Description

Summary

Ashland stock is a very compelling, event-driven long investment opportunity.  First, the return potential is quite strong with ~40% upside from current levels.  Second, the risk/reward profile is very attractive with a downside price of $100 and a target price of $150, equating to $8 down and $42 up from current levels, a ~5:1 ratio.  Third, the overall "set up" for the stock to perform well over the next 6-9 months is excellent.  Additional detail on the set up of the stock is provided below, but the headlines are:

• Shorter-term investors have recently cleared out of the stock and a near-term price floor has been set at $100.
• The company just initiated two large scale share repurchase programs to be completed by June 2015 which will place significant near-term upward pressure on Ashland's share price
• The Company will be buying back even more stock after these programs are completed
• Bullish sell-side analyst coverage has just been reinstated on the stock
• Ashland is experiencing fundamental tailwinds in its business through recently announced price declines for base oil, a key raw material for manufacturing Valvoline.

Fourth and finally, there is an element of "differentiated view / variant perception" here in that the market appears to be missing the fact that Ashland will have a very sizeable amount of excess cash on its balance sheet even after all of these share repurchase programs are completed.  This cash can be used for even more share repurchases or accretive M&A, either of which could drive the stock even higher than $150.

Company Description

Ashland is a specialty chemical company which, pro forma for the 8/1/14 sale of the Company's Water Technologies business, now has three reportable segments described below.  Of note, Ashland recently "realigned" some of its business portions, switching some from being included in Specialty Ingredients to Performance Materials and vice versa.  For a description of this realignment, see Note O in the Company's 3Q14 10-Q filing.  Also of note, the "realigned" financials for each of the business segments can be found on the Company's website by going to the "Investors" section, clicking on "Reports and Filings" and then "Financial Information".  The PDF file is listed under "New Business Alignment" and is called "Related Financial Information".

• Specialty Ingredients - This segment is organized into two divisions: (i) Consumer Specialties - produces specialty chemicals for use in personal care products (oral, hair, skin, etc.), pharmaceutical and nutraceutical products, and food and beverage products, and (ii) Industrial Specialties - produces specialty chemicals for use in architectural paints and coatings as well as fluids for oil and natural gas drilling and production.
• Performance Materials - This segment has three main business lines:  (i) Composites - manufactures specialty chemicals for end use in the construction, transportation, marine and other markets, (ii) Intermediates/Solvents - produces butanediol for Ashland's internal needs as well as the merchant market, and (iii) Elastomers - manufactures styrene butadiene rubber primarily for use in tire manufacturing.
• Valvoline - This segment produces Valvoline motor oil and also operates and franchises ~900 Valvoline Instant Oil Change centers in the United States.

Favorable Set Up for the Stock

Here's why the set up for the stock to perform well over the next 6-9 months is so favorable:

• Short-Term Investors Have Recently Cleared Out of the Stock - On 7/31/14 and in conjunction with reporting 3Q14 earnings, Ashland management announced they would not be selling the Company's Valvoline business at this time.  The announcement of the sale was anticipated by the market, and the negative news caused the stock to decline from ~$108 to $100.  The stock then stayed down in the $100 range for several days as many holders cleared out of their positions.  This is significant for two reasons.  First, any short-term holders who wanted to get out of the stock have now left, leaving the stock now owned by more "sticky" shareholders.  Second, this price action has likely established $100 as the floor in the stock.
• Initiation of Large Scale Share Repurchase Programs to Be Completed by June 2015 - On 8/5/14, Ashland announced that it entered into a $750 million accelerated share repurchase program.  Then, on 8/6/14, Ashland announced that it
  entered into a $250 million 10b5-1 plan to repurchase $250 million worth of stock.  Management expects to complete these buyback programs by June 2015 (see 3Q14 earnings call transcript, pg. 2).  Given Ashland's market cap is $8.5 billion, these buybacks totaling $1.0 billion mean Ashland will be repurchasing 12% of its market cap over the next 10 months.  That is a VERY LARGE AMOUNT of stock to be repurchased in a relatively short timeframe and should place a significant amount of upward pressure on Ashland's share price.
• Still More Share Repurchases Afterward- After the $1.0 billion in buyback programs listed above are completed, Ashland intends to repurchase another $270 million worth of stock by the end of calendar 2015 (see 3Q14 earnings call transcript, pg. 5).  In aggregate, Ashland is purchasing $1.35 billion in stock, funded by the $1.4 billion in after-tax proceeds the Company received from the sale of their Water Technologies business, completed 8/1/14.  Of note, Ashland repurchased $80 million worth of stock during 3Q14, so it's $80mm +$750mm + 250mm + $270mm = $1.35 billion total.
• Reinstatement of Bullish Analyst Coverage - On 8/11/14, Credit Suisse, after being restricted from covering the stock due to their advisory role with the Company, reinstated analyst coverage with an Outperform rating and a $135 price target (up from $115 before).  Credit Suisse's sales force can now reengage with its client base and "sell" Ashland stock to its accounts, adding more upward pressure on Ashland's share price.
• Recent Base Oil Price Decline, Providing a Near-Term Fundamental Tailwind for Ashland's Valvoline Business - As reported in trade publications, Motiva, a major producer of base oil which is a main raw material for Valvoline, announced a $0.20/gal, or 5% decrease to $3.65/gal for its Group II 200 grade effective 8/15/14.  The decrease in raw material prices should improve margins for Ashland's Valvoline business, a fundamental positive.

