Flexible Solutions International: Growing But Overpriced

Flexible Solutions International (NYSE:FSI) is an American producer of TPA products. The company has a profitable segment that delivers TPA chemicals to several industries, mainly oil & gas, agriculture and detergents.

Because two of the markets for TPA products are commodities, FSI’s strategy did not generated higher revenues during most of the past decade. However, the company was successful in decreasing costs of sales and improving margins.

We believe that last years’ experience shows that FSI’s TPA products may face a cyclical increase in demand as both O&G and row crops industries start to invest more heavily.

Also, FSI’s management has shown an ability to keep costs at bay even under a difficult context, and to apply capital conservatively.

However, overall, we believe that FSI is a risky proposal, trading at a current P/E of 15x. The reason is that cyclical commodities are risky by their very nature. If commodity prices do not remain in current levels and FSI’s customers do not increase their spending, then the stock may fall.

Note: Unless otherwise stated, all information has been obtained from FSI’s filings with the SEC.

FSI is a chemical company specialized in TPA products. TPA is the acronym for thermal polyaspartate, a family of chemicals with diverse applications in several industries.

TPAs’ downstream and demand opportunities

For oil and gas, some TPAs are used to protect off-shore extraction facilities from corrosion. Other TPAs are used as additives in the process of fracking.

For agriculture, some TPAs help avoid damage in fertilization and watering equipment, while other TPAs prevent the crystallization of fertilizers while they are in the ground, therefore incrementing nutrient acquisition by the crops and increasing yield.

Finally, other kinds of TPAs are a component in household detergents that increases the product’s effectiveness while being less contaminant than other additives.

Unfortunately, FSI does not provide segment information for these customer industries to understand the specific trends of TPA products on each one of them. FSI only provides aggregate numbers.

However, from the description above we do know that two out of the three main customer industries of FSI are commodity industries, therefore cyclical, while the remaining is a defensive industry.

The fact that commodity industries are some of FSI’s big customers may help explain why the company has not been able to increase revenues significantly for much of the past decade. With both oil, gas and agricultural commodities prices in a bear market compared to the previous decade, investment, production and therefore consumption of FSI’s products did not grow a lot.

This also provides the rationale for the expectation that FSI may be able to increase revenues in the following years beyond what we have seen in the last two years. If commodity prices keep increasing or if they remain at significantly higher levels than what was prevalent in the last decade, then FSI’ customers may invest more, therefore tractioning TPA’s demand.

FSI competitors

According to FSI, its competitors in the TPA segment are mostly Asian manufacturers. Unfortunately, the company does not reveal the names of those competitors.

FSI does mention that its main competitor is LANXESS (OTC:LNXSY), a subsidiary of Bayer that was spun off several years ago. LANXESS is a chemical giant that is engaged in many more segments other than TPA.

Interestingly, FSI and LANXESS have reached an agreement through which they share with each other the licenses for each others’ manufacturing processes.

This makes us believe that competition among the two companies may not be very fierce. The fact that FSI has been able to keep high margins (more on this below) is another sign of this.

FSI also competes with TPA competing products, mainly polyacrylic acids, which have the same uses as TPA. In this sense, TPA products have the advantage of being biodegradable and soluble. This reduces both the environmental damage and toxicity of water treated with TPA and the expense of removing it from the water and disposing of its remnants.

TPA’s upstream, operational efficiency

TPA products main component is aspartic acid, which in turn is mostly obtained synthetically from oil. Therefore, TPA’s ingredients eventually receive the impact of oil prices on its supply chain.

To further complicate things, FSI imports aspartic acid from China, mainly. This generates the risk that tariffs for Chinese imports keep increasing in the US, or that the deterioration of the relations among the two countries generates problems for FSI’s supply chain. Most aspartic acids manufacturers are located in Asia.

Under this context, however, FSI has been able to steal some gross margin from its suppliers. FSI’s gross margins stayed around 38 to 40% between 2011 and 2017. The situation changed in 2018, with the introduction of US tariffs to Chinese imports, which generated a fall in gross margins to the 30% level.

