Description

Lanxess AG (“LXS GY” or “LXS”) is a German specialty chemicals company that many among the VIC community are familiar with. Scrooge833 won the VIC bi-weekly contest back in February 2005 with the first excellent write-up as the stock rapidly went up several-fold. I have followed the company since it was spun off from German pharmaceutical giant, Bayer, in 2005. Historically, the company was quite cyclical, driven by its synthetic rubber division, which generated more than 50% of its earnings. With tires being the primary end market, this division was more volatile from a margin standpoint as it was closely tied to the economic and automotive cycle. LXS found its all-time low like many stocks following the Great Financial Crisis of 2008 and bottomed in Q1 of 2009. After recovering back to normalized levels a year later in 2010, LXS has been a good trading vehicle, but largely range-bound for the past roughly 12 years between ~€30 and €75 until it recently dropped below the 2020 COVID low about five weeks ago to  €28. In 2016 and 2017, LXS was written up three times - twice by Pokey351 and once in late 2017 by Andreas947 at  €41,  €62, and  €68 respectively. Having followed this story over the years, while being tradeable at times, it has also been a frustrating investment being rangebound for so long. I think that is likely to finally change soon.  

I find it useful to look back to roughly the time period in 2017 during which this company was last written up, to see what has happened since, what impediments hindered company progress, and why things might be finally coming together for Lanxess. In April 2017, the company made a significant transformative step with the acquisition of Chemtura, which (i) reduced the cyclicality of the overall portfolio, (ii) improved LXS AG's secular growth profile, and (iii) further increased the proportion of value-added products in the business mix. At the time, investors appreciated the improvement in the portfolio but remained skeptical about automotive exposure at what seemed to be very late in the economic cycle. In August 2018, the company announced that it was selling its remaining interest in the synthetic rubber business to Saudi Aramco (LXS GY had previously sold part of the division to Aramco in 2015). The transaction created several benefits for LXS: (i) the synthetic rubber business was sold at a higher valuation multiple than the company's overall valuation multiple, thus making it instantly accretive; (ii) cyclicality was significantly reduced for the remaining business, which should have translated into a higher valuation over time; (iii) at the close, LXS GY would have €1.4 billion in proceeds to retire debt and repurchase shares. 

Initial enthusiasm for the transaction faded rapidly as the generally negative stock market sentiment spread in the fourth quarter of 2018. As a result, LXS GY's valuation multiple contracted significantly (from 14x forward earnings to just 8x at the end of December 2018 and importantly, closer to 4.6x including the expected cash proceeds from the sale of the synthetic rubber division).

I believed the stock to be undervalued at €71/share, so I added to my position as the stock fell. Astonishingly (to me at least), on December 31, 2018, at €40/share, LXS GY was trading at 4.6x my estimate of normalized earnings adjusting for the proceeds of the synthetic rubber transaction. On January 10th, 2019, the company announced it was initiating a share buyback which I felt made tremendous sense. This helped quickly propel the stock from €40 up to €45 (still very cheap at 5.6x normalized earnings). Over the next year, the stock performed well and ran to the mid-€60s until it started descending from late 2019 into COVID-shock in March of 2020 where it bottomed again at around €30. After more than doubling again into Q1 of last year, LXS GY pulled back to the €50s and then plunged following Russia’s invasion of Ukraine with the fears that have wreaked havoc over Europe. 

Looking at LXS GY back in Q1 of 2019, investors seemed justifiably optimistic for the prospects of the company, as management had completed a significant transformation of its business portfolio. Based on LXS GY's portfolio mix of additives, coatings, lubricants, and specialty agrochemicals I believed a more reasonable multiple would be at least 16x normalized earnings. In addition, the two additional assets in the portfolio (water filtration and organometallics), I believed could potentially add an incremental €5/share in value. In total, I was looking for significant upside for LXS GY's fair value.

Perhaps most importantly, I believed at the time (and still do) that the market is not recognizing and giving reasonable credit for the track record of Mathias Zachert, the Lanxess CEO. He has created significant value with the Chemtura acquisition integration, improved the profitability of the synthetic rubber business prior to its sale, as well as fixing and selling several lower-quality assets inherited in the Bayer spinoff that formed LXS GY back in 2005. Given the constant dislocations in the financial markets, I think he will use the strengthened balance sheet to opportunistically create, additional value by making small, highly-accretive acquisitions. 

Fast-forward from Q1 2019 through today. The German chemical producer has been one of the more challenging investment ideas from my universe of stocks. LXS GY has encountered a series of exogenous headwinds, ranging from the spill-over effects of the 2018 USA - China trade war, continual sovereign flare-ups in Europe, and, most recently, of course, the war in Ukraine. In particular, Russia's use of energy as a geopolitical leverage point against the E.U. has stoked investor fears around sustainable profit margins and potential business disruptions at LXS GY. 

While earnings were negatively impacted by these events, the Company's earnings power is actually higher today than when I first invested in Lanxess. In addition, the "quality" of this earnings stream is much improved (i.e., lower volatility, higher structural growth, and lower capital intensity), which normally would warrant a higher multiple. 

This evolution of the business was deliberate, enabled by steady execution by a confident, capable management team. They sold the lowest quality divisions in the portfolio for greater than 8x EV/ EBITDA (synthetic rubber) and 12x EV/EBITDA (high-performance materials). This is notable, as the overall Company trades for ~3x EBITDA today. In addition, LXS GY acquired consumer care chemicals company, Emerald Kalama, for 9.0x EBITDA and IFF's Microbial Control business for 9.6x EBITDA. The effective multiples in these acquisitions were significantly lower than the headline multiples of the transactions, after adjusting for the impact of integration synergies. 

While the original portfolio in my view warranted a blended valuation multiple of ~8x EBITDA, the current portfolio deserves a multiple north of 10x EBITDA, based on comparable company valuations and recent private transactions. The valuation of Lanxess, however, has not expanded. Instead, it has contracted significantly. As a result, LXS GY trades at a surprising ~3.4x EBITDA before adjusting for excess working capital tied to the European energy crisis. Adjusting for the eventual release of that excess capital, the multiple falls to ~3x. In addition to the overall multiple having more than halved despite the significantly improved earnings profile, the company's balance sheet has also been dramatically de-risked, with net debt to EBITDA falling from 3x to 1x. 

For now, investors are avoiding the stock altogether. They worry about natural gas supply to the E.U. and how this might impact input costs and margins. I think significant fears are more than discounted in the current stock price. It is worth noting that the financial impact of higher input costs is being fully offset by the foreign exchange currency benefit of a weaker Euro (which is likely the result of the same fear). 

Over the last few years, the company has developed two assets that are not yet contributing to earnings. These new ventures include a joint venture with Standard Lithium, where its joint-venture partner produces lithium as a co-product of LXS GY's flame retardants business, as well as a company called QuiMondis, which is the largest chemical trading platform in Europe. While estimates vary for the value of these two businesses, comparable company valuations suggest these two segments alone could be worth more than a third of LXS GY's current total market capitalization.

I continue to expect a healthy return for this investment and believe current valuation levels are compelling. I own the core business at 3x EBITDA while I believe the appropriate multiple is greater than 10x EBITDA and there is significant additional potential value to come from the lithium JV and QuiMondis segments.

Catalyst

LXS AG has a relatively near-term catalyst when the deal to sell engineering plastics closes they will receive substantial cash with which to buy back stock and reduce debt further.