Description

Summary

I believe FMC Corp is a compelling bargain at this price, a classic case of (1) time arbitrage as the company faces short-term currency headwinds and a tepid market in its largest division, Agricultural Solutions (pesticides) and (2) a taint related to its smallest division (lithium), which has operational issues in Argentina.

Given the stock’s low forward multiple and substantial cash generation outlined recently by management, it is likely at least a double from here, with a possible end result being a sale to a larger competitor for a control premium on top of that.

Thesis in a Nutshell

FMC has tried and failed to generate close to $6 in EPS by 2015; however, it is moving in the right direction, just not nearly as quickly as management would have liked. The stock is down from a peak of $83 in Mar 2014 when event-driven funds got all excited about a split of the company into two pieces. Since then, the company changed tack and decided to sell one of the divisions (soda ash), keep the other (lithium), and acquire a peer (Cheminova). Event-driven funds sold, the outlook for ag solutions weakened, and the stock appears to have bottomed at $51 in Oct 2014.

While the market was giving the company credit for the future at $83, now, over a year later and with a better mix of businesses, the situation has reversed. This is a high quality business with decent management that appears cheap at < 9x future earnings. As the outlook improves, the earnings materialize and the stock re-rates, this should work out well.

Business

FMC was founded in 1883, but since 2010 has been under the management of Pierre Brondeau (CEO of Dow Advanced Materials and before that COO of Rohm and Haas). Brondeau has reshaped the portfolio away from commodity businesses and towards higher margin, specialty chemicals. The result is a company with roughly $3.4 billion in sales of Agricultural Solutions (pesticides) and ~22% EBIT margins, $815 million of sales in Health and Nutrition (components for color, mouth feel, structure, stability in manufactured foods), with ~22% EBIT margins, and a much smaller Lithium (lithium brine mining in Argentina) division with $250 million in sales and ~10% EBIT margins (all margin figures strip out one-time items).

Argentina? Low margins? The obvious question is, why not sell Lithium? The quick answer is, they can’t. We’ll get to that below.

Industry

FMC recently held their investor day, which provided a great overview of the company and the industry. Link to the slides:

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9Mjg1ODQwfENoaWxkSUQ9LTF8VHlwZT0z&t=1

I also suggest the PAH investor day slides for additional industry and comp information, although their margin numbers for FMC are not adjusted for one-time items:

http://files.shareholder.com/downloads/AMDA-2DC2F1/141508050x0x816760/EAB5D070-3856-4EAA-9659-06C9645EF5BC/2015-3-19_PAH_Investor_Day_vFinal.pdf

In Agricultural Solutions, FMC competes and partners with the Big Six: Monsanto, Syngenta, Dow Chemical, Bayer, Dupont, and BASF. In Health and Nutrition, FMC has partnerships with Sensient and Chr Hansen. There are various competitors in this segment depending on the product; for instance in Omega 3 FMC competes with BASF, DSM and Kroda; in texture it competes with CP Calco, Dupont, Cargill and Danisco. In pharma components it competes with J Retenmeyer, Blanver, and a slew of Asian companies. In Lithium the most expressive competitor is Chilean brine, which is the lowest cost producer.

The agricultural crop protection industry has been consolidating – witness PAH’s string of recent acquisitions – and Brondeau has telegraphed that he believes selling FMC to a larger competitor makes sense. In the Sep 2014 Credit Suisse Basic Materials conference, Brondeau said:

“What I would say, in general, around ag companies, the same way FMC acquired Cheminova, when you're playing in the multibillion and across multiple crops, size matter. Size gives you full portfolio, dollars for R&D, dollars for regulatory, for toxicology, size matters. So, do I believe that DuPont getting together with Syngenta, or DuPont getting together with Dow, or DuPont together with FMC, or FMC with Dow, all of these combinations, not one more specific than another. But I believe the companies which will do that will make some interesting moves.

“I think we are in a world where it's important to have a global reach, to have complete portfolio of product and to have, maybe the most important, dollars for toxicology, registration and research. So, I do believe that in the years to come, I don't know how fast, this business is prone for consolidation. It will happen because it makes sense.”

Who needs pesticides when we have seeds?

For someone new to the industry, the obvious question is why hasn’t Monsanto – which makes genetically modified (GMO) seeds which don’t need pesticides because they already incorporate protection – simply obviated the need for pesticides and destroyed the business of every pesticide maker on the planet?

The simple answer is Darwinian evolution. Pests evolve quickly and the industry has realized that the answer isn’t simply seeds or pesticides, but a combination of both. Also, in some geographies such as Europe, GMO is simply banned. GMO needs pesticides; witness Monsanto’s recent bid to acquire peer Syngenta, which unlike Monsanto, has a pesticide business.

Ag Solutions business model

While FMC invests in R&D, it does so at a much later stage than competitors. The traditional R&D model – similar to Big Pharma – involves years of synthetic chemistry discovery, synthesis, field trials, development, regulatory registration and launch. It is very expensive and requires scale and large balance sheets to support.

