Searching For Value: Could The New Olin Be Through Its Cycle Low Multiples Already?
Summary
- Construction related stocks have been trading down all year, and Olin has been dragged down with them.
- Olin Corporation made a transformational acquisition in 2015 purchasing Dow Chemical's Chlor-Alkali assets. Making Olin the largest domestic producer.
- The acquisition also added downstream exposure, and reduced Olin's total exposure to merchant Chlorine/Caustic Soda pricing in terms of EBITDA.
- Will the New Olin produce shallower troughs In EBITDA through the cycle going forward?
- New Olin might warrant higher multiples due to lower volatility in returns. Current valuation might suggest the New Olin is already trading through the bottom of its appropriate valuation range.
Introduction:
This will sound like a strange introduction to a Buy recommendation, but the company in question: Olin Corporation (NYSE:OLN), is not the greatest company in the world. It's a decent to good business, and historically it is very cyclical. I don't think this is a Buy-and-hold forever type of stock. However, it made a transformational deal with the now DowDupont Inc. (DWDP), back in 2015, that made OLN into the largest domestic producer of Chlor-Alkali products in the industry. It also expanded its downstream products in the process, which reduced its total exposure to merchant pricing on the output of its primary products: Chlorine and Caustic Soda. The million dollar question we'd like an answer to: is does this mean that the new OLN's EBITDA and earnings will be less volatile, impacted less through the business cycle, than they were in the past? Spoiler alert, I don't know with certainty. However, there are reasons to suspect this may be the case, and clearly management believes so as well. If that's an accurate view, then there's a case to be made that OLN's stock has already sunk too far, and going forward it's valuation floor should be higher than what the stock has historically done. Essentially, this is an expensive market, and OLN's stock might make for the rare compelling case on a true valuation basis.
Company Background:
OLN is a commodity chemicals company. There is no case to be made here that it should warrant a specialty chemicals multiple etc... In fact, the new iteration is essentially a reflection of Dow's desire to get a higher multiple and shed as much of its commodity exposure as possible. Having said that, its business is more complicated than one might expect. There are multiple products, with multiple end uses and different sources of customer demands. The important input costs for production can be distilled mostly down to Natural Gas pricing and their cost of electricity. A lot of these variables tend to move counter to one another. Hence, making fundamental calls can be difficult to predict over longer time horizons. I could write all day trying to describe every variance, and put you to sleep in the process. Instead I'm going to focus on what I think are the key issues to my thesis, and strongly encourage anyone interested to dig in further to understand this business first on there own. Here's a link to their most recent presentation that should provide a good place to start.
Source: 9/12/2018, "Olin to Attend the Credit Suisse Basic Materials Conference", P.3
There are three segments that comprise OLN's business, but as you can see from the snapshot above, the Chlor-Alkali segment produces the vast majority of EBITDA. Subsequently, I'm going to focus on this segment in this review. Below is an outlay of the Chlor-Alkali process including inputs and primary outputs.
Source: 9/12/2018, "Olin to Attend the Credit Suisse Basic Materials Conference", P.18
I refer to this acquisition as transformational, because in simple terms it made OLN the worlds top independent producer. It's still a commodity chemical industry in terms of global production and pricing power, but OLN is now the biggest pure play on the business.
Source: 3/27/2015, "Combination of the Dow Chemical Company's", P.12
For a much deeper dive into the chemical processes, and chemistry of the Chlor-Alkali process, I can point you here for a good overview. For our purposes, I just want to highlight that it produces Chlorine and Caustic Soda at about a 1:1.1 rate. The primary source of demand for Chlorine now is PolyVinyl Chloride pipe, or [PVC] for short. This is why OLN's stock tends to move with the construction related businesses as a whole.
Chlorine has a fairly elastic source of demand driven by the construction cycle and demand for PVC pipe. Caustic Soda, on the other hand, has a more diverse demand profile that tends to be less elastic.
