CVR Partners - Nitrogen Fertilizers

OVERVIEW

CVR Partners is a variable distribution master limited partnership that makes and sells nitrogen fertilizers in the United States.

In an oversupplied and rational market, as currently, the marginal cash delivered cost of nitrogen fertilizers should determine their market price. 

In an import dependent market like the United States, the marginal cash delivered cost of nitrogen fertilizers is determined by two elements:

• the marginal importer's feedstock cost; and
• the marginal importer's cash cost to insure, transport, and store the fertilizer product.

and therefore, given CVR Partners' 2017 product mix and $3 Henry Hub gas price:

note: "CAFD" = cash available for distributions, i.e. dividends.

Or, assuming for the sake of argument that (a) the natural gas price faced by the marginal importer is $9/mmbtu; and (b) CVR Partners' product mix reverts back to its historical pattern:

 and therefore:

Investors motivated to look two or four years ahead may find that the feedstock cost faced by marginal importers is likely greater than $9/mmbtu equivalent. 

For example, translating Chinese lump anthracite producers' feedstock equivalent pricing yields the following translation:

Alternatively, as demand growth absorbs the capacity added in the last few years and as capacity utilization rates rise, the list of marginal producers will increasingly include older European plants that are less efficient at converting natural gas into nitrogen:

So at $70/barrel Brent oil one might expect $7.50/mmbtu natural gas prices in Europe. But the older plants consume 35% more gas per ton of nitrogen so the $/mmbtu on an equivalent basis is $7.50 x 1.35 = $10. And so on.

THESIS

That was the overview and what follows is the investment case for CVR Partners at the price that it is trading at today.

This is what the relationship between importers' marginal cash delivered cost and CVR Partners' average selling price ("ASP") looks like for anhydrous ammonia ("ammonia") and for urea ammonium nitrate ("UAN"):

The contention of this write up is that the gap between fair values and actual ASPs, representing as it does cash variable costs borne by financially motivated agents is not sustainable and will close. 

This series of charts is a useful additional clue as to the peculiarity of the situation in 2017.  

 
CVR Partners' 2017 performance would have looked like this in the absence of  the logistics gap:

I have set aside the associated improvements in urea and nitric acid pricing for the sake of simplicity.

95 million in distributions should be good for >$10 unit prices.

RISKS

The risks to this thesis are NAFTA-dissolution and China trade war related. Mexico is the principal consumer of US corn and China is the principal consumer of US soybeans. A trade war with either country will likely disrupt nitrogen fertilizer trade flows and may prolong the time required for the logistics gap to close.

China's response to a tariff war may be to allow the yuan to devalue. That would flatten the cost curve so that the longer term upside potential outlined in the "overview" section above would be reduced.

On the other hand, a potential opportunity outside the scope of this write up is the development of a Chinese ethanol industry which would cause a substantial increase in corn, and therefore, nitrogen demand.

USEFUL RESOURCES

Weekly ammonia and urea prices at the US Gulf Coast http://www.mosaicco.com/resources/3185.htm

Quarterly AN and Urea prices at Black Sea ==> quarterly implied UAN price at Black Sea (using the formula 45% AN plus 35% urea): 
http://www.eurochemgroup.com/en/downloadcentre/

Monthly urea and UAN prices in the US interior
https://marketintel.intlfcstone.com/MIPublic/Home.aspx?secid=158

Anything put out by CF Industries is worth paying careful attention to.

2016

2016 looked like this:

 

My trailing four year pre-tax return is 32.6% which I suppose means that the market owes me two or so years of back pay. Future Bright and Flybe account for most of these payables and I'll no doubt have to wait until such time as their results become machine readable. 

In the meantime, I have acquired shares in Rentech and LSB Industries to underpin the 2016-2018 investment cycle. Over the next few days I will sketch out these two ideas and also update the Flybe idea.

Happy New Year 

LSB Industries - Agricultural & Industrial Chemicals

This is a special situation / turnaround story that appears to have resolved itself.

Management's guidance for 2017 is as follows:

but depends on 95% on-stream rates across its four facilities. I prefer to assume a 90%  figure for the Cherokee and Pryor facilities, a $475 medium term average selling price for Ammonia, and $3 cost of gas. 

Note that facility turnarounds are scheduled for even years so that the 2017 figures slightly overstate earnings power.
 
