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LSB Industries: Value Play Or Value Trap?

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Credit: Shutterstock photo

By Ilya Zaytsev, CFA :

Overview

LSB Industries, Inc. operates in two distinct industries, the Chemicals business and Climate Control business. The firm was founded in 1968 and is based in Oklahoma City, Oklahoma. It currently operates four Chemical and seven HVAC facilities located in Arkansas, Alabama, Oklahoma and Texas. As of the third quarter 2015, LSB has generated 62% ($113mm) of its revenue from the Chemicals business and 37% ($67mm) from the Climate Control division. LSB is primarily a U.S.-based company, generating 96% of fiscal year 2014 revenue from the U.S.

Source: 2014 10K

Chemicals Business

The Chemicals business operates four facilities, manufacturing products for the agricultural, industrial and mining markets. LSD manufactures nitrogen-based fertilizer products for corn and other crops, industrial acids, ammonia and diesel exhaust fluids for the various industrial uses and low-density ammonium nitrate pills used primarily for explosive applications within the mining industry. According to LSD's 2014 10K , the primary end customers are polyurethane, paper, fibers, emission control, and electronics industries, as well as farmers, ranchers, fertilizer dealers, and distributors.

Source: 2014 10K

Climate Control Business

The Climate Control segment manufactures and sells water source and geothermal heat pumps, hydronic fan coils, and large custom air-handler products, primarily to the commercial and residential new building construction, renovation and replacement of existing buildings and systems. LSD holds a leading market share in water source and geothermal heat pumps as well as hydronic fan coils.

Source: 2014 10K

Industry Dynamics

Both the Chemicals and HVAC industries are very competitive with little product differentiation. Barriers to entry in both the Chemical and HVAC business are high. A significant amount of capital invested in production facilities, distribution channels, and human capital is required to effectively compete.

There is a strong threat of substitutes within the Chemicals business due to the difficulty to differentiate products and gain a competitive advantage. Based on the latest (2014) 10K, management mentions two main differentiation factors: location of production facilities and customer service provided to clients.

The HVAC business has a higher degree of moat, but is still subject to intense competition. LSD has developed a leadership position in geothermal issues by offering the highest quality and broadest category in the industry. Based on data from AHRI, LSD continues to maintain a market share leadership position in the heating and cooling market. Despite the leadership position, LSD still participates in an intense industry. Competitors will quickly try to replicate LSD's success in the heating and cooling market, along with an array of alternative methods of heating and cooling large buildings creates intense completion within the industry.

Given the lack of product differentiation and low switching costs, strong buyer power exists in the Chemicals industry. In 2014, 30% of Chemicals business net sales and 19% of consolidated sales were derived from seven customers. Such a high amount of revenue being derived from a relatively short list of clients indicates that each client has a significant ability to negotiate price and other provisions.

The main input into both the Chemical and HVAC businesses are natural commodities and commodities products. Natural gas, ammonia and sulfur are the three main feedstock in the Chemicals business. Given the vast availability of the commodities as well as proprietary information available on spot markets, supplier power is greatly diminished.

The HVAC business primarily utilizes copper, steel, compressors, electric motors, valves and aluminum as the primary raw materials. These are commonly available materials with a large amount of suppliers. As in the Chemicals business, supplier power is low in the HVAC business as well.

Market Data

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Source: Capital IQ

Ownership

Institutions own 88.6% of outstanding shares as of September 30, 2015.

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Source: Bloomberg

Recent Developments

YTD LXU is down 78%.

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Source: StockCharts.com

Investors have grown tired of LXU's mismanagement, and are voting with their wallets. LXU has now increased the cost of the El Dorado plant construction three times. First quarter estimates for the El Dorado expansion project were $495-$520mm, subsequently increasing to $660-$680mm in the second quarter . In the third quarter , management once again increased their cost estimate by ~$170mm, estimating the project will now cost $830-$855mm to complete.

As a result of the cost overruns, management needed to raise capital to complete the expansion project. Management issued a $50mm senior secured note with a 12% annual interest rate and $210mm in redeemable non-convertible perpetual preferred stock with a 14% annual dividend rate along with warrants to purchase 17.99% of the company at an exercise price of $0.01/warrant. Subsequent to the following announcement, the stock plummeted, reaching levels last seen in January 2009.

