Description

Introduction

Chemtrade is a misunderstood, out-of-favor Canadian income trust currently trading at a 16% distributable cash flow yield, with a dividend yield of over 13% paid through monthly distributions (82% payout ratio).  At the end of February a catalyst was introduced to the story as the company announced its intention to explore strategic alternatives due to intense interest from private equity players.  Chemtrade is currently generating ~C$1.46 in distributable cash flow per unit; we believe there is opportunity for distributable cash to increase to as much as C$1.65 per unit (the company has earned meaningfully more than this in prior years), which on today’s unit price would imply a distributable cash yield of over 18%.  We believe that in a reasonable worst case the business is stable and the current distributable cash flow is sustainable.  Applying a more reasonable but still very conservative 12% distributable cash flow yield (based on the C$1.46 the company earned in 2006, which is also the level management has guided to for 2007) would imply an intrinsic value of over C$12 per unit, representing upside of nearly 35% from today’s price plus the dividend payment.  At an 11% yield a unit would be worth over C$13, or upside of more than 45% plus the dividend payment.  And in the homerun scenario, applying the same 11% yield to the upside C$1.65 of earnings power would imply a unit price of C$15, which would be nearly a 65% return from here without including the dividends.   The way we look at it, Chemtrade pays us an annualized 13% each month (taxed at 15% for U.S. holders) while we wait for earnings to improve, a suitor to pay a take out premium or management to recapitalize the business.  That is not such a bad deal.

The Problems

Before giving a detailed business description, it is useful to explain why this company is so unloved.  Chemtrade has suffered from five major factors over the past few years:

1)            The company generates a lot of business from U.S. operations and the movement in the USD has hurt distributions because the company did not hedge its currency exposure

2)            Chemtrade has a major contract with Inco to remove and sell sulphuric acid and SO2.  The contract comes up for possible cancellation in 2009 and is a material contributor to profits

3)            The acquisition of the SHS business in December 2002 was nothing short of an absolute disaster.  The main issue is that Chemtrade has not been able to pass through higher raw material costs (sodium formate) given the presence of a much lower-cost Chinese operator selling its excess capacity in the North American market. To a lesser extent, declining volumes due to lower newsprint demand (from lower newspaper circulation) have also hurt the business

4)            The sodium chlorate market has gone through a downturn as the broader pulp and paper industry continues to suffer.  When Superior Plus Income Fund (the owner of Erco, a major sodium chlorate manufacturer) collapsed (April 2006) on the heels of the sodium chlorate downturn there was an immediate read-through to Chemtrade’s sodium chlorate business

5)            We believe that investors find it difficult to understand Chemtrade’s unique businesses as a result of the non-intuitive nature of what the company does (primarily the logistics of chemicals) and the somewhat opaque nature of the company’s public disclosures

We explain below what the company has done to improve these factors, and what the market is missing in the opportunity to own Chemtrade at such an attractive price. 

Taxes, Balance Sheet and Management

You will notice that this write-up is a little light on the numbers and heavy on the business description and competitive market landscape.  This is because Chemtrade is a stable cash-generative business and the numbers largely speak for themselves.  What is important to understand in assessing the investment opportunity is the likelihood that this stability is materially challenged and that the business goes away.  At a nearly 17% yield we would argue that the market has priced the business as if it will disappear in fairly short order, so understanding whether this conclusion has merit is the most critical issue. 

Although we have also avoided discussion of the Canadian income trust structure as that has been adequately covered in prior posts by other VIC members, the tax status deserves brief discussion.  The new income trust tax law changes in Canada allow for the company to not pay taxes until 2011.  Thereafter the company can utilize its approximate C$130 million in NOLs and avoid paying taxes for another four years or so.  Under the new tax laws of the income trust structure, it is possible that the company could continue to shield the 50% or so of earnings that Chemtrade earns in the U.S. as foreign earnings distributed by company may not be taxed.  We are continuing to investigate this possibility. 

Chemtrade’s balance sheet is in good shape in light of its stable cash flow.  There is C$197 million of net debt on the company, or less than 2.9x 2006 EBITDA.  With 33.6 million units outstanding (the company does not issue options) and a market unit price of C$9.10, the market cap is C$306 million, resulting in an enterprise value of C$503 million.  We believe in light of Chemtrade’s structure as a non-taxpaying trust that distributable cash flow yield is a more appropriate valuation metric than enterprise calculations, though of course the tax assets can be somewhat more precisely calculated. 

