Bill Chen, the founder and PM of Rhizome Partners, has steadily built a reputation as one of SumZero’s best primary researchers. His rigorous research approach is partly inspired by Phil Fisher’s ‘scuttlebutt’ style, and has attracted Rhizome a great deal of interest on SumZero. A recent idea of Rhizome’s on FRP Holdings was the result of a 3,000 mile odyssey to 60 FRP properties scattered across the East Coast. The idea was ranked in the 99th percentile in our community rankings, and generated wide-ranging institutional interest in the name.
Bill recently submitted an idea to SumZero on Calumet Specialty Products Partners (CLMT:US), a manufacturer of specialty petroleum products. Kevin Harris from SumZero sat down with Bill to discuss Calumet, value investing, and scuttlebutt research.
Kevin Harris, SumZero: What about Calumet initially caught your eye as a value investor? What sparked your interest in the name?
Bill Chen, Rhizome Partners: One of Rhizome’s core strategies is to look for broken or misunderstood companies that traditionally cater to yield-driven investors. This could mean a master limited partner (MLP) that suspended its distribution or a real estate holding company that does not pay a dividend. During my career, I have noticed that traditional yield-driven investors will often sell indiscriminately if distribution is suspended. There were a handful of factors that really stood out about Calumet when we first came upon it. First, it is mostly a specialty chemical company residing inside a MLP structure with suspended distribution. Second, it has a BadCo and a GoodCo which tend to make it complicated for most investors to analyze. Third, the publicly-traded debt yields 6-7% while the implied free cashflow yield of the equity is over 20%. When the differential is this wide, we believe that either the debt or the equity is severely mispriced. Fourth, by the time we started analyzing the company, it has become apparent that there is a very competent management team turning around the company. Fifth, the capital structure is such that the market cap is merely 2 turns of EBITDA while the debt is projected to be roughly 4-5 turns of EBITDA for year end 2018. This is analogous to a publicly-traded leverage buyout (LBO) that is rapidly deleveraging which could potentially lead to a multi-bagger opportunity over the next 3-5 years. In summary, Calumet is an Orphaned/Mischaracterized/Public LBO/Broken Distribution/Turnaround Compounder.
Harris: What catalysts should investors pay attention to as your thesis plays out? What developments could most adversely impact your thesis?
Chen: One of the biggest risks to the Calumet thesis is a $900 million senior note due in early 2021. In our model, the company will generate $300-400 million of free cashflow from 2018 to year end 2020. Hence, Calumet will need to access the capital markets in the next 2-3 years to extend the maturity. We believe that any news involving the extension of the maturity of the $900mm senior notes to 5-8 years from today will be a very fundamentally positive development. The Company has communicated that they are actively working on this issue now that they have paid off the $400 million 11.5% senior secured notes.
The second most important item is to track the EBITDA of the specialty products segment. Since the specialty products is worth 10x EBITDA, any improvement in this segment will create enormous value to the company. Within the specialty segment, it is also important to pay attention to the mix of the products. It is preferable to see growth within the subsegment consisting of the branded products such as Royal Purple/TruFuel and Penreco which offers customized solutions to the cosmetics and personal care products. The specialty segment has minimal capital expenditure requirements. Hence any increases in EBITDA will likely convert into incremental free cashflow. We believe that the value of the specialty products (GoodCo) and the refineries (BadCo) can be described as 80/20. Hence, it is more important to focus on the performance of the specialty products segment.
The Company has mentioned that in the next 1-3 years, they may generate taxable income. This will create a tax liability for the MLP unit holders on a pass through basis. Management has expressed that they are reluctant to force the unit holders to pay a tax bill without a distribution. We believe management will be inclined to pay a distribution to alleviate the tax requirement of the unit holders. We believe that any re-instatement of distributions will attract the natural yield-seeking shareholders back to the Company.
On the risk side, the inability to extend the maturity of the $900 million of 2021 senior notes is the biggest risk. If the capital markets were to experience severe dislocation like 2008/2009, Calumet could find itself in a forced bankruptcy filing similar to General Growth. Obviously, any significant structural deterioration of the specialty products segment would impair our investment. Lastly, it is important to be reminded that these products are produced under high pressures and high temperatures. There is a small chance that a facility can catch fire and disrupt the supply and even result in death.
