Investment Thesis

We believe Cytec (NYSE:CYT) is a compelling long at this level. In the past year, the company has undergone a transformation in which an underperforming/highly cyclical business (coating resins) was divested with the proceeds utilized for a large share buyback program. The company’s remaining segments are high quality/high return on capital businesses with growing end markets. The company’s largest division has significant exposure to the growing demand for carbon fiber composites in aerospace, which is essentially a global oligopoly.  The company is led by a strong, shareholder friendly management team and trades at a relatively low absolute valuation and at a large valuation discount to peers.    

Overview

Cytec is a materials and specialty chemicals company focused on developing, manufacturing, and selling value-added products for aerospace and industrial materials, mining, and plastic industries worldwide. It operates in four segments: Aerospace Materials, Industrial Materials, In-Process Separation and Additive Technologies. The Aerospace Materials segment offers aerospace-qualified high-performance carbon fibers and composites. The Industrial Materials segment offers high performance composites to such industries as automotive and alternative energy (wind).  The In Process Separation segment provides mining chemicals, high purity phosphine gas, and biocides.  The Additive Technologies segment offers polymer additives, such as ultraviolet light stabilizers and absorbers, and high performance antioxidants and antistatic agents.

In April 2013, the company completed the sale of its coating resin business to a private equity firm for over $1bn. The segment accounted for around half of the company’s revenue and was, by far, the most cyclical of the company’s segments. Prior to the sale, well over 50% of the company’s revenue was derived from chemicals (coating resins, additive technologies, and in-process separation) leading it to be covered by Wall Street chemical analysts who ascribed low chemical industry multiples.

However, after the recent sale, and acquisition of another carbon fiber composite company, Umeco, in 2012, over 50% of revenue and over 65% of EBIT will be derived from carbon fiber composite materials. The remaining revenue and profitability are in segments that are involved in niche specialty chemicals and that have shown to be strong performers over time. 

Cytec announced a $650mm buyback in conjunction with the divestment of the coating resin business and this program was just completed about three weeks ago.  When completion of the buyback was announced, the company initiated another $200mm buyback program. After the new buyback is complete, net debt on the balance sheet should still only be <1.5x EBITDA and management has said they would feel comfortable putting some more leverage on the balance sheet in the future. Management does not foresee any significant acquisitions on the horizon and has been made it relatively clear that it may look to engage in more buyback programs in the future (especially if the stock is around current levels). 

Cytec’s remaining businesses are extremely attractive. The main driver is in the Aerospace Materials segment, which accounts for ~50% of revenue and a higher percentage of EBITDA. Cytec is one of three main global players that produce composite materials which are qualified by the major global aerospace companies (Hexcel and Toray are the other two).  The outlook for composite material usage in aerospace applications is extremely favorable.  Newer planes such (787, A380, A350, F-35, etc.) utilize significantly higher amounts of composite materials than older models that are still produced but nearing the end of their production lives. Backlogs at the large manufacturers have grown to all-time highs and there will be a significant ramp-up of production of these composite-intensive aircraft over the next decade. Cytec will be a primary beneficiary of this growth.  For example, Boeing produced forty-six 787’s in 2012 and that should ramp up ramp up to 120 per annum run-rate by the end of this year and this could possibly increase up to 168 per annum if Boeing makes the likely decision to expand production (it is estimated that each 787 contains well over $1mm worth of CYT’s composite materials).

In-Process Separation is Cytec’s next biggest division representing ~1/3^rd of current EBIT.  The division sells specialized processing chemicals primarily to the mining space (~75% of the division’s revenue).  The majority of these chemicals are used at existing mines (i.e. not utilized in exploration) and the company has little to no competition.  The majority of the chemicals are utilized at copper and alumina mines.  While we are cautious regarding the mining space presently, we take some comfort that the majority of copper mines using these products are still operating well above their production costs (i.e. the price of copper would likely have to fall another 30% until production at some of Cytec’s customers would face possible curtailments).  The other 25% of revenue from this division is derived from the sale of phosphine, which is used as a specialized insecticide for grains, animal feed and tobacco.  The company is one of the only producers of phosphine in the world and this is the company’s most profitable business.  The company is in the process of doubling their phosphine plant in Canada and the division should see a large increase in EBIT over the next couple of years.      

Additive Technologies is the company’s third biggest division at around 12% of EBIT.  This is a specialty chemical business that has been very stable and profitable over time.  In fact, this business earns the highest returns on capital of the entire company due to low maintenance capex levels.  We believe this business could be sold at some point at a nice valuation.

