Georgia Gulf / Olin Make a Great Pair Trade

I have been meaning to post about this for months; here it is.

An extensive restructuring of Georgia Gulf Corporation (GGC $29) involving a distressed debt exchange, convertible preferred stock issuance, and a 25:1 reverse split has caused confusion and led to a huge mispricing of GGC equity. Enterprise value for GGC is 14x management’s estimated 2009 EBITDA versus about 5x for its closest competitor, Olin Corp (OLN $16.50).

GGC is an Atlanta-based manufacturer of commodity chemicals and vinyl-based building and home improvement products.[1] The company operates in four segments, Chlorovinyls; Window and Door Profiles and Moldings Products; Outdoor Building Products; and Aromatics. It markets its vinyl-based building and home improvement products under the Royal Group brands.

In October 2006, GGC vertically integrated by buying Royal Group, a downstream consumer of chlorovinyls, for $1.6 billion, “transforming Georgia Gulf Corporation into one of the most highly-integrated companies in the residential repair, renovation, and remodeling markets.” The 2005 EBITDA for Royal Group was $224 million for a transaction multiple of 7.1x. This transaction was nearly the ruin of the company as the outdoor building products and window and door profiles and moldings products segments of the company have been performing worse than the commodity chemicals segments, and even had negative gross margins in the most recent quarter.

Olin Corporation is also a commodity Chlor-Alkali chemicals manufacturer, which represents 72% of 2008 sales, with the balance (28%) consisting of the fantastic Winchester ammunition business. This is a much better subsidiary to own than the vinyl-siding Royal Group. For one thing, ammunition is a nice oligopoly with almost all production owned by Olin, Alliant Techsystems (ATK), or Cerberus Capital Management (private). [2]

Also, OLN is better managed than GGC, judging by their decision to sell a subsidiary (Metals) to a New York private equity firm in 2007. (On the other hand, they did buy chemicals competitor Pioneer in 2007.)

What I like about this trade is that on their own, OLN is a good long, GGC is a great short, but they are so comparable that they also pair together well.

GGC Capital Structure
A key factor causing the current mispricing of GGC is confusion over its capital structure, thanks to the restructuring and reverse split. The current enterprise valuation is outlined below. [click to enlarge]


Only a small amount of the notes remains because 92% of them were tendered in July in exchange for stock. Note that Yahoo Finance and other data providers are wrong about the market cap and enterprise value of GGC. The structure I show here is derived from a recent 8-K.

Relative Valuation
GGC has a higher enterprise value than OLN, but lower gross profit, EBITDA, and cash flow. Additionally, OLN has a long history of paying dividends, and currently yields 4.9%.



GGC Valuation
Management has estimated that 2009 EBITDA for GGC will be $110 million. Stretching as far as a 8x multiple would leave only $347 million in value for common shareholders, putting the share price at $9.95, a 66% downside from today's levels. The table below shows value/share available given a number of possible EBITDA multiples. Note that the common GGC shares are a zero if the enterprise is valued based on OLN's current multiple.


GGC Recovery Analysis
Another interesting question is: where should the notes trade? This question is basically ignored by the market given that there are only $64 million notes outstanding now that the exchange has been completed.

Given the current $986 million market cap of GGC, it is odd for the sub debt to be trading at 63, to yield over 20%. If the current equity pricing persists, I would expect the company to make a huge equity issuance and buy back debt. All of the notes have double-digit yields. They would probably find them the best ROI in the chemical industry right now.



The Trade
I like shorting GGC and buying OLN as a hedge. Also I like GGC debt as a hedge.

Notes
[1] Chlor Alkali refers to combination of chlorine (Cl) and caustic soda (NaOH), which are co-produced by the electrolysis of salt (NaCl). These co-products are produced simultaneously in a fixed ratio of 1 ton of chlorine to 1.1 tons of caustic soda. The industry refers to this as an Electrochemical Unit or ECU. As of YE 2008, OLN had a consolidated capacity of 1.91 million ECUs per year, making them the third largest chlor alkali producer.

[2] Olin, by virtue of its Winchester subsidiary, is the most attractive way to gain exposure to ammunition manufacturing. Remington is privately owned by hedge fund Cerberus. Alliant Techsystems, which owns the Federal and CCI/Spear brands, is not as attractively priced.

Comments

[Tom Armistead:]

Olin has expressed interest in making chlor-alkali acquisitions. When they bought Pioneer they soon sold Metals. What if Olin bought GGC's chlor-alkali operations? Then they could sell Winchester to fund it, ammo is hot right now and they might be able to get a premium price.

If that happens, OLN would tank and GGC would soar, making the pair trade problematic.

Long OLN

Oct 23 07:31 AM