Intrepid Potash: FY19 Q2 Update

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About: Intrepid Potash, Inc. (IPI), Includes: MOS, NGL, NTR, WTTR
by: Bumbershoot Holdings
Summary

Q2'19 Update -- Mixed quarterly results taken decidedly negative. Enormous long-term potential being overlooked.

MOP Potash continues to produce solid cash flow. Concerns on Q3'19 pricing through "summer fill" program should be short-lived as demand remains solid, supported by fall-application and spring 2020 forecasts.

Trio continues to stabilize with 3rd consecutive quarter of positive GAAP gross margin.

Oilfield Solutions continues to confuse analysts/investors. Master plan coming into focus with Dinwiddie acquisition, NGL joint-marketing agreement, Select Energy pipeline, etc.

Remains one of my fund's highest conviction ideas and largest long-term investments. Expect 200%-300%+ upside over the next few years.

Intrepid Potash (IPI) reported results for Q2’19 on Tuesday morning. While headline results were somewhat mixed, investors’ reaction to the news was decidedly negative, taking shares down almost 10% to around $3.25. While the cause for concern is not entirely wrong, it does feel misguided, as Intrepid’s story is one that remains both highly misunderstood and of enormous potential. Realizing that potential is never a guarantee, but there are reasons to feel confident in the company’s intrinsic value materializing, as its long-term narrative has only just begun to take hold. Opportunities of this magnitude rarely come along and it is why Intrepid remains one of the largest positions in Bumbershoot Holdings LP, with the fund beneficially controlling more than 250k+ shares.

Quarterly Results

While headlines implied mixed results, Q2’19 was yet another period of solid operational execution. At a high-level, the company demonstrated growth across all three of its business lines and also continues to advance multiple strategic initiatives designed to help diversify & enhance the overall company.

Total consolidated revenue of $62.5m was up 13% compared against the prior year figure (after adjusting/restated for byproduct credits), despite setbacks/adverse weather conditions that resulted in a delayed agricultural planting across many parts of NA (MOP & Trio) and reduced oil completion activity in the Delaware Basin (Oilfield Services).

Consolidated gross profit of 13.2m continued to benefit from high fixed-cost leverage inherent within the company’s operating model, increasing roughly 80% yr-yr. Gross margin of 21% expanded a full 750bps from a year ago level as it combined higher potash pricing and stabilized Trio sales/pricing, along with an expanded Oilfield Service segment activity that is elevating the mix. While it arguably could have shown even stronger contribution margin, especially in MOP Potash, as consolidated gross margin contracted ~200bps sequentially and was cause for disappointment, management was “happy” with the operational performance (even if investors were not); and to their credit (or in their defense), keeping some of the minor anomalies from the quarter aside, it is still performing at a healthy level, especially benchmarked to where the business was just 6-12 months ago.

SG&A expenses continued to be held relatively in check at around $6.4m. This led to a mirroring overall OP of $6.4m, up from a mere breakeven last year. While the sequential OP margin contraction of less-than-100bps qtr-qtr may be frustrating, it is not cause for concern, as the figure still amounts to a perfectly healthy OP margin of 10.3%, in what was once again an otherwise unremarkable, “clean” quarter; and the overall level of profitability is indicative of the company moving into a fundamentally lower cost position since the period of distress a few years ago.

Below-the-line items were relatively immaterial and showed no major surprises. Interest expense of less than $1m reflects the modest level of balance sheet leverage. Tax expense was not recorded due to a valuation allowance, which matches the company’s shielded tax position from a cash taxes perspective as a result of sizable NOLs. This funneled down to bottom-line GAAP EPS of $0.04, in-line vs. consensus of $0.04. The company also reconciled an adjusted EBITDA of $14.9m.

Business Segments

As a reminder, Intrepid now presents in three reportable segments: Potash, Trio, and Oilfield Services. These were reclassified/adjusted in Q4’18 to account for growth in byproducts that are now booked as revenue rather than a cost credit, as well as the sizable/standalone opportunity in the Energy sector.

