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CRR > SEC Filings for CRR > Form 10-K on 24-Feb-2014All Recent SEC Filings

Show all filings for CARBO CERAMICS INC

Form 10-K for CARBO CERAMICS INC


24-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Executive Level Overview

CARBO Ceramics Inc. is an oilfield service technology company that generates revenue primarily through the sale of products and services to the oil and gas industry for production enhancement and environmental services.

Our production enhancement businesses promote increased E&P Operators' production and EUR by providing industry leading technology to Design, Build, and Optimize the FracTM. Our environmental services business is intended to protect E&P Operators' assets, minimizes environmental risk, and lowers operating costs (LOE).

The Company's principal business consists of manufacturing and selling ceramic proppant and resin-coated sand for use primarily in the hydraulic fracturing of oil and natural gas wells. Falcon Technologies, a wholly-owned subsidiary of the Company, uses proprietary technology to provide products that are designed to enable its clients to extend the life of their storage assets, reduce the potential for hydrocarbon spills and provide containment of stored materials. The Company, through its wholly-owned subsidiary StrataGen, Inc., also provides the industry's most widely used hydraulic fracture simulation software under the brand FracPro®, as well as hydraulic fracture design and consulting services under the brand StrataGen.

During 2010, the Company began production of resin-coated ceramic (CARBOBOND® LITE®) and resin-coated sand (CARBOBOND® RCS) proppants. The introduction of CARBOBOND® LITE® addresses a market in which oil and natural gas wells are subject to a high risk of proppant flow-back. The adhesive property of the resin allows the ceramic proppant pack to adhere in place and therefore reduce the risk of proppant flow-back. In the case of CARBOBOND®RCS, the Company made the strategic decision to offer a lower cost, lower conductivity alternative to its ceramic proppants thereby broadening its proppant suite of products. Management of the Company believes that this is a natural extension of its core business and enhances the Company's highly conductive proppant offering.

During the second half of 2013, the Company introduced KRYPTOSPHERETM-H, a new ultra-high conductivity, ultra-high strength proppant. Product testing and qualifications with the Company's clients is ongoing, and it is anticipated that initial sales could begin as early as the third quarter of 2014. The next phase of KRYPTOSPHERETM product development will be to apply this technology to the Company's existing manufacturing footprint.

The Company's products and services help oil and gas producers increase production and recovery rates from their wells, thereby lowering overall finding and development ("F&D") costs. As a result, the Company's business is dependent to a large extent on the level of drilling and hydraulic fracturing activity in the oil and gas industry worldwide. Although the Company's ceramic proppants are more expensive than alternative non-ceramic proppants, the Company has been able to demonstrate the cost-effectiveness of its products to numerous operators of oil and gas wells through increased technical marketing activity. The Company believes its future prospects benefit from both an increase in drilling and hydraulic fracturing activity worldwide and the desire of industry participants to improve production results and lower their overall development costs.

The Company believes international sales will continue to represent an important role in its business. International revenues represented 21%, 23% and 21% of total revenues in 2013, 2012 and 2011, respectively.

Management believes the addition of new manufacturing capacity is critical to the Company's ability to continue its long-term growth in sales volume and revenue for ceramic proppant, resin-coated ceramic proppant and resin-coated sand. The Company is currently constructing the first 250 million pound line in Millen, Georgia and anticipates the Millen plant could commence operations by the end of the second quarter of 2014. The Company will begin construction on a second 250 million pound line in Millen in the first half of 2014 and it


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could start up before the end of the second quarter of 2015. Upon the completion of both lines, the Company's total ceramic proppant stated capacity is expected to be 2.25 billion pounds per year. Although the Company has operated near or at full capacity at times during the previous ten years, the addition of significant new capacity, as well as the addition of resin-coating capacity, could adversely impact operating profit margins if the timing of this new capacity does not match increases in demand for the Company's products. In addition, the ability to construct new capacity will be contingent upon the receipt of all needed environmental emission permits. See "Item 1-Business" and "Item 1A-Risk Factors".

