Rentech Nitrogen Partners, L.P. (“RNF”) is a nitrogen fertilizer producer worth $765 million (at mid-point of today’s proposed IPO price range) that can be purchased for $326 million through its parent, Rentech, Inc. (“RTK”) as RNF is wholly owned by RTK.  Much of this valuation gap should close by November 14^th providing RTK investors a potential return of ~70% in less than one month.  This opportunity exists because the profitability of RNF has been masked by losses in RTK’s consolidated financials. 

On August 5^th, RTK filed a Form S-1 with the S.E.C. to convert RNF into an MLP and IPO the new standalone company with Morgan Stanley & Credit Suisse as joint book-runners.  The company filed its final amended S-1 today and expects to market and complete the IPO before RNF’s numbers go stale on November 14^th (recent conversations with the company confirm this deadline).

Despite current market volatility, deals are still getting off the ground.  While it’s not an exact comparable, Mosaic (“MOS”) announced a $750 million bond offering on October 17^th and we heard the books on that deal were closed in 90 minutes.  Morgan Stanley jointly led the IPO of CVR Partners, L.P. (“UAN”) in April 2011, which was a successful offering providing a road map for RNF.

Background:

RTK has been in the business of developing and providing clean energy solutions since incorporation in 1981.  The company has also been in the business of generating losses and issuing equity as it attempts to commercialize and license its proprietary and patented synthetic gas technologies.  As a result, RTK has a current accumulated deficit of $302 million on a market cap of $326 million, leaving the company unloved and ignored.  However, even loss making companies sometimes get lucky (think K-Fed with Britney Spears) and RTK won the lottery with its purchase of RNF.

On April 26, 2006, RTK announced it completed the purchase of Royster-Clark Nitrogen, a natural gas fed ammonia nitrogen fertilizer plant located in East Dubuque, IL for $70 million ($50 million in cash plus $20 million of net working capital).  RTK originally planned to convert the natural gas fed fertilizer plant into a facility that would use its clean coal gasification technology to produce ultra-clean diesel fuel for an additional $800 million investment.  At the time, RTK was much more bullish on its technology than the fertilizer plant as EBITDA was projected to be just $5 million. 

Then on December 4, 2007, after spending ~$40 million of the planned $800 million, RTK cancelled its plans to convert the plant and decided to let RNF operate as a standalone ammonia nitrogen fertilizer producer due to the price decline in natural gas, which is 75-85% of cash production costs, and increase in fertilizer prices.  As natural gas prices fell from ~$8.00/MMBtu in 2007 to ~$4.00-5.00/MMBtu, and fertilizer prices for ammonia and UAN (RNF’s main products) increased from $351/ton and $209/ton, respectively in 2007, to $663/ton and $328/ton, RNF EBITDA increased from $18 million in 2007 (September year-end) to an estimated $100.6 million in EBITDA in 2012 according to management guidance.  Since management pre-sold fertilizer for the fall, fertilizer pricing has risen and our conversations with management suggest that their 2012 EBITDA guidance is likely conservative (see historical production and pricing in the table below).

The increase in RNF’s earnings was purely a result of factors outside management’s control and they’ll be the first to admit they got lucky.  Another example of a management team that got lucky: CVR Energy (“CVI”) purchased its nitrogen fertilizer plant and a refinery for $116 million in 2004 and recently spun off the fertilizer plant into a standalone company that today is worth $1.9 billion (think Jordan Bratman with Christina Aguilera).

The final S-1 includes details of industry dynamics, but the quick summary is that high U.S. natural gas prices in the mid-2000’s closed over 30 domestic fertilizer plants cutting domestic capacity in half.  After peaking in mid-2008, U.S. natural gas prices declined significantly reducing production costs for fertilizer plants like RNF’s.  After the reduction in domestic fertilizer capacity and natural gas prices, demand for corn increased significantly.  U.S. domestic producers could meet only half of domestic fertilizer demand.  As the rest of domestic demand needed to be imported, higher European natural gas prices set a floor for the price of fertilizer (European natural gas prices are ~2x U.S. natural gas prices).  At the same time, the U.S. grew very strict on granting permits for new fertilizer plants, or re-start permits for plants previously closed, due to environmental concerns.  These events have allowed domestic fertilizer producers to dramatically increase their profitability.

Qualitatively, RNF and domestic fertilizer producers are a play on European natural gas prices remaining higher than U.S. natural gas prices and high demand for corn.  Forward markets are expecting European natural gas to remain much higher than U.S. natural gas prices through at least 2014 (see slide 5: http://www.bergen-energi.com/arch/_img/9379111.pdf).  However, if you are concerned about the difference between European natural gas and U.S. natural gas converging causing domestic fertilizer prices to decline, you can hedge this risk by shorting UAN and/or TNH (TNH has a natural gas fed plant whereas UAN has a pet coke fed plant, so TNH is probably the better hedge).

