Barron’s conducts an annual roundtable interview with seasoned money managers to gather insight into the markets and showcase some interesting investment opportunities. Midway through the year, Barron’s publishes a follow-up to see how these managers’ picks have performed and to see how expectations have changed. I was interested to see commentary by Meryl Witmer, general partner of Eagle Capital Management, about a company called Innophos Holdings (IPHS), a producer of specialty phosphates.
This is what Witmer had to say about IPHS:
Innophos Holdings [IPHS] has 23 million shares and sells for 43. Innophos, along with its main competitor, ICL, are the two main producers of specialty phosphate products in North America. The majority of Innophos’ business is specialty ingredients such as minerals fortification, leavening agents in bakery products and excipients in pharmaceutical tablets, which bind the ingredients. The company also makes additives for deli meats and abrasives in toothpaste.
Specialty ingredients usually account for less than 1% of the overall cost of a product. They deliver technical effects that are hard to replicate with substitutes, and it can take months to qualify a specialty phosphate in a product so it generally isn’t worth switching suppliers. These attributes allow Innophos to pass through cost inflation in its key input, phosphate rock. It recently restructured its rock sourcing to have multiple suppliers and shorter lag times between price fluctuations. The company buys phosphate rock in Mexico and converts it to an intermediate product. It also buys intermediate product in the U.S. and processes it further into specialty ingredients. Innophos is working to shift some sales in Mexico to higher-value-added products.
How much does Innophos earn?
The company could earn about $4.70 a share of free cash flow in 2011 and about $5 in 2012. Reported earnings are about $1 a share lower. Innophos has a strong balance sheet with little net debt. It is worth about 12 times free cash flow. Our target price is $65.
Witmer’s description makes IPHS sound extremely compelling: Ongoing sales of a consumable product with price-inelastic characteristics and high switching costs usually translates into a competitive moat that allows for persistent and strong returns. I decided to investigate further.
The first thing I do after I’ve found an interesting possibility is to rebuild the financial statements in my Excel model. At this stage, I want to know very little about the company’s strategy or growth prospects so as to avoid bias when assessing the company’s history; once I am done looking at the company’s past performance, I’ll then consider these things in formulating assumptions for different future scenarios.
To start, this is a young company. It was formed in 2004 and went public in 2006. This presents an immediate problem in that a short track record provides little insight into management’s abilities. I like to look at companies that have been able to grow revenues for more than a decade without sacrificing return performance or free cash flows. For IPHS, it will be difficult to draw these conclusions.
The following chart shows the variability of the company’s returns since inception (note, this is a zoomed-in version to give a closer look at quarterly returns):
[Click all to enlarge]
IPHS Returns, 2005 - 1Q 2011
The variability in these returns is significant, which makes it difficult to have any conviction about management’s abilities. How about revenues and margins?
This chart provides a bit of evidence to suggest the company is doing something right. It's been able to maintain upward trending revenues despite the recession, but it seems it may have accomplished this through discounting, as its gross margin has contracted significantly since 2008, and seems to be approaching a more normal level in the high teens. You can tell that it has a highly variable cost structure, in that its margins largely move in sync – this is a good sign. Let’s check to see whether these sales have been accomplished through looser customer credit, or some other financial shenanigan.
Everything looks good here. Days Sales Outstanding have been remarkably stable, and management is making the right moves by bringing inventory back into line after a drastic decline in revenue in 2009 caught it off-guard. Let’s check free cash flow.
Unfortunately, unlike other companies we’ve looked at, IPHS has not had a stable relationship between revenue growth and free cash flow growth. To quantify this, free cash flow has averaged 9% of revenues over the last six years (using annualized figures), but the standard deviation of this relationship is a whopping 7.6%, making it more difficult to form expectations about how relationships will continue in the future.
One last thing to take a look at is the company’s capital structure. The following chart shows how the company has been aggressively reducing debt, which is a good thing in that it reduces the overall riskiness of the enterprise.
Where does all of this leave us? As expected with a relatively young business, operations have been characterized by volatility, which introduces risks when we are forming expectations. On the plus side, management seems quite capable and focused on improving operations, as we see revenue trending upward, working capital declining, and debt being quickly being paid off. Given the company’s relatively low share count, improvements in revenue should lead to a corresponding jump in EPS, which is a focal point of many investors and could lead to some upside if the company’s earnings multiple remains stable (though, given its relatively high multiple, this will be contingent on future growth expectations remaining quite high). Unfortunately, it is difficult to draw conclusions about free cash flow, given the particularly intense volatility in that metric.
The final step is to value the company using different scenarios for its future growth and margins. Having done this, I believe the company looks fairly valued in the high $40s (as of June 27), and that any expected upside would be based on speculation about the company’s future growth. Consequently, I don’t believe this is a value opportunity, as it reflect a “heads I win, tails I lose” situation rather than the far more favorable “heads I win, tails I don’t lose much.”
An investment in IPHS necessitates a high level of insight into the company and industry, and extremely strong convictions about its future growth. I would rather find a situation where the company is immediately undervalued, rather than undervalued only if my best expectations come true.