Value Investing Ideas

This will just be a brief update. However, the price fall of the stock suggests either an incredible buying opportunity, or incredibly bad recommendation on my part. As always, I don’t invest based on short term (meaning under 3 years) price movements, but on long term value.

At the moment of posting, Innophos is trading at $8.84, for a PE of 1.0. That reflects an extraordinary pessimistic view of the long term earnings of Innophos. Innophos had their year end conference call in Febuary, and the transcript is available on their website here: http://ir.innophos.com/

Let’s look at what they had to say. I’m not going through the full thing; I’ll extract a few telling comments. Let’s start with the previous year’s performance:

“Full-year results can only be described as exceptional.”

“Innophos delivered solid results in the fourth quarter despite a selling environment that became significantly more challenging through the quarter. Net sales for the fourth quarter were up 50% over fourth quarter 2007”

But, of course, we buy stocks based on their future potential, not previous glories. And yes, we can’t expect a repeat of 2008. Here’s what Innophos has to say about that:

“Going forward as result of these pressures, we expect to see downward pressure on selling prices which are currently at historically high levels. In response, we are taking a more aggressive stance to retain our leading market position and keep profitable business going forward.”

“We are benefiting from declining sulfur, energy and transportation costs in comparison to 2008 levels”

There is about a 2 page description of all their business segments, with the market’s effects on costs and sales estimated. I can’t summarize all of that. Needless to say, there is pressure on them. They summarize with:

“In expressing an outlook for Innophos financial performance in 2009, we must consider several issues. We cannot now predict how severe the recession will be, nor the associated impact on industrial and agricultural demand. With the uncertainly around Mexican phosphate rock cost and operating levels, and along with greater competitive intensity, we have to conclude that we cannot offer reliable and specific operating income guidance for the year.

We can give you an idea of first quarter outlook. We expect that first quarter 2009 volumes will be up approximately 15% from fourth quarter 2008 levels. For selling prices, with the usual puts and takes from various customer agreements, we expect to increase prices in some areas, primarily in the US, but this will be offset in our less specialized product areas and should result in overall prices that should remain somewhat similar to those of fourth quarter 2008. Lastly, our cost structure should remain relatively flat as well.
Beyond the first quarter, volume impacts are uncertain and we believe are recession dependent. We do expect to see selling prices trending down, while Mexican cost structure increases also start to kick in mid-second quarter, again, to some extent affected by operating levels.”

Okay, not perfect news, but exactly what we would expect from a stellar company selling staples in a recession. In short, they (like everyone else in the world) have no particular insight into when the recession will end, and they will have to tighten their belts a bit until it is over.

Note that all of the uncertainty here is to the extent of the profitibility during the recession, not whether there will be profit, or whether IPHS will survive. Yet stock prices have plummeted. IPHS is currently selling for 40 cents less than last years EPS! They are being priced as if they are a fertilizer business, and as if fertilizer will never go up again. Hoewever, they are primarily a specialty products business, with margins in the 30%+ range, not the under 10% margin of raw products like fertilizer. They do sell raw materials, and lower end materials, and there they are facing significant competition from the Chinese and such.

I feel like typing more, but the situation is uncertain. We can set and weigh the different components of the business, try to estimate the future of the recession, predict prices for raw materials, predict how changes in China will effect competition, etc. I’d be a fool to think I could do that better than the managment of IPHS, and their position is: “I don’t know”.

So is the price fall justified? Well, they are going to be cash flow positive in 2009, they will continue to pay down debt, they will continue to be profitable. They still sell specialty products required for all kinds of staples. A segment of their business is still highly resistant to competition - food additives. They expect to maintain their margins in their specialty products.

Investors confuse uncertainty with risk. We cannot reliably make 2009 EPS predictions. We cannot clearly see what the competitive landscape will be in 2011 and on. What we can see is a company that has been making specialty chemicals for a very long time, remaining highly competitive, with high margins, with a strong balance sheet, cash flows, and the ability to compete and react to the market (something a debt heavy, poor balance sheet company often can’t do).

I don’t know what 2009 will bring IPHS. Read the transcript for some of the possibilities. What I do know is that this company will continue to make money, will continue to be very competitive, will continue to try to increase market share. Nothing is looming to make us think that IPHS is about to disintegrate - the uncertainty about it’s future is no more uncertain than a JNJ, Berkshire, etc. We don’t know next year’s earnings, but we know in the long term the company will continue to make money, and thrive. A PE of 1.0 gives us a huge margin of safety - far beyond the 50% required by value investors.

IPHS is a quite small, underappreciated, underfollowed specialty chemical business. Who cares? A small chemical business – how good could it be?

Simple. IPHS sells food additives to the major food and beverage manufacturers in the United States. These additives add flavor and shelf life to products – products like Bisquick, Oscar Meyer, and Coca Cola. They also produce phosphates for things like detergents, toothpaste, asphalt, etc. In short, pick up a name brand food product from your grocery shelf, and there’s a very good chance that IPHS has a tiny piece of that product (and thus, profit). Go to the cosmetics counter, and IPHS is there.

Before we look at the numbers, let’s look at the business as a business. Who do they sell to, do they have a moat, what are their sales prospects in this environment, and do they stand to grow.

The specialty chemicals business has several very large barriers to entry. First, these are largely food additives with a relatively low cost/lb. A China upstart couldn’t easily enter the business because 1) cost of shipping would eat into the margins, and 2) freshness – you don’t want food additives intended to enhance flavor, purity, clarity, or shelf life sitting around on a cargo ship. China is trying to compete, read the latest conference call transcript for details, but to date it is not a significant factor, and it will always be a difficult environment for them.

