Rising Star Buy: A Diversified Small-Cap Bargain

This article is part of our Rising Star Portfolios series.

One of the best things about screening (and this is a portfolio based on screening) is uncovering great companies that would normally fly under the radar. Today, thanks to my Modified Foolish 8 screen, I'm announcing my intent to buy a small, underappreciated company in a boring market -- LSB Industries (NYSE: LXU). I think if you can stay awake through the business description, you'll find it's a compelling value.

LSB operates a great business that's pretty easy to understand. It has two main segments:

Climate Control (41% of 2010 revenue)
This segment manufactures and sells heating and air-conditioning products to hotels, schools, apartment and office buildings, and homes. One of the key takeaways here is that LSB claims to sell "the most energy efficient climate control systems commercially available today." What's more, its geothermal heating and air-conditioning products are considered "green" technology and a form of renewable energy. Sales of these products should continue to benefit from the tax credits and incentives enjoyed by the buyers.

Chemical (58% of 2010 revenue)
The chemical segment is a bit more complex, serving three separate markets:

1. Agricultural -- Products for farmers, ranchers, and fertilizer dealers include, among other chemicals, anhydrous ammonia and fertilizer-grade ammonium nitrate.
2. Industrial -- Acids for the polyurethane, paper, and electronics industries, such as nitric acid.
3. Mining -- Industrial-grade ammonium nitrate for the mining industry.

The demand in all three of these markets is such that LSB is running all four of its chemical plants -- in Arkansas, Alabama, Oklahoma, and Texas -- at optimal production rates.

Competition
Because they serve entirely different markets, these two segments provide nice diversification for the company. That makes it harder to find true competitors, but here are the major companies that compete in some of LSB's markets, along with a few select metrics:

Source: Capital IQ, a division of Standard & Poor's.

Why I'm buying
The Modified Foolish 8 screen is pretty tough, requiring sales and earnings growth of greater than 25%, high margins, high insider ownership, and a reasonable valuation. Only one company passed the screen this month, and that was LSB Industries.

One criterion that knocks out a lot of contenders is the requirement for return on equity of 15% or greater not only for the last four quarters, but the last three fiscal years as well. This kind of consistency in LSB's case points to strong management and solid competitive advantages.

For Climate Control, this is a function of a flexible manufacturing process that allows for custom designs, the tailwind (and tax breaks) of the geothermal "green" movement, and a 38% share in that geothermal market. For Chemical, it's location advantages for the geographic regions it serves, which allows for lower freight and distribution costs than competitors. These factors all help contribute to the high margins.

Strong management is another factor in my purchase decision. The team is led by founder, CEO, and 12% owner Jack Golsen, who has ably guided the company since it started up in 1968. No doubt influenced by the credit crisis, management has strengthened the balance sheet, which now has more cash than debt and a debt-to-equity ratio that has plummeted downward from over 100% in 2007 to an appealing 26%.

Risks
With roughly half the business tied to housing and construction, a double-dip recession that takes these markets downward would certainly dampen LSB's growth.

The company also relies on various commoditized raw material feedstocks, such as anhydrous ammonia, natural gas, and sulfur for its chemical business. A spike in these feedstock prices could harm sales. Through price arrangements, the company is able to pass these costs on to most of its customers, but about 39% of 2010 chemical sales were into the agricultural market without such arrangements.

Another risk is the power of the Golsen family on voting matters. Besides Jack Golsen, his son Barry (who is president and COO) and other family members own another 11%. While not probable, it's possible their interests may conflict with those of outside shareholders.

Foolish bottom line
In LSB Industries, we have a small cap with room to grow in several distinct markets. The inevitable recovery in the housing and construction markets will provide a huge catalyst, but the chemical markets are booming right now. If we dip back into a recession, LSB's strong balance sheet should help it weather the storm.

With the stock down about 25% in the past couple of months, it's nice to catch this company on a dip. I'm going to buy a half position for my portfolio tomorrow. To practice the patience I've preached, I'll monitor things closely and fully digest the next earnings announcement and conference call before considering adding to the position.

If you're interested in keeping up with any of these companies, add them to your free watchlist by clicking below. You can also follow me on Twitter and check out the multivitamin discussion board.

• Add LSB Industries to My Watchlist.
• Add Terra Nitrogen to My Watchlist.
• Add PotashCorp to My Watchlist.
• Add Lennox International to My Watchlist.
• Add Dow Chemical to My Watchlist.
• Add CF Industries to My Watchlist.
• Add Agrium to My Watchlist.

This article is part of our Rising Star Portfolios series, in which we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).