With Trinseo (NYSE:TSE) reporting earnings and providing guidance in just over two weeks, I wanted to provide an update on the company given the dramatic (~33%) price decline over the past four months. While I think chemicals is the most compelling S&P sector by far, and I continue to like DOW, HUN, OLN and other deep value names such as WRK, with the aggressive selling in TSE last week, it is now the cheapest chemical company in the world with an excellent management team and business model. With such risk/reward asymmetry, TSE stock is truly "Christmas in July" and a gift from the market. And given the market action this morning (Monday July 19, 2021), investors have a chance to pick up TSE under $50! There are rare times for investors to be provided with such obvious mispricing of a public company. Trinseo was already cheap back in March. Now, it feels reminiscent of the share price situation from late 2014/early 2015 shortly after Bain IPO'ed TSE, and the stock was sold off to similarly absurd levels before proceeding to provide patient investors with a 5-bagger over the following 18 months. Trinseo - Excellent Risk/Reward.
Before delving into the current valuation and disconnect between reality and basic math, when TSE was ~$20 per share last year when I was calling for ~$10 in FCF while street consensus was looking for less than half of that in FCF per share (Math is Perfect Part 2). Thus, when I explain to investors that TSE will likely see in the neighborhood of $16 if we look out 18 months, the number may sound like hyperbole until one simply looks at the math. Last month, I wrote an article about Trinseo, Huntsman and Dow, (HUN, TSE and DOW - New Inflection Point on Chemical Names) and how they had been beaten to levels that are simply nonsensical. If one reads the comments section, in addition to the main article, it is easy to see the confusion and skepticism based on incorrect assumptions and what is actually factored into the numbers. It is rare to find such extreme stock price dislocations and I urge serious investors to dive into the numbers and confirm for themselves that my assumptions and numbers are not only reasonable but probable. If I am correct, investors stand to make 3-5x their money buying TSE in the low $50s over the next 18-24 months with the initial move being substantial over the next couple of months as analysts and investors see the quarterly numbers and more importantly, the outlook. And if I am incorrect and failed to calibrate the variables correctly, we probably only see a double from here. Skeptical? Read the earnings release and listen to the conference call in early August.
Valuation
At the current share price, the market cap is just below $2 billion. While profitability has improved since the last guidance and the company has not yet factored in the accretion from the PMMA acquisition (just closed in May), let’s use the company free cash flow guidance given when the company reported Q1, which was $445 million for 2021, or $11.50 per share. This means the stock is trading at 4.4x free cash flow or over 22% free cash flow yield. So the stock is trading at 4.4x free cash flow without factoring in the accretion of the acquisition which adds over $2 in free cash flow per share AND it assumes zero profitability of styrene in H2.
If we pro forma the impact of the acquisition, the FCF per share would be north of $13.50 for a valuation of 3.8x free cash per share or a free cash flow yield of 26.3%. Again, this assumes that styrene makes no money (styrene being oversupplied is the bear case, which as I have explained earlier, has already played out). We are well into the styrene downturn, and the market will start to improve in about 18 months. Obviously, as styrene starts to tighten the styrene division will start to add incremental earnings. For context, styrene has historically earned over $125 million when the market is healthy. That would conservatively be an incremental $2.5 in free cash flow per share. If you add $2.50 to the $13.50 pro forma per share you get to $16+ per share in free cash flow or 31% free cash flow yield. I understand this is over a year out, but at this rate, the company would be capable of taking itself private in 3 years with the cash flow it generates.
Earnings Accretion from the Sale of Synthetic Rubber
The company recently announced the sale of its synthetic rubber division, which will be finalized next year. The numbers above do not factor in the benefit of this transaction on the valuation as the sale of the synthetic rubber division is substantial in reducing Trinseo's debt. The synthetic rubber division is being sold at over 11x free cash flow, so between 3x and 4x the current TSE adjusted free cash flow multiple. Needless to say, this reduces the valuation multiples of TSE even further from what I demonstrated in the valuation section above. In addition to bringing down the leverage further (will be less than 1.5x post the rubber sale) making the risk/reward for the equity even more compelling.
Buybacks
While the company put the buyback program on hold after announcing the PMMA acquisition, now that company leverage will be comfortably below 1.5x, I expect the company to soon re-start its buyback program. The company has shown excellent capital allocation historically, and while other accretive acquisitions are possible, it will be hard to compete with the undeniable appeal of buying back TSE’s own stock when the cash flow yield is as high as 31%. Recall this is not the first time the market pressed down TSE stock to silly valuations because of some misplaced narrative. The same happened shortly after the company went public in 2014. Over the ensuing couple of years, the company bought back 20% of the stock while maintaining a much higher dividend than today. At the current level of cash flow and with today’s lower dividend they could buy back significantly more stock at a much faster pace.
Trinseo's End Game
If you look at the CEO’s history, the end game for TSE seems likely to be to sell the company at a much higher valuation. The CEO has already made a lot of progress improving the mix of the TSE portfolio to become increasingly higher value-added and deserving of a much higher multiple. While he can always sell it to private equity (Bain Capital bought this company with the old portfolio which was worse at a significantly higher valuation back in 2010), I suspect to achieve maximum value for shareholders, the company could likely be sold to a strategic buyer. I do not think this is likely to happen in the next 12 months as I think the CEO will wait for styrene profitability to move above the break-even level so he can sell that business first. This means that a sale is probably 18-24 months away. If investors can step away from the market noise and look at what this portfolio should be worth in the private market, one will quickly see that today's investors are likely to make several times their money from here (I suspect 4x). This is consistent with the numbers we discussed. Even if you want to be conservative and haircut the numbers, and use $12.50 to $15.00 in free cash flow (remember they are doing $11.50 this year WITHOUT the acquisition and WITHOUT normalization in styrene), you get to $187 to $225, or 4x at the mid-point using a 15x cash EPS multiple (average historical multiple for specialty chemicals). If you want to be more bullish and take my $16+ cash EPS number and you grow it as the share count shrinks through buybacks or the company uses some of the cash for more accretive acquisitions like the PMMA deal, you will arrive at a higher number still. I think what is clear is that the stock has no business being at $51.50 per share and is unlikely to remain at such levels for long.
