Olin: Capex Is Creating Value; Share Prices Will Follow

| About: Olin Corporation (OLN)
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Olin Corp (NYSE:OLN) is a long term holding for me, and a profitable one. Over the years, various complex analytical efforts have been relatively ineffective, while a basic tendency to buy low and sell high has paid off. With that in mind, this article represents an effort to answer some simple questions: 1) what does the investor receive for owning this stock? 2) how should these outputs be valued? and 3) how to invest profitably?

This article has a relatively narrow focus. For more complete coverage, StreetAuthority published a good analysis back in February. I've done two previous articles on it, the most recent in April 2011. With the shares trading in the $20 area, my target is $26. StreetAuthority sees $27.

What you get

The dividend has been very reliable, 20 cents a quarter, unchanged for the past 10 years. It's secure, and well covered on a cash flow basis.

The current ratio has been stable in a range around 2:1 for the past ten years, and debt as a percent of capitalization stands at 35%, consistent with the company's long term average. Cash flow has been devoted to capex, in increasing amounts over the past several years. So, in addition to the dividend, the investor receives capex, an estimated $2.83 per share for 2012.

What it's worth

When a company has an ongoing capex program, the low level of free cash flow at times operates as a deterrent to the market. In the past, I've had some success by thinking of the capital budget as being the output to be valued. Several years ago, I looked at Verizon (NYSE:VZ), spending $5.98 per share on FiOS and Wirelss capex. Evaluating that as a 15% return on investment, I saw a target price of $40, which has since been reached and exceeded.

Proceeding along analogous lines for Olin, the 80 cent dividend, capitalized at 8%, is worth $10.00. The company spends about $200 million per year on capex. $200 divide by 81 shares is $2.46 per share, capitalize that at 15% and it's $16.46 per share. Adding $10.00 for the dividend and rounding, I see a value of $26 per share.

Here's a chart reflecting this line of thinking (click to enlarge images):

The red line is a value computed by capitalizing the dividend payout at 8% and the forward looking 3 year average capex at 15%. The three year average considers the past year, the current year, and one future year. Over the period covered, value has been created at about 6% per year. Where capex for 2013 is currently estimated at $100 to $125 million, compared to midpoint guidance of $230 million for this year, I took a guess that the dividend will be increased to 90 cents.

The overall pattern is similar whenever share prices are graphed against some kind of reasonable and stable metric over the past decade: since the financial crisis valuations are not the same. Multiples have compressed. There's a definite before and after.

Strategy and tactics

Olin is classified as Basic Materials: Chemical Manufacturing. As such, it's cyclical and responds very strongly during boom times. The Winchester segment manufactures ammunition, and is countercyclical. For whatever reason, sales of ammunition increase during hard times.

Between the secure dividend and the countercyclical Winchester segment, there's a floor under the shares, around $15, breached only during the insanity of the financial crisis. During boom times, capacity constraints have occurred in the Chlor-Alkali business, leading to considerable pricing power and a surge in share prices. Here's a 5 year chart, comparing OLN (green) and the S&P 500 (gray):

Beta checks in at 1.2. Given the observable volatility and economic sensitivity, as opposed to the relatively stable valuation metric, a program of scaling in as prices fall below estimated value, and scaling out as prices move up to and beyond it, makes intuitive sense.

I've been a buyer at prices under $20, selling covered calls at the 22.5 and 25.0 strikes.

A dividend oriented investor, along similar lines, might buy it when the dividend yield exceeds 4%, pigging out at 5%, and sell it when the yield falls to 3.5%.


Olin is optionable, to include LEAPS. Implied volatility is 28.75% (per CBOE) with a high of 68% in August last year. Spreads are wide, particularly for deep in the money calls. Open interest is adequate near the money, and very thin elsewhere. I've been able to get prices that I consider fair, after consulting an options calculator.

I've been playing this situation since 2007 by means of diagonal call spreads: long deep in the money LEAPS and short out of the money calls with shorter durations. The trade has been profitable and it makes sense to me.

The thinking is, the LEAPS have relatively low time cost due to the dividend, so that shares can be controlled with less capital, creating leverage. Meanwhile, the sale of covered calls against the position provides income.

An inflection point

CEO Joseph Rupp, from the Q1 2012 conference call:

In the first quarter of 2012, Olin generated adjusted EBITDA of $94.9 million, which represents the highest level of first quarter adjusted EBITDA ever. Our first quarter 2012 adjusted EBITDA increased 38% when compared to the first quarter of 2011. This is the first quarter that we've discussed EBITDA, and we believe it clarifies the impact of the capital investments that were made in 2011 and are continuing in 2012, including investments to exit mercury cell technology, the acquisition of PolyOne's 50% interest in the SunBelt joint venture, the Winchester's centerfire ammunition relocation project to Oxford, Mississippi and the bleach expansion projects. These investments have caused annual depreciation expense to increase by approximately $35 million, or 50%, since 2009. In 2012, Olin has the opportunity to generate the highest level of adjusted EBITDA in the 120-year history of the company.

CFO John Fischer, in the Q&A:

Our expectation is that capital spending next year will probably be a round number, $100 million less than it is forecast to be this year. We'd put it at somewhere between $100 million to $125 million, keeping in mind that maintenance capital is probably in the $80 million to $85 million range today. And I think we've said all along that our preference for the use of cash is to invest in the business first. We would look at the dividend, second; and we'd be more aggressive on share repurchases, third.

Looking at the possibility of record EBITDA, and with capex currently estimated to slow in 2013, it's possible the board will be considering a dividend increase. To go from 20 cents per quarter to 25 cents would be $16 million per year, vs. the $100 to $125 million reduction in capex.

Disclosure: I am long OLN.