Fundamental Analysis

Below is some fundamental commentary on each of Ashland's business segments as well the rationale for the financial projections for them.

• Specialty Ingredients - This segment is often referred to as the "crown jewel" of Ashland.  It's a high-quality, high-margin business that produces essential ingredients for a variety of applications.  The Consumer Specialties portion of the business is driven by consumer staple and health care end markets which are stable and defensive in nature.  The Industrial Specialties portion of the business is driven by (i) residential and non-residential construction, the outlook for both of which is currently favorable and (ii) drilling activity for oil and natural gas, the outlook for which is also favorable.  Management projects that the business will grow at 2-3x US GDP which appears reasonable given its specialty chemical nature (providing it with some pricing power) and exposure to both defensive and growing end markets.  In addition, management has been pursuing a cost restructuring of the business and expects to remove $75 million in costs by the middle of fiscal 2015 (see 3Q14 earnings call transcript, pg. 4) and for EBITDA margins to be in the 25-27% range by the end of fiscal 2015 (2Q14 earnings call transcript, pg. 3).
• Performance Materials - This segment is lower in quality than Ashland's other businesses.  It is more commodity-like in nature and generates lower margins.  Of note, Ashland is in the process of divesting the Elastomers portion of the business which produces butadiene rubber for use in tire manufacturing.  Management expects the sale to be completed by the end of 2014 (see 3Q14 earnings call transcript, pg. 6).  The financial projections assume status quo for now but will be adjusted when the actual sale, which is likely to be completed, is announced.
• Valvoline - This business is an excellent business.  Although it’s referred to as a “specialty chemical” business, it’s really more correctly described as a “branded consumer product” business.  Valvoline is a well-established brand in the market, with customer loyalty and pricing power.  The business’ main competitors are Castrol, Mobil, and Pennzoil.  Margins for the business do fluctuate in the near-term with the movement of raw material costs.  Although there is a lag effect, historically the business has been able to eventually pass along raw material cost increases to consumers through pricing.  Of note, management believes that sustainable EBITDA margins for the business are 18-19% (2Q14 earnings call transcript, pg. 5).

In addition, here’s some commentary regarding other fundamental aspects of Ashland’s business:

• Restructuring Initiatives - Ashland is pursuing a global restructuring initiative which is expected to result in $200 million in annual cost savings and an overall increase in the Company’s EBITDA margin to 20%.  Management has removed in excess of $80 million in annual costs through this initiative through 3Q14, and they remain on track to achieve >$100 million in annual run-rate savings by the end of the 2014 fiscal year (3Q14 earnings call transcript, pg. 5).
• Capital Expenditures – Expectations are that Ashland will spend ~$250 million on capex for the next several years (3Q14 earnings call transcript, pg. 9).
• Interest Expense – Based on Ashland’s current capital structure, future annual interest expense is projected to be $155-175 million annually (3Q14 10-Q filing, pg. 59).  Of note, the Company has $600 million of 3.00% notes outstanding due 03/15/16.  While it’s most likely that Ashland will simply refinance these, the financial projections conservatively assume that they are paid down (it is unclear where interest rates will be in 2 years).
• Tax Rate – Management is projecting a 21% tax rate for 2014 (3Q14 earnings call transcript, pg. 2) and conversations with management indicate this is a good level to use going forward.

Financial Projections

Based on the fundamental analysis above, below are summary financials for the Company:

Note that the fully diluted share count being used is based on the following share repurchase schedule and the conservative assumption that the Company is buying back stock at $125/share.

Valuation Analysis

Over the next 12 months, I believe Ashland’s stock should reach $150/share.  This is based on four methodologies included below.

PE Multiple – Based on my projections above, Ashland will generate $9.21 in 2016E EPS.  Currently, US specialty chemical comps trade at 16.8x 2015E EPS and 14.7x 2016E EPS.  As Ashland is a high quality company, I think it’s fair and reasonable to project that it will eventually trade to 16.0x 2016E EPS.  This equates to a $147/share price.

EV/EBITDA – Also based on my projections above, Ashland will generate $1.28 billion in 2016E EBITDA and will have $1.4 billion in cash on its balance sheet by 1Q16.  Assuming no debt paydown, the Company will also have the same $3.3 billion in debt on its balance sheet that it has now.  Currently, US specialty chemical comps trade at 9.5x 2015E EV/EBITDA and 8.7x 2016E EV/EBITDA.  I think it’s very reasonable to project that Ashland will eventually trade to 9.5x 2016E EV/EBITDA and have 68.3mm FD shares out.  This equates to a $150/share price.

