Description

It seems like a lot of VIC members are pursuing martyr status.  At the very least they are trying their darnedest to prove to everyone (and maybe themselves too) how dedicated they are to value investing – to the point where they are recommending highly cyclical stocks at the dawn of quantitative tightening and before the economy has even started to shed jobs.  Perhaps these stocks are cheap once we have a stable global economy.  However, after many incinerate value in the coming quarters or years, the IRR’s to fair value likely leave a lot to be desired… and the mark-to-market might shorten careers.  I am mostly out of highly cyclical industries and am under-writing to a recession in my longs.  I am looking for opportunities that are cheap today and have a chance of beating estimates in 2023 with a recession embedded in my assumption set.   I think Compass Minerals (“CMP”) fits the bill and also provides an ENORMOUS and high quality lithium option which I believe is basically free at today’s valuation.  Further, the recent deal with Koch at $36.87/share is within spitting distance of today’s price of $39.67 – providing a modicum of price support in volatile times.

CMP has an a-cyclical demand profile, earnings upside and an extremely large lithium option.  CMP operates in four segments. 

-          Highway rock salt for de-icing

-          Consumer & Industrial salt

-          Plant nutrition / potassium

-          Lithium extraction (start-up)

CMP’s core business is mining and distributing salt to regulatory authorities who apply it to roads for de-icing.  The industry competes on a regional basis and has a concentrated industry structure.  The cost structure is driven primarily by logistics.  A high cost mine might operate at $30/ton and the best is around $10/ton.  However, it costs at least $30/ton to move the salt 50-60 miles via truck.  This greatly reduces the importance of efficient mining.  The industry competes on the logistic costs of each operator to a location.  On the very eastern edge of the East Coast, salt is imported from Chile and distributed from ports there.  Away from that, the industry has three national players, Compass, Morton/Kissner and Cargill.  There are a few regional operators away from that.  De-icing salt contracts are annual with terms set from May to August on a pre-set price basis.  The mine operator takes diesel cost risk.  Annual profits are impacted by snow-fall, diesel and periods of competitor irrationality.  We foresee an upswing in profits for the following reasons.

1)      2022/2023 Winter Impact:  The winter of 21/22 was marked by a surge in diesel prices and trucking rates.  This hit profits incredibly hard as the industry is typically unhedged on these expenses.  As competitors started to bid for 22/23 this May, our research points to a more rational approach to bidding as the 21/22 winter was freshly burned into their wallets and oil and trucking rates were substantially higher and most forecasts pointed to prices remaining high.  Further, CMP explicitly stated that it would retreat from marginal tons which are typically located at the edge of the concentric circles away from its mines, effectively reducing supply to the industry.  This reduced urgency of all participants to place tons where routes cross.  As such, with prices set higher and diesel/trucking rates lower – we suspect that CMP is well set up for 2022/23.

2)      Industry consolidation:  CMP’s rational retreat marks a new trend in the industry.  While the industry was always consolidated, K+S used to own Morton’s and was desperate for cash.  As a result, K+S/Mortons was unnecessarily aggressive in pricing to drive share.  It is now a highly leveraged LBO that needs FCF to deleverage and is run by a savvy management team that “gets it.”  Cargill seemingly gets it.  If CMP didn’t “get it”, they now have a $250mm investment from Koch Industries who will take 2 board seats.  We suspect that this industry should operate more like aggregates and with the new owners in place we should start to see improvements.

3)      No mine down time:  Mines go up and down for repairs.  As described above, a mine is only competitive in a tight circle where it operates.  When a mine is down, new competitors enter the circle.  To push them out when they resume production, the local mine needs to lower price which can be disruptive.  Mine operators that usurped the incumbent’s position are accustomed to higher volumes and attempt to place these tons in other regions – dislocating a far bigger region.  CMP had a mine restart in 2020 and the return to service was disruptive to 2021/22 winter pricing.  At this time, there are no idle mines that can return to service and cause disruption.  In fact, downtime can only improve results.

