Description

Summary and Recommendation

Chemtura (CHMT) is a global specialty chemical company that produces niche products and sells to a diverse customer group.  The company emerged from bankruptcy on November 10, 2010 and its stock has been trading since October 25, 2010.  In addition to emerging from bankruptcy, several other meaningful events have occurred in the last few months: 

• Prior to emerging from bankruptcy the company was involved in a contentious valuation fight with equity holders who argued that the company was worth $2.3B - $2.6B, substantially more that the valuation of $1.9B - $2.1B in the company's Chapter 11 plan. Ultimately the judge approved the company's reorganization plan and ruled that Chemtura was worth $2.05B (roughly $13.50/share). Note that the company's reorganization plan was supported by a group of bondholders who were satisfied with the valuation and wanted to conclude the reorganization process.
• On November 5, 2010 the company reported 3Q10 financials that demonstrated strong revenue growth (+17%) but missed EBITDA expectations by roughly 10%. The weak EBITDA results were due to management putting additional expenses into the quarter as it was the last quarter that Chemtura was in bankruptcy. The weak results were also due to the lag between raw material increases and price increases to customers. To fix this problem management changed three month contracts to 30 day contracts. This will allow raw material increases to be passed along to customers more quickly.
• On November 10, 2010 management's incentive plan was filed and shows that employees can get rich if Chemtura meets or beats FY11 EBITDA guidance. This demonstrates that management and shareholder interests are aligned. The Emergence Award Plan shows that management will be awarded 1M shares in 2011 if the company hits the EBITDA guidance contained in the Disclosure Statement. The stock will trade up if FY11 EBITDA guidance is hit and the 1M shares should have a value of roughly $20M. Additionally, there are 11M shares and options reserved for employees under a long term incentive plan.
• Management has recently been speaking at several conferences to get the story known by investors. The stock is currently in a void as bondholders who know the story are selling and equity investors are not familiar with the story. During the presentations management reaffirmed the FY11 guidance included in the Disclosure Statement.
• On November 16, 2010 Director John Wulff bought 10,000 shares of Chemtura at $13.73/share. Wulff has been a Director of Chemtura since October 2009 and previously worked with Chemtura's CEO Craig Rogerson at Hercules. Wulff served as the Chairman of Hercules from 2003 - 2008 until it was sold to Ashland.
• On March 7, 2011 Chemtura reported 4Q10 earnings that beat consensus EBITDA expectations and exceeded the FY10 EBITDA projections contained in the Disclosure Statement. Management also confirmed the performance targets for FY11 (specifically the target of $395M in EBITDA).
• On March 7, 2011 Chemtura issued the 2010 10K which showed substantial NOL balances (roughly $2.7B). It would appear that Chemtura may pay little to no taxes over the next several years which will result in much more free cash being generated than current expectations.
• On March 14, 2011 Berkshire Hathaway announced the acquisition of peer company Lubrizol for 7.3x trailing EBITDA and a 30% premium to where it was trading in the market. This acquisition demonstrates the value of Chemtura's petroleum additives business.

Putting all these events together, it appears that management has set up the company and the stock so that they can make a lot of money.  The solid 4Q10 earnings report and reaffirmation of 2011 EBITDA guidance helps confirm this view.  Now that management's incentives are in place, they are on the road telling the story and an insider has bought the stock.

The way this situation should play out is as follows:  Following the 4Q10 earnings report, more sell-side equity analysts will initiate coverage (there are only two analysts currently covering this stock).  Throughout 2011 Chemtura will report solid quarters as price increases, new products, operational efficiencies and cost cutting will allow the company to meet or exceed FY11 EBITDA guidance of $395M.  The company will generate substantial free cash flow during 2011 which will be used to pay down debt and other liabilities.  The catalysts of favorable earnings reports and sell-side coverage will move the stock higher and in 12 months Chemtura should trade at least 7x FY12 EV/EBITDA and be worth $22 (for upside of +35%).  Longer term, management may sell assets or potentially the entire company - CEO Craig Rogerson was the CEO of Hercules when it was sold to Ashland in 2008, so there is a precedent.

