Value Investors Club / CALUMET SPECIALTY PRODS -LP (CLMT)

Description

Overview

Calumet Specialty Products Partners is a rare MLP that is trading at below bankruptcy liquidation value

and yet offers 2-6x upside in the next 5 years if the company simply pays down debt. Calumet owns a

specialty chemical business and a fuel refining business which creates a GoodCo/BadCo dynamic that is

hard for most investors to understand. It is also a MLP that does not pay a distribution which means

there is no natural shareholder base for the company. In the last 8-9 years, the company has gone from

making $2.5bn of acquisitions and capital intensive organic projects to divesting non-core assets and

ramping down to an $80-90mm of annual cap ex run rate. We believe that the sum-of-the-parts is

worth over $2.4-2.8bn today which leaves $896-1246mm to the equity consisting of the following:

$1.8-2.0 billion for specialty chemical business – 9-10x of $200 2019 annual EBITDA

$400-500mm for Montana refinery

$50-100mm for San Antonio refinery

$25mm for 10% of a JV for previously sold fluid handling business

$153mm of cash @ Q1 2019

For a total of $2428mm to $2778mm of total gross value

Less $1532mm of long and short term debt @Q1 2019

Implied equity value of $896mm to $1246mm divided by 78mm units equals

Implied share price of $11.49 to $15.97 per unit or upsides of 156% to 256%

The 2019 EBITDA should be in the $280 to $320mm range. This implies a market cap of $350mm and an

EV of $1882mm. Obviously, net debt is higher than we like at 4.3x to 4.9x. We believe that this will

rapidly change in the next 18 months. The reason why we have an opportunity to buy a company

trading below bankruptcy liquidation value with 2-6x of upside in the next 5 years is because there were

some missteps in 2018. Admittedly, some of the missteps were out of the management teams’ control.

But there were some self induced missteps that could have been avoided. First, CLMT had very large

turnaround activities in 2018 that were very poorly communicated to the buy side. Management team

has a tendency to talk to all the sell side analysts and the sell side models tend to be more on par with

the reported figures. But the buy side were blindsided by the degree of the turnaround activities

(shutting down plants to conduct maintenance work so that they can run for another 6-7 years at high

efficiency). We believe this is due to the CEO not having public company experience and is learning on

the job on how to be a public company CEO. Some of the other shareholders has more choice words to

describe this dynamic that starts with F.

Near Term Asset Sale

The company has consistently said that they want to sell the refining assets and go back to being a pure

play specialty chemical business that sells branded lubricants, customized white oil, waxes, base oil, and

specialty solvents. They have been saying this for a couple years now, so why is it going to happen in

the next 18 months? Management team has also consistently said that they want divestitures to be

deleveraging transactions. Now that we have the 2018 reported financials, it is clear that management

team knows that specialty EBITDA will be quite low on a TTM basis. Calendar 2018 specialty EBITDA

came in at about $166mm excluding LCM/LIFO. So if they sold the refining assets for the midpoint of

$450mm and $75mm, they will be left with a net debt of $1532mm-$153mm cash less $525mm sales

proceeds = $854mm which equates to a net debt to remainco EBITDA of 5.3x. Yes, it will be pure play

specialty EBITDA, but it will be hard to try to roll the 2021, 2022, 2023 debt coming due with a high

leverage ratio like 5.3x. We believe that the management team wanted to extract the cashflow from the

fuel refinery for an additional year and show the 2019 results which will not have non-recurring items

like turnaround activities, ERP implementation cost, acquisition cost, etc. We believe that Calumet’s

2019 specialty EBITDA is on target to do $200-225mm. If we fast forward to when the company reports

Q3 2019, we will generate another $50mm of FCF. The net debt will likely be reduced to $804mm. With

a denominator of $200-225mm of specialty chemicals EBITDA, this will imply a 3.6 to 4.0x net debt to

EBITDA. A lot of the MLP unit holders would like the company to start paying a distribution. Frankly, we

prefer the company to get leverage to sub 3.0x before they turn the distribution back on.

