Description

Sherritt International Corp. is modestly valued on an absolute basis, e.g., 4.5x trailing EBITDA, 1x tangible book value, ~1x replacement costs, and trades at a 30% discount to similar companies. The most likely explanation for this discount is that four of Sherritt’s five businesses are located in Cuba. Yet, if we value Sherritt’s coal business (completely domiciled in Canada) like other North American coal companies and Sherritt’s nickel / cobalt business (half in Canada, half in Cuba) like Norilsk, which is completely domiciled in Russia, we account for 95% of the Sherritt’s enterprise value. This means that we are paying less than $100 million for Sherritt’s other businesses, which generate $180 million of EBITDA annually (after absorbing all $40 million Sherritt’s G&A) i.e., we are paying 0.56 x EBITDA for the other businesses. Interestingly, all of Sherritt’s businesses are desirable and are likely to grow earnings in the coming years. The company is modestly leveraged and has considerable holdings of hard assets. Considering these facts, Sherritt represents an outstanding investment.

Sherritt was previously posted to VIC on 12/29/04 by gearl1818 when its shares were trading at C$9; we recommend gearl’s write-up in addition to our analysis below. All figures in this report are in Canadian dollars unless otherwise noted.

Why is Sherritt cheap?

Cuba
Before exploring the key risks when investing in a company that does business in Cuba, consider this: if we value Sherritt’s thermal coal business (100% domiciled in Canada) like similar North American coal business and value Sherritt’s metals business (half in Canada, half in Cuba) using Norilsk’s (a large Russian based nickel producer) current EBITDA multiple, we account for 95% of Sherritt’s enterprise value. For the additional $85 million we get three businesses that will generate $180 million of EBITDA after absorbing $50 million of corporate costs.

Risks when investing in Cuba
There are three risks specific to Sherritt’s investments in Cuba: 1) What happens when Castro dies? 2) the provenance of Sherritt’s Cuban assets; and 3) U.S. sanctions against Cuba.

1) What happens when Castro dies?
The riskiest aspect of Sherritt’s Cuban investments, to our thinking, is Cuba’s lack of a system for transfer of political power. Cuban President Fidel Castro is 79, one of only two people to lead Cuba since 1933. As Cuba does not have much experience with leadership transitions, lacking an institutionalized system for the peaceful transition of power, it is not knowable what will happen upon Castro’s death. And more to our point, how will that event impact Sherritt’s Cuban investments.

This risk is mitigated by the fact that Sherritt is managing complex businesses in Cuba that are critically important to the country’s economic and political stability. For instance, the Moa nickel mine, which Sherritt manages and has indirect ownership interest, was floundering before Sherritt partnered with the Cuban government. During the 33 years prior to Sherritt’s involvement, Moa’s average production was 1.6 million tonnes of ore per year. The mine produced 2.5 million tonnes of ore during 2004, a 56% increase, and is being expanded to reach 4.5 million tonnes annually. What does this mean to Cuba? Until recently, sugar was Cuba’s primary export, but this is no longer the case. In 2003, Cuba exported US$824 million of nickel (its top export) and US$324 million of sugar (its #2 export). Furthermore, Sherritt’s ore refinery operations, located in Alberta, are a critical in the conversion of Cuban ore into finished product. Since the Cuban government has a 50% economic interest in the Canadian refining facilities, one would surmise that a “rational” government would want to continue this arrangement.

A similar situation exists with Sherritt’s other Cuban businesses. For instance, Cuba is chronically short of electricity. A breakdown at Cuba’s largest generating station (not owned by Sherritt) during 2004 caused several months of disrupted service and resulted in the firing of the Minister for Basic Industries. Sherritt’s power business provides 16% of Cuba’s electricity. Given the problems Cuba has operating its other electrical generation plants, it would make little sense to the next Cuban leader to disrupt the arrangement they have with Sherritt.

2) Provenance of Sherritt’s Cuban assets
We initially disqualified an investment in Sherritt because we did not want to pay for something that Sherritt did not own, e.g., at least some of Sherritt’s Cuban assets can be traced back to the pre-Castro days and may have been taken from their rightful owners. After doing further research, this does not appear to be a critical consideration.

