Consider Salting This Stock Away

One of the features of our StockInvestor newsletter is that I routinely publish detailed notes from our visits with companies that are of interest. In mid-September, analyst Parvathy Krishnan, my colleague Josh Peters over at DividendInvestor, and I all traveled to Kansas City to meet with the management of Hare Portfolio holding Compass Minerals. We met with new CEO Angelo Brisimitzakis and longtime CFO Rod Underdown for nearly three hours to talk about the business.

Compass Minerals is a salt miner that gets about half of its revenues from rock salt used primarily for highway deicing, one third of its revenues from general trade salt used for human consumption and other industrial uses, and the balance from sulfate of potash, a salt primarily used in specialty fertilizers.

The Source of Compass' Moat
What got me interested in Compass in the first place was the fact that the company operates the largest salt mine in North America as well as the largest salt mine in the U.K., and these mines are the lowest-cost producers in their respective markets. After meeting with management, I got much greater clarity into the structure of the competitive advantage, and I'm glad to report the advantages are exceptionally sustainable.

Salt is one of the most plentiful commodities on the planet, but it can be economically mined only in a relatively few places. Plus, with a low value/weight ratio, transportation costs are critical. The good news is Compass has very good water transportation infrastructure nearby; its main mine in Goderich, Ontario--responsible for just under half the company's production--is literally under Lake Huron with an on-site deep-water port. Plus, the ore bodies the firm is mining are inherently low-cost. Management explained that the vein it is mining at Goderich is over 100 feet thick. This compares favorably with two competing mines under Lake Erie in Ohio that are of a smaller scale with only about a 30-foot-thick vein.

With only three mines that can realistically supply roadway deicing salt to the wider Great Lakes area, and Compass' mine being greatly cost-advantaged versus the other two, it's clear where the moat is and how the high returns on capital are generated.

Management explained that in the mainland U.K.--where the firm has a mine that is responsible for about 10% of the company's production--there are no imports of rock salt (thanks largely to transport cost) and only three mines in the country. Compass' main competitor in the U.K. is mining a vein that is at an extreme cost disadvantage to Compass. Underdown said this rival has 13 times the number of employees that Compass has at its mine, even though Compass runs the larger mine. Compass' mine is also more than 10 times larger than the other competitor.

In an interesting twist, they also explained how they are indirectly in the real estate business in the U.K. Because real estate is so scarce and valuable there, Compass is starting to use the old parts of the U.K. mine for tangential and high-return businesses like document and waste storage. And because the mine is more than 160 years old, there is plenty of subterranean space.

The rest of the firm's mines operate on what we believe is more or less a level playing field with the competition. But with only two competing companies in North America, even a merely average mine can still generate solid returns.

About Salt
There are a couple things inherently attractive about the salt industry today. First and foremost, it is an oligopoly.  Rohm and Hass  and private company Cargill provide the only meaningful competition. Quite simply, oligopolistic companies tend to have moats. Second, salt is unlike other commodity natural resource industries where companies are always on the resource-replacement treadmill. All of Compass' mines are projected to have in excess of 100 years worth of reserves at today's production levels. Any oil or metal mining company would kill to have this sort of reserves stability.

While the sale of rock salt is obviously dependent on the weather, sales are not economically sensitive. Especially given our increasingly litigious society, roads and sidewalks will still need to be cleared of snow and ice no matter if the economy is booming or if it is slowing. Plus, Brisimitzakis explained that a large chunk of the company's sales are to government agencies, which are generally not too price-sensitive. Brisimitzakis correctly pointed out that the quickest way for a mayor to get unelected is to not effectively clear the roads.

Finally, I personally like that Compass is a bit of an oddball company to follow. There are only two competitors, with one being private and the other being a large chemicals conglomerate. Wall Street does not have any analysts focused purely on salt, so this stock flies a bit under the radar and has a greater chance of periodically being mispriced.

Porter's Five Forces for Compass
Looking at the economic moat through the lens of the Porter's Five Forces model, Compass looks quite favorably positioned:

• Degree of rivalry: Low (Oligopoly)
• Threat of substitutes: Nearly zero (No economical alternatives to salt)
• Supplier power: Not applicable (Mother Earth is the supplier)
• Buyer power: Low (Many small buyers)
• Barriers to entry: Very high (Huge incumbent cost advantage)

Future Cash-Flow Plans
One of the reasons we flew down to Kansas City was to see what exactly management had planned for the cash flow the company is currently generating. When a new CEO comes in to a small, well-run company, I'm always worried about the possibility that he or she will start "empire building" by reinvesting the cash in low-return, no-moat businesses.

Thankfully, Brisimitzakis appears to have the proper strategy by taking a sort of Hippocratic oath in saying his first principle is to "do no harm." In his eyes, this means focusing his efforts on operating the existing business more efficiently and with lower cost. I hope our pleas for the company to stick to its knitting resonated with management.

This likely means that the first priority of excess cash flow will continue to be reducing the cost of its debt, since Compass does remain highly leveraged financially. The firm refinanced at lower rates a large chunk of debt in late 2005, and it has still more bonds outstanding with a staggering 12% coupon, a remnant from its days of being the subject of a leveraged private equity buyout. These high-coupon bonds are callable in 2007, and Brisimitzakis and Underdown said reducing the rate the firm is paying is highly important. They did, however, say they were comfortable with the absolute level of the debt being carried, given the relative stability of the underlying business and its cash flow.

One silver lining of being a company just out of a private equity situation is that management believes it has plenty of high-return internal growth opportunities. When the company was owned by entities that had a two- to three-year investment time horizon, they did not invest in business opportunities that may have had a payoff beyond that time frame. After all, you don't do a custom paint job on a home you plan on selling soon. But now that long-term owners are in place, long-term projects with long-term returns--like expanding production and upgrading large-scale equipment--can begin.

While Brisimitzakis and Underdown obviously could not make any promises on this front, they did appear to respect the continuing importance of paying a regular dividend.

The Bottom Line
While Compass only has a narrow economic moat rating due to the commodity nature of its business, it is clearly on the narrow-wide borderline. I also like that the competitive advantages look to be very long-lived.

One of the cornerstone ideas of being a value investor is that if you would not be happy to buy the entire company, you should not buy a single share of the stock. All three of us who traveled to Kansas City agreed that we'd gladly buy all of this company if we had the means and the price was right. (Anyone care to loan me a couple hundred million?) I think coming out of the meeting with this feeling bodes well for the position owned in the Hare Portfolio.

This article originally appeared in the October issue of StockInvestor.