Over the last year, I have written several articles providing coverage on American Arabian Development Co (ARSD). Since the publication of my first article in February, ARSD's common shares have returned over 70%. This entire time my investment thesis has been based on value as well as growth, and since, it has not changed. My first article articulated several reasons why ARSD was a solid buy given its valuation at the time, and the second article reinforced this thesis through providing a more in depth look at the companies fundamentals and elaborating on its internal growth prospects. Following the release of my second article in June, ARSD's stock price remained fairly stagnant, but the overall health of its business was continuing to improve. So, in September, I wrote an third article reiterating the case for value, and specifically, explained to investors why ARSD's stake in AL Masane Al Kobra Mining Company (AMAK) offers substantially more value than the market has price in.
Within the last three months, investors have seen fairly steady growth in its security price. Currently, its shares are trading under $13 per share, and even though several trading sessions have produced large gains, the underlying volatility in its price has not changed. Clearly, ARSD's intrinsic value is starting to become priced in, but with its capital investment in AMAK also beginning to pay off, investors are in a sound position with plenty of more to gain.
(Source: ARSD's One Year Price Graph from Bloomberg Market Data)
The current spread between ARSD's intrinsic and market value tells us that its share remain undervalued. Right now, the current discount its shares offer presents an attractive opportune for investors to make a profit, but on top of that, its intrinsic value does not appear to be declining anytime soon. With ARSD's stake in AMAK, there's a high probability that its intrinsic value will growth at a higher rate over the next two years than we have seen so far. ARSD continues to impress investors as well as analysts. ARSD's market price has finally satisfied the consensus price target of sell-side analyst, and while ARSD's performance is forcing current analysts to raise their price targets, its performance is also generating coverage from new analysts. With that being said, this article is going to serve as an update on ARSD that entails seven reasons why it continues to remain a strong buy. Shortly, you will understand why the combination of having a lucrative set of resources, a strong financial position, and divested interest in outside companies provides ARSD's shares with an intrinsic value that is substantially higher than what market participants have priced in.
Seven Reasons Why ARSD Offers Pretty Solid Value At Under $13 Per Share
#1 ARSD carries a strong set of assets on its balance sheet, which places investors in a keen position to benefit from the potential value these assets have to provide down the road. Over the last four years, the growth in ARSD's total assets has been quite impressive. Let's take a look:
On a YoY basis, the average growth rate of ARSD's total assets is 10.62%, and as you will see above, this has allowed its total asset account to nearly double in just four years. Also, it's important to recognize the vast majority of the growth in total assets can be attributed to the additions to ARSD's long-term assets, and not its current assets. In fact, its current asset account has experienced relatively little change over this time period, and since 2009, this account has only increased from $32mm to $45mm.
Now that we know ARSD's asset growth is primarily due to the increase in its long-term assets, it's time we take a closer look at exactly what these long term-assets on its balance sheet entails. Looking below, you will see an excerpt from ARSD's 10-Q showing the asset portion of its balance sheet. For understanding what makes up ARSD's other long-term assets, it's important to note that financial statements retrieved from Google Finance, Yahoo! Finance, or even Morningstar will appear significantly different. As you will see below, the financial statements from the SEC clearly label the other long-term asset accounts, but if you are looking at a different source, please note that I am referring to the same account that is often labeled "equity and other investments".
(Source: ARSD's 10-Q from sec.gov)
Based on its balance sheet above, you will see that the vast majority of the capital allocated to other long-term assets is invested into AMAK, while only a small portion of the account balance represents ARSD's ownership of mineral properties in the United States. Within the last nine months, ARSD increased its stake in AMAK with a capital investment of $16.499mm, which is an increase of 44% from its financial position at the end of 2012. ARSD's total equity investment AMAK now amounts to $54.4mm, and while many of you may view this large equity stake to be quite risky, it's actually not. AMAK is a Saudi Arabia mining company, and as far as I'm concerned, this is one of ARSD's largest catalysts in terms of future growth. Moreover, the equity stake in AMAK provides ARSD with access to some of the most lucrative resources at its disposal, and shortly, you will understand why the return on invested capital (NASDAQ:ROIC) into AMAK will likely exceed the ROIC into its specialty petrochemical business.
