Description

1.5x P/E for a World leader with stable cost+ biz, high FCF generation, 24% ROE

(this post is priced at close 22 November 2012 - full financial model available on request)

Introduction

Rain Commodities is an Indian small cap company, listed on both the National Stock Exchange of India and the Bombay Stock Exchange (ISIN INE855B01025, current share price Indian Rupees (Rs) 36.0, current FX Rs/US$ 55.0, number of shares post ongoing buyback 333m, market cap US$ 218m). Through its fully-owned, US-incorporated subsidiary Rain CII Carbon LLC (www.raincii.com) Rain is the world leading producer of CPC (Calcined Petroleum Coke), a carbon product that is an essential feedstock in aluminium making. About 450kg of pre-baked anode are consumed to produce one tonne of primary aluminium, with no viable alternative technology available. Anodes are typically made of ~85% CPC and ~15% Coal Tar Pitch (CTP). CPC is produced by processing so-called Green Petroleum Coke (GPC), which is a residue of refining premium, "sweet" crude oil. Basically Rain CII purchases GPC from the refineries and transforms it into CPC, which then sells to the anode manufacturers, which are typically the aluminium makers like Alcoa etc (traditionally aluminium makers tend to buy CPC and CTP and produce anodes in-house). Rain CII has 9 calcining plants, 7 located in the US, 1 in India, and 1 in China, with a combined capacity of 2.5 million tonnes (Mt) and annual production of 1.9 - 2.0Mt.

The CPC story

The CPC industry is well tracked by Houston-based Jacobs Consultancy (www.petcokes.com) and by CRU. Jacobs estimates that approximately 24 million tonnes of CPC were consumed in 2011, of which over 40% in China and ~85% taken up by the aluminium industry (apart from anode/aluminium, CPC is also used in the graphite electrode, steel, titanium dioxide and other carbon consuming industries). Jacobs estimates rated calcining capacity at y/e 2011 to be ~28Mt worldwide, so the industry runs at ~85% utilization. If one strips out China (which is basically self-sufficient and exports relatively modest quantities of CPC) and the "integrated downstream" calciners (i.e. calciners that are integrated within aluminium smelting plants, ~1/4 of total, which tend to concentrate in the world ex-China), based on Jacob's estimates Rain's addressable market as of 2011 is worth some 9Mt. This is the amount of CPC that is actually traded in the world ex-China. After a bout of industry consolidation, since 2007 Rain and Oxbow (www.oxbow.com, a US private company owned by billionaire investor William Koch) have emerged as the two dominant CPC players, with a rated capacity of 2.4-2.5Mt each, current output in the region of ~2Mt each, and combined sales of over 4.5Mt. Other large CPC producers are BP (http://www.bp.com/extendedsectiongenericarticle.do?categoryId=9037957&contentId=7069734) and Phillips66 (http://www.phillips66.com/EN/about/our-businesses/refining-marketing/refining/Pages/index.aspx), which are "integrated upstream" calciners (i.e. calciners that are integrated in refineries) each controlling over 1Mt capacity. Thus the top four players - Rain, Oxbow, BP, and Phillips66 - effectively control some 3/4 of the addressable CPC market ex-China. The rest of the industry is fragmented among several smaller players. Rain is the only significant CPC producer publicly listed on any stock exchange, the only other listed being Goa Carbon (again in India, market cap only US$ 15m, www.goacarbon.com).

