Despite Ongoing Operational Improvements, Cosan Still Undervalued

Following and modeling Cosan Ltd. (CZZ) is a little like training for endurance sports – you spend a lot of time while you’re doing it wondering why you’re bothering to do it. After all, there are two share classes, a somewhat complicated holding company structure, and many commodity moving parts to account for in an analysis. With the shares up more than 30% over the last year and close to 250% from the 2015 lows, though, I think you can certainly argue that there has been some gain for shareholders willing to take on that pain. Better still, I continue to see upside in these shares from both operational improvement and a shrinking discount to the underlying value.

Cosan Seeing Better Results Across The Board

Cosan SA (CSAN3.SA) had one of its best quarters recently, with all parts of the business performing quite well in the third quarter. Revenue was up 10% overall, with growth across the business, and adjusted EBITDA rose 28%. Revenue and EBITDA growth was led by the sugar/ethanol business (Raizen Energia), with strong volumes in sugar and ethanol and benefits from prior hedging.

The fuel distribution business performed well in its own right. Revenue was up 7% on a 4% improvement in volume, and the company continues to gain share in Brazilian’s retail fuel market through its Esso and Shell stations (this business, like the sugar/ethanol business, is run as a 50/50 joint venture with Royal Dutch Shell (RDS.A)). While this business is never going to have great margins, the EBITDA margin did improve 50bp from the year-ago level, helped by a 17% improvement in EBITDA per cubic meter sold.

Comgas, Cosan’s Sao Paulo-based natural gas distribution business, saw a 5% volume improvement translate into double-digit revenue growth and 6% EBITDA growth, while the lubricants business saw double-digit growth on both lines.

But Can It Last?

The various moving parts within Cosan are doing well now, but it’s well worth asking if that momentum can be maintained. At this point, I’m most concerned with the Energia business given trends in sugar prices. Sugar prices are more than 20% below their year-ago level due to significant supply increases in 2017 and 2018 is looking like an even stronger year on the supply side. As Energia held off on hedging this year in the hopes of better prices, that could create some significant revenue headwinds in 2018.

Partially offsetting that risk is the company’s flexibility in production. The company’s mix between sugar and ethanol is usually fairly balanced (57% / 43% in the third quarter), but Cosan may be able to divert more production toward ethanol next year. With Petrobras (PBR) importing more gasoline and the potential for higher prices as Brazilian’s economy recovers, there is at least a possibility that Brazil’s retail fuel market can absorb more ethanol without kneecapping prices. That said, Adecoagro (AGRO), Sao Martinho and others are in the same boat, so I’m keeping my outlook in check and expecting the weaker sugar price environment to have a definite negative impact on next year’s results.

On a more positive note, I see no particular reason why Combustiveis (the fuel distribution business) won’t continue to grow. BR Distribuidora (Petrobras’s fuel distribution business) will probably be invigorated after gaining a greater degree of independence, but there is still a large number of “white flag” unbranded fuel stations in Brazil that Cosan can target for competitive share take-away. Moreover, this business has been doing better at the “little things” like logistics and transport costs and improving the desirability of its fuel station convenience stores.

Rumo Really Starting To Look Better

Cosan Ltd’s involvement with Rumo (RAIL3.SA), a previously troubled operator of railroads and terminals in Brazil, is looking a lot less controversial now that some of the initial turnaround efforts are taking hold. Volume has grown by double-digits in the last two quarters, helped by strong demand for/from agricultural products, but also helped by significant improvements in operating efficiency.

Rumo is also seeing the benefits of its capital reinvestment plans. A lot of Rumo’s locomotives were ancient, but replacing some of those old, inefficient locomotives drove an 8% improvement in fuel efficiency in the third quarter (liters/GTK). With double-digit volume growth, healthy/stable tariffs, and improving cost efficiency, EBITDA improved by 25% on a year-over-year basis.

