Description

Innospec Inc. (formerly Octel Corp.) is a specialty chemicals company that produces fuel additives, lead antiknock compounds (TEL), and various performance chemicals. We believe that the company’s value is masked by excessive fear over one declining division, confusing accounting that hides the excellent free cash flow story, and a lack of analyst coverage on the growth story that lies within. We see double digit free cash flow yield and upside of 50% to 100% from current levels

The company reports in three segments:

1. Fuel Specialties: (58% of sales and 53% of profits in 2006). Innospec manufactures and supplies fuel additives that enhance fuel efficiency and performance, while reducing carbon emissions. Applications include transport engines, power generation, and heating. Key customers are oil refiners and fuel distributors. The segment originated through acquisitions and is projected to grow at over 10% mainly through new product development efforts. Growth is driven by environmental legislation and high energy prices.

2. Active Chemicals: (23% of sales, 7% of profits). Innospec manufactures additives used to in personal care/household products and industrial products such as pulp and paper or plastics. This segment is investing in new product R&D, while seeking M&A opportunities. The company expects 10% annual revenue growth in this segment.  

3. Octane Additives (TEL): (19% of sales and 40% of profits before the impairment of goodwill). Innospec is the only remaining manufacturer of TEL, an octane enhancer for automotive leaded gasolines. The progressive phase-out of leaded gasoline implies a steadily declining market for TEL, which Innospec aspires to manage and smooth out by providing consulting and clean-up services. The segment’s fat margins and near-zero additional CapEx needs make it a strong FCF generator for the Company  

Approximately 33% of sales in 2006 were in the U.S., 40% in Europe, and 27% rest of the world.  

Octane Additives.

 Following the enactment of the U.S. Clean Air Act of 1970 and similar legislation in other countries that restricts the use of leaded gasoline, worldwide demand for TEL has fallen significantly - between 10% and 25% the past few years and 63% in 2006 due to the decision of Venezuela and South Africa to exit the market. Octane Additives share of Innospec’s sales has declined from 56% in 2003 to a projected 15% in 2007. The company projects future annual declines in the 15%-25% range, and has indicated that the segment will eventually cease operations.

The good news is that revenue and margin erosion in the division are occurring more slowly than the company has guided to. There are currently 17 countries that allow the use of leaded gasoline in automobiles and they are not the wealthiest or most environmentally conscious of lands (Afghanistan, Iraq, North Korea, Yemen and Jordan are a few). Lead additives are a cheap way of increasing the octane number of gasoline from a refinery, and going unleaded increases production costs for the refinery. There is also a significant capital investment required. Given the current high oil prices, there is less incentive for existing customers to switch to unleaded fuels. We project phase-out of leaded gasoline by 2010, but at current rates of decline, it could take twice as long.  Given that the Octane Additives segment has virtually zero capex, that potentially adds a lot of cashflow and value to IOSP.

Fuel Specialties.

Innospec is the clear leader in fuel additives for diesel fuel, treating ~2/3rds of the world’s diesel fuel. The Company has benefitted from recent US ultra low sulfur diesel (ULSD) regulations limiting sulfur levels (500ppms down to 15ppms).The trend should continue as further US regulation applying to rail and off-road transportation comes online through 2012. Similar regulation is expected in Europe, Asia and Russia driven by environmental concerns. In addition, high oil prices should encourage a move to more efficient diesel engines (diesel is already nearly 50% of automotive fuel in Europe). Other high-growth sub-segments include ethanol and biodiesel, where IOSP is a leading provider of anti-corrosion additives. The booming ethanol market should yet again favor IOSP, though sales in this sub-segment take off from a small base.

Products are used in the personal care, pulp and paper, fragrance, aroma chemicals, household, institutional care, industrial and plastics and polymer markets. Active Chemicals has more competitive end markets and lower returns than either of the other two divisions. The management team has moved to fully integrate the acquisitions that the former CEO made, and to revamp the sales structure along the same line as Fuel Specialties. The expectation is that this will get them closer to their customers for many of the niche products that they sell, and to leverage their customized products and service. Though not a big part of the thesis, the track record of management gives us confidence that this division should be able to grow sales and maintain margins over the next few years.

Accounting issues mask earnings power

To add an extra wrinkle, the GAAP earnings of IOSP are not a thing of beauty. Because of the declining nature of the Octane Additives segment the company writes off goodwill on a quarterly basis. Impairment charges totaled $134.4 million in 2005, $36.7 million in 2006 and $10 million so far in 2007.  In addition, depreciation and amortization charges ($23mm YTD) are significantly greater than capital expenditures ($8.6mm YTD). The net of all this is that cashflow is significantly greater than earnings.

Stock Buyback/Flexible Balance Sheet

IOSP’s management team have used the cash from TEL wisely, investing in the various Fuel Specialties divisions and Active Chemicals businesses when prices were low. More recently, they have been repurchasing their own stock ($17.4mm YTD) as target prices have risen. In the current environment, we would not be surprised to see management look for new acquisition opportunities. Given their track record of operational improvements and capital allocation, we are happy to have them shopping during a downturn.  

Valuation  

Catalyst