News Column

CARBO CERAMICS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

July 31, 2014

Business

The Company generates revenue primarily through the sale of production enhancement products and services to the oil and natural gas industry. The Company's principal business consists of manufacturing and selling proppant products for use primarily in the hydraulic fracturing of oil and natural gas wells. These proppant products include ceramic, resin-coated sand and raw sand. The Company also provides the industry's most widely used hydraulic fracture simulation software, FracProฎ, as well as hydraulic fracture design and consulting services. In addition, the Company provides a broad range of technologies for spill prevention, containment and countermeasures.

Gross profit margin for the Company's ceramic proppant business is principally impacted by sales volume, product mix, sales price, distribution costs, manufacturing costs, including natural gas, and the Company's production levels as a percentage of its capacity. In 2013 and 2014, gross profit margin was also impacted by spending to bring the Company's new KRYPTOSPHERETM proppant technology to a commercial state.

During 2012, the Company experienced lower pricing for its proppant products due to market conditions resulting from a decline in North American activity in the natural gas industry caused by a drop in natural gas prices and an over-supply of imported ceramic proppant. The lingering effects of the conditions driving these pricing pressures, while improved, have continued into 2014.

As a result of the decline in North American activity in natural gas basins experienced in 2012, the oil and natural gas industry experienced an increased amount of activity in infrastructure-limited, liquids-rich basins, which introduced supply chain challenges to the industry. These challenges resulted in higher supply chain costs for the Company. As a result, the Company has invested in strategic projects to enhance its distribution network in order to meet the present and future demands of its clients. The Company believes these investments should help address the quarterly fluctuations in industry activity, and the increased amount of proppant being used per well. These enhancements are important as the tight supply of available trucks in certain areas is creating additional challenges with transporting proppants to the well site throughout the industry.

Although most direct manufacturing costs have been relatively stable or predictable over time, the cost of natural gas, which is used in production by the Company's domestic manufacturing facilities, is subject to volatility. The cost of natural gas has been a significant component of total monthly domestic direct production expense. In recent years, the price of natural gas has been low compared to historical prices, as well as fairly stable from period to period. However, in an effort to mitigate potential volatility in the cost of natural gas purchases and reduce exposure to short-term spikes in the price of this commodity, the Company has contracted in advance for the majority of its future expected 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 profit margins as a percentage of sales may decline and changes in net income may not directly correlate to changes in revenue.

Additionally, in 2012, the Company expanded its resin coating operations and also began processing raw sand for use in resin coating operations. In 2013, the Company began selling raw frac sand. Resin coated sand and raw frac sand products sell at much lower prices and with lower gross profit margins than the Company's ceramic proppant. While gross profit is generally not meaningfully impacted by the sale of these products, given the current sales volumes, the Company's overall gross profit margin as a percent of revenues can be impacted as can the overall average selling price of all proppants sold.

In late June 2014, the Company completed the first production line at the new Millen, Georgia facility. Once this first production line reaches its stated capacity, the Company's total annual ceramic capacity will be two billion pounds. In addition, construction continues on the second production line at Millen, as well as the retrofit of an existing plant to the new proppant technology, KRYPTOSPHERETM.

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Critical Accounting Policies

The consolidated financial statements are prepared in accordance with United States generally accepted accounting principles, which require the Company to make estimates and assumptions (see Note 1 to the consolidated financial statements included in the annual report on Form 10-K for the year ended December 31, 2013). The Company believes that some of its accounting policies involve a higher degree of judgment and complexity than others. As of December 31, 2013, critical accounting policies for the Company included revenue recognition, estimating the recoverability of accounts receivable, inventory valuation, accounting for income taxes and accounting for long-lived assets. These critical accounting policies are discussed more fully in the Company's annual report on Form 10-K for the year ended December 31, 2013. There have been no changes in the Company's evaluation of its critical accounting policies since December 31, 2013.

Results of Operations

Three Months Ended June 30, 2014

Revenues. Revenues of $176.6 million for the second quarter of 2014 increased 15% compared to $153.7 million for the same period in 2013. The increase is mainly attributed to an increase in proppant sales volumes, partially offset by a decrease in Falcon revenues and a 2% decrease in average ceramic proppant selling price. Worldwide proppant sales volumes in the second quarter of 2014 compared to the same period in 2013 were as follows.

Three months ended Proppant Sales Volumes June 30, (in million pounds) 2014 2013 Ceramic 454 378 Resin Coated Sand 43 68 Northern White Sand 271 11 Total 768 457



North American (defined as Canada and the U.S.) proppant sales volume increased 71% on higher sales of Northern White Sand and ceramic proppant. North American ceramic proppant sales volume increased 22%, partly as a result of weather issues in the first quarter of 2014 that pushed activity into the second quarter of 2014. International (excluding Canada) sales volume increased 51% primarily due to increased Northern White Sand sales volumes in Mexico and increased ceramic proppant sales volumes in Russia, partially offset by decreased ceramic proppant sales volumes in China.

