At some point a company's problems cease to be cyclical and start looking increasingly structural. I'm getting close to that point with Axiall (AXLL). Six consecutive earnings misses may say more about the analysts following the stock than the quality of the company, but management's own missteps and changes in the chloralkali space have more concerned about the prospects for this company. I do still believe that the company can leverage positives like an improving U.S. construction market (whenever that arrives...) and increasing shale gas production, but I'm not convinced that the value is so compelling as to be worth the risk anymore.
Missteps Here And There
As I said, earnings misses aren't always the fault of the company, and particularly so when management doesn't give much (or any) guidance. In the case of Axiall, a lot of analysts were too reluctant or stubborn to realize that their assumptions regarding firmer PVC prices and stronger housing-related demand for building products weren't going to materialize.
Some of Axiall's wounds are self-inflicted, though. The Lake Charles facility, which was damaged by a fire in December of 2013, was supposed to be back to full operating rates in May but management didn't actually manage that until July. Other assorted operating issues have bedeviled the company along the way, leading to pretty significant underperformance when compared to other chemical companies like Occidental (OXY), Olin (OLN), and Westlake (WLK).
I also have to wonder if the company misplayed its hand with respect to ethylene. Even granting that domestic ethylene production hasn't always been all that profitable or offered good returns on capital (the surge in domestic natural gas production has helped), Axiall still knew years ago that it was leaving hundreds of millions of dollars on the shelf by not being vertically integrated. What's more, it's relatively easier (from a cost/engineering perspective) for an ethylene producer to add chloralkali/chlorovinyl capacity than the other way around.
If you doubt that, consider this - every one of Axiall's major non-integrated PVC peer companies is moving into ethylene. Shintech is looking to build a cracker, Occidental and Mexichem are teaming to build a cracker, and Formosa is expanding existing capacity and looking to build a new cracker in the U.S..
Given these developments, I wonder if Axiall's move to integrate ethylene is a little too little too late. The company is exploring a 1M ton, $3B facility in partnership with Lotte Chemical, with a FEED study due by the end of this year (which will presumably drive a yes/no decision by Axiall's board). What's the problem? Axiall's share of this facility will fill about 50% of its ethylene needs, but likely not until 2018 (E&C company order books are pretty full right now) and quite possibly at a higher cost. I think the long-term ROIC on this plant is going to be pretty good, but I can't help but wonder if Axiall's public flirtation with building ethylene capacity was part of a plan to coax a partnership with an existing ethylene producer and when that failed to happen, management had no choice but to move ahead.
Tough Trends In The Meantime
Right now it's good to be an ethylene producer and not so good to be a PVC producer. Spot ethylene is just under $0.70, up more than 30% over the past year while PVC price increases have been on the order of single digits. Making matters worse, electrochemical unit values (or ECU, a unit of chlorine plus 1.1 units of caustic soda) have likewise been pretty weak, leading to pretty sluggish chlorovinyl performance for Axiall.
Conditions are even worse in the aromatics business, where prices have weakened on increased capacity in Asia. Management has said it may divest this business, but getting full value in this market could be tricky. While the building products business isn't doing too badly, North American residential construction still has yet to stage that long-awaited recovery.
Can Operations Legitimize Underlying Value?
I do think Axiall is undervalued in at least some respects. Looking at announced projects (newbuilds and expansions) over the past couple of years, I'd estimate that the replacement value of Axiall's asset base is in the range of $85 to $100/share. Chemical companies almost never trade at parity to replacement values (let alone premiums), but Axiall's 50%-plus discount seems pretty extreme when you consider that most U.S. chemical companies traded around 75% of replacement value before the expansion of domestic shale gas production.
With that, I do still believe there is an inherent value to these assets. Established ethylene producers may look at Axiall as a way of extending their value chain even further and more fully integrating their operations. I don't have a particular ethylene company in mind as a likely acquirer, but companies with meaningful U.S.-based ethylene capacity could be candidates.
Discounted cash flow analysis isn't particularly helpful right now, in large part because the company will quite possibly be spending large sums on that ethylene facility and the amount of capacity on the books for 2017-2019 makes projecting realized prices for ethylene and PVC even more difficult.
Turning to EV/EBITDA, I see a range of possibilities. Analysts are treating 2014 as a lost year, but projecting a significant improvement (around 36%) for 2015. If you look at the 12-month EBITDA forecasts and use a 6.5x multiple, the resulting fair value is about $38.50. Use the 2015 estimate, though (totally ignoring 2014), and the same multiple leads to a target of almost $47.50.
The Bottom Line
I liked Axiall in mid-2013, but was cooler on the shares in January of this year. My feelings are quite a bit more conflicted now. I really don't like what I've seen over the past year in terms of operating efficiency or efficacy and I am more worried that there are structural problems here that may demand a more radical change in management's approach (or a change in management). On the other hand, I believe Axiall's assets are collectively undervalued and that the company remains leveraged to positive long-term trends in residential construction and North American gas production.
That $47.50 price target would suggest Axiall shares are worth enough to merit a closer look. A lot of bad news seems to be in the price and while some of it is justified, this is starting to look like an asset-based turnaround opportunity.
