Description

Thesis

We are recommending a short position in LZ.  Over the last three quarters, Lubrizol has over-earned due to significantly improved unit margins, as lubricant additive prices have held relatively steady while raw material costs have collapsed y/y along with crude.  Earnings per share have jumped from $3.57 in 2008 to $7.55 in 2009 (and beyond).  Management is extrapolating current trends into the future, trumpeting a "new equilibrium" that augurs sustainability of these record results.  The Street is buying it - 6/8 Street analysts who cover the name have "Buy" ratings on the stock.  Consensus shows  ~19% EBIT margins in 2010 and beyond, margins never before seen in the Company's history going back to 1991 and 2x LZ's sub-10% average EBIT margins of the last decade.  LZ is trading at 10x 2009 earnings - we believe those earnings are not sustainable.  Complementing the short thesis, management has displayed poor judgment in building the Advanced Materials (AM) business through overpriced acquisition.  We see 40% downside to the stock price from current levels (~$74).  This is not a trading call, since we believe it could take time for the thesis to play out; however the Street is bullish and the stock is held by fast hands, so we think any disappointment from already lofty expectations will produce swift downside moves.  Otherwise, short interest is low and the cap structure is minimally levered, minimizing the danger of a melt-up if the Company continues to exceed expectations.

Background

70% of LZ's revenue comes from lubricant additives, which are added to engine and driveline lubricants to enhance performance.  They are primarily sold to major oil companies who then sell finished lubricant to the OEM and retail market.  The lubricant business is not subject to rapid technological change and generally grows low single-digits annually.  LZ estimates the size of the lubricant additives market at $9bn in 2008, giving the Company a roughly 40% market share.  While this market share no doubt affords the Company some degree of pricing power, oil companies supply LZ with base oil and some oil majors also have subsidiaries that manufacture lubricant additives, providing a healthy degree of competition.  The competitive environment can be hostile as evidenced by Exxon's patent lawsuit against LZ in late 1993 that resulted in $129mn in damages.

So it is not surprising that additives pricing has tracked raw materials cost in a relatively narrow range over the last five years.  Given the fluctuations in crude oil prices, the last two years have been an exception (80% of the Company's additives raw material cost is derived from petrochemicals).  During 2008, Lubrizol's numerous price hikes could not keep up with the rapid run-up of raw materials costs, and unit margins contracted substantially, leading to an unusually weak 21% gross margin in 3Q08 (the Company's raw materials costs generally lag crude by 60 days or so).  Even so, additives volume growth in the first 9 months of 2008 (before volumes collapsed violently by 18% in 4Q) allowed LZ to grow gross profit dollars and keep per share earnings relatively stable from the year ago 9 month period. 

Less than a year later, a mirror image - LZ's additives raw materials costs collapsed, falling 23% and 29% y/y in 2Q09 and 3Q09, respectively, as crude oil fell 40%-50%.  Meanwhile, Lubrizol was surprisingly able to maintain pricing consistent with year ago levels - okay, there was a 3% and 6% y/y fall in 3Q09 and 4Q09, respectively, but the prior two quarters saw price hikes of 7% and 13% y/y.  LZ management recently stated that Additive volumes have returned to pre-recession levels.  When you run these year-ago volumes through what we estimate to now be the highest Additives unit margin over the last 5 years, it is perhaps no surprise that 2H09 produced record earnings for the Company.   Gross margins of 35.4% / 36.1% / 32.6% in 2Q09 / 3Q09 / 4Q09, were significantly above the 26% 2001-2008 average.   EBIT margins of 20.4% / 22.1%/17.6% in 2Q09 / 3Q09 / 4Q09 were more than double the annual EBIT margin pre-2008 average of 9.4%.  While management believes current LTM EBIT margins in the mid-to-high teens are sustainable, in February 2006 Charles Cooley, the Company's CFO, commented that 11-12% was the longer-term norm and the Company's target.  Have the economics of this commoditized industry really changed that much over the last few years? 

James Hambrick, the CEO, has told a good story for why 2009 performance is not really the "new normal" but rather a return to normalcy after a decade of unusually sub-par results.  Blame it on the environment in 2002, a period of static engine design, oil companies that were consolidating and demanded synergy savings, price-conscious customers and capacity imbalances.  This is in contrast to comments from Q104, when management claimed there was no excess capacity problem in the industry.  On the 4Q09 earnings call, Hambrick was adamant that after the painful over-capacity issues of the last 25 years, industry players would be rational about capacity.  Meanwhile, LZ is doubling its capex vs. 2009 to greater than historical levels, including a $200mn greenfield investment in China over the next three years.  Blame it on an outdated company strategy centered on market share over profitable growth and unfocused R&D.  Now, however, we are at a "new equilibrium" (Hambrick's words, which differ from NewMarket's (NEU - a smaller competitor) comments that it "hasn't been a steady state" in reference to price/cost and 3Q09 margin expansion).  Customers want to pay up for value and product differentiation, there are higher performance requirements on vehicles, and of course, China.  We find it interesting that before the dramatic collapsing oil price-induced margin expansion that began in 2Q09, there was no talk of any of these trends; are we to believe that coincident with an unprecedented drop in raw material prices, this new equilibrium suddenly snapped into place?  Or is it more likely that management is trying to finding reasons to validate the sustainability of this anomalous event and resulting margins?

