segment EPS, and maybe that involves risk as well. 

From the oil slide this past week, Gasoline RBOB has slid big time.

As shown in the chart above, RBOB is now close to the lows in late August. This directly affects EMES income in its fuel segment. It indirectly affects frac sand. But frac sand was already tumbling, as EMES CEO said in the Q315 earnings call:

There are continuing indicators which suggest that we will see further pricing erosion in Q4. More and more, we are heading and hearing FOB mine gate sand pricing moving further down into the $24 to $22 a ton range.

We don’t know for sure how much worse frac sand prices are going to be due to last weeks slide in oil. But we do know for sure that it directly affects EMES fuel segment.

As we mentioned in our report, one of EMES upcoming negative catalysts is its debt amendment and delayed 10-Q filing. We don’t know the depths of EMES debt problems right now. EMES management said:

Over the past several weeks, our management has been, and continues to be, focused on addressing Emerge Energy Services LP’s compliance with its Amended and Restated Revolving Credit and Security Agreement, dated June 27, 2014, as amended. On October 19, 2015, we entered into a limited waiver to the Credit Agreement whereby the lenders waived any default or right to exercise any remedy as a result of the Partnership’s failure to be in compliance with the total leverage ratio covenant for the fiscal quarter ended September 30, 2015. This limited waiver expires on November 13, 2015. Our management is currently negotiating an amendment to the Credit Agreement that would be entered into prior to the expiration of the limited waiver. These efforts have required significant amounts of management time that ordinarily would be devoted to preparation of the Partnership’s Quarterly Report on Form 10-Q for the period ended September 30, 2015 and related matters. The terms of the amendment to the Credit Agreement or, in its absence, an acceleration of the outstanding amounts under Credit Agreement would materially affect the financial statements presented in the Quarterly Report and the disclosures set forth in the Quarterly Report. The issues described above, which have caused the Partnership to be unable to timely file the Quarterly Report, could not be eliminated without unreasonable effort or expense. We expect to file the Quarterly Report within the 5-day extension period afforded by Rule 12b-25

The limited waiver expiry, November 13, 2015, has come and gone and EMES management still hasn’t amended its credit agreement. The negotiations with the lenders have obviously been tough, or it wouldn’t have taken weeks. Now that oil was smashed just last week, the lenders are probably going to make the terms even worse than before.

With all of its segments losing money, and an increase in interest rates, EMES is on track to lose $20-$40m per quarter in 2016. By the end of 2016, EMES could have a debtload of $400m if it doesn’t get an equity financing. By that time, oil will have lost even more market share to renewable energy sources. As cars start moving more on electricity and companies like Tesla (TSLA) keep expanding, oil demand decreases. As shown in this video, it’s not just one alternative energy source that will dethrone oil’s reign but all of them together.

The Bullish Case For EMES

Where we might be wrong in the bear case, is if some big investors have faith that oil will make a strong comeback within the next couple years. If they feel that EMES is in a strong position for a resurgence of oil, they could take a large position in EMES if they have patience and deep enough pockets to wait through a couple years of pain in order to be well positioned for oil’s rebound. But there are so many risks at stake with EMES, it would have to be a high risk tolerant investor to do it.