First, only $130 million of Sherritt’s assets are at question from a provenance standpoint. The only asset in which Sherritt has an interest that pre-dates Castro is the Moa mine; the remaining Cuban assets are less than 15 years old, consisting of off-shore oil wells, new electrical generation plants, etc. Sherritt’s total metals business has capital assets of $194 million. These assets consist of its interest in the Moa mine as well as the company’s refining assets located in Alberta. Sherritt estimates that 2/3rds of the metal assets are in Cuba, i.e., $130 million, which represents 7% of Sherritt’s enterprise value, and 9% of its capital assets.

Who then rightfully owns the $130 million of Moa assets? The background is as follows: In 1957, Freeport Sulphur (now Freeport-McMoRan) negotiated a deal with the Batista government to build a nickel mine near Moa in exchange for tax concessions. Freeport invested $19 million and raised an additional $100 million from Citibank and a consortium comprised of steel and auto companies. The funds were used to build a nickel refinery in Louisiana ($44 million) to process the laterite (a high iron-content clay mined in Cuban that contains nickel and cobalt) and start the Moa mine ($75 million). Coincidentally, the refinery licensed technology from Sherritt to process the laterite.

In 1959, soon after the mine was commissioned, Castro seized power and proceeded to renege on the tax breaks negotiated between Batista and Freeport. Convinced it had considerable leverage because it had one of the few refineries capable of processing the Cuban ore, Freeport threatened to close the mine if Castro did not honor the Batista tax commitment. Conditions deteriorated between the U.S. and Cuba and negotiations broke off between the countries in August 1960. Castro “intervened” in the mine to keep it operational, though the U.S. claimed he seized it. In April 1961, the U.S. invaded Cuba in what is known as the Bay of Pigs; this ended any hope of an amicable resolution.

Who in fact “owns” the mine and how will this be settled? Cuba claims damages of $88 billion against the United States as a result of 45 years of embargo. The U.S. has a similar claim against Cuba for property seized in the early years of the Castro regime. This type of claim often is settled government-to-government when relations are normalized. Whenever it happens, the eventual reckoning is unlikely to have an impact on Sherritt.


3) U.S. sanctions
The U.S. has maintained an embargo against Cuba since 1961 which bars “U.S. Persons,” including companies and subsidiaries of companies, from participating in transactions with Cuba without a specific license from the U.S. Department of the Treasury. Sherritt states in its filings that “U.S. Persons” may not be permitted to own securities of Sherritt, but goes on to say:

In general written guidance, [the U.S.] Treasury has stated that it permits portfolio investments in non-US firms that have commercial dealings with Cuba, but it bars injecting capital into an enterprise in a manner supporting its Cuban transactions.

We are not in a position to dispense legal advice, but note that Fidelity owns 4.5 million shares of Sherritt; other large U.S.-based mutual funds are also shareholders. Note that according to Bloomberg, several large US based mutual funds, including Fidelity, own Sherritt shares.

Beyond the ambiguity of the U.S. stance toward investing in companies that do business in Cuba, the Helms-Burton Act, passed in 1996, authorizes sanctions on individuals that “traffic” in Cuban property confiscated when Castro seized power. Sherritt’s investment in the Moa mine is deemed to be a form of trafficking under the Helms-Burton act. There are three mitigating factors to this:

1) The Helms-Burton Act specifically exempts publicly-traded securities.
2) Since the passage of the Helms-Burton Act in 1996, both presidents Clinton and Bush have suspended the rights of claimants to sue under the act.
3) Sherritt believes it is unlikely that a court in any country in which Sherritt has material assets would enforce a Helms-Burton Act judgment.

Clearly, the ambiguous nature of U.S. policy regarding investing in companies that do business with Cuba is not enhancing Sherritt’s valuation, but it is not reasonable to conclude that this effect is likely to persist. Consider that Sherritt’s businesses not only produce cash flow, but also produce materials that are needed worldwide, e.g., nickel, cobalt, oil and coal. Several Asian countries have a great deal of foreign reserves to invest, e.g., as of December 2005, China held US$820 billion. Not surprisingly, a Chinese company recently announced a US$600 million investment to develop a nickel mine in Cuba. With so much money to invest, and such a large need for raw materials, one possible outcome is that Sherritt will be purchased by a non-U.S. based company in need of its assets.

