Thursday, June 27, 2013

Rentech: An undervalued special situation investment

Today I was looking at the list of companies in the Chemicals - Major Diversified industry to see if I found any good investment candidates. Although there are many interesting names in this industry, only one of them caught my eye because it seemed deeply undervalued simply based on the assets it owns. That company is Rentech, Inc. (RTK), a supplier of nitrogen fertilizers and wood chips and pellets for the utility industry. The company was formerly engaged in the research and development of alternative energy technologies designed to produce synthetic and renewable fuel on a commercial scale. However, the company recently changed its  strategy due to the inability in finding a commercially viable way to implement their technologies and is refocusing on projects that can provide positive near-term returns. Thus, all research and development activities related to alternative energy projects were essentially discontinued. Their acquisition of Fulghum Fibres and two facilities in Canada to be converted for the production of wood pellets are two of the projects that management believes can provide positive returns in the near-term and beyond for the company. The nitrogen fertilizer business is conducted by its majority-owned and publicly-traded subsidiary, Rentech Nitrogen Partners, L.P. (RNF). RTK owns approximately 23.25 million, or 60%, of the common units that represent limited partner interests in RNF. 

Valuation

In my opinion, the value of RTK's shares comes from three sources:

  • The value of the company's controlling ownership in Rentech Nitrogen.
  • The value (if any) of the new lines of business (Fulghum Fibres and wood pellet mills).
  • The value (if any) of the company's intellectual property for development of alternative energy technologies and knowledge of on the implementation of these technologies obtained from running their Product Demonstration Unit (PDU).

As mentioned earlier, RTK owns approximately 23.25 million common units of RNF. Taking the value as of today (July 2, 2013) of RNF's shares, the approximate value of RTK's holdings is $667 million. Dividing this amount by 226 million shares outstanding as of March 31, 2013 (Form 10-Q) yields a value of $2.95 per share. This would be the value of RTK's investment in RNF at current market prices. If one assumes that the value of the new lines of business and of the company's intellectual property is zero, then this would be a logical value for RTK's shares which would imply a potential upside of 42.5% from its current price of $2.07. This would be the same as buying a dollar for 70 cents. However, I believe there are a couple of problems with simply estimating RTK's value in this manner.

First of all, there is the issue with taxes. RTK's basis in RNF is zero. Therefore, for the $2.95 in value to be realized, RTK would have to sell its RNF holdings and pay tax on the proceeds. If we apply a capital gains tax rate of 20% (to account for any state taxes), the after-tax value of these holdings would then become $534 million and RTK's share value would drop to $2.40 per share. As disclosed by management in an investor presentation, the same tax problem would arise in a spin-off of RNF to RTK's shareholders. However, I believe that the probability of this scenario occurring very slim. This is basically a liquidation scenario and RTK's management (with its recent change in strategy) has made it very clear that they are not thinking about liquidation. On the contrary, they are shutting down cash-burning segments and setting their sights on projects that could generate cash flow in the near-term (or at least break even). For this reason, their holdings in RNF become of extreme importance since the distributions they receive from this subsidiary are a key source of financing for these new projects. 

The other problem I see with using RNF's quoted price to estimate RTK's value is that it does not take into account the controlling position of RTK. Remember, it owns 60% of RNF's common units as well as its Board of Directors (four of the seven directors are also RTK directors). Therefore, this controlling position must have some value over quoted prices (which reflect non-controlling interests). If we add a control premium (say 20%) to the current price of RTK's holdings, then their value would become $800 million pre-tax. If we apply the same 20% capital gains tax rate to this value, then the after-tax value would become $640 million, or $2.83 per share. This means that the potential upside, without assigning any value to the other businesses, would be 36.7%. 

I like this kind of upside, especially when I still get some pretty interesting assets basically for free that can generate some additional cash and value for shareholders. First, there is the potential cash that could be generated by the sale of the PDU as well as other assets related to the company's alternative energy business. As disclosed in their annual meeting presentation, they already entered into a definitive agreement on April 18 to sell their 450 acre Natchez site for $9 million. If they are able to sell their PDU, this would mean that a significant inflow of cash would be available to fund their wood pellet projects. Also, the potential licensing (or sale) of their alternative energy  intellectual property could yield some additional income. Altogether, I think these assets sales (and the cost saving associated with them) can generate at least $35 million, or 15 cents per share in value. 

Additionally, the company has a large amount (approximately $100 million) in both federal and state Net Operating Losses available to offset future taxable income. These NOL's clearly have some value since RTK's management went as far as to implement a Shareholder's Rights Plan to avoid any change in control that would limit the company's ability to use them in the future. To this we can also add their recently announced $25 million share repurchase plan which, at recent prices, can reduce share count by more than 10 million shares. 