It is also worth noting that the company has a considerable disconnect between D&A and capex.  The company reported annualized deprecation and amortization of about C$40 million in Q4 2006, about 40% of which is amortization that is not at all indicative of recurring expenditures.  Depreciation is overstated because the company depreciates its plant and equipment over 10-15 years, versus a useful life that is easily in the 25-40 year range.  Run-rate Q4 2006 maintenance capex of around C$10 million is probably a reasonable figure going forward. 

We have met with management on multiple occasions at company headquarters and have a great deal of respect for their understanding of the company’s operations and markets, and their business acumen and creativity.  We also believe that they are honest operators.  The CEO, Mark Davis, owns about C$1.5 million worth of stock at market prices (roughly 0.5% of the outstanding units) and therefore takes home a distribution check every month just like us. 

The one knock against management is they have not shown themselves to be particularly astute with acquisitions, with SHS the most flagrant example.  The SHS acquisition aside, though, our conversations indicate that they do seem to have an understanding of sophisticated capital allocation concepts that is unusual in a company of this size.  We have assessed their recent plans to allocate the small amount of capital they have retained through a recent cut in the payout ratio (from around 100% to the current 82%) and believe these projects to be an intelligent use of capital (the projects are discussed in detail below).  The need to distribute cash flow on a monthly basis provides some level of discipline over this important issue of what to do with the cash, and we are reasonably comfortable with the current situation as we believe management has learned their lesson.

Business Overview

This is from the company’s website: “Chemtrade Logistics is one of the world’s largest suppliers of sulphuric acid, liquid sulphur dioxide (SO2) and sodium hydrosulphite (SHS), and a leading processor of spent acid, particularly in the U.S. Gulf Coast region.  Chemtrade is also a leading regional supplier of sulphur and sodium chlorate, one of only two North American producers of phosphorous pentasulphide (P2S5) and also produces zinc oxide at three North American locations. Chemtrade obtains these products from its own production facilities and through long-term marketing services agreements and distributes them to customers around the world.”

It is extremely important to recognize that Chemtrade is not a chemical company; it is largely a logistics company.  The business is really a service business – the removal and disposal (through sale) of hazardous chemicals.  Chemtrade boasts a number of competitive advantages that should keep current earnings secure.  These include: (1) partial or full contractual pass-through of chemical market price volatility in most business lines, (2) contractual security of volumes in many business lines, (3) dominant market share in many business lines and regional geographies (including an outright lack of competition in some), and (4) high customer switching costs including tie-ins to mission-critical logistics functions and physical plant located on customers’ premises. 

Chemtrade as it exists today came about due to four significant corporate actions since 2001.  The initial creation of Chemtrade as a public company resulted from spin-off of Chemtrade from Marsulex through an IPO in July 2001.  In December 2002, the company acquired the SHS business for approximately C$97 million from Clariant.  In August 2003, the company acquired the Pulp Chemical business from Canfor for C$117 million.  Finally in August 2005, the company acquired Peak Sulphur and Peak Chemical for C$220 million.  Although each of these businesses has unique characteristics, the company aggregates Chemtrade North America, SHS and the Peak businesses into its Sulphur Products and Performance Chemicals (“SPPC”) segment while Pulp Chemical and International are broken out separately.   The following chart shows a breakdown of revenue and EBITDA contribution by segment for 2006:

Each of the major businesses is described below.

SPPC Segment

Sulphur Products (historical Chemtrade North America and Peak Sulphur)

Chemtrade North America: Sulphuric Acid

Chemtrade North America primarily removes, stores, markets and distributes several bulk, sulphur-based industrial chemicals, including elemental sulphur, sulphuric acid, liquid SO2 and oleum that it obtains primarily under long-term agreements with industrial firms (mostly smelters) that produce many of these chemicals as a byproduct of their core processes.  Environmental regulations require that smelters and other industrial firms remove and dispose of the harmful chemical byproducts they produce. Such firms rely on the services of Chemtrade in meeting their environmental obligations, minimizing costs of environmental compliance, avoiding production interruptions and preventing the imposition of regulatory fines and penalties. 