Harris: Could you walk us through the BadCo / GoodCo section of your thesis? How will Calumet shift from a highly levered 4-5x EBITDA multiple refinery company to a 10x EBITDA specialty chemical company?
Chen: The transformation is 80% complete as the value of the GoodCo and BadCo is roughly 80/20 at this point. The next step is to sell the BadCo at the right price. Calumet has two segments, specialty products (GoodCo) and refineries (BadCo). The BadCo was created through the undisciplined acquisition spree under the previous management team. From 2013 to 2017, GoodCo’s EBITDA margins ranged from 11.0% to 15.1% while BadCo’s EBITDA margin ranged from -0.5% to 5.2%. GoodCo had consistently generated around $200 million of EBITDA each year while BadCo’s EBITDA ranged from $-10 million to $128 million. Applying a 10x multiple to the GoodCo 2018 run-rate EBITDA of $220 million yields a $2.2 billion valuation. Applying a 5x multiple to the BadCo’s mid-cycle EBITDA of $90 million yields a $450 million valuation. Management team has already sold off the Superior refinery in Wisconsin for $433 million plus $98 million for excess working capital last year. They have publicly stated that the remaining Montana refinery is for sale at the right price. Management team has consistently stated that they will focus on growing the GoodCo’s specialty business. This is apparent by their allocation of capital to Royal Purple to sell into industrial applications and increase capacity to meet the growing organic demand of TruFuel. The company also recently gained 71 patents by acquiring Biosynthetic Technologies for $7 million. While the company is already mostly a specialty chemical company, the sale of the Montana refinery will allow the company show mid-teens EBITDA margin for the entire company. This will make it easier for most analysts to value the company and this will allow people running EV/EBITDA screens to more easily identify the company.
Harris: How much of Calumet’s specialty chemical supply chain is based on the sourcing of component chemicals in house? In their most recent 10K, Calumet purports Cotton Valley Refinery to being the “most complete, single-facility line of paraffinic solvents in the U.S.” How much of Calumet’s success with specialty chemicals / branded products is predicated on the company’s ownership of upstream base oil feedstock producers?
Chen: Calumet owns two kinds of refining facilities, traditional and specialty. The traditional facilities are refineries that produce fuel such gasoline, diesel, jet fuel and asphalt. These tend to operate at a higher temperature and pressure and require more capital expenditure. These facilities belong in the BadCo and Calumet is looking to divest them over time. As a matter of fact, there is only one remaining traditional refinery in Great Falls Montana that The Company is looking to sell. The facilities in the specialty chemicals segment produce a mix of traditional fuel products and other refined products such as cosmetic and pharmaceutical white oil, solvents, base oil, lubricants, petroleum jelly, and waxes. Calumet will retain the specialty facilities. Hence, there is no risk of Calumet losing the ability to source component chemicals in house.
We believe that Calumet’s success with specialty chemicals/branded products is heavily predicated on sticky relationships with their customers, customized formulation, and strong brands that offer high performance and innovative solutions. Calumet’s Penreco product lines created customized formulations for cosmetics and personal care products such as Hawaiian Tropic tanning oil, ChapStick lip balms, Jergens body lotion, etc. Since these products go on the human body, buyers are reluctant to switch suppliers given the headline risk of XYZ products causing scary looking rashes. We believe that Calumet provides the entire liquid content for WD-40. In general, Calumet’s value proposition is customization, small batches, and high touch sales efforts. As a result, the customer relationships are sticky, pun intended. Royal Purple is a strong brand that offers high performance in high end racing engines. We have analyzed online reviews and talked to racing enthusiasts. The feedback is generally along the line that Royal Purple’s synthetic lubricants allow the engine to run cooler and smoother while generating more horsepower. It is a premium product among the synthetic category. It is not meant for your family Honda minivan. The company also discovered that Royal Purple’s lubricating characteristics extend beyond car engines. Per our conversation with management, they have discovered that Royal Purple functions well as an industrial lubricant helping their refineries operate efficiently, resulting in less wear and tear of their equipment. The Company has initiated efforts to sell Royal Purple into the industrial market to end customers such as refineries, pulp and paper mills, chemicals manufacturers etc. We believe this could help them grow the 20+% EBITDA margin product line.