This is one of the interesting dynamics of the Chlor-Alkali business. The demand drivers for Chlorine drive the production of both Chlorine and Caustic Soda. Usually in high Chlorine demand periods, the production of Caustic Soda exceeds the more inelastic demand and prices decline for the latter. It's vice-a-versa when Chlorine demand declines. This acts as a bit of a buffer for the highly cyclical nature of the Chlor-Alkali business.
Current Market Outlook:
OLN's stock tends to track the outlook for Chlorine prices, and since Chlorine demand is driven mostly by PVC pipe for construction, it thereby tends to follow the outlook for home construction as a whole. Clearly the forecast for residential construction has been down in 2018, and the group as a whole has followed suit.
US Existing Home Sales data by YCharts
Whether we look at actual home sales, or the median home price, the trend has been down this year.
Since stocks are forecasting securities, the construction related equities have been littering the new low list all year long. OLN's closest peer is Westlake Chemical Corporation (WLK), and its stock too has been hammered this year.
Source: Fidelity Active Trader Pro: WLK in Yellow, OLN in Blue, ITB in Year-to-date chart.
Clearly, the market is discounting the future assuming a material decline in earnings and cash flows going forward. Normally, trying to catch an anvil isn't the best strategy once the market moves in this direction. However, there are reasons to suspect that the degree in volatility of OLN's earnings and cash flows should be less than historically experienced.
Mercury based production of Chlor-Alkali has been banned in Europe, and almost completely abandoned in the United States. This has reduced global capacity in the industry, as some plants decided to close permanently instead of paying to modernize to a mercury-free based form of production.
Source: 9/12/2018, "Olin to Attend the Credit Suisse Basic Materials Conference", P.6
The result is that the next down cycle in Chlorine, that the market is now forecasting, may lead to an even stronger cycle for Caustic Soda than normal. Recall that Caustic Soda's demand is less elastic than Chlorine. Normally, when Chlorine production declines, the price of Caustic Soda rises as the two are produced in concert. This time the market has already been strong on pricing due in large part to the recent reductions in capacity. This could be a good reason to expect a higher than usual trough in OLN's cycle-low earnings.
New Olin's New Attributes:
Another reason to suspect a higher low for the New Olin's cycle earnings power, is due to the changes in OLN's business products due to the acquisition of Dow's segment. Specifically, OLN now has significantly more downstream products it produces than before.
Source: 9/12/2018, "Olin to Attend the Credit Suisse Basic Materials Conference", P.19
The above is how management describes it. Theoretically, there are 14 more end uses for their production than before the acquisition. This should provide some value added in terms of margin. Another way management expresses this is the following:
Source: 9/28/2015, "Olin and DCP Merger Update", P.8
Revenue exposed purely to Merchant Pricing of Chlorine or Caustic Soda, has declined from 40% to 20% of total for New Olin. We don't know in practice to what degree this will help mitigate declines during the down cycle. The reason why I'm not sure, is because we don't have pure comparables between Dow's Chlor-Alkali segment and Old Olin. The best view we may have into this question comes from the S-4 released after the announcement of the deal in 2015.
Source:(figures in millions)
Looking at just OLN's Chlor-Alkali segment, and the data from the S-4 for Dow's Chlorine business, we can get a hint of what the degree of volatility may be in Dow's assets relative to OLN's. Unfortunately, there wasn't a good comparison based on cash flows or earnings. Hence, looking at revenue is the best we can do here. Focusing on those last three years, may suggest there is some counter cyclicality to Olin's legacy business from the addition of the Dow's assets. Although 2013 suggests it might have exacerbated the down turn. Overall, I can't get comfortable making a definitive statement from the data we can see through SEC filings alone on this matter, but at least the magnitude of the swings appear more muted for the Dow assets, than they did for legacy Olin during this period.