As we look into 22/23, we see enhanced margins based on improved bidding practices and diesel prices that are lower than when the industry bid – at least for now.  As time passes, we suspect the new ownership structure in the industry drives higher ROIC. 

Consumer/industrial salt.  The majority of this segment is salt that is used to serve consumer and industrial applications – as opposed to table salt which is a small component of CMP’s business.  In this sector, the competitors are the same but CMP and peers must add a smidge more value to the product whether it’s processed a bit more, purified or packaged in smaller containers.  Salt is used in water chemicals, polyester, animal nutrition and hundreds of other applications.  The sales here are very steady.  Deicing represents ~10-15% of the segment and is the most volatile due to weather.  Consumer stables like water care, animal nutrition, pool care and fisheries represent 20-30%.  Industrial applications like municipal water treatment and food ingredients represent 20-30%.  Lastly, Chemical demand (chlor-alkali) represents 10%+.  In the pandemic volumes declined in this segment, but this was a function of sharp drop-off in consumer deicing demand while the catastrophic hit to the economy did not appear to be a driver.  As mentioned above, the competitors are mostly the same and logistics is key to determining economics.  Contracts here are annual in nature with more flexibility on price.  This segment should be seeing improved results faster than the highway business which must wait for 2022 contracts to reset to see improvement.    

Food nutrition:  the company competes in food nutrition with sulfate of potash (“SOP”).  SOP represents 8% of potash sales and is a premium-quality when compared to Muriate of potash (“MOP”).  SOP provides both potassium and sulfur.  SOP is prized in its ability to ripen high-value crops like fruits, vegetables, nuts, tea and coffee.  Without SOP, tomatoes would not be bright red or as robust.  CMP extracts the SOP via evaporation ponds at the Great Salt Lake.  These ponds yield salt as well.  In addition, the company has SOP facilities in Saskatchewan which serve the export market more aggressively.  The segment competes globally and is enjoying the rally in agriculture pricing as it drives up pricing.  Currently, the Great Salt Lake is not yielding as much volume as normal due to drought conditions.  This is more than offset of late by higher pricing/margins.  This is a highly attractive segment with an attractive cost position and consistent margins.  It is a smaller part to the CMP story though.

Lithium:  in addition to the above.  CMP has a nascent lithium mine opportunity in the Great Salt Lake.  The company will extract water/brine from the lake and place them into evaporation pools.  It will then extract the brine.  It is WORTH NOTING that this technology is highly conventional and used in dozens of locations around the world with zero fanfare.  This is NOT at all like Standard Lithium.  The problem Standard Lithium (“SLI”) faces is that SLI must extract the lithium from the brine in real time as the brine in Arkansas is not allowed to pool.  As such, SLI must extract the brine as it flows through the equipment as the brine is immediately returned to the mine 10,000 feet down.  In the Great Salt Lake, the evaporation does most of the work and concentrates the brine to a level that makes it easier to extract.  Given that the brine sits in a pool indefinitely, CMP can wait for the extraction process to work.  The company has provided an exhaustive presentation on the opportunity.  https://investors.compassminerals.com/investors-relations/events-and-presentations/presentations/default.aspx   The first phase requires $262mm of capex and is fully funded via the Koch investment and FCF from the core business.  The after-tax NPV is $626mm with a 28% IRR based on an assumed LCE selling price of $15.9k/MT.  The LCE selling price is incredibly conservative versus today’s lithium price of $75k.  While pure-play lithium miners do not appear to embed $75k into valuations, most anticipate far higher prices than $16k/MT.  if you use a higher price assumption, the value explodes higher.  In addition, the play has a second phase which requires $710mm of capex with a $1.4bn after-tax NPV at $16.7k/MT.  With phase 1 running, the 2^nd phase is fully funded by FCF.  As such, CMP has $2.0bn of NPV attributable to lithium but something the market would likely value at a premium.  It is worth mentioning that CMP’s lithium extraction technique is extremely environmentally friendly and with limited greenhouse gas emissions.  We will provide more data to support this claim but it’s our assertion that the stock is cheap on 2023/normalized figures before the benefit of $2.0-4.0bn of lithium.  For context the current market capitalization is $1.6bn. 

