U.S. Silica Holdings, Inc.
Q2 2018 Earnings Call Transcript

Published: 31 Jul 2018

[Operator:]

Greetings, and welcome to the U.S. Silica Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operation Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host today, Mr. Michael Lawson, Vice President of Investor Relations and Corporate Communications for U.S. Silica. Please proceed.

[Michael Lawson:]

Thanks. Good morning, everyone, and thank you for joining us for U.S. Silica's second quarter 2018 earnings conference call. With me on the call today are Bryan Shinn, President and Chief Executive Officer; and Don Merril, Executive Vice President and Chief Financial Officer. Before we begin, I would like to remind all participants that our comments today will include forward-looking statements, which are subject to certain risks and uncertainties. For a complete discussion of these risks and uncertainties, we encourage you to read the company's press release and our documents on file with the SEC. Additionally, we may refer to the non-GAAP measures of adjusted EBITDA and segment contribution margin during this call. Please refer to the press release or our public filings for a full reconciliation of adjusted EBITDA to net income and the definition of segment contribution margin. Finally, during today's question-and-answer session, we would ask that you limit your questions to one plus a follow-up to ensure all that who wish to ask a question may do so. And with that, I would now like to turn the call over to our CEO, Mr. Bryan Shinn. Bryan?

[Bryan A. Shinn:]

Thanks, Mike, and good morning, everyone. I'll begin today's call by reviewing important highlights from our strong Q2 performance and I'll then spend a few minutes discussing progress on our strategy to make U.S. Silica an even more dynamic enterprise that's positioned to generate strong, consistent returns through energy cycles. I'll conclude my prepared remarks with an outlook for key markets before turning the call over to Don, who will provide more color on our financial performance in the quarter before we open up the call for your questions. For the second quarter, total company revenue of $427.4 million increased 16% sequentially, and adjusted EBITDA of $123.6 million improved 30%, benefiting in part from our acquisition of EP Minerals, which closed in the second quarter. Record contribution margin in the second quarter for Oil & Gas of $114.6 million increased 15% sequentially, driven by higher volumes, higher pricing, and continued improved performance from our industry leading, last-mile logistic solution, Sandbox. Sandbox margins in the quarter were up 15% sequentially from a combination of higher volumes, higher pricing, and continued operating cost improvements. We exited the quarter with 76 crews deployed and expect to end the year with over 90 crews working. Crew sizes have grown over the last year from an average of 40 boxes and 10 chassis to 60 boxes and 20 chassis today as the amount of proppant pumped per well continues to expand. We estimate current Sandbox market share is between 18% to 20% and we're targeting market share of 30% to 35%. As previously announced during the quarter, our Sandbox unit received a decisive jury verdict against Arrows Up in a breach of contract and fraud lawsuit. The jury awarded monetary damages to Sandbox totaling more than $43 million. The judge in this case is expected to rule on the award and the additional relief that Sandbox is seeking in the next couple of months. This verdict should serve as notice to others who have misappropriated our intellectual property that we will continue to vigorously defend our products and patents. During the quarter, we also decided to exit the resin coated sand business, which primarily serves to oil and gas market, based on customer feedback that demand for this type of product is rapidly declining. This has been a very small business for us, and we don't anticipate any impact to earnings beyond the announced impairment charges in the second quarter. Turning to our other operating segment, Industrial & Specialty Products, they posted record revenue contribution margin dollars and contribution margin per ton in the second quarter, driven by strong legacy ISP business profitability and the addition of two months of results from EP Minerals. Revenue for ISP in the second quarter of $103.4 million and contribution margin of $41.3 million improved 83% and over 100%, respectively, on a sequential basis. Pricing was strong, driven by a new round of increases in the quarter and the successful renegotiation of several key agreements at higher prices. ISP also delivered their highest quarter volumes since 2015. The integration of EP Minerals has been virtually seamless. We're hard at work on several new initiatives to drive growth by expanding into attractive adjacent segments through bolt-on acquisitions and continued investment in our R&D pipeline. While our focus today continues to be on enhancing our core competencies as an industry-leading mining and logistics company, we're executing a strategy to increase profits from the non-energy side of our company to complement the cyclicality and volatility inherent in our Oil & Gas business. Accordingly, we think it's prudent to invest in leading industrial specialty material businesses, like EP Minerals, that have a favorable market structure, high barriers to entry, and a robust new product pipeline. Businesses with these characteristics are natural extensions of our current high growth Industrial & Specialty business. These type of investments deliver strong, sustainable earnings, solid, dependable cash flow, and substantial growth, while ultimately enhancing our long-term competitiveness. Just to be clear, diversifying the company does not imply less focus on the oil and gas market or our customers in that sector. For example, we expect to continue to invest in Sandbox capacity and capabilities, and we continue to evaluate numerous attractive M&A opportunities across the space. Further, we're completing the previously announced doubling of our oil and gas volumes to meet customers' growing needs for frac sand, and we expect to start accreting cash in the second half of the year and quickly generate significant cash flows in 2019, delivering free cash flow yield approaching 15% next year. We can deploy these substantial cash flows into M&A, paying down the debt or repurchasing shares, as we did in the second quarter as part of our new $200 million share repurchase program. Let me now turn to the outlook for our business in the near term. In Oil & Gas, we expect to see higher sales volumes in the third quarter as we continue to ramp up new capacity in West Texas and with our brownfield expansions now fully online. We've turned on the second line at Crane, and expect to sell our first tons out of Lamesa in late August. We also signed four attractive new contracts in Q2 for a combination of Northern White and local sand, and sold approximately 65% of our Oil & Gas volumes under long-term supply agreements. We are actively negotiating several other new agreements for both Northern White and local sand, and expect to sell over 70% of our Oil & Gas volumes in the third quarter to contract customers. Frac sand demand continues to be very strong, and we estimate that current usage is between 100 million to 110 million tons per year. Furthermore, we think that the trend towards longer laterals and more sand per well is continuing and will drive strong demand into 2019 and beyond. From a supply standpoint, we continue to carefully monitor new in-basin capacity announcements, and generally believe that supply will come online much slower than many model, and that some mines will not be built at all. For U.S. Silica, once we finish our West Texas expansions, we will have an effective Oil & Gas capacity of approximately 27 million tons per year, and our product portfolio will be approximately 70% regional and local sand and 30% Northern White. Reviewing the outlook for ISP, we expect increases in sand pricing and margin driven by a full quarter of the strategic price increases implemented in Q2, and a full quarter of EP Minerals. ISP should also benefit from favorable product mix as higher margin products make up a larger percentage of overall sales. ISP has a robust pipeline of new products that we will continue to introduce during the year. We're also very active on the M&A front, pursuing bolt-on acquisitions that will enable value-added growth for our Industrial segment. And with that, I'll now turn the call over to Don. Don?

