Israel Chemicals would seem to be undervalued

Israel Chemicals Photo: Eyal Yizhar
Yaniv Pagot

Experience has taught me not to disparage market wisdom, while not embracing collective wisdom as if it were infallible, argues  Ayalon Investment House's Yaniv Pagot.

2018 was an excellent year for investors in Israel Chemicals (TASE: ICL: NYSE: ICL), which outperformed comparable groups around the world, and whose share climbed 57% during the year. But a few months later, however, investors' attitude towards the share reversed, costing the company a quarter of its market cap so far this year, similar to the global trend in most of the comparable groups.

An analysis of Israel Chemicals' financial results in the first half of 2019 does not explain the weakness in the share price, because the results were a noticeable improvement in comparison with the first half of 2018. Furthermore, the company's profit guidance for the rest of the year and for 2020 projects continued improvement in financial results. This is thanks to smaller expected losses in activity in mines in Spain and the UK and a projected increase in potash production at the Dead Sea resulting from the maturing of investments and an absence of maintenance costs like those expected in the fourth quarter, which will reduce production in 2019 as a whole.

These figures give rise to the question of why gloom has replaced euphoria among investors in Israel Chemicals' share and in other shares in the sector, with respect to the companies' future performance. In analyzing the behavior of Israel Chemicals' share price, investors' basic instinct is to examine the development of potash prices, even though Israel Chemicals' operating profit has other important pillars. Despite its pigeonholing by many investors, Israel Chemicals is not a pure potash company.

Prices in the potash contracts signed in 2018 were substantially higher than in previous contracts. It was expected that prices would continue rising in the coming years, given a moderate rise in global demand to balance the increase in supply. The operating profit in the sector in recent years has been $400 million. In the current situation, investors fear lower prices in future potash contracts because of the global trade war's affect on global growth, especially US agriculture. As if the gloomy expectations for global growth were not enough, the rainy weather in the US is having a negative impact on crops and has affected demand, while at the same time causing a diversion of output by potash giants outside the US. The World Agricultural Supply and Demand Estimates report for August by the US Department of Agriculture confounded optimism about a recovery in demand next year.

Israel Chemicals' second profit center, which contributed $340 million to its operating profit last year, is bromine and bromine compounds, in which the company is an important market leader, due to the unusual concentration of bromine in the Dead Sea. Israel Chemicals' global bromine market share is 39%, enabling the company to affect market prices. An examination of the trends in this market, excluding seasonal factors resulting from the behavior of Chinese companies during the summer, shows no decline in conditions in the sector, which have markedly improved in recent years. Furthermore, Israel Chemicals' efforts to increase the mix of its bromine compound sales supports the company's competitive positioning and its future profit margins.

In my opinion, Israel Chemicals' bromine activity is being substantially undervalued because it is being concealed in the company's general pricing, which involves more cyclical elements. Holding a separate offering for this activity could have created added value for the company's shareholders.

Phosphates is another activity, which contributed $120 million to Israel Chemicals' operating profit last year. Price competition resulting from the Chinese policy in the sector is continuing, but there have recently been certain indications that price pressure in the sector is easing. Israel Chemicals' strategy of focusing on special products with added value for customers supports the profit margin in the sector, in which commodity activity is unprofitable and competition is intense.

Market wisdom is not infallible

The dramatic strengthening of the shekel against the dollar since the beginning of the year is having a negative impact on Israel Chemicals' value, because the company's cash flow has both dollar and euro elements that are eventually translated into shekels.

In analyzing Israel Chemicals' share, it is impossible to avoid mentioning the understandable regulatory concerns about investing in the share, above all the future of the Dead Sea franchise, scheduled to expire in 2030. What will happen in this crucial question is impossible to predict, but it will definitely affect investors in the coming years, and increase volatility in the share, which accounts for the conservative pricing of the share by some investors.

Israel Chemicals' share is perceived as a fairly defensive share in a potash market environment in which prices are rising, because the company sells all of its supply at market prices and cannot increase quantities, in contrast to the major players in the sector, which have unused surplus capacity. This is one of the most prominent reasons for the consistently low multiple at which the share is traded in comparison with equivalent shares. It could therefore have been expected that this defensiveness in a weakening potash market, combined with a relatively low leverage of 1.9 times EBITDA, compared with 2.9 times EBITDA at the end of 2018, and the dispersal of its business, would have resulted in Israel Chemicals' share outperforming the market. As of the summer of 2019, however, this is not the case; Israel Chemicals' share price is taking the same beating as the rest of the companies in the sector.

A business overview of Israel Chemicals in late August shows a big difference in the market's perception of the risk incurred by investing in the share and the objective figures derived from the company's markets. Experience has taught me not to disparage market wisdom, but on the other hand, not to embrace collective wisdom as if it were infallible.

The author is chief strategist of the Ayalon Investment House. The author of the article and/or the company are likely to hold or trade in the securities mentioned in the article. Nothing in the article constitutes a substitute for investments marketing and/or investment counseling that takes into account each individual's special particulars and needs

Published by Globes, Israel business news - en.globes.co.il - on September 1, 2019

© Copyright of Globes Publisher Itonut (1983) Ltd. 2019

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