Rain sits at the bottom of the calcining industry cost curve. Due to its competitive advantages (proximity to and long-term relationships with the refineries, waste heat recovery facilities, and - most important of all - scale and global network), Rain enjoys a cost advantage of >$50/t vis-à-vis the marginal players, which are basically merchant mono-plant calciners located primarily in China and India (like Goa Carbon) or integrated upstream mono-plant calciners like Bahrain-based Alba (the only smelter recently constructed with captive calcining facilities). With calcining capital replacement costs ranging $300-$1,000/t (depending on technology and location), plus $100-$200/t working capital (30%-40% of revenues on CPC prices ranging $350 to $500, depending on market conditions), and cost of debt in India and China (where many marginal CPC producers are located) for SMEs typically double-digit, the marginal calciner needs to earn at the least ~$50/t margin to be long-term viable. Add to that Rain's >$50/t cost advantage, and one derives a sustainable long-term margin for Rain of ~$100/t. The proof is in the pudding: since establishing itself as a global player in late-2007 with the LBO of US company CII Carbon, Rain has enjoyed a remarkably stable business in its calcining operations. Over the 5-year period 2008 - 2012 (calendar, all actual numbers, only Q4 2012 our forecasts) Rain CII generated average revenues of $776 millions (range $590m - $1,022m), average EBITDA of $190m (range $144m - $242m), average EBITDA margin of 24% (range 22% - 28%), and average EBITDA per ton of CPC of $97 (range $77 - $124). In fact, the odd quarter is always possible, because GPC is priced on 3-month contracts, while CPC is priced on 6-month contracts, so there may be a quarter when GPC prices shoot up and CPC prices are unable to catch up for up to three months, or there may just be one-off events (like Hurricane Isaac that disrupted GPC and CPC shipments over the Mississippi River in Q3 this year, hurting volumes and thus margins in the quarter). However, on a 12-month basis Rain has proven to be able to essentially run a cost+ business, which looks even more remarkable if one considers that such stability was obtained despite a relatively grim global macro-economic backdrop and severe distress in the downstream aluminium industry, with LME aluminium prices averaging only $2,200/t over the 5-year period 2008 - 2012, a level where roughly 1/3 of the aluminium industry is estimated to be loss-making.

Corporate structure and management

All of Rain's CPC assets are held under the fully owned US subsidiary Rain CII (based in Kingwood, Texas). Rain CII also holds virtually all of the company's cash and debt. The India-based (based in Hyderabad, the capital of the southern India state of Andhra Pradesh) and India-listed holding company Rain Commodities is virtually debt and cash free. Apart from its 100% shareholding in Rain CII, Rain Commodities also holds 100% of Rain Cements Limited, an Indian company where Rain's (legacy, ancillary) Indian cement business is held: two relatively new cement plants in Andhra Pradesh with a combined capacity of 3.5Mt, operating in Andhra under the brand of Priya Cement. About 50% of Rain's shares belong to the controlling Reddy family, the balance is free float. Second-generation Jagan Reddy (45) is in charge of the core CPC business, along with US-national and CPC industry veteran Gerard Sweeney (50), CEO of Rain CII.  Reddy is a very common surname in Hyderabad. Rain's Reddys though have no relationship with the flamboyant Reddy political family that used to rule Andhra Pradesh for so long. Rain's Reddys are very low profile hard working industrialists. Jagan virtually never attends socialite events as typical of Indian tycoons, he spends most of his time in the US (where he got his engineering degree), and when he's in India he's often seen driving his own car (very atypical for Indian tycoons), a modest old Maruti Zen.

The Rutgers acquisition

Last October Rain CII announced the acquisition of Belgium-headquartered (but German-rooted) company Rutgers from PE fund Triton for €702m, or~$900m  (www.raincii.com/news). Rutgers (www.ruetgers-group.com/en) is the world second largest producer of coal tar pitch (CTP) after Koppers (listed in the US, ticker KOP). As mentioned earlier, CTP and CPC are the two building blocks of aluminium anodes. By combining the two, Rain will be the only global merchant calciner able to provide one-stop-shop solutions to its aluminium making customers, greatly enhancing its bargaining power and its ability to customize the optimal "blend" of the product for each smelter. Such "blending" skills are becoming more and more crucial, as for both CPC and CTP demand is bound to secularly outstrip supply, with the gap being filled by "non-traditional" material (i.e. lower quality, which traditionally would have been burned as fuel) getting blended with traditional material (i.e. high quality, anode-grade). This for the strategic rationale of the acquisition. As far as the economics are concerned, Rutgers generates ~$1.1bn revenues, with EBITDA margin in the region of ~12%, which puts the acquisition on ~7x EV/EBITDA. The acquisition will be entirely self-funded, with €169m cash and €533m straight bond to be issued in early '13 and expected to yield 7%-8%, in line with the current YTM of Rain's existing $400m 2018 bond (ISIN: US75079RAA68). Citigroup advised Rain CII on the Rutgers transaction, so likely Citigroup will also take care of the placement of the new €533m bond. We expect the acquisition to be 30% to 40% EPS accretive for Rain. Leverage is set to increase significantly, with consolidated net debt/EBITDA set to increase from ~1.8x as of Dec '12 to ~3.4x as of Dec '13. Whilst this is quite high, it doesn't look alarming in light of the cost+ characteristics of Rain's core CPC business, which Rutgers seems to share. Rutgers' margins have historically remained very stable, allowing Rutgers to sustain a highly successful LBO amid a very tough macroeconomic environment (Triton acquired Rutgers in 2007, in 2007-12 Rutgers' EBITDA margin ranged 8% - 12% and EBITDA increased >50% from ~€65m to ~€100m). In fact, S&P  decided not to downgrade Rain CII existing $400m bond further to the acquisition (http://www.reuters.com/article/2012/10/24/idUSWLA517320121024), taking the view that the higher leverage will be somewhat offset by the increased scale/bargaining power, as well as by the wider geographical and product diversification that the acquisition will bring. Thanks to the consistent FCF generation of the business, Rain Commodities CFO publicly announced on Indian TV that the company expects to bring down Rain Commodities consolidated net debt/EBITDA ratio below 3x within the next 2 years, i.e. by the end of 2014. In its rare public guidance the company has always been highly conservative.