Complexity
A second reason Sherritt trades at a discount to its peers may be its complexity. Sherritt is in five businesses: coal mining, nickel and cobalt mining, oil and gas production, electricity generation and a collection of small businesses including soy processing. While none of these businesses is particularly complex to understand individually and Sherritt’s disclosure is reasonably good, gaining an understanding of the drivers of all of the businesses takes some time. From a practical standpoint, it is difficult for sell-side firms to decide which analyst should cover the company. As a result, Sherritt is covered by a few metals analysts and one coal analyst, yet metals will generate 40% of Sherritt’s 2005 EBITDA and coal will account for about 13%.

From Sherritt’s perspective, there is a simple solution to the complexity problem: break up the company. Considering that the company’s chairman holds 2.4 million shares and options to purchase an additional 4.6 million shares, it would not surprise us if Sherritt were to become a bit simpler to understand in the near future, e.g., convert the coal business to a trust and sell the metals business to Asian investors.

Having addressed two possibilities for Sherritt’s modest valuation, next we explain Sherritt’s businesses represent an outstanding investment opportunity.

Sherritt’s Businesses
In addition to being modestly valued, we think Sherritt’s businesses are very good and, in fact, earnings figures probably understate the value of the businesses due to large holdings of assets and the option value of its Cuban oil business and its Canadian coal business. If we define pre-tax cash flow as EBITDA minus maintenance capital expenditures, Sherritt is trading at about 6x 2005 pre-tax cash flow and about 4x 2008 pre-tax cash flow (after completion of capital expansion projects currently underway).


Coal
Sherritt’s Luscar subsidiary is the largest producer of thermal coal (coal burned to generate steam) in Canada. Sherritt owns 50% of Luscar, the balance owned by the Ontario Teachers’ Pension Plan Board. (Unless otherwise noted, all figures in this report reflect Sherritt’s net portion of its subsidiaries).

The company’s mines are located in western Canada. All their coal is surface mined and is low-sulfur (less than 1% sulfur by weight). Sherritt’s coal production is 76% subbitumininous, 3% bituminous and 21% lignite. Sherritt sells 95% of its coal to Canadian companies, primarily under to adjacent electric utility plants under long-term contracts with inflation escalation clauses. There is increasing demand for coal in the markets Sherritt serves driven by Calgary’s growing electricity requirements as well as the oil sands businesses in the region. The company’s average selling price for coal is about C$13 per tonne, i.e., metric ton.

In addition to growing demand for coal in Sherritt’s markets, there are three aspects of Sherritt’s coal business we find attractive:

1) Predictable cash flow
2) Large reserves (45 years proven).
3) Option value: possibility to spin-off its traditional coal business in the form of a trust with a second option on supplying coal to fuel the production of oil from the Canadian tar sands projects.


In addition to stable cash flow, Sherritt’s coal business can generate substantial cash flow. Exploration for coal companies is primarily to identify the geometry of known deposits, not the existence of the deposit. As a result, coal businesses have the potential to generate substantial free cash flow. Luscar’s return on assets was 8% pre-tax during 2004, a representative year; this is quite low but reflects Luscar’s enormous asset base (see below for a discussion of Luscar’s coal holdings). Note that the company generated cash flow (EBITDA less maintenance capital expenditures) of $65 million in 2004 on sales of $250 million. The primary customers for Sherritt’s coal are the electricity generators in Alberta and Saskatchewan, businesses unlikely to renege on contractual obligations. Demand for power in Western Canada is increasing due to the growth of the oil sands businesses, e.g., Calgary is the “Houston” of Canada. In conclusion, Luscar has excellent free cash flow characteristics and they are likely to have more demand for their coal in coming years.

Second, Sherritt’s coal business has large coal reserves. At current mining rates, Sherritt has 45 years of proven and probable coal reserves and 400 years of what it calls undeveloped coal resources. Using Sherritt’s proven and probable coal reserves (the 45 year number) and assuming a value of C$752 million valuation for their coal business, Sherritt coal business trades for about US$ 1 per ton of reserves, making it one of the cheapest coal companies in North America.