Perhaps better still, there is still ample room for improvement. Ongoing investments in rolling stock will drive operating costs lower, improve network speed, and improve network capacity (modern rolling stock can carry more cargo, faster, with less downtime and fuel consumption and with higher reliability).

With Rumo shares (RAIL3) having risen from less than R$2 in early 2016 to more than R$12 now, the company’s financing/funding situation has also improved. The company recently raised over R$2.6 billion through a secondary offering, and the company’s improving financial situation (as well as Brazil’s improving situation) is leading to lower capital costs for this still-capital-hungry business.

There are two “buts” that remain in place with Rumo now. First, the business remains very reliant on agricultural production, and those volumes are likely to ebb and flow with global crop prices and weather. Second, the company is still looking to get its Malha Paulista concession renewed. This is a crucial line through the state of Sao Paolo to the port terminals at Santos, where Rumo has over 50% market share in ag products and where over 70% of Brazil’s soy, corn, sugar, and fertilizer exports are handled. While the delays in the concession renewal seem to largely related to “that’s Brazil”, losing this concession would be a major negative surprise with around $1.50/ADR downside to Cosan Ltd. by my estimation.

Complexity Still An Issue, But Cosan Ltd. Willing To Put Its Money Where Its Mouth Is

One of the marks against Cosan Ltd. is the complexity of the business. That was illustrated again recently in a transaction between Cosan Ltd, Cosan, and Royal Dutch Shell. Shell announced in October that it was exercising a put option to sell its stake in Comgas (around 17%) to Cosan Ltd. for a 5% stake in Cosan (CSAN3) and R$424 million. This wasn’t surprising; this option was known and I believe most observers expected it given the non-core nature of the Comgas business and the fact that it was the last opportunity for Shell to exercise the option. The slightly more confusing bit is Cosan Ltd. granting Cosan a call option to buy the stake at exactly the same terms (which Cosan is exercising). It’s not really a big deal, and it makes sense, but it arguably gives some ammunition to those who believe the business is just too complicated.

Less controversial was Cosan Ltd’s just-completed tender offer. Cosan Ltd. launched a tender offer for around $200 million in stock at prices 10-15% above the price before the announcement. The company ended up slightly exceeding that target by buying back $212.5 million of tendered shares (about 13% of the Class A shares). I believe this was a good use of capital given the meaningful discount to the underlying value of the assets (the “holding company discount”) and the prospects for ongoing growth.

The Opportunity

The sharp rise in Rumo shares (up more than 100% over the past year) has erased the undervaluation I saw there, but I still believe that Cosan is undervalued and that Cosan Ltd. carries too high of a discount to the value of its parts. I’m expecting mid-single-digit revenue growth from Cosan over the long term, and slightly higher FCF growth, as I continue to expect the fuel distribution business to gain share in Brazil and for the sugar/ethanol business to continue benefiting from its strong operational efficiencies and its advantaged cost position. Comgas is more of a “nice to have” but it generates good cash flow and should be leveraged to the recovery in Brazil.

Around three-quarters of my estimated value for Cosan Ltd. is tied to Cosan, with the rest tied to Rumo. Although I don’t think Rumo is particularly undervalued on a long-term FCF basis at this point, the business is likely to see exceptional EBITDA growth in the next few years and there are opportunities here for outperformance (especially on the cost/efficiency side).

My fair value for Cosan Ltd. moves from $10-$12 earlier this year to $12-$14 now, and that includes a 20% “holding company discount”.

The Bottom Line

Weak sugar prices are certainly a risk factor over the next year, but I believe the shares remain undervalued. Cosan Ltd. has shown that it is a smart allocator of capital and that it can identify attractive investment opportunities within Brazil, particularly those that involve hard-to-beat entrenched competitive advantages (like a well-placed footprint of crushing mills, vertical integration into fuel distribution, a utility gas company, and railroad concessions) where management can drive better cost leverage. The sheer scale of moving parts here is always going to be an issue with some investors, but I see more upside for those willing to take on that burden.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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