Innophos Holdings, Inc. IPHS W
May 24, 2008 - 11:43am EST by
2008 2009
Price: 25.18 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 540 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Ignore for the moment the price chart and focus on the business fundamentals - because they're only getting better.  Innophos has been written up on VIC twice in the past 18 months first by rookie964 in December 2006 and again in August 2007 by madler934.  I refer you to both writeups for a more detailed discussion on the business, industry and other background material.  At the time of the original writeups Innophos stock was trading in the low-teens and was quite cheap on just about any metric.  It was the true proverbial 50 cent dollar if you were willing to do the work to get comfortable with the primary downside risks, because the upside was quite clear.  For instance, with the stock at $12, you were buying a defensive, stable business for close to a 20% free cash flow yield and less than 6x EBITDA.  In the year and half following a very under-the-radar IPO, Innophos share are up nearly an astounding 100% to $25 per share.  But the valuation is only playing catch-up to the rapidly improving fundamentals that have essentially altered Innophos' industry dynamics and drastically improved the company's earnings profile.  While Innophos is not quite as compelling of a risk-reward at $25/share as it was at $12/share, I believe that there is still meaningful upside of something north of $10/share and very modest downside risk supported by solid cash flow generation.  This may no longer be a 50 cent dollar but it is 70 cent dollar at my base case and maybe even a double (ie a 50 cent dollar today) if everything goes right (upside case).  Again the two things you may need to get over is the price chart which is a difficult one for a value investor as well as the overhang from the nearly 50% stake that Bain still holds in the company.  It is worth nothing that Bain has board representation and was widely expected to be a seller (company has a shelf filing ready to go) in the $15-$17 range but have not indicated an interest in selling yet.  I think they see the earnings potential over the next 12-24 months and they are pretty comfortable waiting until Mr. Market catches up.  

Innophos is a market share leading producer of specialty salts, acids, purified phosphoric acid and other phosphate-based derivatives.  Essentially the company purchases phosphate rock as its main raw material and turns into value-added products further downstream.  Innophos' bread-and-butter business is specialty salts and specialty acids used in and sold into the food and beverage markets.  Leavening agents found in bread, the soda we drink and the toothpaste we use all contain various types of phosphate-based salts and acids for taste, texture etc.  Defensive end-markets such as food and beverage, personal care and pharmaceuticals make up more than 60% of Innophos sales. In the phosphate-based food additives market Innophos is the market share leading with an approximate 40% share.  It competes primarily with two giants of the phosphate industry, Potash Corp of Saskatchewan (PCS) and Israel Chemicals (ICL).  The industry has undergone several rounds of capacity reductions in the early 2000s, with Innophos (then Rhodia) and ICL (then called Astaris) shutting down several facilities which resulted in improved pricing and higher levels of profitability.  The specialty phosphate industry is currently undergoing a similar process on the supply side, but as a result of very different factors.  As Innophos outlines in their 2007 10-K, the specialty phosphate market experienced a significant and unprecedented tightening of supply in the fourth quarter of 2007.  Specifically, imports from Europe and Asia into the U.S. market dropped by an astounding 40% as producers diverted their phosphate capacity into the booming fertilizer end-market.  This dynamic was further exacerbated in the first quarter of 2008 when the U.S. slapped anti-dumping duties on Chinese importers of SHMP, a specialty acid used in water treatment and various food applications.   Not surprisingly Innophos was able to gain market share from foreign competitors following this action and the company is expanding capacity in one of its facilities to meet demand.  
In summary, over the recent past there has been a confluence of very positive developments:   (a) exploding demand for agricultural grade phosphate for fertilizer, (b)  import duties sucking foreign competition out of the North American market, (c) China starting to view phosphates as a strategic resource and clamping down on exports through its own export tariffs, (d) Innophos' competitors PCS and ICL diverting phosphate production into the more lucrative fertilizer end market and away from the specialty acid side and (e) stable demand and little substitution options by the core food and beverage buyers of specialty phosphates. For Innophos as really the only pure-play specialty salt and acid producer in North America, the net net result of all this has been a drastically tightened market and much improved pricing power.  Whlie Innophos' ability to raise prices reflects the raw material inflation it is seeing on its own purchases of raw materials, the company acted swiftly and aggressively to put through price increases in anticipation of costs going up.  That is to say, Innophos was able to raise selling prices before taking the full brunt on the cost side.  The company has implemented three rounds of price hikes this year and will implement another increase in June; when all's said and done, company expects the realize the full impact from these pricing actions by the middle of the third quarter of this year.  Its supply contracts for its key raw materials (primarily phosphate rock and sulfur), on the other hand, will not reflect the higher raw material pricing until the fourth quarter of 2008 and first quarter of 2009.  Innophos buys its raw materials under long-term supply agreements, and this has provided the company with some buffering against the recent spikes in costs.  At the end of the day, this lag effect basically means that Innophos will earn outsized, and likely temporary, profits over the next seven months as its costs play catch up to its revenue. 