Operating profit margin for the Company's ceramic proppant business is principally impacted by manufacturing and distribution costs, sales price and the Company's production levels as a percentage of its capacity. During mid-2012, the Company experienced lower pricing for its proppant products due to market conditions resulting from a decline in activity in the oil and gas industry caused by a drop in natural gas prices and an over-supply of ceramic proppant. Conditions driving these pricing pressures continued through 2013. Although most direct production expenses have been relatively stable or predictable over time, the Company has experienced volatility in the cost of natural gas, which is used in production by the Company's domestic manufacturing facilities, and bauxite, which is the primary raw material for production of the Company's high and intermediate density ceramic proppant. The cost of natural gas has been a significant component of total monthly domestic direct production expense. In an effort to mitigate volatility in the cost of natural gas purchases and reduce exposure to short term spikes in the price of this commodity, the Company contracts in advance for portions of its future natural gas requirements. Despite the efforts to reduce exposure to changes in natural gas prices, it is possible that, given the significant portion of manufacturing costs represented by this item, gross margins as a percentage of sales may decline and changes in net income may not directly correlate to changes in revenue. Investments continue to be made to enhance the Company's distribution capabilities. Having completed an expansion of its distribution center in South Texas, the Company is continuing to add storage capacity at new and existing stocking facilities in the areas of highest activity, including the Permian and Bakken regions.

With regard to resin-coating and sand operations, during 2012 the Company completed a second resin-coating line at its New Iberia, Louisiana facility and began to utilize its Northern White sand in its sand processing facility in Marshfield, Wisconsin. The production of resin-coated sand is a different process than the manufacture of ceramic proppant, and profit margins associated with resin-coated sand are not as high as those historically received for the Company's manufactured ceramic proppant.

As the Company has expanded its operations in both domestic and international markets, there has been an increase in activities and expenses related to marketing, research and development, and finance and administration. As a result, selling, general and administrative expenses have increased in recent years. In the future, the Company expects to continue to actively pursue new business opportunities by:

• increasing marketing activities associated with our production and enhancement technology; and

• focusing on new product development.

The Company expects that these activities will generate increased revenue. Selling, general and administrative expenses may, however, increase in 2014 from 2013 levels for these or other reasons as the Company pursues these opportunities and continues to expand its operations.

General Business Conditions

The Company's proppant business is impacted by the number of natural gas and oil wells drilled in North America, and the need to hydraulically fracture these wells. In markets outside North America, sales of the Company's products are also influenced by the overall level of drilling and hydraulic fracturing activity. Furthermore, because the decision to use ceramic proppant is based on comparing the higher initial costs to the future value derived from increased production and recovery rates, the Company's business is influenced by the current and expected prices of natural gas and oil.


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Late in 2011, a severe decline in natural gas prices led certain customers to reduce drilling activities and capital spending in natural gas basins and increase these items in liquids-rich basins. Low natural gas prices continued throughout 2012 and operations were impacted by the shift in drilling activity away from natural gas basins. The impact resulting from this shift included higher distribution costs due to the logistical challenges in these infrastructure limited regions and competitive pricing pressures resulting from an over-supply of Chinese ceramic proppant. While natural gas fundamentals remain weak, the continued strength in oilfield activity through 2013 by the Company's new and existing clients in oily, liquids-rich plays remains positive.

Critical Accounting Policies

The Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the U.S., which require the Company to make estimates and assumptions (see Note 1 to the Consolidated Financial Statements). The Company believes that, of its significant accounting policies, the following may involve a higher degree of judgment and complexity.

Revenue is recognized when title passes to the customer (generally upon delivery of products) or at the time services are performed. The Company generates a significant portion of its revenues and corresponding accounts receivable from sales to the petroleum pressure pumping industry. In addition, the Company generates a significant portion of its revenues and corresponding accounts receivable from sales to two major customers, both of which are in the petroleum pressure pumping industry. As of December 31, 2013, approximately 37% of the balance in trade accounts receivable was attributable to those two customers. The Company records an allowance for doubtful accounts based on its assessment of collectability risk and periodically evaluates the allowance based on a review of trade accounts receivable. Trade accounts receivable are periodically reviewed for collectability based on customers' past credit history and current financial condition, and the allowance is adjusted, if necessary. If a prolonged economic downturn in the petroleum pressure pumping industry were to occur or, for some other reason, any of the Company's primary customers were to experience significant adverse conditions, the Company's estimates of the recoverability of accounts receivable could be reduced by a material amount and the allowance for doubtful accounts could be increased by a material amount. At December 31, 2013, the allowance for doubtful accounts totaled $2.1 million.

