Trecora Resources (TREC on the NYSE) presents an investor with the opportunity to buy a small, growing, recurring revenue business operating in a duopoly at a reasonable price. This situation exists as TREC is investing in building additional facilities to take advantage of growing demand for its products and services, and some one-time hits to revenues and profitability in 2016. The capital outlays are nearly done and in late 2016/early 2017 new plants begin to come on line which will cause demand for its specialty products will take a step function higher. My price target is $29.54, which is a 188% gain on the $10.27 share price as of 9/12/2016. This is based on a 10 times multiple to my projected 2018 cash flow. In addition, TREC owns a 33.4% minority position in a copper/zinc/gold mine that is worth an extra $5.68 per share based on a transaction for its shares in July 2016 that I am ignoring in this price target.
Trecora Resources is a specialty petrochemical manufacturer that operates two petrochemical plants with its main facility, South Hampton Resources (“SHR”), located in Silsbee Texas and the other, Trecora Chemical (“TC”) in Pasadena Texas, just outside of Houston.
South Hampton Resources
The South Hampton Resources plant currently generates the lion’s share of TREC’s cash flows. This plant produces extremely high purity (99.9%) pentanes and hexanes that are used predominantly as a small component in the making of polyethylene, the building block of plastic. It is also used in the manufacturing of foams and rubbers and by Canadian Oil Sands refiners to help liquefy the bitumen so that it may flow through pipelines. SHR has only one competitor that can produce equivalent quality (99.9% purity) chemicals on a consistent basis, Phillips 66 (PSX) which currently lists Warren Buffet’s Berkshire Hathaway (BRK) as its largest shareholder. For PSX, this is a very small and insignificant portion of its business and TREC management believes that it has 70% market share of this market.
The list below of SHR’s products and applications comes from Company slides:
No other petrochemical company has the technical know-how to make the high purity pentane/hexane manufactured by PSX and TREC. This is a relatively small market and helps create a moat around the business. The other driving factors keeping competitors out of this niche are:
Large polyethylene and petrochemical customers are very slow to approve any changes in chemicals used in their manufacturing processes. Once the target customer is convinced to start testing the higher purity chemicals in its operations, it continues to review the products for long periods of time (approximately 18 months) before it decides to completely make the switch.
Customers must carefully and frequently inspect to ensure that the supplier’s facilities can safely and reliably make the desired products. TREC even had some customers perform extensive testing of products that were produced from its new manufacturing line “D-train” to make sure that it could be used confidently in polyethylene production and not cause any disruptions.
The customer also must be confident that the producer can supply the chemicals in the amount and time that it needs without disruption. This service level is one of the key differentiators that allows for TREC to capture more market share than PSX. In recent years, PSX has gone down for maintenance and had issues restarting its refinery. This type of delay upsets customers and drives business to SHR, who had been able to fulfill the entire market demand during the disruption and maintained its larger share of the market.
TREC’s customers (shown below) are Fortune 500 companies who manufacture large amounts of chemicals in processes that run 24 hours a day, 7 days a week. This makes the demand for TREC’s chemicals highly recurring. These companies are very reluctant to have any variation in a chemical that makes up such a small component of the cost of goods sold “COGS” that if not supplied can disrupt their processes.
TREC’s largest purchaser Exxon Mobil (“XOM”) (source: TREC’s 2015 10-K filing) is listed as a 20% customer, however this is a company that has many different products, divisions and plants that purchase from the Company. Bloomberg supply chain estimates that TREC makes up only 0.02% of XOM’s COGS, which, as spoken about above, bodes well for TREC since it is not worth it for XOM to risk changing suppliers or spend capital attempting to build its own supply for such a small part of its production.
SHR’s business was very stable during the last downturn, aka the “Great Recession”. Other than a small dip in 2010, volumes have increased at SHR every year from 2006 until 2015. For example, in 2007 SHR sold just over 40 million gallons of product and in 2008 that grew to over 46 million gallons. SHR’s customers are large, low cost producers who were able to take market share from less effective competitors. The only blip in 2008 was a negative impact TREC’s gross margin due to an attempt to hedge the Company’s feedstock prices, which is the major component in its cost of materials. From TREC’s 2009 10-K (emphasis in bold is my own):
Cost of Materials increased dramatically from 2007 to 2008. The Petrochemical Company attempted to maintain, when the market was suitable, a hedge position on approximately half of its feedstock needs, buying financial swaps to protect the price for three to nine months in advance as opportunities arise. The numbers in the table above reflect the final price of materials, including results of the realized and unrealized gains and losses of the hedging program. Material purchase costs rose by 96.5% from 2007 to 2008. However, when adjusting for the effects of derivative losses, material costs rose by 65% from 2007 to 2008.
If TREC did not have these hedges in place, the company would have had petrochemical gross margin of nearly $21 million in 2008 instead of its loss of -$1 million. To make sure this does not occur again the Company has instituted formula pricing for approximately 50% of its customers instead of utilizing a hedging program. This reduces risk and provides natural hedging for TREC and its customers.
Trecora Chemical is a plant that was purchased in late 2014 to sell specialty polyethylene waxes and custom processing services. Since acquiring the plant, TREC has significantly improved the purity of the waxes produced to levels that have allowed it to become the third entrant into certain niches of this market. Similar to the pentane/hexane business at SHR, the purity of waxes takes some time to have its quality tested and approved to be used in high volumes by customers. One of the major markets that use these types of waxes are hot melt adhesives. These adhesives must melt at a very narrow range of temperatures and are mainly used to seal shipping boxes (think Amazon) and automotive carpet. The largest producers of adhesives in the world are companies such as 3M, Henkel and Huntsman. Once again, similar to TREC’s customers at SHR, these are very large, slow moving companies that take quite a while to approve any new supplier.
To demonstrate this point, the following three Company comments show the length of this process for receiving approval to ship large quantities of waxes to TREC’s customers.
First, during TREC’s business update call on October 2, 2014 after it acquired TC, a question is asked about whether the selling process is as long at TC as it is for SHR. Here is Simon Upfil-Brown’s (TREC’s CEO) answer:
“I think some of them can be fairly lengthy too, John. I'm not 100% sure on all of the markets. But I know of some of the markets they go through a lot of testing to make sure that you're not messing up their process. So, it might not be quite as long as ours, but some of the markets are of the 18 months’ timeframe plus.”
Second, here is an update about six months later from TREC’s 1Q 2015 conference call about TC’s progress, approximately 18 months post acquisition:
Finally, here is the update about 20 months later from TREC’s 2Q 2016 conference call about some additional progress at the TC plant: