Olin: Worth Its Salt

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 |  Includes: DOW, OLN, OXY
by: Tom Armistead

Basic chemicals manufacturer Olin (NYSE:OLN) recently reported a very respectable 4th quarter, bringing the year in at 2.09. Shares closed Friday at 12.13, for a P/E of 5.85. I adjusted the earnings to look past a 26.6 million dollar loss on an investment in corporate debt securities, unlikely to happen again and adjusting it I see 2.43, in line with what I expected for the year. I was looking for a P/E of 13, so I am not a happy camper. The market is treating the earnings as unsustainable. Guidance for the next quarter comes in at a range of .50 to .65; beyond that, management has no visibility. I wrote Olin up favorably in August last year at a price of 23.xx, and added to my position at that level, so now I have some thinking to do.

Thesis vs hypothesis - There is a school of investing which holds that the investor should develop a strong thesis and exit when the stock meets price expectations or when the thesis is “broken.” From a philosophical point of view, a thesis that can be broken is fragile, and not a good underpinning for an investment decision. After some thought, I have come to the conclusion that I will be better off by developing a hypothesis and examining quarterly results and other developments for information that confirms or disproves it. In a best case scenario, it may be confirmed over a period of time, permitting me to add to a position with increasing confidence and frequently at decreasing prices. Or, if confirmation is not forthcoming, the position can be reduced or abandoned, or the hypothesis can be modified to a more factual basis.

Original Hypothesis – When I first started buying Olin several years ago, I felt that it would become very profitable when the housing industry would get back up to speed and the chlor-alkali industry would be capacity constrained, leading to extreme pricing power. That has not occurred, and the housing industry is unlikely to improve until the 4th quarter at the earliest, with an anemic recovery expected. Meanwhile, Olin has been posting very respectable profits. But the original hypothesis has been disproved.

Present Situation - Olin's primary business is chlor-alkali chemicals, the production of chlorine and caustic soda in fixed proportions by the electrolysis of salt. It is third in the industry, after Dow (NYSE:DOW) and Occidental Petroleum (NYSE:OXY). Because the co-products are produced in a fixed ratio, and the demand for chlorine is more volatile than the demand for caustic, the laws of supply and demand operate in ways that are difficult to project with certainty. Chlorine is heavily used in making plastics such as PVC, which in turn are heavily used in the construction industry. Demand for chlorine has declined rapidly, reducing prices. However, demand for caustic has not slowed at the same pace, leading to serious pricing power.

The industry looks at overall production and prices in terms of ECUs. (electrochemical units) consisting of 1 ton of chlorine, 1.13 tons of caustic soda (NaOH), and .03 ton of Hydrogen. ECU net-backs are the combined net prices received for the two co-products. Here is a history of Olin's net-backs:

2006 Netback

2007 Netback

2008 Netback

Q1

$590

$500

$580

Q2

$560

$510

$590

Q3

$540

$540

$660

Q4

$520

$555

$740

Click to enlarge

While overall production was down 30% for the 4th quarter, the increased net-backs permitted profitable operation.

Caustic demand seems to be relatively inelastic. Doing a little research on the internet I have been able to learn that soda ash can be used as a substitute, or as a raw material from which caustic soda can be manufactured, providing some substitution potential. Asia generally produces caustic beyond what it can consume because they use a lot of chlorine. Some of the extra caustic can be transported if the price is right, and that has been happening.

Chlorine demand is more sensitive to the economic slowdown and will not increase until housing and construction begin to recover. In 2001-2002, caustic prices started to go down about 6 months after chlorine demand began to increase. PVC is unloved, to put it mildly, by the Green movement. Improperly manufactured or disposed of, it produces dioxin, a carcinogen. If the use of chlorine based plastics in housing and construction is reduced by law or a change in public taste, chlorine demand would be seriously affected.

Chlorine will possibly not be in sufficient demand to reduce the pricing power on caustic for a substantial period of time. If the recovery in chlorine demand is anemic, as seems likely, a worst case scenario for Olin would be that chlorine demand would be sufficient to produce an abundance of caustic but still well less than industry capacity. Management sees strong pricing into the 1st half of 2009. To me, strong caustic pricing through the 3rd quarter seems likely. Who can see into the future with that kind of detail?