The Company values inventory using the weighted average cost method. Assessing the ultimate realization of inventories requires judgments about future demand and market conditions. The Company regularly reviews inventories to determine if the carrying value of the inventory exceeds market value and the Company records an adjustment to reduce the carrying value to market value, as necessary. Future changes in demand and market conditions could cause the Company to be exposed to additional obsolescence or slow moving inventory. If actual market conditions are less favorable than those projected by management, lower of cost or market adjustments may be required.

Income taxes are provided for in accordance with ASC Topic 740, "Income Taxes". This standard takes into account the differences between financial statement treatment and tax treatment of certain transactions. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates is recognized as income or expense in the period that includes the enactment date. This calculation requires the Company to make certain estimates about its future operations. Changes in state, federal and foreign tax laws, as well as changes in the Company's financial condition, could affect these estimates.

Long-lived assets, which include net property, plant and equipment, goodwill, intangibles and other long-term assets, comprise a significant amount of the Company's total assets. The Company makes judgments and estimates in conjunction with the carrying values of these assets, including amounts to be capitalized, depreciation and amortization methods and useful lives. Additionally, the carrying values of these assets are


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periodically reviewed for impairment or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. An impairment loss is recorded in the period in which it is determined that the carrying amount is not recoverable. This requires the Company to make long-term forecasts of its future revenues and costs related to the assets subject to review. These forecasts require assumptions about demand for the Company's products and services, future market conditions and technological developments. Significant and unanticipated changes to these assumptions could require a provision for impairment in a future period.

Results of Operations

Net Income



                                      Percent                       Percent
     ($ in thousands)     2013        Change           2012         Change           2011
     Net Income         $ 84,886           (20 )%    $ 105,933           (19 )%    $ 130,136

For the year ended December 31, 2013, the Company reported net income of $84.9 million, a decrease of 20% compared to the $105.9 million reported in the previous year. Operations in 2013 continued to be impacted by the shift in drilling activity away from natural gas basins due to the severe decline in natural gas prices in late 2011. While the Company achieved record sales volume of nearly 2.1 billion pounds, net income in 2013 decreased primarily as a result of a decrease in the average proppant selling price, spending to bring the Company's new KRYPTOSPHERETM proppant technology to a commercial state and higher selling, general and administrative costs. Income tax expense in 2013 decreased primarily due to lower pretax income.

For the year ended December 31, 2012, the Company reported net income of $105.9 million, a decrease of 19% compared to the $130.1 million reported in the previous year. Operations in 2012 were impacted by the shift in drilling activity away from natural gas basins due to the severe decline in natural gas prices in late 2011. The impact resulting from this shift included higher distribution costs due to the logistical challenges in infrastructure limited regions and competitive pricing pressures resulting from an over-supply of Chinese ceramic proppant. Net income in 2012 decreased primarily as a result of a 5% decrease in the average proppant selling price and a decrease in the proppant gross profit margin as a percentage of sales, partially offset by a 7% increase in proppant sales volume and a greater contribution from the Company's other business units. Income tax expense in 2012 decreased primarily due to lower pretax income.

Individual components of financial results are discussed below.

Revenues

                                          Percent                      Percent
   ($ in thousands)          2013         Change          2012         Change          2011
   Consolidated revenues   $ 667,398             3 %    $ 645,536             3 %    $ 625,705