FMC decided to focus on later stage active ingredients, or those which have already been approved or whose patents have expired. Its field expertise, close contact with customers, localized R&D labs in various countries, allows it to formulate solutions that best meet the needs of those customers.

In places like Brazil, FMC utilizes its strong balance sheet to extend credit to farmers who buy its products. This is both a feature and a bug. While it allows FMC to operate in an attractive market like Brazil, it constrains FMC’s ability to operate at higher debt levels. More about this below.

Product registrations are expensive and extremely time consuming, sometimes taking as long as five years. This acts as a barrier to entry and provides a competitive advantage once a product has been registered. While the market is intensely competitive, all peers sustain attractive EBITDA margins and returns on invested capital in the mid to high teens.

Vision fail meets Groundhog Day

When Brondeau took over, he outlined something he called “Vision 2015”. In November 2011, the company made a presentation on the topic:

http://www.sec.gov/Archives/edgar/data/37785/000003778511000035/exhibit99111032011.htm

There’s an item on slide 25 showing a cumulative $3 bn of capital to deploy between 2010 and 2015. Given the company’s own $6 bn market cap at the time, this must have surely sounded exciting. The cumulative cash flow from operations from 2010 through 2014, however, fell far short: $1.8 bn. Even with another year tacked on, it would have been far less than Brondeau’s estimate.

In 2012, the company reiterated the Vision 2015 ideas, with an EPS target by 2015 of $5.75 - $6.25 (slide 98 – not even close) and $1.2 bn of EBIT in 2015 (way off):

http://www.sec.gov/Archives/edgar/data/37785/000003778512000033/investorday2012.htm

At the recent May 2015 investor day, Brondeau did it again. Slide 93 of the presentation shows Vision 2020 EPS of $6.6-$7.7 and cumulative cash for deployment, including incremental debt, of $2.5 - $3.7 billion ($19-$28 per share).

Why is this time different?

In Brondeau’s defense, he divested out of two cyclical businesses, peroxygens and alkali (soda ash) which together provided ~$200 million of EBIT. The agricultural market slowed much more than expected. So while management was probably overly optimistic back in 2010, they have recalibrated and hopefully their assumptions today will turn out to be overly conservative.

Here’s why the future may be better than the recent past, which was pretty good already:

• The business mix is more favorable, with divestments and acquisitions having put the company on a more focused path, with the two spearheads of Ag Solutions and Health and Nutrition;

• The industry appears to be consolidating, and this company may get sold;

• The sole remaining taint is Argentina, and I bet it eventually gets sold (below);

• The company seems intent on generating more cash going forward than it has in the past and acknowledges this as one of their goals;

• Instead of assuming a 10%/year growth in the ag market, the company is modeling a down 5% market in 2015, a flat 2016, and then 5% growth per annum from there, with FMC taking share.

Room for activism

While activists Third Point and Jana bought into FMC after the announcement of the split last year, they quickly exited the stock in the market turbulence of Q3-Q4. The closest thing the company has to an activist today is Alex Roepers’ Atlantic Investment new position established in Q4. What might the activists want to change?

• Split the role of Chairman and CEO (currently both Brondeau);

• De-stagger the election of BOD members;

• More closely align executive compensation to cash generated, not to adjusted numbers (FMC blew through $23.6 million on business separation costs even though it later pulled the plug on that; it further burned through $32.2 million for the acquisition of Cheminova and $9 million for the sale of the soda ash business. These are in aggregate material numbers for a business generating ~$370 million in cash flow from operations.);

• Implement zero-based budgeting (this company could use it);

• Sell off the Lithium business;

• Dramatically increase the stock buyback program;

• Increase allowed leverage;

• Sell the company.

Buy me and fire me (please)

Like many companies, FMC has installed change of control provisions that richly reward its NEOs in the event the company gets acquired and the execs fired within 24 months. If they don’t get fired within 24 months, they also get rich, but less so. Here’s a link to the proxy, with this data on p. 36:

http://www.sec.gov/Archives/edgar/data/37785/000130817915000066/lfmc2015_def14a.htm

You’ll also notice from this document that long term incentive and restricted stock awards vest immediately for all awards prior to Feb 2013. For more recent awards this only happens if the execs are fired.

The most recent grants were made close to $73, so they’re incentivized to raise the stock price beyond that level before attempting to sell the company.

All in all, it appears the execs are aligned with shareholders for an eventual sale of the company.

Stuck in Argentina

When the company invested in the Argentina brine lithium operation, it agreed to remain at least a 51% owner while the mine was in development. The language is vague and it is unclear if it would hold up today if FMC tried to sell off this asset, since it is no longer in development. It is also unclear if anybody would notice. On the other hand, if anybody did notice, that would be enough to prevent a sale.

