Description

Although a dark cloud follows wherever this company goes, its stock rose 400% after the Gulf War. On the brink of Gulf War 2, it trades at 2x 2002 cash flow, will maintain break-even profitability during a weak demand period ahead, and will be debt free with $12-15m in cash in two weeks when they redeem their outstanding notes.

APFC is a monopoly specialty chemical maker with $75m in trailing sales, a $56m market cap and $41m enterprise value. There are 7.38m fd shares out with another 500k proposed for options at strikes not less than 10% above trading price at issuance. Trailing ebitda-capx is $20m, but circumstances have changed for the worse for the year ahead. Trading liquidity is low. It’s cheap, but the laundry list of problems is severe. However, the likely downside is relatively small (maybe $2) while the upside is $20+.

Risks
This is not for the faint of heart. There is event risk, explosion risk (literally), obsolescence risk, customer concentration, environmental concerns… That’s how it got to 2x ebitda-cap ex.

The main product is Ammonium Perchlorate (AP), an oxidizing agent for solid fuel propelled rockets, missiles, and booster motors. AP fuels the Patriot and Tomahawk missiles along with other DOD rockets including the Minuteman, Delta, Pegasus, and Titan programs.

So, if these missiles start flying as they did during the Gulf War, we could see rapidly rising interest in the component suppliers. The actual amount of increased DOD related sales (+10% for a short war) would likely be disproportionate to stock movement due to its relatively illiquid trading and the magnitude of media hype a war would receive.

But, AP’s main use is in the solid fuel rocket boosters on the Space Shuttle. The Columbia tragedy halts sales to this program while they decide when to fly again. After the Challenger tragedy, the Shuttle did not fly for approximately 18 months, though long lead times mean orders would renew well in advance of a launch. A similar program cutback is likely, although one mission will conceivably be flown to retrieve the six people (including 3 Americans) from the International Space Station who have been there since Nov. 25th. The recent tragedy will cause a reexamination of the proposed Shuttle Orbiter design, which would use a greater ratio of liquid vs. solid fuel, hurting AP demand. However, I feel it is highly likely that budget constraints on NASA will keep them using existing solid rocket fuels for a long time to come, rather than scrap the billions in existing investment on a fleet designed for 30 years of use.

The company was forecasting 16 to 20 million pounds of AP demand (flat with 2002) before the Columbia tragedy. The CEO estimates that 6 million of that was slated for sale to ATK who in turn supplies NASA’s shuttles.

With a 40% gross margin on 10 million pounds of product at an average price of $4.60/lb they could conceivably earn gross profit of $18.4m before adding war related demand. The company stated operating costs for 2003 would be $12 million, so they could maintain profitability assuming their raw material costs can scale down to smaller volumes without an increase in costs. Also, the $12m of operating costs is before any cutbacks due to the changed situation. This is not worst case, but likely case with NASA grounded.

History… (bad history)

Factory Explosions
American Pacific, formerly PEPCON, operated in Henderson, Nevada along with competitor Kerr-McGee. In 1988, PEPCON’s factory blew up killing two workers. They moved to a new site near Cedar City, Utah in July 1989. That facility blew up in 1997 killing one worker. In 1998 American Pacific acquired rights to Kerr-McGee’s contracts becoming a domestic monopoly, but did not buy Kerr’s Henderson, NV facility. It is now selling off its NV real estate while operating out of the rebuilt Utah factory.

A nitrate factory in Toulouse, France that did not belong to the company blew up in Sept. 2001 killing many and destroying the adjacent factory which was the sole alternate source of AP for the EU and supplied the European Space Agency. The factory has not been rebuilt and American Pacific has taken all of that business which is an offset to NASA’s pullback.

Environmental
Perchlorate chemicals are a potential health concern and trace amounts of AP (8 to 14 parts per billion) have been found in the Clark County, Nevada drinking water (from leaks at Kerr-McGee’s facility, Not American Pacific’s doing). The grounds of the company’s nearby facility are contaminated and the company operates profitably while spending one million+ a year for cleanup and testing. No contaminants from their site have hit the water supply, but it could happen (company estimates any possibility is 10+ years away). Conceivably, they could be required to pay up in size for a full-scale cleanup. Although not on the EPA’s list of hazardous substances, AP did make the Contaminant Candidate List and will eventually be regulated. The EPA’s water table recommendation is for 1 part per billion or less. So far, there is no known harm caused by AP in the water to anyone. A big cleanup is unlikely, though certainly possible.

Joint Venture
In December 2002 the company invested $10.7m for a 50% interest in Energetic Systems and will use the equity method for its accounting.

Good financial management
Before the Shuttle disaster they offered to redeem all debt on March 1 (funds already in escrow) and instituted a dividend program based on the set formula of 25% of Cash Flow from Operations plus funds from exercise of options minus cap ex to be distributed in dividends or used for share buybacks. Had this program been in place for 2002 the amount would have been $3.65m. That equates to a dividend of 50 cents or 6.5% yield.

Given the new circumstances and the more attractive buyback price, there will probably be only a minimal dividend in 2003.

Nonetheless, NASA’s shuttles will eventually fly again. And, there are other potential catalysts for increased demand. The Bush Administration wants a national missile defense shield, and North Korea’s recent taunts give Bush’s proposed NMD increased possibility. A deployment (or even contemplation of one by congress) would be good for APFC. Plans include approximately 200 ground based launch sites with solid fuel boosters all using AP.

So the likely case for the year ahead above break-even before adding any help from increased military activity. The worst case is that the jinx on this company continues and they have another bad event. The best case is that the EU fills much of NASA’s slack demand and a NMD gets put into the works. In such a case they could sell 25m+ lbs of AP and earn $4 per share.

Catalyst

1. Gulf War uses lots of rockets fueled by AP
2. NASA will resume flights (eventually)
3. European demand partially offsets NASA
4. Potential new demand from NMD
5. No debt and $2 per share cash cushion