S CN ($11.25) <Sherritt International > by chris815

**Value-Investing-Forum** Tue May 30, 2006 10:34 am

S CN ($11.25) <Sherritt International > by chris815
4/10/2006 1:34:00 PM S CN ($11.25) <Sherritt International > by chris815 (from Value Investor Club)

Description:

Sherritt International Corp. is modestly valued on an absolute basis, e.g., 4.5x
trailing EBITDA, 1x tangible book value, ~1x replacement costs, and trades at a 30%
discount to similar companies. The most likely explanation for this discount is that
four of Sherritt’s five businesses are located in Cuba. Yet, if we value Sherritt’s
coal business (completely domiciled in Canada) like other North American coal
companies and Sherritt’s nickel / cobalt business (half in Canada, half in Cuba) like
Norilsk, which is completely domiciled in Russia, we account for 95% of the Sherritt’s
enterprise value. This means that we are paying less than $100 million for
Sherritt’s other businesses, which generate $180 million of EBITDA annually (after absorbing
all $40 million Sherritt’s G&A) i.e., we are paying 0.56 x EBITDA for the other
businesses. Interestingly, all of Sherritt’s businesses are desirable and are likely
to grow earnings in the coming years. The company is modestly leveraged and has
considerable holdings of hard assets. Considering these facts, Sherritt represents an
outstanding investment.

Sherritt was previously posted to VIC on 12/29/04 by gearl1818 when its shares
were trading at C$9; we recommend gearl’s write-up in addition to our analysis below.
All figures in this report are in Canadian dollars unless otherwise
noted.

Why is Sherritt cheap?

Cuba
Before exploring the key risks when investing in a company that does business in
Cuba, consider this: if we value Sherritt’s thermal coal business (100% domiciled in
Canada) like similar North American coal business and value Sherritt’s metals
business (half in Canada, half in Cuba) using Norilsk’s (a large Russian based nickel
producer) current EBITDA multiple, we account for 95% of Sherritt’s enterprise value.
For the additional $85 million we get three businesses that will generate $180 million
of EBITDA after absorbing $50 million of corporate costs.

Risks when investing in Cuba
There are three risks specific to Sherritt’s investments in Cuba: 1) What happens
when Castro dies? 2) the provenance of Sherritt’s Cuban assets; and 3) U.S.
sanctions against Cuba.

1) What happens when Castro dies?
The riskiest aspect of Sherritt’s Cuban investments, to our thinking, is Cuba’s
lack of a system for transfer of political power. Cuban President Fidel Castro is 79,
one of only two people to lead Cuba since 1933. As Cuba does not have much
experience with leadership transitions, lacking an institutionalized system for the peaceful
transition of power, it is not knowable what will happen upon Castro’s death. And
more to our point, how will that event impact Sherritt’s Cuban investments.

This risk is mitigated by the fact that Sherritt is managing complex businesses in
Cuba that are critically important to the country’s economic and political
stability. For instance, the Moa nickel mine, which Sherritt manages and has indirect
ownership interest, was floundering before Sherritt partnered with the Cuban government.
During the 33 years prior to Sherritt’s involvement, Moa’s average production was
1.6 million tonnes of ore per year. The mine produced 2.5 million tonnes of ore during
2004, a 56% increase, and is being expanded to reach 4.5 million tonnes annually.
What does this mean to Cuba? Until recently, sugar was Cuba’s primary export, but
this is no longer the case. In 2003, Cuba exported US$824 million of nickel (its top
export) and US$324 million of sugar (its #2 export). Furthermore, Sherritt’s ore
refinery operations, located in Alberta, are a critical in the conversion of Cuban ore
into finished product. Since the Cuban government has a 50% economic interest in
the Canadian refining facilities, one would surmise that a “rational” government would
want to continue this arrangement.

A similar situation exists with Sherritt’s other Cuban businesses. For instance,
Cuba is chronically short of electricity. A breakdown at Cuba’s largest generating
station (not owned by Sherritt) during 2004 caused several months of disrupted
service and resulted in the firing of the Minister for Basic Industries. Sherritt’s power
business provides 16% of Cuba’s electricity. Given the problems Cuba has operating
its other electrical generation plants, it would make little sense to the next Cuban
leader to disrupt the arrangement they have with Sherritt.

