Description

Innophos (IPHS) provides the opportunity to invest in a quality business, with a high quality management team at a 14.9% free cash flow yield.  Furthermore, cash flow is likely to grow significantly from these levels in the next year and while you are waiting for the market to value the business properly, you get a 5.6% dividend yield.

 

This writeup serves as a short update on IPHS from the original writeup posted by rookie964 back in December 2006 – please refer to the original idea for a detailed description of the business.  For purposes of this writeup I’ll just provide a brief overview of the business, recent events, and valuation. 

 

Brief Business Description

 

IPHS operates in the specialty phosphates business.  Specialty phosphates are primarily used in a wide variety of consumer products including carbonated beverages, deli meats, toothpaste, vitamins, baking powder, cake mixes and laundry detergents.  To a lesser extent, products are used in industrial applications such as water treatment, asphalt and fertilizers.

 

IPHS’s products are used by consumer products manufacturers to enhance flavor, texture, mineral fortification, color and purity.  IPHS’s products tend to be highly engineered and once they are used in a certain consumer product, it is very unlikely that a customer will switch suppliers.  This is because the products are essential to the taste, appearance, and effectiveness of major consumer product brands, but their contribution to the overall cost of those products is extremely low.  Switching costs are extremely high due to the complexity and risk of changing suppliers.

 

In short, IPHS is not a commodity chemicals company, it is a food additives business with extremely high barriers to entry and high switching costs.

 

Recent Events Update

 

• Strong Financial performance:  IPHS reported extremely strong operating results on Aug. 6^th.  For the first 6 months of the year, revenues were up 7% and EBITDA increased 11.3%.  Free cash flow was up 4.7% year over year despite an elevated level of capital expenditures related to the Company’s co-generation project which will be operational as of Q1 2008.  This project is on schedule and management reiterated guidance of $12-15 million of cost savings generated by the cogeneration project as well as other operational initiatives.  These results are consistent with management’s goals at the time of the IPO and exceed analyst reports that were published in late 2006.  There has been little to no analyst coverage since the initiation reports were written in late 2006.
• Resolution of Salt Water Tax Claims:  One of the primary risks to owning the stock has effectively been removed as the Company has resolved the $107 million of Mexican Salt Water tax claims – this case is now over.  The Fresh Water tax claims remain, a $31 million potential liability however there are two levels of defense here and I would handicap it as highly unlikely that the Company is liable for any of this amount.  First, the claim remains pending before the Mexican tax court.  Second, the Company is indemnified by Rhodia for any liabilities under this claim.  That indemnity itself is subject to litigation, however IPHS won summary judgment in 2005 with respect to this claim and that decision was affirmed again in March 2007.  In summary, since the IPO the litigation picture has improved significantly.
• Accretive Debt refinancing:  In April, IPHS refinanced its floating rate senior notes (priced at L+800) with new senior unsecured notes at a fixed 9.5% coupon.  The capital structure remains reasonably leveraged, and there are no major debt maturities until 2014.  See the cap table below for a summary of debt outstanding at 6/30/07.

 

Capitalization:			Rate	6/30/2007	Interest	Leverage
Cash			4.500%	23.0	(1.0)
Senior Debt			7.60%	139.1	10.6	1.4x
Senior Sub Notes			8.875%	190.0	16.9	3.3x
Senior Unsecured Notes			9.500%	66.0	6.3	3.9x
Total				$395.1	$33.7	3.9x
Net Interest Expense					$32.7

 

 

• In-sourcing of “pharma” sales: In the second quarter, IPHS paid $9.0 million to Rhodia to terminate the sales agency relationship for products sold into the pharmaceuticals and nutritional supplement markets.  IPHS believes it will cost $1.5 million to execute the sales function in house, and was paying Rhodia $3.7 million to outsource this function.  Essentially, the Company paid $9 million for $2.2 million of annual savings, or 4.1x EBITDA.
• On track to achieve cost savings: On the Q2 conference call, management reiterated that it is on track to deliver $12-15 million of annual cost structure improvements.  The cogeneration facility is on track to be operational in Q1 2008, and will account for about half of those savings.
• Postponement of Secondary Offering:  Bain’s lockup expired in May and the Company announced plans for a secondary offering in order for Bain to get liquidity on its shares.  This was concurrent with a decline in the stock price and Bain was not interested in selling at those levels.  The secondary offering remains on the table, subject to market conditions.  This remains an overhang on the stock, but it is nice to know that Bain is not simply dumping shares on the market and is acting in a rational manner.

