Summary
- The sale of the North American Terminal Operations (NATO) removes cash flow uncertainty to cover near-term debt obligations, while giving Canexus improved bargaining power for the sale of its chlor-alkali business.
- With a 13% spike in prices after the NATO sale announcement, further upside of 42-54% is possible, assuming Canexus negotiates a higher valuation for chlor-alkali by July 2015.
- Long term, it will likely take years to rebuild shareholder value towards the 52-week high.
For those who have followed Canexus (OTCPK:CXUSF), you are familiar with the challenges the company has faced over the last two years resulting in a staggering loss of shareholder value from a high of $9 a share to a low of $1.36 CDN. Although Canexus has had its roots in the specialty chemical business for many years, with significant competitive advantages, it were one of the first companies to jump on the "crude by rail" trend to service the growing demand for crude oil transport options in Western Canada. The rail terminal, better known as the North American Terminal Operations (NATO) facility, was an execution disaster, with costs and timelines soaring past initial estimates. Doug Wonnacott was brought in to replace Gary Kubera as CEO as a result. His first mandate was to strategically align the portfolio of assets back to a pure-play chemicals company by putting NATO up for sale.
After months of negotiations, NATO was finally sold to Cenovus (NYSE:CVE) for $75M, almost 85% below its total cost. Calling this a fire sale is putting it mildly. However, during the company's most recent conference call, it was clear that indicative bids were well below $100M, despite total cost estimates of over $500M to build the facility. No doubt, this was a colossal gamble on the future of WCS (Western Canada Select) to WTI (West Texas Intermediate) spreads that failed miserably and destroyed significant shareholder value. Doug Wonnacott has taken appropriate steps to get the company back on track. While some investors may have been hoping for Canexus to ride out the storm and sell the asset at a much higher valuation perhaps into 2016 or 2017, I would argue that management and their advisers made a very smart decision squeezing out some money from this lemon, and have started a very slow process to rebuilding shareholder value.
This isn't the first time an asset has been built at astronomical costs, only to be sold at pennies on the dollar. For those in Toronto, you'll recall the SkyDome was built for close to $500M ($900M in 2015 dollars), only to be sold to Rogers Communications (NYSE:RCI) for $25M, given the cost to operate the facility. IBM Corp. (NYSE:IBM) recently paid a company $1.5 billion to actually take over its struggling chip-making division (yes, that's correct, it paid a company to take over an asset). These are perfectly rational business decisions companies make to eliminate underperforming assets and the subsequent drag on earnings. Canexus faced the same struggle with NATO. To be fair, the timing couldn't have been worse, as no one could have predicted the fall in global crude prices. However, management also wildly overestimated NATO's contribution to overall cash flows, based on a flawed assumption that future WCS/WTI spreads would make crude by rail an economically viable transport option to Western Canadian producers.
As an accountant by trade, I know that an organization should never make future strategic decisions based on sunk costs - i.e., costs already incurred to build or develop an asset. An asset is only valuable if there is long-term potential to generate positive returns. The window for crude by rail may be nearing its end. Indeed, there are still many roadblocks to pipeline capacity, with projects such as Keystone XL or Northern Gateway still up in the air. However, where crude by rail enjoyed astonishing growth over the last few years with limited pipeline capacity, predictions for future growth are ambiguous, at best. With tapering production expected in the coming quarters as a result of lower oil prices, coupled with adequate pipeline capacity in North America, one might find it difficult to argue an economic case for crude by rail anytime soon. Crude by rail is profitable for producers if the WCS grade of oil is selling at a material discount to WTI. Over the last quarter, that crude differential has averaged below $10 USD a barrel. Demand by refineries who have retrofitted their facilities to accommodate medium and heavy oil blends remains robust, supporting the narrow spread. There is little indication that the differentials will begin to widen anytime soon. The economics of crude by rail only works when that differential is greater than $15-20 a barrel (for unit trains, the numbers are closer to $12-15 a barrel; but nevertheless, with the current differential below $10 a barrel, even unit trains are unprofitable relative to pipelines). Despite committed contracts starting in Q3, I suspect there would have been a declining trend in nominations quarter-over-quarter, which would have exacerbated the negative cash flow contribution of NATO.
Another reason for the divestiture was NATO's high fixed cost. To merely breakeven from a cash flow perspective, the company would need to operate 5.5 trains per week. In the current oil environment, that target was dubious, at best. This doesn't take into account any variable costs to maintain its commitments to existing customers. However, with NATO off its hands, Canexus can take steps to lower overall costs in line with its Business Improvement Program targets.
Canexus was also in no position to ride out the storm, given its horrendous balance sheet. With debt to EBITDA at over 5x, the company had little choice but to put up assets for sale to bring debt loads to more manageable levels. More importantly, with negative forecasted cash flow related to NATO in 2015 and potentially into 2016, it was at risk of potentially violating its debt covenants.
All these factors combined likely led to a decision to "dump" the asset at 85% of cost. Indeed, I modeled a scenario where it actually made economic sense to give NATO away for free - just to eliminate the future drag on earnings. A $75 million recovery for NATO was a necessary concession, despite the discount to cost. Canexus simply was unable to absorb the negative cash contribution of NATO for an extended and uncertain period of time, even with solid cash flow generators related to its chemicals assets.
Now begins the long road to recovery. With some simple calculations, this is a stock with some near-term upside potential now that Canexus has eliminated some uncertainty. Make no mistake, the sale of NATO doesn't really dent the company's debt load. What it does, however, is buy time and negotiating power to reap higher returns for its chlor-alkali business, which is also up for sale and nearing the final bid stage. With a book value of approximately $290M, and with NATO off the books, there is no urgency to dump this asset at fire sale prices.
I suspect the company traded a low value proposition asset (NATO) to potentially recover the losses with a much higher valuation on the chlor-alkali business, which may indeed be a smart play. The sale of NATO allows Canexus to redeem $60M in convertibles maturing at year end with a few extra dollars to spare. The company's next debt obligation matures in 2018, with another $60M due. Assuming an 8.2 multiple, which is on par with other chemical businesses for 2015, and a sale of chlor-alkali at $280M (96% of book value, given its renewed negotiating power), the price target range for 2015 is $2.30-2.50 a share.
It will likely be years before we see anything close to $5.00 share level the company enjoyed only a few months ago. Much shareholder value has been destroyed with the NATO debacle, but that's water under the bridge. The path forward is slow and steady - what one might expect for a stable, boring, pure-play chemicals business yielding close to 2%. With liquidity issues under control, and breathing room to negotiate a better price for the chlor-alkali business, the near-term upside is potentially 42-54%, given a closing price of $1.62 as of Friday, June 5, 2015.
As the following analysis suggests, Canexus will have sufficient cash flow in coming years from existing operations to meet its interest and debt obligations, while funding a small annual dividend of 4 cents a share. With a stronger balance sheet and a very stable cash-generating chemicals business, the uncertainty that has plagued the company over the last two years is finally coming to a close.
Canexus Valuation Analysis
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