Koppers Holdings (NYSE:KOP), a specialty chemical manufacture, embodies some of the core characteristics of a great company. It continues to show improvements in performance even in times of an unfavorable economic environment, provides meaningful, measurable and attainable targets and shows progress towards achieving those targets.
KOP currently trades at a significant discount to its peers. The discount ranges from 20% to 50% to the industry based on various price multiples. The company also has a PEG of 0.75 that is approximately 38% below the industry average. Given the company's history of achieving double digit top and bottom line growth such a low valuation is unjustified. I expect this to be overturned as the company tackles its current challenges and looks towards achieving long-term growth in revenues and earnings.
KOP is a leading integrated global provider of carbon compounds and commercial wood treatment products and services. The primary raw material used by the company is coal tar that is used to produce various intermediary products. These are then used by its subsidiaries and customers for the manufacturing of various end products.
The commodity-like nature of most of its products means that the company can serve various markets and this has, to some extent, enabled the company to sustain its revenues and earnings over the course of the last few years. However, this does not mean that the company is immune to macroeconomic factors and a majority of its revenues are still derived from a few key markets that will be discussed later.
Results and Market Sentiments:
The prevalent poor economic conditions in Europe, together with slow recovery in North America, and a slowdown of growth in Asia have hit the company hard and have led to devastating results for FY2013. Net sales fell by 5% and earnings per share fell by more than 38%. The company posted its worst results in its history as a public enterprise, second only to results achieved in FY2009 during the global financial crisis. However the results are not as poor as the raw figures suggest and were primarily impacted by the results in Europe. To put this in perspective, excluding the results of Europe the company's adjusted EPS, excluding non-recurring items, would have been 10% higher than last year.
The company's stock price has been falling since the start of November 2013 when it announced its FY2013 third quarter results. During the third quarter the company achieved a solid 10% growth in its bottom line, beating analysts' estimates by more than 15% despite missing top line targets by slightly more than 1%. Despite the positive growth in its earnings I believe that the expectation of increasingly difficult circumstances in the marketplace had put off investors from this small cap company.
With an established negative market sentiment built up against the company, the share price has continuously fallen. This price trend was given further impetus when the company announced the closure of its distillation facility in the Netherlands and significantly weaker-than-expected FY2013 fourth quarter results. Although the company's shares have stabilized at around $38 per share, KOP has lost approximately 23% of its market cap since November 2013.
The increased volumes over the last few trading days tend to suggest that investors now perceive the company to be grossly undervalued and the current price to be a viable entry point. Although the price multiples tend to paint a similar picture, the difficult circumstances in the marketplace continue to prevail. Thus in this article I will be looking in detail at some of the reasons for the decline in the company's performance and I will try to conclude whether the company's prospects make a case for a reversal in the recent price trend or support a further deterioration of shareholders' wealth.
European Markets:
The performance of KOP, like any other chemical manufacturer, is highly correlated to economic growth. With KOP primarily serving the aluminum, plasticizers, concrete surfactants and tire markets, the company is highly vulnerable to the tightening of economy and reducing consumer and government spending.
The Euro area's economic growth over the last few years has ranged from being slow to negative. This has led to a slowdown in growth of disposable income and consumer spending (which have stagnated in the last few years). The unemployment rate has also risen significantly and has put additional constraints on the growth of disposable incomes and consumer spending. The stagnation of disposable income, consumer spending, and rising unemployment has significantly impacted the region's retail sales growth, which has been negative from mid-2011 onwards.
The above mentioned factors have led to a decline in demand in KOP's critical end markets, such as the automotive and housing sectors. Thus the company's overall performance, particularly in the last year, has been negatively impacted by the general low demand and oversupply in the European region.
Another factor that has negatively impacted the company's performance in the region has been the reduction in stimulus spending in Europe which is a significant driver of demand for its produced naphthalene. Although government spending in Europe has increased drastically over the last few years, a majority of this spending has been aimed towards social security benefits rather than infrastructure development. Thus the lower spending in this particular category has led to a reduction in demand for the company's products.
The lower demand has created a condition of oversupply of the company's major products in the European region. Thus the company's earnings in this region have not only been hit by lower volumes but also due to a fall in realized prices.
The future prospects of the European region are only modest at best in the short to medium term. Although it is expected that the regional economy will enter into a growth period in the long run the recovery is expected to be slow. The region still faces mammoth problems of high unemployment rates, capital outflows, and negative investor sentiments that will not be easy to overturn and would need some concerted effort on the part of the central governments. However with running budget deficits and high debt levels, the central governments have little room to maneuver. That being said, the structural changes implemented by the European Central bodies will certainly help in improving the economic condition in the region.
The European economy has already shown signs of improvement with reported positive GDP growth in the fourth quarter of 2013 and four straight months of increased industrial production after a long streak of declining production in the region. Unemployment has also seen a slight improvement in the latest reported figures. The housing sector has seen a slight improvement as is evident from the 0.6% increase in the housing price index after 8 straight quarters of falling prices from mid-2011. Meanwhile, European construction output also showed signs of stabilizing in the last few months as the decline in construction output reduced by 0.2% in December 2013 from double digit decline at the start of the year.
