Basic Chemicals company Olin Corporation (OLN), at Monday's closing price of 23.58 is undervalued based on its future earnings capacity, which I estimate at 2.86 per share. Over the years, the Chlor-Alkali chemical business in which Olin operates has been cyclical, with periods of over-capacity; and competitive, yielding uneven profits. However, the industry has been undergoing a period of capacity rationalization, and Olin is well-positioned as a low cost producer with a very strong presence in the bleach market.
Historically, Olin operated in three divisions: Metals (brass), Winchester (ammunition), and Chlor-Alkali chemicals, which involves the production of chlorine and caustic soda by the electrolysis of salt. The metals division generated most of the revenue but operated at very slender margins. In 2007, Olin acquired a chlor-alkali competitor, Pioneer, and sold the metals division. The transactions were of approximately equal value, so they basically swapped out the poorly performing metals division for a profitable, bolt-on acquisition in their chemicals business. I consider this a coup on management's part.
To assess the potential profitability of the combined entity, here are three years pro-forma results, from the 2007 10-K:
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Management states they are on target to realize approximately 45 million of expense savings on the merger, which would add .61 per share. Averaging three years pro-forma EPS from continuing operations and adding the .61 of expense savings and synergies, I get 2.86 as a target going forward. I estimate 2008 EPS at 2.43. Applying a P/E of 13 to the 2.43 yields a target of 32.
In the chlor-alkali process, chlorine and caustic soda are produced in a fixed ratio by the electrolysis of sodium chloride. Production is measured in ECUs, or electrochemical units, consisting of 1 ton of chlorine, 1.13 tons of caustic soda (NaOH), and .03 ton of Hydrogen. Chlorine is widely used in plastics, and is dependent on the housing and automotive markets, among others. Caustic soda is used in the paper industry, and has recently been finding use in scrubbers for coal-fired electrical generating plants. Chlorine is toxic, expensive to transport, and not easily stored. Caustic soda can be stored, subject to space requirements. Because production is on a fixed ratio, while demand varies between the two products, and chlorine cannot be stored easily, pricing is variable. Overall prices are measured as ECU netbacks, meaning the dollars received per ECU.
Here is a recent history of ECU Netbacks:
In the 2Q 10-Q, Olin projects 3Q EPS at $0.65 to $0.70, citing improved ECU netbacks. They go on: “During the three months ended June 30, 2008, we announced four caustic soda price increases that totaled $410 per ton.” Chlorine pricing is expected to weaken into 2009, but ECU netbacks are expected to to improve sequentially. As chlorine demand weakens, it is being compensated by pricing power in caustic soda.
Olin is third in the chlor-alkali market, after Dow Chemical (DOW) and Occidental Petroleum (OXY). OXY's approach to the business: "Manage the chemical segment to provide cash in excess of normal capital expenditures.” DOW is not aggressive in terms of capital expansion, preferring to do joint ventures in a strategy that has been described as “capital light.”
This raises the possibility that capacity will become constrained in the event of increased economic activity. In their presentations, Olin includes a display estimating net capacity reductions of 843,000 short tons of chlorine from 2000 through 2010. Noting that the industry operated at more or less full capacity in 2004, I expect that capacity will be very closely aligned with demand when a recovery in the housing and automotive industries develops.
According to industry data, Olin is the largest north American producer of industrial bleach, which is manufactured using both chlorine and caustic soda. ECU netbacks are generally better when the co-products are sold as bleach. Olin also believes that it is one of the low cost producers in the industry. This information, together with the demonstrated pricing power in caustic soda and capacity rationalization in the industry, suggests strong long term earning capacity.
So far this year, on January 22 OLN hit a low of 15.01, reaching a high of 30.23 on July 30. It has since declined to 23.58, including a sharp drop on September 4. I have been long OLN since last year, accumulating at under 20 and reducing the position at prices above 25. I think the recent dip is connected to rotation out of materials/commodities and does not reflect the company's strong fundamentals.
With that it mind, I will again be adding to my positions, looking toward a target of 32 per share within the next two years.
Disclosure: Author is long shares and calls of OLN