Revenues of $667.4 million for the year ended December 31, 2013 increased 3% compared to $645.5 million in 2012. Revenues increased primarily due to a 20% increase in proppant sales volume, partially offset by a 13% decrease in the average proppant selling price in response to market conditions during mid-2012 and higher volumes of sand-based products, which have a lower average selling price than ceramic proppants. Worldwide proppant sales volume totaled 2.060 billion pounds during 2013 compared to 1.712 billion pounds in 2012. North American (defined as Canada and the U.S.) sales volume increased 29% due to continued success of the Company's products in oily, liquids-rich basins and despite a decrease in the North America rig count. International (excluding Canada) sales volume decreased 17% primarily due to decreases in China, Mexico, and Africa, partially offset by an increase in Europe. Ceramic proppant sales volumes increased to 1.718 billion pounds in 2013 from 1.649 billion pounds in 2012. Resin-coated sand sales volumes increased to 241 million pounds in 2013, as compared to 57 million pounds in 2012. Other Proppants (defined as raw sand sold in the


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course of producing substrate for the resin-coated sand business) represented 101 million pounds of the Company's worldwide sales volume in 2013, as compared to 6 million pounds in 2012. The average selling price per pound of all proppant was $0.297 per pound in 2013 compared to $0.343 per pound in 2012.

Revenues of $645.5 million for the year ended December 31, 2012 increased 3% compared to $625.7 million in 2011. Revenues increased primarily due to a 7% increase in proppant sales volume and an increase in the revenues of some of the Company's other business units, partially offset by a 5% decrease in the average proppant selling price resulting from competitive pricing pressures. Worldwide proppant sales volume totaled 1.712 billion pounds during 2012 compared to 1.605 billion pounds in 2011. North American (defined as Canada and the U.S.) sales volume increased 3% primarily attributed to an increase in the oil rig count in the U.S. as well as acceptance of the Company's products in oily, liquids-rich basins. International (excluding Canada) sales volume increased 25% primarily due to increases in China, Russia and Mexico, partially offset by a decrease in Europe. Resin-coated sand sales volumes increased to 57 million pounds in 2012, as compared to 27 million pounds in 2011. Other Proppants represented 6 million pounds of the Company's worldwide sales volume in 2012, as compared to 3 million pounds in 2011. The average selling price per pound of all proppant was $0.343 per pound in 2012 compared to $0.360 per pound in 2011.

Gross Profit



                                                      Percent                            Percent
($ in thousands)                      2013            Change             2012            Change             2011
Consolidated gross profit           $ 192,995              (14 )%      $ 223,505              (15 )%      $ 261,715
As a % of revenues                         29 %                               35 %                               42 %

The Company's cost of sales related to proppant manufacturing consists of manufacturing costs, packaging and transportation expenses associated with the delivery of the Company's products to its customers and handling costs related to maintaining finished goods inventory and operating the Company's remote stocking facilities. Variable manufacturing costs include raw materials, labor, utilities and repair and maintenance supplies. Fixed manufacturing costs include depreciation, property taxes on production facilities, insurance and factory overhead.

Gross profit for the year ended December 31, 2013 was $193.0 million, or 29% of revenues, compared to $223.5 million, or 35% of revenues, for 2012. The decrease in gross profit was primarily the result of a decrease in average selling price and spending to bring the Company's new proppant technology to a commercial state, partially offset by higher proppant sales volumes. The gross profit margin as a percentage of revenues also declined due to the change in the product sales mix resulting from volume gains of the Company's lower-priced and lower-margin sand-based products.

Gross profit for the year ended December 31, 2012 was $223.5 million, or 35% of revenues, compared to $261.7 million, or 42% of revenues, for 2011. Operations in 2012 were impacted by the shift in drilling activity away from natural gas basins due to the severe decline in natural gas prices in late 2011 and the resulting logistical challenges and costs and the competitive pricing pressures created by this shift. Despite a 7% increase in proppant sales volume, gross profit and gross profit as a percentage of revenues decreased primarily as a result of a decrease in the average proppant selling price, an increase in freight and logistics costs, higher fixed cost absorption, and a shift in sales mix towards lower-margin heavyweight and sand-based products. Greater contribution from the Company's other business units partially offset the decrease in gross profit from proppant sales.

