12. Project Cupid Flashcards
Walk me through project cupid.
I am part of a four person deal team that is currently advising an activist hedge fund on its proxy battle with a $15 billion fertilizer producer and agricultural retailer.
Nine months ago, our client picked up a large equity stake in the company and privately pressured the company to address historical problems and unlock value for its shareholders. However, our client was met with intense opposition and subsequently launched a public proxy fight with the company.
We were asked to analyze the historical performance of the company relative to its peers as well as evaluate a potential spin off of the target company’s Retail business. As the only analyst on the deal team, I have been in charge of all of the analysis and modeling surrounding our client’s investment thesis.
Although our engagement is still ongoing, our client has been able to force positive change as a direct result of our efforts. However, Continued shareholder engagement is needed to address substantial remaining value creation opportunities
Walk me through your evaluation of the company’s total shareholder returns.
Total shareholder returns: persistent underperformance regardless of the time period prior to our client’s involvement and regardless of which comp set you choose
- 5 Year: 98% vs 160%
- 3 Year: 53% vs 75%
- 1 Year: -11% vs -1%
Failure to deliver full value of shale gas tailwind
- NGas accounts for ~80% of the product cost of Nitrogen fertilizers
- NA shale gas revolution dramatically reduced US and Canadian ngas prices, significantly improving the profitability of the target’s largest business, nitrogen
Walk me through your evaluation of the company’s dividend payouts.
Dividend payout ratios: End of Year Annualized / NTM Net Income
Historically
Target ~4% vs Wholesale ~8% vs Retail ~35%
Current
- After months of prodding, the target finally increased its dividend
- Target 20% vs Wholesale 20% vs Retail ~35%
- Currently ranks #6 of 9
Walk me through your evaluation of the company’s return on capital.
Failed growth strategy
- Target touts the success of its growth strategy; but its strategy has destroyed value; failing to achieve its own stated minimum hurdle rate
- Pre 2006 Retail ROCE: mid to upper teens
- 2012 Retail ROCE: 8%
- Minimum return hurdle = 9%
- Dramatically underperforms peers in generating returns on capital; 9% vs retail peer average of 16%; UAP 15%
Walk me through your evaluation of the company’s trading comps.
We analyzed the comps on a historical basis and at present. However, due to the unique businesses that make up the company, we could not just take a straight average. Instead, we constructed a peer composite based on LTM EBITDA weightings.
TEV / NTM EBITDA
- 5 Year: 6.5x vs 7.0x (~$15 of upside)
- Current: 6.75x vs 7.25x (~$30 of upside)
Price / NTM EPS
- 5 Year: 10.0x vs 13.0x (~$20 of upside)
- Current: 10.0x vs 12.5x (~$30 of upside)
What were the comps? How did you choose them? What were they trading at?
We chose the comps based on their similarity to the target company’s distinct business segments. Similarities we looked for included, geography, cash flow characteristics, and capital structure
Target is currently trading at: TEV / LTM EBITDA: 7.0x TEV / 2013E EBITDA: 6.7x P / LTM EPS: 10.4x P / 2013E EPS: 10.0x
Peer weighted average is currently trading at: TEV / LTM EBITDA: 8.2x TEV / 2013E EBITDA: 7.3x P / LTM EPS: 15.0x P / 2013E EPS: 12.7x
What were the nitrogen trading comps? What were they trading at?
Nitrogen: ~4x 2013E EBITDA
CF Industries – North American Nitrogen fertilizer producer; $13bn market cap; $12.5bn TEV; $6.1bn Revenue; $3.3bn LTM EBITDA; TEV/LTM EBITDA 3.9x; TEV/2013E EBITDA 4.2x; P/E 7.5x
- Generated 90% of EBITDA from Nitrogen fertilizers in 2012
-Beneficiary of the North American Shale gas boom that has dramatically improved target’s Nitrogen business
-CF 10-K lists target and Koch Nitrogen (private as principal competitors
What were the Potash and Phosphate trading comps? What were they trading at?
Potash: ~8x 2013E EBITDA
Only large publicly traded North American manufacturers of Potash and Phosphate fertilizers; along with target, form the three company Canpotex trade organization for marketing Potash fertilizers outside of North America
Potash Corp – $35.5bn market cap; $39bn TEV; $7.4bn Revenue; $3.5bn LTM EBITDA; TEV/LTM EBITDA 11.1x; TEV/2013E EBITDA 9.3x; PE 17.2x
Mosaic – $26bn market cap; $24bn TEV; $10bn Revenue; $2.8bn LTM EBITDA; TEV/LTM EBITDA 8.4x; TEV/2013E EBITDA 7.3x; PE 18.9x
What were the AAT trading comps? What were they trading at?
