Description

NewMarket is a high ROE business in an oligopolistic industry, run by an owner-operator that invests in the business for the long-term at the expense of short-term results, and whose family owns a significant stake in the company.  THE Oracle of Omaha also purchased one of NewMarket’s primary competitors in 2011.

That’s the Bull case.  Some people also think this is a top decile business and deserves the high multiple it trades at today.

On the other hand, the business is barely growing the top line, operating income has gone nowhere since 2011, the stock has seem massive multiple expansion over the past five years, and now trades a peak multiple of what is likely peak earnings as all of the main players in the industry are bringing capacity online in Asia at a time when NewMarket is already having pricing issues.

The NewMarket / petroleum additives story is similar to many industries that consolidated during the Great Recession and rewarded their investors.  Management teams behaved responsibly, capacity was not added, pricing and in turn margins improved, all of which led to multiple expansion in their respective stocks.

A number of these semi-cyclical industries pitched to investors as a “this time is different” thesis have blown-up recently.  We think NewMarket could be next.

Business and Industry

NewMarket, through its wholly owned subsidiary Afton Chemical, is one of four players that dominate the worldwide market for petroleum additives, controlling a combined 80%+ of the market.  Their three primary competitors are Lubrizol, which was purchased by Berkshire in 2011, Infineum, which is a JV between Exxon and Royal Dutch Shell, and Chevron Oronite.  All of these companies are extremely well capitalized and willing to invest in their businesses while taking a longer-term view on returns.

NEU’s operating results are broken out between Lubricant Additives and Fuel Additives.  Lubricant Additives are blended with base fuels to improve efficiency, durability, and performance and are used for lubricating oils and engine oils, transmissions fluids, etc.  Fuel additives are used to improve the refining process and performance of gasoline, diesel and other fuels.  Over the past few years Lubricant Additives have grown (or fuel has shrunk) to be nearly 90% of the business.

The company is run by Thomas Gottwald who took over the Chairman and CEO posts from his father - both father (10%+ shares outstanding) and son (5%+) own a ton of stock.  Their track record of value creation has been strong - capital has been returned to shareholders via buybacks, the initiation of a recurring dividend and a $25 per share special dividend in 2011 while noncore assets have been divested.  They have done all this while simultaneously investing in the business.  Their CFO retired in March of 2015 after 40 years at the company – we would be shocked if there is anything nefarious here but think he might top-ticked his exit within a few days.

Berkshire purchased competitor Lubrizol in an all cash deal in early 2011 at 7.6x EBITDA and a low double-digit multiple of current year earnings.   This looks like another well-timed deal for Buffett as 2011 was the last year of big revenue and earnings growth at NewMarket – yet today NewMarket trades at 2x the multiples Buffett paid for control of Lubrizol even as capacity is coming online at a rapid clip.

Recent Results and Outlook

The business had a big jump in revenues and profitability in 2011 and has been growing low single-digits since - EPS has been juiced by buybacks but Operating Income has gone nowhere since 2012.

Their recent earnings, which took the stock lower, showed poor North America results and Management’s focus on capacity growth (more on this later).

A large headwind for the lubricants business that is not going away is vehicles no longer need their oil changed every 3,000 miles like they did in decades past.  Management estimates that 70% of this business (which is almost 90% of NEU’s total business) is represented by engine oil additives designed for passenger cars and heavy duty equipment.  Key performance drivers here include total vehicle miles driven, number of vehicles on the road and the age of the fleet.  Given that total miles driven in the US have recently broken out to all-time highs and the average car is a record 11.4 years old it is tough to argue business conditions were unfavorable.  Instead, we think this is - and will continue to be - an issue for NewMarket moving forward.  Many new cars require oil changes every 10,000 miles, others recommend 5,000 – so we’re talking about a very significant increase in the number of miles you can drive without changing your oil. 

Not only does changing your oil every 3,000 miles provide no benefit to vehicle performance, it’s an unnecessary expense and it is harmful to the environment.  California has gone as far as to run advertisements and set up a website that will let you know how frequently you should be changing your oil by the make/model of your car http://www.calrecycle.ca.gov/UsedOil/OilChange/FindInterval/ .

We would also argue the company is forced to spend more on R+D moving forward and that this is a maintenance – not growth – expenditure.  R+D increased from $118 in 2012 to $137 million to $139 million and will be higher in 2015.  Management further breaks this out as spending on new products and processes which has increased from $45 million in 2010 to $51 million, $55, $59, $68.  You can’t claim they are starving the business of capital but even with new products they are barely growing the top-line.  In a competitive industry, we think they need to spend increasing amounts just to tread water.  The life cycle of their products is hard to predict, new regulations are unknown but a constant, and in order to meet customers changing needs this spending is recurring and growing.  Making matters worse, some new products have lower margins than the products they replace so they are spending significant sums of money to reduce margins on certain products.

With headwinds in developed markets, and management expecting 1-2% increases in global lubricant demand, NewMarket will need increased Asia-Pacific (and Latin America) demand to hold the top and bottom line steady.  That also holds true for the other members of the oligopoly and there is seemingly an arms race to increase capacity in Singapore and China.