Finally, we can add the value of the new lines of business. Based on their Form 10-Q for the quarter ended March 31, 2013, Fulghum Fibres was purchased for a total price of $112 million of which $59 million was related to the assumption of existing debt. This means that its equity was purchased for approximately $53 million. Just to be conservative, I will use this same value to add to RTK's value. Also, it was disclosed that the purchase and conversion of the Wawa and Atikokan facilities in Canada for the production of wood pellets would cost approximately $70 million. To be conservative, let's say that purchase and conversion costs goes over-budget and becomes $90 million. My final value estimate for RTK would look like this:

Value of holdings in RNF: $640 million
Value of asset sales and associated cost savings: $35 million
Value of NOL's (70% of $100 million): $70 million
Value of share repurchases: $25 million
Value of Fulghum Fibres: $53 million
Cost of building wood pellet mills: -$90 million
Total Value: $733 million
Shares outstanding (post-buyback): 216 million
RTK's Per-Share Value: $3.40

Conclusion

Rentech is a company that, although it has interesting assets (e.g. Rentech Nitrogen), it always seemed to be brought down by the huge losses in their alternative energy segment. I believe the recent shift in management focus is a step in the right direction. Moving away from the money-losing alternative energy business and refocusing on businesses that promise to generate operating profits should lead market participants to re-value the company's share price and future prospects. As the company has a couple of quarters under their belt, we will get more information about the future prospects of the new projects and of the company as a whole. However, as of this moment, I believe that RTK's shares should at least be worth $3.40 per share. 

Tuesday, June 25, 2013

Basic Materials: Aluminum Industry - Coming up empty

Today I was sorting through the companies listed under the Aluminum Industry category to see if there were any companies that might be deserving of some further analysis. Some of these companies include well known names such as Alcoa (AA), Alumina Ltd. (AWC) and Aluminun Corp. of China (ACH) as well as lesser known companies such as Century Aluminum (CENX), Kaiser Aluminum (KALU) and Noranda Aluminum (NOR). 

Unfortunately, the aluminum industry has been hit hard in the last few years due to the economic recession and falling aluminum prices caused by high inventories of the resource. Demand seems to be doing well and increasing but increasing capacity and production in certain areas of the world (especially China) have taken their toll on prices. As a consequence of these industry dynamics, companies have taken a large hit to their profitability and, therefore, to their share prices. Many of these companies' shares are trading at multi-year lows and may seem like bargains at current prices. However, based on the metrics I like to see in the companies I consider for investment, these companies simply do not make the cut. There is no definite consensus as to when these inventory problems will correct and if aluminum prices will start to recover in the near future. For that reason, I prefer not to invest in some of these companies at this moment and wait for a catalyst that may start to move aluminum prices upward. Until then, I'm in the sidelines. 

If you noticed, I said I would prefer not to invest in SOME of these companies under the currently present conditions of the aluminum industry. There is one company that caught my interest because, as a fabricator of aluminum products to end-users (and not a producer of aluminum), it benefits from lower input prices to its manufacturing process. This company is Kaiser Aluminum (KALU). Although it's had a very good run up in price during the last 5 years, I believe this company deserves some further consideration if price drops under  $60 per share. Since price is currently around $61.50, I will keep it on my watch list to see if Mr. Market gives us a better price. For now, I think it's better to stay clear of any of these companies. There are better opportunities out there.  

Monday, June 24, 2013

Looking for Value in the Basic Materials: Agricultural Chemicals Industry

When looking for companies to analyze, most people like to use stock screeners to search for companies that meet the individual's screening criteria. While this is a great way to search for possible investment opportunities, I like to search for companies by industry. For this, I use the Yahoo Finance Industry Browser tool and begin to search for companies by sector and industry. Today, I am looking at the Basic Materials sector and, more specifically, at the Agricultural Chemicals industry.

My goal here is to find the company that I believe will outperform other companies in the same industry. For this, I try to get an estimate of value for the shares. I like to keep things simple and try to avoid overly complex calculations or making estimates or revenues, earnings, dividends or free cash flow 5 to 10 years out. This is the reason I use a combination of price multiples (P/E, P/B and P/S) as well as single-stage present value models (FCFE, DDM, and Residual Income) to get an estimate of the value of the shares as well as to establish a range of possible fair values for the stock I am analyzing. After that, I like to use some basic technical analysis to establish whether the current price offers a good entry point to establish a position and will only sell the stock if price reaches or surpasses my fair value estimate.