The end game appears to be to transform LXU into an MLP.  In the interim, however, using 5.5x EBITDA which is both the average historical multiple and the forward multiple at which CF Industries is trading would imply LXU is worth  ~$40/share as a C Corp (on 29.7 million shares) and ~$54/unit as an MLP.

Disclosure: I own some shares in LXU 

Rentech Nitrogen Partners LP - Fertilizers

There is a wealth of information in the  Rentech Nitrogen Partners' and CVR Partners' investor presentations and Form S-4 filings that I won't reproduce here. The basic outline of the investment case, however, is as follows:

• UAN plans to merge with (i.e. acquire) RNF;
• RNF's unitholders would receive $2.57 per unit in cash consideration, retain 100% of the value of the Pasadena facility,  and would have a 35.6% interest in the post-merger entity;
• the merged entity should be able to deliver average annual distributions of ~$248 million representing $2.18 per pre-merger RNF unit, for a yield of >60%.  
• A 12% yield is more apropriate, valuing the new, post-merger CVR Partners at the marginal cost of supply of new fertilizer capacity in the United States;
• Sum of the parts -- cash consideration, value of the Pasadena facility, and share of the MergerCo's dividends at 12% yield values RNF's units at ~$22;
• UAN is similarly undervalued in case the merger succeeds (the merger proposal has the votes, only regulator intervention could prevent it) but less so if the merger doesn't succeed.
• Price action: some part of it is attributable to UAN's dividend suspension, some part to the sell off of MLPs and yield vehicles generally, and some part is attributable to RTK's distress. 

The partnerships' own estimates of future numbers can be found here and here. I have assumed that RNF's debt is refinanced at 3.5% in line with UAN's debt.

The shale revolution has spurred new investments in North American fertilizer capacity. I have chosen two of these investments as representative of the marginal cost of supply: the Dynatec facility on the Gulf Coast, and the facility at Wever, IA that is now owned by CF Industries. The latter is a close comparable to RNF's East Dubuque facility. The economics of the Incitec Pivot facility are, because of transportation cost differentials, ~25% inferior to UAN's fertilizer plant in the Southern Plains. 

Other projects with economics similar to Dynatec facility have been delayed because EPC costs have gone up by 20%, suggesting that an IRR of 12% at 8% cost of capital does, in fact, represent the marginal cost of supply.

So we might say that the reproduction value of the East Dubuque and Coffeyville plants = 1283 + 1055 = 2,388 million. Plus the MLP tax advantage of, say, 30% = 3,039. This implies an equity value of $2,580, or ~$23 per RNF unit.   Plus or minus, give or take. The scale is more relevant more than exact amount.

Disclosure: I own some RNF units

2015

Bent out of shape

2015 turned out thusly [the weighted average portfolio allocations for the year are in blue]:

This was a year in which the results were driven by Future Bright Holdings. Its market cap halved -- and halved again. A market price at, in my view, a deep discount to the value of the business (see below) brings about its own risk of loss via privatization by the owner operator. Chan Chak Mo diluted his ownership stake at $4.30/share halfway through 2014; the shareholder base must, by now, have completely turned over so that there is no longer a constituency to howl in protest; and the potential for a "take under" is therefore not inconsequential. So I kept buying and allocating an ever increasing share of my portfolio to it. 

Given that both Macau and O&G sentiment turned south at the same time I was left with an ever diminishing slither of my portfolio to allocate to regular industrials. And that, in turn, meant greater turnover (the average trade in the third column lasted two or three months), underweighted positions in straightforward value propositions (Thorntons and Flybe in particular), and two execrable errors (Enterprise Group, Republic Airways) as I sought near term payoffs to recycle into Future Bright.

Keck Seng Investments Ltd

This is an opportune moment to mention my position in Keck Seng Investments, an opportunity written up very well by gvinvesting at the Value Investors Club. This is what I see:

One way of looking at Keck Seng from a public market valuation perspective is to reorganize the parts as follows and to apply a discount -- 20% to 30% -- customary on the property net asset value for assets of this quality:

Alternatively one might count the present value of dividends. Keck Seng pays out ~35% to 40% of earnings and has grown dividends at 20% to 25% per year over the long term. So we might say that the markets should be willing to accept a 2% yield -- decomposed into 7% income less 5% forward dividend growth rate. If so:

If Vietnam's anticipated legalization of gambling for its own citizens occurs within a reasonable time frame or, if Keck Seng decides that it doesn't want to repatriate its US earnings -- tax, anticipation of currency trends -- and opts to spin off its US subsidiary into a REIT, then there may be upside beyond what I have indicated above.  If China's VIP gaming troubles spill over into Vietnam -- and on balance I think they will -- there's likely some share price volatility ahead.

