Description

Olin Corporation (ticker: OLN, price: $15.4) ("Olin", or "the Company") is a $2.5 billion market cap chemical company. It is a cheap business that is poorly understood, dismissed by many as a low quality commodity business, at the mercy of both the housing cycle and hurt by low caustic soda prices. This simplistic view misses the hidden qualities and competitive positioning of Olin, and the long-term trends in supply and demand that it is poised to benefit from.

Olin is the low-cost operator in Chlor-Alkali (by far its largest business), has a good Epoxy business and a cash source in its Winchester ammunition business. Because of the ongoing weak single family construction figures, the Chlor-Alkali market is perceived by the sell-side to be in a perpetual state of overcapacity.  The few covering sell-side analysts are generally bearish on the space (Bank of America is the latest to downgrade). Given this sentiment and the washed out stock prices, we think this sets up Olin as a very interesting and timely investment. The industry is performing at depressed levels, competitor capacity has been shuttered and at current prices there is no risk of significant additional capacity entering the market for years to come.  New capacity, if announced today, would take at least 3-4 years before it hits the market, and at current pricing, would not earn its cost of capital.

Olin stands to benefit from both internal and extermal drivers. Internally the Company is in the process of starting new contracts, finishing brownfield expansions and getting past some one-time costs in 2019. Management have been good stewards of capital, and are buying back stock at current levels. Externally the Chlor-Alkali market will be tightening for the next several years, and as the low cost supplier, Olin should see massive upside.

On a mid-cycle basis, we estimate that “normalized” EBITDA could be up 60% from current levels, FCF would be over $8/share and the stock could increase 4-5x over the next 4-5 years.  Even if we are wrong about the recovery, at current trough levels of product pricing, we think the Company would generate $3.65 in pro-forma EPS and $5.15 of FCF as current initiatives and near term contracts kick in.   In the meantime, you pocket a 5% dividend while you wait.

This is a commodity business, so there will be volatility, but for those willing to look out a couple of years, we think OLN stock has not been as attractively valued since the depth of the recession in 2009.

Background

Olin is a unique company, and is comprised of two independent businesses – chemicals (subdivided into Chlor-Alkali & Vinyls, and Epoxy) and ammunition (Winchester).  Historically it has attracted dividend investors, given its impressive and uninterrupted history (over 92 years) of paying steady dividends, with a current yield of 5%.  

In 2018, the Company generated revenue of $6.95 billion and EBITDA of $1.265 billion.  In that year, 57% of revenues and 84% of segment EBITDA (pre-corporate costs) came from Chlor-Alkali and vinyls, 33% of revnues and 11.5% of EBITDA from Epoxy and 9.4% of revenues and 4.3% of EBITDA from Winchester. 

The Company has a history of integrating Chlor-Alkali assets successfully, notably having acquired Pioneer in 2007 and it has generally been thought of as the best operator in the space.  Olin transformed itself in 2015, absorbing Dow Chemical’s Chlor-Alkali business, which was twice the size (in terms of revenue) of the standalone Company, in a Reverse Morris Trust transaction.  The merged entity became the de-facto market leader in a newly consolidated industry with almost twice the capacity of its next closest peer. 

Chlor-Alkali

Olin is best known for its Chlor-Alkali & Vinyls business (“Chlor-Alkali”) and the Company is considered the best operator in the space.  The domestic US Chlor-Alkali industry is dominated by three large players (Olin, Oxy and Axiall). Olin is the largest and lowest-cost Chlor-Alkali business in the world, due to access to low cost electricity (including some owned cogen facilities), low-cost brine and superior scale facilities. Somewhat little noticed is the 20 year cost-based ethylene supply agreement that Dow signed with the new Olin.  This provides the Company with a guaranteed supply of low-cost ethylene, is a strategic asset as Dow’s ethylene is natural gas-based, and allows Olin to enjoy a cost advantage as long as natural gas remains at low prices relative to oil.

