I Hear the Train A' Coming...
North American rail transportation has proven to be a very rewarding sector to be in recent years. The rail industry has attracted the attention of several notable investors for several key reasons: it is one of the most fuel efficient methods of transporting goods and barriers to entry are extremely high - they simply aren't going to be making any more railways soon. Railroads also hold a very special place in the hearts of the students of Ben Graham, as many of the examples set forth in Security Analysis discuss the valuation of railroad bonds.
In an earlier article, I discussed a possible "cigar-butt" opportunity in a rail car producer, FreightCar America (NASDAQ:RAIL). Today I will be discussing a company that is on the other end of the value spectrum, one that I believe is firmly in Warren Buffett's "good business at a fair price" camp. The company is Koppers Holdings, (NYSE:KOP). One segment of the company provides products used by the rail and utilities industries in addition to a wider product portfolio of chemicals engaged in aluminum, steel and plastics production.
Koppers produces significant free cash flow, pays a healthy and growing dividend and enjoys operating and geographic diversity. It also has a demonstrated capacity to generate significant cash flow relative to assets employed in addition to being able to internally compound its earnings at a high rate, making it a compelling candidate for future research or purchase.
A Little History
Founded by the German industrialist Heinrich Koppers in 1912, the company has enjoyed an operating history of over a century. The company is headquartered in Pittsburgh, Pennsylvania - with its headquarters, Koppers Tower, considered to be one of the finest examples of art-deco architecture in the United States. In the modern era, the company was purchased by Beazer during an acquisition spree in 1988 for $1.8 billion in cash (not adjusted for inflation and more than twice the current market capitalization of the company). Due to excessive expansion, operating with a highly levered balance sheet and economic headwinds - the fortunes of the Beazer conglomerate significantly declined, leading the company to divest assets and merge with another English firm.
The Numbers on Koppers
In the aftermath of Beazer's collapse - a leaner version of Koppers was repurchased by management and went public in 2006, with the price of the stock peaking at $50 in 2008 and declining to $10 in 2009. The company is currently priced at $39.93 per share. With a P/E of 15, and $7.55 of book value and $3.05 of cash per share - investors are paying a premium for the assets of the company. The company is trading currently at 14x free cash flow, or 13x free cash flow when subtracting the cash holdings from the balance sheet. The company pays a dividend, currently yielding 2.50%. The payout ratio of the company is also low, at 33% - indicating potential for a dividend increase, an outcome that I consider very likely when viewed in conjunction with the robust cash flow of the company.
Insider ownership stands at 6.87%, a number that is on the lower end of what I consider "acceptable" levels of insider ownership - however, I also must acknowledge the fact that insider ownership in companies with a long history of operating is often lower than average.
A Discussion of Operating Segments:
Carbon Materials & Chemicals
Koppers produces various carbon chemicals - including types of pitch, naphthalene, phthalic anhydride and distillates of coal tar. Even though these chemicals may not sound terribly exciting, the products they go into are everywhere. The company makes feedstock for aluminum production, pitch that coats telephone poles, the chemicals that go into waterproof seals on roofs and automobiles and chemicals used in the production of tires, concrete and drywall. While investors are not aware of the presence of the company's products in their everyday life, the company's chemicals make a huge contribution to modern living.
Railroad and Utility Products
This area of business is the most interesting to me as an individual investor. Railroad transportation is a critical part of modern life and will continue to remain so for years to come. It simply is the most cost efficient way to transport goods in the absence of large bodies of water. As a result, any company engaged in providing services to the broader railroad industry is situated to enjoy a long-term source of business.
Koppers is the largest supplier of rail-ties to Class-1 railroads in North America. What's a crosstie? Allow me to illustrate with a capital "H" - If the vertical lines in the letter are the train tracks, the horizontal line is a crosstie. Now imagine just how many of those exist in North America. Just as roads must be repaved, crossties must be replaced as they can rot, degrade or crack under stress. When one considers the enormous amount of rail-track miles in North America and the constant capital investment by railroad companies in maintenance - the advantages of being in this niche business become apparent. In addition to crossties, the company also produces track panels and rail joints. The company also produces reinforced concrete products, which include concrete cross-ties and reinforced concrete utilized in the construction of walls and other aggregates.
Another very interesting part of the company's business is the manufacture of pressure and chemical treated poles utilized by electric and telephone companies. Walking through the average town or city in America is all it takes to understand that the potential market for telephone and electric poles is enormous - especially that poles are often known to occasionally break or fall over because of extreme weather, thus producing a natural source of replacement business in addition to the increased demand caused by housing developments.