Selling, General & Administrative (SG&A) and Other Operating Expenses



                                             Percent                      Percent
($ in thousands)                2013         Change          2012         Change          2011
Consolidated SG&A and other   $ 68,404              6 %    $ 64,619              1 %    $ 64,113
As a % of revenues                  10 %                         10 %                         10 %


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Operating expenses consisted of $68.4 million of SG&A expenses and $43.0 thousand of other operating income for the year ended December 31, 2013 compared to $64.0 million of SG&A expenses and $0.6 million of other operating expenses for 2012. The increase in SG&A expenses primarily resulted from higher marketing and research and development spending. Other operating expenses in 2013 decreased $0.5 million compared to 2012 due primarily to a loss on disposal of assets in 2012 related to the wind down of the geotechnical monitoring business. As a percentage of revenues, SG&A and other operating expenses for 2013 remained consistent to 2012.

Operating expenses consisted of $64.0 million of SG&A expenses and $0.6 million of other operating expenses for the year ended December 31, 2012 compared to $62.4 million and $1.7 million, respectively, for 2011. The increase in SG&A expenses primarily resulted from higher administrative spending. Other operating expenses in 2012 consisted primarily of a $0.5 million loss on disposal of assets related to the wind down of the geotechnical monitoring business. Other operating expenses in 2011 consisted primarily of an impairment of goodwill of $0.9 million related to the Company's geotechnical monitoring business and a write-down of $0.8 million related to a 6% interest in an investment accounted for under the cost method as a result of the sale of the business by majority shareholders. As a percentage of revenues, SG&A and other operating expenses for 2012 remained consistent to 2011.

Income Tax Expense



                                           Percent                       Percent
($ in thousands)              2013         Change           2012         Change           2011
Income Tax Expense          $ 40,315            (23 )%    $ 52,657            (22 )%    $ 67,314
Effective Income Tax Rate       32.2 %                        33.2 %                        34.1 %

Consolidated income tax expense was $40.3 million, or 32.2% of pretax income, for the year ended December 31, 2013 compared to $52.7 million, or 33.2% of pretax income for 2012. The $12.3 million decrease is due to lower pre-tax income and a lower effective tax rate primarily associated with additional R&D tax credits and the final preparation and filing of the Company's prior year income tax returns.

Consolidated income tax expense was $52.7 million, or 33.2% of pretax income, for the year ended December 31, 2012 compared to $67.3 million, or 34.1% of pretax income for 2011. The $14.7 million decrease is due to lower pre-tax income and a lower effective tax rate primarily associated with the final preparation and filing of the Company's prior year income tax returns and additional tax benefits relating to mining depletion deductions.

Outlook

Given the cyclical nature of the industry, the Company believes that market conditions will continue to fluctuate, driven by several factors, including oil and natural gas commodity prices and quarterly seasonality trends. The Company expects activity over the short term will be variable and driven by a focus on reduction of well costs and a continued over-supply in the proppant market. However, the Company believes an increase in capital spending on the part of exploration and production companies in 2014 should result in solid industry activity. Consequently, the Company anticipates demand for its production enhancement products and services to remain intact. Specifically, regarding ceramic proppant sales, the Company believes 2014 will be another good year for volumes, aided by the Company's technical marketing campaign that continues to highlight the superior conductivity of its ceramic proppant compared to low-quality Chinese ceramic proppant. In the near term, the Company expects ceramic proppant volumes for the first quarter of 2014 to increase when compared with the fourth quarter of 2013. Current market conditions remain competitive, which leads the Company to believe that pricing may remain at current levels.

Based on the demand the Company witnessed in the second half of 2013, ceramic proppant capacity expansion remains central to the Company's growth. Construction on the first line in Millen, Georgia remains on schedule with completion expected by the end of the second quarter of 2014. In addition, construction will


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commence on the second line in Millen in the first half of 2014 and the Company anticipates startup could occur before the end of the second quarter of 2015. Once both lines are completed, the Company's ceramic proppant manufacturing capacity will increase by 500 million pounds to a total of 2.25 billion pounds per year.

With respect to the Company's resin-coated sand product line, further market expansion was experienced during 2013. The Company anticipates continued demand for its high quality, high conductivity resin-coated sand during 2014. Resin-coated sand products are unlikely to realize large, near-term price increases, given the current low natural gas activity and industry oversupply. While the Company continues to focus on improving margins from these products, they are expected to remain challenging until the oversupply situation improves.

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