As mentioned, Sherritt owns rights to large tracts of coal which are not currently included in reserves, e.g., Sherritt’s inferred coal reserves which total 2.25 billion tons; obviously, to the extent the inferred coal reserves are real, the company is that much more of a bargain valued at C$752 million.

Third, is the option of converting Sherritt’s coal business into an income trust. The coal business has the right characteristics for the trust structure, e.g., predictable cash flow, low capital expenditure requirements. The trust structure is of particular interest because trusts trade at fat multiples. There is value in owning this option, and based upon Sherritt’s current market valuation, one is not asked to pay for it. Interestingly, prior to Sherritt’s acquisition of Luscar, Luscar was a trust. At the time, Luscar had a substantial metallurgical coal business. Metallurgical coal is used to make steel, and as such, is quite cyclical. During the down cycle in the late 1990s, the trust’s dividend was cut and its unit price deteriorated, giving Sherritt the opportunity to buy the business. The metallurgical coal components of the business have been sold, and demand for thermal coal is increasing due to the high costs of competitive fuels, e.g., natural gas and oil. Our conclusion is that Sherritt’s coal business is a business we want to own.

Nickel/Cobalt
Sherritt’s metals business earned a pre-tax return on assets of 31% in 2003 and 56% in 2004. With these returns, the only questions that come to mind (after valuation) is how long can they persist and can we invest more at these rates. It appears these returns are likely to continue and Sherritt is currently expanding its metals operations by 50%. Sherritt’s production costs are about US$2 to 3/lb., depending on the price of cobalt (cobalt is a byproduct from producing nickel from laterite ore). By comparison, Inco, Canada’s largest nickel producer, average US$2.40.

Note that nicke and cobalt prices have risen substantially in recent years and nickel prices have remained consistently above US$2/lb (Sherritt’s cash cost). The explanation for recent nickel and cobalt price increases is becoming a cliché: Chinese demand. In fact, four contries (China, Japan, South Korea and Taiwan) represent about 42% of world nickel demand (the US represents 11% of world demand).

The bull case for nickel is that low prices during the 1990s, partially driven by excess metal (both scrap and primary) from the former Soviet Union led to underinvestment in the industry. Surging Asian demand has absorbed the slack and now the industry is short capacity. Very high nickel prices during 2004 led to a large availability of recycled scrap (stainless steel) and substitution (200 grade stainless steal which does not contain nickel). These factors depressed prices during first three quarters of 2005. Inventories now are low, demand is increasing and end users are finding that 200 grade stainless is not suitable for many applications. Nickel prices therefore are increasing.

A look at the cobalt market shows a similar pattern. Asian demand for cobalt is growing as a percentage of world consumption, currently representing about 45% of demand while North America represents about 17% of demand. On an absolute basis, world cobalt consumption is up 2.7x since 1992.

Nickel is used primarily as an alloy with steel, 2/3rds of nickel consumption to produce stainless steel. Since most of the demand growth for nickel is in China and the largest use of nickel is to make stainless steel, the logical question is what is the stainless steel being used for? One third of nickel is used for industrial applications, another third is used for consumer durables and25% is used by the construction industry.

Industrial uses for nickel consist of equipment for chemical, pharmaceutical, food and beverage plants, oil refining and electricity generating stations. Consumer durables consist of flatware and white goods. Construction consists of plumbing fixtures, elevator and escalator parts and building decoration. These continue to be attractive markets in China specifically, and Asia as a whole. For a second opinion on the outlook for nickel, here is what Inco’s president stated during their earnings release on February 14, 2006:

With strong growth in nickel demand forecast for 2006, and with limited new nickel projects or expansions currently expected to come on stream before at least 2008, we believe that nickel demand should continue to outpace supply in 2006, which will continue to put upward pressure on prices.

World demand for cobalt increased from 20,000 tonnes in 1992 to 54,000 tonnes in 2005. Cobalt is a much smaller market than nickel and is not exchange traded. The primary uses for cobalt are high temperature alloys (turbine engines), catalysts (chemical and oil refining), paint dryers, cemented carbides (machine tools) and rechargeable batteries. The increase in cobalt production in the next three years will be dependent on the continued availability of ore from the Democratic Republic of Congo (DRC), which supplies 30% of world’s cobalt production. Most of China’s cobalt currently comes from minerals mined in the DRC and refined in China.