2) Provenance of Sherritt’s Cuban assets
We initially disqualified an investment in Sherritt because we did not want to pay
for something that Sherritt did not own, e.g., at least some of Sherritt’s Cuban
assets can be traced back to the pre-Castro days and may have been taken from their
rightful owners. After doing further research, this does not appear to be a critical
consideration.

First, only $130 million of Sherritt’s assets are at question from a provenance
standpoint. The only asset in which Sherritt has an interest that pre-dates Castro is
the Moa mine; the remaining Cuban assets are less than 15 years old, consisting of
off-shore oil wells, new electrical generation plants, etc. Sherritt’s total
metals business has capital assets of $194 million. These assets consist of its interest
in the Moa mine as well as the company’s refining assets located in Alberta.
Sherritt estimates that 2/3rds of the metal assets are in Cuba, i.e., $130 million, which
represents 7% of Sherritt’s enterprise value, and 9% of its capital assets.

Who then rightfully owns the $130 million of Moa assets? The background is as
follows: In 1957, Freeport Sulphur (now Freeport-McMoRan) negotiated a deal with the
Batista government to build a nickel mine near Moa in exchange for tax concessions.
Freeport invested $19 million and raised an additional $100 million from Citibank and
a consortium comprised of steel and auto companies. The funds were used to build a
nickel refinery in Louisiana ($44 million) to process the laterite (a high
iron-content clay mined in Cuban that contains nickel and cobalt) and start the Moa mine
($75 million). Coincidentally, the refinery licensed technology from Sherritt to
process the laterite.

In 1959, soon after the mine was commissioned, Castro seized power and proceeded
to renege on the tax breaks negotiated between Batista and Freeport. Convinced it had
considerable leverage because it had one of the few refineries capable of
processing the Cuban ore, Freeport threatened to close the mine if Castro did not honor the
Batista tax commitment. Conditions deteriorated between the U.S. and Cuba and
negotiations broke off between the countries in August 1960. Castro “intervened” in the
mine to keep it operational, though the U.S. claimed he seized it. In April 1961, the
U.S. invaded Cuba in what is known as the Bay of Pigs; this ended any hope of an
amicable resolution.

Who in fact “owns” the mine and how will this be settled? Cuba claims damages of
$88 billion against the United States as a result of 45 years of embargo. The U.S.
has a similar claim against Cuba for property seized in the early years of the
Castro regime. This type of claim often is settled government-to-government when
relations are normalized. Whenever it happens, the eventual reckoning is unlikely to have
an impact on Sherritt.

3) U.S. sanctions
The U.S. has maintained an embargo against Cuba since 1961 which bars “U.S.
Persons,” including companies and subsidiaries of companies, from participating in
transactions with Cuba without a specific license from the U.S. Department of the Treasury.
Sherritt states in its filings that “U.S. Persons” may not be permitted to own
securities of Sherritt, but goes on to say:

In general written guidance, [the U.S.] Treasury has stated that it permits
portfolio investments in non-US firms that have commercial dealings with Cuba, but it bars
injecting capital into an enterprise in a manner supporting its Cuban transactions.

We are not in a position to dispense legal advice, but note that Fidelity owns 4.5
million shares of Sherritt; other large U.S.-based mutual funds are also
shareholders. Note that according to Bloomberg, several large US based mutual funds,
including Fidelity, own Sherritt shares.

Beyond the ambiguity of the U.S. stance toward investing in companies that do
business in Cuba, the Helms-Burton Act, passed in 1996, authorizes sanctions on
individuals that “traffic” in Cuban property confiscated when Castro seized power.
Sherritt’s investment in the Moa mine is deemed to be a form of trafficking under the
Helms-Burton act. There are three mitigating factors to
this:

1) The Helms-Burton Act specifically exempts publicly-traded securities.
2) Since the passage of the Helms-Burton Act in 1996, both presidents Clinton and
Bush have suspended the rights of claimants to sue under the
act.
3) Sherritt believes it is unlikely that a court in any country in which Sherritt
has material assets would enforce a Helms-Burton Act
judgment.

Clearly, the ambiguous nature of U.S. policy regarding investing in companies that
do business with Cuba is not enhancing Sherritt’s valuation, but it is not
reasonable to conclude that this effect is likely to persist. Consider that Sherritt’s
businesses not only produce cash flow, but also produce materials that are needed
worldwide, e.g., nickel, cobalt, oil and coal. Several Asian countries have a great deal
of foreign reserves to invest, e.g., as of December 2005, China held US$820 billion.
Not surprisingly, a Chinese company recently announced a US$600 million investment
to develop a nickel mine in Cuba. With so much money to invest, and such a large
need for raw materials, one possible outcome is that Sherritt will be purchased by a
non-U.S. based company in need of its
assets.