Harris: In extension of the above question, could the success of Royal Purple and other products in the Specialty Chemical segment be obfuscating the value of the refinery ‘BadCo’?
Chen: It is the other way around. Specialty is 80% of the value. The combination of refining and specialty business makes it hard to highlight the attractiveness of the specialty business.
Harris: What gives Calumet a moat in its specialty chemical segment? Royal Purple has several highly ranked gas-station branded competitors (e.g. Shell, Mobil #1), who control distribution at the point of sale for most consumer oil changes. What differentiates Royal Purple, and can it maintain its 20%+ growth rate?
Chen: The specialty chemical business consists of a few major subgroups of products including branded products, Penreco personal care products, esters, waxes, petroleum jelly, base oil, and solvents. On the branded side, Calumets owns loyal brands. Royal Purple is a high performance niche synthetic engine oil favored by racing enthusiasts. It really does not compete with the mass brands like Shell, Mobil, etc. Its target customer is not the minivan soccer mom taking her car in for an oil change. Its target user is someone who drives a high performance vehicle. Years ago, the Company disclosed that Royal Purple has about 4% market share. It fills a very niche space in the market. We have also spoken with racing enthusiasts and the feedback is generally that Royal Purple allows the engine to generate more power, runs smoother, and keeps the engine cooler, etc. They often rave about the product. The reason why we are excited about its future is that Calumet has found that Royal Purple is also an excellent industrial lubricant. Calumet has started their effort to sell Royal Purple into the industrial market and we are eager to see how that plays out.
TruFuel is an innovative product invented by the company. When the US started mandating the blending of ethanol into gasoline at the pump, it created an unintended problem for small engines. People have to drive around to find a gas station that does not have ethanol-blended gasoline. Ethanol tends to “gum” up engines and it has a propensity to attract water which is quite harmful for these engines. Calumet came up with a formulation that uses high octane gasoline without ethanol and blended it with engine oil and stabilizers. This creates an easy solution which allows the user to pour, start, and work. There is no second guessing if you mixed it with the right ratio of gas to engine oil. There is no worry about draining the yard equipment at the end of the season. There is no worry about the gasoline being in the engine for more than a week. The product is a hit among home owners. What really surprised us is that professional lawn care specialists use the product. They buy TruFuel in drums and leave it in their trucks. TruFuel allows lawn care specialists to focus on lawn maintenance. They do not need to worry about damages to their expensive equipment. I believe the company has a patent on the metal container for TruFuel. They currently are the 800-pound gorilla in this niche category. If you see Husqvarna Pre-Mix at Home Depot or Lowe’s, Calumet actually makes them for Husqvarna and some of the other brands. If you check Amazon reviews of Calumet’s branded products like Royal Purple, TruFuel, Belray Grease, etc., they are overwhelmingly 4 to 5 stars.
In the Penreco personal care products section, Calumet creates customized formulation for personal care products like Hawaiian Tropics tanning oil, Jergen’s lotion, Chapstick lip balms, Vaseline, Vicks, Avon, Cosmetics, etc. Since these products require customization, certifications, approvals, and touch the human body, we believe that the relationship is rather sticky. Calumet’s products are also used in household products such as WD-40, Turtle Wax, Raid Pest Control, Pledge, Zippo etc. We believe the same relationship exists there where the customers are reluctant to switch suppliers.
Calumet supplies two types of base oil – Paraffinic and Naphthenic. About 1/3 of the capacity is Naphthenic and 2/3 of the capacity is Paraffinic. In North America, there are only 6 suppliers of Naphthenic base oil suppliers as a lot of the capacity had left the market years ago. The behaviors among the suppliers are quite rational and Calumet enjoys good margins. There are more competitors on the Paraffinic side and Calumet typically competes by offering smaller batches and slight customizations. They also focus more on customer service. Per our conversation with industry contacts, the slight customization may allow lubricant buyers to reduce the use of expensive additives. The bigger guys like Chevron and Exxon tend to focus more on volume.
Calumet also recently acquired 71 issued patents and 76 pending patent applications for $7 million through the 50% acquisition of Biosynthetic Technologies. Biosynthetic owns proprietary technology that converts renewable plant oil into high-performance specialty products. They will conduct an industrial, commercial scale proof-of-concept at their existing plant in Missouri right away. This was one of the key value-adds of the acquisition. The seller would have to construct a plant costing over $100 million while Calumet has the existing facilities to conduct production trials.