[Donald A. Merril:]

Thanks, Bryan, and good morning, everyone. I'll begin with the results from our two operating segments, Oil & Gas and Industrial & Specialty Products. Second quarter revenue for the Oil & Gas segment was $324.1 million, a sequential increase of 4%, driven by record sand volumes, increased pricing and increased Sandbox activity. The ISP segment revenue was $103.4 million, up 83% over the prior quarter, primarily as a result of the acquisition of EP Minerals, but also due to higher volumes and price increases in our ISP sand products business. Oil & Gas segment contribution margin on a per ton basis was $33.08 compared with $30.58 for the first quarter of 2018. This 8% increase was primarily a result of increased volumes, a favorable 3.5% price impact, as well as improved Sandbox performance. On a per ton basis, contribution margin for the ISP business of $40.32 represented a substantial increase over the first quarter as a result of including EP Minerals for the first time as well as strategic price increases and favorable product mix. Now taking a look at total company results, selling, general, and administrative expenses in the second quarter of $42.2 million is an increase of 22% over the first quarter of 2018. The increase in SG&A expense is largely due to the addition of EP Minerals as well as increased head count to support the growth of the business. Depreciation, depletion, and amortization expense in the second quarter totaled $36.6 million, up 28% over the first quarter of 2018. Our DD&A expense increased primarily as a result of the inclusion of EP Minerals, but also continues to grow due to our growth capital projects. Interest expense for the quarter was $20.2 million. The increase in interest expense is the result of the new term loan completed in the second quarter, and also includes a debt extinguishment charge of $2.3 million related to the refinancing. The company anticipates interest expense for the rest of the year to be in the range of $25 million per quarter at the prevailing LIBOR interest rate. The effective income tax rate for the quarter was 14%, and we expect the full year 2018 effective rate to be approximately 16%. During the second quarter, the company recorded several adjustments and expenses that negatively impacted the results. We incurred acquisition-related expenses of $17.6 million, which is comprised of $8.9 million of transaction-related expenses, $6.4 million of expense related to the fair market value adjustment for inventory, and $2.3 million of debt extinguishment related to our refinancing. We also closed our resin coating facility and eliminated the associated product portfolio of resin coated sands. As a result of this action, we recorded an asset impairment charge of $16.2 million. Additionally, we incurred $10.7 million in plant startup and expansion expenses, which cannot be capitalized or put into inventory. These charges are a continuation of similar expenses in prior quarters and are primarily associated with the construction of our new West Texas mine location. We anticipate these expenses to be eliminated by the end of the year. Moving on to the balance sheet, cash and cash equivalents as of June 30, 2018, was $322.4 million compared with $329.5 million at March 31, 2018. As of June 30, 2018, we have $96 million available under our revolving credit facility, and our total debt was $1.27 billion compared with $510.9 million as of March 31, 2018. After completing the $100 million share repurchase authorization in the first quarter of 2018, our board of directors authorized a new share repurchase program in May of up to $200 million of common stock. During the three months ended June 30, 2018, we purchased 536,139 shares of our common stock at an average price of $28.91 per share for a total amount of $15.5 million, leaving $184.5 million available under the program. Year-to-date, the company has purchased roughly 3.4 million shares for a total of just over $90 million. During the second quarter, we incurred capital expenditures of $86.9 million, primarily associated with our West Texas and Sandbox growth projects as well as other various maintenance and cost improvement projects. With the addition of EP Minerals, the company now expects the capital spending for 2018 to be approximately $350 million. As our capital expenditures related to capacity expansions and new mines wind down and those facilities ramp up to their full production levels, we expect cash flow generation to grow substantially. In fact, we expect to be cash flow positive beginning in the latter half of this year. Ultimately, as Bryan has previously stated, in 2019, we expect to have a significant free cash flow yield approaching 15% at current market capitalization levels. This cash flow generation will give us the financial flexibility to pursue M&A opportunities, repurchase shares or pay down debt. And with that, I'll turn the call back over to Bryan.