Complexity
A second reason Sherritt trades at a discount to its peers may be its complexity.
Sherritt is in five businesses: coal mining, nickel and cobalt mining, oil and gas
production, electricity generation and a collection of small businesses including
soy processing. While none of these businesses is particularly complex to understand
individually and Sherritt’s disclosure is reasonably good, gaining an understanding
of the drivers of all of the businesses takes some time. From a practical
standpoint, it is difficult for sell-side firms to decide which analyst should cover the
company. As a result, Sherritt is covered by a few metals analysts and one coal
analyst, yet metals will generate 40% of Sherritt’s 2005 EBITDA and coal will account for
about 13%.

From Sherritt’s perspective, there is a simple solution to the complexity problem:
break up the company. Considering that the company’s chairman holds 2.4 million
shares and options to purchase an additional 4.6 million shares, it would not surprise
us if Sherritt were to become a bit simpler to understand in the near future, e.g.,
convert the coal business to a trust and sell the metals business to Asian
investors.

Having addressed two possibilities for Sherritt’s modest valuation, next we
explain Sherritt’s businesses represent an outstanding investment
opportunity.

Sherritt’s Businesses
In addition to being modestly valued, we think Sherritt’s businesses are very good
and, in fact, earnings figures probably understate the value of the businesses due
to large holdings of assets and the option value of its Cuban oil business and its
Canadian coal business. If we define pre-tax cash flow as EBITDA minus maintenance
capital expenditures, Sherritt is trading at about 6x 2005 pre-tax cash flow and
about 4x 2008 pre-tax cash flow (after completion of capital expansion projects
currently underway).

Coal
Sherritt’s Luscar subsidiary is the largest producer of thermal coal (coal burned
to generate steam) in Canada. Sherritt owns 50% of Luscar, the balance owned by the
Ontario Teachers’ Pension Plan Board. (Unless otherwise noted, all figures in this
report reflect Sherritt’s net portion of its subsidiaries).

The company’s mines are located in western Canada. All their coal is surface mined
and is low-sulfur (less than 1% sulfur by weight). Sherritt’s coal production is
76% subbitumininous, 3% bituminous and 21% lignite. Sherritt sells 95% of its coal
to Canadian companies, primarily under to adjacent electric utility plants under
long-term contracts with inflation escalation clauses. There is increasing demand for
coal in the markets Sherritt serves driven by Calgary’s growing electricity
requirements as well as the oil sands businesses in the region. The company’s average selling
price for coal is about C$13 per tonne, i.e., metric
ton.

In addition to growing demand for coal in Sherritt’s markets, there are three
aspects of Sherritt’s coal business we find
attractive:

1) Predictable cash flow
2) Large reserves (45 years proven).
3) Option value: possibility to spin-off its traditional coal business in the form
of a trust with a second option on supplying coal to fuel the production of oil
from the Canadian tar sands projects.

In addition to stable cash flow, Sherritt’s coal business can generate substantial
cash flow. Exploration for coal companies is primarily to identify the geometry of
known deposits, not the existence of the deposit. As a result, coal businesses
have the potential to generate substantial free cash flow. Luscar’s return on assets
was 8% pre-tax during 2004, a representative year; this is quite low but reflects
Luscar’s enormous asset base (see below for a discussion of Luscar’s coal holdings).
Note that the company generated cash flow (EBITDA less maintenance capital
expenditures) of $65 million in 2004 on sales of $250 million. The primary customers for
Sherritt’s coal are the electricity generators in Alberta and Saskatchewan, businesses
unlikely to renege on contractual obligations. Demand for power in Western Canada is
increasing due to the growth of the oil sands businesses, e.g., Calgary is the
“Houston” of Canada. In conclusion, Luscar has excellent free cash flow characteristics
and they are likely to have more demand for their coal in coming years.

Second, Sherritt’s coal business has large coal reserves. At current mining
rates, Sherritt has 45 years of proven and probable coal reserves and 400 years of what
it calls undeveloped coal resources. Using Sherritt’s proven and probable coal
reserves (the 45 year number) and assuming a value of C$752 million valuation for their
coal business, Sherritt coal business trades for about US$ 1 per ton of reserves,
making it one of the cheapest coal companies in North America.

