Innospec (IOSP) is a business that has been on my radar for a while. The company recently released its quarterly results and announced a fairly large acquisition at the same time, sufficient reasons to revisit the investment thesis.
There are a lot of moving parts to Innospec. Besides the announced deal, Innospec will lose fat profits from its octane additives business as the oilfield service unit is posting depressing results as well. Given the good track record and other qualities, I like the business, although I am patiently waiting for shares to fall below the $50 handle.
Innospec is a chemical business split up across three segments - actually four, following the latest reporting changes.
The company is active in fuel specialties, performance chemicals, and octane additives. The reporting of segment results has changed lately as the fuel specialties results are split out, with oilfield service revenues now reported separately.
The fuel specialties segment is by far the largest segment, generating roughly 75% of the $1 billion in annual sales in 2015. Note that this figure, at the time, included the oilfield service business. With operating margins of nearly 14%, before the allocation of $38 million in corporate costs, it is a major profit driver. Innospec is a market leader in these products, which include detergents, cold flow and conductivity improvers as well as frac fluids, among others.
The performance chemical business posted sales of nearly $200 million in 2015, accompanied by margins of 12%. The company is just a very small player creating silicones among others for skin and hair care brands. These chemicals have the potential to reduce irritations and create luxurious foams. Brands like Nivea and Dove are among those using inputs from Innospec.
The octane additives business posted sales of merely $59 million in 2015 but did report operating profits of $25 million. This segment will be phased out with no customer orders being committed going forwards into 2017.
All in all, Innospec posted sales of $1.01 billion in 2015 accompanied by "clean" operating earnings of $114 million.
A Great Growth Story Making Another Deal
Innospec has pretty much grown from a $500 million business in 2006 to $1 billion by 2015. This growth of roughly 7% per year has been achieved while the outstanding share base has been flat. The company made a few smaller deals in the period 2012-2014, at a cumulative cost of roughly $250 million.
This growth gets another major boost as Innospec announced the purchase of the European personal care and home care business of Huntsman (NYSE:HUN). Innospec values the business, with manufacturing locations throughout Europe, at $225 million.
That is equivalent to 1 times annual sales of $230 million and nearly 10 times EBITDA of $24 million. With this deal the performance chemical business will double overnight, reducing the reliance on fuel specialties. The improved market positioning will undoubtedly lead to unspecified synergies as well.
The Pro-Forma Picture
Innospec reported a 6% decline in second quarter sales which came in at $228 million. This decline can be explained by a 35% fall in oilfield service revenues which came in at $46 million, as sales would otherwise have been up substantially. This is certainly the case as the divested Aroma business contributed nearly $12 million in quarterly sales last year. Operating profits fell from roughly $31 million to $26 million, in part as a result of $1.6 million loss in the oilfield service segment.
If we extrapolate the current trends, full year sales might come in at around $900 million. Operating profits might come in at roughly $100 million as EBITDA should come in at about $160 million.
Continued cash flow generation resulted in net cash holdings of $153 million by the end of the second quarter. Debt stood at a similar amount, although there are other liabilities as well. Including plant closure costs (some are coming up), earn outs, pension liabilities and lease obligations, debt stands at roughly $220 million. Fortunately, pension assets stand at $60 million suggesting that it is fair to say that net debt is close to zero. The $225 million deal in Europe will increase net debt to a similar amount as the EBITDA contribution should boost pro-forma EBITDA to roughly $185 million. That results in a modest 1.2 times leverage ratio.
The pro-forma business is on track to post sales of roughly $1.1 billion, EBITDA of $185 million and operating earnings of around $125 million. If we assume $10 million in interest costs on the net leverage, and apply a 25% tax rate, we end up with profits of $86 million. With merely 25 million shares outstanding that amounts to $3.50 a share, for a mere 14-15 times earnings multiple.
Where Is The Catch?
A company which reports stable margins, has doubled revenues per share over the past decade, uses little over 1 times leverage, and trades at a non-demanding 15 times multiple looks almost to good to be true. This is certainly the case as the oilfield business is in turmoil, creating a $25-30 million headwind in terms of operating profit contribution versus last year.
The issue is that octane additives have seen their last shipment as this business will end. Given that the business contributed $25 million to 2015s operating earnings, and another $20 million in the first half of 2016, this will be a major blow to the overall business.
On the conference call, Innospec confirmed that the Huntsman deal will add roughly $10 million to earnings after funding costs, and that is significant at $0.40 per share.
So there are a lot of moving parts in here. I assume full year operating profits of $100 million for fuel specialties, $20 million from performance materials, a negative $10 million contribution from oilfield services, no longer any contribution from additives going forwards, and $20 million contribution from the acquired Huntsman assets. If this assumption is correct segment earnings come in around $130 million going forwards.
After applying $45 million in corporate cost allocations, operating profits would come in at $85 million. With interest costs seen at $10 million, and effective tax rates around 25%, net earnings come in at $56 million, or $2.30 per share.
If however oilfield turns around and starts to report profits of $10 million going forwards, while synergies can be achieved in Europe, operating profits might improve towards $110 million. That results in potential after-tax profits of $75 million, equivalent to $3 per share.
You get the point. In the worst case scenario in which oilfield does not improve, Innospec trades at 22 times earnings. If however the situation turns around and some synergies are achieved in Europe, the multiple quickly drops towards 17 times.
I like the business of Innospec. Headline earnings results are inflated as a result of the additives business which posts record profits before being dismantled. The good news is that Innospec made a solid acquisition from a strategic and financial point of view, representing roughly 20% of the current enterprise valuation.
While this deal is nice, it can not offset the headwinds in terms of the huge profits reported by the small additives segment, as a turnaround in the oilfield business is needed in order to create real appeal. With shares now trading towards the high end of the $35-55 range over the past years, I would not chase the stock at these levels.
A market multiple on potential earnings of $2.30 to $3.00 per share of 17 times earnings suggests fair value at $39-$51. As a result, I would start to buy if shares re-test levels in the mid-forties and get more aggressive on dips from those levels.
Disclosure: I/we 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.