Description

Rentech Inc. (RTK) is an enigmatic hodge-podge of assets that has experienced significant changes over the last few years and that is severely undervalued.  The most important asset that they own is their 60% ownership of Rentech Nitrogen Partners (RNF), a publicly-traded MLP that is currently up for sale and that I wrote up on VIC last year.  RTK’s partial ownership of RNF at current prices is worth roughly $328 million, or $1.16 per RTK share assuming full dilution.  That means that RTK investors are buying the non-fertilizer RTK assets for less than free.  My view is that RTK shares at current prices have an upside of 76% (or more) from current levels. 

Historically, RTK owned a series of technologies for the development of synthetic fuels; this was a money-losing business that has successfully been divested, so historical financials do not provide a lot of assistance in valuing the business.  RTK purchased a nitrogen fertilizer plant a decade ago for close to nothing, and then the economics of nitrogen fertilizer improved dramatically and RTK then spun off a portion of their ownership into an MLP called Rentech Nitrogen Partners (RNF).  With the cash flows provided by the RNF distributions and increased debt leverage, RTK has been buying wood chipping and wood pellet businesses.  They plan on converting these wood products business into an MLP in the intermediate period ahead.     

GSO Partners, a division of Blackstone, essentially controls RTK’s board of directors and thus the business as well.  GSO wants to accelerate the growth in the wood products businesses due to the potential for a predictable, steady stream of cash flows and is not very interested in the less predictable fertilizer businesses. 

Nitrogen Fertilizer

My VIC report on RNF contains an in-depth analysis of RTK’s fertilizer assets, and that investment thesis remains more or less the same, with several caveats as time has passed:

-          RNF announced several months ago that it has hired Morgan Stanley to explore strategic alternatives for the fertilizer businesses, which includes selling part or all of RNF’s business.  Certainly, buyers are going to be more interested in the E. Dubuque facility, while the Pasadena assets are going to be harder to value and sell given ongoing operational difficulties.  In my view, it is likely that the assets will be sold together or not at all, as selling Pasadena on a standalone basis may prove to be a difficult task.

-          Former CEO Hunt Ramsbottom has been given the boot, and he has been replaced by a real MLP operator, Keith Forman.

-          New management believes that the new right-sized Pasadena facility will generate positive EBITDA in 2015 (we are keeping our fingers crossed).  The operational issues plaguing E. Dubuque in 2013-2014 are now seemingly under control.

-          According to management, the spring fertilizer application season seems to be going well.

-          So far this year, natural gas prices are down 13% YTD (major positive for RNF investors), corn prices are down -5% (negative), and Brent is up 2% (slight positive).

I continue to believe that RNF is undervalued on a stand-alone basis and should be valued somewhere in the mid-$20s using an 8% distribution yield on normalized mid-cycle earnings.

Fulghum Fibres

Following its decision to exit its money-losing alternative energy businesses, RTK shifted its focus to acquire energy assets that (theoretically) “provide mid-teens unlevered after-tax returns with stable revenues.”  In May 2013, RTK made the announcement that it planned to acquire Georgia-based Fulghum Fibres for $112 million.  With nearly 25 years of operating history, Fulghum Fibres had a stable and diversified industrial customer base in the United States, South America, and Japan.  The management team at Fulghum Fibres has on average 30 years of experience and remains in place post-acquisition.

With 32 wood chipping mills (26 in the United States and 6 in South America), Fulghum Fibres accounts for ~70% of the domestic contract wood chipping business.  It operates under long-term fee per ton contracts with large paper companies (e.g., Weyerhaeuser, International Paper, and Rock-Tenn).  Business retention is very high (circa 95%) and 60-70% of expected EBITDA has already been contracted through 2017.  The cash flows are theoretically very stable, and the revenue model is rather simple -- based on per ton processing fee with minimum volume requirements.  The customer bears supply and off-take risk.  The end products that use wood chips are liner, fibre, box & container boards, tissue, dissolving pulp, and paper.

The price paid for this acquisition was not high (5.6x EBITDA).  This business provides a reasonably stable operating and financial platform from which RTK plans to launch into the wood pellet industry.   Should RTK be able to drop Fulghum Fibres into another MLP, the market would likely ascribe a 10-12x EBITDA multiple to it, even though it is a slow-growth business (2-4% annual growth).  That being said, the previous management team has been on record saying that, post-acquisition, they believe that there are good growth opportunities for chipping in both North and South America.

In North America, roughly 94% of wood chipping is performed in-house rather than contract.  The demand for wood chips is growing for packaging and other applications, and the growth in wood pellet market should also expand the wood chipping market.  Future growth in wood chipping can be achieved by taking share from in-house facilities by providing wood yard management services to existing customers, establishing chip mills in countries with low-cost feedstock, and/or acquiring mills currently operated by their customers.  Additionally, the Company has plans to co-locate future pellet mills at chipping mills.

Wood Pellets

A form of fuel, wood pellets are generally made from compacted sawdust or other waste products from sawmilling and other wood products manufacturing.  Pellets are produced in multiple types and grades as fuels for electric power plants, homes, and other applications.  Pellets are extremely dense and can be produced with a low moisture content that allows them to be burned with a very high combustion efficiency.  Emissions such as nitrous oxide and other volatile organic compounds are in general very low in comparison to other forms of combustion heating.  Usage across Europe varies, depending on government regulations, but pellet use is led by the United Kingdom, Denmark, the Netherlands, Sweden, Germany, and Belgium (combined, these six countries use 14 million tons of wood pellets).  Canada is just starting to use this renewable fuel for electric power purposes.

