Arabian American Development Company (ARSD) is a manufacturer of various specialty chemical products and also owns a 35.3% interest in Al Masane Al Kobra Mining Company (AMAK), which produces copper, zinc, silver and gold. We have a target value for ARSD's specialty chemical business of $11.56 per share based on projected 2014 financials and conservatively value AMAK based on a recent transaction that occurred at $6.27 per share in December 2012, which gives us a target price for ARSD of $17.83 per share. This implies an upside of 131% over the current share price of $7.71 per share as of March 12, 2013.
ARSD's petrochemical facility is located near Silsbee, Texas, approximately 90 miles east of Houston. The plant, which was originally owned by another company, opened in 1955 and is located near the South Hampton oil fields. The facility was located next to a gasoline plant, which had issues selling its liquids. The South Hampton plant purchased these liquids to make motor fuel. After deregulation in 1982, which drove many independent refiners out of business, the plant cut its staff to 10 employees. In 1985, the facility was adapted from a typical petrochemical facility to produce specialty high purity solvents, due to requests from customers of Phillips 66 (PSX) to create a viable competitor to PSX's near monopoly for these high-purity solvents. In 1987, ARSD acquired the South Hampton plant for $600,000, which was well below replacement cost. In 2008, ARSD expanded the plant to double capacity. Prior to the expansion ARSD had 49% market share of the North American C5 market and by the end of 2012 had grown it to 75%, according to management.
Most petrochemical companies supply highly commoditized products. It is important to understand that while ARSD produces what are typically commodity petrochemical products, the company differentiates itself by the extremely high purity levels of its products. Management claims that their purity is unmatched by any other company except PSX. This high purity level has been found to be advantageous by ARSD's customers for use in their own processes compared to products of lower purity. Anecdotally, one of its customers searched the world looking to find a supplier that matched or exceeded ARSD's purity levels and could not find any. ARSD's products are used as solvents, additives, blowing agents and cooling agents and make up a very small percentage (typically less than 1%) of its customers' finished product costs.
ARSD's products are generally used in the process of making polyethylene and polypropylene, which are the building blocks of plastics. This industry tends to be cyclical as the demand is spurred by overall economic activity. However, ARSD's products have found a new application for use in preparing mined "oil sands" to be transported via pipeline, which will create a non-cyclical demand as the oil sands producers continue to increase production. The quantity of product, which can be sold to the oil sands industry, has the potential to be greater than the total current production sold by the company today. We will discuss one of the potential oil sands customers in detail a little later.
The dynamic between ARSD and PSX is similar to that of David and Goliath. ARSD has an enterprise value of $203 million compared to $44 billion (over 200 times larger) for PSX. Up until a few years ago, PSX was pricing under cost for these chemicals. Since they constituted a miniscule portion of PSX's volume, PSX didn't really pay attention to their profitability. PSX has returned to rational pricing over the past few years and has recently consolidated its facilities and now produces these chemicals in two locations. Between 2nd half of 2011 and the beginning of 2012, PSX was unable to produce these chemicals due to operating problems, which allowed ARSD to pick up volume and market share from PSX, some of which ARSD has been able to maintain even after PSX came back online.
ARSD has a few meaningful competitive advantages over PSX. The first is that ARSD uses natural gasoline as its feedstock instead of crude oil, which is PSX's feedstock. Natural gasoline enjoys a significant cost advantage over oil due to its plentiful supply resulting from the recent US shale gas finds. We believe this advantage will continue well into the future as additional natural gas wells are brought online.
Secondly, ARSD's employees are not unionized unlike those at PSX, which are unionized. Not only does this result in cost advantages to ARSD, but it also allows the Company more flexibility with its employees. All ARSD employees take part in a profit-sharing program, which began in 1985. This aligns the incentives of all employees with that of the company. In 2005 when Hurricane Rita caused the plant to shut down, employees came back to the plant almost immediately to get the plant up and running again as soon as possible.
Finally, since the specialty chemicals are such a large part of ARSD's business and such a small part of PSX, ARSD provides its customers with higher quality and personalized service. Being small allows ARSD to be nimble and react to customers' specific requests compared to PSX where it is difficult to do so.
