Description

Innophos provides investors with the opportunity to own a very stable growing business at 6x FCF and a 5.5% dividend yield.  This is a Bain Cap IPO that broke range (priced at $12, down from $15) primarily because those playing deals had no interest in a small ($270mm mkt cap) specialty chemicals company without a sexy growth story.  I believe this stock provides investors with upside in excess of 100% while maintaining significant downside protection.  

Valuation Stats (2007/2008):

EV/EBITDA – 6.3x / 6.0x

EV/EBITDA Less Cap Ex – 8.7x / 7.3

EV/EBITDA Less Main Cap Ex – 7.1x / 6.7x

P/FCF – 8.9x / 6.1x

P/FCF (Main Cap Ex) – 5.6x / 5.1x

Dividend Yield – 5.0% / 5.5%

Below are some tenets of the thesis:

1. Regional Market – International competition is almost non-existent
2. Extremely High Switching Costs – Requires customer risking the taste of a product and must go through FDA & USDA approval process with new supplier (takes 12-18 months)
3. Two Player Market
4. Not a cyclical business – not tied to ethylene chain
5. Revaluation of assets from Bain acquisition in 2004 skews true earnings power – Cap Ex is sustainably below D&A
6. Enormous Barriers to Entry
7. Cost of product is immaterial for customer – represents about 1% of total COGS for customers.
8. Significant Discount to Comps
9. Pricing Power over Customers

Let’s get straight to the point. Innophos is not a specialty chemicals company, but rather a food additives business with no cyclicality and a stable growth profile.  The company’s products add flavor and shelf life to most of the large food & beverage manufacturers in the US.  To give you a sense of some of the products, the company has sold into Bisquick pancake mix since the 1920s, as well as other well know companies like Oscar Meyer and Coca Cola for years.  The key things to touch on here it that these end markets are highly stable (Coke has not shown large declines during economic down turns) and are tied to GDP growth over time.

While the majority of the profits come from the food & beverage division of Innophos, the company does play in the phosphoric acid space, where it supplies ingredients into detergents, personal care, asphalt, and water treatment.  While I am not as bullish about these businesses, they do have a couple decent growth stories.  The water treatment business should benefit from the lack of water infrastructure and clean water in the US and the asphalt business should benefit from the current push to repave the roads in the US.  

Cost Benefit Analysis

Assume a box of Bisquick pancake mix costs $1 to manufacturer, and is then sold to the supermarket for $2.50.  Of that $1, Innophos sells about $.01 of ingredients to Bisquick or 1% of the cost.  Lets look at the implications to Bisquick if Innophos wants to raise prices by 10% to Bisquick.  You need to consider the odds that Bisquick would want to change suppliers to save 10bps of cost or 4 bps of margin, when doing so would risk the taste of the pancakes and require a 12-18 month approval process from the FDA prior to starting up production again.  Just to give you a sense of what is at risk, Bisquick cannot afford to sell more than one less box of pancake mix out of every 1,500 boxes because of a change in taste or delay from the transition of suppliers.  My point here is that large food and beverage producers are not willing to make any change to their business unless it has a material impact on their profitability. It is for this reason that Innophos experiences little turnover from a customer switching to a competitor (keep in mind that most of these products are sole sourced).

Regional Market:

Generally speaking, when looking at a US specialty chemicals company I am inherently concerned about competitive threats from lower cost countries like China.  For the most part, Innophos operates in a regional market (Intl imports have represented about 12% of total volume historically and have not shown any signs of increasing).  This holds true for a few reasons. 1) The shipping costs relative to the overall products costs makes it uneconomical, 2) a number of the products will go bad due to a short shelf life and cannot be shipped, and 3) customers demand products within a very short notice (1-2 weeks) making it essential for the plants or distribution centers to be in a close proximity to its customers.

Enormous Barriers to Entry:

You cannot just spend the capital and open a plant.  Generally, it takes 3-4 years and a couple hundred million dollars to build a Greenfield, but that is not the hard part.  The key here is that no one will deploy the capital to open a plant without knowing the future business is booked and no customer will consider purchasing these products until they are comfortable with the taste and performance of the product.  It is for this reason that there is no new capacity coming on line in the next few years and no announcements of anything thereafter.

Two Player Market with Tight Capacity:

Innophos competes with Astaris in most of the food business, particularly in the specialty salts.  Capacity utilization in currently in the 90% range, but pricing is still well below reinvestment levels.  It is worth mentioning that replacing the assets of Innophos would costs about $900mm, implying a doubling of the equity value (talks to pricing relative to reinvestment economics).  The fact that these markets are extremely consolidated provides the customers with little alternatives for sourcing.

Raw Materials & Margins:

The key raw material here is phosphate rock which Innophos sources through a long term supply contract from Morocco.  The key thing to think about here is that 85% phosphate goes into the agricultural (Innophos is not in this market) market, so you need to pay attention to the underlying demand of the raw materials.  While there is increasing demand from fertilizer (tied to ethanol) which can use some processed phosphate rock, I do not believe it to be a threat to this business.  There is a large amount of capacity coming on over the next few years in Saudi Arabia, whereby pricing should actually decline.  To the extent this happens there will be some material upside in my estimates.