As mentioned, Sherritt owns rights to large tracts of coal which are not currently
included in reserves, e.g., Sherritt’s inferred coal reserves which total 2.25
billion tons; obviously, to the extent the inferred coal reserves are real, the company
is that much more of a bargain valued at C$752 million.

Third, is the option of converting Sherritt’s coal business into an income trust.
The coal business has the right characteristics for the trust structure, e.g.,
predictable cash flow, low capital expenditure requirements. The trust structure is of
particular interest because trusts trade at fat multiples. There is value in owning
this option, and based upon Sherritt’s current market valuation, one is not asked to
pay for it. Interestingly, prior to Sherritt’s acquisition of Luscar, Luscar was a
trust. At the time, Luscar had a substantial metallurgical coal business.
Metallurgical coal is used to make steel, and as such, is quite cyclical. During the down
cycle in the late 1990s, the trust’s dividend was cut and its unit price
deteriorated, giving Sherritt the opportunity to buy the business. The metallurgical coal
components of the business have been sold, and demand for thermal coal is increasing due
to the high costs of competitive fuels, e.g., natural gas and oil. Our conclusion
is that Sherritt’s coal business is a business we want to
own.

Nickel/Cobalt
Sherritt’s metals business earned a pre-tax return on assets of 31% in 2003 and
56% in 2004. With these returns, the only questions that come to mind (after
valuation) is how long can they persist and can we invest more at these rates. It appears
these returns are likely to continue and Sherritt is currently expanding its metals
operations by 50%. Sherritt’s production costs are about US$2 to 3/lb., depending on
the price of cobalt (cobalt is a byproduct from producing nickel from laterite ore).
By comparison, Inco, Canada’s largest nickel producer, average US$2.40.

Note that nicke and cobalt prices have risen substantially in recent years and
nickel prices have remained consistently above US$2/lb (Sherritt’s cash cost). The
explanation for recent nickel and cobalt price increases is becoming a cliché: Chinese
demand. In fact, four contries (China, Japan, South Korea and Taiwan) represent
about 42% of world nickel demand (the US represents 11% of world demand).

The bull case for nickel is that low prices during the 1990s, partially driven by
excess metal (both scrap and primary) from the former Soviet Union led to
underinvestment in the industry. Surging Asian demand has absorbed the slack and now the
industry is short capacity. Very high nickel prices during 2004 led to a large
availability of recycled scrap (stainless steel) and substitution (200 grade stainless steal
which does not contain nickel). These factors depressed prices during first three
quarters of 2005. Inventories now are low, demand is increasing and end users are
finding that 200 grade stainless is not suitable for many applications. Nickel prices
therefore are increasing.

A look at the cobalt market shows a similar pattern. Asian demand for cobalt is
growing as a percentage of world consumption, currently representing about 45% of
demand while North America represents about 17% of demand. On an absolute basis, world
cobalt consumption is up 2.7x since 1992.

Nickel is used primarily as an alloy with steel, 2/3rds of nickel consumption to
produce stainless steel. Since most of the demand growth for nickel is in China and
the largest use of nickel is to make stainless steel, the logical question is what is
the stainless steel being used for? One third of nickel is used for industrial
applications, another third is used for consumer durables and25% is used by the
construction industry.

Industrial uses for nickel consist of equipment for chemical, pharmaceutical, food
and beverage plants, oil refining and electricity generating stations. Consumer
durables consist of flatware and white goods. Construction consists of plumbing
fixtures, elevator and escalator parts and building decoration. These continue to be
attractive markets in China specifically, and Asia as a whole. For a second opinion on
the outlook for nickel, here is what Inco’s president stated during their earnings
release on February 14, 2006:

With strong growth in nickel demand forecast for 2006, and with limited new nickel
projects or expansions currently expected to come on stream before at least 2008,
we believe that nickel demand should continue to outpace supply in 2006, which will
continue to put upward pressure on prices.

World demand for cobalt increased from 20,000 tonnes in 1992 to 54,000 tonnes in
2005. Cobalt is a much smaller market than nickel and is not exchange traded. The
primary uses for cobalt are high temperature alloys (turbine engines), catalysts
(chemical and oil refining), paint dryers, cemented carbides (machine tools) and
rechargeable batteries. The increase in cobalt production in the next three years will be
dependent on the continued availability of ore from the Democratic Republic of Congo
(DRC), which supplies 30% of world’s cobalt production. Most of China’s cobalt
currently comes from minerals mined in the DRC and refined in China.

