Description

Thesis:

MTX is a specialty chemical producer trading too cheaply b/c it's a mediocre business, supplies two very hard hit industries, steel and paper, it is under followed by the street, and because they haven't provided long term plans on a multi-year restructuring effort.  We think MTX is currently trading at a 9% 09' FCF yield at cycle troughs, has a net cash balance sheet, and offers a safe way to participate in an improving macro environment + longer term restructuring potential + potential hit product filler fiber for free.   

We think MTX offers 40% upside in a base case and ~90% in a return to normal scenario with free options for further operational improvement that take the upside to 110% to the equity.  While we wait for these scenarios to play out we should be able to collect a ~9% FCF yield to the enterprise and invest in a management team that is highly free cash flow focused.  Prior to the economic downturn MTX was growing top line 5 to 7% a year, with slightly better cash flow growth from margin improvements.   

Business Description:

MTX sells specialty minerals to the paper industry, which represents 65-70% of EBIT in normal times, and offers a chemical / servicing to steel refractories which is another 30-35% of EBIT in normal times.  MTX has a near monopoly with 80-90% domestic share in their paper chemical business, which is their cash cow.  The steel supply/servicing arm competes in a more fragmented market, has more cyclicality, but MTX still has strong positioning. 

Price                $38

Shares              18.7

Cap                  713

Cash                191

Debt                 112

EV                   634

Tangible BV $34 per share

Most of debt is 2013 maturity

PCC business.  The cash cow in a duopoly industry:

PCC stands for Precipitated Calcium Carbonate and is a key chemical used in the Uncoated Free Sheet Paper industry.  MTX pioneered the use of PCC in 1986.  Since introduction its use has been adopted by ~80% of the domestic paper industry. PCC is essentially a cheap chemical that allows paper producers to use less of other, more expensive raw materials.  Paper mills use as much PCC as can be structurally supported by paper; around 17% of composition. 

PCC is produced through satellite plants located at customer facilities by mixing lime, water, and other ingredients; there are ~ 58 MTX satellite plants globally located at the paper mills. MTX is a captive supplier.  The plants are built under 10 yr supply agreements.  Anytime a plant is modified the contracts automatically renew for another 10 years.  The contracts have volume / price benefits built in, such that when the volume falls the chemical price goes up, this of course works in reverse but it has the effect of adding stability to the business.  It is not a 1 to 1 ratio and tends to lag in periods of fast moves in volumes, like what is happening today.  Contracts also have raw materials escalators.   

Since inception, MTX appears to have lost virtually zero plants from a competitive standpoint; once depreciated they have a cost advantage vs. peers.  Plants that have been lost, which are few, are lost to bankrupt customers.  The paper industry is currently operating around 85% utilization vs 95% in 07. 

The PCC industry is largely a duopoly.  MTX is a monopoly in the US, but has 60% global share.  The next closet competitor is Omya AG, a privately held company with 20% global share. 

The company targets mid teens IRR on PCC plants.  The market for PCC plants in the US is mature but is growing in the rest of the world in the mid single digits in normal times.  There does not appear to be any viable cost effective substitutes. 

Refractory business.  Highly cyclical but nearing a bottom. 

In the refractory business, MTX supplies steel producers with chemicals that aid in steel production & chemicals used to heat treat furnace walls.  Above 80% utilization rates in the Steel industry MTX becomes a strong option for steel producers.  MTX heat treatment chemicals allow steel mills to operate longer without shutting down for cleaning / repair.  When utilization is below 50% it is hard for MTX to earn an operating profit in this business given the low customer demand.  For Q109 Steel mills were running around 40-45% utilization.  MTX posted a small operating loss.  When the steel business was firing on all cylinders during 07' steel refractories were running ~85% utilization.    

History of company.  Margins are depressed vs. historical levels:

Back in 2000-2002 the company was highly focused on PCC and earning 14-15% EBIT margins.  As growth slowed in the PCC business, MTX began to reinvest the cash flows from PCC into a host of unproven science experiments with little to no concern for ROC, hoping to find the next big chemical revolution for the paper industry, just like PCC was back in the early 90s.  After 5 unsuccessful years and 4 new chemical programs each losing money with underutilized production plants and expensive free customer trials, ebit margins dwindeled down from a peak of 15% to a low of 8% (quarterly), in addition to ROC substantially below their cost of capital.  Meanwhile, the cash cow PCC business is rumored to be operating near the old margins and supporting numerous money losing ventures. 

You can go back through the press releases to see when new products were launched / facilities became under utilized to match against the margin deterioration by year.  Calls to plant managers suggests PCC contracts are largely unchanged since 2002, further highlighting the drag on earnings from new products.  Mapping out product launches / plant openings shows a string of new plants tied to new product testing beginning in 02 and largely remained a drag on earnings until 07 when these began shutting down.  In March 07', Joe Muscari, former EVP of Aloca came aboard to turnaround the business.

New CEO w/ history of success:

Joe Muscari is the former EVP / CFO of Alcoa.  Joe is rumored to have been very successful overseeing Alcoa's operations in Asia and building a successful business for Alcoa overseas.  He spent 2 years on the board of MTX prior to taking over as CEO.  We take note when any manager jumps ship of a large company to join a small company, especially if that manager had 2 yrs to get familiar with operations prior to joining.  Since joining MTX, Joe has delivered as promised, boosting operating margins by 200bps to 10% and bringing the ROC to levels just above their cost of capital.  Joe has already shut down a number of bad investments.  In addition, Joe has been relentlessly focused on optimizing cash flow & free cash flow is a term you can find in the first few paragraphs of every press release. 

