Georgia Gulf Corporation GGC W
April 23, 2007 - 9:26am EST by
coda516
2007 2008
Price: 16.12 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 555 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

What do you get when you combine high leverage, a seasoned management team with a history of earning high returns on capital, decent insider ownership, and a ridiculously cheap multiple (5.4x EV/EBIT) on normalized operating earnings? Most people would answer that the scenario described is probably just another example of private equity ignoring short term market worries to acquire (“steal”) some high quality assets on the cheap from foolish and short-sighted shareholders. In reality, this is a perfect description of the current opportunity in GGC available to any public investor willing to look beyond the next 6-9 months.

Company Description
For the sake of this discussion, we’ll divide GGC into three separate segments:
  • 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.
I can already hear the groans. A housing-related company, with a ton of debt, when we might be headed into a recession? Am I nuts?
How did we get here?
So why is GGC trading in a range last seen six-and-a-half years ago? In early June of last year, GGC announced that it would acquire Royal Group, a Canadian building products company (described above as the “building products” segment) for a total enterprise value of ~$1.55B, including the assumption of ~$450M in debt. In order to finance the acquisition, GGC issued a ton of junk debt and no equity. The result was the addition of $1.55B in debt onto a fairly clean balance sheet of what is perceived to be a very cyclical business. The market did not take it too well and the stock dropped 25% in the three days subsequent to the announcement.
Since then, with a few ups and downs, it has pretty much been all downhill. The housing market, upon which the entire company is obviously dependent, has tanked badly since the middle of last year, and GGC’s stock has been down along with it.
Our basic thesis is as follows: the market has, to use a cliché, thrown out the good with the bad. GGC, notwithstanding the housing downturn, is a phenomenal company, with a phenomenal management team that is being priced as if one or more of the following is true:
o Not only was the Royal acquisition bad, but it was worthless. That’s right, those $1.4B in annual sales, any normalized earnings on those sales, and any opportunity for improvement (and boy, are there plenty as we’ll see later on) – the market is giving the entire thing a value very close to zero.
o The core legacy chlorovinyls business will never perform as it has in the past. Forget peak margins – the market is pricing in that future average margins over the cycle will not be even near past average margins.
o The aromatics business is worthless – that’s right, the market thinks this business (annual sales - $500M) is worth nothing.
We think the market is wrong on at least the first two counts, which results in an opportunity for enormous returns. How much?
Chlorovinyls
The most important piece of the GGC business is the core legacy chlorovinyl operations. While this is a commodity business for the most part, we think that a rigorous analysis of GGC’s history in this operation shows two things:
  • 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.
Here are the numbers for GGC’s core chlorovinyls business for the last nine years (no data mining here, just that the 1997 numbers are not comparable to 1998 for accounting reasons):
Chlorovinyls
1998
1999
2000
2001
2002
2003
2004
2005
2006
Sales:
549,525
672,851
1,244,734
983,362
1,011,011
1,159,035
1,452,404
1,592,749
1,642,782
Operating Income:
73,737
98,750
192,325
61,979
114,582
86,289
165,910
202,555
238,792
D&A:
26,488
31,854
52,479
52,992
49,831
50,072
51,345
52,584
57,630
EBITDA:
100,225
130,604
244,804
114,971
164,413
136,361
217,255
255,139
296,422
Capex:
18,694
10,281
15,166
15,737
16,847
22,596
18,326
28,311
70,315
Total Assets:
429,757
867,487
808,218
741,472
729,501
715,368
725,712
807,873
1,221,540
Operating Margin:
13.42%
14.68%
15.45%
6.30%
11.33%
7.44%
11.42%
12.72%
14.54%
EBITDA Margin:
18.24%
19.41%
19.67%
11.69%
16.26%
11.77%
14.96%
16.02%
18.04%
Capex Rate:
3.40%
1.53%
1.22%
1.60%
1.67%
1.95%
1.26%
1.78%
4.28%
ROA:
17.16%
11.38%
23.80%
8.36%
15.71%
12.06%
22.86%
25.07%
19.55%
Sales Growth:

22.44%
84.99%
-21.00%
2.81%
14.64%
25.31%
9.66%
3.14%
There are a few things you can get from analyzing these numbers:
  • 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%.
Along with the margin information, the ROAs that this management team has achieved demonstrate the two general points I made above: a) GGC’s core business is maniacally obsessed with operating efficiency and b) this management team executes really well. So what’s this business worth?
We estimate that normalized EBITDA-minus-maintenance-capex for the chlorovinyls division is about $150M annually. We assume:
  • 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.
What multiple of EBIT do you pay? If I gave you the table up there and didn’t tell you that we’re dealing with a chemical company, you’d probably pay a lot more than if I gave you that table and also told you we’re dealing with a commodity chemical company. Our argument is that this is not just a simple commodity chemical company. It’s a company with a first class management team that runs a first class operation, and the numbers bear it out.
In our simple discounted cash flow model, we assume a 15% pre-tax ROIC (lower than past ROAs), a 3% growth rate, a 13% cost of equity, and an 8.3% cost of debt. We also assume a 50% debt to total EV (the present debt/EV is much higher, which leads to a lower WACC, but we’re trying to be conservative, and we also don’t think that the present debt/EV will remain so high). All of that, of course, is conservative. The ROICs should be higher than the ROAs, not lower; the growth rate in the long run is probably higher than 3% given increased penetration of PVC and market share gains from wooden products (if we’re willing to give USG a 4% long term growth rate, we should be willing to give GGC at least that); and a 13% cost of equity is high, but I’m willing to plug it in there because of the high debt levels. Further, the valuation does not take into account the asset value of the new PVC capacity that is being built and will increase the future rate of normalized revenues. Using the above assumptions, we get an EV/EBIT of ~8.2x for an EV of ~$1.25B.
Building Products / Royal Group Valuation
Before a few years ago, Royal Group was actually considered a pretty good building products company. Looking at the period between 1998 and 2004, Royal routinely registered more than $300M (CAD) in EBITDA annually, on a smaller amount of revenue than it has today. In the trough year of 2001, Royal rang up $315M (CAD) in EBITDA. Even today, Royal has #1 North American market share in PVC-based window profiles and in PVC-based mouldings. The company also has a substantial position in siding and pipe fittings across North America, and is #1 and #2, respectively, in the Canadian market for these products.
So why was Royal trading close to its all time lows when GGC offered to buy it last year? Why did Royal register a pathetic $96M (CAD) in EBITDA and 5.8% EBITDA margin for the 12 months ending June 30, 2006? Fortunately, the answer is simple – really bad management of expenses in the last 5-7 years; the preoccupation with several lawsuits has taken management’s eye off the ball; and the company has been soliciting bids for a long time leading up to the June announcement of GGC’s acquisition, which resulted in Royal not being able to maintain the confidence of its customers and not being able to secure new customers.
For those of you questioning the broad excuse of “bad management of expenses” to explain the dramatic 5-year decline in EBITDA margins, here’s a bit more detail. Based on GGC management’s analysis, Royal’s expense ineptitude included:
  • 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.
I could go on, but I would recommend that anyone interested check out Slide #23 in GGC’s June 26, 2006 8-K release (the road-show presentation). It looks like Daniel Loeb lambasting a company’s operations, sans the third grade insults, and with a lot more in the way of tangible solutions. It’s fairly clear that GGC thinks there’s a lot of fat to cut here, and we’ll soon get into just how much.
There are two ways to value the building products segments of GGC. The first is just to look at what the enterprise value of the company was before GGC “overpaid” for acquiring it. That value is the $9 (CAD) that the stock was at, times 95M shares outstanding, translated into US dollars and added to ~$430M (USD) in debt, gets you $1.2B in EV. Add that to the $1.25B in EV that we think the chlorovinyl operation is worth, and the entire GGC entity is presently worth ~$2.45B, with the equity worth ~$1.1B and the subsequent stock price is $30-31/share. This, again, is quite conservative because we’re valuing Royal at its lowest ever valuation on the back of the weakest year in its history when it was beset by many of the previously detailed operating problems. We could stop right there, assume the aromatics division is totally worthless, and it’s pretty obvious you’re getting a good deal here. But we think that the building products segment is worth a lot more.
We estimate that normalized EBITDA for the building products segment is ~$240M (USD) (to clear up all confusion, we’re talking USD and will be talking USD for the remainder of this discussion). We get this by taking normalized EBITDA for the Royal operations and adding in the cost-cuts that GGC has already achieved:
  • 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.
Adding the $160M in normalized EBITDA before cost-cutting and the $80M in cost cuts, we get to normalized annual EBITDA of ~240M. We subtract ~$35M in annual maintenance capex (as per discussions with management) and another $25M in allocated corporate overhead, and we get to a normalized EBIT number of $180M.
For our valuation, we use the same ridiculously conservative assumptions as we used in our valuation of the chlorovinyls segment to get a fair EV/EBIT of 8.2x, which leads to a fair EV of ~$1.5B.
Consolidated Valuation and Free Options
You can easily put together our value estimates of $1.5B for building products and $1.25B for chlorovinyls, subtract out the $1.35B in debt as of March 31, and get a fair equity value of ~$1.4B. That means a stock price of ~$40/share. I’d like to emphasize that we made grossly conservative assumptions along the way, put a multiple of 8.2x on a high-quality growing company, and there’s a lot of free stuff you get that’s not included in that $40 stock price:
  • 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).
Risks
Obviously, with so much debt, everyone wants to know what the odds are of a liquidity crisis. Thankfully, not high at all. Here are the facts arguing against liquidity problems:
  • 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).
Another risk is that of an industry-wide capacity glut in the chlorovinyls division. A large competitor is in the process of bringing up more capacity toward the end of this year. If the housing market continues to be in a funk, this may result in too much capacity across the industry. This risk is mitigated by the fact that GGC, with the acquisition of the PVC-intensive production of Royal, now has an open avenue to sell its production. Further, even at its worst, the GGC chlorovinyls operation is the most efficient in the industry and will remain cashflow positive. Weaker competitors may not be so lucky.
The final fact mitigating the risk in GGC is that GGC would be worth significantly more to a strategic acquirer than our valuation assumes. Many large integrated chemical companies are trying to expand their value-add operations, and the acquisition of Royal puts GGC right in the sweet spot of being a totally vertically integrated manufacturer with little risk in the supply chain. Further, a strategic acquirer like DOW could instantly lower GGC’s high cost of capital and probably even gain greater efficiencies in the areas of purchasing and plant rationalization, in addition to acquiring a top-notch management team.
If you’re afraid of leverage, this isn’t the idea for you. We don’t mind leverage if we’re fairly confident that the company will be able to cover its leverage costs and that the company is on the rebound. The restructuring story in the building products segment here is incredibly compelling and should provide more than sufficient cashflow to meet GGC’s requirements.
In sum, we think that as the housing market recovers, debt is paid off, and most importantly, the true normalized earnings power of the new Georgia Gulf Corporation in unleashed and recognized, GGC stock should provide massive returns to equity holders and continue creating value on top of the $40/share we think the stock is worth presently. This is a public LBO with the management team, leverage, and valuation, but without the fees.

Catalyst

1. Sustained sales level at building products segments
2. Further non-core asset sales and debt reduction
3. Housing market rebound (we don’t count on it)
4. Acquisition by strategic competitor
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