Source: 9/28/2015, "Olin and DCP Merger Update", P.5
The next reason to believe that the New Olin could have a shallower cycle-low, is presented by management's overall view of the combination. Dow's assets were part of an integrated business. When they sold them to Olin, some things were going to have to change to reflect public market returns. Some of that was reflected in new contracts, and some of that essentially was born by Dow going forward, but another key aspect is the classic reduced cost through synergies. At least in this case, it is more reasonable to assume this level of consolidation into the largest domestic manufacturer, could indeed lead to great enough economies of scale, to effectively produce synergies in the range management has envisioned.
As of last quarter, management had raised their guidance for 2018 EBITDA to 1.3 Billion. They also stated they expect the New Olin Mid-Cycle EBITDA to be about 1.5 Billion. That's been a floating target, and their latest thought is they could get there by 2019-2020 time frame. However, in this case I'm interested in trying to figure out what the trough EBITDA might be. While I haven't seen them state a specific number, I think we could potentially find an answer from this exchange from the Q2 '18 conference call:
Karl Blunden - Goldman Sachs & Co. LLC
Got you. That's helpful. So, part of it is you and then part of it is an expectation on market pricing holding up. Just on the capital structure here, you've announced a $300 million debt reduction target, what's the rationale for that? Is that tied in some way to the cash flow expectations you have for the business? Is it maybe more precision on where you want debt to be through the cycle? Any thoughts around that, from Todd, perhaps? It'd be very helpful.
John E. Fischer - Olin Corp.
This is John. We have a debt target that is based on what do we think the trough EBITDA in this business will be. Because, as you know, it's a highly cyclical business, when the cycle turns, it turns and I'm not forecasting a turn to the negative cycle here. But that's what we are targeting, a specific debt level based upon what we think we can earn in a trough. And that would be our objective.
Todd A. Slater - Olin Corp.
And Karl, what we've said is that by the time you get to the $1.5 billion range of EBITDA, we'll have net debt to EBITDA under 2 times. And doing that math, you need to repay approximately $700 million of debt from where we ended 2017. So, approximately $300 million and a minimum is coming out this year.
Source: (Italics added)
Here's the math: If debt needs to be under 2x at 1.5 Billion EBITDA, then we're talking about targeting debt around 2.85 Billion to get to 1.9x debt-to-ebitda. What might that suggest for what they think the trough EBITDA should be? I'm guessing that they would want to keep their debt-to-ebitda multiple below 3x at the trough. That would suggest around a 950 million figure for EBITDA at the trough of the cycle. To be clear, these are my estimations. Looking over legacy OLN's historical EBITDA performance, you can see their EBITDA often moved between about 120-360 million, with 240 million being our mid-cycle. That's about a 50% decline from mid to trough. New Olin's mid-cycle of 1.5 Bil to 950 million trough, is about a (36%) decline. It sounds like we're in the ballpark, and that would suggest a significant reduction in volatility of cash flows if it proves accurate.
OLN EBITDA (Annual) data by YCharts
Valuation:
My primary interest though in OLN right now is pure and simple: I think the valuation suggests it's time to pay attention. If we look at the stock on an EPS basis, it's not screaming that the New Olin is a stock to watch. Estimates are expected higher, but within the old top of the range they've accomplished in the past.
OLN Normalized Diluted EPS (Annual) data by YCharts
My interest starts in OLN's historical valuation ranges. When looking at companies that are cyclical in nature, it is always important to consider the different metrics one uses. Specifically, just using earnings based metrics will always get you into trouble at the start of a down cycle. That's why I like to use as many non-earnings based metrics as possible in these cases. First, let's look at Price to Book Value:
OLN Price to Book Value data by YCharts
Normally I prefer to use Tangible Book Value, but the acquisition of Dow's assets created a lot of Intangibles that skewed the metric. That might be reason enough to discount this view, but at least it does suggest we're in the neighborhood on this basis. It did get down to 1x BV in 2016, but even in 2008-2009 a 1.2x multiple was more the normal bottom.
