- Analysts are still underestimating the company. Nor are they factoring in the ethanol blending policy that may affect Cosan's profits.
- As well as Cosan is performing today, the company still has not reached its full potential.
- With shares currently trading at 7-times EPS estimates of $1.64, I'm projecting fair value to reach $15 to $16 in the next 12 to 18 months.
With the U.S. equity markets soaring to new highs, investors have developed a bit of anxiety about a potential bubble. Recently joining the list of pessimists is hedge-fund superstar David Einhorn, who insists "we are witnessing our second tech bubble in 15 years."
Einhorn's chief concern is on stock prices, believing investors have rejected "conventional valuation methods." He stopped short of identifying which companies fit the bubble criteria. But one thing is certain, it's unclear what will pop it. Although investors enjoy their gains, they're also looking for safety. And diversifying their stocks with overseas companies is one great way to offset your risk.
To that end, Cosan Limited (NYSE:CZZ), which is a strong play in the growing Brazilian industry for sugar and ethanol, deserves strong consideration as one of the best kept secrets in overseas markets. Despite Cosan's position in Brazil's two largest industries, the company has yet to participate in the recent rebound in Brazilian equities. But it's only a matter of time. Some of Cosan's underperformance is due to its capital structure, which, admittedly, is not easy to understand. But I'll clear things up for you in a moment.
For now, let's focus on the potential ethanol commodity boom, which Cosan is well-positioned to exploit. And in a broad sense, Cosan's newer business initiatives also look promising. That's not to say there aren't risks. This is still a highly levered business. And when you consider the (at times) lack of visibility in quarterly reports, it makes for some sleepless nights. But what I do like about Cosan is management's growth ambitions, which, when combined with improved logistics and capacity, will turn sugar into cash. And the company's first-quarter earnings results offered the first glimpse.
The company was able to reverse an uninspiring fourth-quarter by posting revenue growth in all of its major segments for the first quarter. Consolidated revenue arrived at $913 million, up 13% year over year. And this was after 12% growth in the fourth quarter.
As I said earlier, some of the financials aren't easy to understand. One of the reasons is that, since the second quarter of 2013, segmental breakdowns no longer appear in the consolidated financials. Nevertheless, revenue from the Raizen Combustiveis segment was better than Street expectations, growing 19% year over year. Cosan benefited from strong pricing (up 9%) and was able to offset lower than forecasted volumes (up 10%).
Revenue and margins at Raizen Energia (up 11%) also topped Street projections, as sugar sales and ethanol sales climbed 41% and 16%, respectively, on a sequential basis. Like the Combustiveis segment, Energia enjoyed solid volume growth in both sugar and ethanol. And when you factor in the strong pricing, this supports my belief of the company's long-term underlying financial strength.
Not to be outdone, Comgas posted a 5% jump in revenue, due to a 9% increase in pricing. The better pricing helped offset a 4% decline in volume. Likewise, revenue in the Rumo logistics business surged 23%, while Lubricants rose 3%. The smaller Radar segment saw revenue surge by four-fold on a reported basis. All told, this is a company that is operating on all cylinders. There was no noticeable weakness in any segment.
From an operations standpoint, Cosan's 12% year-over-year growth in EBITDA beat Street estimates by roughly 2%. Cosan posted 18 cents in earnings per share, beating Street estimates by 80%. Analysts were looking for 10 cents per share. The earnings beat was driven by (among other things) lower-than-expected interest expense, which lead to inline operating results.
Management expanded gross margin by over 50 basis points. It was this that led to the strong adjusted EBITDA performance. The company posted a 23% profit increase in Combustiveis, while both Comgas and Energia advanced 9% and 10%, respectively. There was significant cost management as well. Cosan saw its debt-service costs dropped and it recorded a one-time gain on exchange variation. The company's net profit totaled 256 million Brazilian reais ($114.8 million) compared with a net profit of BRL27.14 million in the year-ago period.
As well as Cosan is performing today, the company still has not reached its full potential. Earlier this year, management announced plans to spin off Rumo Logistica for the purpose of merging with ALL, a leading Brazilian logistics company. The spin-off and subsequent merger would create a larger and stronger logistics brand, forming a company with increased presence in energy logistics, as ALL is already the largest company of its kind in Latin America.
However, this move will leave Cosan shareholders largely unaffected, as the holding company will retain its ownership interest in the subsequent entities. At the consolidated level, Cosan will hold shares in the newly created Cosan Logistica and Cosan Energia, but the ownership interest in underlying entities will essentially remain the same. This merger, which has already received shareholder approval, is awaiting regulatory approval.
There are plenty of benefits to doing this spin. Brazil's sugarcane crushing industry has historically been highly fragmented. While there have been signs of consolidation in recent years, with some small players exiting the industry and large players acquiring other mills, the competitive landscape remains challenging.
To date, when compared to companies like Adecoagro (NYSE:AGRO), Cosan is the only fully integrated producer of ethanol and sugar in Brazil. And when you factor the logistical advantages, including the ability to crush and refine both ethanol and sugar, Cosan is in no danger of ever being overtaken by smaller players like Tereos and Sao Martinho.
Plus the company also has the advantage of its Raizen joint-venture with Royal Dutch Shell (NYSE:RDS.A), which is Cosan's largest business. From a risk perspective, Cosan, by virtue of its Shell relationship, has a large network of Shell stations offering the sort of growth stability and risk protection that several rivals don't have.
To that end, management has made it clear that "growth and stability" are what they're striving for. And execution is falling into place. The company should also benefit from potential fuel price hikes as a result of ethanol blending. To date, ethanol blending in Brazil stands at 20-25%, which is relatively high when compared to the U.S., where the EPA is struggling to spur adoption of blends above 10%.
But there are regulatory discussions indicating that blending targets may be boosted in Brazil due to oversupplied conditions. Given inflation concerns from bouts of retail fuel price hikes for Petrobras, especially ahead of the October elections, higher ethanol blending could ease the impact of raising gasoline and diesel prices toward international levels. Cosan is well-positioned to benefit from this policy shift.
With that in mind, I've become bullish on Cosan's long-term valuation, based primarily on projected 2015 earnings-per-share of $1.64, which is too conservative. Recall, Cosan beat its first-quarter EPS by 80%. Analysts are still underestimating the company. Nor are they factoring in the ethanol blending policy that may affect Cosan's profits. I'm also taking into account projected 2015 EBITDA and a target multiple of enterprise value to projected 2015 revenue.
With shares currently trading at 7-times EPS estimates of $1.64, I'm projecting fair value to reach $15 to $16 in the next 12 to 18 months on the basis of free-cash-flow growth and long-term earnings per share growth.