Description

Ethyl Corp (EY) manufactures fuel and lubricant additives, used in any kind of engine (cars, ships, locomotives, airplanes...). Following industry consolidation throughout the 80's and 90's, there are only 4 major companies left globally in that line of business. The consolidation was driven by the high amount of R&D and Testing required to develop new additives.

EY now enjoys a 20% share, versus 40% for Lubrizol (LZ). Chevron has a 10% share, and a JV between Shell and Exxon, the remaining 30%.

In 1997, the Company bought back 25% of its shares outstanding through a tender offer at 9.25/share, incurring significant debt (reducing the share count to 83.5 MM). This proved to be a disastrous decision for the following reasons:
- after years of high profitability, the industry was complacent regarding capacity. This overcapacity was exacerbated when a new plant from a competitor began producing in Singapore on the verge of the Asian Crisis.
- buyers were concentrating fast through merger and acquisitions (major oil companies, Quaker State/Pennzoil), pressuring prices and margins down.
Profitability suffered significantly for all the players. Margins still have not recovered. With the added burden of significant debt due to the ill-fated buyback, the share price collapsed to a low of 1 in March 2001.

As a result, EY recently announced that it would close down some of its plants, abandon some business lines, and sell peripheral assets.

Looking forward, the situation is the following:
Sales will drop from 800+ MM to around 600 MM+ in 02, due to discontinued business lines. EBITDA margins on those 600 MM+ should reach 12% in 2003, versus 13%-14% before the Asian crisis. Maintenance capex is estimated at 15 MM, giving an adjusted EBIT of 55-60MM.

The pension plan is overfunded by more than 100 MM and is in the process of being liquidated (50% taxes). Sales of other non-core assets (the Company is more than a 100-years old), capital released by reduced sales (inventory and receivables) should generate an additional 50 MM, according to management.

EY also has a marketing agreement with Octel (OTL) to distribute TEL, a chemical used in lead gasoline in emerging markets. The payments fall directly to the bottom line, but are declining at a fast pace, around 15% - 20% /year.
In 2001, this agreement will generate 35 MM in free EBIT. I value this stream of cash from 2002 on using DCF with the following assumptions: 10.5% discount rate, 15% decline per year : 110 MM [ 110 = 35*.85/(10.5%+15%) ]

Bottom line: by end 2002, financial debt will have declined to 250 MM from 440 MM in December of 2000 ( 110 MM from operations, 100 MM from liquidating peripheral assets ). Assuming the core business sells for 9 x adjusted 03 EBIT of 55 MM + 100MM TEL business - 250 MM net debt gives equity value of: 345 MM : 4/share by end 2002 versus 1.60 today.

Another way to look at it: Free Cash Flow should be stable and of the order of 50 MM/year from 2002 on (declining TEL being offset by declining interest payments on the debt after 2002). Market cap is currently 135MM, less than 3x 2002 FCF !

Let’s check how the EPS and FCF will look like in 2003: sales of 600 MM * 12% EBITDA margins: 72 MM
TEL EBIT in 2003: 35 (2001 number)*85%*80% = 24 MM
Interest on debt of 250 at the beginning of the year, 8%: - 20 MM
Reported D&A: 60 MM (lots of excess depreciation due to idled factories – they may chose to write them down in the next 2 quarters)
Reported 2003 pretax income: 16 MM
Corporate Taxes of 40% : - 6.5 MM
Net income will be 9.5 MM – ie roughly 11c reported 2003 EPS, not exciting versus a stock that sells for 1.60 today (PE of 14x)

Adjusted EPS: of the 60 MM in D&A, 15 is amortization of goodwill. That leaves 45 of depreciation. Part of the depreciation comes from old TEL manufacturing facilities, that will never require any reinvestment (Ethyl stopped manufacturing TEL years ago – EY gets paid by Octel to distribute the product manufactured by Octel). The rest of the overdepreciation comes from idled additives factories acquired in the 80’s and 90’s during the consolidation phase of the industry, capacity that will never be used again. The sustainable, long term maintenance capex required in the remaining business therefore is only 15 MM per year (capex in 99 and 2000 were less than 14 MM each year – CFO claims capex in 01 will be around 13 MM).

2003 FCF:
Reported net income: 9.5 MM
Depreciation and amort: 60 MM
Minus capex of 15 MM
Working capital change of 0 (the core business is very low growth)
Gives FCF of around 55 MM…versus a market cap of 135 MM

Sustainable FCF/share = true economic EPS of EY : 66c (55/83.5) 2003 P/FCF = 2003 P/ adjusted EPS : 1.60/0.66 = 2.4 adjusted 2003 PER – (The share count of 83.5 MM should remain stable as no options were granted in the last two years, and the existing options have strikes of 8 USD +)

At the price target of 4, EY still sells for a very reasonable 6x 2003 adjusted earnings. Should investors decide that EY is worth 10x 2003 FCF or adjusted EPS, the shares would sell at more than 6 ½ ie 4x the current price.


It's obscure, complicated, and you have to look beyond the surface. These days, it's hard to find anything cheap! However, I think the potential reward is worth the effort.

Catalyst

None in the next 12 months. Within 2 years: fast deleveraging - recovery in margins after heavy restructuring – potential acquisition candidate by an LBO shop – LBO by the Gottwald family, which owns 25% of the Company.