Finding Value At Starboard Value Target LSB Industries
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I love companies that are undervalued on a sum-of-the-parts basis. I absolutely gobble up investment cases that I come across that talk about companies' SOTP valuations (this acronym seems to be much more widely used abroad than it is here in the U.S. for some reason). The problem with investing in companies just because they are undervalued like this that they can often stay like this for a long time. That's why I look for undervalued companies that have some sort of catalyst that will help to unlock that hidden value. The entrance of a successful activist investor into the picture can be one such catalyst. That's exactly what's happening with a company that I invested in back in January called LSB Industries $LXU.
Sometimes the best companies to invest in are ones that you are already familiar with. I actually originally invested in LSB Industries in early 2014, but I subsequently sold after becoming frustrated with the inherent nepotism at the company. Its management seemed as though it was more interested in protecting their fiefdom and their relatives' jobs than creating shareholder value. Once Starboard value got involved and started knocking some heads, I revisited the stock and loved what I saw.
I reopened my position in early January 2015. Since that time it has outperformed the S&P 500 +27.09% to +6.07%...and I expect that outperformance to grow significantly over the next several years.
LSB is a mini-conglomerate that has two main yet completely unrelated business segments, chemicals (mainly fertilizer) and climate control. The thesis here is that Starboard will unlock value by convincing LSB to split up its two divisions, which currently trade at a discount to independent peers. Additional value could be unlocked by the conversion of the fertilizer assets into a more tax-efficient MLP, which yield-hungry investors often pay high multiples for.
A Mini-Conglomerate With Huge Upside. Activists have been agitating for a breakup of the small conglomerate, which makes fertilizers.
In addition to my original reasons for buying he stock that I mentioned earlier, the column talks about the plant expansion that LSB's chemical division is undertaking and how it should help it to significantly improve its results going forward. The article also provides more of a timeline for when a breakup of the company could potentially happen, looking at its debt maturities.
At the time the article came out, an analyst from Avondale Partners who is in it said that he sees 60% to 100% upside in the stock if some of the initiatives hat I mentioned are taken. Even if they take a year or two to unfold, he sees 15% upside in LSB over the next year as a result of operational improvements.
Flash forward to today and I came across another, even better write-up on LSB Industries, this one in the always excellent quarterly letter to investors from Horizon Kinetics. Here's what they had to say about the company, which is one of their holdings:
"Now here is a company, temporarily referred to as Company X, held in the Horizon Core Value strategy. Over the past 5 years and 7 years, or since year-end 2007 and 2009, which straddle the 2008/2009 financial crisis, its book value per share has increased at about a 23% annual rate. This may be compared with S&P 50-type companies like Disney, Johnson & Johnson, Wal-Mart and General Electric, which grew book value more at a 3% to 7% rate. Only Wal-Mart, with 50% inside ownership, and Company X, with 17%, have any meaningful inside ownership. Company X is owner-operated, which is another attribute associated with higher than average returns over time. The P/E ratio for Company X is also about twice as high, at 40x consensus estimates of this year’s earnings, as the other companies. A high valuation, of course, is not associated with excess future returns.
For those passingly familiar with the holdings in Core Value, one might think that this is Google. However, if a Disney or Wal-Mart rate 30 or more Wall Street analyst earnings estimates, ergo Company X, with only 4 estimates, cannot possibly be Google. Google has 37. Company X, clearly, is not much followed on Wall Street. Google is a significant holding in 30 ETFs; Disney is a significant holding in 31. Company X is a significant holding in none.
So why is it held in Core Value? Company X is LSB Industries. It has a $925 million market value, and was founded in 1968 by Jack Golsen, who was the company’s Chairman and CEO until Jan 2015, when those posts were assumed by his son Barry Golsen; Jack Golsen is now Executive Chairman. Barry Golsen is 64 and has worked in increasingly senior capacities at LSB Industries since 1978. LSB Industries operates two sets of businesses. It has a chemicals business, the primary output of which is nitrogen based chemicals such as ammonium nitrate, nitric acid and ammonia. These are sold predominantly to agricultural users for fertilizer, to a broad range of industrial clients as ingredients for other processes, and to mining companies. It also has a climate control business. This segment manufactures geothermal heat pumps, which are used for efficient, ‘green’ heating and cooling for both residential and commercial buildings, and hydronic fan coils and specialty HVAC products for large commercial structures such as office buildings and hotels. About 60% of sales and 70% or more of operating income in recent years have come from the chemicals business.