[Bryan A. Shinn:]

Thanks, Don. Operator, would you please open up the lines for questions?

[Operator:]

Thank you. We will now be conducting a question-and-answer session. Our first question comes from James Wicklund with Credit Suisse. Please proceed with your question. James Wicklund - Credit Suisse Securities (USA) LLC Good morning, guys.

[Bryan A. Shinn:]

Good morning, Jim. James Wicklund - Credit Suisse Securities (USA) LLC The biggest issue we're dealing with is that nobody believes in the sanctity of contracts. Everybody looks at 2015, 2016, and 2017 as projects – as contracts got thrown out or negotiated down, and now everybody seems to believe that sand prices are going to decline through 2019 and all of your contracts are going to be renegotiated on a quarterly basis, and there's no way on God's green earth you're going to hit your 15%, or approaching 15%, free cash flow yield next year. Can you address that topic for me?

[Bryan A. Shinn:]

Sure, Jim. So I think, couple of things. When you look at the contracts that we have signed over the last, say, 6 to 12 months, they're a bit different than contracts that have been signed in the past. We signed quite a few contracts with cash payments upfront from our customers. So, we've got now about $90 million of customers' money in the bank, if you will, and they need to buy tons from us to get that back. So, I think that's one big difference. The other difference that I think, perhaps, people are missing between 2015 and 2016, and the realities of 2018, is in 2015 and 2016, customers just didn't need the sand as the market rapidly deteriorated in oil and gas. And for me, that's quite a different situation than if someone has a contract and wants to renegotiate or buy from someone else because they think they can get a lower price. And so, I think you'll see our industry being much stricter in enforcing contracts, particularly in an environment where demand is projected to be very strong as we go forward into 2019 and 2020. So, there's no doubt the industry is going to need the sand. And I think maybe the third point is that customers have told us again and again that our mine sites are extremely well positioned. We're right at the bottom of the cost curve. And so, I think customers are going to choose to buy from us. And you can see that by the kind of contracts that we sign with customers. And by the way, we're continuing to sign very attractive contracts. We signed four new contracts in Q2. That brings us to over 30 contracts signed now, the mix of Northern White and local stand, and... James Wicklund - Credit Suisse Securities (USA) LLC And are these fixed price contracts, Bryan? Are these fixed price contracts or will the prices fluctuate with whatever the leading-edge spot price is?

[Bryan A. Shinn:]

No, these are fixed price contracts, Jim. And if you look at these contracts, in particular, to your question around generating the earnings to get to 15% free cash flow yield, these four contracts alone over the next four years will generate about $250 million of contribution margin, and that's just four contracts out of the 30. So, we feel really good about the contracts that we have and the customers that we have chosen to align with. And maybe just one last point, this is kind of a long answer to your question, but it's really important one. A lot of the contracts we signed in this kind of cycle, if you will, put cycle in quotes, are with energy companies, not with service companies. And I think that is another big difference between what we're doing today and, say, 2015 and 2016. The energy companies are going to need the sand, and we've also tied a lot of those contracts in with Sandbox. So if they walk away from our contracts, they're not just walking away from the sand, they're walking away from the last-mile transportation. And so, there's half a dozen reasons there, Jim, why I think things are really different now. And we feel extremely good about our contract portfolio. James Wicklund - Credit Suisse Securities (USA) LLC That's more helpful than you know. And my follow-up question is going to be anticlimactic as a result of that. Can you talk about the emerging trend of in-basin sand popping up in Oklahoma and Arkansas and Mississippi? Do we have something to fear from a repeat of what the Permian and other basins?

[Bryan A. Shinn:]

So, I think you'll see a few of those local mines. It's not surprising that there are local mines in the Mid-Con for example. We've had one there for the last 21 years in our Mill Creek facility. So, you'll see some onesies and twosies pop up, but we don't see anything like the Permian Basin eventuating in many of the basins today. We've looked ourselves in some of the basins, and the struggles you run into is that the quality of the sand is pretty poor in a lot of the basins, and also the well density is not sufficient to support a mine operation. So, you'd have to have kind of multiple small mines scattered all around even if you could find the sand, which is pretty difficult. James Wicklund - Credit Suisse Securities (USA) LLC Right. Okay. That's very helpful. Gentlemen, thank you all very much.

[Bryan A. Shinn:]

Thanks, Jim.

[Operator:]

Our next question comes from George O'Leary with Tudor, Pickering, Holt. Please proceed with your question.

[George O’Leary:]

Good morning, guys.

[Bryan A. Shinn:]

Good morning, George.

[George O’Leary:]

Switching gears a little bit on the ISP side and given you guys have rolled EP into the fold, it was just curious to me if either the results that you printed were so strong in that business either mean that the legacy ISP business grew more than we anticipated or EP Minerals had stronger earnings generation than we anticipated. So, I wonder if you could just maybe help couch the relative growth rates between those two businesses or maybe just provide how much EP contributed during the quarter as a percentage of the contribution margin.

