Description

In Crompton Corp (CK) you have the opportunity to be a participant in a turnaround that appears reasonably conservative in its goals, and one that should result in significant share appreciation. While CK trades at a discount to its peers already, the potential exists for accelerating earnings through price actions, cost reductions, and further divestitures / restructurings. One can win in two ways: multiple expansion as the overhangs (especially litigation) dissipate, and fundamental business improvements.

(To be up front, I wish I had posted this a little bit earlier - I started putting this on below $6 but it's raced higher in the last 3 weeks...)

CK manufactures and markets specialty chemicals, polymers, and polymer processing equipment. The company is a leader in a number of its markets; for instance, it is the top player worldwide in castable urethane polymers, PVC additives, and miticides, amongst others. In recent years, however, CK – the entity remaining after the 1999 merger of Crompton & Knowles and Witco – has squandered these leadership positions and obscured the value proposition in a number of its products by chasing market share in a downturn at the expense of pricing. The resultant pressure on margins was only the start of the company’s problems, as it also (ironically) became subject to US Department of Justice, Canadian Commissioner of Competition and Attorney General of Canada, and European Commission investigations into alleged price-fixing of certain chemicals during the 1995-2001 period. As a result of these overhangs, CK has and continues to trade at a discount to its peer group (on EV/EBITDA...P/E is a bit skewed by new debt deal discussed below). Specifically, CK today is at 5.6x 2005 EV/EBITDA and 16.3x 2005 EPS; its peers FOE, GLK, and POL trade on average at 7.0x 2005 EV/EBITDA and 15.1x 2005 EPS.

Enter Robert Wood. In January 2004, CK announced that it had named Wood, who had most recently served as the business group president of Thermosets and Dow Automotive at Dow Chemical, as the President and CEO of the company. Since his arrival, CK has laid the groundwork for a strategic transformation, beginning the process of improving prices, reducing costs, realigning the portfolio, strengthening the balance sheet, and other measures designed to enhance shareholder value.

My price target is $10, suggesting upside of >35%, with the potential to be much higher depending on progress on various initiatives (see below for scenarios and valuation).

Pros

1. Expectations for CK’s potential are relatively low even though it is making progress.
In July 2003, the Company announced a cost reduction program targeting $40mm of annual pre-tax savings in 2004, which was expected to reduce its global workforce by approximately 375 positions. While $23.4mm has been achieved thus far in 2004, management anticipates $50mm in savings this year from that plan. This followed a successful $60mm cost reduction initiative announced in 2001 and a plan to relocate its corporate headquarters (now complete). With the arrival of the new management team, CK announced that it was implementing an activity-based restructuring initiative that would result in another $50mm in savings in 2005. For this program, the company expects to incur one-time charges not exceeding $50mm, mostly in Q3.
Notwithstanding these results, sell-side analysts are mixed, with only one recommending the stock as a buy and the other three – with no published price targets – rating CK a neutral. Consensus appears to be that CK cannot combat raw material prices and that it still has substantial legal exposure, and the new management team seems to be receiving little credit.

2. Leadership position gives CK some leverage with pricing.
As mentioned above, CK is the top player worldwide in castable urethane polymers, PVC additives, and miticides. It is also the world leader in urethanes and extrusion equipment, a top three EPDM manufacturer in North America, and the third-largest manufacturer globally of rubber chemicals. In a number of these product lines, CK’s specialty chemicals are high value-added materials, and one of the new management team’s priorities is to capture the value of their products to customers with more rational pricing. Thus far in 2004, the company has implemented $80mm in price increases, and plans to have recouped increases in raw materials by year-end (which at the end of Q2 represented a $90mm price increase…management has suggested recently that they will surpass that amount and will be higher on a run-rate basis). This performance corroborates management’s assertion that it can recapture its position as an industry price leader, which it was as it drove prices down over the previous three years.

According to the CEO, a 5% price increase would lead to $120mm in EBITDA.

3. Fresh management team highly motivated to make this work.
Robert Wood, Karen Osar, and Myles Odaniell are all new faces charged with turning CK around. In the case of Wood, he was brought in to replace long-time chairman/president/CEO Vincent Calarco – who served in that position for 19 years – and in a sense is viewed by many as CK’s (potential) savior. His reputation is clearly dependent on the success of CK’s plans, and he has been clear in saying that credibility is awfully important for this team. Management is also financially motivated to improve the share price

4. Fix/divest program will focus the company.
An early transaction was the April 2003 sale of its OrganoSilicones business unit to GE, in return for GE’s Specialty Chemicals business and cash proceeds of $633.4mm (including proceeds from its first quarterly earn-out payment of $8.75mm less transaction-related fees of $18.4mm). The deal also gives CK the opportunity to receive quarterly earn-out payments through September 2006 based on the combined performance of the two businesses; the minimum payout will total $105mm and the maximum will be $250mm (the minimum was recorded on a PV basis as a receivable on the date of the transaction).
Management has further identified Rubber Additives, Refined Products, and Polymer Processing Equipment as candidates for a fix/divest program (Equipment being an almost guaranteed divestiture, perhaps for $100-150mm according to management). EPDM was also in this category but the fixes implemented thus far seem to be working.

