Description

Arkema

I think Arkema is worth 75% higher than here by the end of 2006. The margin of safety is its 5 times trailing EBITDA multiple, trading at a shade over book value, and only 1.2 times tangible book value. I see many similarities with Lanxess which I wrote about in Feb. 2006. I just hope I did not fall for the “next big one” jinx as mentioned by Peter Lynch in his book.


Arkema is the world’s eight-largest chemicals company by sales with 90 industrial sites (60 in Europe, 20 in North America, 10 in Asia). It owns 5,728 patents and 3,202 patents pending.

The spin-off ratio is a favorable 1 share + 1 right of Arkema for every 10 shares of Total. Total is one of France’s biggest oil companies. This favorable ratio, the trading mechanics of unexercised rights, lack of trading history, plus the spin-off behavioral mispricing lend to a credible reason for why the stock could be mispriced. From an accounting point of view, the spin-off technically happened in 2006, but in reality, Arkema has been running almost independently since 2004, when as part of Total, Arkem began executing its restructuring plans. This leads me to believe that the chemistry of the new management team has been given enough time to develop.

One of the things to watch out for in spin-off situations is whether the parent company is dumping debt into its spin-off. Such is not the case with Arkema. Total even injected capital of 532 Million Euros to reduce the current term debt to essentially zero and assumed some pension obligations, and environmental liabilities. I also looked at the supply/customer agreements between parent and spin-off and they look reasonable and fair.

BACKGROUND OF THE CHEMICAL INDUSTRY

The chemical industry is a processing industry that is based on the transformation in one or several stages
of raw materials (oil derivatives, gas, minerals, natural products, etc.) into more or less complex chemical
products, or into plastics obtained by polymerisation.
At the two extremes of this wide spectrum, there are, on the one hand, commodities (characterised by
few transformation stages, large volumes, and cyclical unit prices and margins), such as olefins and
polyolefins, ammonia, methanol and caustic soda, and, on the other hand, sophisticated products like
pharmaceuticals and agrochemical derivatives. Between these two extremes is a large number of chemical
intermediates, polymers and fine-chemical products.
The chemical industry also includes specialty products such as adhesives, paints, inks, varnishes,
cosmetics and detergents, developed in response to the need for application products.
With estimated total production of almost 41,740 billion in 2004, the world chemical industry ranks third
among industrial sectors behind manufactured goods (equipment goods, transport, machinery, etc.) and food
production. The chemical sector is a worldwide industry located in three main geographic regions, namely
Europe (about 37% of world production), North America (about 26% of world production) and Asia (about
30% of world production)5. Trade in chemicals between these three main production regions is growing,
though is still limited at present.
The chemical industry is a very fragmented sector, both in terms of products (several tens of thousands),
final markets (most industrial sectors are consumers) and industry players (the share of the world market of
the top ten companies does not exceed 20%).

I. Arkema’s Products(Applications)
A. Vinyl Products
1. Chlorochemicals and PVC – PVC (chemicals-aluminum,pulp and paper,detergents and soaps;construction-wall covering,automobile industry,pipes,tubes,solvents,raw material for fluorinated products)
2. Vinyl Compounds-cables,bottles,automobiles,medical
3. Pipes and Profiles
B. Industrial Chemicals
1. Acrylics – resins, emulsions for adhesives, paints and coatings, superabsorbents, methyl methacrylate
2. Polymethyl methacrylate – acrylic glass used in construction, automobile industry, advertising boards, sanitary ware
3. Thiochemicals – chemical intermediaries for agrochemicals and pharmaceuticals polymerization agents and additives, natural gas odorisers
4. Fluorochemicals – refrigeration, air conditioning, foams, solvents, intermediates
5. Hydrogen Peroxide – Hydrogen peroxide, sodium chlorate, hydrazine, hydrate and derivatives
C. Performance Products
1. Technical Polymers – technical polymers used in the automobile, aerospace and aeronautic industry, the electronics industry, hot-melts, fluorinated polymers used in construction, chemical engineering, manufacture of paints and anti-corrosive coatings, adhesives, electrical and electronic industries, and packaging
2. Specialty Chemicals – separation of gases and liquids, adsorption/filtration, specialty surfactants
3. Organic peroxides – polymerization catalysts for polyethylene, PVC, polystyrene, and cross-linking agents
4. Additives and Urea-Formaldehyde Resins used in glues resins, formaldehyde
5. Agrochemicals – Pre-harvest and post harvest treatments for pesticide, fungicide, insecticide, herbicide, waxes and coatings.