While there has been no formal long term turn around plan issued, since joining Joe has already shut down the worst of the money losing operations, cut overhead, and prior to the economic downturn had improved ROC to his target of above the cost of capital.  We think there are likely many more levers Joe can pull to return MTX to more historic levels of profitability.   

High free cash flow:

One of the best elements to the MTX story is that maintenance cap ex is around ~20m.  In their most recent conference call management noted that "sustaining cap ex is actually below 20m."  If we took 2007 CFO and added back 16m in cap ex to bring cap ex to a 20m maint level, MTX would have generated 150m in FCF, or a 23% yield on today's enterprise value.  However, we do not believe MTX is ready to stop spending growth cap ex, as they plan to develop their PCC business in India / Asia.  But, it is an interesting way to look at how cheap MTX is today.  We feel if the CEO did not believe good ROC investments existed he would cut cap ex to maintenance like levels. 

In Q109, likely to be one of the worst quarters for the year, free cash flow still totaled ~19m, or an annualized yield of 13% to the EV.  However, FY cap ex for 09 is planned at 50m, ramping from 4-5m in Q1.  Management sees growth in Asia for PPC plants and is adding PCC capacity in India which will cost ~9m in cap ex. 

Misperception:

We think MTX is cheap today b/c it serves bad end markets, doesn't have much of a growth story attached, is under followed by the street with 4 firms listed but only 1 well recognized institution and because they have not formally provided LT targets for restructuring other than bringing the return on capital above the cost of capital.  The market is overly focused on earnings, which are depressed by a large depreciation shield, and ignores the strong free cash flow generation.  The D&A shield should remain large for years. 

New product lines not yet performing.  Free upside:

MTX is still betting their filler fiber could be a large winner in the paper industry.  Essentially, filler fiber is a PCC like product that might allow the paper industry to remove more higher cost fillers such as pulp fiber to replace with cheaper filler fiber.  The product is still being trialed with customers.  Early tests have gone well and this is a free option of being adopted across the industry.  It is a positive sign that Joe shut down much of the other new product lines but has kept this one alive.  It's hard to put precise numbers on the value here, but if filler fiber were to take off as planned it could add ~$1 to FCF within a few years if it is widely adopted by the paper industry.  200m in sales @ 14% EBIT fully taxed gets you there.

Return on Capital:

MTX is not a high return on capital company.  After years of underperforming management had only recently gotten the ROC just above their cost of capital.  There's no guarantee they'll succeed in creating a meaningful EVA spread, but it is a goal of management's.  Typically, buying when a company is improving their ROC is the time to get involved. 

Valuation:

While MTX is not a high quality franchise, we believe it should ultimately trade for a 9% free cash flow yield to the EV on normalized numbers.  If MTX can get back to 07' free cash flow levels in a few years the equity should be slightly less than a double, or 90% up before factoring in additional cash flow that will accumulate on the balance sheet while we wait.    

If you factor in potential cost improvements by shutting down more unprofitable plants / product lines leading to a 2% EBIT improvement over 07, or 12% you get an additional 20% upside to the above scenario, or 110% upside to the equity.  You could also get to this scenario if filler fiber works but management cannot really improve margins vs. 07 levels. 

Even we are wrong and it takes many years to get back to a normal environment and MTX can not pull any more costs out of the business from unprofitable business ventures, i.e 12-14% EBIT will never be realized again, MTX should still be able to get at least half way back between 07' free cash flow levels and today, or 100m in FCF representing a 16% EV yield.  With a target EV yield of 9% the equity today has 43% upside before factoring in cash flow accumulation while we wait. 

Mgmt compensation:

Incentives are well aligned.  The CEO has 35k of options with an exercise price of $60 that expire in March 2010, with another 58k of options expiring in 2017/2018.  The compensation structure is 60% cash 40% equity for most sr. managing members.  Performance hurdles are a mix of ROC and EBIT targets.  The co. does not disclose the targets. 

Risks:

Mgmt has not been personally buying shares

Paper industry operating at 80-85% utilization.  Mills tied to MTX PCC plants could close. 3 or 4 look at risk.

Given their dominance in the industry hopefully another MTX customer would pick up the lost volumes. 

Refractory business needs steel industry to be above 55% utilization to breakeven & above 80% to earn norm.

Catalyst:

Sometime in the next year it is likely the co. will begin buying back shares

Paid to wait for economy to improve given the high FCF

Mgmt continuing to cut cost out of the business / unprofitable initiatives

Potential for filler fiber program to succeed

Disclosure:

We and our affiliates may have an investment in MTX.  We may change our positioning in MTX at anytime without notifying anyone of our changes.  This is not a recommendation to buy or sell shares. 

Catalyst

Sometime in the next year it is likely the co. will begin buying back shares

Paid to wait for economy to improve given the high FCF

Mgmt continuing to cut cost out of the business / unprofitable initiatives

Potential for filler fiber program to succeed