Volatility and complexity have long been aspects to the Cosan (NYSE:CSAN) story that investors just have to learn to accept if they want to own the shares. None of that has gotten any easier since I last wrote about this Brazilian commodity and logistics conglomerate, though, and the shares have been hit by weaker commodity prices, adverse currency moves, and a lack of enthusiasm over the complicated and often opaque structure of the business and management’s longer-term capital allocation plans.
I can definitely make an argument that valuation is too low today, but that argument always has to carry the asterisk that a great deal of that thesis relies on unpredictable commodity price swings. I like the core businesses at Cosan, particularly the Raizen ethanol, sugar, and retail fuels business and the Rumo railroad operations, but I don’t like the complexity and I don’t think management does a particularly good job of communicating to investors, even if I do believe they have a good eye for long-term value creation.
I won’t be surprised if Cosan shares are substantially higher in a year’s time, but I’m finding it harder to argue that, in an investible universe of so many companies and stocks, it’s worth an investor’s time to take on the complexity that goes with owning Cosan shares.
Okay Q2 Results Amid A Lot Of Moving Parts
Analyzing the quarterly results from Cosan is never especially easy, and the company makes it worse by changing the way they present information (the Earnings Releases) seemingly every quarter. What’s more, there are a lot of accounting adjustments and consolidated/unconsolidated details you have to sort through.
On balance the second quarter results were okay despite weaker commodity prices for ethanol and sugar, not much progress on yields, and some sluggishness in volumes for lubricants and natural gas. Rumo was a standout and I have little to criticize there.
Revenue rose 15% year over year and about 8% sequentially. Raizen, the company’s joint venture with Shell plc (SHEL) delivered 18% yoy and about 8% qoq growth, with ethanol and sugar both up strongly (19% and 21%, respectively) on stronger volume (up 19% and 26%, respectively). Rumo saw 29% yoy revenue growth on modest traffic growth (up 3%) and a 32% improvement in tariff rates. Other contributors were softer, with Compass down 5% on weaker residential gas volumes and still-sluggish industrial demand, Moove up 3% as pricing offset some volume weakness, and Radar down 6%.
EBITDA is where things get complicated. Raizen EBITDA declined 29% as reported, but if you adjust the numbers for inventory carry, IFRS 16, and other factors, underlying “adjusted adjusted” EBITDA was up 13%. The rest of the business is fortunately more straightforward, with Rumo up about 49% yoy and Moove up about 16%; Compass saw similar discrepancies in reported adjusted and “adjusted adjusted” numbers, with EBITDA either up 42% or 18% depending on how you do the math. When it’s all said and done, EBITDA rose by 15% by Cosan’s adjusted methodology, or as much as 26% by an alternate methodology.
Core SEE Prices Have Become More Challenging
With Raizen accounting for a large part of revenue (almost three-quarters) and EBITDA (close to 30%), the market dynamics for sugar, ethanol, and energy (collectively referred to as “SEE”) matter quite a bit.
When I last wrote about Cosan I liked the prospect for near-term leverage to healthy sugar prices and market dynamics, but was concerned about the longer-term outlook. Prices where in the $0.19’s/lb at the time of that writing, and while they moved into the $0.28’s/lb at one point late in 2023 (when Cosan shares were a fair bit higher), they have since retreated to around $0.177/lb for spot and the futures suggest further erosion in the low-to-mid-$0.17/lb range.
Likewise with ethanol prices in Brazil. Sao Paolo anhydrous ethanol prices have moved from R$ 3.08/liter to about R$ 3/liter, admittedly not a particularly dramatic decline.
With the decline in sugar prices, ethanol production has become relatively more attractive, but the market has had to deal with oversupply as there are limits to how far companies can shift production from one to the other. There are attempts underway in Brazil’s legislature to increase the ethanol fuel blend from 27.5% to 30%, which should drive a roughly 4% increase in consumption, but the process of passing the “Combustivel do Futuro” bill has been slow and a decision has been pushed into September (at the earliest).
Meanwhile, it’s hard to talk about the sugar market in terms much beyond educated guesses. I don’t mean that flippantly, it’s just that there are too many variables with respect to weather and the export policies of other governments to speak definitively about pricing. I will say that the market looks relatively balanced right now based on expect harvests and exports over the next two years, and adverse weather or export restrictions could drive another round of higher prices.
Numerous Moving Parts, And Not All Are Easily Visible
One of the ongoing issues with Cosan is that there are a lot of moving parts and accounting complications due to the nature of the company’s structure (like the prior EBITDA discussion). I don’t believe that Cosan attempts to be deliberately obtuse, but I also think there is more that they could do to provide clean, consistent reporting that gives investors an easy look into the health of the business – institutional investors can devote a lot of time to unwinding the accounting, but your average retail investor cannot.
Speaking of moving parts, at least tangentially, Cosan has unwound its collar financing for its stake in Brazilian iron ore company Vale (VALE) and converted 66M shares into a direct ownership interest. The company now has a direct 4.2% stake and a call spread with another 1.4%. This investment into Vale has always been at least somewhat controversial, as there are few obvious synergies with the other parts of Cosan and management hasn’t really made a compelling case for it from a strategic perspective.
This is part of an ongoing issue with Cosan. While I do believe management has a good eye for value, and I can appreciate why they don’t want to publicly tip their hand regarding investment plans, it leads to the appearance of a hodgepodge of assets with little coherence or synergy. Holding companies have largely gone out of favor and those that remain typically trade at double-digit discounts to the sum of the parts due to the complexity and inefficiency of these structures.
The Outlook
Cosan isn’t the most efficient SEE producer in Brazil and likely never will be (Adecoagro (AGRO) scores better there), but they have been improving yields and I’d say the SEE operations are still well-run on balance. Were Raizen available to invest in directly (it trades on Brazil’s exchange), I’d strongly consider it. I’m even more positive on Rumo, where management has turned around a business that had a lot of operational issues and where there is still a pressing need for more efficient logistics to get key products like grains and fertilizers to Brazil’s ports.
The rest of the business is more of the “it’s okay, I guess” variety. I don’t have any particular issues with Compass (natural gas distribution) or Moove (lubricants), but they’re not thesis-changers for me.
I’m expecting long-term revenue growth of around 3% to 4% from Cosan over the long term, and with the further development of Rumo (including a new port terminal project that the company announced earlier this year) there could be upside. EBITDA margins have been on an unsteady upward trajectory, and I expect further improvement with 13% margin this year, over 14% next year, and around 15% in FY’26.
Given the significant reinvestment needs of the business, though, as well as the low-margin nature of the commodity operations, I don’t expect long-term FCF margins to move much beyond the low single-digits on a sustained basis.
Even with modest expectations for FCF leverage, discounted cash flow suggests a fair value around $15. EV/EBITDA suggests even more undervaluation, with a fair value above $17 using a 4.5x multiple. While this is a lower multiple than I’ve used in the past, I do think it is reasonable compared to how global SEE and agriculture companies have traded in the past, particularly considering the higher rate environment.
The Bottom Line
I do think there’s a good argument to make that Cosan shares are too cheap, and I think a lot of bearishness related to the SEE business is already in the share price. Likewise, I think Rumo is a very attractive asset and another that I’d buy if it were easily available.
As is, though, investors wanting to invest in Raizen and Rumo have to take all of the additional baggage and challenges that come with Cosan’s corporate structure and capital allocation/investment philosophy. More and more, while I do respect Cosan management quite a lot, and I do see value here, it’s harder to argue that the value I see is worth the hassle, but readers should of course decide for themselves.
Read the full article here