Harris: Is the rise of electrified tools (chainsaws, lawn care, etc.) a threat to TruFuel?
Chen: Yes, eventually. TruFuel is a relatively new product. It has been growing organically while housed under a mismanaged company for the last few years. The company simply did not have the production capacity to meet all the demands in the past. Despite the dysfunction, it managed to grow at high rates. We believe this is proof of the organic demand for the product. We believe that TruFuel will plateau at sales and EBITDA figure that are likely much higher than the 2018 figures. This could be 50%, 100%, 200%, 300%, or 500%. We do not know. Then it will start to decline as electrification slowly takes over. We believe that Calumet will generate substantial cashflow from TruFuel before there is 100% electrification of tools.
Harris: How sensitive is Calumet’s pricing to spikes in oil prices? How sensitive are consumers to price hikes for their specialty products?
Chen: From 2013 to 2017, Calumet’s specialty volume ranged from 25,863 barrels per day to 27,807 barrels per day. This is a range of 7% during a crude oil environment that ranged from the $26 range to $110. We believe that the specialty business sells recurring consumer stable products that are less sensitive to spikes or freefalls in oil prices.
Calumet’s pricing generally lags crude oil prices by 8-12 weeks. In the last few years, Calumet’s gross profit per barrel was $41.07, $40.24, $34.57, and $33.93 in 2014, 2015, 2016, and 2017 respectively. 2014 and 2015 experienced sharp falls in crude oil prices. 2016 and 2017 experienced sharp increases in crude oil prices. In absolute dollars, there is roughly a $40 million difference in gross profit depending on whether crude oil prices are falling rapidly or increasing rapidly. We like to use a constant crude oil price environment to value the business and we believe that investors should add back $20 million of crude-related price adjustments to the 2016 and 2017 EBITDA figures and take away $20 million from the 2014 and 2015 EBITDA figures as well.
Harris: Could you detail your and Rhizome’s background in deep-dive, fundamental research? [Please use your excellent pitch on FRPH as a case study]
Chen: We start with the philosophy that as shareholders, we own a part of the company. We then ask ourselves what we would want to know if we own an operating business. We generally think that understanding the competence and incentives of the management team is extremely important. We love to visit management teams in their elements. This means attending annual shareholder meetings and getting a tour of the factory, facilities, or office. I personally get excited when I go to shareholder meetings of smaller companies and meet with the CEO, chairman, family members, and long-term shareholders. There is a lot that you can learn from a third-party shareholder who has owned the stock for 5, 10, or even 20 years. They are often very candid with regards to their opinion of the management team and how they have been treated over time. You can learn a lot from meeting management at their headquarters. You can have a good sense of how they manage cost by looking at the cars in the parking lot and by assessing the opulence or dullness of the office. Prior to launching Rhizome Partners, I accompanied a management team on a deal roadshow across the US over the span of two weeks. I noticed that the CEO gave more unrehearsed answers in the beginning. After two weeks on the road and over 60 meetings, the CEO was able to answer all sorts of questions with ease. With the coaching of the investment bankers, he became polished and gave answers that conveyed a more positive image of the company. This experience taught me to go visit management teams in their own environment. This is especially true for smaller companies with minimal analyst coverage. We get really excited if we are one of less than a handful of outside investors at the shareholder meeting.
With regards to understanding the business, we try to figure out what we need to research to really understand the earnings power and competitive strength of the company today and in 3, 5, and 10 years. This could mean talking to industry experts, customers, suppliers, and attending conferences. Sometimes, the highest return on time is to show up at the company and ask them to walk you through their products and talk about their competitors from their perspective. From my experience, CEOs and CFOs feel a lot more obligated to chat with you if you flew from New York City to Indianapolis in the middle of the winter to visit them as I have done with Calumet. Our 1 hour conversation turned into a 3-4 hour ordeal. We got to talk about the challenges of getting employees to buy into the vision while you cut $140 million of cost in a $300 million EBITDA business over the course of 2 years. We talked about how the CEO has brought in his own team of executives and how they are actively implementing best practices. Prior to his arrival, the company was managed like a family business with decision-making at the top. The new management team has now delegated decision-making to the product groups and holds them accountable for P&L directly. These conversations provided qualitative insights into very important cultural changes within the company. You cannot infer this from the $200 million of specialty segment EBITDA that has stayed relatively flat in the last few years. A typical 30 minute meeting in New York City would not allow me to understand the company at that level.
