Newsletter Value Investor Insight carried an interview December 22nd with Robert Jaffe, who started his own fund, Force Capital, after working with Steven Cohen of SAC Capital for eight years. Force Capital now manages about $1.2 billion, and its core long-short fund has earned net returns of 17.0% per year since inception in mid-2002, versus 13.0% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview (also with co-workers with Mark Cohen, Paul Klibanow and Eric Newman) in which they discuss Cabot Corp. (CBT), which was trading at $41.63 at the time of the interview (current price here):
Why are you high on Cabot Corp [CBT]?
Mark Cohen: Cabot’s primary business is in producing carbon black, which is by weight the biggest ingredient in making tires. It’s an ugly, dirty business, but it supplies 90% of the company’s current cash flow. There are only three main carbon- black producers – Cabot, the Bass family of Texas and Degussa of Germany – which has brought some price rationality to what has been a cyclical business.
Cabot has an established culture of taking their strong cash flow from carbon black and investing it in new, differentiated products. They’re in Boston and can attract very smart scientists from Harvard and MIT to cook up new ideas.
Two of their ancillary products, in particular, are very interesting. One is a scarce, high-performance drilling fluid called cesium formate, which is a lubricant used in oil drilling that is particularly effective in high-pressure, off-shore drilling – where much of the new oil exploration is going on right now. There are some wells that simply cannot be drilled without cesium formate, which is why Cabot is able to charge for it 10x the price of conventional drilling fluids. The company owns roughly 80% of the total global supply and as the business grows, we expect it to attract the attention of one of the large oilfield-services companies, which could better exploit the full potential of the product. We think this is eventually a $100 million-a-year cash flow business – three times the current level – that could eventually be sold for 10x that.
The other product that we’re excited about is a printer-ink pigment Cabot has developed that is a key component in the enormous bet Hewlett-Packard is making on a new generation of inkjet printers and copiers, called Edgeline. Up to now, inkjet printing hasn’t had the quality or speed necessary to compete with laser with higher- end business customers, but – in no small part due to Cabot’s pigment – H-P believes that’s changed with this new line. They’ve invested more than $4 billion in the technology and are building a sales force to go against Ricoh and Xerox. The first generation of the new machines starts shipping in volume next quarter.
We like that H-P is highly motivated for this to work. A key reason it’s making such a huge investment is because it makes a higher margin on inkjet products. On their laser machines, they have to pay royalties to Canon for the laser technology. Because Cabot is the sole provider of ink pigment for these H-P machines, we see significant growth upside over many, many years. Our model, based on successful penetration of the Edgeline products, puts the present value of this business at $1.2-1.3 billion.
Is there a risk H-P will source the pigment elsewhere?
MC: It’s similar to car manufacturing, where once your part is sourced into a car you’re rarely taken out. They’ve perfected these printers over years of development with the very specific formulation Cabot provides. Once that’s set, it’s highly unlikely H-P would change suppliers. That makes Cabot a long-term razor in a razor/razor-blade situation.
With the shares just under $42, how are you looking at valuation?
RJ: Quite simply, we think the carbonblack business and the drilling-fluid business justify the current share price. Everything on top of that, including the $20 per share we think the inkjet-pigment business is worth, is upside.