|Shares Out. (in M):||24||P/E||0||0|
|Market Cap (in $M):||525||P/FCF||0||0|
|Net Debt (in $M):||300||EBIT||0||0|
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On Friday, August 7, 2015, LSB Industries’ stock (ticker: LXU) dropped 35%, creating a tremendous opportunity to get long a business undergoing a transformative vertical integration that by itself will double the Company’s EBITDA by 2017. In addition, two other items I discuss below will lead to EBITDA actually tripling by 2017. Finally, there are going to be a number of very hard, value-creating catalysts that will lead to value and thesis realization, including: (i) a large activist investor, (ii) the purging of a terrible management team, (iii) a lawsuit filed by the company against its general contractor, (iv) a spin-off, and (v) a C-Corp to MLP conversion. I believe the combination of these items will lead to a nearly 90% cash-on-cash return for LXU’s common equity and a 40% IRR over the next 24 months.
LXU is a mini-conglomerate comprised of a climate control business and a chemical business. The climate control business makes geothermal heat pumps (heat generated from the ground), hydronic fan coils and other HVAC products that are sold into the new construction and repair and maintenance markets primarily for buildings used for education, hospitality, retail, healthcare, multi-family housing and single-family housing. The chemical business makes ammonia, UAN, ammonium nitrate and nitric acid for fertilizer, industrial and mining applications. Both businesses operate primarily in the U.S. You’ll notice these two businesses have no “business” being together. That’s part of the story.
I don’t want to overburden you with business description here as getting into the chemical fertilizer space can lead to volumes of information on world population growth, crop types, acres planted, fertilizer applications, import/export dynamics, weather cycles, etc. If this high level thesis interests you enough, I suggest you give a thorough read to LXU’s 10-K and I will happily answer questions. Instead, I will provide what I believe are the salient points that will make this investment work as well as the key risks you’ll want to get comfortable with.
For the past three years, LXU has been the poster child for Murphy’s Law, as the company describes in its 2014 10-K
During the last three years, our Chemical Business encountered a number of significant issues including an explosion in one of our nitric acid plants at the El Dorado Facility in May 2012, a pipe rupture that damaged the ammonia plant at the Cherokee Facility in November 2012, unplanned downtime at the Cherokee Facility in December 2014, and numerous mechanical issues at the Pryor Facility, all resulting in lost production and causing an adverse effect on our sales and operating income for the periods presented.
The silver lining to this mess is that the company received $100mn of insurance proceeds and a blank slate to build a new facility that will significantly improve its cost structure and allow for additional, highly profitable revenue generation. Unfortunately, LXU’s bad luck didn’t cease in 2014. This new facility was estimated to cost about $510mn and come online in Q1’16. In July 2015, the company’s general contractor informed it that one of the subcontractors was not performing and would be let go. The preliminary cost overrun estimate communicated to the market was $60mn. The stock dropped $2.00 from that news, from about $40.00 to $38.00. Three weeks later, on the company’s Q2’15 earnings call (Friday, August 7), the market was told the cost of this facility would go up another $100mn and that the start date was pushed back to Q2’16. This sent the market into a panic and caused the stock to drop 35%. After a number of years sticking with the bull thesis that called for a $70.00 share price, investor’s had finally had enough – too many explosions, pipe failures, mechanical issues and cost overruns: faith in management was obliterated and capitulation took over. But I believe from this wreckage, a great opportunity has emerged.
In the spring of 2015, the company put forth a plan showing how it will grow EBITDA from about $80mn in 2014 to $240m in 2017. As I’ll show later, this growth doesn’t rely on hefty assumptions, but rather is a function of three simple changes currently taking place at the business. The key fact is that this cost overrun and timing delay has no impact on the $240mn EBITDA. While the $160mn cost overrun does take value out of the equation (in fact, exactly $160mn, or, on a 24.2mn share base, about $6.50 per share), it does NOT take out the $12.00 hit on Friday plus the $2.00 hit after the first cost overrun announcement. The market has overreacted via an emotional response (losses are 2x more painful than gains are exhilarating).
