Weekly Findings – September 16th, 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 16th, 2018

Weekly Findings – September 16th, 2018

Thought for the week: “Some M&A Good – Some Not So Much”

  • Chart of the Week – Should TiO2 Be Privately Held
  • Quaker – Why The Math is Likely Wrong.
  • M&A – Some Cheap Cash Flows Available in SMID Chemicals
  • WAB – A Bad Deal – At Last We Have Some Company
  • Weekly Winners & Losers

Chart of the Week

  • Chart of the Week – Who Should Own TiO2

The chart of the week shows the 20 worst performers in our coverage universe year to date and we highlight in red the 5 publicly traded TiO2 stocks, all of which are in the bottom 12. TiO2 is a very difficult market to model and one of the reasons why the stocks have been so weak is that there is a sense and expectation (though not much hard evidence) that pricing is peaking and that TiO2 is an early cycle play – so the first place to run from if the economy is peaking. The question is whether the market becomes as weak as it was in the last downcycle because the stocks are beginning to discount something like that.

The second reason may be somewhat easier to model – perhaps there is simply too much TiO2 levered equity relative to investors interested. For years TROX was the only real TiO2 pure play – VHI and KRO having complex ownership structures and limited liquidity. Now we have Chemours and Venator. A lot more opportunity to buy TiO2 levered equity – if you care.

The last downcycle was driven primarily by oversupply, with significant new capacity coming on line in China as well as a significant addition from DuPont – now Chemours. The EBITDA downturn is illustrated roughly in the first exhibit below, where we have an approximation for Chemours by using the DuPont Performance Chemicals data before 2013 (the data is not precisely comparable but close enough and the EBITDA margin is good enough). TROX is more of a pure play and is more volatile, CC has a fast growing Fluoro Products business that was 40% of 2017 EBITDA. CC’s TiO2 EBITDA in 2017 was 50% of the prior peak and much lower on a per ton basis because of the added capacity – additionally, CC has cut costs since the spin from DuPont – so if the market for TiO2 has peaked, it has peaked well below prior highs and is unlikely to show a “through the cycle” return that justifies further capital investment.

The second chart below shows estimate revisions for the next twelve months versus YTD performance. The numbers are not that bad if you accept that Venator has a prolonged plant outage in Europe which continues to drag down expected earnings and TROX expectations will have factored some benefit of the proposed Cristal acquisition – which is facing delays and possibly may not happen based on injunctions filed last week by the FTC. While TiO2 profitability is clearly not in freefall based on the second exhibit – the positive revisions at CC are more a consequence of the refrigerant business than TiO2.

Given the low multiples – third chart – and the clear challenges that the companies are having in both attempts to consolidate further, to respond to the China surpluses, and to tell their stories to a public market that may not care enough, maybe these companies are better suited to private ownership. Cristal is currently privately held and most of the assets were previously privately held by Hanson in the 1990s. Venator’s assets were part of much larger companies – ICI and Rockwood and Chemours was a division of DuPont. In every case the assets imbedded in larger companies traded at a higher EBITDA multiple as part of a larger company than they do on their own. Maybe this is a simple cycle – spin the business or take it public as TiO2 improves and then sell back to PE when the public market loses interest! HUN has a hard decision to make here; as Venator declines it weighs on HUN’s valuation – part of the risk of owning VNTR today is the HUN overhang. At current valuations HUN might be better off selling its stake to Private Equity rather than selling blocks into a market that is not interested. VNTR is a stock we have liked, and we have been very wrong – that said, at current values something is likely to happen. With its recent pullback, CC also looks quite compelling, helped by having several businesses – not just TiO2. CC could do some creative M&A with the right mind set and unlock considerable value – we are adding CC to our favorite list

  • Quaker – Why The Math is Likely Wrong.

Acquisition modeling is always complex and is clearly causing controversy at Quaker, as the run up in the share price, while welcome given our recommendation, has now pushed the stock well above the top end of the target price range and well above what current estimates should justify. If you take a snap-shot of our valuation model today you get what appears to be a very expensive stock (first exhibit), but you get a skepticism index of zero and forward earnings suggest a premium to returns on capital that mirror the premium to value – second exhibit.

