Description

Summary Thesis

I am recommending a long position in Cosan Ltd stock (CZZ, $6.76), a Brazilian conglomerate trading at a 37% discount to the value of its publicly traded subsidiaries. After adjusting for holding company debt and expenses, Cosan Limited (CZZ)  is trading at a historically high discount (37%) to the market value of its two publicly traded subsidiaries, Cosan SA (CSAN3 BZ) and Cosan Logistica (RLOG3 BZ). I believe the subsidiaries themselves are undervalued and offer attractive upside. There are multiple catalysts at the operating companies which should lead the stock of both subsidiaries to appreciate over time. I also believe that the holding company discount will revert to the historical average of 20% as dividend flow through to CZZ shareholders improves.

Brief History of the Company

Cosan Limited is a holding company controlled by Rubens Ometto. It is a family controlled business whose origins date back to a sugar cane mill built in Sao Paolo state in 1936. In the 80’s, 90’s and 00’s, the company grew through greenfield expansion and acquisitions within the sugar industry: growing, su processing, ethanol production, and cogeneration from sugar cane bagasse. In 2005 the group debuted in the public markets through the IPO of Cosan SA (CSAN3 BZ) on the Sao Paulo stock exchange, raising $400 million via a primary deal. In 2007 Cosan Limited (CZZ), Cosan SA’s parent company and the primary investment vehicle of Rubens Ometto, listed its shares on the NYSE. In 2008, Cosan SA expanded outside of the sugar and ethanol business through the acquisition of ExxonMobil’s fuels distribution business in Brazil. In 2011, Cosan SA combined its sugarcane and ethanol business (S&E) and its fuels and lubricants distribution business with Shell’s distribution assets in Brazil, creating a 50/50 joint venture with the name Raizen Energia. In 2012, Cosan SA acquired 63% stake in Comgas (CGAS3 BZ), the largest gas distribution concession in Brazil. In 2014, Cosan SA spun out a 35% stake in a newly created entity called Cosan Logistica (RLOG3 BZ) which held the transportation, logistics, and infrastructure assets associated with the sugar business. In 2015 Cosan Logistica merged its assets with Brazil’s largest railroad focused on the transportation of agricultural products, America Latina Logistica, creating Rumo SA (RAIL3 BZ). Cosan Limited, through its 72% interest in Cosan Logistica (RLOG3 BZ), has a 20% economic interest in Rumo Logistica (RAIL3 BZ).

Why does the company trade at such a wide discount to NAV?

Between 2007 and 2015, CZZ traded between parity and a 20% discount to NAV.  In 2016 this discount widened to 40% and has remained in the 30-40% range since then.  The reasons for the widening of the discount are the following:

1. Disappointing results. Management did a lousy job of managing investor expectations. Overly optimistic assumptions combined with multiple operating headwinds resulted in a string of earnings disappointments in 2014, 2015, and first half of 2016.  

2. Recapitalization of Rumo Logistica (RAIL3 BZ). In 2016, Cosan Limited was required to inject liquidity into Cosan Logistica (RLOG3 BZ) in order to participate in a 70% dilutive rights issue intended to shore up the balance sheet of Rumo Logistica (RAIL3 BZ). Uncertainty around this event, combined with all the macroeconomic issues affecting Brazil at the time, contributed significantly to the widening of the holdco discount.

Other reasons why Cosan Limited and its subsidiaries are undervalued by the market:

3. Complex corporate structure. The company has a complex corporate structure. Furthermore, the structure has evolved significantly over the past seven years making it difficult to analyze the company.

4. Complex accounting. The biggest asset owned by CZZ via CSAN3 is Raizen, a 50/50 joint venture with Shell. Under IFRS, this asset is accounted for under the equity method. The company provides pro-forma numbers to show what the company would be like on a consolidated basis, but the reconciliation to GAAP is cumbersome. The accounting of the sugar and ethanol business is complex involving currency hedges, commodity hedges, and a seasonal cycle that does not match the calendar fiscal year resulting in volatility from year to year.

5. Brazil has undergone a major recession and political crisis which has had a negative effect on some of the operations especially Comgas and Raizen Combustiveis. Even after a strong rally last year, iShares MSCI Brazil ETF (EWZ) is trading 66% below its peak in 2008. Brazil still has not emerged from one of its biggest economic crises in modern history and a lot of macro and political issues remain unresolved. Brazil still has one of the highest real rates in the world making debt expensive. Both fuel distribution volumes and gas distribution volumes are economically sensitive and have been declining since 2014. The first quarter of this year started to see signs of stabilization in volumes at Comgas and Raizen Combustiveis.

