Based on YTD performance, there are quite a few firms in the basic materials sector that have experienced a drastic time in the market. For this industry in particular, margin compression and the overall negative sentiment associated with the industry are typically the driving forces that create a downward pressure on valuation, but fortunately for Calumet Specialty Products, LP (NASDAQ:CLMT), this does not seem to be the case. The pressing issue at the moment actually pertains to the environmental regulatory concerns that are posing implications on its cost structure.
Recently, there have been numerous issues among refineries surrounding pollution and the use of ethanol in their products. Unlike other refineries, CLMT does not want to use ethanol in its products, and as a result, its cost structure is going to see dramatic changes in the short-run. For not complying with the use of ethanol in its products, the additional cost per quarter is going to be in excess of an estimated $20mm. Additionally, CLMT has sizable expansion options that it's currently engaged in, and while its cost of issuing equity remains higher than its after-tax cost of debt, CLMT has chosen to engage in additional debt issuance to finance these expansion activities. The combination of its evolving cost structure and the short-term impact it's bound to have on earnings has created a large amount of uncertainty among investors, and unfortunately, it appears to have influenced its valuation quite a bit over the last six months. On the bright side, this has created an opportunity for investors to purchase shares at a discount.
Operating in the basic materials sector, CLMT maintains a dominant position above its peers through having one of the most diversified specialty hydrocarbon capabilities in the world. Its customer base is extensive in nature, and consists of both, domestic as well as international customers from across the globe. The geographical placement of CLMT's business facilities and other units extends across the United States, which is shown below. CLMT is headquartered out of Indiana, and you will see the majority of its remaining facilities are designated for refinery/production and distribution.
The unique attributes of CLMT's product offering are essentially what makes it capable of sustaining a niche customer base. And while being able to generate an economic profit from a monopolistic competitive market is advantageous, it also implies there is a high degree of specialization that goes into its final goods, which can be seen through the customized products that are catered to its customers needs.
In terms of its product offering, CLMT processes crude oil into a wide variety of different products, including branded products, personal care, food grade lubricants, base oils, specialty aliphatic solvents, synthetic lubricants, waxes, and different asphalts. Through its ability to process crude oil, CLMT also produces a diverse line of fuel-related products including gasoline, jet fuel, diesel, marine fuel, bio diesel, and ethanol-free fuels. Its final goods are then sold to individual consumers, corporations, as well as retailers for distribution to other end consumers. Here's an overview of some of its key customers:
(Source: CLMT's September 2013 Investor Presentation)
Over the last year, CLMT's shares have fallen by about 7%, which is 28% behind the performance of the market as a whole. While initially its performance in the last year may not justify the extreme discount, its YTD performance does. Since the beginning of this year, its shares have lost nearly 25% of market value; shown below you will see the steady downward trend in its price.
(Source: Bloomberg Market Data for CLMT)
Despite the percentage lost current investors are faced with, CLMT's consistently high dividend yield provides an additional measure of downside risk protection for investors. Currently, CLMT provides an annual dividend of $2.74, which equates to an annual yield of roughly 10.05%. CLMT's management has implemented a strong dividend policy, and has made an effort to not only sustain its dividend, but increase it over time. Here's an overview of CLMT's dividend over the last six years.
(Source: CLMT's September 2013 Investor Presentation)
According to the September 2013 investor presentation CLMT's management gave, there's expected to be $420mm in additional capital expenditures over the next 12-24 months, and its important investors account for this when analyzing its valuation. While this appears relatively high, it must be looked at as simply an investment with the capability of providing a ROIC substantially higher than these initial costs. In modeling the intrinsic value of CLMT's operations, you will see I have included these expected costs set forth by management. Furthermore, I have included the majority of the capital expenditures in my share price estimate for 2014 to provide a more conservative estimate for investors. Although a portion of these cost are already being included in the end of this year's capital expenditures and a sizable portion may realized in early 2015, including a large amount of these costs in 2014 will provide a estimate investors can rely on. Looking below, you will see I forecasted CLMT's operating cash flow and capital expenditures to derive its free cash flow. Next, I used a variation of the basic corporate valuation model to project the future intrinsic value of its operations. In doing so, I multiplied the free cash flow estimate by 1 plus its perpetual growth rate, and then discounted it back by dividing it by the difference between its weighted average cost of capital and the perpetual growth rate. After accounting for debt, I arrived at the intrinsic value of equity, and finally, its intrinsic per share value. For the end of 2014, I anticipate its common shares will be truly worth roughly $36 on a per share basis. Given its current market price, this suggest a potential upside of nearly 33% from its current valuation, and if you factor in its dividend yield, investors are looking at potential return of just above 40% over the course of one year.
Looking forward, the return on capital invested into expansion will most likely not translate into any significant income until the next 12-24 months. However, this does not eliminate the fact there is room for investors to capitalize off the discount its shares provide in the short-term, and with a strong dividend yield, there is an adequate level of downside risk protection for investors who wish to initiate a position in the near-term. While CLMT undergoes expansion, it still has its niche customer base. The widespread consistency among its end consumers will continue to allow CLMT to generate operating cash flow to add value to the firm in the short run. In the long run, I feel patient investors will be rewarded the most, and as CLMT begins to receive the return on its capital investment, investors will begin to see a large increase in its operating cash flow.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CLMT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.