Description

TPC Group (TPCG)

TPCG is a good example of a business that is a significant beneficiary of the massive shale gas discoveries in the US. To understand TPCG and its business, it is helpful to think about the uses of oil and natural gas beyond fueling our cars and powering our homes. About 20% of oil and gas volumes are used to make plastics and synthetic rubber. The plastic production process begins by heating either naphtha from crude oil or natural gas liquids (like ethane) in a "cracking process." These larger molecules break down into smaller ones such as ethylene, propylene and butane (“C4”). The resulting products are then used as the starting materials for several types of plastics and synthetic rubber.

By volume, the “cracking process” yields significantly more ethylene than the smaller derivatives like C4. As a result, most of the economic value of cracking is derived from the sale of ethylene as opposed to C4. Consequently, the supply of crude C4 is tied to the production of ethylene and not to demand for C4.  This is important to TPCG because it purchases crude C4 for further refinement in order to resale derivatives like butadiene to its customers.  Customers like Goodyear Tire and Firestone then use butadiene to make synthetic rubber for tires.  

Historically, US refiners are somewhat unique in that they are able to flex up to about 70% of their capacity between natural gas (light cracking) and oil (heavy cracking) feed stocks.  This is particularly important since the abundance of shale gas has driven down the price of ethane relative to naphtha.   As a result, the cash cost of ethylene in the US is around $800 per metric ton vs. around $1,100 in the rest of the world.   This is important to TPCG because when refiners crack a light feed stock like ethane the C4/BD ratio can be as low as 1/40 vs. 1/5 for feed stocks like naphtha.   Consequently, the supply of crude C4s in the United States is about 20% lower than it was about five years ago.  These tight supply conditions led to Butadiene prices rising from around $.50 a pound to around $1.80 in the summer of 2011 before falling back below $1 and rising again close to its previous level.  Currently, the BD price is at about $1.47 per pound. 

TPCG acts as a refiner and distributor of butadiene by taking C4 from refiners and then breaking C4 down further into other products like butadiene which they then distribute to their customers. TPCG is a market leader with 35% of the overall North American C4 processing capacity and approximately 65% of market share for non-integrated C4 processing.  The logistical network associated TPCG's distribution of butadiene is extensive and it would be extremely difficult for TPCG's customers to reproduce.  TPCG has about 264 miles of product and feedstock pipelines which gives them the ability to connect to many of their customers and suppliers facilities, docks and product terminals.  

TPCG receives fixed margins on indexed based contracts with its customers. The supply constraint in the United States has led to considerably more market power for TPCG as they are able to leverage their position as a bottleneck in a tight market.  As a result, TPCG is in a position where it can raise the fees it charges to refine and distribute C4 derivatives.

In late 2010 and early 2011, TPCG’s GAAP earnings benefited significantly by ever higher butadiene prices Since TPCG uses FIFO (first-in-first-out) accounting.  In a market of rising prices, TPCG gets the benefit of price appreciation that occurs from the time they purchase their oldest inventory to the time that they sell that inventory.  This effect inflated TPCG’s EBITDA in the first nine months of 2011 by $50 million as butadiene prices rose violently. As a result, the stock increased from $20-25/share to $40/share.   When butadiene prices fell late in the 3^rd quarter and throughout the 4^th quarter of 2011, it caused TPCG’s profits to suffer by approximately $30 million dollars as TPCG was forced to sell higher priced inventory at lower prices. The stock has risen significantly since the beginning of the year as investors as investors bid up the stock in anticipation of improving FIFO stimulated earnings.    

Valuation

If we back out the GAAP benefits that TPCG received as a result of the FIFO tailwind, then TPCG should earn around $140 million in EBITDA per year.  TPCG requires about $25 million of maintenance capital annually but its depreciation is about $40 million.   As a result the true economic earnings of the business in conditions of flat feed stock prices are typically understated by about $15 million dollars. 