[Bryan A. Shinn:]

So just to get a feel for EP, for example, we had announced at the time of the acquisition that the TTM EBITDA was $60 million or, say, like $5 million a month. We were sort of on that track or a bit better in Q2. So, we saw strength there, but we also saw strength on the industrial sand side. Really good results in industrial sand as well. So, I'm pleased to report that it's really strength in both of the businesses. It wasn't one that was really strong and the other was not. It was kind of universally strong across the industrials portfolio. And we continue to get a lot of price in the industrial sector as well, which is really encouraging to me. We signed a number of new contracts as well during the quarter, some for as long as five years, at really attractive prices. We had some cases where we raised pricing 10%, 15%, 20%, and we were able to get that pricing in long-term contracts as well. So, I think you're going to find that the industrials portfolio that we have is going to be a tremendous strength for the company, and it's another one of the reasons that we feel really confident that we can generate the cash needed to hit that free cash flow yield target that we talked about earlier.

[George O’Leary:]

Great. That's very helpful color. And then, we picked up wind of some pricing pressure in pockets in the sand space that started late in the second quarter, namely industry participants kind of pointing us towards 30, 50 and 100 mesh being under pressure, again just in pockets. You're in a good position today because of the contracts you have in place and sand prices are at an attractive level, so a little bit of pricing pressure is not a terrible thing. But I just wondered if you could elaborate on what you're seeing, just kind of leading edge on the frac sand front, from your view?

[Bryan A. Shinn:]

Sure. So, I think the way you characterized it is probably just about right. There was a little bit of pricing pressure as we got to the end of the second quarter. Q3 started off pretty well. For us as a company, we were up about 3.5% in terms of price from Q2 to Q1, so really nice job by our commercial team there. I would say probably the biggest trend for us, and you'll see this in our results coming up over the next couple of quarters, is that we have a lot of new contracts coming online. And the good news is that those are the contracts that are going to generate a lot of the cash flow for us over the next few years here. But as we all know, as we'll be exchanging some spot tons that we sell today at a higher price for contract tons, which are at a little bit lower price and perhaps more kind of a steady pull, we will see some price degradation as a result of that. And we've been talking about that for the last couple of quarters. I don't think that's anything new to the Street.

[George O’Leary:]

Great. Thank you guys very much for the color. Thanks, Bryan.

[Bryan A. Shinn:]

Thanks, George.

[Operator:]

Thank you. Our next question comes from Marc Bianchi from Cowen & Company. Please proceed with your question.

[Marc Bianchi:]

Thank you. Following up on that last point about the price degradation, it just sounds like a result of contract mix. Can you help us with what sort of margin per ton we should be expecting in the back half as a result?

[Donald A. Merril:]

Yeah. Hey, Marc, it's Don. I think what you're going to see is, is you are going to see a little bit of pressure on the contribution margin per ton in Oil & Gas, probably a 5% to 10% reduction going into Q3 as we see more of our West Texas volumes come online.

[Marc Bianchi:]

Okay. Thanks for that, Don. And then, would you expect that fourth quarter is down slightly from there or maintains flat?

[Donald A. Merril:]

No, I think we're bringing on – as Lamesa comes online in the fourth quarter, I think you'll see a little bit more pressure, but just a little bit into the fourth quarter.

[Marc Bianchi:]

Okay. Bryan, you mentioned I believe 27 million tons of Oil & Gas capacity. Correct me if I didn't hear that right, but that would be an increase from what we were anticipating after you had Crane and Lamesa ramped. We had you guys getting to 23 million tons. Can you explain the difference there?

[Bryan A. Shinn:]

So when we ramp up all of the sites, Marc, we'd be at that 27 million. I think perhaps the delta is attributable to the permitting and what was announced at Crane and Lamesa. As typical, we start out with Permit by Rule or the sort of PBR permit, and that's kind of at one level. And then once you go through your official permitting and get everything done, which takes several months, you get what's called an NSR, a New Source Review permit. And that's sort of for the full capacity of the equipment. So I think that's probably where there's some confusion.

[Marc Bianchi:]

Okay. So would that put you at about – by my numbers, about 8.5 million tons of capacity between Crane and Lamesa?

[Bryan A. Shinn:]

I think we're probably closer to 10 million tons capacity between those two.

[Marc Bianchi:]

Okay.

[Bryan A. Shinn:]

And then the rest of the system would be at about 17 million, all the other, the Northern White and the regional sand. So 27 million is what we have in our ongoing outlook for Oil & Gas sales capacity once everything gets fully started up and everything is running at design rates.

[Marc Bianchi:]

And would you anticipate that 10 million of West Texas to be at that 70% contracted rate once you're fully ramped?

[Bryan A. Shinn:]

Yeah, that's probably actually at a higher contracted rate. That's probably 75% to 80% contracted. We have some really good contracts in West Texas. I'm very happy with what we have there, Marc.

[Marc Bianchi:]

Great. Thanks, Bryan. I'll turn it back.

[Bryan A. Shinn:]

Thank you, Marc.