Even after factoring the cash drawdown and the additional debt that will be incurred to pay for the cost overrun, the company is trading at sub-5.0x management’s $240mn EBITDA estimate. This is too cheap.
Highlights and the investment thesis are as follows:
Benefitting from improvement in the commercial construction market (lags cyclical recovery, so just now gaining steam) as well as the steady improvement in residential construction
Achieved organic revenue growth of 8.0% in Q1’15 and 6.5% in Q2’15
Management believes the segment will experience a 10% revenue CAGR through 2017 as commercial construction accelerates, consistent with forecasts by The American Institute of Architects
On higher revenues, better fixed cost absorption and some efficiency gains, management sees segment EBITDA growing from $27mn in 2014 to $60mn in 2017
I’ve run these numbers through a more detailed model and they work; this is the only manufacturing business I’ve seen that has generated a consistent 30%+ gross margin every single year, including the Great Recession years, since 2003
Comparable climate control businesses, most notably Aaon, Inc. (ticker: AAON), trade > 10.0x EBITDA; but the value of LXU’s climate control business is being suppressed by the chemicals business, as fertilizer is the larger, more visible part of LXU
To unlock this value, the company announced it will spin-off the climate control business sometime in the second half of 2016, after its 7.75% senior notes become callable (this is required to “dividend” shares of the climate control business to shareholders)
A jump in multiple from sub-5.0x current to even just 9.0x, on $60mn of EBITDA, would create $240mn of additional value
The U.S. is the low-cost producer of nitrogen fertilizers because natural gas represents over 50% of the raw materials cost; no other country comes close
Demand for U.S. crops, and thereby fertilizer, has been stable to growing for decades, relating to population growth, demand for protein by the emerging middle class of China (grains used as feed) and demand for corn used to make ethanol
While the underlying prices of fertilizer can be volatile, being the low cost producer provides some buffer and for investors that can’t get comfortable with price volatility, natural gas futures are a simple hedge to remove this element of the story (LXU is short natural gas, so go long)
On the industrial and mining side of the chemicals business, the company operates under cost-plus contracts, so these parts of the business are much less volatile. Almost 40% of the industrial sales are from a captive supply contract with Bayer AG that is cost-plus. The mining side of the business is weak as coal mining is in a trough, but this was only 15% of sales in 2014 and has been priced into the stock since spring of 2015
The company’s new plant will allow it to make ammonia at its largest facility, El Dorado. This facility currently buys ammonia at spot then upgrades it into other fertilizers
The delta between the cost to make ammonia (~$200/ton) and buy ammonia (~$500/ton) is about $300/ton, which is huge relative to average selling prices
Based on current market prices for natural gas and ammonia, the company will save $45mn a year that will drop straight down to EBITDA
The new plant will also allow the company to make more ammonia than it needs for feedstock, so it can actually become a supplier of ammonia; the company already has customers interested in offtake agreements
Being able to sell excess ammonia at $500/ton, with a cost of $200/ton leads to another $45m of incremental EBITDA
After numerous years of troubleshooting mechanical problems at its other two chemical facilities, the company has gotten on-stream rates close to 100%, better on-stream rates vs. 2014 rates in the 80%’s leads to another $45mn of incremental EBITDA
Combined, that is a quick path to an extra $135mn of EBITDA that doesn’t rely on management competence, just simple math of making vs. buying and better volumes run over fixed costs
After the climate control spin-off, the company will convert the fertilizer business from a C-Corp to an MLP, which will shield it from taxes, creating a tremendous amount of value for shareholders
MLPs were trading at 10.0x EBITDA for the past few years, but have fallen out of favor in 2015. Regardless, the fertilizer MLPs now trade at about 7.5x, which is still much higher than LXU’s sub-5.0x multiple, and the cash tax savings will show real cash value accretion to equity holders
Putting the pieces together, I value LXU looking at what the business should be in 2017 when its vertical integration transformation is complete and it has one full year of normalized operations under its belt. A quick and dirty look at the balance sheet progression from here to then is as follows:
The company currently has $450mn of debt on its balance sheet and $158mn of cash. It will use $125mn of that cash, draw $75mn on its revolver, and tap an additional $50mn on its 7.75% notes (which currently trade well above par, so the company will be able to issue that $50mn at a nice low yield) to fund the cost overrun and complete this large project.