OLN PS Ratio (NYSE:TTM) data by YCharts
If the intangibles on the balance sheet have you concerned about using Price to Book Value, then Price to Sales might be the better metric to use as a yardstick. This .50x on a trailing basis, has been a very solid bottom end of the range over many decades, and we're here now. I consider these two my favorite non-earnings based metrics for long-term valuation ranges, and thereby I weigh them higher than the rest we're about to look at. Still, what does OLN look like on a trailing basis by cash flow valuation metrics?
OLN EV to EBITDA (TTM) data by YCharts
Historical OLN has tended to bottom out around 5x EV/EBITDA. That's about where the guidance currently is for 2018. It has dipped lower from time to time, but again so far even this cash flow metric is saying we're in the zone.
OLN Price to Free Cash Flow (TTM) data by YCharts
Price to Free Cash Flow metrics are tricky for timing purposes, since there are a lot of variables that figure into this equation. However, OLN is a significant free cash flow generator, and it's an important reason for my interest in the company to begin with. This too suggests that based on recent performance, this is a low ratio for the stock to be trading.
We have a series of valuation metrics that suggest OLN's stock is either at the bottom of its historical range, or in the zone of a bottom. However, part of this thesis is that the New Olin should maybe have a higher range in terms of valuation, due to it theoretically having less volatility in its returns.
DWDP EV to EBITDA (TTM) data by YCharts
DWDP EV to EBITDA (TTM) data by YCharts
If we look at the past EV/EBITDA ranges for Dow and Olin over a couple of previous cycles, we certainly can see that generally Dow did trade with a bit of a premium to OLN. Unfortunately, Dow was also a significantly larger capitalization stock in the market, which tends to lead to some form of premium over smaller companies. Of course, Dow was also a significantly more diversified company business wise as well. On the surface, it's hard to draw any decisive conclusions. Nevertheless, I still believe that if the New Olin's returns are less volatile as management believes, then it should be rewarded with a higher multiple than it has in the past. Thus, if it's trading at the bottom of its valuation ranges currently, then I don't think it's a stretch to argue that it's probably gone too far down already.
Risks:
This is a case where the market already knows the forward numbers are coming down. The stock is trading at 7-8x PE multiple for next year. We could see OLN miss or guide down numbers from here, and yet watch the stock trade higher. In other words, lower and slower is already being discounted to some degree. That doesn't mean there isn't a potential downside. I've already made the argument that we're pretty much at the bottom of the ranges on a number of key valuation metrics, but how much worse could it get?
OLN Price to Book Value data by YCharts
At the bottom of the '15-'16 growth scare decline in the market, OLN did actually trade just under its book value. That would suggest the stock could trade down into the $16's again if that were to repeat. However, historically it didn't usually trade down to 1x book value, and I would argue that in January of 2016 you had an unusual dynamic. The deal with Dow had been completed in early October of 2015, and subsequently shares in OLN were distributed to Dow shareholders. This likely lead to increased pressure from weak hands in a declining market in OLN's stock.
OLN did use leverage to complete this acquisition with Dow, and while paying off that debt is a primary goal for the company in the near term, it's still a risk as it looks like the cycle is turning down now. Obviously, this will restrict their ability to reduce the debt going forward as cash flows decline. Right now, net debt is just over 3 Billion. If we're right about the trough EBITDA level of New Olin, then that would suggest a Net Debt to EBITDA level of something just over 3x. That's not bad on a trough basis. The risk though is if I'm wrong about the trough EBITDA. A multiple over 4x would imply trough EBITDA just under 800 million currently. The most recent amendment to their credit agreement in March of 2017, lays out a schedule for a declining Leverage Ratio. At 3.75:1.00 by the end of 2019, that would suggest we need to pay attention to that trough EBITDA figure getting down to 800 million, or to the degree by which they're able to retire debt.
Source: P.5
Due to some good decisions around swapping floating rate to fixed rate debt in 2016, OLN currently has only 20% of their total exposure to the current rising rate environment.