The company has been here before. Rain has grown to its current leading status within the CPC industry through highly successful M&A. Rain acquired US company CII Carbon (later merged with its own Indian calcining operations, resulting in Rain CII) back in late 2007 for US$ 595m, virtually entirely debt-funded. In 5 years, on a consolidated basis (Rain CII + Indian cement operations) the company managed to reduce net debt from US$ 725m as of Dec '07 to less than $400m as of Dec '12 (~$400m as of Sep '12), i.e. ~$330m net debt reduction, with net gearing falling from 8.5x to 0.8x. If one adds to the ~$330m net debt reduction the dividend payments ($6-7m a year), share buybacks (2 carried out over the period costing ~$7m each), and interest expenses (>$40m a year on average over the period), one derives a cumulative free cash flow generation over the 5-year period of approximately $600m, i.e. on average ~$120m per annum.

Financials and valuation

On a consolidated basis we expect Rain to generate some Rs 18 EPS in calendar 2012 (>Rs 13 already generated in the first nine months: http://www.bseindia.com/xml-data/corpfiling/AttachHis/Rain_Commodities_Ltd1_021112_Rst.pdf). At the current Rs/US$ exchange rate of 55, we expect the consolidated EPS to increase to ~Rs 24 in calendar 2013, on the back of the strongly EPS-accretive Rutgers acquisition and rupee depreciation (all CPC and CTP profits are in hard currency). As Rain's current share price is Rs 36, on our forecasts the stock is sitting on a 2013 P/E of only 1.5x. Looking from an EV standpoint: Rain's current market cap is ~US$ 220m, net debt as of Sep '13 stood at ~US$ 400m. The acquisition of Rutgers will add ~$900m to net debt, bringing it to ~$1.3bn, so EV is now ~$1.5bn (virtually no minorities, pension or any other hidden liability). Rain CII generates over the cycle ~$100/t EBITDA on annual CPC production of 1.9Mt - 2.0Mt (so ~$190m out of its CPC operations), plus some tiny profits in its ancillary fuel-grade petcoke trading business ($5 to $10 per ton x 800kt tons per annum). To this one should add further ~$130m EBITDA from Rutgers. Hence post Rutgers acquisition Rain CII should generate >$320m EBITDA. The Indian cement operations typically generate an EBITDA of $10 to $20 per ton on annual production of ~2.5 million tons, so say $30m to $50m per annum. All in, on a consolidated basis post Rutgers acquisition Rain Commodities' consolidated EBITDA should be in the region of $350m, and net income on our estimates in the region of $150m. $1.5bn / $350m = ~4.3x EV/EBITDA, with EV calculated on current net debt (under conservative FCF generation assumptions net debt should fall to ~$1.2bn by y/e 2013). US-listed carbon peers (Koppers, Graftech) trade on 9x-10x P/E and ~6x EV/EBITDA, let alone German-listed SGL Carbon that is on ~25x P/E due to its superior growth profile. Put Rain on 6x EV/EBITDA and get an equity value of $350m x 6 - $1.3bn = ~$800m, vs. current market cap of $220m. Even at $800m market cap the stock would be trading on just a little over 5x P/E. In fact, EV valuation peer comparisons are penalizing for Rain due to its low depreciation charge, reflecting high capital efficiency, and due to its high (yet cheap and sustainable) leverage. Even 5x P/E (let alone 1.5x) would look cheap in light of the company's impressive track-record, stable cost+ business model, strong free cash flow generation and high returns (ROE in 2008-12 averaged 25%, range 20% - 27%).