#2 ARSD's capital structure serves as positive reinforcement for maintaining a strong financial position. It's fairly rare to come across a small, high-growth firm with a capital structure that's this shareholder friendly. ARSD's capital structure effectively caters to its financing needs, yet it also reduces the investor's overall exposure to risk. Currently, ARSD's long-term debt to equity ratio and debt to equity ratio are only 0.15 and 0.17, respectively. Since ARSD does not use debt as the primary source for financing its operations, we can eliminate the magnitude of the risks that are associated with a firm being to leveraged in terms of debt. Anytime a firm uses a lower level of debt, the fixed interest payments will automatically be lower, and with lower level of fixed interest payments, a firm's overall financial leverage with be lower. As you will see, ARSD's financial leverage is extremely low, which implies there is a low level of sensitivity of EPS to the changes in operating income, or EBIT. So in order words, ARSD's final EPS figure is not heavily influenced by dramatic changes in its EBIT.
For financing its operations, ARSD's high level of liquid assets on hand usually does the trick, but in the case financing sources were to dry up, its low cost of equity at only 9.5% make issuing equity a viable option. As we saw earlier, ARSD's assets have experienced excellent growth over the last four years, and for ARSD to continue gaining market share over the next two years, asset growth is clearly going to play a major role. As of now, ARSD utilizes a large portion of its current assets to fulfill short-term finding needs, and given this does not appear to be changing anytime soon, it's important that investors watch out for changes in liquidity. So while its operations remain dependent on current assets for funding, the current and quick ratio are two metrics that should be monitored on at least a quarterly basis.
As you can see, both ratios suggest ARSD is fairly liquid, and with the exception of a several small fluctuations, its liquidity has remained relatively the same since 2010. In practice, the current ratio tends to hold popularity over the quick ratio, however since ARSD has a high level of inventory, the quick ratio is far more appropriate for ARSD becauase it excludes inventory. Inventory is not always perceived to be liquid because it may not be physically capable of being sold right away or it may have to be sold at a discount. Regardless, ARSD's quick ratio is above 2, which tells us that it still has a large portion of current assets that are highly liquid and available for funding needs. The primary reason ARSD is capable of sustaining this liquidity level is because of how quickly it can convert its resource inputs into cash flows, which can be quantified by computing the cash conversion cycle. Having a cash conversion cycle that's less than 40 days allows ARSD to quickly recycle funds into reserves for working capital.
#3 The performance of ARSD's specialty petrochemical business has been steady, and by offering a product line with a wide array of different applications, its developed sustainability within its customer base. The specialty petrochemicals segment of ARSD's business is conducted through its wholly owned entity, South Hampton Resources (SHR). SHR is a facility covering 115 acres and is fully operated by ARSD in southeastern, Texas. The products manufactured at SHR are sold as intermediate components to manufacturers competing in a variety of markets, including expandable polystyrene, polyethylene, adhesives, building foams, synthetic rubber, and food processing. Clearly, ARSD offers a diverse set of products in terms of its application. For further reference, here's an overview of the specific applications and uses of its products.
(Source: ARSD's Investor Presentation from the LD Micro Conference on December 4, 2013)
By operating at such a large facility, SHR has established a name and position for itself within the industry. More importantly, this has allowed ARSD to enjoy the profits along the way. Among its industry competitors, SHR lies at the top in terms of the quality it provides. Currently, it's estimated that SHR commands roughly 80% of the market share for C5 solvents in North America. In addition to C5 solvents, we already know that its products have quite a few applications. Therefore, it's easy to understand why ARSD's is capable of satisfying the end consumers need across a wide variety of different industries. Here's an overview of the end market uses for its products with the respective percentage they demand of the total market for its products.