6. Poorly timed expansion. The company expanded via acquisition into adjacent segments precisely as Brazil was about to enter its biggest economic and political crisis in modern history. Many rightfully question the capital allocation decisions that were made by management. Comgas and the Raizen joint venture in retrospect appear to have been very smart decisions. The infrastructure business was over levered and had to be capitalized.

7. Leverage. Although leverage has been reduced to 2.1x net debt to EBITDA at the largest subsidiary (CSAN3) and RAIL3 has been recapitalized, the company entered the economic downturn with high leverage. The low point occurred in 2016 when Cosan Limited was obligated to inject capital into Rumo Logistica (RAIL3 BZ) in order to stave off bankruptcy.

8. Regulatory Uncertainty. Both the Rumo Logistica, the railroad, and Comgas, the gas distribution company, have faced regulatory delays and uncertainty. In the case of Comgas, regulatory uncertainty has delayed the leveraging of that subsidiary for the benefit of the parent.

9. Sugar prices. Sugar prices have declined 35% this year. Despite the company being hedged for the next year and sugar and ethanol representing roughly 20-30% of the value of CSAN3, the market still thinks of  Cosan SA as a  sugar company.

10. Oil prices. Although fuel distribution EBITDA is up 16% year over year in the past quarter, the stock of Cosan Ltd (CZZ) and Cosan SA (CSAN3 BZ) both trade with a high correlation to not just sugar but also oil. The Brazilian market is also closely correlated to oil. Contrary to popular belief, Brazil is not a big net exporter of crude and is a net importer of refined products.

11. Corruption scandal. Brazil has been mired in a huge corruption scandal that has engulfed large swaths of politicians and business executives. There have been rumors that the Chairman and largest shareholder, Rubens Olmetto, could be implicated. So far, nothing has emerged, but this is a real headline risk.  

Cosan Limited (CZZ) Discount to NAV

Upside at Cosan SA (CSAN3 BZ)

The biggest upside would come from the market assigning a higher multiple to the  fuels distribution business within CSAN3, Raizen Combustiveis. This business operates in a consolidated market with three major players: BR Distribuidora (subsidiary of Petrobras), Ipiranga (subsidiary of Ultrapar, UGP), and Raizen. The business generates a 20% ROIC and is just beginning to recover from a recession. Long term growth prospects are reasonably good, nominal GDP +.   

Cosan Logistica (RLOG3 BZ)

Cosan Limited’s 72.3% stake in Cosan Logistica (RLOG3 BZ) only represents 17% of NAV; however, I believe this is  asset has the most upside over the next three years.  Through its ownership of Cosan Logistica, Cosan Limited owns an indirect 20% stake in Rumo Logistica (RAIL3 BZ). Rumo Logistica is a levered railroad in the third inning of a turnaround. It is a fantastic, historically undermanaged asset with a new, very capable CEO. The balance sheet has been recapitalized and the debt has been termed out. It is a very interesting stock in and of itself. If management achieves the targets it has laid out, which appear reasonable when benchmarked against the industry, the company is trading at 4x 2020 EBITDA. However, because it does not have an ADR, it is only suitable for investors who are set up to trade domestically in Brazil.   I will leave it for another write up.

Catalysts That Could Unlock Value at CZZ

• Improving results and lack of disappointments at CSAN3 in 2017 and 2018 should lead to rerating of the stock.  As the economy in Brazil stabilizes, volumes at Comgas and Raizen Combustiveis will continue to improve. This was evident in 4Q and 1Q results. CSAN3 management is doing a better job of giving realistic guidance and achieving targets. They met guidance in 2016, and they met guidance in 1Q17. In the absence of any more “transformative” deals and with better results and a manageable balance sheet (2.1x net debt/ebitda), CSAN3 could re-rate and trade more in line with its peers: Ultrapar (UGP) in fuels distribution and Sao Martinho (SMTO3 BZ) in sugar and ethanol.

• Comgas (CGAS3 BZ) recapitalization. Once the third tariff review at Comgas is completed, the company will seek to add debt to Comgas which only has 1.2 turns of debt despite being a regulated utility. These dividends will flow through to Cosan Limited.