Suffice it to say, there is no risk of obsolescence for Arkema’s products for the foreseeable future.

BUSINESS SEGMENTS

Financials and 3 year strategy for each of the 3 business segments

Vinyl Products Segment
(In Euros) 2003 2004 2005
Sales 1.2B 1.37B 1.39B
Recurring EBITDA 1M 44M 20M
Recurring Operating Income -59M -16M 8M
Capital Expenditure 72M 59M 61M

Characteristics:
Commodity-like, low barriers to entry.
Energy Costs require 3MWh of electricity per tonne produced.
Very weak demand growth in Europe estimated between 0-2%
Arkema has contracted Electricity supply agreement until 2010 with EDF.
Strategy:
Shut down several production facilities in France. Most of layoffs will be in this segment.

Industrial Chemicals Segment
(In Euros) 2003 2004 2005
Sales 2.0B 2.1B 2.4B
Recurring EBITDA 191M 220M 316M
Recurring Operating Income 72M 106M 204M
Capital Expenditure 121M 135M 145M
Characteristics
The use of patented, complex manufacturing processes and existence of world markets offer prospects of strong growth, particularly in Asia.
Strategy
Increase acrylics capacity in Asia where growth is strong, increase acrylic glass capacity in Korea while increasing acrylic glass prices in Europe, increase hydrofluorocarbon capacity in the U.S. where demand is growing, increasing hydrogen peroxide capacity in China.


Performance Products Segment
(In Euros) 2003 2004 2005
Sales 1.8B 1.8B 1.9B
Recurring EBITDA 132M 99M 109M
Recurring Operating Income 27M -4M 19M
Capital Expenditure 102M 100M 117M
Characteristics
High value added products, brand differentiation, innovation and Asia offers growth potential. Company is considering investments in China particularly.
Strategy
Increase capacities in Technical Polymers, take advantage of strong brand name, increase molecular sieve capacity in the special chemicals, control costs in organic peroxides due to pricing pressure, restore profitability in additives through price increases and strengthening its China in PVC additives, new applications of existing molecules through strategic partnerships such as with Nippon Soda.


The prospectus articulated the company’s very well laid out strategy. I recommend anyone who wants to invest in Arkema, especially the many concentrated investors in this forum, to read it. I will highlight some of the main points.

1. Plan began in 2004 and will go until 2007.
2. Layoff of about a thousand employees or about 5.5 of the workforce. (Note: When Arkema was part of Total, the political environment made it very difficult to cut costs and lay off employees.)
3. These steps should improve operating income by an estimated 80 million euros in 2008, above the impacts of inflation.
4. Maintenance capex is 55% of the Capital expenditures which averaged 310 million over the last three years. They have invested roughly 420 million in growth capex.
5. Total and Arkema have long-term supply and customer agreements for crude oil, natural gas and a lot of other raw materials and for Arkema’s end products. These agreements are described in further detail in the prospectus and looked fair to me. I view this as an advantage to offset cyclical risk and prices of raw materials, etc.
6. Management owns 5% of the company.
7. The CEO is paid an annual salary 500,000 to 600,000 Euros. This is small by most standards and I view the CEO’s upside is in the stock appreciation. The CEO is an engineer and holds a Stanford MBA. He is very much keen on adopting entrepreneurial American policies to the culture of Arkema. My subjective review of the energetic 43 year old CEO is very positive.
8. Crude oil, natural gas represent huge portion of costs.
9. 18 month share buyback of up to 10% shares outstanding has been authorized.

