LSB Industries, Inc. (LXU) Earnings Call Transcript & Summary

Hello, everyone. I'm Will Tang, and I'm one of the associates on the U.S. chemicals and agriculture team here at Morgan Stanley. Before we get started, I'd like to remind everyone that this webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So first off, I'd like to welcome LSB Industries to our conference. Today, we have Cheryl Maguire, who is the EVP and CFO.

Just to kick off the discussion, could you talk to us -- kind of provide us a brief overview of the company and your key businesses?

Sure, Will. So LSB is a chemical manufacturing company, and we manufacture chemicals for 3 primary end markets, including agricultural, industrial and mining. We have 3 facilities that we own, 1 in Cherokee, Alabama, 1 in Pryor, Oklahoma and 1 in El Dorado, Arkansas. And then we also have a facility that we manage on behalf of Covestro in Baytown, Texas.

Got it. And then if we could dig a little deeper into kind of the pricing dynamics you could -- you guys are seeing. First off, just on the agricultural side, are the prices that you guys kind of realized entirely based off of like, I guess, the nitrogen benchmark prices that we can kind of see in the market today? Or what strategies do you employ to capture the best pricing, particularly in the market like we're seeing today?

Sure. So the agricultural markets, as you point out, are very, very strong. And I would say the strategies that we are employing are patience and discipline. I think most of our competitors as well as ourselves have been holding back somewhat on forward sales, which you typically want to do in a rising pricing environment like we're seeing today. And so it becomes being patient, not taking orders as quickly, not selling forward as much as you can allow to do with the inventory that you -- the inventory and storage capability that you have. And so for us, it really comes down to, like I said, being patient, being disciplined, holding off, holding back on orders as much as possible so that we can capitalize on the continued price momentum that we're seeing in the market.

Got it. And then just on the Industrial business, how should we think about how your selling prices are determined? And is there any advantage to being in this business relative to just focusing entirely on the agricultural side?

Sure. So we really like the Industrial and Mining businesses. They're generally more contract -- longer-term contracts, sometimes up to 7 years. And a lot of those are cost-plus type arrangements where we can pass through the cost of gas and then plus a margin, which is generally a pretty healthy margin. And so even in really tough markets, the Industrial and Mining margins tend to hold steady around 30%, 35% from an EBITDA margin perspective. And so I guess I would say the advantage to the Industrial and Mining business is really -- it provides some good downside risk, one. And if you compare it to agricultural, which can be pretty volatile based on spot pricing, the Industrial and Mining is really strong margins even in tough market environments, which is -- which provides some good protection against the volatility.

Got it. Yes. I mean just speaking about natural gas, I mean, a significant portion of your cost base kind of is associated with natural gas prices just being a nitrogen producer, I mean, could you kind of give us a rough percentage of that is? And to what extent are you hedging slash -- like managing this exposure?

Sure. So gas, I would say, ballpark is probably 60% to 70% of our cost structure and probably more -- a bit more than that in today's cost environment, given natural gas has been trending upwards to $5 and $6 per MMBtu. And in terms of hedging, our strategy there, it's interesting because we have lots of investors that tell us, look, we don't buy you to speculate on gas and to take positions on gas. But having said that, given it's such a huge percentage of our overall cost, we do take a lot of -- spend a lot of time and energy and thinking about how to buy gas forward. And so we typically do that with locking in for physical supply at fixed prices with our current vendor who supplies all of our gas needs for all of our facilities. And we generally look a quarter out. So we're about 75% hedged for the fourth quarter, and we're looking now into the first quarter. But generally, overall, we like to be about 80%, 90% hedged as we head into the next month. So if you're thinking about today, for us, that would be December. So as we get through the end of this month, we would like to be 75%, 80%, 90% locked in on December and at least to the point where the minimum turndown rate of the plant. We never want to be in a situation where gas spikes so high in a given month that we have to take the production off-line. So we look to hedge at least to that minimum turndown rate.

Got it. And then kind of just switching to the rest of that 40% of your cost base, I understand LSB has made significant progress in improving the rest of that 40% through the performance of its facilities. I think Mark Behrman, your CEO, mentioned opportunity for incremental EBITDA from further operating performance improvement kind of in like the $25 million to $30 million range. What would you guys have to do to capture this opportunity?