The main byproduct that smelters produce is sulphuric acid.  After H2O, sulphuric acid is the most widely used chemical in the world and has a correspondingly large market consisting of about 50 million tons in North America.   Fertilizer companies are far and away the largest consumers, accounting for about 90%, or 45 million tons, of total demand, with the industrial market totaling only 5 million tons.  Most fertilizer companies produce sulphuric acid internally by burning sulphur as their demands far outstrip supply from byproduct markets.  Because the voluntary production of sulphuric acid in this fashion actually has a cost associated with it (natural gas and sulphur) versus smelters’ involuntary byproduct production, these two separate means of production tend to lead to very distinct markets.  The only time the markets cross is when a fertilizer company dumps excess acid on the industrial market.  Dumping is not a major issue in Chemtrade’s markets, however, as the low value-to-weight characteristic of sulphuric acid limits the ability to economically ship product over long distances (according to our research, industrial market sulphuric acid sells for about $80 per ton so shipping it long distances makes no economic sense).  As a result, fertilizer companies typically limit their excess sales to their area of production (primarily the southeastern U.S.) and Chemtrade stays out of these geographies.   Because of its near ubiquitous use, industrial sulphuric acid consumption tends to be very stable.  This is why Marsulex decided to utilize the income trust structure when it took Chemtrade public in 2001. 

The majority of Chemtrade’s sulphur business is derived from removing both sulphuric acid and liquid SO2 from Inco’s Greater Sudbury smelting facility and solely liquid SO2 from Xstrata’s (formerly Falconbridge’s) Timmins operation.  The Canadian smelters collectively produce about 3.5 million of the 5 million tons of sulphuric acid that is sold into the industrial market each year; nearly all of this production is sold into the northeast region of the U.S.  Eastern Canada’s Inco and Xstrata together account for the vast majority of this production, with Xstrata being about double the size of Inco.  Western Canada’s Cominco is the bulk of the remainder.  We believe Inco provides Chemtrade with about 700k tons of sulphuric acid per year (representing ~14% of the total industrial market).  Inco expects its byproduct sulphuric acid production will grow over time.

Chemtrade and Inco have a 70-year history of doing business together.  The current Inco contract was due to expire in December 2008, but because Inco did not terminate with two years’ notice, the contract was extended until 2009 and will roll thereafter unless cancelled.  We expect that Inco and Chemtrade will come to a new long-term agreement that looks similar to the existing one. 

In the existing agreement, Inco and Chemtrade split exposure to end market chemical prices on a 60 / 40 basis (Inco / Chemtrade).  The lack of visibility with this contract is one of the material risks facing the company; however, we believe an assessment of Inco’s strategic options shows an adverse outcome is unlikely.  While Inco outsources removal and distribution of sulphuric acid, Xstrata does all of its own removal and distribution in house.  Inco is unlikely to take over this function itself as it does not make sense for Inco to invest in the required infrastructure.  Barring that, Xstrata is the only entity besides Chemtrade with the scale sufficient to remove Inco’s large quantities of industrial sulphuric acid byproduct.  If the tanks used to hold byproduct sulphuric acid are not emptied, smelting production would literally shut down, and because the tanks hold only seven to ten days’ worth of byproduct sulphuric acid it does not take a long delay to cause problems.

 We think it is highly unlikely Inco would put its mission-critical operations at risk by relying on a key competitor rather than staying with its trusted partner of 70 years.  Furthermore, Inco has told us of its intention to renew the contract and it is our impression that the contract is not heavily scrutinized by the smelter.  As a result we believe the probability of non-renewal is extremely low and Chemtrade’s primary risk is a negotiation on terms rather than outright cancellation.  Even so, Chemtrade would appear to have leverage in this relationship in light of Inco’s limited options, so we do not anticipate an adverse outcome. 

Chemtrade North America: Liquid SO2

Chemtrade removes and distributes liquid SO2 from both Xstrata and Inco, with Inco historically the larger contributor of the two.  The primary use of liquid SO2 is for the production of SHS, which we describe in detail below.  The liquid sulphur dioxide market is much smaller and more difficult to due diligence than the sulphuric acid market.  One reason is that NO ONE wants this stuff around for environmental and safety reasons.  The market for SO2 has suffered over the past few years due to a fall in domestic SHS production, which has been a direct result of increased imports from China’s Zhongcheng Chemicals.  Management believes that the SO2 market has currently stabilized. 