[Operator:]

Thank you. Our next question comes from Ken Sill with SunTrust. Please proceed with your question.

[Ken Sill:]

Yeah. Good morning, guys.

[Bryan A. Shinn:]

Good morning, Ken.

[Ken Sill:]

Just wanted to follow-up on that. So when you guys are talking 5% to 10% drop as you bring on the in-basin, is that in contribution margin or pricing?

[Donald A. Merril:]

That's in contribution margin per ton.

[Ken Sill:]

So the contribution margin per ton, 5% to 10% Q3, and then a little bit more in Q4?

[Donald A. Merril:]

That's correct.

[Ken Sill:]

Okay. And then, you guided in the press release to 80% of the volumes are going to be contracted. Could you kind of break out – I mean, I would assume that when you're saying 75% to 80% at Crane that it ultimately is closer to 80% or higher? Or how does that break out between the in-basin in Texas versus the rest of the company for the 80% contracted?

[Bryan A. Shinn:]

So I would say it's 75% to 80% in West Texas, and it's kind of in that same range for the rest, quite honestly. Across our 30-plus contracts, we've got a pretty strong mix of Northern White and local sands.

[Ken Sill:]

Okay. And then just one final question, just to try to get the modeling. How much volume did you guys get out of Crane in Q2 because volume seemed a little bit light, so I'm assuming that was where that came from.

[Bryan A. Shinn:]

Yeah. So, we haven't disclosed volumes from specific mines, but the difference I think between what you saw in terms of Oil & Gas volume and where some of the initial guidance was for the quarter was all around West Texas and just the pace of bringing up the capacity. I am pleased, though, that the team seems to be making really good progress. I was out there a couple of days ago and I think we're going to see some substantial increases when we get to the next quarter here. We've got at Crane our wet processing up and running pretty effectively. We've just started up our second drying line there, so we're making good progress at Crane. At Lamesa, the wet section came up flawlessly. And just for folks on the call here today, if you look at most of the issues in West Texas that folks have had getting mines started up, it's all in and around the wet section. So, the drying is pretty similar to what we do at any mine site around, but the wet section is where the challenges are. Anyway, Crane started up, Lamesa came up flawlessly, and we're starting to build a wet stockpile there that you can probably see from space. So in the next three or four weeks, we'll get our first dryer started up in Lamesa, and that'll start cranking out tons as well. So I think you'll see us in the coming months here ramp up pretty quickly in terms of our West Texas production.

[Ken Sill:]

Thank you.

[Bryan A. Shinn:]

Thanks, Ken.

[Operator:]

Our next question comes from Kurt Hallead with RBC. Please proceed with your question.

[Kurt Hallead:]

Hey, good morning.

[Bryan A. Shinn:]

Good morning, Kurt.

[Donald A. Merril:]

Good morning, Kurt.

[Kurt Hallead:]

Hey, guys. So, I'm just kind of curious, right, when you guys talk about 27 million tons of total effective capacity, you talk about 70% to 80% of your contract volumes being under contract. So, is that kind of fair to then just take that 27 million, multiply that by 75% or 80%, and that becomes kind of your quarterly – we can kind of run that into a quarterly kind of volume dynamics, and I guess if you're selling especially oil and gas volumes into E&P companies, they're pretty much going to take what they contracted for based on what I heard. So, is that fair? Take 27 million, multiply it by 80%, kind of divide that by 4 and that becomes your quarterly run rate on volumes through 2019, is that fair?

[Bryan A. Shinn:]

Yeah, look, that's the way I see it. My sales guys and our ops guys always tell me, it's a little more complicated than that. I want to do the simple math, right? But I think that's about right. That's how I tend to think about it, Kurt. So you take that capacity, say multiply it by 75% and pick where you think that contribution margin per ton is going to be, and then that's the profits that I feel like we can reliably generate out of those assets. And then whatever spot volumes we have would be in addition to that.

[Kurt Hallead:]

Okay. And then on the follow-up there, relating to Oil & Gas. So Don, you mentioned the contribution margin progression through year-end. Once we get into 2019, does that contribution margin stabilize?

[Donald A. Merril:]

Yeah, right now, we think it does. We'll see how everything kind of works out. But right now, we're thinking we're going to have most of our volume up online by the end of this year, which means that those margins should stabilize going into 2019.

[Kurt Hallead:]

Okay.

[Bryan A. Shinn:]

Yeah. And also, the reality is a lot of these contracts, in fact almost all of them, are fixed price contracts. So, I think that it will give you a good sense of where the margin is going to be as we exit Q4, Kurt.

[Kurt Hallead:]

Okay. And then, obviously, with your substantial – your acquisition of EP Minerals and the performance here in the quarter on your contribution margin, if you provide the kind of guidance, dynamics for Oil & Gas, wonder if you could do the same for ISP as it relates to prospective volume growth there and what do you expect from contribution margins as we head into the back half of the year?

[Donald A. Merril:]

I think if you look at contribution margin in the quarter, I think you would see something very similar going into the third quarter, and then what you have is the seasonality that will kick in for Q4.

[Kurt Hallead:]

Thanks, guys.