Capacity Expansion

I’m not 100% sure what happened to kick-start the current massive round of capacity additions but I’d guess IHS put out a very compelling piece in 2010 or 2011 extrapolating Chinese growth far out into the future and predicting a massive surge in vehicles in Asia over the coming decade.  Whatever it was, it worked as every major player is in the midst of adding capacity in Singapore or China for the first time in over a decade.  It’s also likely everyone wants to diversify away from a stable to potentially shrinking US market.

We don’t have great data here (not holding anything back, companies seem fairly tight lipped for competitive purposes) but capacity additions in Asia have been large and are increasing into suspect demand.

NewMarket – The company broke ground on a new facility in Singapore in 2014, expects to complete construction this year and begin commercial production in 1Q16.  The facility will cost in excess of $100 million and is expandable.  Management believes they will begin an expansion project shortly after the plant begins production.   On the last earnings call management was not backing down from capacity expansion plans.

From the call:

“We still anticipate capital expenditures to remain in a higher than normal range for each of the next several years or in the $80 million to $120 million range in support of our global growth plans. This is no change from the position we discussed over the last few quarters.”

“I can directionally tell you that a lot of the increase will be new capacity. It's substantial for us, it's not currently enough to move the industry supply demand picture. But we are looking at adding beyond the current Singapore construction. And probably next time we'll have a little bit more detail for you on that.”

All told, NewMarket will be adding a significant amount of capacity, and spending a huge % of CapEx as a % of total assets.

But NewMarket is hardly the only industry participant ramping up capacity.

Lubrizol completed a $200 million greenfield additives plant in China in late-2013 as part of a 10 year phased investment plan to increase global capacity in additives.

http://newscenter.lubrizol.com/phoenix.zhtml?c=250972&p=irol-newsArticle&ID=1795164

file:///C:/Users/Peter/Downloads/LZ_F_LIntlQuarter1-2010.pdf

Based on Lubrzol’s most recent SEC filing from mid-2011 this appears to be a major expansion:

http://www.sec.gov/Archives/edgar/data/60751/000119312511211739/d10q.htm

This was the first “big investment” in the additives space since Oronite’s Singapore plant in 1998 at the end of the last wave of capacity expansion.  Guess who else is getting back in the building capacity mix?

Chevron Oronite has been busy putting capital to work in a series of projects that collectively represent their highest level of investment since 1998/9.

http://business.asiaone.com/news/chevron-oronite-completes-plant-expansion

Chevron completed a plant in Singapore in 2014 and will be doubling capacity at said plant by 2017 amongst other major projects.

Lastly, Infineum announced its $150 million plant on Jarong Island, Singapore in the middle of 2014.  The facility is their biggest single investment in the world to date.

These plants take 2-3 years to get approval, build, begin production – we think the assumptions regarding China and Asia-Pac demand were a lot rosier in the Boardroom when the build decisions were made than they are today.

Valuation

We think the risk-reward on a short here is compelling.  Moving forward we’ll take the under on margins, earnings and the multiple the market will be willing to pay for those earnings - AKA we think this is a peak/peak.

Management expectations are:

“We expect our margins to be in the mid to upper teens over the longer term as there has been in recent years as the fundamentals of the industry have not changed.”

That could be a tense issue, NEU has kept margins in a tight 16.5-16.9% range the past three years, but the future could be a lot worse as capacity comes online.  In the current environment management has been unable to push pricing, in the K when comparing 2014 to 2013, and 2013 to 2012 both mention “unfavorable selling price variance.”  When all this capacity comes online it seems unlikely they will be changing that wording in the 2015-17 K’s.

In a bull case scenario – maybe the Singapore investment works out, pricing and margins hold steady in the face of massive capacity increases, the global economy picks up, they retire a few shares and earn low $20’s in 2016 and 2017.  Maybe the 100%+ multiple expansion isn’t enough and they trade at 25x that.  The trade won’t be a winner but that requires a lot to go right for a 30% return (loss) in 2 years.

In a realistic case we think margins can drop to levels above, but near, where they traded prior to the Great Recession.  The industry is in better shape than it was back then following the last round of capacity additions but with capacity coming online this might be as good as it gets.

In such a scenario the company should earn in the neighborhood of $13.50 and the multiple should contract given it is currently trading well above 5 years multiples on well above 15 year margins.

It would not surprise us if NEU earns single-digits in the upcoming years which would be great but is not needed for the short to work.

In the meantime, if they want to use their excess cash for additional capacity and purchasing overpriced stock that’s fine.

Catalysts

Increased capacity leads to lower operating margins; as margins contract the multiple comes down in a virtuous cycle for the shorts.

Risks

Capacity additions do not effect pricing as feared

M+A – management has been vocal about wanting to acquire petroleum additive assets, pricing the issue here

Capital Allocation – there will be excess cash generated and the management team is competent

Asia growth picks up

Continued multiple expansion

Catalyst

Increased capacity leads to lower operating margins; as margins contract the multiple comes down in a virtuous cycle for the shorts.