A good management of costs has allowed FSI to improve its operational profits by almost a 100%, depending on which years are compared, without increasing revenues, prior to 2018. The posterior increase in revenues and gross profits was not accompanied by a similar increase in operating expenses, again allowing FSI to reach its current profitability level.

This makes us believe that FSI’s management is cost conscious, something very valuable when operating in a commoditized industry. Adding to this belief is the fact that although 2020 and 2021 saw enormous disruptions in global supply chains and cost increases coming from many different sources, including labor, logistics and supplies, FSI margins actually increased in these two years.

Lygos, a small bet in the future

FSI invested $1 million during 2021 in a private company called Lygos that specializes in developing processes that permit replacing petrochemical processes with biological equivalents. The company has had some success in the development of biologically synthesized cannabinoids.

In the case of aspartic acid, it can be generated biologically, in fact our body generates it. It can also be generated through enzymes, a biological process, and from oil derivatives. Currently petroleum based processes are much cheaper than enzyme based processes.

FSI’s equity investment in Lygos has the objective of developing a process for biologically producing aspartic acid that is economically feasible. Although the process may never be cheaper than petroleum based processes, it may reach a point where it is at least an option to consider.

FSI has not provided any details regarding Lygos development phases. The investment will probably take many years to pay off, even after the process has been developed, because it has to be implemented at scale and tested.

However, and considering it a minor investment that also provides some equity in another company, we believe FSI’s investment in Lygos is a sign of management’s preoccupation with the future.

FSI strong financial structure and conservative capital allocation

In general, FSI has not made use of significant debt, the only exception being a significant increase in 2018 used to finance the acquisition of ENP (more on this below).

Currently, FSI holds $7 million between cash and term deposits, plus $16 million in current capital, against $2.5 million in a credit facility, $1.5 million in long term debts and $7.5 million in working capital liabilities. Combined with long term cash flow positiveness, currently in the level of $5 million for the last two years, FSI has significant financial strength.

This is a great factor reducing risk, given that FSI profitability depends on some commodities’ cycles. If FSI was more leveraged, the risk of commodities falling in price would be much higher.

Part of FSI’s lack of debt is explained by lack of investment. During the last decade the company did almost no investment, in any form.

The situation changed in 2018, when FSI purchased 65% of ENP Investments, a company engaged in TPA products for grass protection. Unfortunately, and because FSI consolidates ENP under its only segment, we are not able to gauge how much profitability the investment has generated in these three years.

In 2019, FSI invested $1 million in a Florida company engaged in the export of fertilizers and TPA products for the agriculture industry, for a 50% stake. In this case, because the company is not consolidated, we can know for certain how much it has generated. The Florida company generated $600 thousand, $1.5 million and $1 million in 2019, 2020 and 2021 respectively. That means that in less than three years TPA has recovered, in equity terms, its investment in this subsidiary.

Of course, this example alone cannot characterize the company’s capital allocation policy. What we do know, or tend to believe, is that FSI’s management has not been destructive of value, which in itself is a good sign.

Conclusion

FSI’s stock is currently selling around $4. Compared to FSI’s profitability for the past decade, with EPS never above $0.2, it is significantly overpriced.

As we mentioned, the new situation in the commodities market may change FSI’s level of mature profits. If commodities prices remain at current levels, or above what we saw in the last decade, then FSI profits may settle at a higher level than before.

However, FSI is definitely not a growth company, as it has no new products and very shallow marketing or R&D expenses. Therefore, any new profitability level will be stable as long as commodity prices are.

As commodity prices are cyclical, we believe the best we can hope for is to see an incremented level of profitability for a few years, to later return to lower levels with a downward cycle.

In the average, therefore, we believe a price of $4 for the stock is not justified for FSI. However, the situation may change if commodities markets do not return to previous price levels, therefore justifying FSI’s long-term EPS nearer to $0.4. Also, if new developments in enzymatic aspartic acid are announced, but these will probably take years, as mentioned.