Description

The following is an idea on an under-the-radar company (only covered by one analyst), with a relatively small capitalization (US$1.4bn) based and with operations solely in Mexico.

Why do we think it is interesting?

Consider the following:

• A good (albeit boring) underlying business: salt and chemical products (caustic soda and refrigerant gases). Also a small, profitable textile operation.
• Controlling family has economic majority and their interests are fully aligned with those of its shareholders. Long term planning.
• Prudent managers. Not risk takers. The company had almost 40% of its market cap in cash and equivalents as little as two years ago. They still have a net cash position though resources have been allocated to projects that will immediately impact margins and cash flow and with a high mid teen’s IRR.
• Those projects hit the income statement in 2015. Capex has been made, no return is still evident. Little coverage and thus investors are now stuck with a high ttm multiple that is not reflective of the current business.
• Other (important) real estate assets in Monterrey (the 2^nd largest city in Mexico in GDP contribution after Mexico city), and Aguascalientes. The real estate was bought many years ago and now lie right at the center of the city. They are carried at book value and are worth significantly above that in the current market
• Current business + real estate, with very conservative growth scenarios (basically we assume no real growth, more detail later) approximate the company’s current market cap.

So you are probably asking why is this such a great opportunity if we are saying that the company (with conservative no growth scenarios) is fairly valued right now?

The answer- Cydsa has entered into various contracts with Pemex (the oil state-owned monopoly in Mexico), to provide storage of natural gas in gas caverns. These projects by themselves are worth (depending on the final number of caverns) between $15 and $30 pesos, or between half and double the current share price.

1. Company background

Cydsa was founded in 1945 as a textile business, the Company then entered the chemical business. Growth was driven through JV’s and acquisitions in the chemical industry.

In 1973 Cydsa went public and for the next 20 years the Company aggressively expanded its PVC and plastic business. In the early 2000’s Cydsa faced liquidity issues and as such, the Company entered into a restructuring process. As a result, the PVC and plastic business were sold and Cydsa decided to solely focus on the caustic soda, gas refrigerant and textile business.

The Company is controlled by Tomás González Sada, who currently serves as Chairman and CEO. Mr. González has 50.15% of the shares outstanding. Today, the Company has a free float of 20%.

2. The business

The Company operates through two business segments:

Chemical Products

Salt:

Manufactures refined, iodized and fluoride salt for household an industrial markets. Uses: Table salt, food industry and industrial processes. Revenues US$113 million, EBITDA margin 22%.

Chlorine - Caustic Soda:

Manufactures and sells chlorine, sodium hypochlorite, hydrochloric acid, muriatic acid and liquid and solidified caustic soda. Uses: Chemical and petrochemical industries, textiles, cellulose, water, paper, pesticides, bleach, detergents and soaps, mining and extraction of metals, plastics, pigments and paints. Revenues US$200 million, EBITDA margin 23.5%.

Refrigerant Gases:

Manufactures refrigerants, propellant and blowing gases. Certified Emission Reductions (CER's). Uses: Industrial, commercial and domestic refrigeration, home appliances, pharmaceutical industry and automotive industry. Revenues US$78 million, EBITDA margin 8.5%.

Cydsa today has the highest margins within the Mexican chemical industry. They are extremely efficient operators and are fully vertically integrated, starting from salt extraction up to the final consumer. Salt is the chemical division’s main raw material.

Salt storage in caverns further extends the vertical integration of the company.

Textiles

 Uses: Clothing. Revenues US$16, EBITDA margin 20.3%.

The chart below shows Revenues and EBITDA breakdown by business segment:

Production Process and products

Salt Mining Process

1. The first part of the operation is known as solution mining: by injecting water at a high pressure to the salt dome trough a concentric tube to the earth. The salt dome is located at 1,500mts depth.
2. Water is pumped down one tube, the salt below is dissolved, and the resulting salty water (brine) is pumped out through the other tube, and taken to a plant for evaporation.
3. At the plant, the brine is treated to remove minerals and pumped into vacuum pans, sealed containers in which the brine is boiled and then evaporated until the salt is left behind.
4. Finally, salt is dried and refined. Depending on the type of final product, iodine and an anti-clumping agent are added to the salt.

Chlorine and Caustic - Soda Processes

1. Chlorine can be manufactured by electrolysis of a sodium chloride solution (brine).
2. The production of chlorine results in the co-products caustic soda (sodium hydroxide, NaOH) and hydrogen gas (H2).
3. This chain begins with the chlor-alkali process which basically is the dissolution of NaCl into chlorine and caustic soda by electrolysis. There are 3 processes for electrolysis that are mainly used by industry players (mercury amalgam cell, diaphragm cell and membrane cell).