Recommendation:  Chemtura is a BUY.  Start buying now - the catalysts (earnings reports and sell-side coverage) will occur throughout 2011.  Buy a full position if the stock drops dramatically due to a pull back in the market - ie, at $14 there is very little downside in the stock at that price.  The position could be partially hedged with a basket of specialty chemical peers including Albermarle, Arch Chemicals, Cytec and Syngenta.

Variant View

Most sell-side analyst's estimates are derived directly from management's projections from the Disclosure Statement.  Minimally, this misses the upside to earnings from lower taxes and paying down debt and other liabilities from free cash flow.  Chemtura's 4Q10 earnings report and guidance indicate that management should meet and could exceed EBITDA targets for FY11.  This view is definitely not reflected in the price of the stock - If consensus believed FY11 EBITDA guidance was achievable the stock would be trading at a multiple closer to peer's and at a price 20% higher than where it is currently selling.  As previously mentioned, the recently filed 2010 10K showed that Chemtura emerged from bankruptcy with Federal, State and Foreign NOL's totaling close to $2.7B, so further earnings upside should come from the actual tax rate being substantially lower than the 40% tax rate used in management projections and cash taxes will be lower than expected (note that limitations on the Federal NOL are between $60M to $90M per year, enough to offset roughly 20% of estimated 2011 taxes; there is no information given about limitations on State and Foreign NOL's).  Therefore, the variant view is that the earnings and free cash flow actually produced by Chemtura have the potential to be substantially higher than analysts are assuming in their financial models.

The Company

Chemtura is the successor to Crompton & Knowles and the current corporate structure is the result of the acquisitions of Uniroyal in 1996, Witco in 1999 and Great Lakes Chemical in 2005.  The company is a specialty chemical producer with leading positions in niche businesses.  Its operations are global as products are marketed and sold in more than 100 countries and 51% of sales are outside the U.S.  The company manufactures products at 31 sites in 13 countries and has 4,200 employees.  A slowdown in business coupled with a liquidity event caused Chemtura to seek bankruptcy protection on March 18, 2009 (see "Chapter 11 Review" for more details).  The company emerged from bankruptcy on November 10, 2010 with new management, a leaner cost structure, reduced legacy liabilities, reduced exposure to commodity chemical products, a deleveraged balance sheet and improved liquidity.  The restructuring program included reducing headcount, closing or selling six facilities, improving IT systems and outsourcing warehouse functions.

The company produces products used as additives, ingredients or intermediates in a variety of industrial applications including automotive, transportation, construction, packaging, agriculture, lubricants and plastics. The company operates four business segments:  Consumer Performance Products, Industrial Performance Products, Chemtura AgroSolutions and Industrial Engineered Products.

Consumer Performance Products (17% of Sales; 21% of EBITDA; 44% of EBIT):  This division produces specialty chemicals that are sold to consumers for in-home and outdoor use.  Approximately 90% of the revenues in this division are from sales of branded recreational water purification products that are sold through mass market and dealer networks to assist consumers in the maintenance of their pools and spas.  The remaining 10% of sales in this division are household cleaning products.  Chemtura is one of the two largest manufacturers of pool and spa chemical products.  These products have strong brand recognition and while it is a global leader, 70% of sales come from North America.  Management's growth strategy entails expanding into geographies such as Latin America.  This is Chemtura's most stable and business and is expected to grow in line with GDP and continue to generate strong cash flow.