We have approximately 20% of our debt at variable interest rates, after the debt refinancing that we completed in January. We are forecasting 2018 interest rates to be higher than those we experienced in 2017. We are forecasting to generate $500 million of free cash flow in 2018. We are targeting a minimum debt reduction of approximately $300 million this year, while paying our normal quarterly dividend totaling approximately $134 million.
Source: Q2 Conference Call
Debt maturation isn't a near term concern, as the first primary issue is the Credit Facility which was recently extended to March of 2022. After that, there's 720 million of a 9.75% note due in 2023.
While leverage should be the primary concern with this stock risk wise, one last thing to remember is that working capital should provide excess free cash flow in a down turn. Hence, while a declining EBITDA figure should be the primary concern, a reduction in working capital would also help alleviate their debt burden at the same time. Thus, this is something to monitor, but I'm not overly concerned at this point with OLN's ability to reduce their debt burden.
Conclusion:
What we have here is a stock, with a significant change in its competitive positioning in the market place, after a transformational acquisition with its largest domestic competitor. It's trading on the bottom of its valuation ranges, and we have a few reasons why we can suspect this next down cycle should actually be less severe than historically: reduced industry capacity from mercury plant closures, more end-use products from Dow merger, less merchant pricing exposure, merger related contracts and deals plus synergies. Its been dragged down with the markets discounting for everything construction related, but the market seems to be missing that this iteration of OLN should be different this time in the down cycle. It looks to me like the market may have already gone too far.
What should the New Olin's EV/EBITDA multiple range be: 5x-10x, 6x-12x? If we used our assumed New Olin EBITDA trough figure of 950 million, then OLN's stock at $20.15 would be trading at a 7.1x multiple. If we look out to 2020 and assume management is correct in reaching a mid-cycle 1.5 Billion in EBITDA, and use a 7.5x mid-cycle multiple with their targeted amount of debt at 2.85 billion, then we're going to have a stock trading at about $50. I don't know what the odds are of all of that occurring. The market obviously is saying it thinks the cycle is turning down. Still, if it's right, then the stock looks like it's already discounting it. A stock that may have very limited downside on a valuation basis, and the ability to more than double in two years on a mid-cycle thesis, has to get some attention from value investors in this environment.
I'm going to end with a look at OLN using my Adjusted Book Value Growth analysis with Free Cash Flow. For those who would like a refresher on this form of analysis that I use, you can find a section in this past article I wrote that goes into greater detail. The synopsis version is that this is a method I developed that adjusts book value by adding back cash used as a return of capital: dividends and stock repurchases, as well as subtracts for capital raised. In the top right is the Compound Annual Growth Rates of this Adjusted Book Value based on 5, 10, and 15 year time frames. the line below is the theoretical number of years it would take for the company to grow to 1x book value at the given period rates. Below that we have a mean average of Free Cash Flow, defined as Cash Flow From Operations minus Capital Expenditures, over again the same given time periods. Plus, what the stock is currently trading at over those average free cash flow generations. Last, to the left there's a simple sustainability measure for Dividends, dividing it by the free cash flow generated in each given year.
This is what I mean when I say it's a good to decent business trading at a cheap valuation. It's adjusted compound annual growth rates for book value are high single to low double digit rates. I like companies to be firmly in the teens preferably, but when they trade this cheap to book, it still becomes interesting in this range. Also, note how the free cash flow generation has been more consistent in recent years. It's trading at just over 11x its average free cash flow over the last five years. We know that they're targeting debt pay down going forward, so we should expect them to continue to produce free cash in the near term at least. If all of this isn't enough, then I'll mention that the stock currently yields almost 4%, and last quarter they started to use some free cash flow to repurchase stock as well.