[Bryan A. Shinn:]

And so, I think that one of the differences, Kurt, with our industrial business is that we tend to be a bit more seasonal to – Q4 is typically the lowest quarter. We have a lot of our customers who take annual outages. Even EP, for example, they sell into some markets like the pool and spa market that has seasonality to it. So, I think there's that. Also, Q3 will be a little bit different in that we'll have a full quarter of EP Minerals, we only had two months. So Q3, I think you'll see a jump up, and then feels like, absent seasonality, we'll see some stability in the industrial sector.

[Kurt Hallead:]

And to be clear, just including the EP Minerals, what sort of volume growth are you talking about off the second quarter reported level?

[Donald A. Merril:]

I think volumes going from Q2 into Q3 are going to be relatively flat. Quarters two and three tend to be the biggest quarters for the traditional ISP business. The EP Minerals, there's not a lot of volume there compared to the traditional sand business. So, I think it's going to be relatively flat going into Q3. And to elaborate on Bryan's point, you're going to get another month of EP Minerals into Q3, so you will see a jump in contribution margin per ton from Q2 to Q3.

[Kurt Hallead:]

Got it. That's awesome. Thank you. Appreciate it.

[Bryan A. Shinn:]

Thanks, Kurt.

[Operator:]

Our next question comes from Connor Lynagh with Morgan Stanley. Please proceed with your question.

[Connor Lynagh:]

Yeah. Thanks. Good morning.

[Bryan A. Shinn:]

Good morning, Connor.

[Connor Lynagh:]

Wondering if you guys could elaborate a little more on the capacity that you can actually produce at versus the permitting dynamics you were discussing earlier. Is this an industry-wide thing, or is this just you guys came out conservative and probably others were less so? Just wondering if you could comment on that.

[Bryan A. Shinn:]

So, I think the whole sort of permitting, if you will, this NSR, PBR, these kind of two levels of permit, it's pretty common everywhere. However, what we've seen is that when almost everybody else announces capacity, they talk about the kind of ultimate, once it gets fully permitted, capacity. We talk about it in steps because, look, we didn't have those permits, and so we weren't ready to talk about that. But I would say that's generally true across the industry. The other reality, though, Connor, is that, once again, when we talk about capacity, we talk about what we actually expect to make. What we've seen is a lot of others announce so-called nameplate capacity, which means the assets run 24 hours a day, 365 days a year. And obviously, no manufacturing equipment actually does that. So, we believe a lot of the other capacities that have been put out there are substantially overstated.

[Connor Lynagh:]

Yeah. And if we could stay with that, I think you've made comments in the past that the effective capacity in a lot of these Permian mines could be even lower than what we've seen in the Northern mines historically. Could you just sort of update us on that? What are you seeing out there? What's sort of the feedback from the field?

[Bryan A. Shinn:]

Sure. So, look, I think that's for sure. And what we see in our modeling is that if you typically take an announced nameplate capacity, you have to reduce that by about 25% to get to kind of the effective capacity. And then if you sort of further reduce that, just given all the difficulties on the ground in West Texas, really, what comes out the back end of the mine is substantially less than that. And then, if you want to kind of do a kind of a real-world reality check, we go out and look at what mines have actually been started, and so the number goes down even further, right? So, I think you have to go out and really understand what's likely to be produced, what's been started in terms of construction, and when that's going to come online. And when you do that, it's not surprising that the ramp in capacity is much slower than what we've seen predicted in many of the third-party models.

[Connor Lynagh:]

So when you guys sort of build all that in, do you have a feel – obviously, the timing has slipped somewhat, but if we, say, extend it to mid-2019 or something like that, what's your feeling on incremental effective capacity growth in West Texas, in particular?

[Bryan A. Shinn:]

So I think if you get to, let's say, three or four quarters out, so mid-2019, maybe third quarter 2019, I think we could see maybe 50% to 60% of the Permian demand being supplied locally, for example. Maybe a little bit higher in a 100 mesh, a little bit lower in terms of the percentage of 40/70. But the thing that, I think, also has been missed by a lot of folks is that there's a cost curve in the Permian, just like there was for Northern White mines. And we believe that there's easily a difference of, let's say, $5 to $10 a ton on a delivered basis between the advantaged mines and those that are disadvantaged. And we tend to think of it internally in terms of Tier 1 local mines and Tier 2. And the Tier 1 mines have those advantaged logistics, are at the bottom of the cost curve, have multiple water sources. The company has the technical know-how to operate the facility. Typically, they're in the low- or the no-DSL habitat and they've got ready access to skilled employees. So, we categorize the mines that way. And when you do it that way as well, you kind of get a sense of who's advantaged, who's going to be long-term more profitable in the industry versus the others. And when we look at our combination of Crane and Lamesa, we've got two really good Tier 1 mines, and we're right at the bottom of the cost curve, and advantaged from a delivery and logistics standpoint. So, we feel really good about Crane and Lamesa. I think others who made different choices out of the basin perhaps will be more challenged, but we feel like we're in really good shape.

[Connor Lynagh:]

Interesting. Thanks a lot.

[Bryan A. Shinn:]

Thanks, Connor.

[Operator:]

Our next question comes from Scott Gruber with Citi. Please proceed with your question.

[Scott A. Gruber:]

Good morning, gentlemen.

[Bryan A. Shinn:]

Good morning, Scott.

