Description

“We cannot direct the wind, but we can adjust the sails” -Aristotle (Lanxess annual report p.9)

(Note: All figures in euros)

Lanxess (LXS:DE) trades at €41 and has 91m shares for a market capitalization of €3.7bn. Net debt after adjusting for cash proceeds from the Saudi Aramco joint venture “Arlanxeo” (which closes 4/1/16) is 0 (€1.2bn of cash proceeds to be received offset by €1.2bn of net financial liabilities at year end 2015). Therefore, the adjusted enterprise value is €3.7bn. I believe the shares offer compelling value with a target price of €60 euros, or ~50% from current levels.

My thesis rests upon 1) the closing of the joint venture highlighting the attractiveness of the remaining businesses and high returns on capital that they generate, 2) the proceeds from the joint venture will enable Lanxess’ management to reinvest the cash at attractive returns, and 3) the joint venture will be set up to consolidate the industry and create value. I believe the opportunity exists because investors have a poor understanding of the remaining businesses that will form the new Lanxess. For the past several years all the analyst focus has been on the performance polymer/synthetic rubber business which is being spun off into Arlanxeo. The remaining businesses that have been ignored yet consist of specialty niche chemical businesses with strong leadership positions in attractive end markets.

I believe that with the closing later this week of the joint venture and cash proceeds to be received by Lanxess one is creating the remaining company at 6x Operating Free Cash Flow (EBITDA – Sustaining CapX). That is simply too cheap.

Background:

On September 22, 2015 Lanxess announced they would be forming a joint venture will Saudi Aramco whereby they would contribute their synthetic rubber business (tire and specialty rubbers) in return for a 50% interest in a new JV “Arlanxeo” and €1.2bn in proceeds. The venture was valued at €2.75bn (the €175m delta between proceeds and 50% value was put in place to provide starting capital to the JV). The JV vertically integrates the most sophisticated and technologically advanced synthetic rubber manufacturer with the largest raw material producer (oil and its derivatives). While raw material procurement in the near term will not be a synergy (for one it’s a commodity and two Lanxess has existing long term contracts) the rationale for this deal was to begin a process of industry consolidation and rationalization as the low cost producer. Furthermore, Lanxess management will run the joint venture and Lanxess’ Chairman/CEO Mattias Zachert will be its chairman.

A brief history of Lanxess is instructive at this point to understand why this deal was important. Lanxess was spun off in 2004 from Bayer and the company under its then CFO Mattias Zachert performed very well. Mattias cut costs, sold businesses, and streamlined operations. During his tenure returns on capital went from the worst in the industry to among the best and the stock compounded at 21.5%. He left in 2011 to become CFO at Merck KGAa (the stock compounded at 19%.) in April of 2011.

Synthetic rubber prices started increasing rapidly in 2012 in conjunction with raw material prices (butadiene which is the major raw material is derived from oil). Viewing the cycle as permanent then CEO Axel Heitman began aggressively expanding new capacity. Other industry players, namely NKNK and Exxon did not want to be left out and expanded as well. This cycle like others eventually turned (2013) which led to the current situation of excess capacity globally and depressed pricing and margins. In 2014 Lanxess was faced with weak synthetic rubber demand, falling prices and hundreds of millions in planned capital investment and little cash with which to fund the projects. Furthermore, customers accused Lanxess of having used the 2011/2012 price spike to “gouge” them and were reluctant to give them business.

In April of 2014 the board realized a change was needed and brought Mattias back, this time as CEO. The first thing he did was issue capital (he raised €450mm through the issuance of 8.5mm shares @ €52) to give himself time to formulate a plan. He then put together a three point plan to 1) take €150mm of costs out of the business and administrative structure (achieved in 2015), 2) take another €150mm out by improving manufacturing competitiveness (closing underperforming plants, etc by 2019) and 3) optimizing the business portfolio (i.e. finding a new home for the synthetic rubber business. The company has focused on cash generation (CapX has been reduced from the mid-€600mm to low €400mm) and working capital has improved which has enabled them to pay down debt and have their credit ratings upgraded.