Recently, ARSD completed major upgrades of the fire suppression and electrical systems at the plant. Going forward, this should allow for lower maintenance capital expenditures. In addition, ARSD usually has a week-long shutdown of the plant in November or December for maintenance work, however, this year there was a problem replacing one of their catalysts which caused the plant to be out of operation for an additional week, negatively impacting the 4th quarter 2012 results. This catalyst was last replaced 7 years ago, thus making this extended shutdown unlikely to reoccur for the foreseeable future.
ARSD charges its large volume customers using formula based pricing. These customers include Exxon Mobil Corporation (XOM), The Dow Chemical Company (DOW), Chevron Corporation (CVX), 3M Company (MMM), Goodyear Tire and Rubber Co. (GT), Imperial Oil (IMO), Baker Hughes Inc. (BHI), Calumet (CLMT), Lyondell (LYB) and many more. ARSD gets paid a service fee per gallon and passes on the volatile feed costs directly to its customers on a monthly basis. This formula-based pricing accounts for over 50% of ARSD's revenue. For all other customers, ARSD can adjust the prices as long as it gives notice ranging from 14 to 30 days, depending on the customer.
We calculated the average service fee that ARSD receives from its customers by backing into the number using its public financial statements. Looking at ARSD's petrochemical revenues and taking out the cost of materials, we developed a proxy that determines the spread that ARSD charges its customers. Dividing this amount by the number of gallons processed gives us ARSD's processing charge per gallon. Looking at ARSD's processing charge per gallon compared to the monthly price of natural gas liquids shows us that ARSD's spread is independent of the price of natural gas liquids and averages out to approximately $1.02 per gallon since January 2011. Our financial model utilizes this spread and gallons sold to arrive at gross margin dollars earned. This is important as revenue changes are not a meaningful proxy for earnings momentum due to the constant fluctuations in the price of feedstock.
US Natural Gas Liquid Composite Price for NGL Prices
Source: Click here.
Canadian Oil Sands Customer Relationship
In the second half of 2011 and first half of 2012 ARSD began shipping chemicals to an unnamed oil sands customer to fill tanks in advance of an expected second half of 2012 startup for a new plant. The plant's start was delayed due to the difficulty in shipping and receiving the required capital equipment on a timely basis. It is now expected that this plant will go online early in the second quarter of 2013. In the Q3 conference call on October 30th, 2012, CEO Nicholas Carter mentioned that the volumes should grow late in the 4th quarter due to a large oil sands customer coming back online. In the Q&A portion of the call, Carter gave more color on the volume of the customer, saying that ARSD will need to increase throughput by 15% to 20% to meet the needs of the oil sands customer. This fits with comments from the second quarter conference call in which the CEO said that when the contract comes back later in the year, it should increase production by 1,000 to 1,200 barrels per day.
When converting barrels per day to gallons per quarter, the potential increase of 1,000 barrels per day is equivalent to 3.6 million gallons per quarter. Using the service fee of $1 per gallon that ARSD makes from its formula pricing, this customer coming back online should thus generate an additional $3.6 million in gross profit per quarter for ARSD, while not adding much in additional operating expenses as the capacity to handle the larger volume is already in place. All ARSD needs to do is have the control room increase the plants throughput, as simple as turning some knobs and pressing some buttons - even Homer Simpson could do this in his sleep.
In the latest press release, ARSD states: "our customer's delay in production at the Canadian tar sands project carried through in fourth quarter 2012. Going forward, it is our understanding that the tar sands' orders are coming back online in the second quarter." Then on the March 7th, 2013 earnings call, ARSD's CEO mentioned that this customer has placed orders for March and April delivery. According to Wikipedia, there are two oil sand mines under development (Jackpine and Kearl) (source).
Both of these projects were expected to be completed by the end of 2012 and both have had delays. ARSD's customer is likely one of these two mines. The Jackpine mine has been having environmental issues with lawsuits holding back its development, while the Kearl mine has had delays due to problems transporting equipment to the mine followed by extremely cold weather which caused delays in the final stages of construction. Now, the Kearl mine is set to commission this quarter (source).
Below are our projections for ARSD for 2013 and 2014. We kept 1Q 2013 projections flat then added half the additional volume due to the oil sands customer coming back online in 2Q 2013, with it fully ramping in 3Q 2013. Due to some of ARSD's chemicals use as a cooling agent by some customers, there is typically an increase in demand for these products during warmer months which we accounted for in our projections. We expect average plant utilization in 2013 of 76%, up from 70% in 2012, with utilization growing to 91% in 2014.
