Quarterly Letter from Corsair Capital (Up 15% annualized since 1991) – Including Specific Stock Idea Innophos (IPHS)
Interesting commentary and a stock idea for a long term outperformer:
After declining in August on continued worries about the European Economic Union and sovereign debt risk, the U.S. equity market rebounded strongly with its best September in 71 years. Most pundits believe the catalyst for this rally was a speech by Ben Bernanke at the Federal Reserve.’s annual meeting in Jackson Hole, Wyoming, where the rationale for a second round of quantitative easing (QE2) was first formally suggested.
Then, in mid-September, the Federal Reserve released the statement that .“measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability..”
In other words, the Fed signaled it was still quite concerned about continued high unemployment and near term deflation and thus, was again ready to perhaps print hundreds of billions of dollars (QE2) in order to help the situation. Unfortunately, history shows that devaluing one.’s currency through money printing and deficit spending is not a recipe for long-term success (otherwise Argentina would now be an economic powerhouse).
Since the Bernanke speech, the U.S. dollar has already declined approximately 7% against a basket of our trading partners.’ currencies. And our trading partners are not content to sit by and see us devalue the dollar. .“We are in the midst of an international currency war, a general weakening of currency.” Warned Brazil.’s Finance Minister .– reminding his fellow International Monetary Fund partners of the.“beggar thy neighbor.” policies (competitive currency devaluations) which exacerbated the Great Depression of the 1930.’s.
In the meantime, investors have assumed that the Fed will spend this new money on a large buying spree of Treasury bonds and other fixed income instruments. This, in turn, has driven interest rates on both 2-year (0.33%) and 5-year (1.03%) Treasury notes to record low levels and reduced the cost of borrowing for most all borrowers. Nevertheless, many economists would argue that lowering interest rates at this point in time is akin to .“pushing on a string..” The real unemployment problem is not due to a lack or cost of capital, but rather that businesses arerefusing to take risks or hire new workers due to uncertainties over government policies, including higher taxes and regulatory (especially health and environmental) burdens.
Meanwhile savers, who have already taken $1 trillion out of money market accounts since January 2009 in search of yield, are again being forced into investing in riskier assets (longer dated or lower rated bonds and stocks). However, savers are not the only ones affected.
Corporations, states and municipalities with pension and healthcare plans now find themselves with massive future burdens as they are unable to earn enough on their assets as originally assumed. For example, according to the National Association of State Retirement Administrators, the top 100 U.S. public pension plans currently use an expected annual return of 8% on their assets when calculating their outstanding pension liabilities. Should the actual returns be 2 or 3% lower (very likely given approximately one-third of their assets are in Treasury bonds), the present value of their obligations would go up by hundreds of billions of dollars. Of course, the liability associated with our country.’s Social Security promises would likewise be hugely underestimated.
As far as the stock market is concerned, however, many stocks are currently trading at 11-12 times next year.’s expected after-tax earnings. This equates to approximately 8 .– 9 times pre-tax earnings or (calculated inversely) an earnings yield of 11-12% which is looking more and more attractive in a 3.8% 30-year Treasury bond world. Investors, who are being forced to take more risk by the Fed, are starting to believe that stocks are cheaper by comparison.
If investor sentiment changes just a little bit, there is no reason why we cannot see stocks at 13-14 times earnings (an earnings equivalent yield of 7-8%). Of course, investors take on the risk that these companies might not earn what they are expected to. Nevertheless, this sentiment shift and search for yield seem to be the driving forces behind the market moving higher right now.
Another factor which might boost the equity markets could be a significant acceleration in merger and acquisition activity. Over the past two years, many corporations have ruthlessly cut costs, improved efficiency and lowered inventories and receivables. In short, even in this relatively weak economy, they find themselves solidly profitable with significant cash reserves and access to capital. Since they are not growing organically, they may very well start to consider growing by acquisition. As was clearly demonstrated by the bidding war for 3Par Corporation between Hewlett Packard and Dell, when companies use cash (which for practical purposes earns them nothing), corporate management teams can justify paying very high prices for target companies IPHS.”) traded up during the quarter as the company reported very strong Q2 results and announced an accretive debt restructuring, cutting interest expense in half starting in Q4. IPHS earned Q2 adjusted EPS of $0.94, or an annualized EPS run-rate of $3.74, despite analyst expectations of $0.69 for the quarter. Over the next few quarters, management believes the combination of effective pass through of higher prices to customers and shifting of capacity to higher-value products in Mexico will more than compensate for increasing input costs.
Based on the company.’s stable end markets, high barriers to entry, leading market shares, under-levered balance sheet, and ramping cash earnings, we firmly believe that IPHS is a very good business and that its P/E multiple will expand to reflect these characteristics (see Appendix). The stock ended the quarter at $33.10.
Appendix .– Innophos (.“IPHS.” .– $33)
IPHS is a leading specialty phosphates company in North America serving stable, diversified end markets. Applications for its products include flavor enhancers in the food and beverage industry and inactive drug additives in the pharmaceutical industry.
Our thesis rests on the view that 2008 and 2009 earnings misrepresent the business.’ stability, and reported GAAP earnings understate the true earnings power of the company.
Because IPHS uses raw materials like phosphate rock and sulfur that overlap with the broader fertilizer industry, fertilizer supply/demand dynamics can create volatility in IPHS.’ results. IPHS historically priced supply contracts on a one year lag to market prices; as phosphate rock prices spiked in 2008 from $50/ton to as high as $450/ton, IPHS benefitted significantly by raising its prices to customers while not incurring higher input costs. However, this dynamic reversed in 2009 when IPHS.’ raw material costs reflected the higher 2008 phosphate rock prices, while lower 2009 rock prices forced IPHS to lower its fees. IPHS.’ earnings in 2009 halved year over year, and based on this volatility, the market now considers IPHS a very cyclical company.
IPHS has since tailored its business to properly align changes in raw material costs with product pricing. Three key changes are worth highlighting: 1) supply contracts for rock will re-price quarterly instead of annually, limiting lag time; 2) capacity in Mexico will be reallocated from phosphorous-based detergents, which face demand headwinds stemming from environmental concerns, to stable food, beverage, and pharmaceutical specialty salts/acids; 3) phosphate rock sourcing will expand from one supplier to multiple suppliers. We believe that these changes will result in future earnings stability at the company.
Our view is that IPHS has a great business stemming from its diversified end markets, specialized products and high barriers to entry (these include the cost of constructing a greenfield plant, locating phosphate rock supply and demonstrating flavor/cleaning agent efficacy).
Bain & Co. recognized the company.’s stable end markets and cash generation and bought out IPHS in 2004. Excess depreciation from the write-up of fixed assets in the buyout has caused reported GAAP earnings to understate cash earnings. IPHS reports around $50m of annual depreciation, outpacing maintenance capital expenditures of only $20m-$25m. This factor leads us to believe that the current reported earnings do not accurately reflect the true earnings power of the business. IPHS earned Q2 EPS of $0.79 .– removing the excess depreciation yields adjusted EPS of $0.94.
We expect sell-side analysts to appreciate IPHS.’s true value in the near term as depreciation begins to decline and approach maintenance capital expenditures.
Because there is little seasonality in the company.’s markets, we can use Q2 performance to measure run-rate earnings; Q2 adjusted EPS of $0.94 equates to an annual run-rate of ~$3.75.
We feel confident that IPHS can earn $4.00 of adjusted EPS in 2011. Our target price of $50 reflects a 12x-14x multiple we view the business warrants. We also believe IPHS is once again a potential LBO target as it is under-levered and generates stable cash flow.