Sure. So we have been on a path to reliability for the last several years. I mean, back in 2015, we were in the high 70s from an onstream rate percentage, and today, we're in the low 90s. And so we've come a long way, and we would be considered, I think, respectable from a reliability perspective. But to go from the 90% to the 95%, there's a lot of EBITDA generation, as you point out, the $25 million to $30 million because if you think about it, every additional ton you produce, once you're covering your fixed cost, you're spreading your fixed costs out over more tons, so your cost of per ton produced becomes lower, which margin will expand as a result of that. And so there's a lot of leverage in going after that last 5 percentage points of tons. And so really, what that means for us is a continuation of what we've done so far. And so we have been very focused on, what I would say, the blocking and tackling. It's really about operating procedures and making sure that we have the right procedures in all of the hands of the people that run our plants. We put in a new preventative maintenance system. And so it's really about tracking the bad actors in those pieces of equipment that take us down and tracking mean time between failure and really getting our hands around understanding the root cause of what takes us down. And we've been -- over the last several years, been building data in that respect, and I think that will help us tremendously as we go forward. We're looking at hiring some key talent within the organization, whereas, historically, we may have focused on using external consultants. It's really about internal expertise around rotating equipment specialists and things like that. And so hiring key talent is helping drive that for us as well as capital investment. We've been spending a bit more on capital, probably $35 million to $40 million this year and something similar to that next year, and that capital investment and 2 key turnarounds next year at El Dorado and Pryor will also really help us drive that reliability plan forward.

Got it. And then if we could kind of switch a little over to the kind of the outlook side. Can you guys just talk about what you're expecting for nitrogen pricing in '22 and what the key drivers of this outlook are? And then, I guess, if you could touch a little bit on the possibility of demand destruction on the ag side, given the high nitrogen prices we're seeing today, that would be helpful.

Sure. So I think I would continue to say that demand continues to outpace supply. So corn demand has been very strong, which is driving strong corn pricing, and we're seeing corn above $5 per bushel, which is very strong pricing for corn and certainly higher than we've seen over the last 6 or 7 years. And with strong corn pricing, farmers want to maximize yield and so generally want to put down more fertilizer and a little less sensitive to the price of the fertilizer. And so that's been a key demand factor, and China has been buying a lot of corn to replenish their swine population that was decimated back several years ago with the swine flu, and they've been buying a lot of corn. And 40% of corn here in the U.S. goes into ethanol. And so ethanol, which is an additive to gasoline, with everyone back driving, following stay-at-home orders last year, we've seen full rebound in ethanol as well. So all of these factors have driven corn demand and corn pricing. And then on the fertilizer side, we've seen supply disruption globally as well as domestically. And so it really started back in early February this year with Winter Storm Uri, which took several, if not 80%, 90%, of our competitors' as well as our own plants offline for a couple of weeks. That really disrupted production. And so it left the industry short, and it seems like we've been trying to play catch-up ever since. Hurricane Ida took production off-line in the summer months. And most recently, with all of the production offline in Europe with rising gas costs, it's really just not economical for European producers to make ammonia today because at $22, $23 per equivalent cost of MMBtu gas, it's really -- you're looking at over $1,000 to produce ammonia. And so it's really not making sense. So you've seen a lot of curtailed production in Europe. And so the supply is just really, really short, which is causing pricing to remain very strong. And so we expect that to continue certainly into 2022 and possibly even longer.

Got it. And then, I guess, longer term, how should we be thinking about the earnings power of the company over the next, like, 2 to 3 years, just based on LSB's current portfolio of assets and organic growth opportunity set, assuming normalized product pricing, I guess, more over that 2023 time frame that you're talking about?

Yes. So we've talked about the potential of $25 million to $30 million upside in EBITDA as it relates to further improvement in reliability. If you think about 2021 for us, we're kind of on record suggesting that we'll probably be around $170 million of EBITDA this year. If you think about the earnings power of the company in a mid-cycle environment, we're probably $150 million to $200 million. And in a more bullish cycle, I'd say we're probably $200 million or better.

Got it. Yes, I mean, it sounds like the outlook is pretty favorable. I mean I guess just given the higher prices that we're seeing and possibly an elevated earnings dynamic in free cash flow generation, how do you think about like capital allocation?

Sure. So I think I would say we have a lot of competing opportunities for capital. We have some -- we like to call them margin enhancement projects, and we did 3 of them here in 2021, and we're looking at our next round of margin enhancement opportunities, which are basically growth projects that basically pay back 2 years or less with an IRR of 20% or better. And so there are several opportunities there that we're considering. This is the first year that we are sold out with respect to our downstream production. And so there are debottlenecking opportunities that we are considering. Like, for example, we are maxed out on production of nitric acid. And so we could consider debottlenecking our nitric acid plants for -- to increase production. And I think that could make a lot of sense for us. We are on record talking about blue and green ammonia and potential M&A transactions as we look to consolidate and grow the company, and so I think that could be another opportunity for us. And then after that, there are some smaller pieces of debt on the balance sheet that we can take out basically at any time with limited prepayment penalties. And so I think we'll look at that. And then after that, it's really returning capital to shareholders.

