Description

Long Idea: MBAC Fertilizer (MBC.TO)

Overview

MBAC Fertilizer is a Canadian listed company that operates in Brazil as an integrated producer of phosphate fertilizer for use in the Brazilian market. MBAC’s primary asset is the Itafós facility, which produces Single Super Phosphate (SSP) fertilizer. Construction of the Itafós facility was completed in 2013, with a nameplate production capacity of 500,000/tons per year of SSP. For various, the ramp up of this facility has been delayed, but the company now expects that it will be able to produce at close to the full capacity at some point in the next year.

The current market price of MBAC’s stock (about $0.16/share as of 9/16/2014) seems to imply that the market does not believe the company can survive, at least given its current capitalization structure. While MBAC is no doubt a risky proposition for various reasons, I will attempt to show below the risk/reward at the current price is favorable—especially after some recent announcements by the company over the past few weeks.

The most important of these announcements (made on 8/26/2014) was that the company was able to successfully extend its ~$180mm of senior debt for 24 months, at essentially the same rates, and also does not have to make interest payments until March of 2016. One of these loans originally had a maturity date of October 2014, so this news came just in time given the company’s liquidity situation.

The other important announcement was that the company received a new working capital loan of $18.2mm. Despite the completion of the basic plant and equipment at Itafós, the company was so short of cash before this working capital loan that it was unable to purchase supplies and spare parts for its equipment, and so had not been able to progress on its production ramp-up on the original schedule.

With these two announcements, the company now has enough breathing room to get Itafós producing at full capacity without the spector of near-term insolvency looming.

To give an idea at how far MBAC stock has fallen, the company did a bought deal public offering on 4/17/2014 of 29.6mm shares at a price of $0.70/share (which include one warrant per share struck at $1.00/share; the current share count is now 181.6mm, and 230mm fully diluted). Interestingly, about 18% of this deal was bought by officers and directors of the company—at a time when the situation and outlook for the company was much worse. It was not clear at that time that the company would get such an advantageous deal with its creditors, or that it would get the infusion of working capital that it needed to finish the ramp-up of Itafós. And yet now the stock price is ~77% lower than it was at the time of the offering!

How did we get here

As is often the case, several things went wrong for MBAC, which has led to the current situation. Besides delays and cost overruns, probably the single biggest factor has been the decline in SSP prices. When the Itafós project was first conceived, the company expected SSP prices as high as $300/ton, whereas current market prices for SSP are ~$200/ton (these are net revenue numbers that include the cost of freight), and got signifcantly lower in 2013 and early 2014. According to MBAC’s management, one of the main drivers of this SSP price volatility is that Vale, the Brazilian mining giant and the largest domestic supplier of SSP to the Brazilian market, suddenly jacked up prices to well over $300/ton in 2013 at a time when global SSP prices were weakening. What Vale didn’t expect was that Brazilian users of SSP would instead turn to imported Chinese SSP; despite the large incremental shipping costs, Chinese SSP was cheap enough that imports to Brazil surged, leaving Vale and other producers with large unsold inventories of SSP. By the time Vale realized what had happened, the damage was done, and Vale was forced to liquidate its excess inventories for very low prices (SSP prices in Brazil got as low as $150/ton at the bottom). This did, however, stem the import of Chinese SSP to Brazil, and imports in 2013 were well over double what is expected for 2014.

According to MBAC management, the cost of Chinese SSP is around $140/ton (this can be easily verified on AliBaba.com), but to that number one must add current shipping costs to Brazil of ~$60/ton, port charges of another ~$40/ton, and then trucking costs to cover the ~1,000km distance to the region where MBAC operates of ~$50/ton, bringing the total effective cost of Chinese SSP in Brazil to ~$290—still cheaper than the price Vale originally sought, but far above the current market price that MBAC is getting of ~$200/ton. In addition, the trucking of SSP over large distances is problematic, as excess humidity can cause the SSP granules to turn into an unusable paste, as some Brazilian farmers learned the hard way. This price disparity versus imports also shows why there is some reason to be hopeful about the market price of SSP in Brazil, which has already moved up ~10% in recent months.

Valuation

While it is important to understand how the company got into the current situation, what really matters from an investment standpoint is the valuation of MBAC today. The best way to approach this question is to separate MBAC into two parts: Itafós, which is expected to generate cash flow in the coming year, and the other non-operating (greenfield assets).

First, let’s look at the non-operating assets. There are two main assets here, the Santana SSP mine (which is similar to Itafós, but actually has a higher grade of ore) , and the Araxá rare earth oxides project. Originally MBAC’s long term plan was to develop these assets themselves, but given the current situation, the company is actively looking to monetize these non-operating assets.

In the case of Santana, the company has a feasibility study that estimates the NPV of the project at ~$400mm. Historically, for an undeveloped project like Santana, the market value of the project might be as high as 0.4 times this NPV, or $160mm, but given how much worse the current market is (and the fact that the feasibility study assumed a much higher $350/ton SSP price), this figure is much too high. Although MBAC management is reluctant to provide a specific value, the CFO suggested that a low-end valuation of ~$50mm for Santana would be reasonable.