The bear argument against nickel is that nickel is cyclical and that current
excess demand will be met with increased supply. One piece of data which indicates that
we may be running up against a demand limit is that China is currently consuming
about 4 kilograms of stainless steel per capita annually: almost half of western per
capita consumption. On the face of it, there is room to grow, but note that in other
commodities e.g., oil, China lags much further behind on a per capita basis.

Two more points we find attractive about Sherritt’s metals business:

1) Cuba has extensive nickel and cobalt deposits. Sherritt’s current concession
includes reserves that will last for another eight years and intended to include
reserves that will last an additional 25 years. Cuba’s nickel reserve base is second
only to Australia and its cobalt base is second only to the DRC.

2) Nickel and cobalt (as well as coal and oil) are hard assets; to the extent we
are in an inflationary environment, we want to be invested in companies that have
hard assets.

In conclusion, Sherritt’s metals business has generated an attractive rate of
return, is reasonably priced (about 5x trailing EBITDA multiple) and has a number of
macro economic factors in its favor. This is a business we want to own.

Power
Cuba is chronically short of electricity. A breakdown at Cuba’s largest generating
station (not owned by Sherritt) during 2004 caused several months of disrupted
service and resulted in the firing of the Minister for Basic Industries. This segment of
Sherritt’s business is clearly providing a service that is indispensable to
Cuba.

Sherritt’s power business consists of two gas-fired turbine power plants.
Sherritt financed the plants and owns a 1/3 interest in conjunction with two Cuban
government ministries. The power business’s pretax return on capital is extraordinary,
ranging 22-30% for the last few years. The target pretax EBITDA less capital
expenditure returns will fall to about 10% once Sherritt has recouped its
investment.

In exchange for financing and managing the construction of the power plants,
Sherritt is provided with fuel (natural gas) free of charge and charges US$45/MWH until
they recoup their investment. After they recoup their investment, they continue to
operate the plants and receive gas at no charge, but sell the power at US$38/MWH. We
are not aware of any other electric utility that has such favorable economics.
Finally, if our analysis is correct about the value of Sherritt’s coal and metals
businesses, we get the power business for practically no
cost.

Oil & Gas
Sherritt explores, develops and produces oil and gas off of Cuba’s shore. The
company’s pretax return on assets (EBITDA less capital expenditures/assets) from this
business has ranged from 14-23% for the last few years. We wrote extensively about
our view of the oil industry in our STO analysis posted to VIC last year; our
conclusion remains that oil assets are likely to appreciate in value in the coming years.
The two aspects that we find especially attractive about Sherritt’s oil business
are:

1) The price is right: if our analysis of the value of Sherritt’s metals and coal
businesses is correct, we get the oil business for free. The company currently has
26.3 million barrels of oil reserves in Cuba; at $10 per barrel, this is worth $263
million.

2) Sherritt is prospecting and developing oil and gas resources in an
under-explored area.

This second point is what we find especially interesting. The 45-year U.S.
embargo has prevented most oil companies from doing any exploration in or around Cuba.
Yet Sherritt states in their 2004 Annual Information form
that:

Cuba’s geological basins have the potential for massive accumulations of
hydrocarbons ….. The basins have been relatively under-explored in the
past.

In a recent presentation, a Sherritt spokesman indicated that there may be as much
as 6.2 billion barrels of oil offshore Cuba. While we would not pay for potential
oil in the ground, we are not even being asked to pay for the US$263 million of
proven oil reserves. This represents a free call option on oil development in Cuba.
Finally, Sherritt’s oil development performance in Cuba has been good: their three year
average cost of finding and developing reserves was US$5.94 and their reserve
replacement ratio was 106%. One may attribute this to luck or simply that they are
looking in under-explored territory. Either way, as an investor, their Cuban oil
business is essentially free, and free is good.

Catalyst:

Catalysts:

1. Spin-off existing coal mining assets into a trust.
2. Win contract to sell coal to one of the tar sands projects.
3. Nickel / cobalt prices don’t collapse (market is pricing these assets as if
they are generating peak earnings)
4. Nickel production increased 50% by 2008
5. Electricity production increased 40% by 2007.
6. Significant oil find in Cuba.
7. Castro dies.