Valuation

Investors need to look past 2016 and the completion of the El Dorado plant and into 2017 in order to determine LXU's potential value. For this exercise, we will ignore any potential value unlocking spinoffs of the HVAC business and conversion from C-corp to an MLP for the Chemicals business, as well as the multitude of lawsuits LXU is facing. Management is targeting FY 2017 EBITDA for the Chemicals business of $200mm and $60mm for the HVAC business.

Using management's assumptions and applying a multiple of 6x for the Chemicals business and 7x for the HVAC business, we derive an EV of $1.2B and $420mm for the Chemicals business and HVAC business, respectively. At the end of 3Q15, net debt stood at $457mm. Adding in $300mm in additional debt as well as preferred stock yields a net debt figure of $757mm. Using the above assumptions yields an equity value of $860mm or $32 per share (share count adjusted upwards for dilution). With the stock trading at ~$6.5, this represents a potential upside of ~390%. While this may seem compelling, this equity value was derived using company EBITDA guidance. Given management's propensity to disappoint, we wanted to see what the equity would be worth if EBITDA targets were lower by 50%. Using EBITDA of $100mm for Chemicals and $30mm for climate control, we derive a value per share of $2.

Here is a look at stock price sensitivities to EBITDA and multiples. We can see how sensitive the stock price is to the assumed EBITDA. Given where the stock trades today, investors do not have much faith in management's $260 EBITDA target.

I also decided to look at LXU's valuation utilizing a DCF framework. Given the uncertainty and riskiness of LXU's cash flows, I used a 15% WACC. I made a somewhat aggressive assumption regarding cash flow growth. I assumed cash flows turn slightly positive in 2016 ($26mm) and really accelerate in 2017 as El Dorado is fully functional, capital expenditures decrease and margins expand. I used a 2% perpetual cash flow growth as well as an EV/EBITDA exit multiple of 6x. The results estimate that LXU is undervalued by 100-150%.

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Source: DCF Model

Risk

The main feedstock for LXU is natural gas. While natural gas is at historically low prices, this creates a material cost advantage for LXU. If natural gas were to spike to higher levels, LXU's margins will deteriorate.

LXU operates in a cyclical business and any weakness in end-market demand will have a substantial effect on LXU's revenue and profitability.

Additional cost over-runs in the El Dorado facility or any unforeseen downtime at any other facility may create liquidity issues and additional financing needs. LXU entered into an agreement with Koch Fertilizer sell ammonia that will be produced at the El Dorado facility and is in excess of any El Dorado's needs. If the El Dorado facility is not operational by July 31, 2016, Koch has the ability to terminate the agreement. It is imperative that the El Dorado facility is operational by the 2nd half of 2016.

Any additional cost increases to complete the El Dorado facility will require new financing, which may not be available or come at a heavy cost to the existing shareholders.

Inability to refinance the $425mm senior secured notes due August 2019.

Conclusion

LXU has been decimated in 2015 as a result of management's missteps and emergency liquidity issues during the last quarter. Liquidity crunches and uncertainty can create potentially huge opportunities for those willing to ride out the volatility.

Based on management's comments and their action during the last quarter, I believe they have a handle on the cost of the El Dorado facility. While there is a ton of executional risk inherent in LXU, the opportunity given today's prices is just as large. For investors with high risk tolerance, LXU equity may be a good bet on a company with a potential to increase your investment 300%-400%. Another interesting angle investors may want to look at is the senior secured debt due in 2019. The stated coupon for the debt is 7.75%, currently trading at 87 with a YTM of 12.25%. Given that these are senior secured loans ahead of the recently issued preferred equity, one would have to feel comfortable with the potential recovery rate if things went awry.

The next few months will be quiet, but we should see more clearance once 4Q15 results are out. If management is on the right path with the El Dorado plant and the path to success is more viable, it may be the time to jump on the LXU bandwagon.

See also Greenbrier: Record Profits, Huge Backlog, And A P/E Of 5? on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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