When Chemtrade shut down its SHS production (discussed below) there was some concern that the resulting lower demand for SO2 would cause a collapse in SO2 pricing as SO2 is the primary input in SHS production.  Fortunately for Chemtrade, Inco has recently found a way to internally utilize a large portion of its liquid SO2.  In this sense Inco’s reduction of SO2 supply is a big blessing as it halves the disposal requirements for Chemtrade from around 60k tons to 30k tons, which should go a long way to keeping supply and demand in check.  Furthermore, Chemtrade has ceased the production of SO2 at its Cairo, OH plant, which had approximately 20k tons of capacity.   The majority of the SO2 volume was not included in Chemtrade’s SO2 revenue as it was used internally by Chemtrade in SHS production and sold at very low margins (see discussion of SHS below).  As a result, we can understand why management thinks the SO2 market has stabilized and why earnings will not be impacted by the reduction of SO2 disposal volumes.

Peak Sulphur: Regen Acid

Chemtrade acquired Peak Sulphur in August 2005 and now includes the business in the Sulphur Products division of its SPPC segment.  Peak Sulphur produces various types of sulphuric acid from its four plants located in Beaumont, Texas; Shreveport, Louisiana; Riverton, Wyoming; and Tulsa, Oklahoma.  As background, during the refining or chemical manufacturing process, spent acid (the industry term for sulphuric acid that is not wholly consumed in the industrial process) becomes diluted and contaminated such that it cannot be used for the acid’s original purpose without further processing.  Chemtrade’s business generates most of its earnings from sulphuric acid regeneration (“regen”), which involves processing spent acid and reintroducing the acid in usable form to those same producers (refineries and chemical manufacturers) in a closed loop.  Peak Sulphur also generates earnings from selling acid to other industrial consumers (called merchant acid) and by producing and selling ultra pure acid, a highly refined and pure form of sulphuric acid, to manufacturers of electronic products.  Approximately half of Peak Sulphur’s capacity is used to service regen customers.  Chemtrade claims significant market share in the Gulf Coast region, and has the only regen facility in the Rocky Mountains.  Rhodia is the big gorilla in this market with 45-50% overall share; other big players include Marsulex, GenTek and Dupont.

In order to make acid in a regen plant, both the spent acid and sulphur must be burned, and to function correctly, the process requires simultaneous burning of both spent acid and sulphur in the same furnace.  Spent acid is burned with natural gas to create SO2 gas, which is then scrubbed and produced into clean regen acid.  Some of the acid is lost during the burning process, so if you make calculations be careful to adjust.  Rather than structuring them as a buy / sell of acid, most of these contracts are negotiated as service agreements where the company will remove, process and return (or sell) the acid.  Because this is a service business, the service is priced off the cost of the natural gas required to burn the acid instead of the price that merchant sulphuric acid sells for in the market.  Sometimes the refinery will only pay for its spent acid to be removed (and not replenished) because the return-trip transport of fresh acid can be uneconomical due to the distance between a refinery and a regen plant.  The refinery, however, must still have the acid removed for environmental purposes. 

Customer contracts in the regen acid business usually have terms of two to five years.  There is typically very little turnover of customers in the regen acid business because the proximity of regen facilities to the spent acid producers largely determines which regen facility will get the business, and it is frequently uneconomical for a competitor to build a new regen facility in the hopes of knocking out an incumbent provider.  As per industry practice, customer contracts almost always contain provisions that adjust pricing to reflect changes in the cost of major raw materials and labor.  As a result this business tends to produce very good margins and a predictable profit stream.

At the time of the acquisition of Peak Sulphur, contracts for only 5% of its regen acid volume was set to expire by the end of 2006, with approximately 70% expiring at yearend 2007 or thereafter.  Approximately 11% of Peak Sulphur’s regen volume is not under long-term contract but is attributable to spent acid producers located in close proximity to Peak Sulphur’s regen facilities, making it difficult for other producers of regen acid to compete with Peak Sulphur in those geographies.  Management claimed in the acquisition prospectus that they believed over 80% of the regen volume was secure through 2007 either by virtue of contractual obligations or the logistical advantages afforded by the location of the company’s facilities. 

