Description

ARSD again. Stock is sitting about 30% above its original write-up price from June 2006. While developments have been frustratingly slow over the last 3.5 years and the company had a horrid cash loss on a new hedging program in 2008, the upside scenario remains largely intact: potential of pre-tax free cash flow per share of $1.5 per share within two years (which could propel stock up 200-300+%). And downside is limited due to shares trading under book value ($2.3 per share) and at a significant discount to replacement value of its petrochemical facility and mining assets (arguably $3.5+ per share).

Like many small caps, the stock has been volatile: rising from $2 in 2006 to $8 in 2007 and now back to just above $2 (after bottoming around $0.50 in late 2008 due to a short-term liquidity crisis from its cash loss on its ill-advised hedging program).

As we know, the company has two primary segments: petrochemicals (mainly C5/C6 solvents) and a mining asset in Saudi Arabia.

The petrochemical facility is based in Silsbee, Texas, and operates as "South Hampton". The company's main product is C5 solvents (about 60% of company sales; about 70% North American market share; competes with a small division of ConocoPhillips). C5 solvent is a blowing agent (also sometimes called a foaming agent) and is used in polystrene, polyethylene and certain food packaging products (e.g. styrofoam cups). The company also produces C6 solvents (about 20% of company sales), which are used in rubber products, polypropylene and various adhesives. The North American market for C5 and C6 is about $250 million, growing about 2-3% a year. From 2003-2008, ARSD grew its petrochemical sales volume an average of 6% a year (2-3x the industry growth rate), which indicates that they have had some success in growing market share (purportedly, ConocoPhillips now only has two high-volume clients left in North America). The company also sells various by-products (around 15% of sales) and "toll processing" fees (about 3% of sales, or $1 million a quarter) . The company has also had some "transloading sales" in the past.

An ongoing difficulty in analyzing the company is predicting gross margin, which exhibits quarterly swings due to seasonality (2Q seasonally strong; 4Q seasonally weak) and natural gasoline feedstock prices (takes 90 days to pass on price changes to customers). Also, unrealized and realized gains on derivatives for feedstock are included in cost of sales; historically, the company has hedged 50% of its feedstock costs. Generally, C5 and C6 solvents receive gross margin of 15-22%. By-products can have 0-10% gross margin. Toll processing, as a fee, is around 50% gross margin. Transloading sales are around 5% gross margin. All-in, the company had average gross margin of 19.3% for 2005-2007, when the company was operating near full capacity, which we think is a good indicator for annual gross margin going forward.

The company roughly doubled capacity in 2008 at a cost of about $18 million, going to 9,400 barrels per day (which is 6,000 a day for C5/C6 and by-products). The company has run at about 60% of capacity for the last two reported quarters (2Q09, 3Q09). The company grew sales volume perhaps 15% in 2009 (despite a slow economic environment in the U.S. with many refineries having excess capacity) and could continue to grow sales volume 15% a year going forward through new international sales (filling new capacity over five years). They arguably have a small moat; the company has a track record for higher quality and faster, more flexible delivery times but price is the main factor. Competition is limited, with only one significant competitor in North America and maybe two in Europe.

A key part of growing sales volume going forward is international. The international market is about the same size as North America and is growing more rapidly. The company recently placed a sales rep in Spain (to cover Europe and Middle East) and has another independent rep in Brazil.  The company has had success in growing internationally (17% of sales in 3Q09, up from 11% in 3Q08 and 8% in 2Q08) and recently announced a few significant new contracts, which means that international sales will grow again in 2010.

The company expects EBITDA of $18-20 million for 2009. With continued 15-20% sales growth (15% volume growth and some price increases) and flattish gross margin, EBITDA should also be growing 15-20% a year. That implies that EBITDA could be $22 million in 2010 and at least $25 million in 2011 (more than $1 per share).