Average selling prices per pound for proppants sold during the second quarter of 2014 were as follows: Ceramic $0.33; Resin Coated Sand $0.21; and Northern White Sand $0.03. Primarily due to the change in product mix, the average selling price per pound of all proppant was $0.21 during the second quarter of 2014 compared to $0.30 for the same period in 2013. In addition to product mix, average selling prices can be impacted by sales prices, geographic areas of sale, customer requirements and delivery methods.

Gross Profit. Gross profit for the second quarter of 2014 was $53.6 million, or 30% of revenues, compared to $39.3 million, or 26% of revenues, for the second quarter of 2013. The increase in gross profit was primarily the result of higher ceramic proppant sales volumes, a change in ceramic sales mix to higher margin lightweight ceramic proppants, and improved margins on resin coated proppants as production volumes increased during 2013, and was partially offset by a decrease in Falcon gross profit. The increase in sales volumes for Northern White Sand did not materially impact gross profit.

Selling, General and Administrative (SG&A) and Other Operating Expenses, and Start-Up Costs. SG&A and other operating expenses totaled $18.7 million for the second quarter of 2014 compared to $15.5 million for the same period in 2013. As a percentage of revenues, SG&A and other operating expenses increased to 10.6% compared to 10.1% for the second quarter of 2013. The increase in SG&A expenses is primarily due to higher compensation costs and increased research and development activities. Start-up costs of $0.8 million related to the start-up of the first production line at the new manufacturing facility in Millen, Georgia.

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Income Tax Expense. Income tax expense was $11.3 million, or 32.9% of pretax income, for the second quarter of 2014 compared to $7.8 million, or 32.3% of pretax income, for the same period last year. The $3.5 million increase is primarily due to higher pre-tax income.

Six Months Ended June 30, 2014

Revenues. Revenues of $325.1 million for the six months ended June 30, 2014 increased 8% compared to $301.4 million for the same period in 2013. The increase is mainly attributed to an increase in proppant sales volumes, partially offset by a decrease in Falcon revenues.

Worldwide proppant sales volumes for the six months ended June 30, 2014 compared to the same period in 2013 were as follows.

Six months ended Proppant Sales Volumes June 30, (in million pounds) 2014 2013 Ceramic 827 776 Resin Coated Sand 91 93 Northern White Sand 429 33 Total 1,347 902



North American (defined as Canada and the U.S.) proppant sales volume increased 56% due to higher sales of Northern White Sand and ceramic proppant. North American ceramic proppant sales volume increased 11%. International (excluding Canada) sales volume increased 14% primarily due to increased Northern White Sand sales volumes in Mexico, partially offset by decreased ceramic proppant sales volumes in China.

Average selling prices per pound for proppants sold during the six months ended June 30, 2014 were as follows: Ceramic $0.33; Resin Coated Sand $0.21; and Northern White Sand $0.03. Primarily due to the change in product mix, the average selling price per pound of all proppant was $0.22 during the six months ended June 30, 2014 compared to $0.30 for the same period in 2013. In addition to product mix, average selling prices can be impacted by sales prices, geographic areas of sale, customer requirements and delivery methods.

Gross Profit. Gross profit for the six months ended June 30, 2014 was $98.0 million, or 30% of revenues, compared to $81.7 million, or 27% of revenues, for the same period in 2013. The increase in gross profit was primarily the result of a favorable change in ceramic sales mix to higher margin lightweight ceramic proppants, improved margins on resin coated sand proppants as production volumes increased in 2013, and higher ceramic proppant sales volumes, and was partially offset by a decrease in Falcon gross profit. The increase in sales volumes for Northern White Sand did not materially impact gross profit.

Selling, General and Administrative (SG&A) and Other Operating Expenses, and Start-up Costs. SG&A and other operating expenses totaled $35.7 million for the six months ended June 30, 2014 compared to $32.5 million for the same period in 2013. The increase of $3.2 million was driven by higher compensation costs and increased research and development activities during the second quarter of 2014. As a percentage of revenues, SG&A expenses increased to 11.0% for the six months ended June 30, 2014 compared to 10.8% for the same period in 2013. Start-up costs of $0.8 million related to the start-up of the new manufacturing facility in Millen, Georgia.

Income Tax Expense. Income tax expense was $20.4 million, or 33.0% of pretax income, for the six months ended June 30, 2014 compared to $15.7 million, or 31.7% of pretax income for the same period last year. The $4.7 million increase is primarily due to higher pre-tax income.