In 2014, the growth in revenue will come from additional demand as oil sands mining ramps up and ARSD benefits from a full year from its current customer. There currently is not enough infrastructure to transfer crude outside of Canada, however in late 2013 there should be some relief as some pipeline reversals should be complete which will allow flow out of the US central corridor to the gulf coast where the refineries are located. Currently oil prices at the oil sands mines are significantly lower than at the gulf coast due to the lack of pipeline infrastructure and resultant higher transport costs. A potential driver of future oil sands production is the Keystone pipeline which is currently waiting for approval by the Obama Administration.
ARSD's chemicals are very valuable to the oil sands customers as it cleans up the oil by removing the tar, resulting in a lighter liquid that can be transported more easily without needing to be upgraded. Only ARSD and PSX supply these necessary chemicals in North America.
Chemicals Business Valuation
One of our preferred valuation metrics is to compare the valuations of similar public companies, called comparables or comps. Unfortunately, there are no true comps for ARSD as the only other direct competitor in North America is PSX and the portion of PSX's business that competes with ARSD is extremely small relative to the rest of PSX. PSX currently trades at an EV to EBITDA multiple (trailing twelve months) of 7.63 as of 2/28/13. Instead, to find a fair multiple for ARSD we used comparison companies who are in the commodity and specialty chemical business. The table below shows a comparable company table with EV to EBITDA multiples and their respective market capitalizations.
Although the average and median are higher on a trailing basis, we decided to use a reduced EV/EBITDA multiple of 7.5 to be conservative since we are using at a forward number. Our projected 2014 EBITDA of approximately $40 million in 2014 along with the 7.5 times EBITDA multiple gives us a target share price of $11.56 for ARSD's chemical business.
Another valuation metric we utilize when valuing companies is evaluating what a potential buyer would pay for ARSD. To do this we took a look at comparable merger and acquisition transactions in the specialty chemical industry. Below is a chart showing these transactions:
We didn't include the Millennium Chemicals transaction in the average or median calculations, because the trailing EV/EBITDA multiple seemed abnormally high. However, when we looked at the forward EV/EBITDA multiple at the time of the announcement, it was at a 7.8x forward multiple which falls in line with the other transactions. We apply the same median 7.5x multiple that we used in the comparable company analysis to get the same $11.56 share price for ARSD's chemical business as above.
Potential Expansion in Chemicals Business
Capacity at ARSD's plant is currently 6,700 barrels per day ((bpd)). Management previously mentioned that they expect to reach the plant's capacity by the end of 2013. In our projections, we had ARSD more conservatively reaching capacity in the 2nd quarter of 2014. ARSD has brought in a new Executive Vice President with extensive petrochemical industry experience to evaluate opportunities to grow the company as the plant approaches capacity in the near future. In the near term, he will implement a de-bottlenecking program that is expected to add about 5% to existing capacity. However, a longer term solution will also be needed.
One idea which ARSD has discussed is to open a new facility overseas in Saudi Arabia. They would consider doing a JV with a local partner and could provide its overseas customers with lower transportation costs and shorter lead times. Since Saudi Arabia also has inexpensive natural gasoline to use as feedstock, this makes it a viable option.
Another idea is to acquire an existing plant and potentially expand into other specialty chemicals to diversify ARSD's product offerings. We are not very excited about this idea as we believe that it can distract ARSD from its core chemicals business where it has a nice and profitable duopoly as well as creating unnecessary integration risks.
A third option for ARSD is to expand capacity at the current location. In 2008, ARSD took 9 months and spent $18 million to add approximately 3,000 bpd in capacity to the plant. ARSD still has vacant land at its current facility where it could do a similar expansion, which today could cost approximately $25 million according to the company. An additional 3,000 bpd is equivalent to over 45 million gallons per year, which at full capacity would add $45 million to ARSD's gross profit based off of the $1 per gallon service fee. To facilitate this growth ARSD can put storage tanks up in Canada to store additional chemicals to better serve its customers up in the oil sands. We feel that this is the best avenue for ARSD to pursue and are confident that management will make the right decision.