Over the course of its history, Koppers has become a global presence - with facilities operating in China, Australia, the Netherlands and the United Kingdom. Australia is a very interesting area of potential growth to me, given the significant amount of rail-travel required to transport goods across the Outback. While Koppers derives the majority of its revenue from the United States, expansion into developing markets can provide the company with a much larger footprint. The railroad and utility segments of the company are concentrated in the United States and Australia - with Europe and China host exclusively to chemical production.
Presence of an Incentive Based Plan for Equity Compensation
Under the terms of the company's 2005 Long-Term Incentive Plan, members of the company are granted restricted stock units which vest after several years (In this case, 3 years for options granted before 2011 and 2 years for options granted after 2011). This program is variable - with stock rewards being commensurate with the performance of the company, firmly aligning the interests of management with those of minority shareholders. As a long-term investor, I would like to see the terms extended by an even longer period, however, in spite of this fact, I believe that current investors have the potential to time their purchases to the "sweet spot" of the period between 2013 and 2014 - in which the interests of both shareholders and executives are very closely intertwined.
Catalysts and Potential to be Acquired
I believe that this company is an excellent candidate for acquisition by a chemical producer or a company engaged in providing services to the rail industry as it makes basic chemicals and products which are in constant demand. In addition, the company has a lean business model and is able to consistently generate a large amount of free cash flow with very few underlying assets. The company also enjoys a considerable geographic advantage in the United States due to its proximity to coal and hydrocarbon deposits - which provide the necessary feedstock for its chemical production.
The revival of the long dormant aluminum industry could also provide Koppers with either the potential to realize increased earnings or a potential suitor, given the fact that the anodes used in the aluminum smelting process require significant amounts of carbon which are typically derived from Anthracite or pitch. Alcoa (NYSE:AA) is also headquartered in Pittsburgh, in addition to having operations in the United States, it also has a stake in a very large aluminum smelter near Geelong, Australia. The shared geography and industrial overlap between both Koppers and Alcoa could indicate the potential for a mutually beneficial commercial relationship if Alcoa returns to higher levels of profitability in the future.
If aluminum and steel consumption in the United States increases over the next several years, I believe that Koppers will be well positioned to further profit. As the company is already succeeding in a healthy fashion, I believe that the virtues of this company will become increasingly obvious to investors when industrial capacity of the United States regains vitality. It is also important to view the healthy performance of Koppers against the backdrop of anemic steel and aluminum markets - the fact that Koppers has been able to prosper at the low point in the cycle indicates that it could enjoy explosive growth when the sector revives.
Despite the anemic performance of American aluminum and steel producers, Koppers has been able to thrive. The company is currently returning over 7% on its assets, and of every dollar the company earns, it is able to retain and profitably utilize .70 cents, generating internal returns much higher than what are available to investors through investment rated corporate debt or treasuries. For a long-term investor, companies that are able to return this level on assets while repurchasing shares can produce significant long-term gains due to compounding - even better - these gains are only taxed once.
There are several risks to be aware of when considering an investment in this company. The first is that the company produces goods and chemicals which serve other businesses and as such, the performance of the enterprise is linked to the development of the global economy. Given the significant premium that investors are paying for shares of the company relative to assets, there is significant potential for the stock price to experience volatility.
As the company is engaged in the production of chemicals, Koppers is also potentially liable for environmental and class action lawsuits as well as regulatory penalties. Though the company was able to reach an agreement with Beazer East when it regained its corporate independence, with Beazer East agreeing to indemnify Koppers against environmental litigation during the period when the company was under ownership of the Beazer conglomerate until 2019 - there still remains the potential for litigation to arise at a later date or due to a current disaster at one of Koppers' facilities.
Per the company's 2012 annual report, the company was also short $76 million in pension obligations. The company's pension plan assets, as of the end of 2012, were 60% invested in equity securities (with over 70% of that 60% invested in the US equity markets). While this could be construed as a benefit given the significant increase in the stock market during 2013 - the specter of volatility and the potential of a significant drawdown in equity markets is always something to watch out for.
In my mind, Koppers amply satisfies several criteria that I utilize when searching for "superior" companies. The company enjoys a diversity of operating segments, stability of earnings, has amply demonstrated both the ability to generate above average returns on capital employed and the ability to pay an increasing dividend using a small portion of its total earnings.
As the company also operates both in the rail and chemical space, there is significant potential that it can be acquired due to its small size relative to its gigantic chemical producing peers. The company could also spin-off or sell its Railway and Utility operating segment to companies engaged in railroad services and support.
As with every company, the price of an asset is all important. I believe that at current levels, investors can either establish a fractional position and employ dollar cost averaging downwards or wait until the stock passes the 3% yield threshold. I will be a buyer of the company when it passes a 3% dividend yield and will also consider purchasing shares if I see management utilizing the $75 million of company funds in the company's stock repurchase program.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.