Description

Quick Investment Case 

I would buy Ingevity, the WestRock spinoff from a few years ago, at the current price of around $84. I see the investment case as one where you can buy a fair to somewhat good business with some interesting niche positions, at a reasonable price of 11x prospective P/E, 9.8% equity FCF yield, 7.7% EV FCF yield, 11.5x EV/EBIT (all based off my 2023 estimates). For this, you’re buying a company with a 12.5% ROIC and much more attractive 36% ROE that I think can probably grow faster than the market over the medium-term, and possibly the long-term. 

Prior to covid, the stock had derated from a forward P/E of about 21x towards the end of 2018 to around 16x by the end of 2019, I think driven by a combination of: 

·         Concerns over exposure to ICE in their activated carbon business

·         Concerns over market share loss in the relatively large Tier 3 part of that business, where they service the North American market and enjoy a 95%+ market share but have a key patent expiring in Q122

·         Concerns over the concentration of their exposure to certain feedstocks, which has driven volatility in pricing

·         Some earnings disappointments 

While the ICE will eventually be regulated away, it is unlikely to be something that occurs in the short-term, more of a medium-term thing (https://www.autoevolution.com/news/ernest-and-young-predicts-evs-will-outsell-ice-car-by-2033-164286.html) , which will give Ingevity time to diversify away from this area using their ~$250m pa of equity FCF. The activated carbon market as a whole is likely to grow over the medium-term as content per vehicle in China and Europe moves a little closer to North American levels by the middle of the decade. While I would expect them to lose share in Tier 3 over time, I think the revenue loss will be fairly modest and should be compensated for by overall market growth and pricing offsetting volume losses. I think that the ESG headwind that many perceive in the shape of ICE exposure could wind up being a tailwind in the Performance Chemicals business, which should drive organic growth and might even help in terms of a rerating. 

I think that the company can probably grow revenues in the 5% pa range once we exit the easy comps from covid, while operating profit should grow by slightly more due to some modest margin expansion and lower restructuring. This gets me to $1.48bn of sales in 23, $1.55 in 24, with operating profit of $382m and $412m, respectively, which then translates to EPS of $7.45 and $8.45. For the sake of making life easier in my modelling, I assume that the (substantial FCF) will be used to buy back shares, but in reality, they are probably going to use it for acquisitions to bolster the Performance Chemicals division to diversify away from ICE, which has weighed on the multiple. 

For a business that can grow faster than GDP, with attractive gross margin and ROE and an adequate ROIC, with substantial FCF generation, I would say that 16x P/E (about where it was trading pre-covid, having derated meaningfully) is not leaning too much into the case. That would imply about $119 on my 2023 estimates, for upside of just over 40%. 

Company In Detail 

They are a specialty chemicals company spun out of WestRock in 2015. Prior to covid, they had $1.29bn of sales and $397m of EBITDA, translating into $340m of operating profit, $4.35 of EPS and $170m of FCF. For 2021 I think they will do about $1.34bn of sales, $440m of EBITDA, $332m of operating profit, $5.34 of EPS and $250m of FCF. The company has a market cap of $3.3bn, net debt of $1.1bn and an EV of $4.4bn. Headline multiples of 2021 consensus are 12.7x EV/EBIT, 15.1x P/E, 5.5% equity FCF yield. The net debt represents about 2.4x my estimate of 2021 EBITDA, with the company targeting a range of 2x-2.5x. I have not met the management face to face – friends that have think they have a tendency to overpromise a bit and then suffer “blowups” (his words, not mine). The CEO owns about $6m of stock, so I think that he at least has some skin in the game. 

They have two main divisions, Performance Materials and Performance Chemicals (though Performance Chemicals is split into further sub-divisions). Performance Materials will do about $530m of sales and $265m of EBITDA this year for a margin of about 50% (should normalise down to mid-40’s post covid effects cycling out), while Performance Chemicals will do about $810m of sales and $195m of EBITDA for a margin of about 22.5%. 

Performance Materials 

In this division, the company produces activated carbon, which is used, among other things, for air purification and gasoline vapor purification. There is another writeup on VIC which explains the product and market better than I could, but inputs (either coal, coconuts or sawdust) are combined with phosphoric acid to create pellets (or honeycombs, in the case of Ingevity) which are put inside of a car’s petrol tank. The pellets absorb certain gasoline emissions, but what is unique about Ingevity’s product is that there are able to catch the emissions and release them back into the fuel tank, which improves fuel efficiency. As the previous writeup references, there are differing regions that are on differing emission standards:

North America (17m vehicles) is on Tier 3, which generates about $20-25 per vehicle, which is made up of ~1.5 honeycombs per vehicle, generating revenue of $8-$10, with the rest being the activated carbon pellets. They have upwards of 95% market share here, and the market size is probably about $380m (17m vehicles * $22.5/vehicle – but I can’t find exact data). 