From April 2014 to today Lanxess has been transformed yet the market still views it as a synthetic rubber producer. However, as that JV closes later this week Lanxess will begin a new life and in my view a much more exciting and profitable one. 

What does Lanxess look like?

Lanxess will consist of three business segments - Advanced Intermediates (45% of EBITDA), Performance Chemicals (45% of EBITDA) and High Performance Materials (10%). 

Advanced Intermediates: This segment consists of the advanced intermediates and Saltigo businesses with 2015 revenues of €1,826mm and EBITDA margins of ~19%. Operating FCF (EBITDA – CapX) was €250mm and the pretax ROA was 22.5%.

In Saltigo (~35% of the segment) Lanxess produces customized crop protection molecules, primarily fungicides. As a custom manufacturing business customers have dedicated production lines and often pay a significant portion of the CapX. Lanxess provides their chemical expertise and their site at Leverkusen (replacement value >€3bn) is one of the most sophisticated and efficient plants in the world. The business has a great brand and global reputation. While the current ag chemical market is fairly weak LXS has guided to a relatively robust 2016 and longer term outlook given their focus on fungicides and unique chemistry.

In the Advanced Intermediates business they take Toluene and Benzene and produce intermediate derivatives, amines, polyoles, and inorganic molecules. The main applications are in the automotive, flavors and fragrances, coatings, and plastic end markets. The segment produces ~150 intermediates with significant market shares in a consolidate industry (typically 4 producers have ~80%+ share).

This business historically has been very stable over the last 6 years with EBITDA margins between 17% and 19% and an EBITDA CAGR of 5%.

Performance Chemicals: This segment consists of five different business segments, the largest of which are Rhein Chemie Additives and Inorganic Pigments. In 2015 revenues were €2,085m with EBITDA margins of ~16%, Operating FCF (EBITDA – CapX) of €187mm and the pretax ROA of 17.5%.

Rheine Chemie (~30%) provides additives for rubber, plastic, construction, colorant and lubricant applications. The business operates 20 sites serving 5,000 customers and >4,000 products. In this business unit products are often customized for each customer and LXS technical staff will work alongside the customer to optimize performance. It is often a key ingredient in the manufacturing of a final end product. For 90% of revenues the top 4 players in the industry have >50% market share so it is a fairly consolidated competitor base.

Inorganic Pigments (~25%) is a leading supplier of inorganic pigments (NOT Tio2!) for the coloring of construction materials, coatings, and plastics. LXS is the largest global producer (#2 is Huntsman/old Rockwood assets) with 400kt of capacity and 35%+ share. The company has strong technology, the largest scale (and lowest production costs) and a diversified customer base (top 10 ~20% of sales). EBITDA margins in his business have varied +/-2% since 2010 and sustaining CapX is very low (estimate ~€25-30mm per year).

The remaining three businesses are Leather Chemicals (~20%) where they produce chemicals to treat leather, Material Protection (~20%) and Water Protection (5%).  

While the segment has shown greater variability than AI since 2010 EBITDA margins have ranged from 11% (2013) to 16% and EBITDA has compounded at 3%.

High Performance Materials: This segment is within the Performance Polymer segment where the synthetic rubber business situated and so historical information is hard to come by. In essence the business produces high performance plastics and EBITDA increased from €75mm to €100m last year as they brought on stream a new polymerization plant to become nearly 100% vertically integrated from caprolactam to Polyamide. The business sells primarily to the automotive end market and so is driven by new platform wins.

Opportunities for Capital Deployment:

With the proceeds from the joint venture Lanxess has committed to €400m in debt repayment, €200mm in share repurchases and €400mm in organic growth investments. The remaining €200mm will be used for general corporate purposes but i suspect they will likely be used for bolt on acquisitions. 