FCF Yield – Based on my projections above, Ashland will generate $10.64 in 2016E FCF/share.  If Ashland trades a 7% FCF yield, which I think is very reasonable for a high quality specialty chemical company, this equates to a $150/share price.

SOTP – Based on the 2016E projections above and applying a 10.0x EV/EBITDA multiple for Specialty Ingredients (an “above peer” specialty chemical multiple), a 7.0x EV/EBITDA multiple for the Performance Materials (an “well below average” specialty chemical multiple), and a 11.0x EV/EBITDA multiple for Valvoline (closer to a branded consumer product multiple), Ashland should eventually trade to a combined enterprise value of $12.7 billion.  This equates to a blended EV/EBITDA multiple of 9.9x 2016E EBITDA.  Projecting $1.4 billion in cash, $3.3 billion in debt, and 68.3mm FD shares out, this equates to $158/share price.

Please note that in all of these calculations, any potential negative valuation impact from Ashland’s pension liability has not been included.  As of 9/30/13, Ashland’s total pension and employee benefit plans were underfunded by $1.1 billion.  However, conversations with management have indicated that the underfunded status of the pension will be much smaller when they file their 2014 10-K in a few months.  While management did not provide any specifics, they indicated that the funded status of their pension plans has changed due to (i) the remeasurement of their liabilities from their restructuring actions, (ii) a changes in the discount rate used to measure their liability, and (iii) and changes in their plan assets.  Again, it’s unclear what the current funding status of their plans is.  Obviously, alter the valuation as you see fit by included whatever pension liability you feel is appropriate.

Additional Upside through Excess Cash

While a $150 price target is healthy and presents ~40% upside from current levels, I believe the upside to Ashland’s share price could actually be much greater if the Company deploys the excess cash it has on its balance sheet.  This is valuable imbedded optionality.

Based on the financial projections I included above, Ashland should have $1.4 billion in cash on its balance sheet at the end of its 1Q16.  By this time, the Company will have completed its $1.35 billion share repurchase program.  Also based on my projections, the Company should generate $727 million in free cash flow in 2016, more than enough to fund the paydown of the $600 million in 3.00% notes which are due in March 2016.  Conversations with management indicate that Ashland could easily run its business with $400 million in cash on its balance sheet.  So, Ashland will have considerable excess cash ($1.0 billion) to deploy even after it completes its share repurchase program through calendar 2015.  In my opinion, the market doesn’t seem to be appreciating this.  This is why I believe I have a “variant perception / differentiated view” on how attractive Ashland’s stock really is.

My net income projection for 2016 is $629 million.  With a projected 68.3mm shares out, my “base case” 2016E EPS is $9.21.  If the Company buys back another $1.0 billion worth of stock at a very conservative average price of $150, Ashland could drop its share count by another 6.7 million shares to 61.6 million.  On net income of $629, that’s a 2016E EPS of $10.21.  Applying a 16.0x PE multiple on that and Ashland’s stock could trade to $163, up >50% from current levels.

Looking at it another way, my projections indicate the Company can generate $727 million in FCF in 2016.  On a reduced share count of 61.6mm, that’s $11.80/share.  At a 7% FCF yield, that equates to $168/share.

Ashland could also use the cash for accretive M&A which could also increase the Company’s per share value.

Key Risk

I think the biggest risk to the Ashland story in the near-term is the upcoming change in management.  Ashland’s CEO Jim O’Brien has announced that he will be retiring on December 31, 2014.  Ashland’s board has formed a special committee and has been interviewing candidates for the position, both from inside as well as outside the Company.  The selection process is obviously expected to be completed well before yearend so an appropriate transition can occur.  These processes always entail risk as you don’t know who the new candidate will be, how smoothly the transition will occur, with the new CEO take the Company in a different direction, etc.  Unfortunately, there’s no mitigant to this risk.

Catalyst

Catalysts

• Sale/Spin of Valvoline – Although Ashland management decided not to sell or spin-off Valvoline right now, management commentary indicates it still intends to in the future.  This would be a value-unlocking transaction and has been called on by shareholder activists.  As Valvoline is really a branded consumer products company, it should trade at a higher multiple than a specialty chemicals company.  Divesting the business would force this price discovery.  Conversations with management have indicated that they still believe they can make further changes to improve the performance of the Valvoline business and enhance its value.  They want to do this before they divest it to capture as much value for shareholders as possible.  To management’s credit, despite shareholder pressure a couple of years ago to divest of the Water Technologies business as quickly as possible, they took the time to improve its operations and then sold it at a much better price.  Accordingly, management has credibility in capturing value for shareholders.
• Sale of Elastomers – Ashland is currently pursuing the sale of its Elastomers business, housed within its Performance Materials segment.  The sale of the business is expected to be completed by year end 2014.  Management could use the proceeds to repurchase an additional amount of stock.
• Deploying Excess Cash – In choosing to deploy its excess cash, Ashland could announce additional buybacks or accretive M&A, either of which would positively impact Ashland’s stock price.