The bear argument against nickel is that nickel is cyclical and that current excess demand will be met with increased supply. One piece of data which indicates that we may be running up against a demand limit is that China is currently consuming about 4 kilograms of stainless steel per capita annually: almost half of western per capita consumption. On the face of it, there is room to grow, but note that in other commodities e.g., oil, China lags much further behind on a per capita basis.

Two more points we find attractive about Sherritt’s metals business:

1) Cuba has extensive nickel and cobalt deposits. Sherritt’s current concession includes reserves that will last for another eight years and intended to include reserves that will last an additional 25 years. Cuba’s nickel reserve base is second only to Australia and its cobalt base is second only to the DRC.

2) Nickel and cobalt (as well as coal and oil) are hard assets; to the extent we are in an inflationary environment, we want to be invested in companies that have hard assets.

In conclusion, Sherritt’s metals business has generated an attractive rate of return, is reasonably priced (about 5x trailing EBITDA multiple) and has a number of macro economic factors in its favor. This is a business we want to own.

Power
Cuba is chronically short of electricity. A breakdown at Cuba’s largest generating station (not owned by Sherritt) during 2004 caused several months of disrupted service and resulted in the firing of the Minister for Basic Industries. This segment of Sherritt’s business is clearly providing a service that is indispensable to Cuba.

Sherritt’s power business consists of two gas-fired turbine power plants. Sherritt financed the plants and owns a 1/3 interest in conjunction with two Cuban government ministries. The power business’s pretax return on capital is extraordinary, ranging 22-30% for the last few years. The target pretax EBITDA less capital expenditure returns will fall to about 10% once Sherritt has recouped its investment.

In exchange for financing and managing the construction of the power plants, Sherritt is provided with fuel (natural gas) free of charge and charges US$45/MWH until they recoup their investment. After they recoup their investment, they continue to operate the plants and receive gas at no charge, but sell the power at US$38/MWH. We are not aware of any other electric utility that has such favorable economics. Finally, if our analysis is correct about the value of Sherritt’s coal and metals businesses, we get the power business for practically no cost.

Oil & Gas
Sherritt explores, develops and produces oil and gas off of Cuba’s shore. The company’s pretax return on assets (EBITDA less capital expenditures/assets) from this business has ranged from 14-23% for the last few years. We wrote extensively about our view of the oil industry in our STO analysis posted to VIC last year; our conclusion remains that oil assets are likely to appreciate in value in the coming years. The two aspects that we find especially attractive about Sherritt’s oil business are:

1) The price is right: if our analysis of the value of Sherritt’s metals and coal businesses is correct, we get the oil business for free. The company currently has 26.3 million barrels of oil reserves in Cuba; at $10 per barrel, this is worth $263 million.

2) Sherritt is prospecting and developing oil and gas resources in an under-explored area.

This second point is what we find especially interesting. The 45-year U.S. embargo has prevented most oil companies from doing any exploration in or around Cuba. Yet Sherritt states in their 2004 Annual Information form that:

Cuba’s geological basins have the potential for massive accumulations of hydrocarbons ….. The basins have been relatively under-explored in the past.

In a recent presentation, a Sherritt spokesman indicated that there may be as much as 6.2 billion barrels of oil offshore Cuba. While we would not pay for potential oil in the ground, we are not even being asked to pay for the US$263 million of proven oil reserves. This represents a free call option on oil development in Cuba. Finally, Sherritt’s oil development performance in Cuba has been good: their three year average cost of finding and developing reserves was US$5.94 and their reserve replacement ratio was 106%. One may attribute this to luck or simply that they are looking in under-explored territory. Either way, as an investor, their Cuban oil business is essentially free, and free is good.

Catalyst

Catalysts:

1. Spin-off existing coal mining assets into a trust.
2. Win contract to sell coal to one of the tar sands projects.
3. Nickel / cobalt prices don’t collapse (market is pricing these assets as if they are generating peak earnings)
4. Nickel production increased 50% by 2008
5. Electricity production increased 40% by 2007.
6. Significant oil find in Cuba.
7. Castro dies.