Pricing Power:

When you have a business where switching costs are enormous, your pricing is immaterial to your customer’s costs, no real competition; I would think you can have some real pricing power.  Keep in mind that pricing would have to go up significantly to meet reinvestment economics.  I attribute this to the fact that this business was mismanaged by Rhodia back in the day where the company did not take advantage of the competitive position.  Since Bain purchased the business in 2004, the company has prudently taken up pricing up by about 5% per annum (The reason you do not revenue growth in 04-06 revenues is due to the company’s decision to exit unprofitable pass through business – can see it in EBITDA growth).

Financial Comments:

                                                2004     2005     2006     2007     2008

Revenues                                 538.3     535.5    534.2    548.4    564.7

EBITDA                                    85.5       95.8      99.0      107.0    112.0

EBIT                                         45.5       49.8      47.2      57.0      66.0

Net Int Expense                       14.2       46.6      50.0      37.7      36.0

EPS                                         $1.18     $(0.16) $(0.13)   $0.58    $0.82

Total Diluted Shares                21.3       21.3      21.3      21.3      21.3

EBITDA Margin                        15.9%   17.9%   18.5%   19.5%    19.8%

EBIT Margin                             8.5%     9.3%     8.8%     10.4%   11.1%

Free Cash Flow:                      2004     2005     2006     2007     2008

Net Income                              25.2       (3.2)     (2.7)     11.3     16.7

D&A                                         40.2       49.6      51.8     50.0     49.5

WC                                           (6.7)      (0.6)     (2.0)     (1.0)     (1.0)

Cap Ex                                     (6.8)      (10.9)   (16.4)   (30.0)    (20.0)

     Total                                   51.9       34.9      20.6     30.3     45.2

     FCF Per Share                   $2.56     $1.72    $1.02    $1.51    $2.23

I believe the FCF will grow at roughly 10% over time, but should grow in excess of that for the next couple years.  To get to my 10% growth target, I am assuming volumes will grow in the 2% range with pricing up in the range of 1.5% per annum.  While I believe there is significant pricing power in this business, I am assuming inflationary pricing going forward (conservative approach).  Anyways, my assumptions will get you to EBITDA growth in the 4-5% range with the rest of the FCF growth coming from debt reduction. 

In addition to this, the company believes they can take about $12-$15mm of costs out of the business from improving the energy efficiency of the plant in Mexico.  After tax, this alone should add $.39 in FCF.  From a working capital perspective, I believe the company is already extremely efficient.  There may be a couple million the company can take out of inventory, but from a FCF perspective, I am expecting a couple million outflow each year as volumes increase.

Earnings Expectations:

I believe the company will beat earnings handily during the back half of the year as well as 2007.  If you look at the analysts expectations, they are assuming a significant deceleration of EBITDA growth in the back half of the year (low single digits), despite what looks to be some very strong pricing currently and double digit growth in the first two quarters.  For 2007 and 2008, the analysts are not assuming any real costs savings, which we believe will be significant.  This should set up well for some strong earnings beats going forward. 

Cap Ex v D&A

This is one of the key points of the thesis as the stock does not appear cheap on an EPS basis.   In 2004, when Bain purchased the assets from Rhodia, there was a change in the accounting.  The assets were written up to replacement costs (forcing an increase in the D&A).  While D&A runs at about $50mm per year the true maintenance cap ex is about $12mm.  I am assuming ongoing cap ex is runs at $20mm going forward as the company does put some investment into the business.  It is worth mentioning that the company actually incurs about $45mm of maintenance expenses each year (5% of the value to replace the assets), most of it is actually run through the income statement.  Given that this is the primary driver for the difference in EPS and cash flow, it is very important to understand that the company has not been under investing historically.

Why Was This a Weak IPO?

1. Stock does not look cheap on EPS basis
2. Investors did not see any significant growth story attached to it
3. It is a levered (3.5-4x EBITDA), which certainly scares some investors
4. Investors associate this business with other specialty chemical companies, many of which are extremely cyclical
5. Relatively Illiquid
6. Investors did not take the time to understand the value of these assets

Bain Capital:

Generally I am extremely skeptical purchasing from private equity firms.  They have more information than I do and have made the decision to sell some of equity investment.  I believe there are two things that give me some comfort here.  1) When the offering price dropped from $15 to $12 Bain reduced the offering size from 2mm shares to .7mm.  Their proceeds dropped from $30mm to $8.4mm.  I think this makes a statement as to how they view the business.  2) This company no longer fits the portfolio of a large private equity firm.  In the last two years, the large PE players have seen the size of their deals grow multiple times (now writing $500mm checks).  I believe IPHS is now one of the smallest companies in their portfolio and make sense to start the divestment process.  3) I would have imagined if Bain was concerned with a material problem coming up in the business, they would not have been that price sensitive in selling.

Comparable Valuation:

The only direct comparable valuation is 2005 acquisition of Astaris. The company was bought by ICL (Bloomberg ticker is CHIM IT) for 8x EBITDA and 12x EBIT.  If you place this kind of multiple on Innophos, the stock is a double.  It is also worth mentioning that Innophos’ assets are a touch ahead of Astaris from a competitive standpoint.

Catalysts – 1) A couple strong quarters of earnings, 2) Analyst initiations/recommendations, 3) Dividend yield catching the eye of investors.

Catalyst