On the real estate side, we are extremely old school. We want to kick the dirt and see the assets ourselves. We shared our analysis of FRP Holdings on Sumzero.com in late 2015. During the summer of 2015, my brother and I drove down to Washington DC to visit their warehouses in Baltimore and their multi-family developments on the Capitol Riverfront. We had no idea what these assets looked like. We were amazed by how one-of-a-kind the Capitol Riverfront location was. It is across from the new Washington National Baseball stadium and it sits right on the edge of the water. Forest City has spent a large amount on building public spaces, restaurants, amenities, and a river walk that connects directly with FRP Holding’s development site. The area has all the signs of an up-and-coming neighborhood. We were so excited about FRP Holdings that we decided to drive all the way down to Georgia and Florida to visit their massive rock pits in over a dozen locations. We paid attention to the location of the rock pit relative to nearby cities and communities. When rock pits are exhausted, they have valuable second lives as industrial, residential, or commercial developments. By driving through the surrounding area, we knew which of the rock pits could be developed into housing developments and which ones would likely be a giant hole in the ground. That was a very memorable trip as we wound up in a new city every night after driving 500 to 700 miles. We ate a lot of Chick-fil-A and lived out of our suitcases that were only packed for a weekend. All together, we drove over 3,000 miles in a week and we saw 50-60 properties. While it is hard work, it is a luxury having seen the warehouses, multi-families, and rock pits that you own in your portfolio. We always felt that if there were a crisis, we would have no problem backing up the truck and buying more shares because we have done all the work upfront.
We also spoke to the management team. The first thing the CFO told me is “Our motto is do no harm.” John Milton Jr and the Baker family at FRP Holdings are some of the most astute and shareholder- friendly management teams that I have had the pleasure of investing with. We found an interview in a newspaper in which John Baker II, the Chairman, talked about how his grandfather lost the sand company. His father bought it back from the bank and built it up without the use of debt. In 2007, he felt obligated to sell Florida Rock to Vulcan Materials because Vulcan made an offer that he couldn’t refuse. They were not looking to sell but realized that it was the best option for the shareholders. We love management teams that are conservative, act in countercyclical ways and believe that there is a right price for every asset they own. We were not surprised when FRP Holdings sold their warehouse portfolio to Blackstone in 2018.
Harris: What is the biggest risk to your thesis? Why?
Chen: I think the maturity of the $900mm senior note in 2021 is the biggest risk to the thesis. We believe that the company will grow their EBITDA and thus free cashflow over time. If the capital markets shut down like they did in 2008-2009, Calumet may be forced to file for Chapter 11 bankruptcy. The company is working with rating agencies to raise their debt ratings. S&P recently raised their rating for Calumet’s debt around the time they paid off the $400 million 11.5% coupon senior secured note. On the other hand, structural deterioration of the specialty business would be another risk to the thesis. We worry less about the impairment to the refining business as it represents less of the overall value.
Harris: Where else do you see value in the market today? Where else does Rhizome focus?
Chen: We also own Griffin Industrial Realty (Nasdaq:GRIF). The company owns a portfolio of warehouses in Hartford, CT, Lehigh Valley, PA, and Charlotte, NC. They also own over $90 million of various legacy land holdings in Hartford, CT. Some of those land parcels have been and will be developed into additional warehouses. The company’s pipeline of shovel-ready warehouse projects should dramatically increase net operating income. Those should come online in the next two years. We think the net asset value of the company will be roughly $72 per share in two years and shares currently trade below $40 today. LAACO, Ltd (OTC:LAACZ) owns a portfolio of valuable self-storage facilities in Los Angeles, San Diego, Houston, Las Vegas, and Phoenix. The company’s Southern California assets are particularly interesting because they can add more density on the existing sites. They also own a building in Downtown LA that is not generating a lot of cashflow, but the value of the building is worth significantly more than the cashflow implies. Overall, the company trades at roughly 13x P/FFO with a debt amount that is less than 10% of the total asset value. We expect FFO to grow overtime as new facilities are leased up overtime. We think the company is worth 50-60% more. The family controlled management team is shareholder friendly. The stock pays a 3.2% distribution with an equal amount of cashflow going towards developments. Ben Stein called LAACO “as good an investment as I ever have made, except for Berkshire Hathaway.” Both ideas are available on Sumzero.com
Harris: You believe that it is important to calibrate the overall performance of the Company and specifically the Specialty Segment. Why?
