I recently finished reading the book "You Can Be A Stock Market Genius," and while it suffers from an unfortunate title that makes it sound like it might have been written by Jordan Belfort of "The Wolf Of Wall Street" fame rather than by noted value investor Joel Greenblatt of the wildly successful hedge fund Gotham Capital, it does offer solid advice on how to benefit from unusual situations that can unlock value, most notably spin-offs and mergers.
I recently uncovered a company that happens to meet both these criteria, and while the spin-off and merger was completed a while ago, temporary events have depressed the value of the resulting company and prevented it from capitalizing on the cost saving synergies that were envisioned when the company was assembled.
Axiall Corporation (NYSE:AXLL) is a chemical company that was formed through the spin-off of the Commodity Chemicals Business of PPG Industries (NYSE:PPG), which then merged with the Georgia Gulf company. This tie-up created a diversified chemical company with $5 billion in annual sales, with the scale to smooth their cyclical business results and achieve better free cash flow with reduced financial leverage.
However, like early in most marriages, there have been some speed bumps on the way to wedded bliss. On the most recent conference call, Paul Carrico, the CEO, succinctly outlined some of the obstacles that affected the company in the first quarter as follows:
"As we previously outlined, the quarter was impacted by severe weather in a number of ways. First, the sharp spike in the natural gas price increased our cost by about $24 million. Second, storms slowed rail and barge traffic, and this reduced sales in the quarter and increased supply chain cost. Third, the cold temperatures at our Gulf Coast facilities negatively impacted operating rates. And finally, we believe the severe weather slow[ed] the seasonal sales ramp-up in Building Products."
Wow, other than that, Ms. Lincoln, how was the play? Adding insult to injury, one of Axiall's plants sustained some damage in a fire late last year, and the subsequent shut down spilled over into this last quarter. Luckily there were no actual injuries, but talk about running hot and cold.
The aforementioned outage at the PHH VCM (vinyl chloride monomer, used to make vinyl resin, a type of plastic used in vinyl pipes and siding) facility cost them $27 million in first quarter adjusted EBITDA, bringing their total down to $67.6 million, which was compounded by the other headwinds and came in at only half of the $133.4 million they were able to achieve in the same quarter last year. However, many of these issues may prove temporary, since the Mr. Carrico goes on to mention some possible relief from the rough winter:
"As we have entered this current quarter, we are seeing some relief from these headwinds. First, PHH has resumed operation, and we expect to be back to full rates later this quarter. Natural gas costs have come off the recent peaks, and PVC price increases announced for January, February and March have been implemented. We expect a meaningful expansion of vinyl margins in the second quarter to partially offset the lower ECU values compared to last year. Additionally, our Building Products segment is seeing the seasonal increase in sales volume that typically occurs during the second quarter. And we expect results in this division to reflect that increase."
Once some of these pressures abate, Axiall should be able to return to the better operating results shareholders are accustomed to. This could also be enhanced by the continued cost saving synergies that were anticipated when the merger was consummated. Axiall's CEO states that some of these are beginning to be realized, including "$22 million of these cost-based synergies" in the first quarter, as well as a longer-term run rate total synergy target of $140 million for the year, and they "are confident we will meet this target."
With these cost savings beginning to kick in and business likely to improve over the dismal first quarter results, the company should be able to get back on track later this year. While second quarter results are expected to be better than this quarter, they are still supposed to be below the robust results of last year, when the company earned $197.9 million of adjusted EBITDA.
Obviously these shortfalls are well below what management envisioned when they combined the companies, since they were targeting EBITDA north of $850 million in the typical mid-cycle business environment. Even if business improves in the latter half of the year, results will probably be more in line with the reduced profitability more reminiscent of the trough of the cycle.
However, these downturns often prove to be the best time to buy cyclical companies like Axiall, even though the Enterprise Value to EBITDA ratio of the company might appear temporarily elevated during these down times. While I share Warren Buffett and Charlie Munger's tendency to dismiss EBITDA as "earnings before everything," it is often how these types of industrial companies are valued.
Still, at about 13 times EV/EBITDA even using just half of last year's likely better numbers, this is still roughly in line with other similar companies, such as PPG at an 11.5 EV/EBITDA ratio, Dow Chemical (DOW) at 9.9, and Dupont (DD) at 11.7 times. If Axiall can indeed turn things around and manage to approach even last year's results, much less the $850 million adjusted EBITDA target, which the CEO still recently said they "should be able to achieve under normal conditions," the company would appear to be significantly undervalued compared to the competition.
If the company is able to eventually achieve the EBITDA target once the initial growing pains, exacerbated by temporarily harsh operating conditions, subside and the combined business begins to run in the manner they expect, results should continue to improve and the stock would be rewarded with a likely higher multiple. With $850 million in EBITDA at even a below market multiple of 8 times EV/EBITDA, Axiall has the potential to command a $5 billion plus market cap after adjusting for debt.
This would be almost 80% higher than the level where the stock is trading now. While I'm not suggesting this type of return is possible right away, it suggests the company is likely trading at a significant discount to their intrinsic value, especially if things improve from the most recent rough patch and begin to resemble the vertically integrated yet diversified powerhouse the company has the potential to be.
Disclosure: I am long DOW. 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.