We believe this is not only a contractually stable business but also a segment that should grow nicely in the next few years, perhaps in the 8-10% per year range.  Much of this growth is projected to come from regulation surrounding the removal of methyl tertiary butyl ether (MTBE) from gasoline.  MTBE is a chemical compound that is used as an additive in gasoline to raise the octane and oxygen content of the gasoline with which it is blended.  The majority of the MTBE produced in the U.S. is used to meet the federal oxygen content requirement for reformulated fuels.  Increasing the oxygen content of fuels reduces harmful air emissions.  The remaining MTBE production is used to boost the octane of premium gasoline. 

While the use of MTBE as a fuel additive in gasoline has helped to reduce harmful air emissions, it has also caused contamination of many of the nation’s drinking water supplies.  Unlike other components of gasoline, MTBE dissolves readily in water.  It resists biodegradation and is difficult and costly to remove from groundwater.  Low levels of MTBE can render drinking water supplies un-potable due to its offensive taste and odor.  At higher levels, it is believed to pose a risk to human health.

To replace the octane and oxygen function of foregone MTBE, petroleum companies have begun to add alkylates as high-octane blending components.  In the alkylation process, isobutane is combined with light olefins in the presence of a strong acid catalyst.  The only catalysts used for industrial production of alkylates are sulphuric acid and hydrofluoric acid (“HFA”), with sulphuric acid currently accounting for about 50% of North American production capacity.  In addition, there is some effort to convert alkylation units from HFA to sulphuric acid catalysis because of the more serious health hazards associated with using HFA (highly concentrated solutions may lead to acute hypocalcemia, followed by cardiac arrest and death, and will usually be fatal in as little as 2% body exposure, or about the size of the sole of the foot).    In HFA units, the acid is recovered by distillation within the unit and recycled back to the reactor; whereas in sulphuric acid units, the spent acid is separated and withdrawn from the unit and regenerated outside the unit while being replaced with fresh regenerated acid. 

As a result of the growth driver inherent in the move from MTBE to alkylates, management is exploring ways of expanding their regen plants to accommodate more volume.  Also, a portion of Chemtrade’s volume is currently earning low margins because the company has had to outsource some of its regen acid volume to meet customer demand.  Part of the retained earnings resulting from the cut in payout ratio announced in January 2007 will be used towards this end – to accommodate growth driven by MTBE-to-alkylate conversion, which will mitigate the need to outsource low margin regen acid swing volumes.  Given the generally high margins on regen business, the additional capital spending should produce very attractive incremental returns as there are no incremental ongoing fixed costs associated with the incremental capacity additions. 

Performance Chemicals (historical SHS and Peak Chemicals)

SHS

At the time of the acquisition in December 2002, this business was the largest North American producer of SHS.  SHS is primarily used in the pulp and paper industry as a bleaching agent, or brightener, for mechanical and de-inked pulps. SHS is also used to treat kaolin clays that are used as coatings and fillers for paper and in the textile industry for bleaching indigo and vat dyes, though these applications represent a smaller portion of the business.  The pulp and paper market has seen the greatest growth in demand for SHS, principally because of the increased use of recycled feed, which requires more SHS than higher quality feedstock

SHS can be produced in either powder or liquid form, with each representing about half the market.  Powder SHS is diluted with water prior to introduction into any bleaching system, while liquid SHS is delivered in a ready-to-use form. At the time of the acquisition, the SHS business was the only North American producer of SHS in powder form, and at that time the company had approximately 90% overall market share of powder SHS, and a high but un-quantified share of liquid SHS (for which markets are delineated more on a regional level). 

Liquid SHS has become more popular because of the convenience associated with receiving a ready-to-use product in a storage tank.  SHS liquid has a seven- to ten-day shelf life and its use is thus limited to those customers who receive large volumes on a regular basis within reasonable shipping distances from a manufacturing location.  Customers who prefer the powder form are typically either large consumers with dissolving and delivery systems already installed at their plants, have facilities at remote locations where regular shipments are difficult, or have only intermittent demand and need to keep a small inventory on hand. The larger paper mills typically have dissolving systems and tend to be the bigger consumers of powder.  