MOP Potash

Looking at the divisions more closely, the Potash segment produced solid results on the back of significantly higher realized pricing for traditional MOP product. Total reported gross segment sales of $35.5m increased by more than 10%+ yr-yr. This came on relatively comparable tonnage volume (~95k, down -3% yr-yr), despite reduced byproduct sales and impacts from severe weather/flooding in the Midwest. Average net price-per-ton increased 18% yr-yr and 4% sequentially to $299/ton, reflective of the continued protracted recovery in the commodity’s pricing over the past 12-24 months.

Costs are relatively fixed based on production levels from the previous “harvest” and the improvement in realized pricing drove a leveraged increase in margin/profitability. Gross margin expanding over 350bps yr-yr to 23.1% and gross profit increased ~30% to $8.2m on a GAAP basis, inclusive of significant non-cash D&A charges. While not the most efficient quarter, as contribution-margin-per-ton contracted on a sequential basis from Q1’19 record levels, it was still reflective of the fundamentally lower cost position reached following a furlough of the West mine and the conversion of the East mine to Trio/Langbeinite/SOPM product during the period of distress a couple of years ago. The lower efficiency appears to primarily be related to reduced byproduct sales, mag-chloride in particular, although I’m willing to chalk it up as a 3-month anomaly, rather than a more meaningful trend. While there may also be some hidden (temporary?) cash-cost inefficiency, it is difficult to analyze without seeing additional results on a go-forward basis. While certainly a metric to track, the step back from last quarter is not overly surprising given how far ahead Q1 had been from a performance perspective, with the reality probably being somewhere in the middle.

From a production/cost perspective, it is important to remember that while the segment is marketing MOP potash that is “traditional” in a chemical sense (i.e.: Muriate of Potash, potassium-chloride, KCl), Intrepid is not producing it's product in the customary fashion via traditional underground mining. Rather, Intrepid instead relies on an evaporation mining technique that it employs at various mine locations in Moab UT, Wendover UT, and Carlsbad NM, affording it a top-quartile cost structure when viewed in the context of the global cost curve. Additional information on the locations and physical attributes of the mines was detailed in my initial write-up on the company from 2016 titled, Betting on Bob! Despite being a couple of years old, it is still relevant to help fully understand and assess the current productive asset base. Details on the new cost structure and financials were included in a follow-up report titled, Betting on Joc, which was published later in 2016.

The outlook for the Potash division remains encouraging, as it is on track to deliver its best year since the breakup of the BPC (Belarus/Russia) cartel in 2013-2014. The fall application should be strong given the limited amount of corn acreage leading to a jump in pricing, along with firming soybean pricing. Demand is expected to remain strong heading into the 2020 spring planting due to increased intentions for corn acreage, etc. Overall demand growth has been supported by relatively stable, “affordable” pricing; and Nutrien’s (NTR) forecast for long-term tonnage growth of 2.5%-3.0% is the highest of any of the primary nutrients. Despite investors being a thrown a curveball on pricing from the “summer fill” program down more than expected, in the grand scheme this should be a “blip” on the radar with pricing already recovering a majority of the way. On the production side, Intrepid should continue to benefit from favorable evaporation conditions, leaving it with more concentrated brine grades that can bring its production closer to/above the “nameplate capacity” of the solar mines set at 400k tons. This should provide it with solid levels of inventory from a cost/tonnage perspective to sell at a time when pricing remains supportive of meaningful cash-flow and profitability. This would advance the view on valuation in the $500m-$1bn+ range, supported by traditional FCF/earnings metrics.

Trio

The Trio division continues to stabilize. As a reminder, Trio is a “specialty potash” known as langbeinite, or sulphate-of-potash-magnesia (SOPM), which competes primarily with Mosaic’s K-Mag, as well as other makeshift blends of product (Kieserite, etc) for chlorine-sensitive applications and sulfur/magnesium deficient soils & geographies. The segment reported a 3rd consecutive quarter of positive GAAP gross margin, despite weather challenges and reduced average net pricing on international shipments.