Competition and positioning - Chlor-alkali is OLN's primary business. Its two larger competitors, DOW and OXY, have segments that compete in basic chemicals, to include chlor-alkali. OLN has also positioned itself as a major player in bleach. Bleach is made from chlorine and caustic soda, but ECU netbacks are better ($100-200 better) and more stable for bleach than for the two co-products sold separately. While OLN is at a disadvantage due to lack of diversity, it is stronger due to being better positioned and perhaps by being more focused. With ECU netbacks holding up better than other chemical prices, OLN may be at an advantage in the slowdown.

DOW has its own problems. The failure of the K-Dow deal and the high price agreed to on the Rohm and Haas (ROH) acquisition, which is in litigation, are not the only troubles afflicting DOW. The company has several years of declining margins on the books, going into a severe slowdown. CEO Andrew Liveris, in interviews, has used expressions like “black hole.” If forced to acquire Rohm and Haas at the price agreed to, DOW will not be competing with anyone – the company will be fighting for survival, and very possibly shedding assets.

My personal opinion is that Liveris did not stick to his knitting: he was too busy doing big deals and did not manage DOW's sprawling business effectively to be prepared for a slow-down. He cited Alcoa's (NYSE:AA) efforts to reduce its cost of caustic soda as indicative of problems for pricing. Alumina is only 3% of overall caustic soda demand in North America so that concern may be unique to DOW and may have been exaggerated on Liveris' part.

OLN has a strong balance sheet with no debt coming up for renewal until 2011, and the most recent conference call featured questions about possible acquisitions or buybacks. OLN would be interested in chlor-alkali or even something electrochemical. I take that to mean they are satisfied with their narrow focus and believe they have found a profitable niche.

Talking about DOW's messed up deals, you could even compare and contrast OLN's maneuver when it acquired chlor-alkali competitor Pioneer and almost immediately disposed of its own under-performing Metals division. The two transactions were of more or less equal size, so CEO Joseph Rupp can claim a coup by swapping out an under-performing segment for a very profitable bolt-on acquisition. Compare that to DOW getting hung up between the K-Dow and ROH deals, jeopardizing the company's performance for years to come.

OXY is an oil company with a basic chemicals segment. Here is its approach to the business: “Manage the chemical segment to provide cash in excess of normal capital expenditures.” Basic chemical is a cash cow and not a growth business for the company. It should not be expected to provide particularly aggressive competition.

Management efficacy - Olin's CEO Joseph Rupp came up through the Metals division, so presumably his skills and loyalties would have been centered there. Nevertheless, he acquired the Pioneer business and sold the Metals Division soon thereafter. The price received for the Metals division didn't seem impressive at the time, and aroused some questions from analysts, but in hindsight the decision looks extremely good.

Synergies and expense savings expected from the Pioneer acquisition have been fully realized. Admittedly, it was a bolt-on, but credit must be given for the prompt and smooth integration. Capex seems intelligent: the expansion/conversion of the St. Gabriel, LA plant is expected to produce annual savings of 30 million or .39 per share.

Legacy pension expenses have been dealt with: the company does not expect to be required to add anything to its defined benefit plan in 2009.

New Hypothesis - A well run company in a difficult cyclical business, doing surprisingly well in an economic downturn, with a strong balance sheet. Electrolysis of salt is not rocket science. Working with a combination of proforma, historical, and projected results I think OLN can earn 2.50 a year and gain market share over the long haul. The dividend of .80 is secure and yields 6% while you wait. The stock trades in the 12 area, I still see over 30 per share.

How about: due to the fixed ratio of co-products inherent in the chlor-alkali process, combined with the relative inelasticity of caustic soda demand and the weakness of chlorine demand, OLN will have pricing power and will outperform the basic chemicals industry during a deep recession.

I think that's an interesting possibility, good to hold my position and perhaps add to it; meanwhile I will monitor results quarterly and also keep tabs on what DOW and OXY have to say about their chlor-alkali operations.

Disclosure: Long OLN, no position in OXY or DOW.