Ontario offers sustainably grown Crown Fibre, a highly desirable fibre due to Ontario’s long-term forest management regime.  Northern Ontario’s mixed hardwood trees possess chemical composition that is beneficial for use as combustion fuel, allowing for production of top-tier quality pellets.  Power generation through the burning of wood pellets is a fast growing industry, with global demand expected to grow at a 15-20% clip over the next decade – particularly so with natural gas prices in Europe indexed on Brent crude benchmarks.

Simultaneous with the Fulghum Fibres acquisition, RTK made the announcement that plans to convert two previously decommissioned Canadian fibre board facilities to wood pellet production in Wawa and Atitokan.  RTK believes that it will become the largest supplier of wood pellets in Eastern Canada for the Canadian and European utility market with annual contracted production of 485,000 tons.  In total, these two facilities can produce up to 1 million tons of wood pellets per year.  RTK continues to build its acquisition pipeline in wood pellets by doing due diligence on additional brownfield development opportunities.

The original combined acquisition and conversion cost for these two mills in Ontario is roughly $70 million.  First pellet delivery was originally scheduled for Q1 2014, and EBITDA generation was supposed to begin in 2014.  Due to cost and schedule overruns, however, this business will not be generating any EBITDA in 2015.  Eventually, these two facilities should theoretically ramp up to $15 million in EBITDA.  Atikokan still in the commissioning process, and is now making and selling pellets.  Wawa is close to the commissioning process (scheduled to start in Q2 2015), will be able to make major deliveries by year-end 2015 (more specific delivery timing will be filed probably in the 2015 Q1 10Q in about a month). 

RTK has already signed long-term contracts to sell and transport more than 4 million metric tons of pellets over the next several years with Drax (English power utility) and Ontario Power Generation (Canadian power utility).  These take-or-pay contracts are indexed for inflation, fuel, and fibre supply costs.  RTK has exclusive priority access to the only large scale pellet handling facility in Eastern Canada.  It has deep water access at the port of Quebec for international deliveries, and it has a long-term rail contract with Canadian National Railway for domestic transportation of product.

New England Wood Pellet (NEWP)

On May 1, 2014, RTK announced that they were purchasing New England Wood Pellets (NEWP), the largest producer of wood pellets for the U.S. heating market with a 15% market share in the U.S. Northeast market. NEWP operates three wood pellet facilities with a combined annual production of 240,000 tons. RTK spent $45.1 million on NEWP (6.1x 2013 EBITDA), plus a potential earn‐out consideration of up to another $5 million.

In the U.S. Northeast, pellet consumption, which has outpaced demand at a pace of 375,000 tons/year, has been growing at a 7% CAGR. Excess demand has been met from pellet imports from other parts of the United States and Canada. Pellet boiler sales are increasing at a very fast pace (75% in 2013), and pellet stoves are growing at an annual pace of 6%. Wood pellets remain the lowest cost source of heating in this part of the United States, and prices are far less volatile than other heating fuels. Low population density and lack of gas pipelines in the Northeast makes traditional natural gas infrastructure uneconomical.

NEWP is a very stable business with significant shelf space to major retailers in the Northeast. The deal was immediately profitable with an expected after‐tax IRR in the mid‐teens. Importantly, the income generated from NEWP is qualify‐able for an MLP.

On February 24, 2015, NEWP purchased Allegheny Pellet Corp, expanding RTK’s presence in the consumer market for wood pellets. NEWP paid $7 million for Allegheny and plans to expand production by 30%. Allegheny is anticipated to generate $10 million in revenue and EBITDA of $1.5 million, once the expansion is complete. The plant is located in an area of strong hardwood harvesting and processing. Customers include big box stores, specialty retailers, and bulk channels.

In an MLP, we think it is likely that the wood pellet businesses would warrant a valuation in the 10-12x EBITDA range.

Valuation

Here’s is my sum-of-the-parts valuation on RTK:

It should be noted that this valuation gives zero credit to the business for any growth in it in the years to come.  It also gives little credit to any increase in valuation multiples as a result of RTK dropping the wood products business into an MLP with stable cash flows and a high dividend.  A $2 valuation may seems inexpensive in the future, once these wood pellet facilities are up and running. 

Also, my valuation implies full dilution from the GSO convert, but that does not impact valuation because the strike is north of my implied valuation.  Accordingly, there is likely to be significantly more upside than the implied $2.04/share.

Risks

-          Execution

-          Capital misallocation.

-          The balance sheet has a fair amount of leverage.

-          Investor thirst for MLP income wanes as interest rates increase.

-          Regulatory/environmental.

-          RNF is sold at an unreasonable price.

Disclosure

I do not hold a position of employment, directorship, or consultancy with the issuer.  I and/or others I advise do hold an investment in the issuer’s securities.

Catalyst

RNF is sold at a reasonable price.

The wood products/wood pellet business is dropped into an MLP.

RTK gets their arms around execution in their wood pellet facilities.

GSO/Blackstone puts more growth capital to work in RTK, given the opportunities involved.