The outlook for Trio remains contentious, with investors generally being of two minds. In one camp, the focus is on the huge gap in “agronomic value” of the nutrient blend that is not being realized. This lends itself to the view that Trio should be able to benefit from material price increases over time, allowing it to return to being a sizable cash-flow generator. There is some credibility to this view, given that Trio used to be priced at premium to MOP and was selling as a $400+/ton product with no complaints. The other side, however, is that while the business is no longer detracting from results—and is mildly additive/accretive at current price level—it has shown no signs of being near to turning the corner on a meaningful inflection higher. This has been exacerbated by erratic pricing behavior from Mosaic; and while management appears confident in the strategic trajectory, recapturing the historical variance and reclaiming its former glory as a structural profit machine, it is unlikely to happen with any immediacy.

Depending on which camp you’re in, it should weigh heavily on any view of valuation for the asset base. Although, at the current moment, there is effectively zero value being awarded to the share price for Trio—so a more constructive view would only represent upside.

Oilfield Solutions / Water

In the Oilfield Solutions segment, reported revenue grew 40%+ yr-yr with the inclusion of 2-months from the Intrepid South (Dinwiddie Ranch) acquisition. Gross profit held similar vs. the prior year though as additional costs and lower completion activity in the Delaware Basin held back near-term performance.

Overall, the segment continues to confound investors & analysts that are troubled to look through this short-term volatility. The key is to simply understand that a lot has changed; and the business is developing into a much larger potential opportunity than just an annuity on water sales. Fresh water sales within the Northern Delaware shelf of the Permian Basin remains the prime ambition, but it is bolstered by a wide variety of activities (KCl mixing, produced salt water disposal wells, caliche, right-of-way/easements, etc.) that are taking place in both the Permian, as well as other geographies/basins. This is a challenge, as investors will need to have patience while the story develops.

This transformation is not just coming from Intrepid. It is the story of the entire Energy sector. For the Permian Basin specifically, there are major developments in takeaway capacity being put in place, price differentials on oil/gas that are narrowing, and completion activity that is now primed to take off with frac schedules being set to begin running through the massive build-up of inventory of drilled-but-uncompleted wells (DUCs).

Intrepid is doing its part in the transformation. On a company-specific basis, it announced a major new development via a joint marketing agreement with NGL Energy Partners (NGL). This agreement will combine the land area of the Dinwiddie Ranch acquisition (Intrepid South) with two adjoining ranches (Beckham & McCloy) that NGL purchased in late 2018 for $93m. It also announced a small land deal just across the border in TX that has successfully permitted salt-water disposal wells with capacity of over 100k+ barrel-per-day. Construction of Select Energy’s pipeline coming down the east side of Intrepid’s mine in the Northern Delaware also remains on time, and on budget. This will allow the company to market additional water from its “legacy” water rights to the combined area, after it sells through the combined annual allotment (~3,000e acre-ft). It is also using its “captive audience” position to leverage caliche sales and right-of-ways/easements.

Most of this is still evolving. While the outside of the “jigsaw puzzle” has now been framed, transparency remains somewhat limited; and the majority of the new activity will not start showing up in the numbers until at least next year. I have an exceedingly high level of conviction/confidence in management’s decisions to date, though, and the value being created. The Permian Basin (and Delaware shelf specifically) is the most exciting/dynamic component of the oil & gas sector for domestic, tight oil production. Intrepid appears to be positioning as one of the leading players in a critical subsection of the market. This was the aspect discussed in significantly more detail in a report from earlier this year titled, Betting on Blue, which focused on the company’s substantial water rights as one of the largest legacy holders in Southeastern New Mexico. As detailed in that report, I believe the company’s water rights could eventually be worth in excess of $1b+ on their own.