All my picks and their performance will be periodically updated and posted in the Latest Picks and Performance page. Remember, nothing in this blog must be taken as investment advice and/or recommendations to buy specific securities. Please do your own homework when investing.

CF Industries (CF): Best Value in the Agricultural Chemicals Industry

Of all the companies listed in this industry, I believe CF Industries (CF)  offers the best overall value of the group. The company has a market capitalization of $10.41 billion and an enterprise value of $10.22 billion. I like it when market cap is greater than enterprise value because it means that the company has a substantial cash cushion to defend itself from any temporary downturn in the business or to deploy in acquisitions, expansion, debt reduction, share repurchases or dividend increases. Current cash and cash equivalents in the quarter ended March 31, 2013 amount to $2.21 billion whereas total debt amounts to only $1.60 billion. The company's debt to equity ratio currently stands at 26.23% which is below the 50% level I like to see in any company. The current dividend rate is approximately $1.60 per share. This leads to a yield of 0.91% based on the price at the time of writing of $175.62. The average payout ratio for the last 5 years is 5.20%. Therefore, CF has some room to increase its dividends for the foreseeable future. Additionally, the company has an established share repurchase plan in the amount of $3 billion through 2016 of which $2.25 billion still remains available. At current market prices, this should lead to a reduction in shares outstanding of approximately 20% which should boost E.P.S. and dividend yields.

Return on Assets and Return on Equity stand at a solid 18.14% and 33.47%, respectively. Operating and net profit margins also look pretty good at 48.97% and 31.91%, respectively. On the valuation side, CF is currently trading at a trailing P/E multiple of 5.95 and a forward P/E multiple of 7.62. Based on analyst estimates, revenues and earnings are expected to decline during 2013 and 2014. The decrease in estimates is mainly due to concerns about lower demand for products, higher capacity expansion in other markets (which give rise to concerns about lower future selling prices and margins) and uncertainty about input costs (mainly natural gas). Although these concerns are valid, I believe that CF's management is capable enough to overcome these near-term issues and maintain the company well positioned to take advantage of future opportunities.

The Price to Sales ratio is currently 1.83 and Price to Book is 1.93. The company's expected PEG Ratio for the next 5 years is 1.02 and its EV/EBITDA ratio is 3.09. I always like to see these numbers as low as possible. I particularly like to see the PEG Ratio lower than 1.5 and the EV/EBITDA ratio lower than 7.5. So based on these metrics (PEG and EV/EBITDA), the stock seems undervalued. Finally, the last thing I like to see is a Forward Earnings Yield (the reciprocal of the Forward P/E ratio) larger that my calculated CAPM cost of equity. My calculated cost of equity for CF is 10.85% and the Forward Earnings Yield is 13.12%, so it also passes this test.

Based on my valuation models (discussed above), I believe CF Industries' shares are worth between $233 and $249. My target price is somewhere in the middle of these two values at $240. Therefore shares are currently between 32% and 42% undervalued and my target price gives an upside for the shares of approximately 37% from current levels. I believe this is a good upside for a financially solid company with good management. Due to the near-term headwinds that the company faces, shares may come down some more from these levels which would be a good time to pick up more shares at even better prices.

Thursday, June 20, 2013

Hi, everybody

First, I want to thank everyone that takes a little of their time to join me in this journey of creating my own investment blog. I hope this will be a very rewarding experience and that I get to meet new friends through this medium to discuss ideas about investments. 

Although most of my investment funds are in Roth IRA's that I set up for myself and my wife, I recently started to invest in Dividend Reinvestment Plans (DRIP's) outside of these accounts as a way to establish an active component to my investment portfolio. This is due to the fact that all investments in the retirement accounts are in index funds. Since I can only invest small sums at a time (after contributing to the Roth accounts), DRIP's give me a way to invest these small amounts in individual companies without fees and commissions eating up too much of my investment funds. The purpose of this blog will be to share with you my progress with this active portfolio. I will also share with you my views on the value of individual companies that I select. Of course, any time I share my view of a company, I will disclose whether I own it or I plan to buy it for my portfolio.

Also, I will have a section in this blog where I will list companies that I mention as good investment candidates so you and I can assess the performance of my picks. Please note that stock picks and portfolios posted on this blog should not be construed as providing investment advice or recommendations on securities. If you wish to invest in the securities mentioned in this blog you may do so at your own risk. Please do your homework before investing!! 

Comments and recommendations are welcome on the blog posts and on the overall quality of the blog as long as they are done in a respectful manner to me and other participants. I hope you enjoy this as much as I know I will. Kind regards.