Valuation:

This morning RTK announced its intention to sell 15 million shares, or 39.2% of their interest in RNF, for an indicated range of $19-$21/sh, implying a total value of $727-$804 million for RNF.  At the midpoint of the range, RNF will trade at an 11.7% yield based on management’s guidance for $2.34/sh in distributions versus UAN at a 7.5% yield (based on forward guidance for $1.92/sh in distributions) and TNH at an 8.8% yield (no forward guidance so most recent quarterly dividend annualized).  Assuming RNF deserves to trade at a discount due to its smaller size and prices at the midpoint of its range then RTK’s 54.9% ownership is worth $420 million (assuming underwriters exercise their option for 5.9% of RNF), which is more than RTK’s current market cap of $326 million.  In addition, we estimate that RTK will have at least $135 million in net cash after receiving the IPO proceeds and before any future distributions (see our pro-forma net cash bridge below). 

We estimate the value of the clean technology and RTK patents at zero (recent Brean Murray report with estimate of $0.93/sh of value), and that all the future cash distributions (will be ~$49 million in 2012 based on $89.4 million of distributions and 54.9% assuming over-allotment is exercised) from RNF will be spent by RTK on corporate R&D and SG&A.  While we can’t intelligently opine on the value of RTK’s clean technology, giving no credit to future distribution’s from RNF is likely overly conservative as management noted in an 8K on October 20^th that their new strategy “includes reduced spending on research and development and pursuit of projects that are smaller and require less capital to be invested by Rentech than those recently under development by the Company.”  After years of losses, it seems that management is getting some religion.  In recent conversations, management has stated its intention to hold a call to further discuss reduced spending at RTK post-IPO and that that they expect RTK to be cash neutral (or better) inclusive of RNF cash distributions.

Giving credit to RTK’s ownership in RNF ($420 million at IPO mid-point) and net cash ($135+ million), RTK is worth $555 million, or $2.40/sh.  This is 69% upside from today’s close of $1.42/sh and not far from Sherwood Investment’s 2007 buyout offer of $2.28/sh when RNF’s EBITDA was just $18 million.  If RNF has an IPO pop of 20% to $24/sh, the value of RTK’s stake in RNF is $504mm, putting RTK’s value at $2.75/sh, 94% above today’s close.  $24/sh for RNF implies a dividend yield of 9.8%, higher than UAN or TNH.  The proceeds from the IPO and future distributions are expected to be tax free given RTK’s substantial NOLs, per management. 

With its net cash balance sheet, a corporate strategy to be FCF neutral (or better), incentivized bankers and management, and a very near-term catalyst, we feel there is limited downside to an investment in RTK.

Risks:

1. Timing of IPO – there is always risk the IPO does not get off the ground before the company’s numbers go stale on November 14^th.  While there has recently been strong demand for ag deals, anything can spook the markets.  The road show started today in NY and ends in LA next Thursday. 

1. Corporate Governance – in the past management has been sued by shareholders for misleading investors (see cases #2:09-cv-09495-GHK-PJW and #2:10-cv-00485-GHK-PJW both filed in California) and has turned down credible buyout offers for significant premiums.  The lawsuits have all been dismissed/settled without any wrongdoing for a total of $2.1 million, which was paid for by insurance, and we believe the spin-off of RNF is a step in the right direction to improving corporate governance.  Additionally, in June 2009 RTK dismissed their no-name auditor and hired PricewaterhouseCoopers to help ensure their financial house was in order.

1. Capital Raises – RTK has a long history of raising dilutive equity capital and may do so again at any time. Unfortunately, given management’s past it’s hard to say they’ll never issue equity again, but with a new strategy for funding clean tech projects in a less capital intensive manner through partnerships and JVs, and the company’s sizeable pro-forma net cash balance sheet, we believe it’s reasonable not to expect management to dilute shareholders anytime in the next 12-24 months.

1. Fertilizer Cycle Ends – RNF is a commodity producer and a strong case can be made that the fertilizer plant is currently over-earning and at some point earnings will revert back to a more reasonable mid-cycle range.  However, the outlook over the next few years is very strong for fertilizer demand and pricing and RNF is strongly positioned from both a cost and geographic perspective relative to many domestic producers, allowing RNF to earn premium pricing above domestic producers and a higher mid-cycle level of profitability (see S-1 for more detail).  We feel this risk can also be mitigated by hedging out commodity exposure with short positions in UAN and/or TNH.

Giving credit to RTK’s ownership in RNF ($420 million at IPO mid-point) and net cash ($135+ million), RTK is worth $555 million, or $2.40/sh.  This is 69% upside from today’s close of $1.42/sh and not far from Sherwood Investment’s 2007 buyout offer of $2.28/sh when RNF’s EBITDA was just $18 million.  If RNF has an IPO pop of 20% to $24/sh, the value of RTK’s stake in RNF is $504mm, putting RTK’s value at $2.75/sh, 94% above today’s close.  $24/sh for RNF implies a dividend yield of 9.8%, higher than UAN or TNH.  The proceeds from the IPO and future distributions are expected to be tax free given RTK’s substantial NOLs, per management. 

With its net cash balance sheet, a corporate strategy to be FCF neutral (or better), incentivized bankers and management, and a very near-term catalyst, we feel there is limited downside to an investment in RTK.