Outlook

The Company expects activity will continue to be variable and driven by exploration and production companies focusing on a balance between reducing well costs and investment returns through optimization of well completions. However, the Company anticipates demand for its production enhancement products and services to remain intact. Furthermore, as previously mentioned, the Company remains positive on industry activity and ceramic sales volumes for the balance of 2014. As a result of oil and natural gas well completion activity that was delayed in the first quarter of 2014, proppant sales volumes rose in the second quarter and the Company believes this will continue into the third quarter of 2014. The third quarter has recently been the most active quarter in the year for the industry. The Company believes its ceramic proppant sales volumes will approximate its quarterly productive capacity with the possibility of drawing down some finished goods inventories, which are at lower levels than last year. The Company also believes proppant pricing will remain relatively stable during the third quarter of 2014.

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Construction on the first production line in Millen, Georgia was completed in the second quarter of 2014 and construction of the second production line remains on schedule with completion expected by the end of the second quarter of 2015. Once both lines are completed and operating at full capacity, the Company's ceramic proppant manufacturing capacity will increase by 500 million pounds to a total of 2.25 billion pounds per year. Additionally, the retrofit of an existing manufacturing line continues with the Company's KRYPTOSPHERETM proppant technology. Initial sales of KRYPTOSPHERE LD from this retrofit are presently expected by the end of the second quarter of 2015.

Distribution of proppant to the well site remains an important part of the CARBO service offering to its clients. A recent challenge the industry is facing is a tight supply of trucking services in certain areas to transport proppant to the well site. Given this industry issue, the Company may likely face increased transportation costs and delivery issues.

The Company continues to build inventories of KRYPTOSPHERE HD, the Company's new ultra-conductive, ultra-high strength proppant for deep well applications. Completion activity in the Company's target market for KRYPTOSPHERE HD, the Gulf of Mexico, continues to be delayed. While ultimately this is out of the Company's control, the Company is optimistic that opportunities for lower tertiary completions in the Gulf of Mexico will increase in 2015.

Liquidity and Capital Resources

At June 30, 2014, the Company had cash and cash equivalents of $46.4 million compared to cash and cash equivalents of $94.3 million at December 31, 2013. During the six months ended June 30, 2014, the Company generated $57.5 million of cash from operating activities. Uses of cash included $85.5 million for capital expenditures, $13.9 million for the payment of cash dividends and $5.8 million for repurchases of the Company's common stock.

Subject to the Company's financial condition, the amount of funds generated from operations and the level of capital expenditures, the Company's current intention is to continue to pay quarterly dividends to holders of its common stock. On July 22, 2014, the Board of Directors declared a cash dividend of $0.33 per common share payable to shareholders of record on August 1, 2014. This dividend is payable on August 15, 2014. The Company estimates its total capital expenditures for the remainder of 2014 will be between $95.0 million and $105.0 million. Capital expenditures for the remainder of 2014 are expected to include costs associated with the construction of the new manufacturing facility in Millen, Georgia, retrofitting an existing plant with the new proppant technology, expansion of the Company's distribution infrastructure, as well as various other projects and additions.

The Company maintains a $50 million unsecured line of credit with a bank that matures in July 2018. As of June 30, 2014, there was no outstanding debt under the credit agreement. The Company anticipates that cash on hand, cash provided by operating activities and funds provided by its line of credit will be sufficient to meet planned operating expenses, tax obligations, capital expenditures and other cash needs for the next 12 months. The Company also believes that it could acquire additional debt financing, if needed. Based on these assumptions, the Company believes that its fixed costs could be met even with a moderate decrease in demand for the Company's products.

Off-Balance Sheet Arrangements

The Company had no off-balance sheet arrangements as of June 30, 2014.

Forward-Looking Information

The statements in this Form 10-Q that are not historical statements, including statements regarding our future financial and operating performance and liquidity and capital resources, are forward-looking statements within the meaning of the federal securities laws. All forward-looking statements are based on management's current expectations and estimates, which involve risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Among these factors are:

• changes in overall economic conditions, • changes in the cost of raw materials and natural gas used in manufacturing our products, 13



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Table of Contents • ability to manage distribution costs effectively, • changes in demand and prices charged for our products, • changes in the demand for, or price of, oil and natural gas, • risks of increased competition, • technological, manufacturing and product development risks, • loss of key customers, • changes in foreign and domestic government regulations, including environmental restrictions on operations and regulation of hydraulic fracturing, • changes in foreign and domestic political and legislative risks, • the risks of war and international and domestic terrorism, • risks associated with foreign operations and foreign currency exchange rates and controls, and • weather-related risks and other risks and uncertainties.



Additional factors that could affect our future results or events are described from time to time in our reports filed with the Securities and Exchange Commission (the "SEC"). See in particular our annual report on Form 10-K for the fiscal year ended December 31, 2013 under the caption "Risk Factors" and similar disclosures in subsequently filed reports with the SEC. We assume no obligation to update forward-looking statements, except as required by law.


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Source: Edgar Glimpses


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