| 2007 | 2008 | ||||||
| Price: | 3.80 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 87 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Hidden in a non-operating asset rich balance sheet is a gem of a high ROIC niche chemical business. The real story is South Hampton Refining Company, a historically sleepy assemblage of assets, that is generating profits in its core business as well as capturing material growth opportunities. On top of that there is both downside protection and significant upside potential through the ownership of a non-operating asset owned by the parent Company - Arabian American. ARSD is the ticker for Arabian American Development Co. ARSD has two sets of assets – chemical operations (SHR) and a base metal mine.
To be blunt – I have not come across many opportunities like this over the past 5 years where you have an opportunity to own a good company at a cheap price and have multiple catalysts:
- multiple expansion to peer level,
- expansion / growth of underlying business at incredibly high returns on invested capital (evidenced by recent announcement of BofA financing),
- exploitation / monetization of base metal mine. (third party validation evidenced by $30 million funding of JV last year)
This is a rerun of an idea posted in June of last year. Ran112 laid out a compelling case and has served up a double+ from his price. Even after this run I believe the current business is trading at a 40% or greater discount from current intrinsic value and is capable of delivering returns of 30%-50% per year over the next 4 years.
Background
South Hampton Refining Company (SHR) owns and operates a 97 acre petrochemical facility located in
The Company produces high purity petrochemical solvents and other petroleum based products – it produces a very nominal amount of motor fuel products and other commodity type products commonly sold directly to retail consumers or outlets. 85% of revenue relates to products sold as intermediate components to manufacturers in various markets such as expandable polystyrene (Styrofoam), polyethylene, adhesives, building foams, synthetic rubber and food processing. 10% of revenue is oil related and consists of gasoline blends sold to the majors or other miscellaneous products such as degreasers / flow enhancers, etc. 5% of revenue is for toll processing to customer specific needs.
The facility consists of equipment commonly found in most petroleum facilities such as fractionation towers and hydrogen treatment equipment except the facility is adapted to produce highly specialized products. The aggregate capacity of the facility’s processes is approximately 7,000 to 7,500 barrels per day, via eight different product streams.
The Company is known for consistency in terms of product quality and superior levels of service (being primarily chemical efficacy and delivery). On the production side the Company has approximately 60% of the available North American market share (based on delivery range for their primary products) for C5 solvents (expanding agents). These products replaced CFC related products for expandable polystyrene products (Styrofoam), which are used to make various containers. The Company is also a leader in the production of C6 solvents, which are typically used in adhesives and rubber applications. By products include “flow” enhancers (think “anti glue”) that keeps oil and other “sludgy” chemical products from getting mucked up in manufacturing processes and specialty gasoline blends. A nominal amount of revenue is derived from byproducts sold to other feedstock processors.
On the processing side, the Company is a fee-based processor of customer’s unique feedstock requirements to their specifications – basically SHR is an outsourced chemical processor. SHR contracts with customers to produce customer specific solvents / mixtures (5% of revenue) on a fee basis. Contracts for this business run for 3 - 5 years. SHR receives a toll processing fee in addition to a capital expenditure reimbursement over the first contractual period to cover the capital expenditures made by SHR necessary to produce the specified solvent.
The Company’s prime competitor is a plant owned by Conoco.
Nick Carter is the President and Mr. Do It All. He is a CPA and has worked for the Company since 1977. He has been President since 1987, prior to which time he served as Treasurer and Controller.
Cutomers include Dow, Shell, ExxonMobil, Dupont, BASF, Union Carbide, 3M, Goodyear, Firestone, Lyondell, Penreco, Advanced Aromatics.
The primary cost / material input to processing is natural gas. Thus the Company is very sensitive to natural gas prices. SHR uses what some would call “derivative investing” (swaps and future contracts) to attempt to lock in prices and avoid massive fluctuations – though that would be more of an “accounting perspective” than operational perspective. Essentially, the Company manages feedstock on a rolling basis and prices its products accordingly – thus the overall strategy is designed to protect the company from price spikes, not generate trading profits or take advantage of speculative price changes. Product pricing is based on the “hedged cost”. While this leads to quarterly fluctuations the Company does not expect to be burned or realize any windfalls on a persistent basis from swing in gas prices. The Company reports inventory for fin reporting purposes using LIFO.
Looking back over the past 7 years EBITDA margins have a normalized range between 8% and 16%. Maintenance cap ex is nominal - $1 million per year at the max. Factoring in hedges on raw material management seems somewhat comfortable targeting a normalized gross profit of 20%. G&A costs have recently been around $6 mil – however, that includes one time payments related to past performance and other non-operating expenses that are eliminated going forward. G&A going forward is likely to be between $4 and $5 million on the current asset base.
So…what’s the story here? Well for SHR the story revolves around two factors. The first is a fairly straightforward growth story – nothing sexy. Production capacity for chemical products was increased by about 30% in 2005 at a cost of about $1.5M. This added capacity has been running at 100% capacity. The tolling facilities were expanded in Oct. 2005 to accommodate a major customer and have been running at between 80% and 90% capacity. A second expansion was undertaken in Aug. 2006 for a separate customer, and this expansion is expected to further enhance tolling revenues going into 2007.
The second factor is completely UNRELATED to anything SHR did, but rather what their competitor did. Prior to 2003 SHR faced stiff pricing competition from a division of Phillips Petroleum. Based on discussions with management, the Phillips plant had no reasonable profit metrics to hold to being essentially an orphan plant producing derivative products that had no material impact to Phillips overall results. They simply were an afterthought. It appears that for sheer survival purposes and to justify their existence the Phillips plant demonstrated “volumes” - price be damned. And to make matters more convoluted it appears that there was incomplete internal reporting about the price the Phillips plant paid for raw material (feedstock came from a “sister” plant in the Phillips family). It was a cluster …… and unfortunately SHR had to compete against this “irrational” business.
