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I'm accustomed to quiet excellence from Innospec (NASDAQ:IOSP), a small ($2.7B market cap) specialty chemical company with operations in fuel additives, personal/home care, and oilfield services. Typically not well-covered by the Street, Innospec has generated mid-teens long-term returns for investors and has continued to build the business through a combination of organic reinvestment and selective acquisition. It's been a while since I've written about the company, but it has continued to execute well. Up about 10% since my last update, Innospec has beaten the market over that time, as well as many of its specialty chemical peers.
With management reinvesting more aggressively in growth opportunities within specialty chemicals for personal care and looking to drive improved operating leverage in the oilfield services business, I'm still bullish on the company and I find the valuation more interesting here. If mid-single-digit revenue growth and mid-to-high single-digit FCF growth are credible, these shares could still offer double-digit annualized return potential from here.
A Good Quarter, With A Lot Of Moving Parts
Innospec had another strong quarter, as the company continues to see volume growth on top of aggressive pricing meant to offset significant cost inflation.
Revenue rose 36% as reported, good for a roughly 11% beat against a relatively small number of sell-side estimates. The Fuel Specialties business delivered 24% organic growth, with volume down 6% and price/mix up 30%, a strong result compared to Honeywell's (HON) UOP business, which grew 6% in the third quarter. Performance Chemicals saw 30% organic revenue growth with 4% volume growth and 26% price/mix improvement. Oilfield Services revenue grew 101% in the quarter on strong demand from oil & gas production companies, which compares well to ChampionX's (CHX) 32% yoy revenue growth in Production Chemical Technologies (though it has meaningfully higher margins).
While cost inflation remains meaningful, pricing is keeping pace and gross margin improved 40bp yoy and 50bp qoq to 30.4%. Fuel Specialties margin declined 150bp to 29.9% largely on delayed cost pass-throughs, while Oilfield gross margin improved 50bp to 36.4%. Performance Chemical gross margin was stable at 24.5%.
Innospec continues to execute well on margins. Operating income rose 60%, with margin up 150bp to 9.8%. Segment profits rose 33%, with margin up 130bp to 13.2%. Fuel Specialties profits rose 5%, with margin down 140bp to 15.6%, Performance Chemicals profits rose 43%, with margin up 250bp to 15.9%, and Oilfield profits were up significantly from the prior year, with margin up five points to 8.1%.
Some Recession Risk, But A Durable Business On The Whole
With a short-cycle slowdown on the way and increasing talk about a recession, the cyclical exposure of Innospec's business seems relevant now.
Fuel Specialties has seen refinery demand abate some in the wake of rebuilt inventories, but the company is also enjoying a mix shift with improving air travel activity (additives for jet fuel and av gas are higher-margin). Recessions do usually bring reduced demand for refined products, and I am expecting a cyclical downturn in the trucking industry, but I don't think miles driven will fall off all that severely. I'd also note that, as I mentioned in my last article, Innospec is seeing growth opportunities in areas like gasoline direct injection (or GDI) and low-sulfur marine fuel, as well as renewable diesel.
Oilfield Services should be relatively well-protected in a downturn. Although it's true that refined product demand often declines in recessions, global energy prices are encouraging expanded exploration and production in North America, and I don't see the upcoming slowdown being severe enough to dent that activity meaningfully. What interests me more at this point is whether the company can improve its go-to-market efficiency - this segment's gross margins are good, but the operating margins continue to lag.
Given the durability of demand for personal care items (shampoos, lotions, antiperspirants, soaps, and so on), I'm not really worried about Performance Chemicals going into 2023. In fact, this business has really surprised me over the last two years. I was concerned that this business was going to be relegated to fairly unspectacular long-term growth a bit above underlying volume growth in the industry, but the company has done an excellent job developing and marketing its sulfate-free surfactants and other natural/nature-friendly products.
Sustainability and ingredient quality has become increasingly significant among consumers, and Innospec has leveraged this into significant pricing and volume growth (up 31% year-to-date and 5% year-to-date, respectively, after 10% growth in both price and volume in 2021). Underlining that potential, the company is in the middle of a $70M capacity expansion project to support future growth and continues to reinvest in product development.
The Outlook
I do have concerns that as inflation eases, Innospec will face more pushback on pricing. That's less of a risk in Fuel Specialties, where there are few competitors and Innospec's products provide quantifiable benefits, but I could see it as more of a threat in Performance Chemicals. By the same token, though, sustainable products (like sulfate-free surfactants) aren't quite as commoditized, and successful product innovation could lead to more enduring pricing/margin leverage.
At this point, I believe Innospec should be able to generate strong mid-single-digit revenue growth in the neighborhood of 6%, particularly with a sustained recovery in the Oilfield Services business and ongoing innovation-driven growth in Performance Chemicals. I do think that's not a particularly conservative outlook, but I think it's achievable. Management continues to execute well and has the opportunity to do value-additive M&A, but isn't going to do a deal just to do a deal.
I'm a little more cautious on margins, but I do think that double-digit operating margins are possible on a longer-term basis if management can sort out the operating challenges in Oilfield and continue to add scale in Performance Chemicals while continuing to execute in Fuel Specialties. Long term, I think FCF margins can move from the mid-to-high single-digits into the low double-digits, driving high single-digit FCF growth.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Innospec shares are undervalued. Discounted cash flow suggests an annualized total potential return around 10%, while the margins and returns I expect over the next 12 months support a forward multiple of 11.75x, or a fair value close to $130.
I'm always concerned that with a company like Innospec it's easy to get caught up in a cyclical upturn and confuse over-earning with a new sustainable level of performance. I don't think that's the case here, but it's a risk that I acknowledge. I fundamentally believe, though, that this is a well-run and overlooked specialty chemical company that will continue to build value for shares and outperform its benchmarks over time.