• Ongoing turnaround at Rumo Logistica (RUMO3 BZ) and successful renegotiation of concession contract.

• The market shifts its focus away from sugar prices after realizing that Raizen’s sugar and ethanol business is, globally, a low cost producer and can survive under any realistic long term scenario for sugar prices.

• Controlling shareholder takes steps to narrow the discount. The controlling shareholder has the vast majority of his net worth in Cosan Limited (CZZ) stock, and he is frustrated with the holding company discount. There are several steps he has taken already. Debt at holdco has been reduced to $148 million. Recently, the company took steps to improve corporate governance including the appointment of five independent directors to the Cosan Limited board. A new compensation program for the senior management of Cosan Limited, heavily weighted to the performance of CZZ stock, was recently implemented. Holdco expenses have been dramatically reduced versus last year and in the 1Q17 run rate was below $3 million.

• Now that the company has achieved its leverage target a larger portion of earnings will flow through as dividends to the parent company. The entire group has been deleveraging over the past three years and CSAN3 debt stands at 2.1x EBITDA.

Price Target

If CSAN3 were to trade closer to but still at a slight discount to peers in Brazil, it has upside to BRL 47.61 versus BRL 34.50 today. With CSAN3 at BRL47 and if the holdco discount narrows to 20%, CZZ stock would trade at USD 11.90 per share, 73% above current levels. I’m not predicting where the stock will trade because these things never happen as expected. However, CZZ stock appears cheap under most scenarios. As some of the reasons for the discount dissipate and some of the catalysts I expect unfold, the stock should trade somewhere around were it is now, $6.76, and the low teens.

Risks

• Holdco discount persists.

• CSAN3 discount to peers persists due to accounting complexity or poor results.

Management pursues further “transformational” deals. Management has indicated that their focus now on execution and improving existing operations.  If they were to pursue another acquisition, the market would probably de-rate the stock further.

• Chairman is implicated in a corruption scandal. I think this would be more of a headline risk than a permanent threat to the value of the business.

• Risk that none of the catalysts that I envision come to fruition.

• Accounting. I have done a significant amount of work reconciling all available accounting information and have gotten good references from people who know the CEO and CFO personally and professionally. However, I always worry about what I might have missed when dealing with a complex, historically acquisitive company.

Catalyst

• Improving results and lack of disappointments at CSAN3 in 2017 and 2018 should lead to rerating of the stock.  As the economy in Brazil stabilizes, volumes at Comgas and Raizen Combustiveis will continue to improve. This was evident in 4Q and 1Q results. CSAN3 management is doing a better job of giving realistic guidance and achieving targets. They met guidance in 2016, and they met guidance in 1Q17. In the absence of any more “transformative” deals and with better results and a manageable balance sheet (2.1x net debt/ebitda), CSAN3 could re-rate and trade more in line with its peers: Ultrapar (UGP) in fuels distribution and Sao Martinho (SMTO3 BZ) in sugar and ethanol.

• Comgas (CGAS3 BZ) recapitalization. Once the third tariff review at Comgas is completed, the company will seek to add debt to Comgas which only has 1.2 turns of debt despite being a regulated utility. These dividends will flow through to Cosan Limited.

• Ongoing turnaround at Rumo Logistica (RUMO3 BZ) and successful renegotiation of concession contract.

• The market shifts its focus away from sugar prices after realizing that Raizen’s sugar and ethanol business is, globally, a low cost producer and can survive under any realistic long term scenario for sugar prices.

• Controlling shareholder takes steps to narrow the discount. The controlling shareholder has the vast majority of his net worth in Cosan Limited (CZZ) stock, and he is frustrated with the holding company discount. There are several steps he has taken already. Debt at holdco has been reduced to $148 million. Recently, the company took steps to improve corporate governance including the appointment of five independent directors to the Cosan Limited board. A new compensation program for the senior management of Cosan Limited, heavily weighted to the performance of CZZ stock, was recently implemented. Holdco expenses have been dramatically reduced versus last year and in the 1Q17 run rate was below $3 million.

• Now that the company has achieved its leverage target a larger portion of earnings will flow through as dividends to the parent company. The entire group has been deleveraging over the past three years and CSAN3 debt stands at 2.1x EBITDA.

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