Many specialty chemicals spent the last six months going nowhere fast, OM Group (NYSE:OMG) included. I've been watching this one, wondering if there might be a chance to get shares before the business started to improve on better demand in Europe. I don't think you can say that a recovery in Europe is a fait accompli, particularly in the passenger vehicle industry, but demand for automation, electrical, energy conversion, and alternative energy seems to be picking up. Considering the combination of recovering markets and a clean balance sheet with which to make accretive acquisitions, I like OM Group at these levels.
Skating Where The Puck Will Be
It's worth clarifying that buying OM Group is a play on improving conditions in key markets like Germany, not a play on what has already gone into the books. OM Group's fourth quarter results were better than expected, but underlying core revenue growth was still in the single digits and adjusted EBITDA declined about 20% on a sequential basis.
Even so, I'm bullish on a lot of the core markets that OM Group serves. By virtue of the company's Magnetic Technologies business (aka VAC, which generates about three-quarters of its revenue in Europe), OM Group gets about half of its revenue from Europe.
The sell-side is still skittish on the European auto sector, but companies (and OM Group) clients like Continental AG and BMW seem to be holding their own and European consumer confidence is improving. Auto is a big market for OM Group's magnets business, as the company's products are used in applications like power steering, various auxiliary motors (like water pumps), solenoids and so on.
OM Group is also highly leveraged to an improvement in "general industrial" demand in Europe. OM Group magnets are used by companies like ABB (NYSE:ABB), Siemens (SI), and Schneider for industrial motors, meters, elevators, circuit breakers, and other applications. Wind and solar aren't so meaningful in terms of current sales contributors, but OM Group counts some of the same customers here (ABB and Schneider) and Europe has made a commitment to solar and wind power as a means of weaning off nuclear and coal-fired generation.
One of the challenges with OM Group's magnets business is benchmarking it. For the most part, a lot of OM Group's largest competitors (companies like Hitachi and TDK) have their magnet technology segments buried within other reporting segments, so it's not all that easy to tease out comparable sales, margin, or cash flow data.
Batteries Could Be A Little More Challenging
Even though OM Group's battery business reported double-digit revenue growth for the fourth quarter, I'm not as keen on the near-term growth prospects here. That's really only because defense is more than half of the company's sales base today and while the military may be ordering more drones and other electrified products, I'm not expecting a lot of defense-related growth in the next couple of years. Aerospace is likewise probably not a huge near-term growth opportunity; Orbital Sciences (ORB) has been seeing decent demand for interceptors and is still optimistic about satellites, but I'm not looking for major growth.
Key to the battery business will be expanding into new markets. OM Group is definitely targeting Greatbatch (GB) in the medical battery space, and there are a lot of attractive potential markets like cardiac rhythm management devices, neurostim, ventricular assist, and cochlear implants. Greatbatch has the advantage of long relationships with many of its customers in this space, as well as a history of reliability and a reticence for companies to change what's already working (particularly with already-approved devices). Even so, OM Group believes it has better energy density and can offer better price, performance, and miniaturization. Longer term, OM Group is also targeting markets like energy (oil/gas) and grid storage.
Time To Grow The Specialty Chemicals Business?
I wouldn't be too surprised if OM Group looked to make selective acquisitions to augment its magnet and battery businesses, but the specialty chemical business could be the more likely segment to grow by acquisition. This business is divided mostly between electronic chemicals, where OM Group sells chemicals to PCB and HDD manufacturers, and additives sold to chemical companies for use in paints and coatings.
OM Group had its challenges competing with Dow Chemicals and Albemarle, so I wouldn't expect a deeper dive back into electronic chemicals. Even so, there are a lot of niche specialty chemical markets and companies out there where OM Group could buy a leadership position that also offers some operating synergies with the existing business.
Credible Growth Prospects As Europe Recovers
In the near term, I would like for OM Group to benefit from better results at client companies like Continental AG and ABB, and generate improving sales and margins on a European economic recovery. Looking out a few years more, I would hope OM Group can take those businesses/segments where it is strong in Europe (magnets) and build its presence in U.S. markets. Likewise, I will be watching OM Group's efforts in the battery segment as it tries to elbow its way into growth markets like healthcare.
OM Group also needs to prove it can generate better margins. Management has talked about technology-based differentiation and leadership positions in multiple specialty markets, but if it doesn't show up in the income statement, it's all just talk. I'm currently modeling meaningful improvement, such that OM Group could/should produce high single-digit FCF margins before the next five years are up, and extending down the line.
The Bottom Line
OM Group is a difficult company to classify as it transitions from specialty chemicals to a more mixed set of "technology-driven" products. Whatever it is, I think the shares look interesting today. If OM Group can in fact get FCF margins into the high single digits, just 3% or 4% revenue growth can support a FCF-based fair value in the low $40s. An EV/EBITDA multiple of 8.5x would likewise support a similar conclusion, and 8.5x doesn't seem unreasonable when the largest segment's largest markets are in recovery mode. Investors will clearly be following how the company uses its balance sheet flexibility and whether those green shoots in Europe lead to bigger things, but this looks like an interesting risk/reward opportunity right now.
Disclosure: I am long ABB. 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.