Future Bright Holdings

Here is my sum of the parts valuation of Future Bright. In contrast to Keck Seng SOTP analysis is not going to decide Future Bright's fate but is nevertheless useful as a guide to decoding just what has and hasn't happened to the business over the past year and a half.

These estimates did not and do not assume, incorporate or hint at any recovery in VIP traffic above the levels seen in the first half of 2015 -- and they attempt also to incorporate the effects of market share losses as Macau's center of gravity continues to shift from the peninsula to Cotai.

So what has happened over the past 18 months? 

The company has: 

1. Launched a food souvenirs business

It has purchased the right to use the 80 year old Yeng Kee Bakery brand* in Macau, issued share options to mainland celebrity brand ambassadors, spent up to $28 million in launch advertising, and a further $8 million in training retail staff.  It has rented thirteen shops -- in casinos, at the airport, in the high street, and at its own Yellow House property at the ground zero of fanny pack tourism in Macau. (The Ruins of St Paul is to Macau what the Tour Eiffel is to Paris. Its outline is overwhelmingly stenciled on Macau sold mooncakes. Yellow House is located in the shadow of the Ruins).

The company thinks that it can, over time, command a 4% share of the market for food souvenirs in Macau and the financial justification for this investment is therefore as follows:

Two existing Macanese franchises -- Koi Kei Bakery and Choi Heong Yuen Bakery -- are omnipresent and dominant in the food souvenirs space, controlling 85% of the market between them. Future Bright is competing for a share of the remainder and, if selling mooncakes, almond biscuits and boxes of chocolate is, in the end, a matter of visitor traffic, distribution channels, and branding -- in that order -- the company is in a privileged position in competing for that remainder.

By the end of this year the company will have spent ~$90 million for an implied expected return of $900 million in present value terms, give or take. It looks to me, at this as yet early stage, to be on its way. 

Given the seasonally adjusted sales per sq ft trajectory to date and management's stated intention to optimize the mix of storefronts over the next few months I expect this business to make further progress toward FCF breakeven (after admininstrive expense allocation) in 2016.

* The second generation owner managers of the Yeng Kee brand have used the proceeds of the sale of the Macau rights to fund an apparently successful foray into the mainland.

2. Added 32 catering outlets

Of these new openings the 19 food court counters have not worked out at all well and are responsible for most of the gross operating losses. These food court counters have now been closed.

3. Acquired various properties, including land in Hengqin

Future Bright was awarded the right to purchase a parcel of land in Hengqin. It issued 65.4 million shares in a private placement at $4.30 to finance this purchase. 

If residential property sales are currently transacted in the neighborhood of RMB 40K per Sq M and if things go on to appreciate from there, then

This is the way that the sell side analysts had chosen to assess the value of the Hengqin property. 

If, on the other hand, current retail rents are in the RMB 400/SqM range, then

The legacy business

The legacy business as existed in the first half of 2014 -- presumed by the market to be in disastrous shape (or perhaps I myself am presuming what the market presumes)  -- has performed as follows:

Much of the weakness in the legacy food business is, I suspect, attributable to the absolutely and relatively disastrous performance of SJM's Casino Lisboa in this downturn as well as to the presumably poor performace of the Hotel Lan Kwai Fong. The restaurant in the latter property has now been closed. 

A composite picture

The last 18 months for the company as a whole therefore looks something like this:

and, after adjusting for non-recurring items :

Looking forward

I think the next few years will look something like this, give or take a $20 to $30 milllion in either direction depending on all the usual variables -- macroeconomic, Macau-specific, timing of restaurant openings, relative market shares of Cotai and peninsular properties, etc:

I bought these shares at ~$3.30 and my abolute cost basis is now $1.48.

I have a position in another Macau-centered company -- Paradise Entertainment -- that I think is also misunderstood but I'll leave things here and deal with that in a separate post.