The key question going forward is will the debt capital markets allow the company to roll the debt. We

have spoken to many smart distressed debt investors. When we bring up potential liquidity induced

bankruptcy a la General Growth Properties style, we essentially got called a “lunatic” for even imagining

such a possibility. The view is that the debt will be rolled and the key question is at what coupon rate.

The debt currently trades at roughly an 8% yield. It is easier to refinance the debt on a secured basis.

But that would prime the unsecured that are coming due in 2022 and 2023. Thus management team

would like to access the unsecured market in 2019 if possible.

Business Description - Fuel

So what does Calumet do? On the fuel refining side, they source crude oil and turn it into gasoline,

diesel, asphalt etc. It is important to point out that Calumet owns a strategic asset in Great Falls,

Montana just across the border from Canada’s oilsand fields. Over time, we have grown to appreciate

the strategic value of this asset. It is well known that there isn’t enough takeaway capacity to handle

the Western Canadian Select crude produced by the Canadian E&P companies. A lot of the crude leaves

via rail to the Gulf coast in the US. Hence, this facility can capture a $20 spread between WCS to WTI.

Its refining spread is essentially the cost to ship a barrel of oil from Alberta to the Gulf via rail. We do

not like the capital intensive fuel refining business given that it requires a lot of capital and occasionally

the refineries blow up. But there is a lot of NIMBYism dynamic in owning a fuel refinery and there has

only been five new refineries built in the US since 1998 adding 231,000 barrels/day of capacity while US

crude production has surged from 6.25mm barrels/day in 1998 to almost 11mm barrels/day. Nobody

wants a giant crude refinery in their backyard. This is the reason why banks will finance fuel refineries

and why they get sold in bankruptcy auctions. While they trade for low EBITDA multiples of 4-5x, they

are not like shipping assets.

https://www.eia.gov/tools/faqs/faq.php?id=29&t=6

https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=A

In 2018, Calumet’s fuel refining business generated $134.5mm of adjusted EBITDA excluding LCM/LIFO.

The figures for 2019 will be lower as the WCS/WTI spread has narrowed. By applying a 4-5x EBITDA

multiple, we arrive a combined value of $450 to $600mm for the two refineries.

Business Description – Specialty Chemical

What about CLMT’s specialty business? The previous write ups on VIC have done a good job describing

Calumet’s various specialty businesses. We have spent quite a bit of time looking at them and talked to

industry folks. The way that we understand the business is that there are four subsegments of the

specialty business, Solvents, Base oil (Naphthenic and Paraffinic), Penreco (White Oil), and Branded

products (Royal Purple, Belray, and TruFuel).

Per our conversation with an industry contact, Calumet makes non-commoditized solvents that occupies

a bit of niche market. On the Naphthenic side, Calumet and Argon are the only remaining players.

Many players exited this space in the 90s leaving a bit of a duopolistic/oligopolistic structure. The

Paraffinic base oil is currently being hurt by addition of capacity worldwide. On the white oil side,

Calumet provides custom formulations for their customers. Think Hawaiian Tropic tanning oils, body

lotions, Jergen’s, etc. People put this stuff on their body and the relationship is very sticky, pun

intended. Renkert (Chevron) and Sonenborn (HollyFrontier), and Calument are the three main players in

the white oil business. Calumet can make the white oil from crude while Renkert has to buy an

intermediate product. Calumet also makes the wet content inside a WD-40 can. They make the content

for Vaseline.

