How much would you pay for a stable, but growing asset that generated at least US$90m of EBITDA each year? What if it also had US$68m of cash on its balance sheet and no debt?  Maybe you would pay US$500m?  Maybe just US$400m?  But you’re a value investor, so maybe you would wait for a real bargain – say US$300m?  Well, believe it or not, this asset is currently available for negative US$654m.  And this is not another purely academic conglomerate discount or a hopelessly illiquid theoretical trade.  You can quite easily create this absurdly undervalued asset through a combination of two tangible, liquid publicly traded securities.  And there’s even an imminent catalyst.  Read on.

 

 

 

Industrias CH (“ICH” or ticker ICHB MM on the Mexican Stock Exchange) is currently trading at a nearly 40% discount to the sum of its parts.  Why should we care?  Don’t lots of companies suffer from a persistent conglomerate discount?  Why is this particular situation so compelling?

 

1)      ICH’s largest subsidiary, Grupo Simec (“SIM”), representing approximately 87% of consolidated revenues, profits and free cash flow, is actually publicly traded.  This sets an independent market valuation on this portion of ICH.

 

2)      SIM’s market valuation is “real”.  It has an equity market capitalization of US$3.0b, a publicly held float of approximately US$180m (soon to potentially more than triple) and very healthy liquidity, trading an average of more than US$12m per day.

 

3)      ICH’s stake in SIM alone is worth 135% of its current market value, implying that its remaining assets (all of which are free cash flow positive and generate EBITDA of more than US$90m) are worth negative US$654m.  This is clearly nonsensical, especially when considering that ICH also has a cash position of US$68m (excluding cash consolidated from its controlling interest in SIM) and absolutely no debt.

 

4)      This massive 37% discount has developed primarily over just the past 6 months and was actually a premium a year ago.  Both management and the Company’s sole equity analyst (UBS) attribute this irrational disconnect to a lack of understanding of the economic ownership structure and agree that there is no fundamental logic to this valuation detachment.  For instance, in the past year, SIM shares have risen over 450% vs. just over 100% for ICH, when the assets are substantially identical (literally 87% overlap).

 

5)      ICH has recognized the magnitude of the current discrepancy and is now planning to take advantage of it by issuing equity in SIM – the offering is being handled by Citigroup and the Company expects it to occur before the end of December.  The offering documents list general corporate purposes and future potential acquisitions as the rationale, but ICH management admits that no specific acquisition targets have been identified and that it has no immediate need for the capital.  In fact, ICH has recently traded at a slight discount to its peer group partly due to the fact that it is so underleveraged (with a net cash position).  The Company has filed to sell at least US$250m worth of primary SIM shares and as much as US$425m by some accounts (60m shares).  Aside from the 8%-13% dilution to existing SIM shareholders, the offering should have the more significant effect of increasing the publicly traded float by 140% to 235%.  It is our experience that valuation discrepancies as considerable as the one presented here cannot survive that kind of influx of capital.

 

 

 

It may be easiest to follow these calculations using the tables below.

 

First of all, let’s determine what ICH shares should currently be trading for, assuming that the market is correctly valuing SIM.

 

ICH currently owns 85.1% of SIM (representing essentially complete economic and voting control).  This stake is currently valued at US$2.5b based on SIM’s recent price of US$21.15 per ADS (as of Sept. 30, 2006, there are approximately 140.4m ADSs outstanding).  Republic was acquired directly by ICH (and indirectly through SIM) from Perry Capital in July 2005.  We know from the Company that they paid a combined US$395m for it at the time (consisting of $229m in cash and intercompany loans and $166m in assumed debt, all of which has since been repaid in full).  We also know that Republic generated US$120m in EBITDA in the 12 months before it was acquired and that ICH management immediately proceeded to rationalize the cost structure and improve the profitability.  Nevertheless, for conservatism, we are valuing Republic at its acquisition price, implying US$197m of value for the portion owned directly by ICH (the remaining value of Republic is already included in the value of the SIM shares).  ICH also directly owns a number of other specialty steel mills representing an aggregate 750k tons of capacity.  We have conservatively used replacement value (US$188m) to account for these mills based on guidance from the Latin American steel analyst at UBS.  As further validation for this figure, we can look to ICH’s acquisition of 440k tons of productive capacity from Sidenor Mexico in October 2004 for US$120m.  This valuation represents US$272 per ton for nearly 60% of the Company’s current non-SIM (and non-Republic) capacity.  Instead, we are conservatively assuming a blended per ton valuation of just US$250 (US$188m for 750k tons).  Finally, a review of ICH’s most recent financials reveals that the Company has no debt outstanding whatsoever and has a current cash balance of US$68m (after subtracting US$150m that is consolidated from SIM’s balance sheet).

