The last time we covered Chemtrade Logistics Income Fund (OTC:CGIFF) we made a bull case for the multiple convertible debentures. These presented low risk opportunities versus the common shares. Since our initial thesis on these shares, the convertible debentures have outperformed the common by a wide margin. Since March 30, these debentures are up by almost 40% including interest payments, while Chemtrade has a flat total return. We had stated in our last report that we will keep an eye on this to see whether the stock could make it into our portfolio and we decided to examine this post the Q3-2020 results.

Q3-2020

After delivering extremely well in Q2-2020, this quarter’s results were a big disappointment. This was rather strange as most analysts expected Q2-2020 to be the extremely soft quarter. Chemtrade’s revenues came in at $345.9 million, a decrease of $49.8 million from the third quarter of 2019. Investors should note that Q2-2020 showed similar revenue trends. Revenue for the second quarter of 2020 was $347.5 million, which was $49.2 million lower than the same quarter for 2019. Unfortunately, Chemtrade showed a big decline in adjusted EBITDA which fell to $64.7 million. In the second quarter adjusted EBITDA dropped just 18%, which was pretty spectacular considering the circumstances. Here we have a 28% drop (from $90 million to $64.7 million) in a quarter where GDP has rebounded in the high double digits across North America. So what is going on?

Demand Softness And Margin Pressures

Management mentioned demand weakness in a number of key products, including regen acid, sodium chlorate and hydrochloric acid. Both the EC and the SPPC segments were down drastically year over year.

Source: Chemtrade

The drop in the SPPC was less severe than that in the EC segment where adjusted EBITDA fell by about 40%.

Source: Chemtrade

The water business continued providing steady cash flow and the adjusted EBITDA was notably higher.

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Source: Chemtrade

While the water business held on pricing, the rest of the business segments experienced margin pressures. What is strange here is that if you see our March 30 article, we had predicted severe margin pressures for Q2-2020. When those did not materialize, we assumed we were wrong and moved on. It appears these were just delayed. It was surprising that management did not telegraph this in the Q2-2020 conference call. Management did say though that 2021 is unlikely to create a very big bounce either in pricing of their two major chemicals.

And finally, some comments on pricing. Most of our products did not experience cyclical pricing. However, caustic soda pricing, as most of you know, can move significantly. In 2021, we expect that the Northeast Asia spot index for caustic soda should move higher during the year. The long-term supply demand characteristics still support upward price movements for many years. During 2021, pricing is expected to start increasing and to continue increasing for at least several years. Recall that we generally incur a quarterly lag between our caustic soda price and movements in the index. Due to this lag, unless the price indexes move up soon, the annual index level for 2021 is expected to be lower than 2020, despite the upward movement during the year. Finally, given the reduced demand for sodium chlorate, there could be some pressure on sodium chlorate selling prices during 2021.

Source: Chemtrade Q3-2020 transcript

Distribution Coverage

For Q3-2020, distributable cash after maintenance capital expenditures came in at $12.1 million ($0.13 per unit). This number dropped almost 70% from Q3-2019. This is the amplified impact of a small drop in revenues translating into a bigger EBITDA drop and a much bigger distributable cash flow drop. The current distribution run rate is 15 cents a quarter so Chemtrade fell short of full coverage, despite a 50% cut earlier in the year. The deterioration is extremely sharp and while we expect 2021 to be stronger, the risks of a distribution cut have risen significantly in this quarter. Chemtrade has some room on its leverage covenants, but a very weak Q4-2020 and a moderate Q1-2021 could push its leverage ratios near 5.5X on a rolling 12 month basis. Based on all the information, Chemtrade has a “High” level of danger of a dividend cut on our proprietary Kenny Loggins Scale.

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This rating signifies a 33%-50% probability of dividend cut in the next 12 months.

Valuation

Chemtrade is trading at about 6.0X EV to EBITDA for 2021. That is rather cheap but the firm might be better off cutting the distribution to deleverage. We still like the convertible debentures with the newly listed CHE.DB.F yielding a solid 9.4%. The Debentures will mature on September 30, 2025. These have an over 11% yield to maturity, which we think is a great deal in this market. We would choose these still over the common shares.

Conclusion

We were waiting for some kind of stability in Q3-2020 to pick up the shares. Our logic was that we would miss the first 10-20% off the bottom but we would get a very safe entry. As it stands, the quarter severely dialed back our enthusiasm. In our model portfolio, we have industrials at close to market weight but we are getting more bullish on the sector as inventories have been drawn down in North America quite significantly. We did pick one industrial pick to write cash secured puts on but it is a far stronger and less leveraged company. We think the common shares for Chemtrade could work out as well, simply because there is a lot of demand to be made up in 2021. But this is a much higher risk play.

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Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CGIFF over 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.

Additional disclosure: We might initiate a long position in common shares or convertible shares.



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