Thursday, July 30, 2009

Compass Minerals: A Low P/E Bin Oddity

The general market may have been down yesterday, but Compass Minerals was not. It rose 5.99%, although that gain was shaved with a 1.00% decline in after-hours trading. The company reported 2Q '09 earnings after the bell two days ago that were well above 2Q '08's. That report provided the catalyst for Compass' shares to shoot up yesterday.

Compass Minerals is a miner of rock salt and sulfate of potash, and it buys other products that are compatible with its main lines of business. It's only been a public company since 2003, and a complete set of available financials for it goes back to 2002. During the time it's been a public company, its EPS growth (as measured by logarithmic regression) has been an eye-opening 30.93%. These results have been skewed somewhat by 2008 earnings that were nearly double 2007's. Still, the first two quarters of 2009 show further EPS growth taking place.

Compass' latest 10Q report, for 2Q '09, shows something rather odd for today's revenue-nervous Street. Its revenues decreased 2% in 2Q '09 as compared with 2Q '08, and revenues in the first half of '09 have sunk 14% as compared with the first half of '08. Given today's fashions, this drop should cause concern. However, its gross margin has increased during those timeframes. 2Q '09's gross margin is 11 points above 2Q '08's. The same 11-point jump took place between the first half of '09 with respect to the first half of '08. And this, in a market where Compass' sulfate of potash sales are down because of price concerns amongst its agricultural customers.

Those who are used to seeing a current ratio 'supplemented' by a standby line of credit will find a pleasant surprise in Compass' balance sheet. As of June 30th, Compass' current ratio was 3.21. Using a strict form of the quick ratio, in which all current assets save cash and accounts receivable are excluded, Compass has a number of 1.17. This, from a company whose inventories are likely not to plummet in price as a result of fashion changes. Compass' working capital is equal to more than half of its long-term debt.

There's one easily-found trouble spot in its balance sheet. Compass' debt-equity ratio, including short-term and current long-term debt, is 3.42 times shareholder's equity. This ratio is so high in large part because Compass' shareholder's equity has been negative from 2002 to 2007*. Its long-term return on equity figure is meaningless as a result, and its more recent return on equity figures are misleadingly high. The fact that it has a lot more debt than equity is a concern, as a debt equity of 1 to 1 is the high point of safety.

This weak point can be balanced with the debt-to-working-capital ratio, which is a much lower 1.90. The earliest due date on its long-term debt is 2012. although 80.8% of its debt ($395.2 million) is due in that year.

The last annual spurt-up in EPS before 2008's was 2004's 33.9% gain over 2003's. This gain reversed in 2005, when earnings got knocked down to below 2003's level. In 2006, though, EPS shot back up to over 2004's. This can be taken as a sign that derailed EPS growth will not be permanent, or as a sign that Compass' EPS is quite volatile. 2005's started out below 2004's right from the first quarter; 2009's first two quarters are both above 2008's. Nevertheless, there is a chance that the last two quarters of '09 will not be above '08s. A relatively mild winter could knock down EPS in the fourth quarter, for example.

Another weak point on its balance sheet, from a value-investing perspective, is its book value. Excluding intangible assets, Compass' equity per share is a mere $3.47. Its close in last evening's after-hours trading was $51.51. At that price, Compass is selling at 14.8 times book value.

It's a very high overage, and the reason is the same as for the high debt-equity ratio and misleadingly high near-term return on equity ratios. Compass started off as a public company with a large shareholder's deficit*, for whatever reason**, which has made for its weakness in two standard value investor's ratios.

On the other hand, its dividend is relatively safe. Compass currently yields 2.73%, and the dividend has increased in every year it's been a public company. From 2005 to 2007, its free cash flow was less than double its dividend-payout expenditure. In 2008, though, free cash flow was more than four times' dividend expenditure. For the first half of 2009, free cash flow was about 2.5 times dividend disbursements. Compass has not had a long record of free cash flow being well above dividend disbursements, which makes for another cautionary sign for a value investor. On the other hand, its recent record does show a nice margin of safety.

There's another, more earnings-related, weak point in Compass' most recent balance sheet: as of June 30th, inventories have shot up 63.5% from Dec. 31st's level and 49.2% from March 31st's level. This ramp-up seems seasonal. 2Q '08's inventory level was 67.4% higher than 1Q '08's; that earlier ramp-up did not portend a drop in earnings for the rest of '08 or even the for the first two quarters of '09. 3Q and 4Q revenue growth justified the increase. The company clearly is expecting that seasonal growth to continue this year. If that expectation is not met, however, then Compass will be stuck with a lot of inventory. Revenue for the first half of '09 has grown nowhere near the rate that inventory has, even if annual revenue growth has grown 18% from 2005 to 2008.