 

 

 

 

 

 

The other way to look at this valuation analysis is to assume that ICH’s current market valuation is “accurate”.  In this case, it would imply that SIM is nearly 80% overvalued at current market prices.  This represents potential upside of 44% for a SIM short position.

 

 

 

 

This analysis is predicated on the fact that there are no liabilities or other significant obligations of any sort at ICH that SIM is not also subject to.  Conversely, this analysis assumes that there are no valuable assets or cash flow streams at the SIM level that ICH does not have an 85% interest in.  Management has confirmed the accuracy of both of these assumptions for us.

 

 

 

The simplest trade here involves taking no view on the underlying fundamentals of the two companies and just attempting to profit from the unwarranted valuation discrepancy detailed above.  According to our calculations (shown in the table below), this would involve selling short 0.274 SIM ADSs for each share of ICHB MM that you buy long.  This amount represents your pro rata ownership of SIM shares.

 

 

 

 

 

Described in more detail above, the Company currently plans a US$250m-US$400m equity offering to take advantage of the dramatic relative rise in SIM’s shares.  We believe that this is a no lose scenario.  If the equity deal fails, it will highlight SIM’s unwarranted valuation.  And if it succeeds, then ICH has found a way to successfully monetize an asset that currently represents 135% of its equity value – making ICH shareholders the beneficiaries of this value creation.

We have seen rumors on SIM chat boards that the Company may be taken out by a large international steel player given its small size, strong market position in both the US and Mexico, and healthy balance sheet.  Given ICH’s dominant controlling interest (85%), there is absolutely no chance of this happening without ICH’s approval.  Therefore, the more likely scenario would be that ICH would be the target, which is effectively a much cheaper way for someone to acquire SIM.  Alternatively, if ICH management did for some reason receive an offer high enough to entice them to just sell SIM, the ICH shareholders would be the largest beneficiaries given the negative residual valuation implied by the current market prices.

 

There is speculation that ICH might want to effectively list itself on a US exchange through a reverse merger into SIM and that this could justify a rise in SIM’s shares.  While we agree that this is a realistic scenario, we do not see any reason why this would imply that the SIM public float (only 6% of shares) would receive any premium whatsoever.  In fact, we believe the more likely scenario is that SIM shares would be valued at ICH’s current multiple (or a multiple between the two), either of which would represent a discount to SIM’s current market value.  The reason for this is simple.  The Vigil Gonzalez family controls 63% of ICH (an investment currently worth US$1.2b) and just 9% of SIM directly (worth approximately US$267m).  So, their net worth is stacked 4.4 to 1 in favor of ICH shareholders and they are in complete control of both companies’ Boards.  Furthermore, between ICH’s 85% SIM stake and the family’s additional 9% stake, the Company could probably qualify the transaction as a short-form merger, which would mean that they could potentially effectively deem any merger transaction completed without even bothering with a review of the consideration being offered or a shareholder vote.

 

 

 

One could argue that SIM’s ADSs deserve a premium over ICH’s locally listed security due to any number of factors:  higher liquidity, increased visibility, lower capital repatriation risk, less foreign currency exposure, etc.  However, the best way to test this theory is to look at SIM’s own locally listed security (SIMECB MM) and compare its current trading price to that of the SIM ADS.  Based on recent prices, SIMECB MM is trading at MXN 77.42 or US$6.99 vs. the SIM ADS price of US$21.15 or a local share equivalent price of US$7.05 (SIM’s ADSs each represent 3 local shares).  These prices reflect a premium of just 0.9% for the ADSs, a far cry from the currently implied 78% premium that SIM is receiving based on the current valuation of ICH.  To be sure that SIM’s ADS premium (or lack thereof) was not an outlier for some unknown reason, we also looked at the other 25 publicly traded ADS/local paired securities currently trading in Mexico for which there is reliable pricing information.  This analysis shows that Mexican ADSs are currently actually trading at a modest discount to their local equivalents and that not even one of them trades at as much as a 5% premium.

 

 

 

 

If you are buying SIM because of the underlying fundamental strength in the business metrics, then you are buying the wrong security.  ICHB MM benefits 85% from these same fundamentals and is significantly cheaper – why pay more for SIM than you have to?  If you are buying SIM because of technical momentum, then just be aware of the fact that the fundamental valuation makes no sense relative to ICH and that the upcoming equity offering could nearly triple the float, flooding capital into a questionable valuation (and we believe, providing for a share price reset).

 

We have been able to locate sizable blocks of SIM to sell short, but this has at time required patience (and sometimes calls to more than one broker).  Given the hedged nature of this trade, we have not done the same level of in-depth fundamental diligence on ICH that we would have completed for a long only position, but our initial conclusions are that at its current valuation, ICH also offers quite an attractive absolute long opportunity (as opposed to just the relative value trade we are proposing).