Operating in Argentina hasn’t been easy. Local inflation outstrips peso devaluation, so the company’s operating costs keep rising while its product doesn’t get commensurately cheaper. Corruption is endemic and happens at every step of the way. FMC extracts lithium from Argentina and has several plants in other countries, including the US, where value-added work happens to turn this lithium into a higher value commodity (including turning it into feedstock for Tesla’s gigafactory).

You do get the impression, however, that FMC wouldn’t mind selling this asset at the right price. So maybe they need a push (see “Room for activism”).

The most likely outcome, in my view, is that FMC waits until Argentina’s general elections in October. The winner is expected to allow the peso to devalue, which would (a) trigger a writedown in FMC’s Argentina assets but (b) result in a dramatic increase in EBIT from that operation as cost inflation is offset by currency devaluation. This situational improvement may pave the way for a sale of this division.

Increased capital return

In its Monday investor day, FMC acknowledged it has not been great at generating and returning capital to shareholders. The blame goes to Brazil: the company claims that its ag chem business in Brazil has allowed it to grow faster than peers. On the other hand, it can grow only if it extends temporary credit to large growers in the country. This in turn consumes working capital, tying up cash.

FMC uses its strong balance sheet to finance these receivables with commercial paper costing 25-50 bps. Cheminova, which FMC recently acquired, didn’t have the balance sheet capacity for this, so it had to enter into factoring transactions and sell its receivables at 15-20% discounts to face value. It also grew much slower than potential. Together, this shows both the potential of Cheminova under the FMC umbrella and the need for a solid balance sheet with low leverage.

Despite this self imposed leverage constraint, FMC’s management is projecting between $11 and $18 per share of capital generated by the business through 2020 available for redeployment. This is adjusted EBITDA less changes in wc, cash taxes, cash interest, pensions, capital expenditures and spending on discontinued operations (this should be around $40 million for environmental remediation per year, and I’m modeling $65 million per year in pension contributions, which would more than fund the current projected liability of $224 million).

Using management’s disclosed projections for revenue growth and margins, I arrive at aggregate cash available for redeployment of between $19 and $23 per share. This would indicate a free cash flow yield of over 9% in 2016 and over 12% in 2020.

My numbers are derived from management’s inputs and I am unsure of what the delta is, but in aggregate over the analysis period I’m between $500-$800 million over management’s estimate.

On the debt side, management has guided that it would like to maintain debt levels at ~2.5x net debt to EBITDA. In its presentation, it guides to an additional $1-1.5 billion of debt capacity. This represents an additional $8 to $10 per share, arriving at a grand total of $19-$28 of cash available for redeployment through 2020 (using management’s numbers).

In attempting to back into these numbers, I had trouble arriving at only $1-1.5 billion of additional debt capacity. Even going off management’s lower cash available for redeployment numbers, and increasing the annual dividend by the same amount as earnings growth, I model growing cash balances. These growing balances together with the growing EBIT appear to support substantially higher debt levels than management supposes. In my modeling below, I plow this additional cash into share repurchases, which management does not in its estimates.

How realistic are management’s numbers? Their starting point in 2016 appears realistic enough. Total revenues are estimated at $4.3-$4.65 billion. If one simply takes 2014 numbers adjusted for the sale of the soda ash business and the acquisition of Cheminova, sales would be $4.5 billion. Management expects a down 5% 2015 for the ag division and a flat 2016, with growth thereafter.

Taking those numbers and inputting the growth rates, one arrives at operating margins for each segment that appear realistic for the early years and perhaps optimistic in the out years (with Health and Nutrition at 26-28% margins and Lithium at 14-18%). However, this is not out of the realm of possibility in Lithium with a depreciated peso (this is also a tiny division and the gap could easily be filled by the ag division).

Below are some modeled numbers; inputs are in blue. You can compare my cash generated from operations for redeployment with management’s (the 7-9% of sales). In the grand scheme of things if this is modeled with management’s lower numbers, 2% is lopped off the IRR estimates at the bottom.

If this takes until the end of 2019 to unfold I’ll be disappointed but the results will be acceptable. I would be nice, though, to sell the company to a larger competitor at that point and garner a control premium, which is not included here.

Risks to the thesis

• Ag markets take longer than expected to recover

• Argentina can turn into a bigger headache than expected, although even if this happened, it’s a very small part of the business to begin with

• Foreign currencies to which FMC is exposed devalue dramatically against the USD, providing stronger tailwinds

Catalyst

• Brazil wipes out corruption and elects a latin Lee Kuan Yew; wins the most gold medals in 2016 Olympics
• CFO says "screw it" and follows the PAH playbook, levers up to 4.5x net debt to ebitda and enters into an accelerated stock repurchase with his buddies at Goldman Sachs, taking EPS to $14
• Stock recovers and Dow/Syngenta/BASF/Dupont enter a bidding war for FMC of epic proportions