For this metric, standard interpretation says "stay away." Even if the reason is merely seasonal, its inventory bulge for the first half of this year - on the heel of declining revenue in the same timeframe - sends out warning that Compass might very well stumble soon. The only point of doubt comes from the seasonality factor.

Putting all of the above together, it's evident that Compass is an oddity in the Low P/E Bin: a low P/E speculative growth stock. It's selling at way above its book value. One of its solvency metrics is horrible, even if its liquidity position is great from a value investor's perspective. Its EPS growth is quite high, and its most recent results show no sign of a stumble. Compass is one of those companies with a current knack for expanding gross margin in the teeth of a current revenue drop. Its inventory level, although perhaps seasonally justified, is disturbingly high relative to 2008's and its revenue for the first half of 2009.

The inventory factor is what makes Compass a speculative low-P/E growth stock. In the near term, the speculative element is the weather. If this coming winter if going to be mild, Compass will be stuck with a lot of inventory that it can't unload. If this winter's going to be a cold and snowy one, however, the inventory problem will disappear like 2008's 2Q bulge did.

Ove the longer term, another speculative element is a pickup in demand for Compass' sulfate of potash fertilizer products amongst its agricultural customers. According to the company's most recent M D & A, price sensitivity is the current factor damping demand for this segment. Compass' target customers are evidently not prosperous enough to not worry about the expense. If they become so, then the company will have no trouble selling its specialty fertilizer even at current record prices. So, the second speculative element is the hope that Compass' farmer and turf-seller customers will become prosperous again. To put it another way, Compass is in part a speculative bet on agricultural commodities going up further.

Putting it all together, Compass looks like a great stock to someone who believes that: a) Compass' growth record, not impugned since 2005, will continue; b) the coming winters will be cold and snowy, and winter road conditions will be bad enough to further boost demand for Compass' rock salt; c) agriculture is in for a boom, creating upped demand for Compass' sulfate of potassium specialty fertilizer. For someone who believes that roads won't need that much winter treatment in the future and agriculture won't be entering a boom anytine soon, or that Compass' recent record won't be continued for other reasons, Compass' inventory jump-up sends out a red-flag warning.

A value investor, on the other hand, would shy away from Compass because of its low shareholder's equity. That paucity not only makes for a very high debt-to-equity ratio, but also for a very low book value per share relative to the stock's current price. Although it has a record of increasing its dividends, its free cash flow cushion hasn't been all that great until last and this year. That's not enough of a change in ways to make a true value investor comfortable - and the yield isn't all that high anyway.

What to make of this stock is up to the reader. The above analysis, I hope, managed to clarify what kind of an opportunity Compass represents, for what kind of person, as well as clarifying any cautionary or warning signals from the company's financials.

One more point: Compass has more than $10.2 million in net losses from interest-rate- and natural-gas-price derivatives that it intends to bring on the books as expenses in the near future. Those losses represent a drop of 31.3 cents' worth of EPS that will show up in the income statement soon. Had they been expensed in 2Q '09, Compass' earnings in that period would have been only somewhat above 2Q '08's. If natural gas prices keep dropping, then there will be more losses even though said drop will lower Compass' unhedged natural-gas costs too. Given that 2Q EPS was 42 cents as compared with 2Q '08's 5 cents, even though revenue did drop in the same timeframe, it's safe to assume that Compass will be a net beneficiary from a further natural-gas price drop. I note this point to show that Compass' EPS is going to be sliced downwards by 31.3 cents in the near future. Had Compass expensed the losses last quarter, EPS would have been 10.7 cents - still a gain from 2Q '08's, but far below the reported one.

[Note: I have to remind everyone that I'm not licensed as an investment advisor in my home jurisdiction of Ontario in Canada, nor do I qualify for such designation.]


*: Buybacks were not responsible: Compass started off with a large negative shareholder's equity. As of the end of 2003, right after it first started trading, its shareholder's equity was -$128.1 million. As of the end of 2008, shareholder's equity was +64.5 million. Several years of earnings were required to reverse the initial shareholders' deficit. As of 2Q '09, shareholders' equity was +$143.9 million.

**: Your guess is likely to be better than mine. I don't even want to to try to guess why.


  1. A very well-researched article. It matches my own views on Compass Minerals. I should point out, though, that the low book value, which started out as a deficit as you state, indicates that the accounting figures do not conform with reality, as is often the case with figures. Also, Compass Minerals is a very low-cost producer and occupies a dominant position in its market, so even if it gives up some earnings from its excellent 2008 it should retain its competitive advantage.

  2. Thanks for your comments, Geoff. I guess I didn't give Compass' moat the attention it deserved.