Concerns

1. We can’t predict everything, such as the results of the EC investigation and civil suits.
The EC investigation and suits are discussed in more detail below, and while we (and management) expect the results of these to manageable, there is no way to handicap outcomes with high certainty at this point. CK expects that the EC will resolve their anti-trust investigation by early 2005, and assuming precedent holds, the penalty will likely be similar to what the US DOJ imposed ($50mm fine). As in the US and Canada, management has been cooperative with the investigation and has also taken firm internal actions to rectify their problems. Civil suits are even more difficult to predict, but we do know two things: prices were generally falling during the period in question (making damages harder to prove); and, the company intends to litigate cases in situations where settlements would be more expensive.
Other unknowns include the path of raw material prices, discussed more below.

2. How much more cost is there to cut?
While management is confident that it will easily achieve the cost savings in its new $50mm program, and even suggests there is upside in that number, one must wonder why these cost cuts were not implemented in previous programs, i.e. how could so much fat remain after initiatives that started in 2001?

3. New debt deal was relatively expensive.
On 8/3/2004, CK priced $375mm of 9 7/8% Senior Notes due 2012 and $225mm floating rate notes due 2010 (LIBOR + 575bps). It also subsequently refinanced its credit facility with a new five-year $120mm revolver and a $100mm letter of credit facility, in addition to extending its domestic accounts receivable program. With the funds from the notes the company tendered for or redeemed its 8.50% 2005 Senior Notes ($350mm) and its 6.125% 2006 Senior Notes ($150mm). Although Deutsche Bank has reportedly trimmed the rate on the facility to 300bps over LIBOR from 350bps, the company will see its annual interest expense increase by approximately $15mm. This clearly represents the market’s judgment as to the inherent legal risk at CK as well as the price paid for extending maturities out past the end of the decade.

4. Exposure to raw materials is a difficult battle.
Even though management is in the process of increasing prices to account for cost increases to date, they are limited in their ability to respond to higher raw materials prices. The company does do some hedging – for natural gas, tin, and soybean oil – but it is also subject to the volatility in the prices of petrochemical feedstocks.

Notwithstanding all of these, I calculate downside of ~$3, and upside of $20.

Scenario Analysis

Assumptions

LTM EBITDA $185.2 (includes $70mm of price increases already achieved)
2003 EBITDA $177.7
Annual D&A $115.0 (based on income statement)
Tax NOLs $259.5
PV of NOLs $50.0 (conservative assumption)
Tax Rate 33%
Shares Out 115.3


Scenarios

Bear: CK fails to raise prices further; only achieves 75% of current cost initiative; steady-state raw materials prices; $100mm penalty from EC and suits

Base: CK achieves 2004 goal of over $90mm run-rate in price increases; achieves full cost savings in current plan; raw materials & energy decrease by 5%; $50mm penalty from EC

Bull: CK achieves 5% price increase, thus adding $50mm in EBITDA; achieves full cost savings in current plan plus additional point of margin from systems integration; raw materials & energy decrease by 10%; $50mm penalty from EC

NO ASSUMPTION OF ASSET SALES; NO DEBT PAYDOWN WITH CASH; HAVE ADDED PV of NOLs (instead of shielding net income)

Bear Base Bull

Starting EBITDA (LTM) 185 185 185
Current $50mm Cost Initiative 38 50 50
Next Cost Initiative 0 0 25
(Enterprise Systems)
Price Increases 0 20 50
Raw Materials 0 51 101
(based on 04E sales)
Run-Rate EBITDA 223 306 411 (Bull Case equates to 15.4% margin on 05E sales)

Less D&A 115 115 115 EBIT 108 191 296
Less Interest 74 74 74
EBT 34 117 222
Taxes 11 38 73
Net Income 22 78 149
Per Share $0.19 $0.68 $1.29

Per Share Valuation Bear Base Bull Avg

Discounted EV/EBITDA 6.0x $4.56 $9.31 $14.80 $9.56
Peer EV/EBITDA 7.0x $6.49 $11.96 $18.37 $12.28
Discounted P/E 12.0x $2.77 $8.56 $15.91 $9.08
Peer P/E 15.0x $3.35 $10.59 $19.78 $11.24

Catalyst

Next quarterly earnings announcement
Announcements regarding price increases, asset sales
Litigation settlements