Financial Model

Reviewing the financial model, FY’19 continues to be a year of significant transformation and growth. I commented after last quarter that I expected FCF for the full-year to approach/exceed $75m. That improvement had been based almost entirely on the leverage effect from per-ton pricing improvement in the MOP Potash segment, and actually had included rather conservative estimates for Trio and Oilfield Solutions, pro-forma to include the Dinwiddie Ranch acquisition. While I still believe there is an outside shot to hit that number, depending on the pickup in frac schedules in the latter part of the year that could take water sales above the current guidance and/or vagaries around working capital requirements/capex spending, it is admittedly trending somewhat lower after the Q2’19 inefficiency on the contribution margin/lower byproduct sales and pricing for the Q3’19 “summer fill” program being as it was. Higher levels of growth/investment capex, above sustaining/maintenance capex of less than $15m, is now more identifiable to be spent given the TX land acquisition for disposal wells. While this is a good thing for latter years, it reduces the “non-economic” cash variance between reported depreciation vs. sustaining capex.

Looking ahead to FY’20, these figures should continue to advance. A stable/recovering MOP price environment in NA, anchored by strong intentions for corn acreage, combined with improved pricing/cash flow in Trio and dramatically expanded water sales within the Oilfield Solutions business, should lead to a material lift in consolidated profitability. A lot of the growth in freshwater sales is already in hand, based on the announced joint marketing agreement with NGL Energy Partners, as well as the completion of Select Energy’s Northern Delaware pipeline that will allow Intrepid to sell an additional 100k+ barrels of water per day from its caprock water rights. While it is still early days, I continue to see no impediment to Intrepid approaching $100m of FCF for year, dependent on additional capital investment programs that could further grow the out-years.

Balance Sheet & Capital Allocation

Turning to the balance sheet, despite being only a few years removed from a nasty distress situation, Intrepid now finds itself in a healthy capital position. Net debt was approximately $55m as of Jun-30th, inclusive of the Dinwiddie Ranch completed acquisition. The gross debt of $70m is primarily held in three tranches of Senior Notes that come due in 2020, 2023, and 2025. The first tranche (Series A, $20m) was moved into current liabilities and is expected to be paid in April of next year. The second two tranches, Series B and Series C, are each $15m and at interest rates of ~4.6% and ~4.8%, respectively, which represent the lowest rates available under the credit matrix for the notes. The remaining $20m of debt was from an advance on the company’s ABL credit facility, used to complete the acquisition. It recently amended that credit facility from an ABL to a cash-flow facility and extended it for a term of 5-years until Aug-2024. The facility was expanded to $75m capacity (plus an accordion) with a rate of LIBOR + 125-200bps.

All told, the leverage appears quite manageable based on the company’s return to significant cash flow generation. But this may be both a blessing and a curse, as the financial capacity/flexibility to pursue a wide range of options is causing capital allocation questions to become both the single biggest opportunity and risk factor. Internal/external investment in high margin, ancillary/ bolt-on offerings within the Oilfield Solutions segment remain the focus, but to do so without perception of re-levering too quickly and jeopardizing the company’s progress is a balancing act.

Valuation

In regard to valuation, Intrepid shares continue to be priced “cheap” on both an absolute and relative basis. Using an EV of $480m, based on an FD share-count of 131m and net debt of $55m, shares at the current price of ~$3.25 are implying a FCF yield of 12.5%-16.5% on a blend of FY’19/20 forecasts.

Even with a recent number of E&P stocks imploding, that equivalent level of value is essentially unmatched, except from companies with untenable balance sheet leverage/significantly different risk tolerances. Intrepid’s shares are trading for less than book-value, for a business that has generated a cash yield north of 10%+ on a trailing basis.

As I'd outlined in the last quarter's update, as well as in a lengthier report titled, Betting on Blue, that was specifically focused on the opportunity in the Permian Basin, I believe shares are positioned for 200%-300%+ potential upside over the next few years as the disconnect in valuation is bridged.

Summary

While shares continue to languish in the $3 range, the transformation of Intrepid’s business is upon us. I have confidence in the strategic direction of the company to diversify, expand, & take advantage of its substantial legacy water rights in the Permian Basin; and it remains my highest conviction investment and a top position in my fund.

Disclosure: I am/we are long IPI, NTR, WTTR. 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.