Will Ashland Channel Ben Graham?

By Brad Zigler

Benjamin Graham, were he still alive, would likely be having a field day picking through today's market wreckage for bargains. Graham, the granddad of value investing and mentor to Warren Buffett, earned a reputation for deep-discount investing in the wake of the 1929 stock market crash.

Just as there were valuable bargains to be struck in the aftermath of the '29 collapse, there are enticing buys to be made now.

Graham was no commodity investor per se. His signal work, "The Intelligent Investor," mentions only stocks. Still, you could say that Graham treated stocks as commodities. His analyses essentially dug out the fundamental value of companies and permitted purchases only when substantial discounts from market value could be obtained. Value, rather than brand name, was Graham's standard.

There are, too, so-called "commodity stocks" – equities issued by companies in the commodity "business" – that can be evaluated from Graham's, and presumably, Warren Buffett's, vantage point.

Take the stocks in the Basic Materials sector as examples. This segment, made up of companies in the chemical, mining, industrial metals and forestry/paper industries, was brutalized after a five-year bull run. In just five months, between June and November 2008, the Dow Jones US Basic Materials Sector Index lost nearly 59% of its value. Only recently has the benchmark started to show signs of stabilizing.

Among the stocks contributing to the index's decline was that of Ashland, Inc. (NYSE: ASH), a company Ben Graham would no doubt recognize. Well, old Ben would recognize part of the company, anyway. Originally founded in 1918 as Ashland Oil, the Kentucky-based company is now a diversified chemicals enterprise operating in four divisions.

• Ashland's Valvoline segment is the old-line core of the business which produces and markets automotive lubricants, chemicals and filters. A nationwide chain of oil change stations is now operated out of the division.
• The Performance Materials division supplies specialty chemicals such as resins and adhesives to the building, construction and manufacturing trade.
• A Distribution segment deals in chemicals, plastics and other materials in North America and Europe as well as providing waste collection, recovery and recycling services.
• Ashland's newest enterprise, Water Technologies, supplies water treatment material for industrial and municipal operations as well as providing fuel treatments, welding, refrigerant, sealing and fire-fighting products.

Ashland, Inc. (Price-Only And Dividend-Adjusted)

What Ben Graham would see now if he were looking at Ashland is a company with surprisingly good fundamentals that's been chucked into the bargain basement along with a lot of sector dross.

We looked at Ashland last year as it was still rather uncomfortably refashioning itself into a diversified chemicals outfit (see "Ashland Could Be A Play").

So what would Graham like about Ashland now?

Well, there's the constancy of the company's dividend payments for one thing. Over the past eight years – the length of the current commodity bull market – dividends have added an average 4.4% to Ashland's compound annual return.

Ashland is liquid, too, with a current ratio of 2.5, well above Graham's benchmark. In fact, the company isn't highly leveraged. Ashland could readily pay down its obligations out of pocket: Its $45 million long-term debt is paltry in comparison to the $1.8 billion in net current assets on its books.

Best of all, Ashland's stock is now cheap. With shares at the $14 level, Ashland's price-to-earnings multiple is only 4.9x. A 15x multiple is Graham's bargain threshold. On a price-to-book basis, the stock's also a deal. A 0.3x multiple is screamingly cheap.

Yet, with all that, there's something about Ashland that Graham wouldn't like. The company's earnings have downtrended recently. But then, whose didn't?

Ashland is due to release its first-quarter earnings on April 27. Analysts polled by Thomson are betting that 27 cents a share gets posted. That's the freshest estimate. The guess has actually been a moving target, wobbling from 32 cents to 25 cents over the past quarter as the market's lurched and surged.

Ashland's nemesis last year was margin compression brought on by a then-inflationary spiral in input costs. That pressure's been relieved recently, though pricing power has been maintained on the revenue side.

The question before investors and traders now is whether this margin improvement is accurately discounted in analysts' earnings projections.

The vacillation in the first-quarter earnings estimate speaks to analysts' own trepidation about being surprised. Their fears are justified. The past three quarters' consensus forecasts were well off their marks. Twice, the green-eyeshade set was too pessimistic, and once it was giddily overconfident.

As evidence of the difficulty in modeling profits in the current market, the forecasts' deflection has been widening. Fourth-quarter 2008 earnings came in at 25 cents, 67% higher than expectations. In the prior quarter, analysts' forecast 30 cents in earnings. Ashland instead delivered a penny-per-share loss, a -103% earnings surprise. There was a 20% positive surprise in 2008's second quarter.

The corollary to an earnings surprise is a share price reaction. The immediate upshot to last quarter's higher-than-expected EPS was a 12% pop in the stock price to $8.25. The sparkle quickly fizzled, though. A month after the announcement, Ashland's stock price had been dragged down to $6.26. And a month after that? Ashland shares have made a round trip back to black. The stock's now trading 95% higher than its pre-release price.

Most of that price action is intrinsic to Ashland and not driven by the broader market. The company's r² (r-squared) correlation to the Dow Jones US Basic Materials Sector Index is only 35%, even though chemical outfits like Ashland make up 52% of the benchmark's weight.

So, is another 95% uptick in the cards for Ashland? Maybe. A gain of that proportion would put Ashland's share price at $28, about where it was in October 2008 when the Valvoline started hitting the fan.

Comments

[Joungfan:]

When you cite balance sheet figures for Ashland (debt, current assets, etc.), are you pulling from the company's 10K (for FY ending September 30, 2008) or from its most recent 10Q (quarter ending December 30, 2008)? If you're pulling from the 10K, shouldn't you be using the figures from the more recent 10Q instead?

Apr 14 09:51 AM

[polypro78:]

Ashland now has 5 divisions after the purchase of Hercules Inc. on Nov 13, 2008.

Apr 14 01:19 PM

[turb0kat:]

Yeah your numbers are out of date - they took on $2 billion in debt from the Hercules acquisition. That is why their stock has cratered, on fears that they will default or be unable to pay or re-finance the short-term portion of the acquisition costs.

Also, Graham would not have cared about a short-term downtrend in earnings.

Apr 17 03:38 PM