After that, the company should generate at least $100mn of cash from operations per year (for H1’15, still being short ammonia, the company has generated $40m of CFO) and only has $50mn of maintenance capex needs. This leads to $50mn of debt paydown in each of 2016 and 2017, leaving about $475mn of debt and $30mn of cash at the end of 2017, my valuation date.
In terms of projections, I always build some conservatism into my models. Instead of using management’s projections, I haircut climate control EBITDA to $50mn from $60mn and chemical EBITDA from to $175mn from $200mn. Note, there is also about $20mn of normalized unallocated corporate overhead, which leads to total FY’17e EBITDA of $205mn. I also assume $5mn of additional, recurring stand-alone costs at climate control as a separate public company.
As an aside, my $175mn of EBITDA for the chemicals business corresponds to a natural gas price of $4.00/MMbtu and an ammonia price of $400/ton. Currently, nat gas is at $2.75/MMbtu and ammonia is at $460/ton. The company’s chemical EBITDA sensitivity to this price deck is as follows:
So the overall valuation looks as follows:
Starboard is a large activist investor that is involved in this situation. They have heavily campaigned for the climate control spin-off, the chemicals MLP conversion, changes to corporate governance and a host of other items. They have been winning on all items. In June 2015 they successfully took control of the board. Unfortunately, after getting their way, they have signed a standstill agreement that does not expire for about 135 days, so they cannot take further action post this Q2’15 cost overrun fiasco. When this standstill expires in December 2015, I expect Starboard to take further action.
Pursuant to conversations my colleagues across the hedge fund industry have had with select board members, to which I am privy, I believe the writing is on the wall that management is gone. Investors are furious with their incompetence and mismanagement of this huge project and heat is being applied to the board from numerous directions. When it is announced that management is being replaced, LXU’s stock should jump, because management’s inability to run these assets is the single biggest factor weighing on the stock.
The company won’t say this on a public call because they are beholden to their EPC (Engineering, Procurement and Construction) general contractor until this project is complete, but this $160mn cost overrun is a result of “nonperformance” and is a violation of LXU’s contract with the EPC. LXU is going to sue the EPC, Leidos Holdings (ticker: LDOS). Leidos is a $4bn company and can foot the $150mn of damages. When the lawsuit is filed, the stock will jump b/c there is NO recovery of this cost overrun reflected in the current share price.
I expect the company to call its 7.75% notes in August 2016 or possibly 30 to 60 days sooner given the balance between the call schedule and make-whole provision. When this happens, it will be a signal to the market that the climate control spin-off is happening.
Finally, I expect the company to file for a private letter ruling with the IRS for MLP’ing the chemical business. Some investors have worried about the new proposed rules from the IRS that came out earlier this summer and hit select MLPs. I spoke with the MLP practice of a top tier law firm and was told fertilizer MLPs are the one space that aren’t on anyone’s radar. The proposed ruling preserves all the existing rules for fertilizer MLPs and as such they are at no risk for losing qualifying income status. Filing of this ruling should be another positive for the stock.
In summary, LXU has been a big loser this year, but so much damage has been done and the stock has been beaten down so much, that even with severely reduced expectations, this should be a homerun. A new management team, a smart, sophisticated activist, and a new, cost-efficient, vertically integrated asset base will all work in investors’ favor from here out.
Shareholder activism, change of management, EPC lawsuit, calling bonds, climate control spin-off, chemical unit MLP
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