EUR 850.00 For Business Accounts Only

Morningstar | Lowering Covia FVE, but Market Has Overreacted to Management's Bearish Near-Term Guidance

We are lowering our fair value estimate for Covia to $15.75 per share from $18.50 after taking a closer look at the newly combined company (emerging from predecessors Fairmount Santrol and privately held Unimin). Our no-moat rating remains in place.

We were slightly disappointed by the historical pro forma Unimin results divulged in Covia's second-quarter earnings release. Based on the company's mix of sales, we would have expected a slightly higher gross margins per ton. We suspect that this is primarily due to the somewhat higher cost positions of several of Unimin's Northern White mines. We have adjusted our forecasts for Covia accordingly, including lower Northern White volume assumptions given the likelihood that several of the former Unimin's mines could become uneconomical as frac sand prices fall in coming years with the onset of low-cost Permian capacity additions.

Additionally, we have incorporated slightly lower assumptions for sales volumes of value-added proppant. Value-added volumes were disappointingly stagnant for the former Fairmount from the third quarter of 2017 to the first quarter of 2018, and it appears that customers are displeased with the value proposition of these premium priced products.

Covia looks about 35% undervalued using our new fair value estimate--shares have fallen over 40% since its second quarter earnings release. However, we do not recommend Covia with conviction owing to our extreme uncertainty rating, which we place on most of our covered frac sand companies because of uncertainty related to the level of future low-cost regional sand supply additions.

We think the market overreacted to the issuance of management's bearish third-quarter guidance (5%-10% fall in volumes and gross margins down perhaps $3-$5 per ton on net). The guidance was precipitated by the prospect of flat frac sand demand, ultimately owing to Permian takeaway constraints, as well as increasing low-cost supply from the startup of new Permian mines. Ultimately, we expect margins to fall around $5-$10 per ton for most frac sand producers on a mix-adjusted basis in the next few years as all of the low-cost supply comes on line. We think the market needs to be reminded to not shoot the messenger--even though Covia's management has issued the most bearish guidance for the second half of 2018, the company is merely facing the same pricing pressures as other frac sand companies. Additionally, the company will receive a strong benefit to its margin mix as its own low-cost Permian sand mines (which will make up about 17% of the company's frac sand capacity) ramp up to full capacity in the fourth quarter.