(Source: ARSD's Investor Presentation from the LD Micro Conference on December 4, 2013)
By offering quality goods that incorporate a high degree of specialization, ARSD has been able to gain a large share of the existing market. And with a product line that caters to wide range of different applications, ARSD has developed and is effectively capable of retaining a large customer base. Today, some of ARSD's customer Exxon Mobile (NYSE:XOM), 3M (NYSE:MMM), Dupont, Dow Chemical Company (DOW), Baker Hughes (BHI), Dart, Chevron (NYSE:CVX), NOVA Chemicals, Imperial Oil (NYSEMKT:IMO), Calumet (NASDAQ:CLMT), Advance Romantics, and Lyondell (NYSE:LYB). Having large corporations as primary customers is an excellent way to enhance the consistency of a business and maintain a timely collection of receivables, and since these major corporations are reliant on ARSD's products for their operations, its customer base automatically incorporates a higher degree of sustainability than the majority of its peers.
#4 ARSD is now starting to capitalize on the lucrative resources being retrieved at AMAK, and over the next two years, investors should expect to see a strong increase in the ROIC at this mining property. As previously mentioned, a large portion of ARSD's business entails mining, which is primarily conducted through its 35% stake in AMAK. So far, the ROIC on its mining project through AMAK project has been minimal, however the properties owned and operated by AMAK do contain a significant amount of resources that have been proven to exist. For investors, it's been a wild ride up to this point, but based off management's recent update on the progress at the mine, patient investors will continue to be rewarded. ARSD's investment in AMAK is finally beginning to pay off, and quite well, I must add.
According to management's report on November 18, 2013, ARSD's management reported an update on the operations at AMAK revealing AMAK achieved a milestone of 1.0 million dry metric tons of throughput at the mill. With this production rate, management is confident that AMAK will be capable of reaching its goal of a shipping the projected ore tonnage by the end of 2013. Additionally, management announced AMAK expects to have sold 36,000 tons of zinc concentrate and 36,000 tons of copper concentrate by the end of this year.
So far, AMAK has had a successful year, but there are a couple of internal changes taking place at the mine in order to improve efficiency. Currently, AMAK is modifying the floatation circuits at the mine, which will improve the not only the recovery, but the overall quality of the zinc concentrate as well. Also, construction is underway to modify the gold circuit to achieve the required product specifications and recovery. These two changes are expected to be completed by the end of Q2 in 2014.
#5 ARSD's ability to generate free cash flow is exceptional, and with the cash being generated by its stake in AMAK, investors should get ready to see a sizable increase in this area. Typically, investors of small firms are often faced with period of negative free cash flow in the early stage of business, but with ARSD, that's rarely been the case. With the exception of the two quarters where ARSD suffered from high capital expenditures, its generated positive free cash flow every year since the Q3 in 2009.
#6 The price of Zinc in commodity markets is projected to increase over the next two years, and since Zinc is one of the key metals retrieved at AMAK, this would have a significant influence on ARSD's operating cash flow. The price of metals such as Zinc and Copper do have an influence on the ARSD's annual revenues and returns. Even though the price of metals fluctuated quite a bit in commodity markets this year, ARSD was still able to meet its year end revenue goals. Below, you will see the price of Zinc took a nasty turn at the beginning of the year, and since, its price has yet to make a decent recovery.
As of now, Zinc prices are forecasted to increase by as much as 20% in 2014, and the potential for even more appreciation in 2015. The projected price range for Zinc next year lies between $1,900-$2,400 per ton, which implies there's a lot of variability in its price. On the other hand, it appears that Copper will be much more stable than Zinc in 2014. The projected price range for copper stand at $6,500-$7,500 per ton.
#7 ARSD's shares trade at a current discount of 50% based on its current enterprise value multiple and its expected EBITDA for 2014. Over the last two years, ARSD's P/E has fluctuated quite a bit. Looking below, you will see its currently trading at a P/E of 17.25, which is roughly 16.5x its forward earnings. For a small capitalization for experiencing high growth, the P/E ratio is not always the best measure. For ARSD in particular, I tend to steer away from focusing on its P/E, and instead, concentrate on enterprise value and the intrinsic value of its equity.
In order to provide investors with a better idea of what to expect over the next year, I have used its enterprise value and EBITDA guidance for 2014 in conjunction with the historical average for its EV multiple. For starters, let's see what ARSD's shares are currently worth based on its enterprise value.