To make a long story short - apparently, after the Conoco Phillips merger – some Conoco mgmt figured this out and lo and behold a rationale competitor was created by 2004. Due to Phillips prior stupid pricing – SHR was basically the only survivor. So, what once was a somewhat fractured industry with an irrational participant turned into a “semi” competitive duopoly. Enter the new world of “profitable chemical operations.”
OK, that fixes the existing operations. The result – a business that will this year generate over $100 million in revenue and ebitda in the $13-$14 million range.
Now the story gets better. The Company is running at capacity and management has indicated they have essentially turned away an additional 20% of revenue. Thus, yesterdays announcement. Here are the key excerpts:
“Board of Directors has approved a $12 million expansion of the Company's Penhex Unit, currently operated by the South Hampton Resources, Inc. subsidiary. The expansion is part of the Company's plans to capture additional market share and respond to increased demand for the Company's petrochemical processing services.”
“We are confident that 20 percent of the increased capacity will be immediately utilized," commented Nick Carter, the Company's President.”
"We expect to fill the remaining capacity within three to four years. The expansion will add an estimated $65 million to $80 million of revenue potential that the incremental 3000 barrels per day represents. We believe our current staffing levels and operating infrastructure will meet the near-term processing needs and as we approach full capacity approximately $1 million in additional operating expenses may be required for increases in contract or outsourced labor.”
So to walk through the impact – the Company will spend $12 (I think it will be slightly lower) and in year one following they will generate an additional $20 million in revenue yielding a gross profit of $4 million. No additional operating expenses will be incurred for this phase – dropping the $4 million straight to ebitda. That’s an incremental ebitda margin of 25% and a year one pretax return on investment of 33%.
But the exciting part is over the next 3-4 years. The impact is large. Using the bottom end of their range of $65 million in additional revenue yields $13 million in gross profit and then with $1 million in operating expenses yields $12 million in incremental ebitda. This expansion has the potential to nearly double ebitda at long terms returns on incremental invested capital in excess of 100%.
And the best part is that this is demand driven in the current environment. Based on the timeline – the capital will be put in place this year with operations to begin first quarter of ’08.
As a side note – this growth just relates to their “production” business. The tolling operations (currently at $5 mil) can be grown fairly easily to a $10 million dollar business and management states that this is 50% gross margin business. (Further – cap ex in this business is reimbursed by the customer further enhancing ROIC).
Base Metal Mine
Based on a 2005 feasibility study by SNC Lavalin, ARSD owns a 50% interest in a 700,000 tonne per year mine in
You can refer to Ran112’s writeup and Q&A for ranges of value. Here are some highlights:
- On a bare bones, eyes closed basis its worth $30 million based on the fact that a third party contributed $30 million in cash last year for a 50% interest.
- Using current metals prices and assumptions in the SNC study regarding cash costs, etc. and a 10% discount rate the NAV for their 50% interest is in excess of $180 million!
- Using current metals prices and worse assumptions regarding cash costs, G&A expenses, taxes, etc and a 15 discount rate the NAV for their 50% interest is just under $100 million!
Well, both of those numbers exceed the current market cap of the Company.
If I reduce current metal prices across the board by 35% NAV drops to $50 million. To get to the $30 million value based on the recent transaction metal prices would need to drop by 50%.
Development is expected to occur in ’07 and ’08 with production beginning in ’09.
I’m not going to spend a lot of time here as not much has changed from Ran’s writeup. Well, except for two things – the wick is getting shorter and metal prices remain high. Are those points that relative? I would say very much given that the Chairman of the Board and the President of the mine segment are both in excess of 70 years old! I get the sense that they would like to see their work over many years “play out.”
Valuation
Well, I believe a large disconnect exists. Current market cap is $87 million. Interest bearing debt net of cash and some land in
At a summary level here are the two pieces:
Chemical operations:
Value = $110 - $120 (based on transactions / comps at 8x ebitda, just over 1x sales)
(with EBITDA growing to $19 million in ’08, and $27 - $28 million by 2010/11)
Mine:
Value = $30 - $180 (discussed above).
Total Value = $140 - $300.
Implied returns from current price are 60% to . . . . well lets just say large.
Conclusion
I’ve run the numbers a zillion ways – DCF, LBO, equity FCF, etc. and can get to no other conclusion than this is cheap. I’ve asked management what the business would look like in a worst case scenario (this was based on the assets in place without the expansion). Based on a discussion we arrived at a nightmare 12 month scenario where the business shrunk to $70 million in revenue. At that level management indicated that even at that level they should generate $7 million in EBIT. If you allow $30 million for the mine that is 8x trough ebit currently.
For this not to work would require a scenario of total collapse in the chemical business and the mine is scrapped. Neither seems likely to happen and both happening at the same time seems inconceivable.
The way I see it
1) You own a growing chemical business generating current returns on invested capital of greater than 50% (adjusted for mine assets) at a 25% discount to intrinsic value and you own a monstrous base metal mine opportunity for nothing.
OR
2) You own the chemical business for a ridiculously low multiple and a significant discount to intrinsic value after adjusting enterprise value for the base metal mine (even at the low value of $30 million).
Lastly, I believe when ARSD announces results next week that EPS will be in the 30 cent plus area. This is going to look cheap on a P/E basis excluding the mine as well.
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