I can't confirm or deny the claims for the New Olin's business prospects and cycle EBITDA figures. Time will have to be the final arbiter on that measure. However, at this valuation, it seems to me that the market is giving zero credit to the possibility that this is a better business than historical performance suggests. I think this is a common issue between the market and highly cyclical stocks, and probably why value is often found in these businesses when it's difficult to find in other sectors. With a 4% yield, one might say that we're also getting paid to wait and see. Add in the reasons that we could expect this cycle to be better than normal, and it might be worthwhile to nibble on the long side here despite the carnage in the markets. With that in mind, good luck to all investors out there.
Addendum: Q3 '18 Report.
I originally wrote this article before the Q3 2018 report on 10/29/18, but couldn't get it out in time before they reported. Here's a quick review of what we learned about the New Olin from last quarter.
Olin guided down the total of 2018 EBITDA from 1.3 Billion, to 1.26 Billion. This estimate is a reduction that includes the outlook from about August through December. Clearly, the market was forecasting this.
Olin settled disputes with certain companies over environmental remediation sites. That returned 88.5 million post legal fees to OLN, and allowed them to pay down more debt not reflected on the Q3 end balance sheet. Subsequently, OLN management stated that they expect to be more balanced between debt reduction and capital returned to shareholders for free cash use in the fourth quarter. Since the dividend has been maintained at the same level, this would suggest management will bump up their stock buyback activity at the end of this year.
Management surprisingly expects Chlorine pricing to remain strong, and it's expected to offset weakness in Caustic Soda Export pricing. Alumina is one of the larger sources of demand for Caustic Soda, and one large producer in Brazil has had a force majeure event cutting their production in half this year.
Source: 10/30/2018, "Olin Corporation Third Quarter Earnings Conference Call", P.5
Source: 10/30/2018, "Olin Corporation Third Quarter Earnings Conference Call", P.9
OLN was essentially asked what they thought their trough EBITDA is now, but management didn't give a specific figure as an answer. Instead, they admitted that the 1.5 Billion figure for EBITDA shouldn't be considered a mid-cycle estimate anymore. However, that's because they're arguing that the industry is entering a structural change, not a cyclical one. Essentially they argue that over the next two years they expect Caustic Soda and Chlorine demand to grow at compound annual rates of 3% and 2% respectively. At the same time there hasn't been enough capacity announced to meet those rates of growth. Thus, the global industry is moving to operate at higher rates of utilization than historically produced. This should also reduce the volatility in the cycle swings going forward.
This is great for the thesis I'm suggesting, however, the market clearly isn't buying OLN's story. Post the report, the stock traded down, then up a few percent, followed by another decline down over (5%). Clearly, the market is rejecting management's story, and OLN is going to have to be a Show-Me stock. Management's confidence in higher Chlorine prices in the face of the construction slow down, is likely the primary dispute with the market. To be honest, I'm a bit surprised at the magnitude of the decline post the conference call. Nothing materially changed because of the report. Management is arguing that the forward outlook is still generally higher, and the market disagrees. If management is close to correct at this point, then the stock could be materially better than what I've argued in this article earlier. Structural changes to commodity industries don't happen very often. The Container Paper Packaging industry may be the last one I know of that's applicable in the materials sector. We don't need that as an outcome to make this a good value proposition. Quarter end book value increased to $17.43 per share thanks to returns and the settlement. If that's a viable valuation floor at 1x, then we're less than 10% away from the worst case return.
OLN PS Ratio (TTM) data by YCharts
The stock is already lower than the January 2016 low on a Price to Sales basis using forward estimates of revenue. Value propositions usually require a strong stomach on some level. You don't get to buy great companies, with management everybody loves, in industries that are going to take over the world, at these levels of valuations. The difference here is we're in the zone for worst case valuation support already. The company is actually making good money right now, but the market doesn't want to believe it will hold up. If management's view is correct, then I might have to take back my opening statement about OLN not being a Buy-and-Hold stock. OLN will have to prove that to me, but at this price I'm willing to find out. I finished this addendum before the availability of the transcript, but I encourage readers to review it while doing your due diligence.
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Disclosure: I am/we are long OLN. 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.