TPCG –Base Business Valuation

Market Capitalization:               $ 639 MM

Enterprise Value:                      $ 887 MM

Pre-tax Cashflow:                     $ 115 MM (EBITDA-Maintenance Cap-ex)

After-tax Cashflow                   $ 53 MM (Net Income + Depreciation – Maintenance Cap-ex)

EV/Pre-tax CF:                         7.7 X

Market Cap to After-tax CF:    12.0 X

On an after tax basis, assuming no other improvement in the fees that TPCG collects from its customers TPCG should trade at around its current price of about 41.00 based on a 12X multiple of after-tax cash flow.  However, about two-thirds of TPCG’s contracted butadiene contracts are coming up for renewal in the second half of this year.  Currently, the average customer pays TPCG between $.05 to $.06 per pound of processed butadiene.  Of total C4 volumes processed butadiene represents about 47% of volumes.   Of those volumes, about 90% are under 2 to 3 year contracts with customers.  According to management about 5% of those contracts came up for renewal in late 2011 and 60% will come up in late 2012.   Based on our conversations with management and our contacts with industry participants we believe that TPCG will be able to negotiate a $.02 to $.04 cent fee increase which should lead to about a $4.5 million dollar increase in after tax profits for each penny increase.  If we assume that TPCG gets a $.03 increase in fees that should translate into about $13.5 million in incremental after-tax profits and an extra $10 worth of share value which would make TPCG a $51.00 stock based on a 12X after tax multiple.

Dehydro-Assets

TPCG also has two idled dehydrogenation units at its Houston plant that are capable of producing on-sight Butadiene and Isobutylene. Having these idled units would save them several hundred million dollars in construction costs by re-constructing them rather than building from scratch.

On-Purpose Isobutylene Unit

The first project is to make isobutylene which is a critical feedstock for performance products.  Currently, TPCG has to outsource the majority of its requirements for this critical input for its performance fuels business which represents 25% of its volumes and about 25% of its gross profits.  TPCG estimates that they will spend approximately $150 million on this project and that they will receive an internal after-tax rate of return of 18-24%.  TPCG has already conducted its primary engineering study and has received an operating permit from the EPA.   This project is due to be completed in the first quarter of 2014.   We believe that this project should add an incremental $30 to $35 million dollars of after tax profits.  These cash flows minus the up-front costs work out to have a net present value of about $130 million dollars or about $8.30 per share.       

On-Purpose Butadiene Unit

The second project is to build an on-purpose dehydro unit that would produce about 600 million extra pounds of butadiene a year.  This would represent a 50% increase in TPCG’s butadiene volumes.  TPCG has not given specific guidance with respect to the IRR to be generated by this project but they have stated that it would be significantly higher that the IRR for the on-purpose isobutylene unit.   We provided our valuation based on assumptions of an after-tax IRR of 23% to 27%.  This project is not due to be completed until the 2^nd half of 2016.  We believe that the project will cost around $300 million dollars and will have a net present value of around $370-$490 million dollars or $24 to $31 a share.

Book value

One fear I always have when an outsized opportunity for profit presents itself is that the opportunity will be pursued by competition.  One way to overcome this fear is to analyze the cost a competitor would have to incur in order to replicate the business.  According to TPCG the cost to replicate its current business would be about $1.9 billion dollars or $120 per share.  On a tangible book basis TPCG is valued at $306 million dollars or about $17 per share.  It is feasible that this tangible book has such a wide gap between it and the replacement value of TPCG’s assets because their plants were built in the late 1940’s.  Many of their assets have already been fully depreciated and at the time of their construction material, construction, environmental and regulatory costs were significantly lower.   

The $1.9 billion dollar replacement figure above does not include the reproduction costs of the dehydro units which we believe would cost several hundred million dollars to reproduce today.  Even with the outsized returns that these units could provide it is not reasonable for a competitor to replicate them because TPCG has such an advantage with respect to much lower required initial capital expenditures.    

Below is a sum of the parts valuation. This doesn’t include the replacement cost for the storage facilities. It also assigns probabilities to the chances that the dehydro plans are opened as planned.

Catalyst

Catalysts

The company should see significant earnings improvements once they have announced the completion of their contract negotiations with their butadiene customers.  Also, the stock has been weak as investors anticipate a few bad quarters in terms of GDDP accounting with weaker earnings stemming from FIFO sales of more expensive inventory as butadiene has weekend a bit over the last month and may weaken further during the summer.  This represents a fundamental misunderstanding that the street has of TPCG’s business because it is merely a toll business.  The gyrations of butadiene prices only really result in sort term GAAP accounting movements. Once the next few bad GAAP quarters have passed, any lid on the value of the stock will be removed when price increases are announced.  Also, the stock may start to benefit as GAAP accounting should show an artificial boost in late 2012 from FIFO accounting as butadiene starts to rise again.  Finally, as the dehydro projects draw nearer the market will start to price in the added earnings benefit that TPCG can achieve by their implementation.