AAT: ~7x 2013E EBITDA
Average of CF Industries, Potash Corp. and Mosaic. These three companies represent the full “NPK” fertilizer exposure and are broad comparables for this small segment
What were the Retail trading comps? What were they trading at?
Retail: ~10.25x 2013E EBITDA Peers – there are no publicly traded ag retail companies other than Agrium; thus, we resort to the following distribution comps: Watsco, WESCO, Tractor Supply, WW Grainger and Genuine Parts, which are Agrium’s original comparables as shown in 2011 analyst day, published in white paper, and recognized by CEO as best comps. Also, these comps were listed as peers in the 10-K of UAP, the last publicly-traded ag retailer (acquired by Agrium in 2008) TEV / LTM EBITDA: 12.1x TEV / 2013E EBITDA: 10.4x P / LTM EPS: 22.2x P / 2013E EPS: 19.0x
Watsco – distribution of air conditioning, heating and refrigeration equipment in North America
Market Cap $2.6bn; TEV $3.1bn
WESCO – distribution of electrical, industrial and communications maintenance, repair, and operating (MRO) products; and original equipment manufacturers products and construction materials
Market Cap $3.4bn; TEV $5.0bn
Tractor Supply – (best comp; 11.4x NTM EBITDA) operates retail farm and ranch stores in the US, which provide a selection of merchandise (livestock, pet and animal products), hardware (truck, towing and tool products), seasonal products (lawn and garden items), maintenance products (for agricultural and retail use), and work/recreational clothing
Market Cap $7bn; TEV $6.8bn
WW Granger – distribution of maintenance, repair, and operating supplies and other related products and services for businesses in North America.
Market Cap $15.6bn; TEV $15.9bn
Genuine Parts – distributes automotive replacement parts, industrial replacement parts, office products, and electrical/electronic materials in North America
Market Cap $11.7bn; TEV $11.9bn
Walk me through your evaluation of key operating metrics.
Operating metrics
Net working capital
- Target’s retail business has by far the highest NWC/Sales ratio in the industry
- 23% and 20% in 2011 and 2012 vs 16% and 16.5% industry average
ROCE
- 9% vs industry average 16%
- Prior to acquisition spree, ROCE was mid to upper teens, but now does not even meet minimum stated return hurdle
How did you identify unaddressed opportunities to unlock value? Walk me through each of these opportunities.
We analyzed the historical performance of the target company and its peers and looked for trends.
The Five Cs = the root causes of underperformance
(1) Cost management: duplicative retail store footprint
(2) Controls: retail disclosure and performance targets, management incentives
(3) Capital allocation: capital return, M&A / investment practices, retail working capital
(4) Conglomerate structure: valuation discount, operating issues, appropriate capitalization
(5) Corporate governance: governance missteps, appropriate experience
Walk me through the cost management issues at the company.
Cost management: retail costs (savings potential of $200mm), corporate costs (savings potential of $50mm)
(1) Target’s retail footprint is highly duplicative, violating its own stated guidelines for branch effectiveness
- Retail distribution business is not a traditional walk-in retailer, but is a remote order business where customers have a salesperson as their primary point of contact and rarely visit a Retail location
- Retail locations effectively serve as distribution centers
- Target has publicly stated that it typically serves within ~25-40 miles
- However, there is significant overlap at US locations (75% overlap within 25mile radius and 63% overlap within 20 mile radius)
(1) Redundant footprint is a significant element of cost management problems (as well as capex and working capital issues) and has contributed to Retail’s failure to generate operating leverage
- Duplicative locations have resulted in redundant direct costs (headcount, facilities, maintenance, insurance) and increased organizational costs (district and regional management layers)
- The persistence of Retail’s footprint overlap – which the target has previously acknowledged – illustrates the need to add distribution experience to the board to prioritize key initiatives, improve performance, and unlock value
As a result, margins have declined (EBIT / Gross Profit declined from 37% pre acquisitions to 31% currently) and Retail has failed to generate operating leverage
Walk me through the control issues at the company.
Controls: retail disclosure and performance targets, management incentives
a. Prior to JANA’s engagement, target provided worst-in-class Retail disclosure that has actually worsened as the target spent $4+ billion to acquire scale in Retail
- Eliminated disclosure of key operating metrics (NWC, capex)
- No disclosure of organic performance
- Board has done little to ensure that shareholders in the company have the information they need in order to make informed decisions
b. Inappropriate performance targets: anchored investors on one public performance target for Retail: dollars of EBITDA
- Growth at any cost
c. Misaligned incentives: management incented by an EBITDA dollar value
- ROCE and margin performance entirely absent from Retail management incentives
Walk me through the capital allocation issues at the company.