This estimate was partially based on a recent transaction in Brazil by Yara Corp, where Yara on 8/5/2014 bought a 60% stake in Galvani, another indepenent SSP producer with one producting mine and two greenfield SSP projects that are comparable to Santana. According to the Yara press release, the deal valued the greenfield projects at $186mm (source: http://www.yara.com/media/press_releases/1846451/press_release/201408/yara-to-acquire-majority-position-in-galvani-brazil ), and these two projects have an estimated SSP production capacity of 2 million tons per year. That implies a greenfield valuation of $93/ton/year, which when applied to the Santana project (according to MBAC, Santana should produce 500,000 tons per year) would value Santana at $46.5mm. Note that SSP prices have recently increased, so if anything, that valuation is probably on the low side. Still, it demonstrates that the estimate from MBAC’s management is reasonable. Depending on how such a sale is structured, it might be possible to avoid capital gains taxes on Santana, for which MBAC has a cost basis of ~$15mm.

While it is harder to find a comparable transaction to value the Araxá rare earth oxides project, MBAC management estimates that the project is worth $15mm to $20mm. Because it is not core to the company’s operation, it certainly makes sense to sell it and use the proceeds to reduce debt.

Let’s now look at the enterprise value of MBAC. For now we will ignore the warrants because they are so out of the money ($1.00 strike price versus current share price of $0.16; they would add an additional 48.4mm shares if exercised, but would also generate cash proceeds to the company):

Taking into consideration the working capital loan received by the company subsequent to the end of the 6/30/2014 quarter, and assuming that most of the proceeds of that loan will be used for working capital, we arrive at an enterprise value of ~$298.5mm. If we subtract from this $45mm to $50mm for Santana and $15mm to $20mm for Araxá, we can get a sense of what we are paying for the Itafós project:

So, what is Itafós actually worth? Well, at the full capacity of 500,000 tons/year, and an average net selling price of $200/ton (a bit higher than the $181/ton realized on the pre-commercial amounts of SSP produced by MBAC in the quarter ended 6/30/2014, due to increases in the market price for SSP and discounts that MBAC was offereing customers for paying in advance, which it did because of its liquidity issues before receiving the working capital loan), you get annual revenues of ~$100mm/year. According to MBAC’s CFO, at a ~$200/ton selling price, Itafós should generate EBITDA of between $40mm to $50mm per year, implying a TEV/EBITDA of between ~4.6x and ~6.0x.

Although the high end of this estimate is not particularly cheap, what makes MBAC a compelling play is how levered it is to a recovery in SSP prices—a recovery that seems to be in the works given current trends and the completed liquidation of excess SSP inventories by Vale and other producers. For example, if SSP prices increase to $250/ton—still well below the levels where Chinese imports would start to be cost competitive (~$290/ton, as we saw earlier), this would add an additional $50/ton x 500,000 tons = $25mm of EBITDA (according to MBAC’s CFO, such an increase would go directly to the bottom line from an EBITDA standpoint), which would bring the EBITDA multiple range to a much more attractive ~3.0x to ~3.7.

Given the operating and financial leverage, the return to the equity in this scenario could be quite large. For instance, $75mm of EBITDA at a 5.0x multiple would yield an enterprise value of $375mm. If one adds another $60mm for the Santana and Araxa projects and subtracts ~$269mm of net debt, you get an equity value of $166mm, or $0.91/share— ~5.7x the current market price. Even at a 4x EBITDA multiple, this scenario would yield an equity value of $0.50/share, a bit over a triple versus the current price of MBAC shares. And it is certainly not unthinkable that SSP prices could go quite a bit higher in the coming years. This upside potential is significant enough that even a small probability of a $300/ton SSP price can justify the current market price of MBAC shares. 

Risks

Before the recent announcement regarding the debt extension, by far the largest risk to MBAC was a liquidity crisis brought about by the maturity of its debt. Now that the company has secured an additional 2 years of runway, in which it does not even have to make interest payments, that risk has been significantly mitigated. Still, it would be silly to not acknowledge that MBAC remains a highly leveraged company, especially comparing its current market capitalization to its debt levels. This leverage is also a source of opportunity if there is further recovery in SSP prices. Of course, the flip side of this is that a significant decline in SSP prices would likely be catastrophic for MBAC. But considering that the market is valuing the equity of the company at a mere $29mm, much of this risk seems priced in at the moment. 

Potential Catalysts

Clearly, the complete ramp up of Itafós, which should be largely finished in the first half of 2015, could be a major catalyst in convincing investors that the worst is over. Another possible catalyst could be that institutional shareholders, many of which cannot own stocks with market caps under, say, $50mm, will finally stop selling their shares, which is a likely explanation for the recent and dramatic slide in the stock price despite the relatively good news coming from the company. Finally, MBAC’s management has been very busy executing on the debt extension and the ramp-up at Itafós, and has not made a particularly compelling case to investors. In order to get some idea of the earning potential for Itafós or a sense of the potential value to the non-operating assets, an investor has to read through jargon-filled and possibly outdated feasibility studies, or reach out and talk to management directly, since none of this information is readily available in the company’s current investor presentations or financial reports. A more concerted effort by management to tell the story could go a long way in generating interest in the stock from value investors. 

Catalyst

• Finished ramp-up of Itafós
• Potential asset sales of Santana and Araxá