Valuation 

 

 

Enterprise Value / LTM EBITDA					6.3x
FCF Yield					14.9%

 

				LTM
				6/30/2007
Net Sales				560.8
COGS				461.9
Gross Profit				98.9
Margin				17.6%
SG&A				42.5
R&D				2.1
EBIT				54.3
D&A				46.4
EBITDA				100.7
Net Interest Expense				32.7
Pretax income				21.6
Taxes			40.0%	8.6
Net Income				13.0
Plus: D&A				46.4
Capital Expenditures				(20.0)
Free Cash Flow				39.4
FCF Yield				14.9%

 

A few notes about the financials shown above: 1) the numbers exclude a number of one time charges related to the IPO, $6.3 million for contract cancellation with Rhodia related to the pharma deal described above, and secondary offering expenses, 2) Net interest expense reflects the capital structure pro forma for the debt refinancing, 3) the capEx number reflects management’s estimate of long term maintenance capEx plus an average amount for growth projects that come along from time to time.  Capital expenditures will be higher in 2007, reflecting the cogeneration project, but given that total spending is budgeted at $16 million for this project and the $6 million of recurring savings that will be generated, this seems like a pretty reasonable investment.  Some of the spending for this project was incurred in 2006, and the majority will be incurred in 2007.

 

Risks

 

• High leverage levels:  The leverage levels here are manageable for a company that generates strong free cash flow, is not cyclical, and has a management team that is accustomed to working in a private equity environment.  Further, the leverage levels combined with the dividend commitment force a high degree of discipline in capital management which is a positive for shareholders.  See the table below for credit statistics.

 

					Covenant
Total Debt / EBITDA				3.9x	5.00x
Senior Debt / EBITDA				1.4x	2.75x
EBITDA / Net Interest Expense				3.1x	2.25x
(EBITDA-CapEx-Taxes)/(Interest+Principal)				2.1x

 

• Raw material prices:  The Company has a very strong record of passing on raw materials prices to its customers.  Further, the Company’s supply agreements for phosphate rock are long term in nature and provide the Company with significant protection and visibility on price increases.  Should they occur, management is all over passing along price increases to customers.
• Industry capacity increases:  One of the big concerns around the IPO was that Potash Corp. (POT) was adding production capacity, and that this would reduce pricing in the purified phosphoric acid product line.  This concern has not occurred to a large extent.  Management commented on the Q2 conference call that pricing in purified phosphoric is off 1% year over year and volume mix impact was less than 2%.

 

 

Conclusion

 

Basically, to sum up the value proposition here:

 

• Strong cash flow generating business that is not cyclical, has high barriers to entry and high customer switching costs
• NOT a commodity chemicals company as evidenced by the consistency of earnings over the years and pricing power over customers
• Highly rational management team that has been with the business a long time
• Management is firmly focused on creating shareholder value as evidenced by willingness to pay out significant cash flow in the form of dividends and use the remainder to reduce debt
• Since the IPO, management has delivered on its financial plan, is on track to complete operational goals, and virtually eliminated the litigation risk

 

Despite all of the progress and consistent good news that has come out of the Company since the IPO, the stock price is well below the IPO price and down roughly 30% over the last few months.  Why has the stock not performed?  This is simply a security that has been ignored by Wall Street and is somewhat illiquid.  Further a quick look at the shareholder roster reveals a sizeable stake held by Sowood (roughly 4.5% of total shares O/S and 9% of float).  Sowood has been liquidating many of its equity holdings as the firm winds down – see the recent 13D and 13G amendments from Sowood regarding OCCX and TLCV – so I’m sure they have been putting significant pressure on IPHS as well.  Remarkably, after posting a blowout quarter on Monday, the stock stands virtually unchanged from the end of July – there has been massive selling pressure regardless of the news.

 

In terms of a price target, I believe that a $22 stock price is quite achievable, which would represent a 10% FCF yield and 8.2% FCF yield on 2008E FCF and LTM FCF, respectively.  This price target implies upside of 81%.

 

Catalyst

one of the nice things about the investment is that you dont really need a catalyst. you get paid well to wait with the high dividend yield. however, with a 15% FCF yield, debt paydown and cash flow makes this company its own catalyst for price appreciation. further, operating results are likely to continue to improve as cost saving initiatives begin to take hold.