Description

Down almost 40% from its highs, Chemtrade has been battered by extremely high natural gas costs, hurricanes and a reduction in its supplier base. The unit trust hit rock-bottom when fears about Canadian tax legislation and tax loss selling culminated in an announced distribution cut. Left for dead, Chemtrade represents a tremendous opportunity for investors. In addition to a 12.5% to 14% yield, Chemtrade offers capital appreciation as it sells at a substantial discount to comparable income trusts. As an added bonus since its warning in December, natural gas prices have fallen $14 to $15 to $8 an mcf. On February 16th, the company will announce its distribution for 2006 and will announce earnings. If the stock gets revalued to a 10% yield on a C$1.50 distribution, investors will see nearly a 40% total return on very conservative assumptions. With a higher distribution of C$1.65 and a 9% yield, Chemtrade would see a 65% total return.

Three Business Units

1) Sulphur Products and Performance Chemicals:

Chemtrade removes sulphuric acid, liquid SO2 and sulphur from base metal smelters and oil refineries, and then turns around and sells these “waste chemicals” to industries that need them. Chemtrade also regenerates “spent acid” into “Regen Acid and sells it back to oil refineries that use sulphuric acid.

In performance chemicals, Chemtrade is also the largest producer of sodium hydrosulphite (SHS), which is used as a bleaching unit in the pulp, paper and textile industries. Chemtrade also produces phosphorous pentasulphide, which is used in lubricating oil and grease additive markets.

2) Pulp Chemicals:

Chemtrade supplies sodium chlorate and crude tall oil (CTO) for use in the pulp and paper industry. Sodium chlorate is used to bleach pulp and paper and CTO is used as a cheaper alternative to natural gas.

3) International:

This division does the same things as the Suplhur Products division but internationally in Germany and Central Europe. They distribute these products to as far as South America and the Middle East.

BCT Chemtrade is Chemtrade’s international sulphur marketing arm.

The main industry Chemtrade serves is the pulp and paper industry. 46% of its revenue comes from this industry. The next biggest is other (17%), refinery services (14%), industrial (12%), and finally lubricants (6%).

Hurricane Katrina, Natural Gas, Caustic Soda and Supplier Loss

Several of Chemtrade’s facilities were in the Gulf Coast, and the company lost 15 days of production, plus 7 days of partial production lost. But the biggest impact was the driving up of natural gas and caustic soda prices (key inputs into Chemtrade’s business) to astronomical levels. In a particular bad piece of timing, Chemtrade closed on its Peak Sulphur acquisition in August right before Katrina hit in September.

Then in early December Chemtrade’s primary supplier of sodium formate announced that it was going to close in q1 of 2006. All of these events led Chemtrade to announce a distribution cut for 2006.

After the announced Distribution Cut the Worst Appears to be Over

Chemtrade announced on December 12th, a distribution cut from C$1.84 to a range of C$1.50 to C$1.65 a unit. The company blamed all of the above reasons for the shortfall. This cut was well advertised and after a brief dip that day Chemtrade has slowly recovered value. Analysts and investors are clearly taking a wait and see attitude.

There are several reasons as to why I think the worst is over for the company. First, natural gas prices have plummeted from a high of around $15 per mcf around the time of the distribution cut announcement to a recent $8 per mcf. This is significant because not only does it help on a direct cost basis, but the primary reason why caustic soda prices and sodium formate prices are up is because of natural gas prices. So, this will help on an indirect and a direct cost basis.

The company has also been able to buy overseas supplies from the supplier that is shutting down. And finally, there appears to be no permanent damage from the hurricanes. Surely, the fourth quarter number will probably be a disaster, but what is much more important is what guidance will be for 2006.

Extremely Undervalued on Any Measure, Compensates for Risks

Chemtrade is undervalued on almost any measure. Comparable trusts such as KCP Income fund (Toronto: KCP.un) and Canexus Income Fund (Toronto: CUS.un) average a 9.6% yield. Compare that to the worst case scenario for Chemtrade’s range and it has a 12.5% yield and in the best case scenario, it has nearly a 14% yield.

I estimate that the company will produce C$1.65 to C$1.80 in distributable cash flow, making its multiple extremely low for any income trust much less any chemical company. Chemtrade’s units trade at 6.7 times my distributable cash flow estimate.

Assume that for some reason even the company’s distribution target range is off and they announce an annual distribution of C$1.40 that still indicates a yield of almost 12%. Yet comparables trade for yields below 10%.

There are risks to consider. The risks include the price of natural gas resuming its surge. There are also future hurricanes to consider and there is the strong Canadian dollar. And finally there is a lawsuit from Marsullex for C$73 million, but this won’t be resolved for several years, which makes it not a short term worry.

It seems everyone is waiting for the company to alleviate the uncertainty and announce guidance, which is providing a tremendous opportunity to investors.

Excellent Liquidity

The company possesses excellent liquidity including almost C$1 a share of cash on the balance sheet. Even though it trades at junk bond type yields and financial distress type prices, the company has a very healthy balance sheet and liquid profile.

The debt to equity is 60% and net debt is around two and half times my estimate for 2006 distributable cash flow. Clearly from a liquidity profile the company does not deserve the valuation and discount that it possesses.

A Wave of Money is Soon to Surge into Unit Investment Trusts

There is a wave of money that will soon invest in unit investment trusts in Canada for two reasons. First, seasonally this is a strong period for unit trusts as the Canadian citizens have until the end of February to invest in their retirement accounts and not be taxed for 2005 income. There is normally a surge of money that flows into the market at the end of January and February.

More importantly however is that there are several funds that only invest in income trusts that are raising money right now. There are 8 to 10 syndication deals that will raise about C$1 billion and this will be put to work in February through April.

Finally, a lot of money flowed out of income trusts in the fall of last year on fears of the Canadian government changing taxation on income trusts. The government came out and reaffirmed the income trusts status and most income trusts rebounded. I expect that more and more money will come back into this investment group after investors continue to get over last year’s scare.

How this benefits Chemtrade is that it sticks out as a sore thumb with its extremely high yield and that it has not recovered along with the other income trusts. Chemtrade could be one fund that benefits very much from this investment flow.

**(If anyone has a Canadian trust that they like, please pass it along to me)**

Summary

Resolution of the exact 2006 distribution, along with a wave of money coming into income trusts and a very rich yield makes Chemtrade a fantastic investment opportunity. This stock offers a 40% to 65% total return. February, in particular, should be a strong month for this unit trust.

Catalyst

1) Announcement of 2006 distribution level
2) Natural gas prices stabilizing or falling
3) Caustic Soda prices falling
4) Flows of money into unit trusts