Thus despite the poor performance during the previous year the future prospects of KOP in Europe are positive. The improving economy will certainly enable the company to sustain volumetric sales while the strategic changes implemented by the company (such as closing its distillation facility in the Netherlands) will help it to improve its bottom line. Thus I believe that the company will significantly improve its performance in Europe.
Aluminum Smelters:
The aluminum market is one of the key end markets for KOP as it derives a significant portion of its revenues from its sale of carbon pitch to aluminum smelters. In the recent past aluminum smelters and related industries in the world have seen some difficult times. Despite the growth in demand in recent years the industry has remained in a state of chronic oversupply during the majority of the last 7 years. This has resulted in a sharp decline in aluminum prices, sustaining below $1,700 per ton, forcing aluminum smelters to reduce production, which consequently has impacted the demand for KOP's products.
The lower price has forced some of the aluminum smelters in Europe and Australia to shut down operations in late 2012 and this had a full year impact on KOP's sales in 2013. Despite the closure of certain facilities the production of aluminum is expected to have increased by 2.2 million tons in 2013. The growth in global aluminum production has not been symmetrical as a majority of the growth was in China while production outside of China fell by approximately 1% during the Jan-Nov 2013 period.
Demand for aluminum is expected to increase by 5% to 6% in 2014 and 2015; however, the industry is expected to remain in oversupply due to new production capacities coming on board and the existence of a substantial amount of inventory (current LME aluminum stocks stand at approximately 5.5 million tons). Thus the prices of aluminum are likely to remain below $1,700 per ton over the next 2 years. This will force many high-cost smelters, particularly in developed economies, to cut production or completely close operations in the next 2 years. Thus I expect KOP to continue to see poor carbon pitch sales in the short to medium term although the new aluminum smelters in the Middle East and China might offer potential for growth for the company from its existing facilities in China and Europe.
Supply Constraints in the US and China:
The company's Railroad and Utility Products segment saw revenues increase by 3% primarily due to the acquisition of the Western Pole business in Australia late in 2012 that was partially offset by a decline in segment sales in North America. KOP's US crosstie sales have been negatively impacted by supply constraints, as increased competition from flooring and crane markets have hindered the company's ability to obtain adequate hardwood lumber to meet orders.
In order to meet customer orders the company had to decrease its untreated tie inventory using the boltonizing process. The company expects a rise in prices from Class I railroad customers to help in countering the competition faced in the lumber market. However, even if the expected price rise from Class I fails to materialize the company has sufficient inventory of untreated ties to pull through the short term supply constraints. The company's inventory of untreated ties stood at 5.2 million ties at the end of 2013, down from 6.2 million ties at year end 2012.
The company is also expected to face serious supply constraints at its KCCC tar distillation plant in Hebei Province, China. The company disclosed in its FY2013 third quarter results that Tangshan Iron and Steel Company (TISCO), its joint venture partner in China, had received a notice from the Chinese government to cease operations for their two coke factories as part of the government's air quality improvement efforts. KOP's KCCC tar distillation facility, located adjacent to the TISCO's coke factories, receives most of its utilities and raw material from the coke factories. Although TISCO and KOP are in discussion with officials for a delay of closure as well as financial and other assistance, the company looks to source alternative raw material and utility supply to keep running its operations at KCCC. However it is highly likely that the company might be forced to completely shut down operations. In anticipation of a closure, the company has decided to depreciate the book value of property and equipment of its KCCC facility over the course of 36 months. The KCCC operation contributed about $3 million or 3% of the company's total operating profit in FY2013.
Recent Events:
On January 21st, 2014, KOP completed the acquisition of Tolko's Ashcroft crosstie treating business as the company continues to strengthen its core business and enhance its presence in the North American market. The manufacturing facility acquired is located in Ashcroft, British Columbia, Canada which increases the company's footprint towards the Northern Pacific coast and into Canada. The total acquisition cost, after adjustment for working capital, was CAD$32.4 million that equates to approximately USD29.2 million using the exchange rate on the date the company announced the completion of the acquisition. The new crosstie business is expected to add around $30 million to the company's revenues and also be accretive to the company's earnings.
On January 22nd, 2014 KOP announced the closure of its distillation operations at its tar plant located in Uithoorn, The Netherlands. The oversupply of products in the European market, the under-utilization of its assets, and the regulatory requirement for significant capital expenditure are some of the reasons that forced the company to close its operations. The company expects the complete closure by mid-2014 as it slowly transitions the raw material supply and production to other KOP owned assets in Europe. The closure of the plant will initially cost the company approximately EUR 25 million (approximately $34.4 million as per the exchange rate on January 22) but will result in approximately EUR 3 million cost savings for by year end December 31st, 2014 before reaching an annual run rate of approximately EUR 5 million from 2015 and beyond.