Capital allocation: capital return, M&A / investment practices, retail working capital (potential to release $725mm of NWC)
a. Acquisitions and investments – failed large Retail acquisition ($0.9 bn) illustrates that inadequate board oversight and a lack of distribution experience can lead to value destruction M&A
- Incentives to pursue M&A and grow EBITDA – rather than drive strong returns on capital – result in strategically-unsound acquisitions like Landmark, which was conducted with only 3 days of due diligence
- Overpaid (15x with risk of divesting sizeable unwanted assets, low growth end market exposure (Australia retail), lack of customer/supplier overlap
b. Buybacks / dividends vs M&A – prior to our client’s involvement in the stock, the target prioritized growth and M&A at the expense of returning capital to shareholders. Continued room for improvement still remains
- Cumulative M&A capital deployed prior to engagement: $4+ bn
- Cumulative dividends and buyback prior to engagement: $0.2 bn
- Cumulative dividends and buyback s since engagement: $1+ bn
- Comparable dividend payout ratio: 20% (#6 of 9)
- Reckless execution of share repurchase in November, its first meaningful buyback in a decade, which came when the board faced criticism on capital allocation discipline
c. Retail working capital
- While the target initially rejected our client’s view that Retail working capital could be improved, its newly introduced performance targets evidence our client’s view; target previously argued that the level of working capital proposed by our client would result in lower profits and would be value destructive
- Worst-in-class working capital management
- Currently 20% NWC/sales ratio; target 18% in 2015 as EBITDA margins expand from 8% to 10%
Walk me through the conglomerate structure issues at the company.
Conglomerate structure: valuation discount ($20 share upside), operating issues, appropriate capitalization
a. Before our client’s involvement, the target acknowledged its conglomerate discount and actively lobbied to reduce the discount
b. The target controls a valuable, scarce asset base that would be difficult to replicate, yet shares trade at a modest discount to fertilizer industry peers and a considerable discount to other large distributors. We judge this discount to be large enough to warrant accumulation of AGU shares
c. TEV / NTM EBITDA
- 5 Year: 6.5x vs 7.0x (~$16 of upside)
- Current: 6.7x vs 7.1x (~$29 of upside)
d. Price / NTM EPS
- 5 Year: 10.0x vs 12.9x (~$21 of upside)
- Current: 10.0x vs 12.8x (~$28 of upside)
e. Analysts see potential to unlock as much as $20 per share of SOTP discount, representing 20% of the target’s current share price
f. when challenged by our client to unlock Retail’s value, the target instead changed its long-standing valuation comparable set to talk down its potential value
- Original Comparables were clearly more appropriate
- Lower multiple midnight comps included newly public companies, micro caps with limited liquidity, controlled companies, and companies with dissimilar business mixes
g. Significant issues: The target’s conglomerate structure has significant negative consequences while appearing to provide limited offsetting benefits
- Disadvantageous for both business, compromising procurement, customer relationships and flexibility (Retail competes with Wholesale’s customers, Wholesale competes with Retail’s key suppliers)
- Stuffing Retail with inventory, introducing volatility into a business valued for its stability
- Different natural investor / analyst following
- Persistent conglomerate discount
- Excess corporate overhead
- Leads to underperformance (Morgan Stanley’s view when representing CF)
- For all these reasons, all key competitors have actively rejected the integrated model
h. Limited benefits: market intelligence, ability to conduct superior M&A and to enter new markets more successfully
- Reality: sub-par returns on capital, inventory write-downs, integration issues
Walk me through the corporate governance issues at the company.
Corporate governance: governance missteps, appropriate experience
a. Target’s responses to shareholder engagement have revealed serious governance deficiencies
- Failure of board oversight (e.g. talking down value, failed buyback, refusal to accept even faint criticism, padding director resumes)
- Misleading claims regarding board experience
- Refusal to acknowledge opportunities for improvement
- Misleading attacks on independence of client’s nominees
Positive Results of our client’s engagement
a. Target has begun to slowly address problematic Retail disclosure and performance targets, but significant additional opportunity for improvement remains
- Financial Disclosures: ROCE, NWC
- Performance targets: ROCE, Opex/GP, NWC
b. Our client has started to force positive change
- New focus on dividend growth – dividend increased 4x since engagement
- First sizeable repurchase – repurchased 6.5x more stock than in prior 8 years combined
c. Performance since engagement evidences target’s latent value potential – more shareholder-friendly capital allocation and disclosure policies helped address long-term underperformance. Enhancing the target’s board can unlock even more value
- Before engagement (5 year): 98% vs 160%
- After engagement: 42% vs 25%
d. Continued shareholder engagement is needed to address substantial remaining value creation opportunities
Walk me through the sum-of-the-parts valuation analysis that you constructed.