The major substitute product competing with SHS for brightening mechanical pulps is hydrogen peroxide.  Hydrogen peroxide is preferred in applications where a high level of brightness is required.  However, it is a much more costly product and it does not have the decolorizing properties of SHS.  Therefore, many paper and textile end users use hydrogen peroxide in conjunction with SHS.  As an industry expert explained to us, for most SHS applications (which by definition don’t require the level of brightness provided by hydrogen peroxide – or else those customers would already be using peroxide) the price differential between the two products makes general substitution of hydrogen peroxide for SHS a non-starter.  There is also a significant capital cost to enable the use of peroxide, providing another barrier to substitution.

As mentioned, the primary use for SO2 is in the production of SHS.  Chemtrade management acquired the SHS business because it saw an opportunity to vertically integrate given its access to byproduct SO2 from its smelter relationships.  In theory, the acquisition would have allowed Chemtrade to upgrade a low margin product, liquid SO2, into a high margin product, SHS.  In reality, things did not turn out this way and the SHS acquisition has become the Achilles Heel of Chemtrade since it acquired the business over four years ago. 

Most glaringly, the company deviated from its modus operandi of mitigating significant commodity pricing exposure through contractual means.  By acquiring this business, the company took full market risk of SHS pricing and volume, as well as the risks associated with the cost of raw materials (which became a particularly bad problem in the powder business).  In addition to declining demand for newsprint, which impacted SHS volumes, Chemtrade’s formulation for powder SHS requires sodium formate as a raw material.  Unfortunately, as sodium formate prices rose along with other commodities, the company could not pass on the increased costs because their customers had an alternative supplier in Guangdong Zhongcheng Chemicals (“ZC”) from China, the world's largest and probably lowest-cost producer of powdered SHS.  ZC has an estimated global production of around 270k tons, which compares to 45k tons for Chemtrade. 

It is important to note that while liquid SHS has powerful barriers from foreign competition due to the high cost of distribution and the short shelf-life of the product, powder SHS has no such constraints.  Our understanding is that the Chinese market is very competitive and the price per ton of SHS in China is actually well below the price being sold in the U.S.  Because the Chinese were selling chemicals in the U.S. for prices above what they were selling it for at home, there can be no claim of dumping.  Despite having spent ten years developing its distribution capabilities in the U.S., ZC was only able to deliver product to the coasts and lacked the distribution capabilities to penetrate the interior of the country.  As Chemtrade tried to raise prices to recover costs, ZC gained market share in the areas they had penetrated.  As of October 2006, ZC had gained approximately 35% market share in only 5 years, leaving Chemtrade with 60% of the market. As such, Chemtrade got killed with declining sales and a high fixed cost operation.  This has been the major cause of economic deterioration of the company and the subsequent reductions in distributions.

In October 2006, Chemtrade announced that it had entered into a long-term supply and marketing arrangement with ZC.  Under the arrangement, Chemtrade became ZC’s exclusive marketer of SHS in Canada, the U.S. and Mexico (only for non-textile uses in Mexico).  We believe this new arrangement removed a major thorn in Chemtrade’s side while creating significant optionality for the company.  As a result of the deal, Chemtrade effectively eliminated its fixed costs in running its SHS plant while gaining all of ZC’s customers and reclaiming significant market share, bringing its current share of the SHS powder business to 95%.  Chemtrade now has pricing power over the powder customers as there is no longer a viable alternative.  In addition, the contract embraces the company’s modus operandi as the Chinese take the majority of any pricing and volume risk.  Furthermore, the contract allows Chemtrade to capture the margin from all price increases that it can pass through until 2008, essentially providing Chemtrade with a “catch-up.”  After 2008, we believe price increases are split 60 / 40 in favor of ZC.

As for the Chinese, this is a no-brainer.  ZC has five times the productive capacity of Chemtrade.  By adding the volume of the entire North American market, rather than the 35% share it had to fight for, ZC will generate pure incremental cash flow to help cover its fixed costs in China.  We do not believe the threat of entry from another Chinese competitor is very high for two reasons: first, the entrant would need to spend years establishing a distribution infrastructure (as ZC did) and second, the entrant would be competing against the low cost structure of ZC, the largest producer of SHS in the world, not the original high-cost Chemtrade business as was the case with ZC’s entrance.  As a result of the ZC deal, we believe management has turned a very bad acquisition into a real strength. 