Catalyst

Why the stock is so cheap and why future equity returns are likely to be outstanding

To remove immediately one natural scepticism that might arise, Rain's stock is not cheap because it has ever been involved (or even rumoured to be involved) in any accounting fraud. Emerging markets fraud  companies typically raise equity money from investors and then loot it; Rain never raised a penny of equity, in fact it's buying it back. Both Rain Commodities and its key subsidiary Rain CII are audited by Deloitte. Apart from the cement business which should contribute less than 10% to the consolidated 2013 EBITDA, all assets are held by the subsidiary Rain CII, which is incorporated in the US and is well under the rating agencies' and SEC spotlight due to its $400m 2018 bond, a scrutiny that is set to increase once the new €533m bond will be issued. Rain CII management regularly attends high-yield conferences organized by the major investment banks (next they will be presenting at JP Morgan's high-yield conference in Miami on 25-27 Feb 2013). In other words, the company is subject to a degree of scrutiny that eludes most other India-listed companies. Effectively Rain is more a US company than an Indian company. Neither the company nor its controlling shareholders have any track record of abusing minority shareholders. Although dividend payments have always been modest (single-digit payouts), this reflects the fact that since the CII buyout the company has always been leveraged and in expansion (and debt-repayment) mode, which will continue to be the case. However if one adds buybacks (two carried out over the past year, each worth ~3% of the outstanding shares, of which one still ongoing), total cash return to shareholders topped ~10% over the past 12 months.

Rain has released only very scant information about the Rutgers acquisition, as the transaction still hasn't closed (closing expected by end 2012 - early 2013). Admittedly though, investor relations activity at the company is almost absent. The CFO does normally meet investors on request, however no public analyst/investor presentation has ever been held.  Management is entirely focussed on growing the business, which of course in the "media society" doesn't pay off. To be fair, the company had made an effort in the past of improving investor relations, holding every quarter from 2008 throughout mid-2011 open investor results calls, always attended by the senior management (including Mr Sweeney and Jagan Reddy), which used to be very informative and typically lasted well over an hour. And yet even that effort didn't yield any noticeable impact on the stock rating. It's basically a case of mutual distrust between the company and the Indian equity market, which the Rutgers acquisition has only exacerbated, with the stock correcting over 20% in the month since the announcement of the acquisition. Indian investors scratch their heads on how a $200m+ market cap company can execute a $900m acquisition without raising any equity, and fear it may go bankrupt. They harboured exactly the same fears when Rain acquired CII 5 years ago.  Frankly they should scratch their heads on how come a global leader with such an impressive track record could be trading on such low multiples. It's not that the balance sheet is being overly stretched, it's the equity that is severely underpriced.

In our view, Rain's stock has traditionally traded on low multiples primarily due to the fact that it operates in a niche industry that Indian investors are not familiar with, where independent reliable information can indeed be found (both Jacobs and CRU track the CPC industry well) however is out of the reach of most if not all Indian investors, both retail and institutional. India is still a highly inefficient equity market, trading-driven and research-light, where inefficiencies can get out of proportion both ways. Thousands of small caps are listed in India, and ultra-cheap stocks sometimes can be found, along with plenty of super-expensive stocks with hardly any business substance behind them, and lots of fraud companies. Of course ultra-cheap stocks don't remain cheap forever. Traditionally, when the business is niche and inherently hard to understand (that is, requiring some research) as in the case of Rain, it's been FIIs (foreign institutional investors) that discover them and trigger the re-rating. Unfortunately, due to the hecatomb of small cap/illiquid funds and prop desks since 2008,  bottom-up FIIs have largely deserted the Indian small cap space, those left focussing more on betting on the Indian macro growth story, in which Rain has very little stake.  However, if we are entering a bullish 2013 with no major mid-summer hiccup as in the past 3 years, looking for the gem in the rough even in relatively exotic locations like India should come back into fashion, prompting a gradual re-rating in Rain's stock. We believe the stock has the ability of delivering equity returns in excess of 50% per annum over the next several years, even in the absence of any re-rating to its lowish ~4x EV/EBITDA, purely on the back of free cash flow generation and gradual de-leveraging (the company targets to bring down net debt/EBITDA by ~0.5x per annum, and P/EBITDA is now only 0.6x on 2013e). This is what had happened this year prior to the Rutgers transaction, when the stock significantly outperformed most other commodity/industrial stocks (up ~50% on the year prior to the Rutgers announcement), purely as the cash was piling up on the balance sheet by virtue of FCF generation.