Description

Summary: Kraton is the 800-pound gorilla in the very tight styrenic block copolymer (SBC) market, with a 60% global market share in the highest-margin segment. KRA emerged from a painful reorganization having transformed from the prime victim of rising butadiene prices to the prime beneficiary, and the Street is just beginning to appreciate this foundational shift. KRA shares are cheap even on understated Street expectations, which KRA should handily beat.

Key Points

• KRA is beneficiary of butadiene (BD) inflation, which looks likely to persist. BD, one of the key inputs in KRA's 4,400 products, is up nearly 50% YTD. Previously, this was a headwind causing massive earnings volatility. But KRA now has immediate pricing power, no need to reset prices lower and little price competition from Asian peers.
• Stock remains 'cyclical' cheap. KRA trades at a ~20% discount to peers and single-digit '12 P/E, despite double-digit sales growth/20%-plus EPS growth for next three years.
• Pricing power, mix shift fuels sustained operating leverage. In addition to pricing power, KRA shifted its focus to hydrogenated SBCs (60% market share), which have ~2x-2.5x the profit margins of unhydrogenated SBCs. This segment should continued to grow to as much as 40% of sales, driving Ebitda margins to 18%-plus from 10%-12% range.
• FCF drives expansion, further debt paydown on already-clean balance sheet. KRA, already one of the least leveraged chemical companies, will use its FCF to further cut interest expense and also expand further into Asia.

Key Risks:

• Macroeconomic shock is by far the biggest risk. Weak end markets, including housing-tied roofing, could cause earnings disappointment, muted valuations.
• Raw material prices sap demand, pressure margins. Soaring fuel prices could damp demand while driving higher BD prices, worst-case scenario.

Company Description

Kraton Performance Polymers is the world's largest producer of styrenic block copolymers (SBC). SBCs are used to provide greater flexability/elasticity for a wide range or products: Adhesives, coatings and sealants  comprise 32% of sales; advanced materials 31%; paving and roofing 26%; and emerging new businesses (11%). KRA has 760 customers worldwide, with the top 10 customers comprising ~25% of sales and have been customers for more than two decades.

Brief But Relevant History

Kraton invented the SBC industry in the 1950s when it was the elastometers division of Shell. Shell sold the business in 2001 to Ripplewood Holdings, which in turn sold it to TPG and JP Morgan in 2003. The company went public in December 2009. KRA suffered for a long time with a 'volume first' strategy - trying to sell as much as it could at all times with no surcharges for fluctuations in its pricing. The failure of this strategy - akin to steel companies from 1970-2000 - came to a head in 2006-2008, when KRA nearly went bankrupt despite selling a record amount of SBCs.

Kevin Fogarty, now CEO, came up the 'Price Right' strategy: he realized one-third of product lines were perpetual money-losers. KRA instituted a one-time above market price increase, with near-constant surcharges for additional increases in COGS. Since in place, KRA has successfully implemented 42 prices increases over the past 18 months - and has not once had to step back prices. SAP implementation tracks customer by customer pricing for 200 grades and 4,400 SKUs. These changes give KRA considerable pricing power. If competitors are able to compete and lower prices, KRA will exit the business because it wants only high-margin business.

Pricing over volumes

The company appears comfortable with gradually ramping up volumes while maintaining a tight market. However, these assumptions could prove conservative given the two quarter tsunami-related disruption in production at Kurary, its largest competitor in the higher-margin HSBC market.

 Business/Segments

KRA has four reporting segments:

• Adhesives, sealants and coatings (~33% of sales): tapes, labels, industrial adhesives and sealants. Good business with loyal customer bases and surcharge power.
• Advanced materials (~31% of sales): Tooth brushes, razor blades, totes, automotive components, PVC-alternative tubing, diapers, etc. (KRA's best business, dominant position in high-margin business for specialized, technology-intensive products - many of which are rubber alternatives benefitting from soaring rubber prices.
• Paving and roofing (~29%): asphalt modification for roadways, bridges, airports, roofs, shingles. (Weakest business at the moment due to housing/government spending weakness, but there is potential cyclical upswing here.)
• Emerging businesses/other (~7%): Surgical gloves, condoms, fuel additives, footwear. Hybrid of two small segments: new product lines, and small vestige of old footwear line.