We evaluated each business line (including Nitrogen, Potash, Phosphate, Advanced Technologies and Other Wholesale, and Retail) separately using 2013 pre-corporate EBITDA and public trading comps.
We determined that the company is currently trading at a 20% discount to its sum-of-the-parts. Additionally, we calculated that the company’s Retail business trades at an implied 8.1x multiple (in comparison to its peer multiple of 10.25x)
Nitrogen: 1,100 * 4.0x = 4,400 (21%) Potash: 450 * 8.25x = 3,700 (18%) Phosphate: 180 * 8.25x = 1,500 (7%) AAT/Other: 230 * 6.75x = 1,550 (7%) Retail: 1,068 * 10.25x = 10,947 (53%) Corporate: (170) * 8.50 = (1,450) (7%) Implied TEV: 2,858 * 7.23x = 20,652
Less: Net Debt (3,300) Implied Equity: 17,352 Shares: 149 Implied Price Per Share = $117.50 Current Price Per Share = $97
Discuss the model that you built.
I built a full valuation model that analyzed the Retail segment. I used all pertinent methodologies in order to triangulate a value for the business, including DCF, LBO, comparable companies, precedent transactions and SOTP.
When building the forecasts, I took into consideration industry research, management guidance and equity research.
How did you value the target company? What was the value under each methodology?
I performed all pertinent valuation methodologies including DCF, LBO, SOTP, precedent transactions and comparable companies in order to triangulate a potential value for the Retail business.
Average = $10.1bn
TEV/LTM EBITDA = 11.7x
TEV/2013E EBITDA = 10.1x
DCF: resulted in the highest valuation; $12.3bn – $13.0bn (11% WACC, 10x exit)
LBO: financial sponsor’s ability to pay; $8.4bn - $9.6bn (5.5x leverage, 10x entry/exit)
Precedents: limited transaction comp set; $10.1bn – $10.6bn (11.75x to 12.25x)
LR Comps: lowest valuation; $8.4bn - $8.9bn (9.75x to 10.25x)
Current Comps (Client): $10bn – $10.5bn (10.0x to 10.5x)
Current Comps (Target): $9.5bn - $10bn (9.5x to 10.0x)
What were the model drivers?
Price: $ margin on fertilizers, fixed % margin on CPC and seed
Volume: increase in market share through tuck-in acquisitions, increase in world population and food demand
Costs: increase economies of scale in order to achieve higher supplier rebates; overhead reduction, elimination of duplicative locations (headcount, facilities, maintenance, insurance, management layers)
Net working capital: NWC as % of revenue was historically 23% and 20% in 2011 and 2012; we step this down to 15.5% (distribution industry average) over the forecast period
Capex: historically ~2% of revenue but keep constant at 1.5% (distribution industry average)
How did you come up with revenue growth rates?
We looked at historical growth trends, and made assumptions regarding the future that were in line with industry research (5-7% annual growth of US ag retail market) and with equity research estimates (12% average growth in 2013E). We also took into consideration management targets ($15bn in sales by 2015E and 10% EBITDA margins)
We did not do a full revenue build partly due to the fact that the company’s Retail segment disclosures make it very difficult to model (e.g. no store information) and partly due to the fact that our client does not think it is necessary at this point in time. If our client’s slate of directors is elected to the board, then we will likely get more granular with our financial projections.
If given the opportunity, I would model Retail based on…
What were the drivers of growth?
Growth drivers for the company include
1) increase in demand for food as the world population grows
2) upward pricing trends as a result of improvements in yield
3) ability to pick up market share through tuck-in acquisitions (e.g. Southeast US)
What were the major cost drivers?
Variable: fertilizer prices ($/tonne), CPC prices ($/gallon) and Seeds ($/gallon)
Fixed: overhead, duplicative locations (headcount, facilities, maintenance, insurance, management layers)
What are the fixed vs variable costs?
