Olin Corp. Leveraged To Cyclical Improvements And A Major Strategic Shift
- Olin saw a significant margin beat in the fourth quarter and future margin improvements look likely as new management prioritizes value and margins over volumes.
- A focus on higher-margin production should lead to further capacity reductions and lower (or at least more efficient) capex investments in the future.
- Internal margin-improvement efforts should be complemented by healthy end-market demand in 2021, including strong resi construction and improving auto and industrial markets.
- Olin is fairly valued based on older valuation ranges, but I believe improving margins support a higher forward multiple and upside into the mid-$30's.
I certainly can’t say that Olin (NYSE:OLN) has been left behind over the last year or so. Between a recovering economy and the hiring of a new CEO in 2020, Olin shares have risen almost 170% since the July 15, 2020 announcement that Scott Sutton would become the company’s new CEO, outpacing most of the company’s peers and comps (except Hexion (OTCPK:HXOH)), including Dow (DOW) and Westlake (WLK), by a healthy margin.
Although Olin is already trading at its highest levels in three years, I think the combination of cyclical demand recovery and a meaningfully different operating philosophy under the new CEO can drive further upside into the mid-$30’s.
A New Set Of Priorities
Scott Sutton, who was previously a senior executive at Celanese (CE), has laid a new course for Olin that is philosophically similar to the plan that was used to significant positive effect at Celanese – focus on the profitability of the business over the size of the business.
For quite a long time Olin focused on its leading share in the chlor-alkali market and prioritized volume for volume’s sake, including overproducing low-margin epoxy products because it facilitated greater chlor-alkali production volumes. Unfortunately, that prioritization of volumes led to weaker margins and weaker asset utilization with a burdensome asset base.
Now Olin is focusing on margins, with Sutton explicitly stating that the company wants to be “on the weak side” of ECU. An ECU, or electrochemical unit, refers to the fixed ratio of chlorine (1.0 ton) to caustic soda (1.1 tons) and hydrogen (0.03 tons) from simultaneous co-production of these products from salt electrolysis. What that means today is that with chlorine being on the strong side of the ECU price/supply-demand curve, Olin is supplying lower volumes of caustic soda.
Olin is also changing how it pursues pricing, choosing to deprioritize indexed cost pricing in favor of freely-negotiated pricing. This move should make it easier for the company to take a more flexible approach to production and better align its volumes with where the best value is in the ECU chain.
As the company is deprioritizing volumes, it shouldn’t be surprising that capacity reductions are on tap. Two plants were closed in Q4’20 and three more are on the block for 2021. Given Olin’s longer-term history of challenging capacity utilization due to running older facilities, I believe there could be more meaningful capacity reduction targets in the future, and I would expect closing older, less efficient facilities to have a bigger positive impact on margins.
I will be curious to see how Olin manages its capital spending in the years to come. Closing plants and deprioritizing volume should lead to lower maintenance capex, particularly if older plants are closed. On the other hand, I wonder if management will at some point over the next few years look to direct capex toward new, modern plants that could facilitate more facility closures/consolidation over time.
A Recovering Economy
Given the end-market uses for chlor-alkali products like chlorine (vinyl chloride monomer, specifically) and caustic soda, as well as epoxies, I like Olin’s leverage to the post-pandemic economic recovery cycle.
The biggest use of vinyl end-products (like PVC) in the U.S. (where Olin generates more than half of its revenue) is in residential construction products, and the U.S. residential market was quite strong in 2020. Although there have been some recent wobbles in the market (like lower starts in January), permitting activity is still strong, the U.S. housing market is still under-supplied, and I’m still bullish on housing demand at least through 2021.
Other end-markets for chlorine include the auto market (vinyls, resins, foams, adhesives, sealants, etc.), inorganics and intermediates used in markets like electronics and refrigerants, and epoxies used in a range of industrial and construction coatings. As the electronics markets remains strong and both autos and refrigeration are improving, these should be positive drivers in 2021.
On the caustic soda side, while caustic soda is perhaps most associated with aluminum production (17% of global demand is for alumina refining), it’s also widely used in pulp/paper production and the production of a wide range of chemicals. Inorganic and organic chemical demand is already improving in 2021, and I believe aluminum production and paper packaging production can drive better demand in 2021.
Winchester Also Offers Upside
Between healthy demand for ammunition and a new contract with the U.S. Army for the Lake City facility (which started in October of 2020), Olin’s Winchester business should be a noticeable positive driver. Sales jumped 120% in the fourth quarter and margins jumped from 4.5% to 13.2%, both helped by that contract, and I believe improving commercial and military volumes, as well as strong commercial pricing (another price increase already announced for Q1’21) will support positive results at least in the near term.
Pricing for ammunition has been strong for a while (ask a gun owner about ammo prices, particularly a target shooter or hunter, and get ready for an earful), with meaningful increases in firearms demand during and before the pandemic, including growing interest in target shooting. With strong demand, higher metal prices, and relatively limited capacity expansion (and virtually all major producers operating at full capacity), it’s certainly an environment supporting robust prices.
I’m bullish on Sutton’s basic plan for Olin, and I think there’s a lot of upside to be gained from prioritizing margin over volume – not just in reported quarter-to-quarter margin, but also in longer-run “core” full-cycle profitability and asset utilization/capex efficiency. Said differently, by not focusing so much on volumes, Olin can be smarter about the facilities it runs and not continue to overspend to prop up less efficient older facilities just to maintain volumes.
While my 4% to 5% long-term revenue growth expectation is above underlying long-term market demand growth, I do expect a meaningful uplift from that prioritization of higher-value business. I also expect meaningful improvement in long-term profitability, with EBITDA margins moving to the high teens versus a long-term average closer to 16% and a more recent average closer to 15%. With that, I expect strong FCF growth over the next decade relative to the levels of the past couple of years, with long-term average FCF margin improving from around 4.5% to 5% to 6.5% to 7% - a modest-looking improvement, perhaps, but very significant for this business.
Given the cyclicality of businesses like Olin, discounted cash flow is a trickier valuation approach; it’s very difficult to predict the timing and magnitude of cycles (both good and bad), and the best you can usually hope for is to get a good sense of the “full cycle” of the business and use DCF to mark periods of notable under/overvaluation. To that end, I think Olin is a little undervalued on DCF, and I’ve done well in the past buying stocks like this at such times.
I put more emphasis on EV/EBITDA valuation, but here too there are some challenges. Olin has historically traded at a forward multiple of 5.0x to 8.0x, but I think 8.5x to 9.0x is more appropriate given the cycle leverage and the prospect of meaningful improvements in profitability and returns relative to the past performance that drove those 5.0x-8.0x multiples.
The Bottom Line
At 8x my forward EBITDA number, Olin is basically fairly-valued, but at 8.5x to 9.0x I see upside to the mid-$30’s ($33 to $37). Olin has already gotten credit for both its cyclical leverage to an improving U.S. economy and the shift in business operating philosophy, but I don’t think all of the improvements are in place yet, and I think there’s still some upside here worth considering.
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