Olin Corp. (OLN) rallied over 20% during the month of March, from less than $19 to close at $23.12 on April 1. This raises the question: Is it time to take profits, or are further gains in store? An analysis of actions taken over the past several years reveals that management has been carefully positioning the company to benefit from recovery in the cyclical chlor-alkali chemical business. Meanwhile, the Winchester ammunition business carried OLN through the trough without a losing quarter.
I wrote OLN up favorably in February 2009, when it traded around $12, setting a long-term target price of $30. This article presents the results of a review conducted on this holding, arriving at the same target. Patience will be rewarded, and there's a 3.5% dividend while you wait.
Olin is a manufacturer concentrated in two business segments: Chlor-Alkali Products and Winchester. Chlor Alkali Products manufactures chlorine and caustic soda, sodium hydrosulfite, hydrochloric acid, hydrogen, potassium hydroxide and bleach products. Winchester products include sporting ammunition, reloading components, small caliber military ammunition and components, and industrial cartridges.
There is an good presentation available on its website: A total of 20 slides, concise and informative.
The Electrolysis of Salt
The chlor-alkali process relies on the electrolysis of sodium chloride or potassium chloride to produce chlorine, sodium hydroxide (caustic soda) or potassium hydroxide, and a small amount of hydrogen. Production is measured in ECUs (electrochemical units) consisting of 1 ton of chlorine, 1.13 tons of caustic soda, and 0.3 tons of hydrogen.
Chlorine and Caustic Soda are produced in fixed proportions, and sold to separate sets of customers. The overall level of pricing is customarily expressed in ECU netbacks. ECU netbacks were $515 for Q4 2010 and both netbacks and volume are expected to increase in Q1 2011.
Price increases for both Chlorine and Caustic Soda have been announced for 2011. It takes a while for the increases to be reflected in actual billings. Because production occurs in fixed proportions and demand for the co-products is variable, it's difficult to predict long-term pricing.
However, over the past ten years industry capacity has been reduced. If and when the economy makes a full recovery, ample pricing power should be evident.
Acquisitions and Divestitures
The company recently announced the acquisition of the 50% of SunBelt it didn't already own from its partner in the joint venture, PolyOne (POLY). The acquisition is expected to be accretive during 2011. OLN has been managing the facility since 1997, so there are no concerns about integration. The transaction makes good strategic sense, as SunBelt is a low-cost producer.
In 2007, OLN acquired Pioneer, gaining access to low-cost hydro-electric inputs. Electricity contributes about 25% of the cost of the chlor-alkali co-products, and energy costs are critical to profitability. The acquisition was funded by the subsequent disposition of Olin's Metals business, for a similar consideration. In effect, the company swapped a loser for a winner, in equal size transactions.
OLN has two plants that use the obsolete and environmentally hazardous mercury cell technology. Under the pressure of legislation imposing deadlines, it will be shutting down one facility of 160,000 ECUs and converting the other to membrane technology with a capacity of 200,000 ECUs. I didn't like the mercury aspect, and I'm happy to see the issue resolved.
After protracted and unsuccessful negotiations with its union, Olin plans to relocate the Winchester center-fire operation to Oxford, Mississippi, with the assistance of $42 million of low-cost state sponsored tax-exempt debt. The total cost will be $80 million, and is expected to save $30 million per year in expenses when complete.
Between 2000-10, industry capacity was reduced by approximately 9%. At the height of the housing boom, utilization was very nearly 100%, resulting in very strong profits. As economic recovery proceeds, demand should be well matched to capacity, resulting in industry pricing power.
During the 2010 peak summer season, Olin operated at 91% capacity.
Cost of Energy and Competition
In the most recent 10-K, the company states that a significant portion of the North American chlor alkali demand improvement came from exports of products made from chlorine, driven by the energy advantage North America enjoys by using natural gas as compared to crude oil.
Industrial bleach is a profitable niche in the chlor-alkali market. Bleach uses chlorine and caustic soda in an ECU ratio, commands a premium price per ECU, and is unaffected by economic cycles. By creating a proprietary rail-car technology and investing in the production of low salt, high strength bleach, Olin is reducing freight costs and gaining market share.