In 2013, after a history of operating with very limited debt (between about $70 and $120 million during the prior decade), the company borrowed almost $400 million, primarily through the sale of senior notes due in 2019. The purpose was to fund both an upgrade of its chemical plants and to expand their capacity. The most significant project is an expansion of the company’s El Dorado Ammonia Plant. There are two dimensions to this project. The first is that capacity at that plant will increase by 70%. The second is that the company will no longer have to buy ammonia as a feedstock, but will be able to produce it internally. The primary feedstock for ammonia is natural gas which, as is widely known, is now plentiful and cheap in the U.S. Over the past three years, the price spread between the company’s expected cost to manufacture versus purchase ammonia has averaged over $300 per ton. That savings, multiplied by the 220,000 tons of existing capacity at the El Dorado plant, without factoring in the 155,000 tons of increased capacity, would add $66 million of pre-tax income. LSB’s published estimates are for a $90 million increase in operating cash flow (EBITDA) based on normalized production at El Dorado and its associated benefits in the production of other products, like nitric acid. Less a rough estimate for increased depreciation and income tax expense, net income could be $50 million higher. LSB is also engaged in enhancing sales and efficiency at its climate control business and expects to roughly double the income from that segment over the next two years, but that will be ignored for the purpose of this exercise.
The nature of the LSB business is that the revenues are fairly cyclical (down 39% in 2009, for instance, down 10% in 2013), despite a long-term trend upwards, but the company has been profitable each year for well longer than the past decade. The low in net income since 2004 was $19 million in 2014, despite higher revenues and higher gross profit. The decline was attributable mainly to higher administrative costs and interest expense, which is coincident with the major capital projects now under way. The high in net income was $84 million in 2011, and it was $55 million in 2013. The average earnings for the past 10 years is $37 million. If that is considered base earnings and if the company will earn an additional $50 million from the chemical expansion projects, then normalized earnings would be $87 million, and relative to its market capitalization of $925 million, the company trades at only 10.6x
At the moment, those earnings are not visible. However, the expansion and upgrade projects will begin concluding in the last quarter of this year. The first increase in production should start in the first quarter of 2016, which means that increased earnings should begin to appear in financial statements around mid-2016. The full benefit, then, will not be visible for a year and longer. It is typical in the marketplace that positive events that will occur beyond the standard institutional time frame are largely ignored, a practice that translates into a higher discount rate/lower share price, which is available to the patient – the equity yield curve in action.
Moreover, there is a form of pending catalyst. In March of this year, Starboard Value LP, which had acquired 7.6% of LSB Industry shares, published an open letter of the scathing type that such activists tend to compose to the LSB Board. The letter was a detailed critique of the company’s operational performance and oversight, and suggested a variety of ways in which profitability and the valuation multiple could be improved. One of the suggestions was a separation or spin-off of the climate control business from the chemicals business, including an observation about the much higher profit margins of a competitor climate control business and relatively high valuation multiple at which that company was acquired. Another was for the creation of a master limited partnership (MLP) for the chemicals business, a structure that has become popular in recent years because of the high dividend stream that
can be created, high dividends, of course, being in great demand. Spin-offs may also be considered a predictive attribute, since such restructurings have been demonstrated to be associated with superior long-term investment returns.
The following month, in April, LSB announced an agreement with Starboard to elect 5 new Starboard nominated directors to its Board, alongside two resignations and, indeed, to seek both to separate the two business divisions and establish an MLP structure for the chemicals business following the completion of the El Dorado facility expansion. Should this come to pass, it is far more likely that each of the two businesses will trade at higher valuations than the current valuation multiple of LSB Industries. Should it not come to pass, there is little reason to suspect that the shares will trade at a lower valuation.
As to the double digit annualized per-share historical increase in book value, there was little subtlety involved; it essentially reflects the accumulation of annual income, so as to future return, one might reasonably expect a reasonable rate of profit growth. As well, at some point, the P/E ratio will no longer be 40, nor will it stay at 10. Even in the absence of a restructuring, it will normalize eventually. Excluding the 40x figure for 2014, in the preceding 7 years the average P/E ratio was about 15x. A 15x P/E multiple, if that’s reasonable, on the earnings calculated above would produce about a 50% increase in price. Accordingly, LSB possesses a number of positive predictive attributes and appears to manifest an asymmetrically favorable risk/reward profile, which is to say that the downside risk seems rather modest while the opportunity for a double-digit annualized return appears quite plausible.
Irrespective of the ultimate fate of LSB Industries, securities like this, with idiosyncratic reasons for their earnings growth and positive valuation multiple changes, are more likely to be able to deliver the required 10% stock returns than those for which their earnings growth and valuations are more closely a function of common systematic variables like ETF fund flows."
Now not everything with LSB Industries is rainbows and unicorns, it just announced cost overruns in its chemical plant expansion...LSB Industries, Inc. Updates Status of El Dorado Facility Expansion.
Also, there's way, way too much nepotism at the company for my taste. However, there's a lot more to like than not. I am strongly considering adding to my position in the company in the future. I'd love to hear others' thoughts on $LXU or any other special situation investing ideas that you have. Please share them in the comments section below.
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