Got it. And then I guess if you could kind of expand on the potential M&A activity that you may see and just to elaborate on the types of acquisitions you're looking at and your thoughts around financing potential deals.

Sure. So I would say we're looking for potential M&A that would be down the fairway in terms of what we do today. And so ammonia-based or ammonia-based derivative type of production across the ag and industrial space, maybe some M&A that would provide for geographic expansion into markets that we are not necessarily in today or maybe some product diversification or something that would be additive in leveraging some of the production capacity that we have. And then the other thing that also could be interesting, we are very focused on a clean energy strategy. And so companies that could make sense for us within blue and green ammonia or hydrogen are also things that could be interesting for us as we think about our M&A strategy going forward.

Got it. Yes. I mean, could you -- I guess going to green and blue ammonia, I guess, could you kind of give a brief overview of what those 2 types of ammonia are, how these markets -- how they might represent potential growth for LSB; and then finally, like how you plan to enter those markets? I know you mentioned M&A, but if any, any other possible ways.

Sure. So blue ammonia basically means capturing the CO2 that's admitted into the air, capturing that, sequestering it and putting it into the ground, basically. So that is a very interesting market for us. We have CO2 that's currently emitted that would be very interesting in terms of return. And the return today for blue ammonia is in the form of a 45Q tax credit, which is somewhere between $35 and $50 a ton. And what's currently making its way through legislation is the possibility of taking that 45Q tax credit and turning it into a straight cash payment, and so that is even more interesting. And so I think we'll hear about more on that over the next kind of several months. And so that's one key area that we are looking at. And you may see us -- there's lots of opportunities, and we're in the middle of feasibility studies, but it could be that we partner with someone. It could be that we decide to build the carbon capture equipment on our property. So there's lots of different opportunities there that are available to capture that, call it, $50 per ton, either tax credit or cash payment. With green ammonia, because we are an ammonia producer, we think we're well positioned to -- we know how to make ammonia. We know how to transport it. We know how to store it. And so we think we're a logical play for green ammonia. And so for us, we'd probably look at dipping our toe in it. And what I mean by that is taking the front end of one of our plants and maybe retrofitting a portion of the ammonia to make it from renewable sources instead of gas. And so I think if you take, say, our location like Pryor, which makes about 200,000 tons of ammonia annually, if you were to say take 200,000 tons and convert that retrofit the plant to make it from renewable sources instead of gas, I think that would be a way to enter the market and work out the demand, and we would look to have an offtake partner in terms of a place to go with that product. And so we think that regardless of what we do with blue or green ammonia, I think the ammonia industry overall is really going to benefit from the blue and the green ammonia opportunities as demand for ammonia will continue to grow.

Got it. I mean you mentioned the returns for blue ammonia would probably -- would primarily be on that 45Q tax credit. How should we think about, I guess, the pricing and, I guess, the downstream like end markets for blue and green ammonia? Would that be going to agricultural customers or more on the industrial side for fuel or stuff like that?

So I think the way that we think about it is, certainly, there's the 45Q as one revenue source. But also, if you look at a lot of our industrial customers, I think we've all -- there's many of our customers who have made commitments to go green. And so I think that there's some willingness to pay more for clean ammonia as they work towards meeting their own internal goals, where they've committed to a clean energy commitment.

Got it. I mean another thing that that's been -- we've been hearing a lot about is this infrastructure bill that went through the House of Representatives. I mean what kind of opportunities does that represent for LSB within the bill?

Yes. So we see a lot of opportunity for that to, again, build demand for the Industrial and Mining businesses. If you think about the infrastructure bill, you're talking about improvements to transportation, roads, bridges. And a lot of our Industrial and Mining businesses are -- will be very much supported by that infrastructure bill as we think about quarry and construction in some of the end markets that our products support.

Got it. And then, I guess, finally, LSB has a large lawsuit and process against a major EPC contractor. Can you kind of just go into the history of that, why you think that's a good case to pursue and then kind of the current time line?

Sure. So we have filed a lawsuit against our EPC contractor, who was responsible for the management of our El Dorado ammonia expansion back in 2015. Needless to say, the project was managed poorly and resulted in significant cost overruns. And we believe that there's a very strong case for gross negligence and even fraud on behalf of our EPC contractor. And so we filed our lawsuit and are seeking north of $100 million in damages. We had been scheduled for trial back in early 2020, and the trial was shut down, of course, with COVID, and so we are awaiting a new trial date. And we're very hopeful to be back on the docket in 2022.

Got it. I don't see any questions in the queue right now. So I guess with that, thank you for participating in the conference here.

All right. Well, thank you, and thank you for your interest in LSB.

Thank you. Bye.