Trinseo: A Case Study Of Cyclicality

May 04, 2016 10:37 AM ETTSE1 Comment
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Contributor Since 2016

I am a value conscious investor looking for bargains.

Philosophy:

1) Price is what you pay, value is what you get

2) Success in investing is limiting losses when you're wrong, and maximizing gains when you're right

3) Start with business model.  Margins reflect value add a company's products bring to the market place.  Does the Gross Margin and the Product match?  High GMs accompany differentiated products with limited competition that do not compete on price.  Low GMs accompany undifferentiated products that compete on price, CAPEX spend, cyclicality.

4) How is the business financed?  Be wary of companies with a lot of debt.  Great businesses do not require huge debt to generate high returns on equity.  There is no achievement in generating high ROEs by levering up like banks, leasing businesses (car rental, equipment rental, aircraft rental).  ROA should be telling here.

4) A company's value changes because the NPV of future profits changes.  NPV of future profits is a function of changes in revenues, gross margins, OPEX, leverage, taxation.  A company's value appreciates when the NPV of profits goes up due to revenue growth, GM expansion, OPEX reduction, leverage (refinancing) / tax (change of domicile) reduction.

5) Markets look forward.  Bottoms coincide with maximum pessimism while tops coincide with maximum euphoria.  

6) A stock is not undervalued because it is cheap and it is not overvalued because it is expensive (based on traditional valuation metrics).  Similarly, a stock is not undervalued because it has gone down a lot or overvalued because it has gone up a lot.

7) Look at market cap when valuing companies.  Don't be overly influenced by management projections, analyst reports, share buybacks, cash on B/S, price movements, other people in the stock. 

8) Companies with significant debt can go bankrupt.  Cash burn typically determines if they go bankrupt before the cycle (for their industry or the economy) turns.

9) Undervalued stocks can get cheaper, overvalued stocks can get more expensive. 

10) Keep emotion out of investing.  You will be wrong.  Unpredictable things will happen.  Stay vigilant to anger, anxiety, exuberance.  Stay vigilant to thesis creep.

11) Leverage will kill you sooner or later.  Companies have large operating and financial leverage. 

12) Have a thesis.  If the thesis plays out, stay with it.  If it doesn't exit.  Always have a thesis.

13) Understand the business you are invested in.  It's valuation and what can go wrong.  Know the business inside out.

13) Don't trade. 

14) Diversify.  There are many good ideas in the market.  Don't put your eggs in one basket.

15) Failing businesses rarely turnaround.

Trinseo is the quintessential case study of a low margin commodity business that has seen a huge cyclical upswing due to capacity cuts, cost rationalization and rising margins.

Trinseo produces Latex, Synthetic Rubber and Performance Plastics. The margins in this business are not under Trinseo's control at all. The input costs are volatile and depend on commodity markets. The output price is determined by supply and demand of a commodity. Macro economic factors have a disproportionate affect on bottom line. THE BUSINESS PERFORMANCE IS COMPLETELY UNPREDICTABLE.

Here's how you can see that. Volume in MMLbs is practically static over 2013-2015 period. Between 5122 and 5339 MMLbs of Performance Materials and Basic Plastics & Feedstocks.

One key aspect of a cyclical business is that you should analyze results on a sequential basis (with slight seasonality for volumes) because Gross Margins tend to be reflective of pricing in the industry.

In 2013, revenues of $5.3b produced Gross Margins of 6.7%. That's Gross Margins. Abysmal. Those sort of margins need HUGE volume to cover OPEX, CAPEX and Interest / Debt expense, and often these sort of cyclical low margin companies can find themselves under financial duress and ultimately bankruptcy. The latest report showed Gross Margins coming in at a healthy 15.6%. So in three years, Gross Margins have DOUBLED.

You know this is a commodity because you can find the Styrene, Ethylene and Benzene prices quoted on Polymerupdate.com. What determines Styrene, Ethylene and Benzene prices? Supply and demand. Commodities trade primarily on PRICE. If you offer a commodity at a higher price than a competitor, you lose. Not like Google or Facebook or Apple.

You saw a jump in Gross Margins and cash flow generation in Q1 2015, as Trinseo went from losing cash to making cash. Revenues FELL 25%, yet EBITDA went UP. This is the strange world of cyclicals. Revenues down, profits up. At that point there was a lot of talk about cost rationalization and capacity cuts etc.

At that point, it was worth going long. The fact that the stock has doubled is neither here nor there, since the subsequent jump in Gross Margins was not entirely predictable. This is a low quality business so it will never get a great multiple. You stick with the trade when Gross Margins show signs of expansion and exit when they start stabilizing. Not a long term buy and hold.

The key thing to remember about Cyclicals is that eventually Gross Margins reach a tipping point (both on the upside and downside) and there is no reliable way of figuring out how high or low they can go. But margins almost always revert back to the mean (often dramatically) with the stock prices reacting even more violently. So for companies in cyclical sectors, the need to be vigilent trumps.

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