Still Waiting For A Better Entry Point On Innospec

| About: Innospec Inc. (IOSP)
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Innospec is serious about building its energy chemicals business, a market potentially worth four times (or more) as much as its core fuel additives business.

The company's TEL business should be nearing its end.

A high-quality, small-cap chemicals company, Innospec's valuation already bakes in pretty healthy growth prospects.

When you find a chemicals company that can routinely post double-digit returns on assets and invested capital, it's worth paying attention. Likewise, not many $1 billion companies can get meaningful share in markets when competing against behemoths like the chemical operations of Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), or Berkshire Hathaway's (NYSE:BRK.A) Lubrizol. Now, with Innospec (NASDAQ:IOSP) making it clear that growing its oilfield chemicals business is a priority, I'd say the story is getting better.

Valuation still remains an issue. I've liked Innospec as a company for quite some time, but as I observed about six months ago, the valuation was and is fairly demanding. The stock hasn't done much in the interim, and I'm likewise concerned that investors buying today may be facing a wait as the company "grows into" its valuation and as the market expects more moves to build the oilfield operations.

Bachman Services Helps, But More Is Probably Needed

Innospec's history in oilfield chemicals goes back a little while now, but it's not exactly a conventional history. Innospec's oilfield chemical business came about in part because customers like Royal Dutch Shell (NYSE:RDS.A) noticed that the flow improvers, surfactants, detergents, and corrosion inhibitors that Innospec developed for the fuel additive market also work in oil/gas drilling and production settings.

Management has been addressing the oilfield opportunity more directly, but the company is still a pretty small player in the space. The oilfield chemicals market is likely about four times the size of the fuel additives market (around $10 billion), but Ecolab (NYSE:ECL) and Baker Hughes (BHI) already have significant positions, with market shares in the neighborhood of 40% and 25%, respectively. The good news for Innospec is that this is a market where significant advances in product performance can outweigh scale and market share.

Even so, scale is important if Innospec wants to establish a seat at the table with Ecolab and Baker Hughes. Innospec announced the acquisition of Bachman Services in November of 2013. Bachman generated about $80 million in annual revenue prior to the deal, and Bachman will expand Innospec's offers with additional products in the drilling, fracking/acidizing, and production categories. This move takes Innospec a little further down the road to being a one-stop shop. Even so, keep in mind that Ecolab will likely generate more revenue in its Nalco Champion energy chemicals business in one quarter than Innospec will generate company-wide in an entire year.

Octane Additives Is Going Away

Innospec should be getting close to the end of the road for its octane additives business, a nicer-sounding name for tetraethyl lead (or TEL) that is additive to gasoline (the "leaded gasoline" of yesteryear in most developed countries). There is little disagreement that TEL is bad news, both for the environment and human beings (it can harm the nervous system and brain development), and most of the world has banned it.

Innospec still sells it in a few places like Algeria and Iraq, and it generates pretty attractive gross margins - nearly 40% in the fourth quarter, versus a company-wide gross margin of 31%. Even though Innospec has come under criticism for continuing to sell it (mostly from the British press) and the company has been involved in kickback scandals tied to this business, it is likely going away in 2014 or 2015. I'm pleased that TEL is going away, but that still represents several million dollars of profits that have to be replaced elsewhere in the business.

Fuel Additives And Performance Chemicals Still Important

Innospec's growing oilfield chemicals business is probably the biggest incremental growth opportunity for the company, but its core fuel additives and performance chemicals businesses are going to remain the strength of the business for some time yet.

Innospec has an estimated 20% to 25% share in the fuel additives market, despite competing with Lubrizol and the chemical operations of Chevron and Exxon, and this is likely to remain a business with relatively consistent (albeit not strong) growth. As refineries in Asia continue to produce more diesel and gasoline to serve local demand, Innospec should stand to benefit.

Performance Chemicals is also a growth opportunity. Revenue was up 5% on an organic basis in the fourth quarter, and though the company competes with larger chemical companies like Lubrizol and BASF, underlying market growth is being fueled by growing global growth in personal care products like shampoos and antiperspirants.

Good Growth Potential, But That's The Expectation

With fuel demand in China likely to grow around 4% a year for at least the next decade, and global growth in personal care products likely to be at least in the 2% to 3% range, I'm not too worried about my top line growth estimate of 5% to 6% for Innospec. Certainly, there will be threats from the actions of competitors, including the entry of emerging market chemical companies that have thus far focused more on primary and secondary chemicals, but I also expect Innospec to continue developing new value-added products and expanding opportunities like the energy business.

On the margin side, I look for upgrading the portfolio over time and better capacity utilization to lead to FCF margins moving from a long-term average of around 6% to 9%. That would fuel free cash flow growth of around 12%, but it is also a risk - it's not easy to improve margins or FCF in competitive industries like chemicals. Then again, it's also not easy to generate double-digit returns on capital, and Innopsec has managed that for four years running.

The Bottom Line

Discounting those cash flows back, I arrive at a fair value in the low-to-mid $40s - below today's price. EV/EBITDA is not much better, as a 9x multiple to 2014 EBITDA estimates leads to a price target of $47, and 9x strikes me as a pretty healthy multiple for a specialty chemicals company. All things considered, Innospec still looks like what I thought it was six months ago - a solid small-cap specialty chemicals company with good growth prospects, but a valuation that already seems to factor those prospects into the price.

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.