Industrial Materials is the smallest division of Cytec but may have the most potential for upside in the future.  The majority of the division was brought into the company via their acquisition of Umeco last year.  The division makes carbon fiber composites for various industrial uses.  As the qualifying process is not as difficult as it is in aerospace, there is more competition in this business.  Sales are made into the very high-end auto market (i.e. Formula One race cars and $500k+ sports cars), wind turbine markets, etc.  The company has relatively high exposure to Europe and has faced some cyclical headwinds in certain applications.  Numbers have already been brought down and this is why the division is such a small % of the overall company’s revenue and earnings.  However, the company did enter a JV with Jaguar Land Rover to look into developing an economic way to produce composites for higher volume vehicles (current limitation is in the processing time).  If/when these issues are solved, a large market could open up.  We ascribe zero value to this possibility in our numbers.

We believe Cytec is a timely investment as there are a couple of market misconceptions and technical factors that should be cleared up in next couple of quarters, allowing the shares to trade more closely with the peer group.  As the majority of the company’s business (prior to the coating resin divestment) was derived from chemicals, the company is mainly covered by chemical analysts who value the company against comps in that space (including commodity chemical companies which tend to trade at low multiples). Now that the divestment is complete, the company should start to be lumped in with other composite materials companies and specialty chemical companies which trade at much higher multiples due to the favorable sector growth outlook and high barriers to entry.  Cytec’s main competitor is Hexcel on the composite side and, even though there is coverage overlap with four different sell-side firms, all but one has different analysts covering each company (i.e. a chemical analyst covering Cytec and an aerospace analyst covering Hexcel).  We believe this will change shortly as the majority of the company’s profits are now derived from the aerospace segment. Also, there were some short-term traders that bought the name in the wake of the divestment and buyback announcement with the thought that the buyback date target was too aggressive and that the company would likely have to execute a Dutch tender with a price well above market. As the company was successful buying back shares at a strong pace, some of these short-term traders sold out leading Cytec to underperform, materially, its competitors over the last couple of months.    

Cytec’s operations are highly specialized and its main division operates in a global oligopoly with two other players. The company is a high return on capital business which should be sustainable for the foreseeable future due to the high barriers to entry and extremely favorable outlook for supply and demand.  We think Cytec is a long-term compounder that is not appreciated by the market.

Valuation

We believe Cytec is attractively valued on both an absolute and relative basis as it trades at a significant discount to peers. We estimate that Cytec is currently trading at ~7.5x 2014 EBITDA and ~12x 2014 EPS.  Hexcel, which is probably the company’s closest peer, trades at ~9.5x 2014 EBITDA and ~17x 2014 EPS.  We expect Cytec to trade at a discount to Hexcel but think the valuation discount is too great as we see Cytec growing earnings faster than Hexcel over the next 3-4 years (Cytec’s EPS should grow at double digits for at least the next five years or so during the current aerospace cycle).  By 2015, we see Cytec trading at less than 6x EBITDA and ~10x EPS. We think there will be a re-rating of the stock in the next six to twelve months as the company’s shareholder base has been turning over significantly. In the meantime, the company continues to buy their stock at attractive prices. We expect the market to move the company into the proper peer group, and that the company will also receive the proper coverage by Wall Street in order to educate investors.  If we place a 14x multiple (lower than Hexcel and about in line with other specialty chemical companies) on 2015 EPS, which should be over $7, we think the stock should move over $100 in the next 1-2 years (35%+ upside).   

Management

Current management took over in 2009 after the former CEO “retired” following poor operating results (mainly due to the now-divested coating resin business).  The current CEO, Shane Fleming, was promoted internally and set out to move the company away from some of their more commoditized businesses in order to focus on the higher-quality core materials business.  Since taking over in 2009, the CEO has led a program where three separate business units have been divested and one composite material business was purchased.  Management has been focused on shareholder value with two large buyback programs over the past couple of years.  They have proven to be good allocators of capital and have only engaged in high return capital projects.  We believe that the management team, along with the current suite of quality business units, should be able to compound significant value over time.

Major Risks

The main risks to the thesis include:

-          Major economic slowdown that affects commercial aerospace production and leads to backlog cuts;

-          Defense cuts start hitting large programs such as the F-35 (aka Joint Strike Fighter)

• This has been speculated about for a while and there have been delays
• There was an article this weekend about further delaying the program to save money but Sec. of Defense Hagel is against this
  • We estimate the F-35 currently accounts for ~4% of company revenues

-          Increased competition in composite materials

• This is highly unlikely in the aerospace segment as the barriers to entry are extremely high.  It takes years to be qualified by companies such as Boeing and Airbus.  There is higher competition on the non-aerospace side but the pie should grow fast enough as composites take share from other materials.