[Scott A. Gruber:]

Just a couple of housekeeping questions here for you, Don. The merger and acquisition costs for EP, did that hit the operating activities excluded from segment costs? Where do those hit?

[Donald A. Merril:]

Yeah, there was some of it in SG&A, and then some of it in the operating cost, excluding from contribution margin calculation.

[Scott A. Gruber:]

Okay. So the $41 million of ISP contribution margin is clean for the quarter?

[Donald A. Merril:]

It's clean, that's right. That's right.

[Scott A. Gruber:]

Got it. And then, how do we think about SG&A into 3Q, if some landed there?

[Donald A. Merril:]

I think as you move forward for SG&A, I actually think that we'll be looking at around a $40 million number for Q3 and into Q4.

[Scott A. Gruber:]

Got it. And then, do you have a crew count for Sandbox during the quarter?

[Bryan A. Shinn:]

Yes. So, we were at 76 Sandbox crews in the quarter, Scott.

[Scott A. Gruber:]

Got it. That's it for me. Thank you.

[Bryan A. Shinn:]

Thanks.

[Operator:]

Our next question comes from John Watson with Simmons. Please proceed with your question.

[John Watson:]

Good morning, guys.

[Bryan A. Shinn:]

Good morning, John.

[John Watson:]

For the incremental Sandbox systems, as you move from 76 crews at the end of the quarter to 90 crews, can you talk to us about those agreements? Are they contracted for the incremental 14 systems, and maybe the duration of the contract, if they are?

[Bryan A. Shinn:]

So, we have several opportunities in the pipeline that we're working, John, and I would expect that we would see some good contracts for those incremental crews.

[John Watson:]

Okay. Are they a year or two years? Is there a way to think about the term?

[Bryan A. Shinn:]

Yes. So, we haven't talked specifically about the contract terms, but I think for those systems, given the contracts in the pipeline, we're probably talking multi-year contracts linked to those incremental systems.

[John Watson:]

Okay. That's super helpful. Thanks, Bryan. And then you guys have done a good job historically of tracking frac fleets. I was wondering if you could fill us in on what you saw in July versus June, and maybe the impact of how frac fleets are tracking on Sandbox demand and number of crews deployed.

[Bryan A. Shinn:]

Sure. So, we've seen a couple of frac fleets go idle or move basins. We haven't really seen a huge pullback, but we've seen other places report crews that were sort of more aggressively laid down or slowed down. What we have seen is a lot of competition out there right now, and there's some share that's changing hands. The good news for us is we have contracts with many of the customers. So, we're somewhat agnostic in terms of which frac company does the job in many instances. So, I think we'll see kind of flattish crew count for the next quarter or so. Obviously, there's still a lot of uncertainty around the whole space in terms of takeaway capacity, which I think most of us believe that in the next three or four quarters that that's going to get resolved. So, that's kind of a temporary issue. But we'll wait to see how that plays out going into year-end as well. You never know with Q4, quite honestly. We've seen some quarters where everyone decided to take a lot of holidays between Thanksgiving and Christmas, and other quarters where, boy, it's just the busiest time of the year. So, it's still a little bit early to see how that's going to play out, but we're hopeful that we'll see some strength going into the end of the year.

[John Watson:]

Okay. Great. And one follow-up. Do you have the percentage of Sandbox systems that are in the Permian as of today?

[Bryan A. Shinn:]

No, I don't think we've ever shared that information by basin.

[John Watson:]

Okay. Got it. Fair enough. Thanks, guys.

[Bryan A. Shinn:]

Okay. Thanks, John.

[Operator:]

Our next question comes from Michael Lamotte with Guggenheim. Please proceed with your question.

[Michael Lamotte:]

Thanks. Good morning, guys.

[Bryan A. Shinn:]

Good morning, Michael.

[Michael Lamotte:]

So, Bryan, it sounds like you're going to use a satellite photo of the wet pile at Crane on your next annual report cover? Is that right?

[Bryan A. Shinn:]

Yeah, I tell you what, hopefully, we're going to work that pile down into some finished sand that we ship out to customers. So maybe it'll just be a pile that you can see from Midland or Odessa, not from space. How about that?

[Michael Lamotte:]

Fair enough. So you can just put the big pile of money that it converts into, right?

[Bryan A. Shinn:]

Well, yeah, I like that.

[Michael Lamotte:]

A question on railroads. I'm curious as you are making these contracts for delivery and fixed price, particularly for the Northern White, on the logistics side, are you getting any kind of – how are you managing, I should say, the transportation costs on those, given sort of the uncertainty of total volumes, the leverage that you get off of unit trains? What's sort of happening with the economics on that side of the equation?

[Bryan A. Shinn:]

Yeah, it's a really interesting question. And we're in the fortunate position of having long-term contracts for a number of our most critical rail lanes. So, we typically have a good feel for what the price is going to be. I would also say that our railroad partners have been pretty accommodating and willing to work with us. And for some, perhaps that doesn't sound like their image of the railroad, but we've always had a great relationship with our Class 1 rails, and I think they treat us extremely well. And so, we feel pretty good about our ability to forecast the rail costs in signing some of these longer-term contracts.