3. CAPEX that has been expensed – The investments the company has already made and when will they hit the Income Statement.

For the past years, Cydsa began a new phase focusing on improving competitiveness and growth capabilities of the Saline and Chlorine – Caustic Soda Chemical Business Units. The expansion projects included production and capacity increase, technological updates and manufacturing process improvements.

The implementation of the majority of the projects is currently underway and will be done in 2014. The estimated Capex for these projects was US$436 million, which has obviously generated an important cash burn. We believe that incremental in 2015, once the projects reach their full capacity, Cydsa will generate FCF.

With a total estimated capex of US$436 million for strategic projects, capex deployment as of 3Q14 has been of US$387 million, 89% of the total investment.

Description of Strategic Projects

• Itsmo Salt

Expansion project to satisfy market needs by reducing 150k tons of salt imports. This project will increase capacity to 570k tons (increase of 42%). The project was finished on 3Q14.

Potential incremental EBITDA of US$7 million, which will increase margins as the Company reduces salt imports to satisfy their internal consumption.

• New IQUISA

A new state of the art production facility for Chlorine, Caustic Soda and Chemical Specialties, located in Garcia, N.L. (Northeast Mexico). This project will increase capacity in chlorine by 60k tons, caustic-soda by 68k tons, an increase of 56% and 57% respectively from current capacity. Furthermore, due to a new membrane technology the plant will reduce their energy expenditure by 30%. This project is expected to be functional by 3Q15.

A potential EBITDA of US$13million that will increase margins.

• Cogeneration I and II

These projects will reduce the Company’s energy costs, as energy represents 60% of variable cost.

Cogeneration plants will help satisfy electricity requirements for Cydsa’s plants located in Coatzacoalcos and simultaneously generate steam based on natural gas. Each plant will have a potential annual capacity of 60MW of electricity and 550k tons of steam.

Cogen I will yield cost of US$24 million, which represents around a 25 to 30% reduction in energy costs and directly impact EBITDA. Cogen I was finished in 1Q14. Cogen II will start production in 3Q15 with additional cost savings of US$14 million.

• Gas Storage Project

This projects consists in the development of a new zone for brine drilling and extraction and drilling of four wells with potential use as caverns for hydrocarbon storage. Two caverns have already been completed and are ready for use as storage facilities. The third and fourth caverns will be ready for storage in 1Q15 and 1Q16 respectively.

The Company has advanced negotiations with Pemex (we believe discussions lie over the target IRR) and we expect a formalized contract by the end 2014.

4. Other assets – real estate

The Company has meaningful real estate in Monterrey and Aguascalientes. The land was bought many years ago and now lie right at the center of the city. 

The value of these assets at book is around US$ 110 million. We believe market value is easily double that amount.

5. The big game changer- gas storage

Why is salt storage a strategic priority for the current administration and pillar to the recently enacted energy reform?

• Although Mexico has the 16^th largest proven oil and 31^st largest proven gas reserves in the world, because of underinvestment in the sector (going on for decades), and thus, the lack of technological and technical expertise needed to develop it’s natural resources, the country is a NET IMPORTER of natural gas and oil production has declined from 3.8 mbpd to 2.9 mbpd in the past 10 years.

• It is important to consider that the shale gas geology that is present in the US, specifically in Eagle Ford, should reach out to Mexico and with a great probability, the country’s oil and gas reserves and production should materially increase when the technological and technical expertise needed to produce shale oil exists in Mexico. This is something that should happen in the next five to ten years as the energy reform contemplates private investment and collaboration with the state owned company. This is a big change and a first since the oil nationalization by President Cárdenas in 1938.

• Having said this, because Mexico is a net importer of natural gas, the electricity cost per unit born by industry is in average 25% higher than those in the US. Given the importance of electricity costs in many industries, this fact has a huge effect in profitability, investment and ultimately employment.

• The state of Texas has TWENTY times the total pipeline mileage and capacity than that of Mexico as a whole. This is a good data point to reflect the current underinvestment and thus opportunity in the sector. Mexico has only TWO DAY storage capacity for natural gas. Compare that to 13 days in the UK, 99 in Germany and 122 in France to set some perspective.

Why is Gas storage important for Mexico?

• Gas storage can be used by producers to store any gas that is not immediately marketable, typically over the summer when demand is low and deliver it when in the winter months when the demand is high.

• Gas storage can be used as an insurance that may affect either production or delivery of natural gas. These may include natural factors such as hurricanes, or malfunction of production or distribution systems.