Second, and far more importantly, these are food additives for very identifiable products (Coke!) which are regulated by the FDA. Say I wanted to start a competitor to IPHS. No problem (ha)! First I have to figure out a flavor profile identical to what Coke currently uses. Then, I have to get FDA approval for my additive. After that, I have to go to Coke and convince them to switch suppliers, a supplier they have been happy with for decades. I have to do all this, then sell at a lower operating margin than IPHS, and somehow pay off the expenses incurred in all the R&D. Finally, the cost of these additives on a volume basis is quite small – it represents a very small fractional cost for the final product. Maybe a penny for a box of Bisquick. You’d have to undercut IPHS quite a bit to get a customer to switch to an unknown company and product. Finally, you’d be undertaking all this risk to get part of a market share from a $300 million company – who in their right mind would do that? No one, so far, in the multi-decades that IPHS has been in business.

Third, this moat and relative low product cost gives IPHS very strong leverage with their customers. Say they doubled the price of an ingredient that currently costs 1 cent per box. This represents a huge increase in IPHS’ operating margin. OTOH, the customer is basically unable to balk – they have no alternative to IPHS’ additives. Sure, they could either go develop the additive themselves, or to a competitor of IPHS (there are a couple), but this will be at least a couple year lead time, all to avoid a 1 cent increase in the cost of the product. To date, since the spinoff, IPHS has not exerted this leverage on their prices, but in their most recent conference call they said this is in the plans for the following quarters. The only risk is raising prices so high that they alienate their customers. A doubling of prices overnight would probably do that, but a quarter by quarter modest increase of prices will be absorbed easily. This is a better moat then Buffett’s See’s Candy has. They raise prices every January 1^st, and people keep buying. IPHS can do the same, and their customers need the product far more than a candy eater needs See’s Candy. Against this we have to balance the cost for IPHS to do business. It’s no advantage to raise prices if operating costs are skyrocketing. As a chemical company, they have to buy raw materials. What does that landscape look like? Well, first, they have a long history of passing along increases in raw prices to the buyer. This is an easy thing to do, partly because of the moat, and partly because all of their competitors face the same raw price increases. These additives are going into consumer staples, so it’s not like the buyer can slow down production in the face of added costs. Everybody is going to buy toothpaste, detergents, bread (IPHS sells bread leavenings) and Coke no matter the price of phosphate rock (the raw material). But IPHS has negotiated long term supply agreements for their phosphate rock. The long term nature allows them to predict costs raises and raise product costs in plenty of time to avoid losing money. IPHS has raised prices several times this year already in light of developments in phosphates (more about that later).

The stability of the business should be clear. They have been selling these chemicals to the same buyers for decades. Bisquick is going to sell this year, it is going to sell next year, it is going to sell ten years from now, regardless of the economy. No one is going to stop washing their undies. I remember when I was a starving grad student – I dug into my couch cushions to find the 50 cents needed to buy a can of Coke. I went without almost all niceties, but I still supported by caffeine habit. Over 20 years later, and I still drink Coke (not Pepsi). 40 years from now, if I’m still alive, it’ll still be Coke. That’s a moat.

While I don’t like trying to predict macro conditions, they have been favorable to IPHS. China has been clamping down on phosphate exports, recognizing how important the chemical is. Phosphates rose, and IPHS passed the cost along to the customer. Demand for agriculture phosphates was way up in 2008. This has gone back down, and I think the market has misinterpreted IPHS as an agriculture phosphate business, because the stock price has been pummeled, back to near the IPO price.

Okay, the numbers. Is it a compelling buy at these levels? 2007 EBITDA was $105MM. In comparison, EBITDA for the last quarter was $112.9MM!! EPS for 2008 should run somewhere over $9/share. In comparison, IPHS is trading at $14.86 at the time of writeup. That’s about 1.5x trailing earnings. The future is hard to see, but their exposure to the ag business is not what Wall Street is thinking (given that low share price). If they hold on prices, they should earn at least as much, and if they start putting in price increases due to their moat, they stand to earn quite a bit more. But let’s not get greedy. Even at 2x earnings this is a screaming buy.

Another way to look at earnings: I don’t have the numbers for the most recent quarter, but this summer they were getting around $12-14MM a month as a spread between what they bought materials for and what they sold them for. Their ROE is 119.5%! Free cash flow should be around $100MM. In that light, they are trading at 3x FCF – an absurdly low multiple for a company with such a large moat in a economically defensive industry. While you wait for the stock price to normalize, you get rewarded with a quite nice 4.5% dividend.

I could make up a detailed spreadsheet for projected earnings, document all kinds of assumptions, but why? If you have to reach for a calculator, move to the next stock. $100MM FCF in a $300MM company.

The naysayer will point out I’m doing computations on market cap, not enterprise value. As part of the spinoff, quite a bit of debt was passed on. This is a typical strategy with spinoffs – create a company with huge cash flows to service the debt, and the returns are very significant. The cash flows will allow them to deleverage, adding shareholder value. Make what assumptions you want on forward enterprise values, and you can come up with a yield, forward PE, whatever. The bottom line is they had around $383MM debt at the start of the year, and should have paid it down to around $327MM as of Sept 30^th, and expect to have it down to around $250MM by year end, with a cash balance of around $125MM.

A growing business with an extremely strong moat, selling products to Coke, Bisquick, toothpaste, deodorant, laundry soap manufactures, at a 2.1PE and 4.5% yield. No calculator needed, this is an obvious buy.