Lanxess has been constrained the last several years from capital investment decisions made in 2011/2012 to expand the synthetic rubber business. Going forward they have agreed to several capital projects with customer already contracted where the returns are north of 20% after tax. This projects includes a €60mm investment at Saltigo for 2 additional large scale reactors and completion of an inorganic pigment plant in China.

From an acquisition standpoint they are looking primarily within the performance chemical segment.

Internally the hurdle rate being used by CEO Zachert and CFO Ponzen (was named CFO 5/2015) is 20% after tax. 

Arlanxeo

The joint venture was valued at €2.7bn at setup. I estimate that before any synergies or industry consolidation the joint venture should generate €350mm of EBITDA (8x EV/EBITDA) and €200mm of operating free cash flow (14x OFCF). The opportunity post integration is that Arlanxeo will have ~€350mm of net cash with a mandate to go and consolidate the industry.

According to management by 2019 Aramco will be long Butadiene, the key raw material required for synthetic rubber. As evidence by the recent supply issues in Singapore (Shell’s Palau Bucom cracker is down for a force majeur) being able to reliably source inputs will not only provide a cost advantage but will also enable the company to enter longer term contracts with customers.

With respect to consolidation it is impossible to say what Arlanxeo will purchase. However, when one considers LXS has only 8% of the SSBR (solution synthetic butyl rubber) market and 12% of the PBR (polybutadiene rubber) market there are multiple opportunities. It is only within Halobutyl where there are 3 large players and consolidation likely won’t happen and where LXS has ~30% share.

Finally, while I use the value of the Arlanxeo joint venture as my base case I think  there are several sources of potential upside. For one, there is a movement towards high performance tires. These tires require premium synthetic rubbers which are Lanxess’ specialty. The margin on high performance tires is better for the producers and demand has been increasing 6-7% per year. These tires provide better fuel mileage and are more environmentally which are needed due to increasing regulations. Additionally, in Europe they are mandating that tires with lower ratings (specifically the E and F tires) not be sold beginning this year. Finally, while demand for tires is growing ~2.5% per year and 75-80% of demand is replacement demand in China the growth is high single digit % and replacement demand is only 50% which leaves meaningful upside demand (and suggests being very careful when driving in China!)

Financials and Valuation:

Post the joint venture Lanxess net debt will be 0 and the market cap/enterprise value is €3.7bn.

Subtracting Lanxess’ 50% interest in the JV of €1.4bn leaves €2.4bn. The remaining Lanxess should generate ~€550m of EBITDA (4.8x) in CY 2017 and ~€400mm of Operating Free Cash Flow (6x). I think that is too cheap for a business that should generate mid-teens returns on capital with low single digit secular growth opportunities and a superior management. I believe the remaining company should be valued at 10x OFCF or €44 per share, the joint venture at deal value or €15 per share and adding in the interim cash flow in 2016 gets me to a target price of ~€60+ per share, or 50%. This target does not take into account any share repurchases, dividends, or debt paydown.

Finally, I cannot understate how impressive CEO Mattias Zachert and CFO Michael Ponzen are. I have followed them for several years and they have consistently under promised and over delivered. Mattias has twice personally bought shares (once when he joined in the high 40s and the second time at the beginning of 2015 in the high 30s). He is a builder and fixer and they both take a lot of pride in rebuilding Lanxess to its position as an industry leader. I think the quote above which is taken from the Lanxess annual report says a lot about the challenges this team faced in 2014 and the vision and strategy they have laid out going forward.

The major risks would be 1) excess capacity in synthetic rubber resulting in even further competitive pressures on pricing, 2) meaningfully stronger euro (an increase of 1c euro/usd decreases EBITDA by €9mm), 3) any large scale force majeure at their chemical sites, specifically in Leverkusen and 4) general industrial weakness.

Catalyst

Spin off of synthetic rubber and proceeds received

Further investment in remaining businesses at high returns on capital

Share repurchases

Industry consolidation within synthetic rubber