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Overview

PolyOne (POL) is a great growth chemical name with a lot of potential to expand sales, earnings, margins, and improve their stock price. The company has a lot of potential with their push into specialty chemicals, and we believe they have a lot of potential to gain equity value over the next 12-24 months as that plan comes into fruition.


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Value

Value is decent for POL with some bright spots and some weak spots. The company has a strong discrepancy between PE and future PE due to large expected growth over the next year in EPS. The company is expecting around 40% earnings growth in 2014 (discussed more in the Growth section). The company is in a growth mode, and for a growth stock, a 17 future PE is actually pretty cheap.

The company is also cheap when compared to sales at 0.9. That discounted price is very solid as well for looking at a stock that is expected to grow sales by 20%+ this year and 12%+ next year. That discounted price can also be seen when we look at the company in comparison to enterprise value.

Issues, though, are that the company is expensive in relation to cash flow. The company has negative FCF, and they have limited OCF. We see this as an issue as it means that we are paying a lot for the company in relation to their ability to create cash, which is the lifeblood of a company. Expectations of future dividends, share repurchases, and adding capex should be limited. The company will have to take on more debt to fund new acquisitions and growth initiatives, which will further hurt cash.

The company, additionally, has a weak dividend yield at 0.84%, which we do not expect to grow given the current cash situation. Another questionable number is the PEG ratio at 2.9. While future PE is low, PEG is higher meaning that future earnings at this point are priced into the stock. We will visit valuations more in our price target analysis at the end.

Growth

PolyOne has some strong growth potential as the company is expected to see nearly 40% growth in earnings next year along with 12% growth in revenue. The key for the company is their growth in various industries as they expand their business continuously and work to move into specialty chemicals. The problem for chemical companies is economic moats as many are easy to replicate.

Specialty chemicals provide larger economic moats, as they are harder to reproduce, and the company has made a push over the last couple years to move towards core business being specialty and spun off generic brands that have less economic moat. The company's movement into this area has sparked global growth that should continue to provide double-digit EPS growth for the next 18-24 months at least. The company has recorded 14 straight quarters of EPS double-digit growth, and we look for that to continue.

The company looks to be on the path to continue to provide this type of growth with smart acquisitions like Spartech, which it made last quarter. Spartech manufactures thermo plastic, polymeric compounds, and other specialty chemical goods. This company fits with the profile POL is building, and the company can take their ability to expand its commercial and operational capabilities. They are pushing the company into aerospace, security, and will be able to cross-sell the products with things in the POL family (creating new growth opportunities).

The company strongly believes they will hit 2.50 EPS by 2015, which places them at a PE of 11.4. That level is quite cheap. We would expect PE to be around 18-20 by 2015, so we are looking for growth to $45 or more for the company in just looking at EPS growth solely.

Profitability

Profits have been on the rise for POL, and one of the big benefits of specialty chemicals is that they produce a higher margin than non-specialty or generic brands. The company has seen over 450% growth in net margins alone in the past five years, and they expect to continue to increase company-wide operating margins to 8-10% by 2015.

Let's take a look at how PolyOne is doing against competition. Some of their similar company competition is A. Schulman (SHLM), Axiall (AXLL), and Dow (DOW). We will take a look at operating margins, return on assets, and ROE for these names to see how POL stacks up.

SHLM has the three categories at 2.8%, 3.3%, and 7.9%. AXLL sits at 6.8%, 2.2%, and 5.7%. Finally, DOW is at 5.1%, 1.4%, and 5.4%. We can see that POL is getting the second-highest operating income and ROA and highest at ROA. We believe its high ROA is very solid because the company is expanding its business, and making the most for its assets. As it acquires new companies and divests others, it will continue to see promising returns. Further, margins continue to expand for the company.

ROIC is very low for the company, but it is low because the company has dividend payments that take away from ROIC.