Chen: I generally agree with my high school wrestling coach’s statement of “would’ve, could’ve, should’ve, didn’t” when it comes to evaluating company performances. As value investors, our job is to identify various companies’ long term earnings powers. However, we need to calibrate Calumet’s past performances due to its past crisis and its ongoing turnaround transformation. It is important to understand the position that Calumet was in prior to the arrival of Timothy Go and his management team. The Company made roughly a dozen acquisitions under its previous leadership. From our experience, the best acquisitions are the ones where the acquirers can realize significant cost synergy by passing along savings and implementing best practices. Cultural fits and backend systems are also critical to the success or failure of integration. Our understanding is that the previous acquisitions lack strategic rationale. The pace of the acquisitions also meant that Calumet’s management and employees never had a moment to integrate them. Instead, they were preparing to close the next deal. From our experience, an active acquisition history with no efforts towards integration is a recipe for disaster. By late 2015, it is apparent that the company has made unwise capital allocation decisions and Calumet is in a precarious position. What transpired in 2016 and 2017 is one of the most impressive turnarounds in corporate history that I have witnessed. I suspect that the overall corporate mantra at Calumet during 2016 was “live another day by all means.” By the end of 2017, they have achieved $140 million of “self-help” goals. They have sold off non-core assets such as the Superior refinery, Anchor Drilling Fluids, and joint ventures that never made strategic sense. The management team even implemented a new ERP system that will allow them to handle logistics more efficiently. The CFO has mentioned a few times that prior to the implementation of the ERP system, they did not know which customer generated profits for them. They are excited to identify which customers actually contributed to their profits and will focus on growing future sales from these profitable customers
I have been a part of some amazing teams and some less stellar ones. The traits of great teams include strategic clarity and purpose. I suspect that under the previous management team, the employees had no idea what the corporate purpose is. The current management team has made it very clear that the goal of Calumet in the long run is to become a well-run specialty chemical company. This is very apparent to me as they have invested in Royal Purple, TruFuel, BioSynthetic Technologies, and created an agreement to use their GP’s research facilities in exchange for a profit share. The shift in capital allocation strategy is night and day. Calumet spent $2.5 billion on acquisitions and mindless capital expenditures from 2011 to 2015. Since the new management team took over, their spent on branded and IP rich products are likely around $50 million. Yet, I think the return on these minimal spends will likely be higher than the $2.5 billion. As a company, I personally think that Calumet is past the inflection point of switching from crisis control and is moving onto growth and innovation. A fitting analogy for Calumet would be a talented athlete who came from an unstable home learning from a third rate coach. Now she has been adopted by a well intentioned and highly regarded coach and can finally unleash her full potential. We are excited for Calumet in the next few years.
We need to further calibrate the quarterly performance of the specialty segment. In the last few quarters, Calumet’s specialty segment’s EBITDA has experienced a myriad of non-recurring costs. We tend to dismiss any items labeled as non-recurring cost. But we think it is warranted here. In the last twelve month, the specialty segment has been impacted by the ERP implementation costs, lower margins due to rising crude oil prices, Hurricane Harvey, planned and unplanned outages, and acquisition costs, etc. So how do we analyze the specialty segment EBITDA performance? Do we take the historical figures or do we use a run-rate figure? Allow me to use another analogy. We think it is important to adjust the specialty segments performance for the above mentioned figures. For example, most Boeing airplanes have rated cruising speed. Yet they will almost never actually fly at that speed due to variances in headwinds and tailwinds. In the case of Calumet, rising crude oil prices act like headwinds and falling crude oil prices act like tailwinds to the specialty chemical business. In addition, Hurricane Harvey, outages, and acquisition cost are the equivalent of weather systems or mechanical systems that cause temporary delays. The big picture is that it is important to calibrate the Specialty segment performance in a run-rate manner and in a neutral crude oil environment.