Industrial Performance Products (44% of Sales; 42% of EBITDA; 51% of EBIT):  This segment produces urethanes, petroleum additives and antioxidants.  Urethanes are used for coatings, adhesives and sealants and Chemtura is the global leader in this niche with highly defensible technology and applications expertise.  Petroleum additives have high margins and are for use in motor oils, greases and turbine lubricants.  Management plans to expand petroleum additives capacity as demand is expected to increase due to tougher emission standards.  Lastly, antioxidants are used to improve the durability and life of plastics in food packaging, consumer durables, automotive components and electrical components.  Management's strategy is to shift out of commodity products and into specialty products.  While antioxidants are the most commodity-like products in this segment, growth should be realized from bringing a recently developed specialty antioxidant product to market.  If this growth does not materialize the antioxidant segment will likely be sold.

Chemtura AgroSolutions (13% of Sales; 8% of EBITDA; 11% of EBIT):  The company is a leading niche producer of agricultural chemical products designed to enhance crop yield and quality.  The product line is designed for use in seed treatments, fungicides, insecticides and pesticides.  This business has recently experienced deteriorating profitability due to lower sales volumes caused by lower commodity prices, drought related weakness in Europe and reduced availability of credit to growers.  High single digit EBIT margins in FY10 are expected to improve to more normalized mid-teens levels in FY11 as volume picks up.  The growth strategy for this segment entails expanding geographically (into markets such as Brazil, India and China) and introducing new products.

Industrial Engineered Products (26% of Sales; 28% of EBITDA; 9% of EBIT):  Chemtura is one ot the three largest producers of brominated performance products such as flame retardants and organometallics.  Brominated flame retardants are used in end markets such as consumer electronics, building and construction and plastics.  The Bromine market is currently experiencing tight supply-demand conditions and prices have been increasing since 2009.  Organomettalics are used in solar cells, pharmaceuticals and LED displays.  This segment represents Chemtura's fastest secularly growing segment.  The profitability of this segment was hit the hardest during the recent economic slowdown due to a high fixed cost structure.  Management expects profitability to improve at this division as the benefits are realized from consolidating operations into the most productive brine fields, restructuring a sourcing agreement, shifting the operations toward a more variable cost structure and the introducing new products with higher margins.

Business Conditions

The first quarter of 2010 saw the end of the customer de-stocking that started in 4Q08.  Some industry sectors, such as electronics, are showing strong recovery.   Management expects the recovery to continue into FY11, although at a moderate pace.  Gross margins came under pressure in 3Q10 as management stuffed expenses into the quarter and due to a widening lag between increases in raw material costs and increases in selling prices.  The pressure on gross margins continued in 4Q10.  As previously mentioned, to fix this problem management changed three month contracts to 30 day contracts which will allow raw material increases to be passes along more quickly.   Chemtura executed reasonably well on this strategy, as the net deficit between raw materials and price increases declined to $5M in 4Q10 compared to $15M in 3Q10.

Improvement in the Industrial Engineered Products and Chemtura AgroSolutions businesses are anticipated to have a meaningful impact to FY11 profitability.  The building and construction end market is a sector that has been weaker than expected when management produced the projections contained in the Disclosure Statement.  Management believes they can make up for the weakness in this sector by accelerating the introduction of products with high margins, accelerating capacity improvement projects (including shifting manufacturing to geographies outside the U.S.) and cutting bloated corporate overhead.

Financial Summary

Chemtura is a GDP plus revenue grower with low to mid-teens margins and free cash flow per share that will exceed EPS going forward.  The key financial drivers to earnings are new products, geographic expansion, government regulations and improvement in cyclically-related end markets. 

Table 1 displays a modified version of management's projections from the Disclosure Statement.  Management's projections have been modified due to year to date performance and due to the assumption that free cash flow is used to pay down debt.  Given the nature of Chemtura's business, it is very difficult to have high confidence in earnings projections further into the future.

Table 1:  Chemtura key financials (2007-2014)(Adjusted Management Projections)

Management

Craig Rogerson (CEO) joined the company in December 2009 and took it into bankruptcy March 2008.  Prior to Chemtura, Rogerson was the CEO of Hercules from 2003 until it was sold to Ashland in November 2008.  Stephen Forsyth (CFO) has been the CFO of Chemtura since April 2007.  Prior to Chemtura he was at Hexcel for 26 year, most recently serving as the CFO.  Regarding the rest of the management team, two-thirds are new to the company or in new positions.