Forward earnings have some benefit of the Houghton deal baked in, but the balance sheet does not reflect the change in capital and consequently you get the disconnect in the first two charts and the high price relative to targets. In the third and fourth chart we re-do the first two charts but add the capital jump associated with the Houghton deal such that forward capital now begins to reflect forward earnings – but this also shows a disconnect.

At trend ROC, current earnings – accounting for the capital jump with Houghton – would be closer to $14 per share than the current 2020 estimate of just under $9.00 per share. Normal value on that basis is around $270 per share and begins to explain why the stock has overshot what would be justified by current estimates and suggested in current target prices. For this higher valuation to be reasonable:

  1. The Houghton deal has to close – note that it was announced in April of 2017
  2. KWR has to get more synergies than suggested and drive returns on capital back to trend – showing that the Goodwill and other intangibles that will come with the deal were worth it.

We continue to like the KWR story here but, if the Houghton deal does not go through the stock has a minimum of 25% downside in our view. Right now, the stock appears to be pricing in a 30-40% chance that the deal is both done and executed well in our view.

  • M&A – Some Cheap Cash Flows Available In SMID Chemicals

Sticking with the M&A theme, we expect more. The strength in the stock market is not being driven by our groups, but the strength in the economy and especially the US economy is driving stronger earnings and stronger cash flows. The best companies are seeing absolute valuation gains but relative underperformance, while some of the expensive names at the beginning of the year are seeing pullbacks from peak absolute valuations. Equally important, any hint of bad news – guidance from MMM this week, or negative opinion – WAB (see below) is being severely punished. Last week we indicated that MMM looked like a relative safe haven given how high its Skepticism Index has risen – but the stock declined much more that the earnings revision should have justified last week – making the valuation even more interesting relative to earnings.

Sticking with Chemicals, the lack of investor interest and the higher cash flows result in some interesting values – chart below, and while some of the names are in businesses that are not very interesting and unlikely to find a partner (KOP for example), others look either ready to be acquired or ready for some sort of creative merger. A few ideas come to mind – no particular order.

  • ASIX is a fairly obvious take out target – still selling at a discount to other recent spins – second chart – and very undervalued against expected growth.
  • HUN should divest its Venator stake – the action is more important than the value at this point (or buy it back!) – some sort of merger with TSE might make sense – assuming that the regulators would not let HUN and Covestro get together.
  • Olin should merge with Chemours – Chemours management leads the combined company.
  • BCPC has to keep acquiring or it will face a multiple collapse
  • We still think that a broader M&A move is in FUL’s future.

  • WAB – A Bad Deal – At Last We Have Some Company

We wrote negatively on WAB as soon as the GE deal was announced, with our logic based on the performance of other RMT case studies where buyers have been more focused on the cost advantage of the tax structure than the quality of the business that they are buying. We felt that that GE had over-sold its Transport business much as Dow did its chlorine products business, leaving the acquirer to manage inflated forecasts and a series of earnings disappointments.

WAB is not an expensive stock on a relative basis but little in the sector is relatively expensive today. Our concern and our “short” view on WAB is a post-deal concern/short – once the companies are combined and cannot meet projections. This week we were joined by another analyst with similar views.

Our argument is best described in the linked document above, but to summarize the charts below:

  • GE is inflating expected growth – first chart
  • Revenue growth for the assets to be sold is more than 10x estimates for GE as a whole – if this were really the case GE would hang on to the business as if the revenue gains are real GE would want the cash associated with these gains – third chart.
  • WAB is not expensive on a relative basis but it is on an absolute basis and despite the pullback on Friday it is still more expensive than when the deal was announced – last chart.
  • WAB is trading at multiple of EBITDA that, even with the pullback, expects to much from the GE deal too quickly.

  • Weekly Winners and Losers

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Sources: Capital IQ, Bloomberg, Government Publications.

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