Wholesale: 80% of the cost of producing nitrogen comes from variable natural gas prices. Given the shale gas revolution, this variable cost component is likely to improve
Retail: Variable costs are driven by the prices of agricultural inputs (fertilizer, CPC and seeds) while fixed costs are related to the number of store locations (i.e. its footprint).
Retail’s redundant footprint has contributed to its failure to generate operating leverage.
- Duplicative locations have resulted in redundant direct costs (e.g. headcount, facilities, maintenance, insurance) and increased organizational costs (e.g. district and regional management layers with ~50 office locations)
- Redundant locations have resulted in excess capital deployment (1) duplicative safety-stock inventory to support overlapping locations, while fewer branches would allow for better demand management and lower aggregate inventory (2) duplicative capex for equipment / maintenance at multiple locations
How much maintenance vs growth cpaex is there?
$200 - $250 million in annual capital expenditures over the forecast period. Majority of this is growth capex as the company continues to make opportunistic acquisitions. However, there is also a need for maintenance capex in order to maintain existing facilities (~30-40% of total capex).
What are the assets? Cash? Debt? Credit metrics?
Total Assets: $16bn
Liabilities: $9bn
Equity: $7bn
Total Debt: $4bn
Total Cash: $725mn
Total Debt / EBITDA: 1.5x
Net Debt / EBITDA: 1.2x
EBITDA / Interest Expense: 22.8x
What are the historical and projected financials?
-Revenue growth
2009 – 2012: Revenue increased from $6.0bn to $11.5bn (23% CAGR)
2013 – 2018: Revenue increased from $12.5bn to $15.1bn (3.8% CAGR)
-Gross profit margins
2009 – 2012: Gross profit increased from $1.1bn to $2.5bn (gross margins increased from 19% to 22%)
2013 – 2018 – Gross profit increased from $2.7bn to $3.5bn (gross margins increased from 22% to 23%)
-EBIT / Gross Profit Margins
2009 – 2012: increased from 13.8% to 30.5%
2013 – 2014: increased from 31% to 36% (which is in line with distribution peers)
- EBIT margins (post corp)
2009 - 2012: $150mm to $670mm (margins increased from 2.5% to 6%)
2013 - 2018: $800mm to $1.2bn (margins increased from 6.5% to 8%)
-EBITDA margins
2009 – 2012: post corp EBITDA increased from $250 million to $865 million (53% CAGR; margins increased from 4% to 7.5% due to economies of scale)
2013 – 2018: post corp EBITDA increased from $1.0bn to $1.5bn (7% CAGR; margins increased from 8% to 10%)
-Net earnings
2009 – 2012: increased from $175 million to $750 million
-UFCF
2014 – 2018: increased from $680 million to $930mm (15% CAGR)
-LFCF
2014 – 2018: increased from $375 million to $775 million (18% CAGR)
What were the margins?
Forecasted margins
EBIT (post): 6.5-8.0%
EBITDA (post): 8%-10%
EBIT / Gross Profit: 31-36%
What was the growth rate of revenue?
4%
CAGR (2013-2018)
What is the growth rate of EBITDA?
7% CAGR (2013-2018)
Walk me through the calculation of free cash flow.
Year 1: EBITDA: $1,150 Capex: ($200mn) Increase in NWC: ($10mm) Taxes: ($260mm) UFCF: $680
Year 5: EBITDA: $1,500mm Capex: ($225) Increase in NWC: $30mm Taxes: ($340mm) UFCF: $930mm
What were the comps? How did you chose them? Where are they trading?
No publicly traded ag retail comps available; used distribution comps instead
LTM EBITDA: 12.50x
2013E EBITDA: 10.25x
LTM PE: 22x
2013E PE: 19x
D/E: 19%
D/Cap: 14%
Why is the company trading at a premium or discount?
The company has suffered from a persistent discount to its peer composite on both a TEV / EBITDA and PE basis. Retail is an undervalued and undermanaged asset, and investors are waiting for bold action to be taken in order to unlock this value.
Lack of fit: pairing a stable distribution business (Retail) with a volatile, commodity-linked fertilizer business (Wholesale) has led to a persistent valuation discount and relative underperformance for shareholders, while generating no meaningful benefits, imposing high costs, and limiting the ability of each to take part in consolidation.
The company’s Retail and Wholesale businesses have different natural investors and research analyst followings, different optimal capitalization, and capital allocation priorities. As a result, the intrinsic value of the company’s stable Retail business is not receiving the credit it deserves due to its attachment to the volatile Wholesale business.
The company controls a valuable, scarce asset base that would be difficult to replicate, yet shares trade at a modest discount to fertilizer industry peers and a considerable discount to other large distributors.
