Debt & Cyclicals - Magic or Catastrophe ?
My attitude to debt and a quick look at Vertex Energy $VTNR
Cyclicals are one of the most interesting type of stocks out there. Oil stocks for example were tradings as if oil is worth nothing in 2020. Just 3 years later many have gone up 10x from the lows ! We all know that you have to buy when the fear is high and stocks look like shit. But when we need to act, we hesitate and wait to long.
So let me give you my notes to the importance of debt while investing in cyclicals (especially commodities).
1/ Break-Even Prices
Buying cyclicals in the downturn requires balls of steal. You know that they could go a lot lower, but you are willing to hold for quite some time to let the market recover.
Let’s assume a world with 2 companies:
A) Breakeven price 70$ a Barrel
B) Breakeven price 30$ a Barrel
The current price is 75$ a Barrel, so company A makes a margin of 5$, wile company B makes a margin of 45$. If you believe that oil goes up to 100$, which stock do you buy ?
Obviously company B, since their profit would go 6x from 5$ a Barrel to 30$ a Barrel ! While the profit of company B expands “only“ by 55%.
But if things stay as they are or get worse, then investing in company A is going to be painful. Therefore I like to stay away from garbage and also stay away from leverage. This reduces the likelyhood of doing something stupid dramatically.
2/ Balance Sheets
We can say that cyclicals will at some point rebound, but making predictions based on time is very difficult. Therefore we want to buy businesses, that won’t go bankrupt. As Charlie Munger put it:
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
— Charlie Munger
One of the best stories to illustrate this is the story of refiners or generally energy companies in 2020. These refiners had debt that would expire in 2024 and beyond. So there would be a window of several years for the market to turn. If you buy cyclicals that have debt expiring 1 year out at the low of a cycle, then the likelihood that you will get diluted or lose everything is very high. One part of the story is how much Net Debt a company has, the other part is when will this debt expire and at which conditions (coupons, terminal value, etc) ?
We should also look at Working Capital (current assets - current liabilities), since a positive level shows at least some financial strength. Going back to the time window of the debt, when you have a window of several years to pay back obligations, then you won’t go bust. This is the result of a simple concept that I call “supply-drop“. Normally companies are profitable, but in the downturn of a cycle they can become unprofitable, therefore Mr. Market is fearful, that the company goes bust. But when you become unprofitable, then many more will face the same issues. Therefore they will reduce production. This reduces supply and the price should move up again.
Generally if you see that mines or production wells are being closed, because it’s unprofitable, then this usually is a sign of the bottom !
With prices moving up and a new bull market, profits will rise again and companies will be able to repay loans. So ideally companies are net cash, if this isn’t the case, look at the dates at which they have to repay their loans.
3/ Vertex Energy
After talking quickly about the theory, let’s have a look at an interesting example.
Vertex Energy VTNR 0.00%↑ is a refining business from California, that has grown it’s revenue from 208m $ in 2021 to 1 Billion a quarter by 2023 ! To make a long story short, VTNR bought a plant from Shell for 75m $ in 2022. This acquisition was a great Dvid vs. Goliat story. In order to fund the acquisition they raised a lot of cash trough debt with horrendous interest rates of >15% ! To make matters worse, crack spreads went down and the management has done some mistakes regarding hedges, this resulted in dilation and a share prices that is down by 75% from it’s high.
From the Q3 earnings report we can see that the business is improving nicely and that the managment is on track again. They have a renewable diesel division that will likely turn profitable by end of 2024. On top of this they will receive government subsidies for Q3 & Q4. The stock is currently trading at an annualized P/E of 5 with a market cap of 400m $ while having assets that are worth billions of $ ! Since it’s basically impossible to build new refineries in North America, the value of their assets is gigantic. And even if you get permissions, then this will cost billions to rebuild.
But most importantly we have the balance sheet that will be addressed in the coming quarters. If successful, then the stock offers tremendous upside. So let’s apply the framework of cyclicals from above on Vertex.
3.1/ The Balance Sheet of VTNR 0.00%↑
This is from their recent Q3 Earnings Report 👇
We can clearly see that the majority of their debt repayments will have to happen by 2025. The Net long term debt is equally to 163m $ as of right now. But since after 2025 the expenses regarding debt are low, let’s focus primarily on 2025. The debt that has to be repaid by 2025 is equal to around 170m $. Subtracting the 80m in cash & cash equivalents, we end up at 90m Net debt till 2025.
In the 3rd quarter they made 20m $ Net Income, which if generated every quarter till 2025 (5 quarters) would mean 100m $. But since I prefer to be conservative, let’s assume that although their will be government subsidies and although 27% of Q4 production is hedged, 60 million in profit will be generated over the coming 5 quarters.
By now you will have realized that they could have financial problems, if the market crashes. But I left out one detail, the inventory !
With 222m $ in inventory that will be likely reduced significantly, they should have no problems paying their debt. In the recent earnings call, managment noted that they are working together with Bank of America to increase the strength of their Balance Sheet. They will likely not raise 222m, but even if it’s 100m, then they will repay the debt much easier.
4/ Conclusion
All in all Margin should be avoided in the process of investing into cyclicals. For companies at the bottom of the cycle, it is worth noting that the expiration date of their debt should be considered while investing in them. Vertex VTNR 0.00%↑ won’t go bankrupt till at least 2025. They have enough time to manage the situation and with a Net debt position of 90m $ till 2025, while they generate conservatively 12.5m $ a quarter and have 222m $ in inventory, I don’t expect liquidity issues.
Please note that I am watching the stock closely and plan to accumulate a position at some point, so if you have any comments or insights please post them below and join the community 🙏
Yours sincerely,
MODERN INVESTING
A painful personal lesson for me is grossly underestimating upward potential of a cyclical company near the bottom. PBF made an illy timed $1.2 billion acquisition of a refinery in Northern California just before the breakout of covid-19. Its stock price crashed from high 20s to ~$7 in January 2021. I noticed one of the biggest shareholders, Carlo Slim, Mexico's richest man, had been buying the share all the way from middle of $30s to ~$9. I spent a weekend to research it. The biggest concern I had was its debt, in particular, ~12% annual interest on a note issued a few months ago (when the fed fund is zero). I remembered that I told my wife in a Sunday evening walk that I wanted to buy a few hundred shares (the closing price was ~$7 on the previous Friday). Since there was some probability of big loss, we would only buy it outside of our retirement accounts. The next day, one of BoA's analyst down-graded PBF and drove the price down to a low of ~$6.3. I was kind of fearful and yet happy. I got a check from my wife and deposited it into our bank and transfer the money to Fidelity. The whole process took 3 days. By the time I could buy it, the price had moved ~$8.3. Because it had rallied over 30% then, I could not buy it. (A few days later, it moved to ~$14 because of short covering).
In retrospect, I made two mistakes. I grossly underestimated the upward potential. Even if I had bought it at $8.5, the recent high of $55 is still ~540% gain. Keep in mind that the $55 may not be the cyclical high for PBF. The second mistake was my anchor bias. I calculated the percentage of the gain from the low of ~$6.3. A 32% gain in 3 days was huge. The fear of buying high prevented me from taking a position. Had I calculated the gain from ~$7 (~18%,) at which I was willing to buy it, I probably would have pulled the trigger.
you miss out on the inventory financing agreement, effectively those inventory wouldnt be used to offset debt as counterparty has these as collateral. So it is not as straightforward for the refinancing risk