We're often asked: what's the difference between price and value? Well, price is what investors pay for a stock, while value is what the stock is actually worth. We like to find stocks that have prices well below their intrinsic value. We have identified many, and Huntsman (HUN) is one of them. We think the firm is fairly valued at $25 per share, representing over 40% upside from today's levels based on our point fair value estimate. It just happens to be breaking out, too.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors. More interest = more buying = higher stock price.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Huntsman posts a VBI score of 9 on our scale, reflecting our 'undervalued' DCF assessment of the firm and its attractive relative valuation versus peers. This is one of our top scores. We compare Huntsman to peers Airgas (ARG), Dow Chemical (DOW), and DuPont (DD). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on Huntsman
• Huntsman's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
• Huntsman's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health.
• Huntsman's relative stock price performance, undervaluation, and dividend yield of 2.4% may make it attractive to a variety of investors. Having more types of investors interested in its shares increases the potential for future stock price appreciation, in our opinion.
• Huntsman makes chemicals for a variety of global industries, including plastics, automotive, aviation, and textiles. The firm generates most of its revenue and earnings from its polyurethane business, where it continues to focus on cost reductions.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Huntsman's 3-year historical return on invested capital (without goodwill) is 7.9%, which is below the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Huntsman's free cash flow margin has averaged about 2.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Huntsman, cash flow from operations decreased about 67% from levels registered two years ago, while capital expenditures expanded about 75% over the same time period.
The estimated fair value of $25 per share represents an implied EV/EBITDA multiple of about 7.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.2%. Our model reflects a 5-year projected average operating margin of 8.1%, which is above Huntsman's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.7% for the next 15 years and 3% in perpetuity. For Huntsman, we use a 9.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $25 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Huntsman. We think the firm is attractive below $17 per share (the green line), but quite expensive above $33 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Huntsman's fair value at this point in time to be about $25 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Huntsman's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $33 per share in Year 3 represents our existing fair value per share of $25 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
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