On the branded side, they paid over $331mm to acquire Royal Purple. We have spoken with a car

enthusiast who claims that Royal Purple helps the engine run cooler and throws off more power. When

we were at a base oil conference, everyone has heard of Royal Purple and was amazed that people will

pay $11-12 a quart for engine oil. Management team has consistently said that Royal Purple is great as

industrial lubricants. By comparing notes with another manager, we realized that after Calumet

acquired Royal Purple at 11.7x 2011 EBITDA in 2012, Royal Purple lost a large industrial customer that

accounted for about half of their EBITDA. Hence, the $28mm of EBITDA associated with Royal Purple is

likely about $15mm today. While previous management team has focused on large acquisitions and cap

ex that are in the hundreds of millions of dollars, the current management team headed by Tim Go has

focused on incremental projects that generates 2 year paybacks. They have recently expanded

production capacity for Royal Purple and want to grow their sale into the industrial lubricant market

such as paper and pulp mills, refineries, steel plants, etc. Calumet also owns Belray which is a heavy

grease used in industrial applications. Per a previous write up on VIC, people have very high ratings for

products like Belray. Belray was acquired for $54mm and seems to have done more in line with

projections.

Perhaps Calumet’s most prized asset is a product called TruFuel. After the US introduced the blending

of Ethanol into gasoline, it created a crisis for 2 cycle engines, thinking leaf blowers and chainsaws.

Consumers have to mix 40 to 50 parts gasoline to 1 part engine oil. The problem is that they have to

drive around town to find a gas station that does not blend ethanol. Then they have to blend it

correctly. It’s a pain in the butt and messy. Most consumers prefer to buy an off-the-shelf solution like

TruFuel which allows them to pour the product into their leaf blower and go to work. Plus the product is

shelf stable for up to five years and you can leave it in your engine rather than having to drain the fuel

mixture at the end of the season. TruFuel has been growing 20-30% a year and sports a 20+% EBITDA

margin. We believe that TruFuel is roughly a $15-20mm business today and growing rapidly. This is the

key difference between the previous management team and the current management team. TruFuel

owns the category and makes private label products for Husquvarna and Stihl. They essentially have a

monopoly. The previous management team would have starved this unit of capital and would have

chose to make acquisitions and spend heavily on cap ex. The new management team is putting capital

into products like TruFuel and Royal Purple. The difference is that each incremental dollar of EBITDA in

the branded side creates $12 of additional value. With TruFuel growing 20% a year on a $15-20mm

EBITDA base, Calumet’s value is growing $36mm to $72mm a year. Due to the market’s focus on debt

refinance and lack of attention to the granular details, these value creation dynamics are easily gloss

over by the buyside. These detailed observations are also why we are confident that specialty EBITDA

will grow from $200mm to $225mm and eventually to $250mm. It is important to note that as the

company grows their branded products and the White Oil business with investments such as Versagel,

the mix will shift to above 10x EBITDA lifting the overall EBITDA over time. Although, the path has been

more arduous than we have previously envisioned. We are reluctant to give a time line, but 2-5 years is

likely the right range.

Organizational Changes and Management Observations

From 2011 to 2015, the company made $2,514mm of acquisitions and cap ex. Cap Ex has since trended

down to the $80-90mm range. The mix has also shifted towards specialty chemicals which is really

getting back to basics for the company. Over time, the market will be able to more easily value the pure

play segment. From our conversation, the previous management team lead by the founder’s daughter,

made 10 acquisitions but never actually integrated them. Feedback from employees is that Calumet

would do a deal and then have to get ready for another deal before they can fully integrate the first

deal. This is why the company winded up with a bloated structure that doesn’t talk to each other. The

decision making came from the top and general manager did not have P&L responsibility. The sales guys

sold and the production guys produced and the procurement guys procured. Often times, the company

winded up with excess inventory of certain products because the sales guys and the production guys

were not coordinated. Excess inventory over time gets liquidated at unattractive margin. This is

changing as the company recently experienced a lot of pain implementing their ERP. Going forward, the

ERP will allow the company to identify and eliminate low margin customers. We have learned that

implementing an ERP is never as easy as they sound and takes a while. The ERP has been implemented

for 1.5 years now and they are starting to reap the benefits of it. There are benefits of digitizing some

process such as invoices which will allow them to reduce a few personnel here and there which will

generate $1-2 million of cost savings here and there. Most importantly, each general manager that

reports to the CEO now has P&L responsibility. So they are driven by financial incentives to make sure

that their division generates profit. We believe a lot of these incremental improvements in process,

incentives, alignment, and culture were masked by the charges of 2018.