It seems to us that Chemtrade now has significant pricing power in a business that most investors have written down to zero.  This pricing power is not reflected in current earnings and therefore represents meaningful upside for the company.  We believe a 10% price increase during 2007 would deliver C$0.11, or nearly 8% growth, of incremental distributable cash flow per unit, with additional growth after that as the company continues to increase pricing.

Peak Chemical: P2S5

Chemtrade acquired Peak Chemical in August 2005 and now includes the business in the Performance Chemicals division of its SPPC segment.  Peak Chemical is one of two North American producers of P2S5, which is a component of lubricants used in a number of applications including automobile engines.  This is a relatively small business operating in a duopoly with a protected franchise and stable outlook. 

Pulp Chemicals Segment

Chemtrade acquired Pulp Chemicals in August 2003 for C$117 million.  The Pulp Chemicals business is located in Prince George, British Columbia and produces and processes certain chemicals principally for sale to Canfor Pulp Income Trust (“CPIT”) which was spun out of Canfor, for use in CPIT’s Prince George pulp mills.  Pulp Chemicals produces sodium chlorate and crude tall oil (“CTO”), with sodium chlorate representing approximately 88% of revenue, and CTO representing the rest (this ratio has been stable since the time of the acquisition in 2002).  Sodium chlorate is used for the production of chlorine dioxide, which in turn is used in the bleaching phase of the kraft pulping process.  Approximately 85% of Pulp Chemicals’ total sodium chlorate capacity is sold under long-term contracts, including 62% of capacity to CPIT’s Prince George mills.

The primary inputs for the sodium chlorate plant are electrical power, salt and caustic soda.  Pulp Chemicals recently renewed its contract with respect to salt supply after having struggled in the last quarter with interruptions due to a force majeure at its salt supplier.  In its contract with CPIT the company has cost pass-through provisions with respect to these inputs.  The ten-year renewable contract with CPIT also includes minimum volume provisions.  With the spin-out of these plants into an income trust, the parent Canfor has remained the guarantor of the take-or-pay provision. 

CTO is used as an alternative energy source for pulp and paper mills. CTO and reduced spent acid (“RSA”) are produced from soap skimmings recovered mainly from CPIT’s Prince George mills.  Soap skimmings are a byproduct of the pulp-making process and their removal is a key operational requirement for pulp mills as it allows them to increase their production capability.  CTO and RSA are both returned to CPIT’s pulp mills for use in their power boilers.  Pulp Chemicals processes CPIT’s soap skimmings into CTO and RSA under a ten-year renewable contract pursuant to which CPIT pays a fixed annual fee, adjusted for changes in production costs.

The Pulp Chemicals plant has excellent margins and very interesting market dynamics.  First is the cost structure.  The company literally sits on the site of CPIT’s plants, which are within a low cost electricity grid.  The vast majority (~60%) of the cost of sodium chlorate is associated with the cost of electricity, so this is particularly important.  Hydroelectric generating capacity provides exceptionally low cost electricity in British Columbia.  Power costs to the company are 35 mils per kilowatt hour compared to 61 mils in many other places in North America.  This implies a C$180 per ton cost advantage to high electrical zones (compare this to Chemtrade’s overall cost of production of around C$300 per ton).  Given the proximity and low cost, it is hard to imagine a competitor being able to supply CPIT’s plants at more attractive pricing.  The BC mills are also in good position to absorb low cost wood supply as forests are being cut down rapidly ahead of the pine beetle epidemic.

Second, CPIT is obligated to purchase 62% of the company’s sodium chlorate capacity, and is entitled to purchase up to 74%.  Furthermore, the price is adjusted for electricity, salt, caustic soda, and steam costs, which are 95% of the variable costs of production and 65% of the total production costs.  As such, Chemtrade is enabled to sell its “excess” capacity at true marginal costs (if not more) without the burden of fixed overhead costs.  Not surprisingly given these dynamics, this plant is operating at full capacity.

