Description

• Chlorovinyls – this is the core GGC business that the company has been operating for the last decade by itself (GGC was originally spun off from Georgia Pacific). In this segment, GGC operates as an integrated producer of chlorovinyl chemicals, controlling the production process from the electrolysis of salt, through the production of chlorine, vinyl chloride monomer, caustic soda, vinyl resins, and finally, vinyl compounds (mostly PVC). If it sounds complicated, it’s not – there are some neat charts you can look at that describe the process nicely in the most recent 10-K.

• Building Products – in the recent 10-K and quarterly earnings report, GGC separates this segment out into “Window & Door” and “Outdoor Building Products.” I’m going to combine these into a large “Building Products” segment because that’s how I’m going to value it later. The segment produces window and door vinyl-based components such as frames, sashes, and trim; interior and exterior vinyl-based mouldings for various (usually home-related) applications; and building products such as siding, pipe, pipe fitting, deck, fence, rail, and outdoor storage products. This entire segment used to function as a (badly run) stand-alone company called Royal Group Technologies Ltd, before GGC acquired it in October of last year for what many people think was an insanely high price ($1.55B, including debt).

• Aromatics – this is a non-core business that GGC has been running for a long time. Also vertically integrated in this segment, GGC has one plant that produces, from start to finish, phenol and acetone, which is subsequently sold to producers of phenolic resins and manufacturers of engineered plastics.

• As Bruce Greenwald explains in the last chapter of his exceptional book on competition – Competition Demystified – it is rare to find companies with durable and long-lasting competitive advantages. These companies are value-creating machines over the long run, but they are rare. In fact, they’re so rare, that most of the value creation in the US economy is driven not by competitive advantages, but by operational efficiency. Companies that have a maniacal focus on operating efficiency can, and do, earn outstanding returns on invested capital as long as they are focused on using that capital in the most efficient way possible. GGC is such a company.

• As Bob Olstein is fond of saying, the numbers can tell you more about a management team than you can learn from any management interview. The numbers on GGC’s core business, as we’ll see shortly, show that this is a management team with the aforementioned maniacal devotion to operational excellence, that has run a truly superb value-creating operation for the last decade.

• Operating margins: Over the last nine years, the division’s average operating margins were 11.98%. For the cycle, which I’m computing using the years 2001-2006, the average operating margin was a bit lower at 11.1%.
• EBITDA margins: Over the entire nine year period, EBITDA margins averaged 16.1%. Over the aforementioned cycle, EBITDA margins averaged 15.1%.
• ROA: it is hard to get capital-employed numbers for each segment because that stuff is only analyzable on the consolidated balance sheet. For us, the ROA number is the most eye-popping number in this analysis. The average pre-tax return on assets for the nine year period was 17.3%. For the last cycle, the ROA was the same – 17.3%.

• Normalized revenue over the last economic cycle: ~$1.3B
• Normalized EBITDA margins of 15% on that revenue means EBITDA of ~$200M.
• $25M in annual maintenance capex. This is based on conversations with management. The last two years, GGC has been working on expanding capacity for their PVC production, and the vast majority of that capex went to building that facility. Capex to maintain the present level of sales is ~$25M.
• $25M in annual corporate expense that gets allocated to chlorovinyls.
• $200M in EBITDA minus $25M in maintenance capex minus $25M in corporate expenses equals $150M in normalized EBIT.

• Unfocused diversification leading to management spreading itself too thin and not focusing on its core operations.
• Above average costs in resin production, high cost formulas in producing vinyl compounds, and fragmented and inefficient purchasing operations.
• Low capacity utilization and inefficient use of capacity.
• Bad inventory management and too many manufacturing sites located in places that are too far away from the customer.
• Badly constructed sales staff that competes with independent sales agents that are way too costly.

• EBITDA excluding non-recurring expenses (including costs to fight lawsuits, restructuring costs, costs for outside consultants, and asset write-downs) was ~$160M in FY 2005, and was ~$133M in calendar year 2006. In both those years, the normalized EBITDA margin was the lowest that Royal had ever achieved. GGC management estimates that without any cost-cutting, the Royal operations would achieve normalized EBITDA throughout the cycle of ~$160M. This will get done gradually over the next year as GGC management meets with legacy Royal customers and prospective new customers and gives them confidence about the future of the building products operations. (For a detailed summary of Royal’s normalized EBITDA numbers over the last 6 years, see the last slide in the GGC road-show presentation filed on June 26 of last year.)
• GGC management has already sold off many non-core operations, many of which were also unprofitable. In addition, management has taken actions in the areas of capacity utilization, facility rationalization, and raw material purchasing. The total annual cost savings that GGC management estimates that it has already executed on are in the $80-95M range. We’ll use the bottom range of that estimate.

• More cost-cutting: GGC management estimates that by the end of 2008, cost-cutting actions taken to improve the operations of the building products segment should add a total of ~$160M in EBITDA. We’ve only valued $80M of that when looking at our estimate of normalized EBITDA. Based on GGC management’s analysis, there are still plenty of costs to cut. Also, this management team has been conservative in its past projections and has frequently low-balled how well it expects things to be. For example, they estimated that non-core asset sales would only get done by the middle of 2008 and that 2007 would see the benefits of only ~$65M in cost-cuts. In fact, they’ve already sold off pretty much all non-core assets, used the proceeds to reduce debt, and have already executed on ~$80-95M in cost-cuts. So when you see that $160M number that management puts out there, you know there’s a pretty good chance they’ll beat it. In our valuation, we assumed they could only get half of it.

• Chlorovinyls capacity expansion: as mentioned briefly earlier, GGC is in the process of completing the construction of a plant that will add to its capacity in the chlorovinyls division. Given past high returns on new assets, this could add substantial value in the years ahead.

• The entire aromatics segment: we assumed in our valuation that the aromatics segment is totally worthless. We don’t actually think it’s worthless, but over the last nine years, the division has contributed a total of $178M in EBITDA and about $165M of EBITDA minus total capex. It’s probably worth in the range of $100-150M, and maybe more to a strategic buyer. Management is presently looking to sell this division, and if they get $100M for it, that would add ~$3 share in value.

• The management team: this is a group that has made several value-creating acquisitions in the past and obviously runs a very tight ship. As stated previously, there is a good chance that they surpass their cost-cutting goals and their sales goals and they are very conscious of value-creation and proper capital allocation.

• Massive reduction in cost of capital: with debt presently at 70% of the total EV, GGC’s cost of equity is obviously quite high. In fact, when doing our valuation backwards – trying to figure out what cost of equity justifies a price of $16-17/share – we got the cost of equity to be in the 21-22% range. As the market re-evaluates the company’s true earnings power and management pays off some debt, we think it doesn’t take any miracles to have GGC trade above $50/share simply by reducing the cost of equity and leaving everything else constant (i.e. not including any value for the aforementioned free options).

• Debt maturities – most importantly, their next debt maturity is in 2011 and their line of credit is fairly secure – they can draw another $500M in case they need it.
• Covenants – excluding the non-recurring stuff that always goes along with a complicated merger integration, GGC is not going to trip any covenants and management is fairly certain that if they do, they could easily get waivers.
• Cashflow – even historically trough EBITDA generation would easily cover their interest expense and necessary capital expenditures. Further, management expects that sales at the building products segment should remain quite robust because their customer reach-out initiatives will offset any weakness in the housing market (and they’re not exactly very optimistic about the housing market – they don’t expect any rebound until well into 2008).

Catalyst