Management has given insightful if somewhat cryptic guidance for 2008.  By far management's most important disclosure is their expectation for a $12-$14MM monthly delta (between the pricing they are getting and the costs they are paying) being fully realized by July/August.  When you do the math you realize how large the numbers get this year.  For a company that did approx. $105MM in EBITDA in 2007, I currently expect Innophos to generate something slightly north of $200MM of EBITDA in 2008.  Obviously 2008 reflects the lag effect described above and I fully expect, as the management has publicly said, that they will give much of that back in the first quarter of 2009 as their supply contracts reset.  However, putting aside for a moment the lag effect of 2008 and associated bonanza profits, I want to circle back to the earlier discussion on the changing industry dynamics. Supply is obviously coming out of the specialty phosphate market.  It is increasingly difficult for anyone in the specialty phosphate market to secure supplies of key raw materials.  The Chinese are cutting back on exports because they need to meet insatiable internal demand.  In such a a market environment, Innophos benefits from its track record of performance and reliability and its customers, some of whom are facing shortages of key raw materials themselves, are coming to rely on Innophos more and more.  The company has said that it has so far had good acceptance of its price increases, which is tied to the fact that Innophos' products are in many cases a small component of the overall product costs for its customers.  In addition, Innophos has the technology and performance developed in cooperation with its customers over many years, making it quite difficult if not almost impossible for customers to look for viable (or less costly) substitutes.  Under Rhodia, the focus was on market share and volume and Innophos was constrained by its parent from being very aggressive on pricing, but it is fairly clear that the technical nature of its products should allow the company to be more firm on pricing that it has in the past (this is something Bain knew when it bought it in 2004, and EBITDA has compounded at 7.5% p.a. since then)  Less crucial but still important to the story today is the U.S. dollar: as is the case for many American manufacturers, Innophos' competitive position has benefited from the declining greenback. 
The street has been a little slow in figuring out the company's guidance and only two analysts have done the necessary math to get it right.  Consensus estimates for EBITDA and EPS are still much too low.  The street is currently estimating $3.44 for this year and $1.91 next year.  My numbers are $4.60 and $2.78, respectively, or about 30-40% above consensus.  Earnings understate actual free cash flow due to high depreciation charges and low capex requirements.  The company should generate close to $100MM of free after-tax cash flow this year and something in the range of $70-$80MM of free cash flow in a normalized environment in 2009 and 2010.  This equates to close to $3.50 per share in FCF in 2009 on which basis the stock currently trades at 13.5% FCF yield.  As the company delevers its legacy LBO balance sheet and/or starts buying back shares, FCF per share should grow by low-teens CAGR, to $4/share by 2011.  By year-end 2009 I believe this is a $40 stock, which would equate to 7x EBITDA and 9% FCF yield (on 2010 numbers).  Decent specialty chemical names generally trade around 7.5-8.5x forward EBITDA.  Following are my projections for the company:
2005 PF
2006 PF
Free Cash Flow
FCF Per Share
As explained in previous writeups, the company generates gobs of cash flow as general maintenance capital expenditure requirements are fairly small, maybe $15MM per year . The company has ratcheted up capex spending in 2007 for a co-generation project that should provide for meaningful ($10MM per year) energy cost savings. 
As for valuation, currently the market is offering Innophos for sale at 5.5x EBITDA and 9x earnings on the more normalized 2009 numbers.  I can't make an argument for what the right multiple is but it certainly is not 5.5x.  A simple DCF using a 10% cost of capital and 2% permanent growth rate yields a $36 present value or 7.2x 2009 EBITDA.  Needless to say however this is not a multiple expansion thesis but rather an EBITDA and cash flow expansion thesis, which in my view trumps everything else.  The stock is worth $40 by year-end 2009 and $46 by year-end 2010 on a combination of higher EBITDA and lower debt balance from deleverging.  The upside therefore is 60%-80%; the downside is limited any time you buy a good, stable business at ridiculously low multiples to cash flow.  Worst case scenario in my mind is $2/share in FCF on a normalized basis, which means you are still getting the business at 12.5x cash flow. 
Valuation as of :
      3/31/2008 12/31/2008 12/31/2009 12/31/2010
Current Price $25.00 $25.00 $25.00 $25.00
Market Cap $537.5 $537.5 $537.5 $537.5
Cash 11.7 11.7 11.7 11.7
Debt 398.0 311.9 255.2 190.3
Enterprise Value 923.8 837.7 781.0 716.1
EBITDA (forward year) $210.0 $151.9 $157.7 $167.2
TEV / EBITDA @ $25 4.4x 5.5x 5.0x 4.3x
P/E @ $25 5.4x 9.0x 8.2x 7.4x
At 7x EBITDA   $50.50 $35.23 $39.85 $46.10
Upside to Target 102% 41% 59% 84%
Implied P/E at Target 11.0x 12.7x 13.0x 13.7x
Catalysts for this story continue to be improved earnings and better than expected numbers through the rest of 2008 with potential for even more bullish guidance from management as they implement new rounds of price increases.  The market will eventually get more comfortable with Bain's presence as a controlling shareholder.  Street consensus will creep up as analysts will have to adjust their numbers upwards to conform with management's guidance.  The key risk is that Bain decides to sell, which is a real possibility, although my guess is they see the upside and are comfortable where they are (but don't hold me to that view as I have no special insight into this whatsoever). 
Disclaimer: do your own work and do not rely on any statements or assumptions made in this write-up for your investment decisions.  I may or may not have a position in Innophos shares and I am under no obligation to provide updates on the stock or my position therein.


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