China (26m vehicles) is on the equivalent of a Tier 2, which generates $6-$8 per vehicle currently. Regulation is uncertain, but the expectation is that they will go onto the equivalent of a US Tier 3 around 2026. In Tier 2, the company think that their market share is “much higher than 60%” (the rough number I put to them). Market size is probably about $180m, but the potential would be north of $600m if China went to Tier 3. 

Europe (18m vehicles) passed the equivalent of a US Tier 1.5, and the content per vehicle is at about $3.5, making it a ~$60m market currently. The expectation from the company is that if/when Europe7 standard comes into play (they think around 2025), content per vehicle will move to “$6-$8 at a minimum”. The rest of the world is then about 23m vehicles at $1 per vehicle, so it is a relatively small market. To make my estimates of the global market reconcile with divisional reporting, I think that their market share below Tier 2 must be about 40%. 

I would thus put the total market at about $650m, with a blue-sky scenario of it going to $1.2bn towards the end of the decade. The company only say that they think there will continue to be growth for all of this decade and plan to increase capacity to service this. They have pricing power, have implemented high single digit price increases historically, and “anticipate meaningful price increases”. 

Aside from the ESG overhang in this business, the other existential risk is around patent expiry. They have a patent around the Tier 3 technology in North America which expires in Q122. There have been some attempts to further extend the patent via litigation which have been unsuccessful. The broad bear case is that North America is probably about $365m of revenue for them ($22.5 of content per vehicle * 17m vehicles * 95% market share), i.e., about 28% of 2019 pre-covid revenues of $1.3bn - due to the better margin profile of this business, you are probably talking 40% of 2019 group EBITDA just from the North American Tier 3 market. You then have market share in the segments where they do not have as much IP protection that ranges from 40%-70%, with the disaster scenario being that Tier 3 market share goes to Tier 1 levels, which would cost them about 16% of group pre-covid revenues, obviously much more of group EBITDA given the margin profile and likely decremental margin they would suffer. 

I think that the way it plays out will be nowhere near that bad. 

First, the expiring patent covers only the honeycomb, not the activated carbon pellets. The honeycomb covers less than half of the total revenue per vehicle, and customers will still need to come to Ingevity for the pellets due to their higher quality. For reference, a competitor in China did try to come to the market with a cheaper alternative to Ingevity for the pellets and had all kinds of quality issues. They won some share and then the clients ended up back with Ingevity. There’s a Japanese competitor also coming in, but they only have capacity to serve something like 5% of the market at the moment. I would therefore argue that, of the ~$380m current Tier 3 market, probably only about $155m of it (17m vehicles * ~$9 honeycomb content per vehicle) is under threat from the patent expiry. 

In terms of the honeycombs, they have actually signed up 40% of their honeycomb clients for long-term contracts (length not disclosed), where they made a “slight” concession on pricing for the honeycomb, but none for the activated carbon pellets, which I think means that “only” around $90m of their 2019 group revenues of ~$1.3bn would be immediately up for grabs, with some risk that the Tier 3 ex-honeycomb market share is chipped away at over time. 

Offsetting this, you will likely see the overall market expanding, while in the meantime they are making efforts to diversify their activated carbon revenues away from ICE - gasoline vapour purification is only about 25% of the activated carbon market by application (but probably much more by share of the profit pool). They are working on applications on water/air purification (currently about $8m of annual revenue with lower structural profitability that the auto part) and natural gas fleets, among other things (presentation with info on some applications here - https://s23.q4cdn.com/855317798/files/doc_presentations/2021/06/Innovative-New-Pathways-for-Activated-Carbon.pdf ) 

In the table below I have included some assumptions I make on the size of the activated carbon market going forward, together with what that means for my divisional forecasts. I think that divisional revenues will continue to grow for the next 6-7 years (with implementation of regulation and timing around this being the key risk)

Performance Chemicals

Performance Chemicals represents a more diverse set of products and end markets. In the largest part of the business (everything excluding the recently-purchased Engineered Polymers sub-division), the take “black liquor”, which is a by-product from using pine sap to make paper products, acidulate the black liquor and turn it into crude tallow oil (CTO) – CTO has two components, rosin and TOFA, and they derivatise 90% of the rosin and 70% of the TOFA and sell it into various industries. Performance Chemicals did about $800m of revenues pre-covid. 

The biggest single part was Pavement Technologies, which was about $185m of the $800m in 2019. It is a fair business – certainly GDP plus (has grown at an 8% CAGR since 2005, they claim – CAGR since the spin has been nearer 5%), while they claim they have the number 1 market share in an $800m-$1bn market, ahead of Nouryon, Arkema and Kao. Their pavement preservation products are a small part of the total road cost (<1%), and the preservative products extend pavement life and drive a lower total cost for authorities vs pulling the road up every 15 years for reconstruction. 