We are betting that the underlying economics of the lubricant additives industry and the competitive positioning of LZ have not materially changed, and expect margins to be competed away to their long-term norms. 

Consensus earnings are stretched

It might be useful to examine the assumptions necessary to arrive at $8.00+ EPS (LZ's estimates).  Hambrick has pointed out that during the recession of the early 80's, the Company saw a two year, peak-to-trough volume decline of 20% that was then followed by 5%+ volume growth in the recovery years.  The Company's 9% 1 year volume decline in 2009 (followed by volume recovery in 2010 from current pre-recession volume levels) is not quite as bad, but we'll presume a 7% bounce back in volume anyways.  NewMarket management recently commented that it sees volume in the mid-single-digits this year before returning to its norm of 1%-2% type growth.  The additives industry as a whole generally grows less than GDP in normal times, though we will concede that the last period of lubricant inventory rebuild in 2004 saw LZ's additives volumes increase by 7%.

Additionally, we will assume lubricant manufacturers who have recently announced 6%-10% price increases pass those benefits onto additive suppliers.  Ignoring FX effects, we thus assume 13% revenue growth on 2009 revenue of $4.6bn, which would be comparable to the largest annual revenue growth ex. acquisitions seen at Lubrizol since 1991.  These assumptions are also being applied to the Advanced Materials business, even though this segment has grown top-line only half as fast as the additives side and has posted lower operating margins as well.  We assume normalized gross margins of 32%, even though those gross margins have not been seen since the 90s.  We will also not punish the Company for future restructuring charges, even though we would be justified in doing so as LZ has taken restructuring and impairment charges every year since 2003.  Excluding the large 4Q08 goodwill impairment, these charges have averaged roughly $0.30 A/T per share per year since 2003.  We know of at least $6.8mn ($0.07 per share after tax) of performance-coatings restructuring charges that will be taken in 2010. 

We also assume that even with strong top-line growth, management is disciplined enough to keep operating costs at 14% of revenue, even though these costs were running at 20%+ during the 90s and averaged 17% in the current decade.  In essence, we look back in history and cherry-pick the best pieces.  This yields an annual EBIT margin of 18%, never before seen in the Company's history going back to 1991.  Assuming $95mn net interest expense and a 32% tax rate, we can get to around $8.30 per share, the upper end of management's 2010 estimate. Applying a full 11x multiple to this gets us to $91 (+24%), which we see as our downside scenario.

A more rational 1990s-ish EBIT margin of 11% (LZ's average 2000-2007 margins average 9%) on flat top-line growth (assuming price declines offset any volume growth) gives us $4.40 in per share earnings.  Applying the current 10x multiple gives us a $44 stock price, ~40% downside from current levels.  We think an overall earnings multiple of 10x may be generous since NEU, a pure-play additives company, trades at around 7.7x 2009 earnings (~8.5x 2010), while about 20% of LZ's operating income is derived from a challenged Advanced Materials segment that in our opinion, deserves a somewhat lower multiple.  Additionally, the additives business has for last several decades earned just a single-digit return on capital, according to Hambrick.

In other words, to buy into current consensus earnings expectations, we must really believe "this time is different" at a Company whose primary business has shown a long history of pedestrian growth and profitability.

Advanced Materials - growth by overpriced acquisition

"As our track record with acquisitions shows, we will do our homework, we will be patient until the businesses....with the right fit come along...." (James L. Hambrick, CEO, 4Q05 Earnings Call)

But Additives is just 70% of the story.  The other 30% resides in the Advanced Materials (AM) segment, which caters to consumer and industrial end markets.  The business makes chemicals that provide, among other things, the emollient in lotion, improvements in wood coatings, color consistency in inks, thickness in shampoo, and heat-resistant PVC pipes.  Management has realigned the segment over the last six years through myriad large and small acquisitions, divestitures, restructurings, and sub-segment naming changes.  Divestitures and improvements in the performance coatings businesses that were supposed to drive EBIT margins higher have disappointed - post 2006 when the divestitures were largely completed, EBIT margins for the segment have moved from 11.5% in 2006 to 6% in 2008 before bouncing back to 13% in 2009.  While the Company claims that this 2009 margin is what was targeted years ago, we wonder where this number would be without the large, one-time assist from lower raw material prices.