Bleach accounted for 10% of ECUs in 2010; that is expected to be 15% to 20% in 2011. Olin now has 18% market share and the capacity to serve 25% of the market.
The ammunition business is cyclical, and strongest when the rest of the economy is weak. The effect was enhanced by the severity of the recent recession, as well as concerns that the Obama administration would be hostile to the firearms industry.
While there is no logical connection between the Winchester segment and the Chemical segment, the fact that the two businesses run on separate cycles is a strength, as results for 2009 and 2010 demonstrate.
As mentioned under capex, the Winchester operations will be relocated to Mississippi, resulting in annualized cost savings that are estimated at $30 million.
OLN is third in the chlor-alkali chemical industry, behind Dow Chemical (DOW) and Occidental Petroleum (OXY). Checking the 10-Ks for these two competitors, OXY states that it manages the chlor-alkali business around its cash flow; it's a cash cow and OXY milks it.
DOW states that it manages the chlor-alkali business consistent with the input needs of its other businesses. DOW does have plans for a joint venture in chlor-alkali with Mitsui (OTCPK:MITSY), a project to be located at DOW's manufacturing complex in Freeport, Texas.
Competition does not seem overly aggressive here. Where chlor-alkali is a primary business for OLN, there is the possibility that it can outperform its larger competitors based on better focus.
The dividend has been unchanged for many years, at $0.20 quarterly going back as far as 2001. The payout ratio fluctuates on a range from 40% to 100%; however, the dividend has always been covered by cash flow, which is generous compared to earnings.
There are substantial demands on cash flow related to funding an appropriate level of capex. Taking that together with the strong history of maintaining the dividend, it seems likely that the dividend will continue unchanged until there is clarity on the effectiveness of the latest round of capex and acquisition activity.
Debt and Access to Credit Markets
Long term debt was 31.8% of capitalization as of 12/31/2010. Earnings coverage of fixed charges stood at 2.1, down from 5.6 in 2009 and 7.3 in 2008.
The company has successfully funded its next round of capex needs. All together, OLN was able to get $153 million in Alabama, Mississippi and Tennessee bonds to finance these projects. During the 4Q 2010 earnings conference call, CFO John Fischer stated that the company intends to pay off the bonds maturing in December 2011 using cash.
Olin has no present need of further borrowing. While its debt is rated Ba1 by Moody's and B by S&P -- not particularly impressive -- it is evident from the forgoing that that company has more than adequate access to credit markets.
When Olin did the Pioneer acquisition, iit ncluded pro forma combined results in the subsequent 10-K, and discussed the expected synergies, which have since been realized. This information provides an indication of the company's earning power under optimal conditions.
Noting the synergies, the rationalization of industry capacity, the successful development of an increased share of the profitable bleach market, and the expectation that the SunBelt acquisition will be immediately accretive, I look at the 2006-07 pro forma earnings of approximately $2.50, round that up to $3.00, and apply a multiple of 10, arriving at a target of $30 by year end 2012. From recent prices in the $23 area, that returns 17% annualized, including the dividend.
Strategy and Tactics
Buying at today's prices provides a reasonable expectation of receiving a stable dividend with eventual price appreciation, returning approximately 17% annualized if the company hits my target price. The stock has spiked recently, and the market has recovered strongly from Japan and MENA concerns. A better entry point may be available.
In spite of the difficulties estimating future ECU netbacks mentioned above, I've consistently made money investing in OLN. I continue to invest on the basis that shares will eventually be valued at 30.
Olin is optionable, to include LEAPS, with implied volatility checking in at 32.63%, somewhat ahead of historical volatility at 26.68%. I've been playing this situation with diagonal spreads, long deep in the money LEAPS and short near-term out of the money calls, since February 2007, with an annualized rate of return of 38%.
I like the OLN Jan. 21, 2012 12.5 call, against which some OLN Aug. 18, 2011 25.0 calls might be sold, in order to fund the time premium.
Disclosure: I am long OLN.