The Chlor-Alkali market is a difficult market to understand because of the co-product dynamics of the two chief outputs: Chlorine and Caustic Soda.  Chlorine is produced by the decomposition of common salt through the application of electricity in the Chlor-Alkali process. Caustic soda (or sodium hydroxide) is co-produced at a fixed ratio of 1.1 caustic to 1.0 chlorine.  Demand for chlorine is predominantly tied to production of ethylene dichloride (EDC) and vinyl chloride monomer (VCM), used in the production of PVC, which is linked to construction activity. Caustic, on the other hand, has broader industry applications than chlorine and is used to neutralize or react with acidic intermediates.

Chlorine drives the Chlor-Alkali process.  In fact, Chlor-Alkali plants are built specifically for chlorine, given the difficulties and costs of shipping long distance.  Chlorine is used internally or transported by pipeline to customers located within relatively short distance from the manufacturing plant.  Caustic is generally thought of as a byproduct of the chlorine process. When demand for chlorine is high and rising, operators would run their plants at higher operating rates.  This also results in higher output of caustic, which would increase supply in the market and cause caustic prices to fall. In other words, caustic acts as a counter-cyclical buffer to chlorine prices in a rising or falling chlorine market.  Net-net, the operators still benefit in a rising chlorine environment (or conversely, are negatively impacted in a falling chlorine environment), as chlorine prices tend to be higher than those of caustic and the price improvement in chlorine is usually much higher than the fall in caustic pricing over a given cycle.

The chlorine market is heavily reliant on polyvinyl chloride (PVC), the third most widely used synthetic plastic polymer in the world.  It is estimated that around half of PVC usage goes into single family construction, mostly in PVC pipes. Single family construction is an important metric for Chlor-Alkali players, as it dictates their operating rates.  Given the uneven recovery in the US housing market post the burst of the housing bubble, and in particular weak single family construction, the Chlor-Alkali market has been in a lengthy state of overcapacity.  

Currently, single family construction is averaging around ~1.25k new homes, the general consensus is that US housing starts should average around 1.4-1.5 million (single family plus multifamily). Thus we are still not in a “normalized” demand environment, and there should be higher construction and permitting activities down the line, and a greater demand for PVC.

The far bigger source of upside for Olin in the present market is caustic pricing. Demand growth has been negative over the last year, pushing down pricing. Partly this is due to soft aluminum volumes, partly due to the effect of trade tensions and tariffs. The big picture is that over time, caustic demand is tied to global GDP growth and unless you expect the consumer economies of Asia and Latin America to stop growing then the long term trend is up. There is no meaningful new capacity coming on line in the near future, nor would current economics justify the investment. In the simplest terms, Olin can be thought of as a call option on normalization of caustic pricing. While there will always be volatility, the most recent data points are positive, as discussed on the Q2 call:

“An upward turn in caustic soda price has occurred later than we had anticipated but we are now seeing positive developments. During the second quarter the caustic soda demand locations that plagued the market for more than a year were largely resolved. In addition, global restraints on the supply side, particularly in Latin America have emerged resulting in the need for additional caustic soda exports from the United States. The tightening supply and demand dynamics taking place today should lead to caustic soda price improvement as we progress through the back half of the year. In fact, we are already seeing indications of upward pricing momentum. For example, U.S. spot export pricing reversed its downward trend in the second quarter with indices of increasing approximately $40 per ton over the first quarter. Resilient domestic pricing has increased approximately $200 per ton since the end of the first quarter. And most recently, the domestic caustic price indices broke its streak of law declines in July by increasing $5 per ton.”

Epoxy

The Epoxy business is one of the largest and lowest cost producers of epoxy resins, curing agents and intermediates for various laminates, coatings and composites (windmill blades, boat hulls, construction materials etc). It is a natural complement to the Chlor-Alkali business as a consumer of chlorine (consumes 10% of Olin’s chlorine production) and caustic. The Company’s strategy is “sell out and sell up” - increasing utilization and changing product mix to drive margins. The Company also has the ability to add low-cost capacity through de-bottlenecking existing plants in a market that is projected to tightening as demand increases while low greenfield returns deter new investment. Combined, Olin expects to double EBITDA from current levels.