Chapter 11 Review 

Chemtura entered 2009 with significantly constrained liquidity.  A decline in 4Q08 operating results from customer destocking was followed by a credit ratings downgrade that limited access to U.S. and European accounts receivable financing facilities.  The credit ratings downgrade reduced the value of receivables that could be sold under the U.S. facility and Chemtura's financial performance resulted in the restriction of the European facility.

The crisis in the credit markets compounded the liquidity challenges.  Due to deteriorating credit markets and deteriorating financial performance, Chemtura believed it would be difficult if not impossible to raise new debt to  refinance a $370M note maturing on July 15, 2009.  As such, the company tried to refinance the 2009 note through the sale of one of its businesses (the Chemtura AgroSolutions and the petroleum additives business were put on the auction block).  When the sales process began in January 2009 there was solid interest for these businesses.  However, with the continuing recession and speculation about the financial condition of Chemtura, potential buyers became more cautious, ultimately deciding not to proceed with a transaction.

By March 2009, dwindling liquidity and growing restrictions on available trade credit resulted in production stoppages as raw materials could not be purchased on a timely basis.  Due to limited access to credit and the inability to sell a business in sufficient time, management determined that debtor-in-possession financing presented the best available alternative for the company to meet liquidity needs and preserve the value of the business.  On March 18, 2009 Chemtura filed Chapter 11. 

Risks

The major risk is that Chemtura is unable to increase prices and cut costs quickly enough to offset rising raw materials and misses FY11 earnings guidance.  The stock price indicates that investors believe the company will miss FY11 EBITDA guidance by at least 10% - 15%.  The company has several levers it can pull to make guidance, including new product introductions, capacity expansion, geographic expansion, operational improvements and cost cutting.  Additionally, management has recently publicly stated that hitting FY11 guidance does not assume price increases - the fact that prices are currently being raised increases the probability that Chemtura can hit guidance.

The wild-card for Chemtura's financial performance is the direction of the global economy.  Assuming a modest economic recovery, the company should be able to meet or beat guidance.  However, given the cyclical nature of the business, if the global economy weakens meaningfully it will be difficult for the company to hit guidance.  This is the primary reason to hedge a long position in Chemtura with a basket of specialty chemical peer companies including Albermarle, Arch Chemical, Cytec and Syngenta.

Conclusion

Chemtura has some good specialty chemical businesses, overall its operations are improving and earnings and free cash flow should grow meaningfully in the future.  The company has emerged from bankruptcy with a strong balance sheet, solid liquidity and manageable legacy liabilities.  Most importantly, management appears to have set this stock up to work and they can get rich if the company hits FY11 EBITDA guidance.  For these reasons the stock is a BUY.

Valuation:  EBITDA is estimated to be $395M for FY11.  At $16.15 Chemtura trades at 6.8x FY11 EV/EBITDA (a 15% discount to peers and a 15% discount to its historical forward multiple).

Target:  Applying a 7x EV/EBITDA multiple to FY12 EBITDA and adding free cash flow generated during FY11 to the enterprise value yields a 12-month target $22 per share (+35% upside).  The pension and post-retirement healthcare liabilities are treated as debt in determining the value of the stock.  Note that the reorganization plan approved by the bankruptcy court judge did not include the pension and post-retirement healthcare liabilities to arrive at an enterprise value of $2.05B.  The likely reason for the exclusion is that Chemtura will be contributing $50M per year on average for the next five years to the under-funded pension and post-retirement plans.  If the pension and post-retirement healthcare liabilities are not included as debt it would add over $4/share to the target price.  Also note that this target price assumes no value for the NOL's which have a face value of roughly $2.7B.

Catalyst