Among specialty chemical companies, Innospec (IOSP) is a relatively low-drama player, with a solid management team that generally does a good job of managing its businesses to the realities of their respective end-markets – maximizing margins in slower-growing businesses, but exploiting growth opportunities where they are available. Innospec doesn’t often get all that cheap apart from broader market/sector pullbacks, but those are good times to reconsider these shares.
Innospec has come off a bit from a recent peak and the shares aren’t all that exciting from a DCF-driven value perspective, though an EV/EBITDA approach offers a little more upside. Capital deployment into growth M&A remains a definite possibility, but I’d prefer to try to pick up shares in the $70’s if possible.
Relatively Healthy Overall Trends
Innospec is barely followed, so performance relative to sell-side expectations isn’t as significant as it would be for other companies. That said, I would argue that Innospec had a basically “okay” first quarter, albeit with plenty of moving parts.
Revenue rose a little less than 8% overall as reported, with gross margin up 130 basis points. Operating income rose 25%, segment profit rose 23%, and adjusted EBITDA rose 18%. Management also announced a 14% increase to the dividend.
By business, the Fuel Specialties business saw good 13% constant currency revenue growth with 8% volume growth and 5% price/mix growth. As a reminder, volume can jump around a lot from quarter to quarter, and the year-ago comp (volume up 1%) was comparatively easy. Gross margin improved almost two points, with segment income up 17% and adjusted EBITDA up 16%. With segment margin above 20%, Fuel Specialties is far and away the most consistently profitable part of Innospec’s business.
Performance Chemicals saw flat revenue, with both volume and price flat. The year-ago comp was tough (vol up 10%, price/mix up 9%), but volume and price have both been pretty “meh” (or at least pretty inconsistent) in recent quarters. Gross margin improved two points, but is still about eight points below the company average. Segment profits improved 12%, while adjusted EBITDA improved 6%, and this remains consistently the second-most profitable business for Innospec, albeit at much lower margins than Fuel Specialties.
In the Oilfield business, revenue rose 23% on a 17% improvement in price/mix and a 6% improvement in volume. That’s an interesting shift from the last two-plus years, where the growth had been driven by strong volume growth on improved drilling and completion activity. Gross margin declined 80bp (still above the company average), with segment income more than doubling and adjusted EBITDA up 70%, but margins still far below the company average.
The Octane business was basically a non-contributor this time around. Management has one auto-related order left to fill and has already been scaling down to service whatever some residual aviation-driven demand will remain.
Ongoing Product Extension Opportunities
One of the major long-term drivers at Innospec has been, and continues to be, the opportunity to repurpose existing capabilities into new markets.
In the case of Fuel Specialties, management continues to target opportunities in the merging low-sulfur diesel marine fuel market ahead of IMO 2020 regulations. At this point, many commercial operators are electing to go with scrubbers from companies like Alfa Laval (OTCPK:ALFVY) or Wartsila (OTCPK:WRTBF), but some operators are using the low-sulfur fuel where it is available.
While low-sulfur fuel is an improvement where emissions and environmental quality are concerned, there are other not-so-positive consequences. Low-sulfur diesels have different handling, stability, and compatibility characteristics, including issues with lubricity, corrosion, and deposit formation that can chew through tanks and parts, wear out pumps and injectors, create sludge build up, and otherwise muck up the works. As Innospec’s core business is in fuel additives that improve lubricity, remove/reduce deposits, inhibit corrosion, and so on, this is a worthwhile longer-term opportunity for Innospec to pursue.
In Oilfield, management is hoping to start logging meaningful commercial sales later this year of new drag reducers. Innospec developed new technology/products in-house, and these new drag reducers should improve pipeline throughput – a key consideration in areas like the Permian where takeaway capacity has been a big issue (particularly as it takes time and money to building all new pipelines).
Innospec hasn’t done much from an M&A perspective in a while and probably has around $400 million in deployable capital – an amount that could add meaningful EBITDA to the company. The “but” is that Innospec’s forays into Performance Chemicals and Oilfield chemicals have had pretty mixed benefits for the company.
Issues with the Oilfield business were in part related to timing (buying in ahead of the major decline in U.S. prices and activities), but margins since then still haven’t been all that impressive and the company has been slow to diversify the business beyond U.S. onshore operators. In Performance Chemicals, progress has been mixed despite multiple M&A transactions over the years. The company has done reasonably well with product development, benefiting from increased demand for anionic and cationic surfactants and dry surfactants, but I believe the margins and growth here haven’t lived up to initial hopes.
Then again, Innospec is in a tough spot when it comes to diversification. The Fuel Specialties business is a fantastic business, with most of its competitors existing as part of much larger entities (like the Infineum JV between Exxon Mobil (XOM) and Royal Dutch (RDS.A) (NYSE:RDS.B)), and while electrification of cars and trucks is a long-term threat, that’s likely going to take decades to make a real dent in the business. There’s not much Innospec can buy here, and almost any diversification into other areas is going to come with lower margins.
I’m still expecting long-term revenue growth around 4% from Innospec, with gross margins in the low 20%’s, operating margins in the low double-digits, and EBITDA margins in the mid-teens (I’m using the conventional calculation here, not Innospec’s homebrewed adjusted EBITDA methodology). All of that should support high single-digit FCF margins and high single-digit to low double-digit FCF growth. A faster pace of growth and/or meaningfully better margins in the Performance Chemicals business would have the most significant positive impact on my model, while a significant long-term deterioration of the Fuel Specialties business would be a major negative driver.
The Bottom Line
As far as valuation, though, I think the shares are already fairly-valued on cash flow and more borderline on EV/EBITDA. I’m fine with Innospec’s above-average margins and strong Fuel Specialties business getting a premium EBITDA multiple, and I wouldn’t really argue with a forward multiple of 11x (a fair value of around $91), but I’d prefer to start a position at 10x or less. Accordingly, while I don’t rule out some upside from this level, I’d much rather start a new positions in the $70’s if that opportunity came around again.
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.