The company anticipates expanding its margins as a result of its mix improvements strategy, which will allow them to make more for each product. It has some products with still very low margin output that they anticipate to either sell or grow. The company's Spartech acquisition should continue to help with this path.

We believe that POL is a strong profit name in a weak margin industry, and the margins look to expand moving forward.

Cash Flow/Efficiency

Cash is an area where we are seeing some weakness. FCF is negative in the TTM, which is due to the acquisition of Spartech, yet FCF/sales was fairly weak for the past ten years. The company has been higher than 10% only once in the past ten years for FCF/sales. FCF had grown a very nice amount from 2007-2012, and we would expect things to rebound quickly after this acquisition. Yet, we see the low amount of FCF as a problem for acquiring more companies and expanding the specialty chemicals without adding debt. Adding more debt hurts cash flow as well.

The company does have a healthy amount of cash/cash equivalents, but we see OCF and FCF as much more important for increasing dividends, acquiring companies, and doing share repurchases. Without FCF growth, the company will have trouble growing these. As for efficiency, let's compare POL to competition to get a sense of how they compare.

POL has fairly high days sales outstanding at nearly 56, days in inventory at 45, and a decent cash conversion cycle at 41. SHLM sees the three at 54.9, 52.9, and 56.1. AXLL is at 53.9, 47.4, and 65.2. Finally, DOW is at 35.4, 70.4, and 49.9. POL has the worst DSO, best days inventory, and best CCC. The company is converting inventory the quickest out of all chemical companies, which makes sense for its specialty role. We are unsure why DSO is so high, and that is a sign of weakness.

Overall, cash flow needs to be improved, and if it is, it will really improve equity value because the company can pay off debt more quickly and can improve capital expenditures over adding debt to acquire new names.

Financial Health

Financial health for POL is also neutral and not exceptional. The company does have a solid current ratio and interest coverage ratio, but they are extremely leveraged and have over 50% of all liabilities and equity in debt, which we believe is a major negative.

We look for a solid current ratio at 2.0. Above 2.5 shows not a strong use of liabilities and below 1.5 shows some issue to cover liabilities. The company is at a solid spot. The company's quick ratio at 1.2 shows pretty solid level as well, which is important because of the high amount of assets that chemical companies hold.

The company, though, can only cover its current liabilities 0.06x with OCF and 0.98 with gross profits. As the levels of profits improve, the company's gross profit to current liabilities will improve and less cash will be moving towards debt payments (thus FCF improves).

The company can cover interest payments 4x right now, so there is no major issue here, but we just see debt as already quite high. They need to improve profits and cash to improve their financial health, and we do expect that to occur over the next 2.5 years, which should improve these levels.

Overall, financial health is not weak enough to curb our enthusiasm for POL. Growth and value are the keys to POL as well as the company's margin potential.

Price Target Analysis

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2013 Projections

2014 Projections

2015 Projections

2016 Projections

2017 Projections

Operating Income

170

240

340

365

385

Taxes

60

84

119

128

135

Depreciation

72

72

75

78

78

Capital Expendit.

-65

-60

-50

-60

-70

Working Capital

18

18

18

18

18

Available Cash Flow

100

150

228

237

240

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for POL: 8.4%

2013

2014

2015

2016

2017

PV Factor of WACC

0.9225

0.8510

0.7851

0.7242

*

PV of Available Cash Flow

92

128

179

172

*

Step 3.

For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for POL: 3.4%

2017

Available Cash Flow

240

Divided by Cap Rate

3.4%

Residual Value

7066

Multiply by 20167PV Factor

0.7242

PV of Residual Value

5118

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

570

PV of Residual Value

5118

Cash/Cash Equivalents

169

Interest Bearing Debt

1056

Equity Value

4801

Step 5.

Divide equity value by shares outstanding:

Equity Value

4801

Shares Outstanding

99.37

Price Target

48.31

Source: PolyOne: Best Name In Chemical Industry With Upside Potential