Description

Innophos is a specialty phosphates company in North America with top market shares in its products, very stable end markets, a conservative balance sheet, and significantly higher earnings power than is being reported. At $28 per share, the stock is trading at just 7.5x Q2 2010 annualized adjusted earnings of $3.74. The investment opportunity in IPHS is driven by 2 factors: 1) the business is much more stable than 2008/2009 earnings reflect and 2) the true earnings power of the company is significantly higher than reported GAAP earnings.

IPHS has 3 major product lines: Specialty Salts/Acids, Purified Phosphoric Acid ("PPA"), and Other. Specialty Salts/Acids serve the food/beverage sector as a flavor enhancer and the pharmaceutical industry as an inactive drug additive (it also has industrial uses). These specialty salts/acids are made from PPA and are the most specialized, complex products at IPHS. The next product line, PPA, is primarily used in carbonated soft drinks and in the treatment of water for industrial purposes. The Other category is simple phosphate products used in the manufacturing of fertilizer and detergents. IPHS manufactures its products at 7 facilities in the U.S., Canada, and Mexico.

The input raw materials at IPHS (like phosphate rock and sulfur) overlap with the broader fertilizer industry and can swing around based on supply/demand for fertilizer in North America. Supply contracts historically were priced on a 1 year lag to market prices. Therefore, spiking phosphate prices in 2008 allowed IPHS to benefit significantly by raising its prices to customers while not incurring higher input costs until 2009. Phosphate rock historically traded at ~$50/ton but went to as high as $450/ton in 2008 (pricing has now settled at ~$100/ton).This dynamic reversed in 2009 when supply costs for IPHS stepped up and lower rock prices forced IPHS to lower its fees.

As a result, IPHS earnings were cut by more than half in 2009 vs. 2008. Also depressing earnings was the loss of a customer in Mexico in the detergent industry. This earnings roller-coaster has caused the market to view IPHS as a cyclical company.

IPHS has since tailored its business so that it has more control over its results:

• IPHS is now securing supply contracts with minimal lag time to prevent the volatility of 2008-2009 from repeating: input costs now re-price quarterly vs. annually
• IPHS has shifted capacity in Mexico to more stable food/beverage/pharmaceutical specialty salts/acids and away from phosphorous-based detergents which declined in volume due to environmental concerns
• Management is on its way to securing multiple sources of phosphate rock supply in Mexico vs. historically buying primarily from one supplier

Because of these steps taken, IPHS is a much more stable company than it has shown to be since becoming publicly traded in November 2006. In actuality, we believe IPHS is a very good business given its diversified end markets, specialized products, and barriers to entry (including the cost of locating/building a greenfield plant, locating phosphate supply and demonstrating flavor/cleaning agent efficacy). In fact, due to its historical stable earnings and cash generation, IPHS was bought out in an LBO by Bain & Co. in 2004.

It is important to note that economic earnings are higher than reported GAAP earnings due to excess depreciation stemming from the write-up of fixed assets associated with the Bain LBO. Maintenance capital expenditures at IPHS run between $20m-$25m per year while depreciation is being reported around $50m. Management expects reported depreciation to drop over the next several years to levels closer to maintenance capital expenditures. Thus, the current reported earnings do not accurately reflect the true earnings power of the business. For example, IPHS earned Q2 EPS of $0.79 - removing the excess depreciation shows adjusted EPS was $0.94. Analysts on the sell-side have not yet appreciated this and we believe this idea will begin to get more recognition as reported D&A gradually declines.

There is no noteworthy seasonality in IPHS results. As a result, Q2 performance is a good proxy for an annualized run-rate of earnings. Q2 adjusted EPS of $0.94 translates into a run-rate of $3.74 on an annualized basis. Based on Q2 results, we feel confident that IPHS can earn $4.00 of adjusted EPS in 2011. We believe Innophos's business warrants a 12x-14x multiple, yielding a target price of around $50. Additional upside exists as management has been highlighting growth opportunities into new geographical markets as well as bolt-on acquisition opportunities.

Catalyst

Catalysts

• Reporting stable and growing financial results on a quarterly basis
• GAAP depreciation falling gradually closer to maintenance capex levels
• Improving results in the Mexico business
• Growth from expanding businesses into new geographies
• Another leveraged buy-out is also a possibility as the company is under-levered and generating stable cash flow

Risks

• Another economic recession in North America could cause lower demand for industrial specialty phosphate products
• Disruptions in the restoration of the IPHS business in Mexico would hurt financial results
• Poor execution of growth strategies