• Gas storage ensures to some extent the reliability of gas supply to the consumer at the lowest cost, as required by the regulatory body. This is why the regulatory body monitors storage inventory levels.

• Gas storage ensures commodity liquidity at the market centers. This helps contain natural gas price volatility and uncertainty.

• Gas storage facilities are gaining more importance due to changes in natural gas demands. First, traditional supplies that once met the winter peak demand are now unable to keep pace. Second, there is a growing summer peak demand on natural gas, due to electric generation via gas fired power plants.

Why storage in salt caverns?

Underground salt formations are well suited to natural gas storage as the walls of a salt cavern have the structural strength of steel and allow little injected natural gas to escape from the formation unless specifically extracted.

These facilities are characterized by high deliverability and injection capabilities and have a better utilization rate.

Other types of storage facilities are depleted gas/oil reservoirs and acquifers. (i) Depleted Gas/oil reservoirs are formations that have already been tapped of all their recoverable hydrocarbons. This leaves an underground formation geologically capable of holding natural gas. These facilities allow the use of the extraction and distribution equipment left over from when the field was productive. (ii) Acquifers are underground permeable rock formations that act as natural water reservoir. These water-containing formations may be reconditioned and used as natural gas storage facilities. Acquifers are more expensive to develop than depleted reservoirs therefore, they are only used in areas where no nearby depleted reservoirs exist. Aquifers are the least desirable and most expensive type of natural gas storage facility.

Is Cydsa competitively positioned to provide gas storage in caverns?

The answer is yes, Cydsa’s concessions are located in one of the richest saline regions in the country. The Company’s facilities have a strategic location as they offer close proximity to the major Pemex interstate pipeline in Coatzacoalcos and the most important petrochemical complex in Mexico known as Pajaritos.

Hydrocarbon storage has strong barriers to entry as any competitor interested in the storage business will require, among others, the creation of a salt business, government authorizations and intensive capital.

Cydsa’s gas storage projects will be Mexico’s first hydrocarbon storage facility.

 Is Pemex the only possible client for gas storage?

The answer is no, there are other possible clients as other companies in the chemical business use natural gas as main raw material. A good example is Mexichem.

The economics per salt cavern

The Company has announced the development of 4 caverns that could go up to 14 in total, with an investment on each cavern of US$100 million and an expected IRR of between 11 and 14%.

6. Adding it all up.

1. Our projected Income Statement

 Additional EBITDA on strategic projects

We believe Cydsa has a very attractive valuation due to the potential cash flow generation on strategic projects. We are estimating an additional EBITDA of US$ 59 million for the next 2 years without taking into account the gas storage projects.

 DCF and FCF valuation

Our price target

Including the value of the salt caverns for hydrocarbon storage, which we are estimating to add an additional MXN $1.5 per share considering the investment that the Company has disclosed (US$100 million) and an IRR of 11.3%.

The potential number of caverns goes up to 14 caverns, which increases our target price by MXN$ 10.5 – 21.  We must mention that the gas storage Project has the potential for more caverns and could increase further value for the stock.

We believe Cydsa is worth between MXN$40.5 to 51, or between 24 and 55% upside from current levels. We have used an 11.3% IRR to calculate the value of the gas storage caverns although we believe the final negotiated return with Pemex (based on contracts awarded recently) is close to 15%. If we are right, the gas storage value is understated by between MXN$5 and 10 per share.

Additionally, we value land at book. If we use a realistic replacement value for the real estate assets we increase the Company’s overall valuation by US$100 million or an additional MXN$ 3 per share.

Suming all up, potential value for the Company could approach between MXN$48.5 to 64 per share in two to three years, double today’s market cap.

Catalyst

• Half of Cydsa’s revenues come from the chemical division. Commodities have a high volatility and in a scenario of slower industrial activity or over-capacity; prices might be pressured and margins might drop. 60% of the variable input of COGS comes from gas and energy, a sharp increase in energy prices would imply a severe margin contraction.

• More than 90% of the Company revenues are generated in Mexico. The products the company sells are cyclical and correlated to economic activity. If the Mexican and the United States economy slow down, Cydsa’s performance could slow down as well.

• The project in which Cydsa is planning to invest most of its capex is the caverns for hydrocarbon storage. We are aware of the potential of the project, but we must take into consideration that the company has not engaged before in any activity similar to this before and results coulf differ from the company’s expectations.

• Competition in the chemical sector has intensified in recent years. Cydsa's strategy has been shifting to become more vertically integrated in an attempt to become less dependent on third parties and to capture margins. Most of the products the Company sells are commodities therefore entry barriers are inherently low.