By Adam Fischbaum
More often than not, a successful investment usually involves a good, basic business that sells a lot of something everybody needs. It's a path that guys like Warren Buffett have taken time and time again to score huge long-term returns.
This should also be the kind of stock you look for to form the core of your portfolio. It's why investors are so attracted to stocks like Procter & Gamble (NYSE: PG), Unilever (NYSE: UL) or Kimberly Clark (NYSE: KMB) for example, using the logic that things like soap, food and toilet paper are basic necessities.
But there's a product that doesn't exactly come to mind when people think of necessity: caustic soda, also known as sodium hydroxide. As it turns out, companies such as Procter & Gamble, Kimberly Clark and Unilever need lots of it to make their everyday necessities. Of course, I quickly became attracted to this unconventional product.
As I started my research for this article, I figured a good place to start was with someone who uses a lot of caustic soda on a daily basis. So I asked my sister-in-law, who happens to be a mom and a chemical engineer, about the main uses of sodium hydroxide. Predictably, I got a mom/engineer answer: "Everything."
And she wasn't joking. Caustic soda is used in everything from the manufacturing of paper, cleaning products and PVC pipes; to soft drinks, ice cream thickeners, olives... you name it. Apparently, sodium hydroxide makes the world go 'round, and there's one company that hears a cash register ring as the world spins.
Olin Corp. (NYSE: OLN) is the third-largest domestic producer of chlor-alkali products, including sodium hydroxide, sodium hypoclorite (bleach) and hydrogen. Last year, caustic soda represented 71% of its $1.96 billion in total sales and 65% of profits which came out to be $2.99 per share. What's more, these numbers represented a 23% increase in revenue and a whopping 269% increase in earnings per share from 2010.
Looking at the company a little closer, you'll see why I think the stock could be a good addition to your portfolio…
Concentrating in two business segments
About 29% of Olin's sales come from an iconic American brand name: Winchester, the company's ammunition business for the consumer sporting, law enforcement and military markets.
Revenue for this segment improved 4% in 2011 to $568 million in relation to 2010. For 2012, consumer-sporting demand is expected to soften, however, military and law enforcement, which represent 30% of the ammunition segment, should remain strong.
But the real strength is Olin's chemical business. The domestic economy is growing, albeit slowly, and demand for the company's core products -- mainly caustic soda and chlorine -- is rising, thanks to increased industrial production.
Meanwhile, Olin's internal metrics position the firm for financial success. Return on equity is impressive at 26%, while the dividend payout is an extremely comfortable 27% of earnings. Better yet, 2011 free cash flow more than doubled to $4.22 per share from $1.90 per share in the previous year -- enough to support the current dividend of $0.80 per share. In addition, the board of directors has authorized a three-year share repurchase program of up to 5 million shares, which should lend support to the stock in the event of a downturn in business.
Risks to Consider: One of the biggest risks to Olin's business is an anticipated slowdown in the ammunition business. But as previously I discussed, the law enforcement and military business should perform better than the consumer sporting segment. Overall, Winchester sales are expected to be flat or slightly down in 2012. Luckily this will be offset by anticipated lower manufacturing costs.
Another consideration is the company's ability to maintain pricing power for the chemical business. While demand for Olin's core product line is expected to rise, a slowing economy would affect its ability to command a premium. Higher input costs and unplanned production outages are also unfavorable factors. I think, however, the company will maintain a tight grip on its financials, which should help it play defense if need be.
As I said before, shares trade near $21, with a forward price-to-earnings ratio of about 11 (based on projected 2012 earnings). Based on the company's strong financials and demand for its core products, a 12-month price target of $27 is justified. This assumes only a 20% multiple expansion to roughly 14 times projected 2012 earnings. With the 3.7% dividend yield, that's a total return of 30% - not bad for a stock with such a stable business model.
Disclosure: Adam Fischbaum does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.