Winchester

Winchester is a premier manufacturer of small caliber ammunition and its brands are revered in the space.  The business sells to commercial customers, as well as law enforcement and military agencies. The latter two clients make up between 30%-40% of Winchester’s business in any given year and are relatively stable.  The commercial side of Winchester is reliant on ammunition sales, which are best thought of as consumables and not subject to the volatility of firearm sales. Consumers have been working through stockpiles of inventory built up during the Obama years, so segment EBITDA has fallen by over 50% in the last couple of years, but is expected to stabilize and grow from current levels.

Why is it cheap?

Sell-side analysts are cautious (if not outright negative) about the Chlor-Alkali market given the recent depressed pricing in the caustic markets, and the fear of a slowdown hitting global GDP growth. Olin is levered from the Dow acquisition, exacerbating those fears.  We believe that investors are ignoring several global drivers of medium to long term upside that are already underway, including:

• A recovery in caustic pricing as capacity has been removed (Braskem) and demand has come back (Alunorte) – these events have only recently occurred, and will boost returns going forward

• Forecast demand increase for both chlorine and caustic soda – current prices don’t justify investment in new greenfield facilities, so operating rates will rise. Olin quotes IHS Markit projections for sold out markets by 2023. Olin is the largest and lowest cost merchant supplier

• Reduced environmental costs vs 2019, which was also affected by a fire at the International Terminals Company storage terminal fire. 

• Improved profitability at Epoxy due to product mix shifts

• Completion of expansions that are already underway

Longer term Olin projects a path to over $2 billion in EBITDA, and to $2.5 billion as pricing kicks in

1) $75M in VCM profits when the Shintech contract starts in 2021

2) $225M from a recovery in caustic soda pricing to 2018 levels

3) $150M Epoxy from improved volumes and margin expansion

4) $100M from Chlor-Alkali and Vinyls operating rate improvements to 2016/17 levels

5) $75M in Chlor-Alkali capacity expansions (currently underway)

6) $120M in low-cost Chlor-Alkali capacity expansion by 2022/23.  

As the slide above shows, the projected $2 billion does not include the potential from long term pricing increases driven by structural supply demand imbalances in Chlor-Alkali over the next 5 years. While there will be plenty of bumps, puts and takes, most of the $750mm of EBITDA above relates to signed contracts, recent levels of pricing and improvements that are largely under Olin’s own control.

Valuation

In terms of Free Cash Flow, D&A runs about $600mm per year, Capex is around $400mm, or which maintenance capex is $225-$275. Taking the high end of maintenance capex, adding on $60mm for luck and the usual projects that come up, subtracting for pension means that recurring FCF/share (before growth related capex and WC) is going to be ~$1.50/share higher than EPS

If the Company delivers on its $2 billion of EBITDA, that would drive EPS to around $6.70, FCF/share of $8.20, for upside to $65 at ~8x FCF, and you still have an option on further upside from Chlor-Alkali markets tightening and driving EBITDA to $2.5 billion laid out in the slide above

What if markets don’t recover and prices and demand stall at 2019 levels? EBITDA for 2019 is guided to $1.125 billion at the midpoint but this number is burdened by a few non-recurring items such as the ITM fire.  Adding those back to get to ~$1.25 billion. You still get the Shintech $75mm plus the expansions underway. Add in something for Epoxy margin improvement and call it $1.5 billion of EBITDA, $3.65 of EPS, $5.15 of FCF/share. The stock should still be worth ~$35-$40 per share (10x EPS), still over 100% upside from current depressed trading levels.

Lastly, management have taken action with the capital structure. They have a loan facility in place which they plan to use to refinance their expensive 9.75% and 10% senior notes in October 2020, generating potential cost savings . They also recently announced a $100 million accelerated share repurchase.

Risks:

• Broadly tied to global GDP. A deep recession will hurt, but long term growth in global GDP will drive demand.
• Capacity additions. There have been some in Western China, but none that can access the export markets. Current pricing doesn't justify new build.
• Leverage. The company is still levered post the Dow deal, but we expect growth in EBITDA and debt paydown from FCF to reduce this burden, the company is targeting investment grade

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author or affiliated funds  presently has a position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

Catalyst

Caustic Pricing increases

Completing existing expansions

Refinance high cost debt (2020) - could save $50+ million

New Shintech contract (2021)