VALUATION ( In Euros)

Tangible Book Value ~ 24 Euros per share
Book Value ~ 28 Euros per share
Shares Outstanding 60.5 million
Share price 29.6 Euros
Market Cap ~ 1.8 B Euros
Net debt ~ 0 M
EV ~ 1.8B
2005 EBITDA 355M
EV/2005 EBITDA 5x
(In Euros) 2003 2004 2005 Sales 5.05B 5.32B 5.71B
Recurring EBITDA 249M 301M 355M
Recurring EBITDA margin 4.9% 5.65% 6.2%
Recurring Operating Income -48M 11M 128M
Capital Expenditure 296M 300M 333M
Maintenance Capex(55%) 163M 165M 183M
EBITDA – Maint Capex 86M 136M 172M
Capital Employed 3.3B 2.9B 3.1B

Management has articulated a very detailed strategy to grow the EBITDA by 10 to 15% a year until 2008. This suggests that EBITDA will reach 430M to 470M by 2007e. I like to use matrices to get a good sense of the central values over possible outcomes and to compare how believable management’s projections are.

For 2007, we are looking at potential outcomes of EBITDA (Sales on X axis, EBITDA margins on Y axis)

Sales(% growth) 5.9B(2%) 6.3B(5%) 6.5B(7%) 6.9B(10%)
6% EBITDA margin 354M 378M 390M 414M
7% EBITDA margin 413M 441M 455M 483M
8% EBITDA margin 472M 504M 520M 552M
9% EBITDA margin 531M 567M 585M 621M
10% EBITDA margin 590M 630M 650M 690M
* Note, Arkema is at 6% EBITDA margins as of now. As of March 2006, they are on track to do sales of 6B annualized.

Given the room for EBITDA margins to grow to at least 10% the 420 million growth capex invested over the last 3 years, I think 6.3B Sales, 8% EBITDA margins look quite reasonable. But let’s assume we make mistakes and because this is an operating margin improvement story, I like to use scenarios for different margins. I use 6.3B(5% sales growth) as estimated sales by 2007 as this seems very achievable. They have demonstrated in the first quarter that they are on track to do 6B in sales by 2006. I assume there is no share buyback(even though authorization is in place) and assume cash build up of $100 million by end of 2007. We then construct a matrix of EV/EBITDA multiple on x axis, EBITDA margin on y axis, and the resulting values will be the equivalent stock price on 60.5 million shares outstanding. I like to think market looks ahead 12 months in advance, so this would be a range of possible trading values for the stock by Dec. 2006.

EV/EBITDA multiple 5x 5.5x 6x 6.5
378M (6% margin) 32.9 36 39.1 42.3
441M (7% margin) 38.1 41.7 45.4 49
504M (8% margin) 43.3 47.5 51.6 55.8
567M (9% margin) 48.5 53.2 57.9 60.9
630M (10% margin) 53.7 58.9 64 69.3

Fair value for Arkema’s stock by end of 2006 would be in the low 50’s range I think the most important driver is if they can execute their margin improvement strategy.

Peer Valuation

There are no clear one-to-one comparison for Arkema.
Peers I use are BASF, Cia, Clariant, Kemira, DSM, Lanxess, Tessenderlo.

Multiples 05 EBITDA 06 EBITDA* (est) EBITDA Margins
BASF 4.5 4.3 20%
Ciba 8.7 8.1 13.5%
Clariant 7.9 6.6 9.5%
Kemira 8.0 7.2 11.4%
DSM 6.1 5.9 13.1%
Lanxess 6.2 5.9 8%
Tessenderlo 6.9 6.3 8.8%
Arkema 5 4.6 6%

None of these peers is a direct comparable: BASF is related strongly to energy and gas transport sectors; Ciba,Clarient and Kemira are pure specialty chemicals companies(that is, with a downstream positioning relative to Arkema); DSM has a large part of its business in fine chemicals and vitamins; Lanxess’s business are not in the same areas as those of Arkema; only the PVC business of Tessenderlo is comparable to Arkema’s; Degussa, which is most closely comparable to Arkema, received a takeover offer in the 8x EBITDA multiple range. Note that Arkema has a large room for margin improvement versus its peers.

I expect one of the biggest concerns people have is the stage in the cycle of the chemicals industry. As usual, I adopted an agnostic approach. If I were tasked to value a non spin-off such as BASF or Ciba where margins are in the teens, I definitely think cyclicality will be a determining factor, but with Arkema, I think the most important driver is if they can execute their margin improvement strategy

Catalyst

Operating margin improvement
Spin-off
Share buyback