[Michael Lamotte:]

Okay. So on a unit basis then, there's really little risk that that starts to creep up if volumes were to fall over the next, say, two to four quarters, in aggregate?

[Bryan A. Shinn:]

Yeah, I don't think there's much risk of that, given the rise of local sands. And generally, I think volumes in rail over the next few years are going to be down. We know that there's going to be a higher percentage, say, in the Permian of local sands, and all that local sand is coming at the expense of rail. So given that type of environment, I think the railroads are pretty accommodating. To the extent we need to work with third-party transload partners, their costs are probably going to be coming down as well, or at least their margin expectations will be. So, there's a lot of things like that that are positive in the chain. So you put it all together, and I'm not really concerned about costs over the next couple of years here.

[Michael Lamotte:]

Okay. Great. And then, last one for me, on – I think that last quarter we talked about some modifications to Sandbox to increase the carry load. Can you sort of provide us an update on where we are on Gen 2 Sandbox design?

[Bryan A. Shinn:]

Yeah, the team is making great progress on that, and I think we'll have some things to say about that more definitively in the future here. But safe it to say that we'll definitely be getting more sand in the boxes based on our initial trials. I'm pretty excited to see the results of that, and will be happy to talk about that once we've got some definitive data on it.

[Michael Lamotte:]

Great. Thanks, guys.

[Bryan A. Shinn:]

Thank you.

[Operator:]

Our next question comes from Lucas Pipes with B. Riley. Please proceed with your question.

[Lucas N. Pipes:]

Hey. Good morning, everybody.

[Bryan A. Shinn:]

Good morning, Lucas.

[Lucas N. Pipes:]

Bryan, I wanted to follow-up a little bit on the M&A strategy. If I recall correctly, in the prepared remarks, you mentioned that you continue to be interested on the minerals side. And I wanted to ask kind of what you're looking for, is it more on – are you looking for synergies in an acquisition? Are you looking for diversification? Or, put differently, kind of what are you looking to bring to the target and what are you expecting the target to bring to U.S. Silica? Thank you.

[Bryan A. Shinn:]

This is a really good question, Lucas. And we have a strong M&A pipeline right now, particularly in the industrial space where we're spending a lot of time. And we've got 15 to 20 candidates in that pipeline today. And there's all kinds of different companies there, EBITDA ranges from $20 million to $100 million or more of things that we're looking at or thinking about. I would say, in the industrial business, we're targeting things that expand our offering into attractive new markets or are complementary to our existing business. And many of the things we're looking at are sort of easier, smaller bolt-on opportunities, but we're not specifically limiting ourselves to deal size if we find something that's particularly attractive. So, I think you'll see us continue to be attractive – or active, rather, in the industrials M&A space. And EP Minerals is a great example of home-run acquisition for us. And so, if we can find more companies that look like that, those kind of attributes with specialty products in very defensible marketplaces, attractive industry structure, high barriers to entry, those are the type of things that we're looking for to complement the more cyclical side of our Oil & Gas business.

[Lucas N. Pipes:]

That is very helpful. I appreciate that very much. A follow-up, switching gears, we discussed last-mile logistics a little bit already on this call. But there are rumblings out there about containerized solutions maybe losing their edge a little bit in the marketplace from a competitive perspective. Could you comment on that specifically? And maybe, more broadly, kind of what are you seeing out there in last-mile logistics? Thank you.

[Bryan A. Shinn:]

Sure. Well, look, I mean, that's certainly not what we're seeing. We're seeing customers who are very interested in engaging Sandbox and customers who want to do more business with us. We have some pretty substantial opportunities in the pipeline. I think you'll continue to see us grow. Today, we're at maybe 18%, 20% market share of the last-mile logistics. We plan to grow to 30% to 35%. And I feel like the customers who are really savvy and have done the math on the savings of having a containerized last-mile logistics versus some of the other alternatives are switching to containerized solutions, like Sandbox. And some of the smartest, most astute customers have made that move. And I think perhaps it's a little bit harder of an initial sell because our solution doesn't look like the traditional kind of sand king, if you will. So if you look at some of the silo solutions out there, they look and feel more like the traditional solutions. But when you lift the hood up and look at all the advantages of Sandbox, I think a number of customers have been sold, and I feel like we're going to win more business than we lose going forward.

[Lucas N. Pipes:]

Very helpful. Great perspective. Thank you, and best of luck.

[Bryan A. Shinn:]

Thanks, Lucas.

[Operator:]

Thank you. At this time, I would like to turn the call back over to Mr. Bryan Shinn for closing comments.

[Bryan A. Shinn:]

Thank you very much, operator. I'd like to close today's call by thanking everyone who helped us deliver strong results in Q2. And I want to reiterate a couple of points. We're positioned for the best year ever in our 118-year history here in 2018 with expected record performance across the company as we finish out the year. I think we're going to have an even better year ahead in 2019. We talked about the profits that we're going to generate, and approaching 15% free cash flow yield, I'm highly confident that we're going to be able to do that. And with 27 million tons of Oil & Gas capacity online and significant new growth from Sandbox and ISP, I think the years ahead are going to be very, very exciting for U.S. Silica. So, thanks everyone for dialing in today, and have a great day.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time. And thank you for your participation.