It's easy to overlook that ARSD also has ownership in a mine that has just started delivering its first shipments of metal concentrates. The Al Masane Al Kobra Mining Company (AMAK) in Saudi Arabia is a mine that has Zinc, Copper, Silver and Gold in proven reserves. It is predominantly a Zinc and Copper mine.
One way to value the AMAK asset to ARSD is to base it off of what a sophisticated buyer was willing to pay for recently issued shares. There have been two recent transactions for shares of AMAK. In July of 2011, Arab Mining Company ((ARMICO)) purchased 5 million shares of AMAK for $37.3 million. This values the mine at $7.46/AMAK share. Since ARSD owns 18.5 million shares of AMAK, this valued ARSD's equity ownership of AMAK at just over $138 million in July 2011. Dividing by the 24.8 million shares of ARSD outstanding, we get a value for AMAK of $5.56 per share of ARSD at that time. More recently, AMAK raised additional capital on December 9th, 2012. ARSD and other shareholders purchased newly issued shares which now values the mine at $6.27 per share of ARSD.
Another way to value the mine is to project its cash flows to ARSD. Using information from AMAK's website and the following assumptions for metal prices:
We project the mine to produce annual net revenue of $108.3 million with operating costs of $22.5 million, thus giving AMAK an annual operating profit of $94 million. The mine pays a 20% tax as well as a 5% withholding tax. Operating profit after taxes will approximate $64.4 million. Using free cash flow to pay off debt of $88 million from the Saudi Industrial Development Fund, it could take about 1.5 years to pay off. Since the mine's life is anticipated to be 11.5 years, there could still remain a solid 10 years of mining left after the debt has been paid off.
If AMAK gave dividends to its shareholders, ARSD would receive an 80% "Dividends Received Deduction" on its portion of dividends received (source).
ARSD should get its 35.3% share from the mine which comes out to $22.7 million per year. After all taxes and deductions, ARSD could receive $20.9 million in free cash flow annually assuming a 40% tax rate at the ARSD entity beginning in the middle of 2014 for 10 years.
On the 3Q call, CEO Nick Carter mentioned that ARSD is planning to account for AMAK on the equity method of accounting beginning on the next 10-K filed. The reason for the change is that ARSD has taken a more active position on the board and also controls the marketing of the products. The switch from the cost-method of accounting to equity will cause ARSD to restate three previous years of financials to show income statement gains and losses from AMAK over that time. This will reflect increased asset value on the balance sheet for the mine when compared to its cost under the previous accounting methodology. AMAK will show operating losses in 2011 and muted gains in 2012 and 2013 as the mine is still in its startup phase as it is still mining developmental ore bodies, but should show normalized profits and pay dividends from 2014 onwards.
Once AMAK is profitable for 2 years, it must issue 25% of the company to the public on the Saudi stock exchange, according to Saudi law.
Additional Value in the Mine
In addition to the current mine lease which covers 44 square kilometers, AMAK has applied for four new land leases which total an additional 294 square kilometers nearby the current location. Three of them are adjacent and the fourth is 30 kilometers to the east of the current site. The geology of the land in the additional leases is similar to the current lease and thus adds additional upside to the value of the mine once the reserves are proven. The resource study is expected to be completed by the end of 2014 and will show the proven reserves of the leases. Assuming that the leases have a similar composition, the leases can produce over six times the amount of the current mine. We estimate the additional infrastructure needed to be 200 kilometers of roads which would cost approximately $25 million to build. Assuming that the current plant is used to process the ore from the additional leases, the mine could remain in operation for an extra 50 years. A quick net present value calculation of this stream of cash flows (net of capex) implies an incremental value to ARSD of $248.5 million in today's dollars, or $10.02 per share, which is not included in our valuation assumption.
What This All Means
Adding the values of the petro-chemical business and the mine together, we get a target share price for ARSD of $17.83 per share. It is clear that the market is paying little attention to this company's quarterly calls and also does not give value to the AMAK mine. In our valuation, we do not take into account any new potential petrochemical customers although ARSD says it has received several test orders. Management has stated that they expect capacity at the current petrochemical facility to be reached by the end of 2013, which would create results well above those that we have projected and push the value of the petrochemical company even higher and thus ARSD's stock price.