We have had disagreement with other shareholders on the quality of the current management team.

We think Timothy Go is a good candidate. We think he is not the best communicator. But he came from

the Koch industry and is implementing many of the best practices at Koch. He lacks public company CEO

experience in being able to charm investors. The CFO is okay. We would probably prefer a better one.

2019 Compared to 2018

We had previously thought 2018 would be the year when Calumet showed a $225mm of EBITDA in its

specialty business. With the heavy turnaround activities, ERP implementation costs, acquisition cost of

BioSynthetics, etc, it was a disaster from a reporting perspective. But the company did manage to pay

off $400m of 11.5% secured bond and recently bought back $50mm of their 2021 unsecured bonds. At

the end of Q1 2019, the company still had $153mm of cash and their intention is to further pay down

the debt and refinance the $900mm bond coming due in 2021. Traditionally, Q2 and Q3 are the

company’s best quarters. We believe that the 2018 results would be very easy beats due to the large

non-recurring items in 2018. Investors may come out of the wood works and start buying the units.

Over time, the company can extract more cash out of the business by simply asking vendors to extend

payment terms. Right now Calumet can’t pay their vendors the typical 30-45 days. With potential rating

upgrades, Calumet could potentially extract $50mm of additional working capital unwind by simply

paying their vendors later.

Risk 2021 Technical Bankruptcy Scenario

In the worst case scenario, let’s assume that the capital markets shuts down and Calumet has to file for

bankruptcy in 2021.

$1.6billion for specialty chemical business – 8x of $200 annual EBITDA

$350mm for Montana refinery

$50mm for San Antonio refinery

$15mm for 10% of a JV for previously sold fluid handling business

$153mm of cash @ Q1 2019

$200mm of FCF from Q1 2019 till Q1 2021

$100mm of FCF during one year spent in bankruptcy process

For a total of $2368mm of total gross value

Less $1532mm of long and short term debt @Q1 2019 and less $100mm of professional fees in

bankruptcy

Implied equity value of $836mm divided by 78mm units equals

Implied share price of $10.71 for upside of 140%

The EBITDA multiple would have to drop to a 5x AND the specialty chemical business would have to

drop to $160mm of EBITDA for the equity to be totally impaired in 2021. I think I like these odds.

Five Year Projection

If Calumet refinance the debt at 8% and sell off the fuel refineries in the next 18 months, we wind up

with a clear path to $16-31 in the next five years.

Net debt gets down to $804mm (see previous part of thesis) at year end 2019/early 2020, and the

specialty EBITDA is $200-225mm. Cap ex trends down to $30-50mm. At 8% interest, the interest

payment is only $64mm. This leaves about $86 to $131mm of FCF available to pay down more debt.

With each year of debt pay down, the FCF compounds by 8% times by the debt pay down amount. In

four more years after the refining divestiture, the net debt could be around $300-400mm. Which would

be less than 2x EBITDA. Thus the FCF would be in the range of $126mm to $171mm. In a bullish case

where the EBITDA goes to $250mm in four years after fuel refining divestiture, we can have potentially

have close to $200mm of FCF as the net debt could be lose to $100-200mm by then. By paying out 70%

of the FCF, CLMT Could pay $0.96, $1.53 to $1.85 of distribution per share. Applying a 6% dividend

yield, the units could be worth $16, $25.5 $30.8 respectively. We think the long game is very important

and can be very lucrative. But this is a bumpy ride and it often feels very lonely.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Sale of Refining Assets

Refinancing of Debt Coming Due

Deleveraging of Balance Sheet

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			2019	2020
Price:	4.52	EPS	0	0
Shares Out. (in M):	78	P/E	0	0
Market Cap (in $M):	352	P/FCF	3.5	0
Net Debt (in $M):	1,379	EBIT	0	0
TEV (in $M):	1,731	TEV/EBIT	0	0