Koch investment:  before we explain our valuation thoughts.  I think its worth discussing the Koch investment.  To begin, we believe the Koch’s involvement is an extremely strong reinforcement of the valuation.  Koch has yet to have much success with its energy transition investments.  It may have made a mistake with Standard Lithium.  EOSE is much more likely to work but their timing was extremely poor.  That said, Koch has a lot of expertise in commodity industries like salt and SOP.  It clearly must have recognized that CMP’s core business was in the middle of an earnings trough.  The fairly leveraged balance sheet limited CMP’s ability to safely fund phase 1 internally – or required CMP to sell a core asset while they were performing on trough.  We think the management team made a huge mistake rushing to fund this project via an equity sale at a modest discount to Koch.  This is especially true as the recently passed IRA bill provides massive amounts of grant and loans for projects exactly like this one.  Given that this project is domestic, highly environmentally friendly and cost efficient, the project seems to be exactly the type of winner that the U.S. Congress was trying to pick.  It is extremely probable that CMP qualifies for this in the foreseeable future – which would provide a modest windfall for phase 1 but it might also provide far more resources and allow them to accelerate phase 2 which would be an enormous catalyst.  Said differently, the first $250mm would be nice to have.  $710mm and the ability accelerate phase 2 would be huge.  My work suggests this is a base case within the foreseeable future and is completely under-appreciated by the current valuation.  Long-story short:  CMP management/board got completely picked off in an embarrassing way.  This is water under the bridge at this point as the deal has closed.  Moving forward, we now have the benefit of Koch’s expertise in materials for the core business and their connections via lobbyists should help them retrieve government grants and loans.  We see an opportunity to greatly improve this company on their pricing practices, opex/capex and capital allocation.

Valuation – excluding lithium:

1)      We strongly suspect that 2022 is an anomaly.  Given the sharp retrenchment in bidding activity where market participants assumed roaring inflation, we suspect that 2023 could become a classic case of under-earning reverting to over-earning as truckload and diesel prices have dropped. 

2)      The results of the last 2-3 years are impaired due to a mine outage and warm weather in 2020, implying that the recovery potential greatly exceeds 2023 sellside estimates.

3)      Long-term: we suspect the new ownership structure in the industry will reinforce rational behavior on participants – driving improved and more stable results.  We also suspect that plant nutrition volumes should recover back to normal.

4)      Koch can greatly improve pricing practices and opex/capex

5)      We believe CMP is spending $10-15 million on R&D and SG&A on lithium a year.  You have to add this back or you are assigning a negative TEV to the lithium asset.  As such, when you see that our base case below is higher than the sellside it is because we are adding this back.  If we are correct about pricing practices, there is substantial upside to this estimate.

6)      In terms of multiple, this industry resembles the aggregates business in many ways.  These are local monopolies with high barriers to entry.  The industry landscape is concentrated too.  Gross profit and EBITDA margins are similar.  Most aggregates have annual capex bills that match D&A.  CMP actually spends slightly less than D&A in capex.  Despite the logic, we won’t apply aggregate multiples of 12-18x to CMP.  There have been three recent M&A transactions in the industry that averaged in excess of 10x EBITDA - but multiples are lower now.  Also, the high margin SOP business has scarcity value and its modestly under-earning its potential in our estimates as we assume drought conditions continue.  We suspect that plant nutrition business is worth >10x EBITDA on our forecasts.  Slapping all of it together, we settle on 8.0x 23 EBITDA.  As you can see, this points to $42/share in our base case which excludes the lithium burn.

7)      If we assume that lthium is worth $2.0bn, the upside potential is enormous.  We think the stock can get to $55-60 based on the core business beating next year.  If so the lithium option remains free and incredibly powerful as you can see from the table below.

Risks:

1)      Weather

2)      A rally in diesel or truck expenses

Catalysts:

1)      Improved 2023 results

2)      Funding for the Lithium mine via the IRA

Catalyst

Improved 2023 results

Federal Funding for lithium mine