KRA makes 4,400 products broken into two categories: unhydrogenated stryenic block copolymers (USBC) and hydrogenated stryenic block copolymers (HSBC). USBC are roughly two thirds of sales, and HSBC comprise one-third of sales. Sales of HSBC, which are used for more high-end applications where ultraviolet resistance is important, have margins of ~2x-2.5x USBC.

 Competitors/Market Share/Customers

KRA competes mainly with Asian competitors for its polymers derived from butadiene, styrene and isoprene - three commodity chemicals whose prices correlate closely with crude prices.

USBC market: KRA (26%), LCY (9%), Baling (9%), Dynasol (8%), Fina (6%).

HSBC market: KRA (60%), Kurary (20%), TSRC (8%), Dynasol (3%).

 When the markets for these polymers are slack, KRA's Asian rivals compete fairly aggressively on price - part of the reason why KRA has exited low-margin, low-tech lines such as shoes to focus on more complex lines. However, the butadiene, styrene and isoprene markets look structurally tight and have been following KRA's lead on pricing aggressively - KRA has successfully made 41 price increases the past 18 months. One of the great things about KRA businesses: all four of its segments are highly consolidated (top four comprise more than 60% market share) with highly fragmented customer base: ~750 customers comprise 75% of sales, with the top 10 comprising the remaining 25%.

Geography

KRA produces 88% of its volumes in low-cost emerging markets but derives only 33% of its sales from EM territories. This is very likely to change, and KRA is likely to deploy more of its cash to expanding its presence in Asia - including new manufacturing facilities. The best part of the growth story is HSBC - relatively mature in the US and EU, but is poised to boom overseas.

Raw materials

KRA's three polymers account for ~50% of COGS. It is vulnerable to some short-term volatility in prices - typically a 30-day delay in increases at the latest. However, all of its contracts have surcharge mechanisms that are easy to implement and difficult to retract.

 Understanding the Butadiene (BD) Supply-Demand Situation Is Key

 Why are the markets for these polymers tight? And why does rising feedstock prices actually help KRA? BD is a byproduct of the steam cracking process used to produce ethylene. Ethylene can be produced either with light feeds or heavier feeds - increasingly, new 'crackers' used light feeds. Butadiene is a byproduct of heavier feeds. According to industry consultants DeWitt & Company, the amount of butadiene produced per 100lbs of ethylene is down to 5-6 lbs from 8 lbs seven years ago. Byproduct production is down 40%-50% -- hence, supply is lower. The same thing is happening overseas. Each new cracker such as the world-scale facility Dow plans to build in the US will accelerate the closure of heavy crackers elsewhere.

On the other side of the ledger, demand is surging. Butadiene and the polymers KRA and others create with it are an alternative to natural rubber, which is expensive and takes seven years to grow trees to production. Many rubber trees were cut down to make furniture in developing nations, and renewed auto demand has caused huge supply-demand tightness in rubber. Since BD prices are highly correlated to movements in rubber prices, BD prices have been soaring on this supply-demand imbalance. There are no fundamental drivers to change the supply situation in the near-term and no easy substitutes for BD - therefore, the biggest risk to BD prices is a macroeconomic slowdown.

Lastly, why is KRA the beneficiary of feedstock price increases? Again, this goes back to the reorganization KRA management undertook as it lost money during its biggest boom period. The ability to pass along prices immediately has been invaluable - ESPECIALLY given the delays in return prices back to lower levels. KRA has passed through 42 price increases, with no price cuts. 

Catalyst