Disclosure: I own shares in Future Bright. No one is quite so crazy as an investor with a large underwater position in a stock he likes so please do your own research and draw your own conclusions.

Northgate Plc - Vehicle Rentals

I have both owned and written about this company in the past. It was then a good company with a bad balance sheet; it is now a good company with a good balance sheet.

The apparent cause of the recent decline in share price is the margin deterioration highlighted above. Management has explained the margin decline as attributable to 15 (now 16) new sites in the UK that take time to ramp up -- there are start up costs and vehicles are introduced slowly but steadily as each site matures. This is not an after-the-fact excuse; I owned the stock and was paying attention in 2012/3 when Bob Contreras explained that this was in the offing. 

From the section labeled "network" in the latest interim filing we can surmise the following, more or less:

So that 

And this before a proper recovery in Spain, its other market.

In any case, a 12,5x multiple on 2017 earnings would not surprise and it seems to me that, along with dividends collected along the way, these shares offer a 100%  return.

Disclosure: No position (yet)

Brammer Plc -- Distributor of MRO components

This company is the leading provider of MRO components to industrial companies in Europe. The business model is, I think, well known: it provides suppliers a direct route to market and offers customers a single interface for accessing vast choice of products. It matches the many to many in a hub-and-spoke arrangement. Market share gains enhance the network effect and thereby entrench the leader's competitive advantage. And so on, I won't belabor the point.

Brammer has been built by acquisition so it is worth taking note of whether it has created or destroyed value as it buys specialist distributors:

The conservative answer is that its acquisitions have thus far been value-neutral:

So one might value Brammer at 2.7x its net operating assets, thereby giving it no credit for growth: 

2.7 x 150 = 410; less 61 in net debt = 348 = 269p/share. This target approximates 11.5x run rate FCF.

Brammer's share price has fallen away because of its exposure to the Nordic area, the weak Euro relative to the Pound, etc. If these things correct themselves in two years then the path to a total return of 95% or so -- 80% from capital appreciation, 14% from dividends -- should be reasonably straightforward.

If not, MRO distributors tend to be cash generative in the downswing of a cycle as they shed working capital. A stylized illustration of that principle as applied to Brammer may look something like this:

  
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Addendum Dec 3, 2015

Commenters below the line have expressed reservations about Brammer that I'll address in more detail here. The reservations raised thus far fall into the following categories:

1. It does not compound value / acquisitions are dilutive / there's no operating leverage.

These are historical questions and this is the long term record. 

Let's say that one bought a share of Brammer in 2004 at 6x underlying earnings. (I'll turn to the exceptional items further down). These are the returns that one would have received:

In and out at the same multiple returns 15%. One can infer, roughly speaking, that the way to have lost money would have been to either pay a higher multiple or, worse, to have applied a higher multiple on peak earnings.

My argument: (a) It is not likely that this is peak earnings per share. (b) It is not likely that 6x earnings is as high a multiple as we are likely to see over the next 2, 5, or 10 years. 


2. It does not convert earnings into cash

This is also a historical question and, again, the long-term record is as follows

 


3. What about all those XO items?

The XO items are acquisitions related. Therefore I treat them as CapEx items as follows:

Again, the XO items have not disappeared and are not being ignored. They have been reclassified in order to make things easier to understand. Like this, for example:

Lever it up (see below) and the marginal return on invested equity is >20%.

4. It doesn't manage its balance sheet well

 
Prior to 2007 it had no equity to speak of. Since then it has effectively had a policy of using a ~ 60:40 Debt:Equity ratio  in order to generate 20% returns on equity.

5. There is no downside protection

In case of a cyclical (rather than secular) downturn, I suppose. 

We've had one major cyclical downturn in the last 10 years and working capital reversals came through as the business model would predict.

6.  Potential future threat of online distribution

This is the most important issue, in my view, and there are no definitive answers. What I can say is that the business most like Brammer that I know of -- Fabory -- with similar exposure to explosive growth in Eastern Europe, was acquired by Grainger at a multiple of 1x sales in 2011. 

So the question becomes, if Brammer is unable to develop its own online distribution capability, would it be cheaper to replicate its 1 million item stock list, its dozens or well-placed distribution centers, and its list of tens of thousands of customers? Or would it be cheaper to buy it at, say, 0.5x sales? I think the latter.

That's all I've got for the moment. 

Disclosure: No position (yet).