Strategic Goals:
The company has in place key strategic targets for growth, margin improvement, and capital deployment and has come a long way in achieving these targets since they were first initiated in 2011.
Growth:
With regards to the first target of growth, over the years the company has expanded its operations and presence in key markets and established itself as the market leader in critical regions. KOP continues to look for opportunities for consolidation of its position in these key markets as well as enhancing its footprint in emerging markets. Although last year brought with it a lot of setbacks for the company, it was still able to acquire another company strengthening its core business and consolidating its position in the North American market.
Through various joint ventures and acquisitions, such as the acquisition of Ashcroft crosstie operations, the company has enhanced its earnings and revenues. KOP has a history of successfully integrating acquired businesses into its own operations and has the intention of continuing to do so. The company, as per management's comments, is in the process of evaluating three such business acquisition opportunities and is expecting to close at least one of these deals during the current fiscal year.
Margin Improvement:
With regards to the second strategic target of margin improvement, the company is aiming to achieve an EBITDA margin of 12% by the end of 2015. FY2013 saw a decline in the company's EBITDA margin by 10 bps to 10.2% but as mentioned earlier the majority of this decline was due to the company's operations in Europe. Excluding the results of Europe the company's EBITDA margin for 2013 would be 11.8% and would place the company well ahead of achieving its goal. Thus it is safe to say that improvements in Europe remain the only linchpin in the company's plan to achieve its 2015 objective, making it essential to evaluate the steps taken by the company in this region to cut costs and improve results.
I have already discussed the prospects of a recovery in the European market that is likely to remain underpinned by macroeconomic factors in the short to medium term and is showing signs of an impending recovery in the long run. I have also discussed a possible growth opportunity in the form of new aluminum capacities being installed in the Middle East. Apart from these factors the closure of its Dutch distillation facility will help the company in improving its performance in the next few years.
The three distillation plants that the company operated in 2013 achieved a capacity utilization of around 60%. Thus the lower efficiency combined with the prevalent low prices in Europe, due to product oversupply, was the major cause of the company's lackluster performance in the region. Now as the company shifts its raw material supplies and production to the remaining two plants the company expects to achieve a utilization of greater than 85%, bringing in efficiency to its operations and improving the region's profitability with existing low prices. Once the Dutch facility ceases its operations and the company pays off the initial costs of closure, the higher efficiency at its remaining two plants will bring immediate improvement to the company's EBITDA margin.
Capital Deployment:
Looking at the third strategic goal of capital deployment, KOP generated $180 million worth of free cash flows over the past two years. This equates to around 6.2% of total sales generated over the same period and the company aims to generate a free cash flow of around 5% of total sales in the coming years. Over this period the company has deployed around $188 million on various fronts. This included returning approximately $66 million to shareholders in the form of dividends and share repurchase, spending $57 million on margin improvement and approximately $53 million on growth areas such as the acquisition of the Australian utility pole business and plant construction in China. Thus the management has been shrewd in spending its cash on meaningful areas that have enabled the company to enhance its return on capital employed in a majority of its business segments.
Conclusion:
Despite the poor performance of 2013, I believe that the market has overreacted to the news and in doing so has ignored many of the steps that the company has taken to enhance its performance. Going forward I believe that recovery in Europe and improving profitability in the region will be crucial for the company to enhance its profits in the future. Apart from its performance in Europe, the completion of its new coal tar distillation facility in China will bring an immediate addition to its revenues and earnings primarily due to the contracted volumes with Nippon Steel and Sumikin Chemical. This new facility will help nullify the negative impact of a possible closure of its KCCC plant as mentioned above. Another key ingredient to the company's future growth is its ability to expand its operations through acquisitions and efficient utilization of free cash flows generated from operations. Given the company's ability to complete and integrate such transactions I believe that the company will continue to do so in the future and that this will help the company in enhancing its performance.
The company currently trades at a 20% to 50% discount to the industry based on multiples and also has a PEG of 0.75 approximately 38% below the industry average. Such a low valuation of a company achieving double digit top and bottom line growth is unjustified and I expect this to be overturned in the near future.
Since its operations in Europe will be critical to the reversal in the current price, the performance in the region also poses a substantial risk to the company and investors. A slip into another economic downturn, as seen in Europe in 2012 and 2013, will result in continued deterioration of the company's overall performance. Since the company expects to complete its plant closure and begin operations for its new tar coal distillation facility by mid-2014, the current fiscal year's third quarter results will be critical in gauging KOP's future prospects. I also expect the situation at its KCCC plants to be much clearer by mid-2014 giving even more importance to the third quarter results.
All in all I believe that the company is well positioned and has been able to efficiently handle all the misfortunes it was served in the last year. The current cheap valuation of the company undermines its ability to counter these difficulties and crawl out of the current situation. I believe the company will be able to improve its performance in the coming years and continue to grow through acquisitions. Thus in my opinion the current valuation of the company only offers a profitable entry point for investors with an expectation of favorable results in the coming periods.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