Given ARSD closed at $12.61 on Tuesday, December 24th, you will see its enterprise value suggests there's relatively no difference between its market and true equity value. Also, you will notice that when using management's EBITDA guidance for 2014, its EV multiple for the end of 2014 is projected to be slightly lower at 7.87x. While this is the implied EV multiple for the end of 2014, ARSD's operations easily command a high multiple, and at a minimum, I feel investors should use the industry average. With that being said, let's take a look at the change in equity value when we apply an EV multiple of 10.5x to its 2014 EBITDA guidance.
The final output of the model provides ARSD with a higher enterprise value, but the real impact can be seen through its equity value. By applying a higher EV multiple you will see that the equity value is projected to be approximately $466mm for 2014. On a per share basis, investors are looking at an equity value of $19.31, which equates to a potential return of 53.15% from its current market price. Conclusively, the enterprise value is a much better way to place a fair value on ARSD's common shares because the enterprise value is the implied cost a firm would have to pay of they wanted to acquire ARSD.
For a smaller firm, ARSD's stock exhibits a low level of volatility in the market. The variance of its holding period returns over the last two years is considerably low, and surprisingly, its beta is only 1.4, which is lower than the vast majority of its peers. Also, we've seen ARSD has consistently been able to maintain a strong financial position, and interestingly enough, ARSD has little need to engage in debt financing. With the absence of large debt obligations, ARSD's operations generate a high level of free cash flow. The combination of having a strong financial position and a stock that presents a low level of volatility provides a fair amount of downside risk protection to investors. The large increases in its stock price have allowed its market price to become closer to reaching its intrinsic value, but while its shares continue to remain undervalued, investors should not fear a short-term sell off. Conclusively, the risk factors affecting its stock price in the short-term are insignificant, however, it's important that investors realize there are risks that have the potential to negatively effect its business in the long-run.
Within its specialty petrochemical business segment the greatest potential risks are an increase in price competition among its competitors and the possibility of losing key customers. Given the degree of specialization is high, its imput costs are not cheap, which means ARSD has to charge a decent price for its goods. Therefore, price competition is always a threat when there are existing firms looking to enter the market. As we saw earlier, ARSD's customer base serves a wide range of different customers, however, there are several customers that constitute a large portion of its total sales from this business segment. If ARSD were to lose one of its major customers, its earnings from this segment would be heavily impacted. Recently, management addressed this concern at an earnings call, and stated going forward they are looking at finding more customers that will engage in large orders to help reduce its dependence on few consumers. While there a couple of risks within this business segment, the potential value to be added from its operations at AMAK makes its capital investment in this business extremely more risky. Typically, start-up mines are very risky. The success rate is fairly low, and in a lot of cases, investors do not see the return on the initial capital invested. With that being said, investors should find the current status of its ongoing projects at the mine quite relieving. So far, AMAK has reached all of its operation goals for the year, and the forecast for 2014 has even been revised. Therefore, the only real risks investors need to be aware of are the price fluctuations of metals in the commodity markets and the potential for delays in operations that could result in backlogged work.
Conclusively, ARSD is an excellent company that is well positioned to continue experiencing the high growth it has recently seen. The specialty petrochemical segment of its business supports a diverse set of different products that exhibit a high demand, yet are highly specialized in nature. However, investors will see the highest future returns from its ownership in AMAK, which has yet to be seriously priced in. Over the last several years, ARSD's management has proven its dedication to shareholders by providing the highest return on capital invested through maintaining a well balanced capital structure. The intrinsic share price estimates I have provided in previous article have been reached, and the same goes for the consensus price target of analysts covering the stock. As of now, sell-side analysts continue to be optimistic, and it appears, ARSD's performance in the market is beginning to attract more attention. At the time my last article was published, there were only a handful of sell-side analysts providing coverage on the stock. Now, there's a total of eight analysts providing coverage with a consensus price target of $15.50 per share. Looking ahead, ARSD serves as an excellent investment for individuals with both short- and long-term investment horizons. Patient investors have the potential to capitalize on another 50% over the next year as the projects at AMAK continue to progress.
Disclosure: I am long ARSD. 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.