The other asset is a 41% stake in AMAK (Al Masane Al Kobra Mining Company) in Saudi Arabia. As quick background, the company was first granted exploration licenses in 1971 and was granted a 30-year mining lease (can extend for another 20 years) by the Saudi government in 1993. WGM prepared a bankable feasibility study in 1994 and WGM and Davy International of Toronto updated the study in 1996. In 2005, SNC-Lavalin of Toronto was hired to update the study again. The company transferred its license and rights in the Al Masane project to AMAK (Al Masane Al Kobra Mining Company). In August 2009, the terms were updated, such that ARSD owns 41% of AMAK; AMAK assumes the company's $11 million promissory note; and, ARSD is not required to make an additional capital contributions.

Initial capital to bring project into production is now estimated at around $163 million. AMAK shareholders have contributed an initial $60 million in cash and recently another $12 million cash for a total of $72 million in cash. AMAK expects the Saudi Industrial Development Fund to provide a loan for the balance (perhaps $100 million) but has been waiting for months. A few other banks have also purportedly expressed interest recently, including Islamic Dev. Bank, but no announcements on the potential financing have been made. AMAK expects to start test runs in February and, with funding, to start full production by the end of 2010. With former CEO Hatem El Khalidi retired, the new mine manager is Ziad Tiwal, with over 20 years experience.

The company lists the mining asset on its balance sheet at an appraised value of $33 million, or $1.4 per share. Company generally publishes a cash flow projection for the mine each quarter. Based on 2009 average metals prices (zinc: $0.75, copper: $2.35 , silver: $14.67 , gold: $972), the company reported a pre-tax PV-10 of only $18 million. That implies ARSD's 41% share has a value of $7 million, or $0.30 per share. However, using current metals prices (zinc: $1.11, 15-forward price of $1.15 ; copper: $3.35 , 15-month forward price of $3.40; silver: $18.66; gold: $1142), I estimate after-tax PV-10 of over $200 million, which implies $82 million for ARSD, or $3.5 per share. As a check, with current metals prices, the after-tax, after-interest cash flow at AMAK in year two (2012) could be about $40 million, which is $16 million net to ARSD, or $0.70 per share (5x after-tax cash flow would also yield $3.5 per share).

So in two years, with $25 million EBITDA a year from the petrochemical business and $16 million in cash distributions a year from the mine, and with low corporate interest expense (around $1 m) and low ongoing capex needs ($3-4 m a year at South Hampton), pre-tax free cash flow to ARSD could exceed $1.5 per share. At 5-6x pre-tax FCF, shares would trade around $7.5-9, up +250-320% from here. Meanwhile, we can wait it out with low downside risk to our investment (stock trades at a discount to book value and at an apparent significant discount to replacement value).

 RISKS:

The company filed a shelf registration for up to $20 million in stock in August 2009 but has no immediate plans for an offering. Management will consider making a private acquisition if accretive and preferably with 80% debt. There is some potential dilution and execution risk if a deal happens.

The company has net debt of about $23 million (about $1 per share in net debt). Generally, the company needs $15 million for working capital (i.e. purchases of natural gasoline feedstock). 

Management created a new hedging program in mid-2008, including buying and then re-buying puts on oil futures, which resulted in a significant cash loss of about $20 million. Management has admitted the gross mistake, but its track record is now questioned.

The future actions of its primary North American competitor, ConocoPhillips, are unclear. ConocoPhillips has been a price follower of ARSD for at least the last five years and that is expected to continue. ARSD recently announced price increases for February 1, which ConocoPhillips is following but at a slightly lower price. ARSD has also recently announced price increases for April 1, which ConocoPhillips has yet to follow. Purportedly, ConocoPhillips only has two high-volume clients left in North America, so at some point ConocoPhillips could become more aggressive on price in order to maintain its market share.

The stock is quite thinly traded. And, it's estimated that over 50% of shares are owned by individual Saudi investors, which likely reduces chances of company ever being acquired.

Catalyst

Petrochemicals sales volume continues to grow and historical gross margin is maintained.

AMAK is funded and goes into production.

Cash flow is generated and eventually returned to shareholders.