Noveon: Advanced Materials was formed through acquisition, primarily the $1.9bn cash acquisition of Noveon (the former BF Goodrich chemical segment) in June 2004.  At the time, Noveon provided the Company with a pro-forma 55/45 additives/advanced materials revenue split; today, it is more like 70/30.  Clearly, Noveon failed to live up to its hype as LZ's growth driver.  2003 was a weak overall year for LZ, with 8% organic volume decline in the Additives business more than offsetting the 9% organic volume growth on the Advanced Materials side, which made up just 13% of the Company's revenue at the time.  This would be the last time AM would see 9% annual volume growth.  Performance chasing, LZ purchased Noveon to bolster its position in the higher growth personal care and coatings markets, paying 10.2x EBITDA (9.5x including 1-year of expected cost synergies) and 1.7x revenue for a levered specialty chemical company - 5.0x net debt to synergy-adjusted EBITDA - that for years was under-investing in PP&E. 

A year later in early 2005, things turned south as organic AM volumes (still, ex Noveon) declined 4% in 2005.   The subsequent y/y % change in AM volume after 2005 including Noveon looks like this: 2006 (+6%), 2007 (+2%), 2008 (-9%), 1Q09 (-35%), 2Q09 (-29%), 3Q09 (-18%), and 4Q09 (+11% off very weak comps) with significant operating weakness first in performance coatings....followed by Estane/TempRite.  LZ's legacy coatings additives combined with Noveon's coatings resins were supposed to create significant product synergies.  Instead, the business has struggled since almost day one of the acquisition, with top-line contraction in every year since 2005.  Volumes in AM have been far more volatile compared to Additives while pricing power relative to raw material costs has not proven much better.  Post-Noveon and excluding 2009, AM EBIT margins have never surpassed 12% in a year, and in 2009 delivered 13% even while the Additives business generated nearly 24%, though obviously we think even this additives margin is ephemeral.

Avecia: Just before Noveon, in January 2004, LZ acquired the coatings and inks additives business of Avecia, paying $130mn, or 2.6x revenue.  At the time, management expected this to be a 10% revenue growth business.  While LZ does not separate Avecia's standalone performance, the Company's coatings business has struggled to churn any revenue growth after 2005, declining 6.9%, 0.5% and 5.5% in 2006, 2007 and 2008.  The business has experienced significant operating difficulties as evidenced by numerous and costly restructurings and asset impairments.

Overpaying for underperforming businesses led to an expected outcome: In 4Q06, LZ took a $41.2mn impairment charge on the Noveon trade name, which the Company disassociated from underperforming industrial businesses like performance coatings.  Two years after that, the Company took a $363mn goodwill impairment charge on Performance Coatings and Estane / TempRite (2/3 of the Noveon business).  Apart from these goodwill write-downs, between 2005 and 2008, AM took restructuring and asset impairment charges in every year totaling $39mn.

Other: In March 2008, the Company announced a 10-year phased investment plan to expand global capacity in Additives, with $200mn going into China over the next decade.  Later that year, the plan was put on hold and the Company took $6.9mn in asset impairments related to this expansion.  Earlier this year, the Company announced plans to resume its China investment.

Insider selling

Since LZ stock's rapid ascent from its early 2009 lows, directors and officers of the Company have sold a net 233,000 shares, with the largest seller over this time period being Charles Cooley, the Company's CFO, who unloaded 67,000 shares, or over 60% of his stake, in early November and early August.  In 2nd place is Stephen Kirk, COO who sold 59,600 shares, 40% of his stake. 

Risks

Volume: According to Department of Energy data, the inventory drawdown in 2009 for refinery lubricant stocks has exceeded anything seen in recent history.  Strong cyclical rebuilding volumes could well exceed LZ Additive's 2004 7% rebuilding volumes, which on current margins, could validate analysts' estimates.  However, we expect pricing declines and margin contraction to offset volume strength and lead to earnings decline.

Pricing: Ashland (ASH), a customer of LZ (they sell lubricant retail under the familiar Valvoline name), recently reported significant margin expansion in their retail lubricant business.  Color from the earnings call indicates that lubricant manufacturers have announced 6%-10% price increases.  NewMarket recently held its 4Q09 earnings call and claimed its 4Q09 mid-teens operating margins were sustainable in 2010.

Other: While Performance Coatings has been a perennial underperformer, TempRite and Estane (part of the Company's Engineered Polymers product line) were strong growers until 2008.  Their products are highly levered to construction and other industrial end markets, and could provide added kick to the upside in the event of strong cyclical recovery in industrial production. 

Catalyst

- Pricing and margins revert to historical levels appropriate for a commodity producer operating in a competitive market and Street expectations are adjusted downwards.  
- Selling by quant funds who aggressively bid the stock in 3Q09, as earnings momentum slows and reverses