Industrial Specialities was more than twice the size of Pavement Technologies in 2019, at about $385m in revenues, but has more diverse end markets. It is everything from inks to packaging adhesives to dispersants used in crop protection, plus lots more. As the previous writeup on the company alluded to, these are pretty much GDP businesses and modelling them accurately is a crap shoot. There have been a couple of issues which have weighed on revenue growth and profitability. First, in China and Brazil, due to the way rosin is produced in those countries, one ends up with two products – gum rosin (similar to Ingevity’s products) and gum turpentine. A couple of years back, a large gum turpentine factory blew up, sending the price of gum turpentine up 500% almost overnight. Obviously, the locals harvested as much of the turpentine as they could, which created an imbalance in the gum rosin market which weighed on pricing and margins, thus you saw Industrial Specialties revenues -13% in 2019 (they don’t disclose sub-divisional margins). The plant came back online in late 20 and markets are now back in balance. The other issue (actually not just for Industrial Specialties) is that the business is very reliant on one raw material to produce their products. Currently they have about 2/3 of their supply locked in under long-term contracts, but their raw material is seeing meaningful inflation (it was spec’d into European biodiesel regulations, increasing demand), meaning they expect to see inflation “for sure”, according to them. The demand dynamics in some of their end markets are a bit disconnected from this dynamic, so there is the concern over the medium-term that they could see margin squeeze. The good news is that it is possible to get fatty acids from other sources, such as soy (and they are looking into rapeseed oil as well), and their refineries have multiple columns now, such that you can run multiple feedstocks at one time, which should be a positive over the medium-term. 

One other issue I should mention is that there is a clear ESG angle here. In most of their end markets in Performance Chemicals, they are up against petrochemical products. Vis-à-vis these products, CTO derivatives are the “greener” alternative. It is now becoming a real consideration for their customers, and they have called out the fact that on many occasions, they are now getting questions regarding the “green properties” of their products. They are currently going through the process of getting certification done on their portfolio. I can’t put any numbers around it, but I think it will be a positive for organic growth and will hopefully provide a bit of a tailwind for the valuation of the stock. ESG has, I think, been a headwind for the multiple over the last couple of years (together with other things), but it might even end up fully reversing over time. 

The final part of the Performance Chemicals division is Engineered Polymers, where they sell derivatives of caprolactone (benzene is the input here, so it is in fact the only part of Performance Chemicals which will not benefit from the ESG halo) which have various industrial applications, for example resins, adhesives and bioplastics. It is a business they acquired in 2019, paying $675m, which was about 11x 2018 adjusted EBITDA pre-synergies. The business did about $167m revenue in 2018, so the margin profile is midway between Performance Chemicals and Performance Materials. When they did the deal, they estimated the total addressable market (not current market size) to be about $1bn, with weighted end market growth of about 7%, using growth rates from 2015-2018. They only have two competitors in the space, BASF and Daicel, but they have around 3x the combined capacity of the competition. All of the current capacity is based in the UK. The products are not quite the same, but if I had to compare the business to anything else listed in terms of margin profile, end market potential, production and so on, it would be Victrex in the UK. While in my model I just assume that FCF is used to buy back shares in order to keep things simple, I think that, in practice, it will be used to do more deals of this nature to try to diversify away from ICE. The FCF is probably enough to drive about 6%ish inorganic group top line growth per annum, on average, with a key consideration being that they overpay for deals. 

Valuation 

I think that the fears over ICE and patent expiries in the PM division are possibly slightly overdone, and I see that division delivering mid-single digit revenue growth over the next few years, driven by robust pricing. In the PC division, I think that the addition of Engineered Polymers (now about 20% of the division) should help to drive a better volume trend overall, while the ESG angle should be a positive, as should the work they are doing on diversifying their feedstock. My estimates on revenues and EBITDA, with the bridges, are as follows:

This then drives the following in terms of P&L:

The company should generate quite strong FCF, which they can use to either buy back stock (unlikely, though they did some in 2020), delever (again unlikely as they seem comfortable with net debt around current levels) or grow inorganically (most likely, in my view).

In terms of valuing the earnings and cash flow, the P/E multiple ex-covid bottomed out at around 13.5x after the Engineered Polymers deal and some earnings disappointments (however the company was more levered then). Currently, the median forward P/E for companies they directly compete with is around 14x, while for the wider speciality chemicals space, it is about 13x, I would argue that Ingevity should trade at a premium given the better margin profile (e.g.  gross margin 39% vs median specialty chem peer around 27%; operating margin 25% vs median specialty chem peer around 17%). On my 2023 EPS estimate of ~$7.50, that suggests fair value ~$120/share.

Key risks would be: 

·         Company understating the risk to market share loss in the Tier 3 activated carbon business in North America

·         Regulatory risk around implementation of emission standards in China and Europe

·         Continued multiple derating due to perceived high exposure (in particular on EBITDA side) to ICE

·         Company squander their significant FCF on overpriced deals

·         I don’t appear to have a differentiated view on earnings when I look at my numbers vs consensus, so slight element of taking on the market head on regarding valuation

Catalyst

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