Third, due to the high value-to-weight ratio (sodium chlorate can be sold for around C$550-600 per ton) Chemtrade can ship sodium chlorate long distances.  Transportation costs of C$50 per ton still leave very attractive margins.  Chemtrade’s low cost structure puts it in position to take advantage of these dynamics, virtually ensuring all of its production is sold.

Fourth, the sodium chlorate market is an oligopoly with Eka, Erco and Canexus essentially controlling the market.  They each have several hundred thousand tons of product that they must place into the market.  These bigger players allow Chemtrade to sell its excess product onto the market without much disturbance because it does not behoove them to get into a pricing war with a small supplier like Chemtrade.  In fact, CEO Mark Davis used to run Erco.  Under his stewardship, Erco would purchase the excess capacity from the Canfor plant because they did not want this “immaterial” volume entering the marketplace and damaging the pricing on Erco’s hundreds of thousands of tons.  It was simply better to let Canfor (which sold its own sodium chlorate at that time) “win” on this business than let the little guy destroy pricing on the rest of the tonnage. 

Given these dynamics, management believes they might be able to de-bottleneck this plant and increase capacity by an additional 20,000 tons.  Management intends to use part of the cash flow freed up by the cut in payout ratio to fund this initiative.  Given the plant’s impressive margins, this project could easily add an incremental C$0.12, or 8% growth, in distributable cash flow per unit. 

Finally, since the time of the Superior Plus Income Trust collapse, high cost plants (those located in a high electrical grid) have been shuttered, thus tightening up the supply of sodium chlorate.  For all of the reasons above we can see why comparing Chemtrade’s sodium chlorate business to the at-the-whims-of-the-market business of Superior Plus Income Trust (the owner of Erco) is misleading. 

International Segment

The International segment is largely in the business of brokering acid, with three roughly equally-sized sub-businesses.  One portion of this segment brokers “stranded” acid, which has no immediate industrial consumer to utilize it.  European producers sometimes pay the company to take this acid away and sell it elsewhere.  Another portion of the business handles sulphur from the Scandinavian refineries (Chemtrade is the only player in this market).  The last portion of the segment is in Germany, where Chemtrade brokers sulphur and sulphuric acid under dynamics very similar to the Inco contract. 

Chemtrade had a problem with a supplier that was a cheap source of sulphuric acid that is no longer supplying the company.  There is also an irrational competitor operating in geographies that do not make economic sense as that business is being positioned for sale.  Chemtrade wants to keep the customer base and management believes they will get the volume back up to historical levels as they find cheaper supply and the irrational competitor’s business is sold.  It will probably take a couple of years for this business to return to former performance levels.

Conclusion

We think Chemtrade is trading significantly below intrinsic value and expect that we will see fair value through either an acquisition of the company or through a gradual re-rating as investors become more comfortable with the sustainability (or, god forbid, growth) of Chemtrade’s earning power.  Furthermore, we believe that the company has significant opportunity to expand their earnings via price increase, de-bottlenecking and intelligent capacity additions.  As such, we can get to reasonable distributable cashflow under different scenarios of around $C1.65.  We believe we have a solid management team and a decent, albeit not particularly sexy, business. 

Management is currently contemplating strategic alternatives because a significant portion of the float is owned by mutual funds established with the express purpose of owning Canadian income funds.  With the change in tax laws, management expects those owners will eventually need an exit.  In light of the recent private equity interest, management believes it is their duty to entertain any offers that would provide their large shareholders value with respect to those shareholders’ liquidity needs.

We are not convinced that a private equity deal is the most value-creating opportunity.  Tendering for shares utilizing 1.3 turns of debt would create distributable cashflow of C$1.75 based on current earnings.  Doing so, however, would require unconventional thinking by the board of directors as no income fund has yet completed such a large recap.  Although we do not love the idea of significantly more leverage on this business, we believe even with the resulting 4.2 turns of leverage that a recap / tender would be much more value-enhancing than selling to a private equity firm. 

Having said that, with a catalyst in hand and units trading at a 16% current distributable cash flow yield – most of which is realized in good, cold, hard cash every month – plus an opportunity for earnings improvement, we believe Chemtrade makes for a particularly attractive investment.  The monthly payment plus any likely takeout premium should provide a very attractive IRR. 

Catalyst