Description

Olin Corporation (OLN US)

Olin is currently made up of three businesses: chemicals manufacturing, chemicals distribution and small caliber ammunition manufacturing. Its two chemicals divisions manufacture and distribute chlorine and caustic soda (known as chlor-alkali) while its ammunition division manufactures small caliber ammunition for consumers, law enforcement and the department of defense.  Olin is, however, in the process of acquiring a significant portion of Dow Chemical’s chlor-alkali and downstream derivatives businesses, thereby becoming the largest chlor-alkali player in the world. The acquisition is on schedule to close within the next few weeks.  Pro forma for the acquisition, but before synergies, the new company will have the following business (2014):

-          Chlor-Alkali (64% of EBITDA) – 672 million

-          Global Epoxy (15% of EBITDA) – 157 million

-          Ammunition (14% of EBITDA) – 144 million

-          Chlorinated organics (5% of EBITDA) – 54 million

-          Chemicals distribution (2% of EBITDA) – 21 million

-          Corporate –(49 million)

Total EBITDA before synergies is therefore $1billion even.  Given the nature of this acquisition, where not only does the combined company have significantly more scale, but Olin achieves significantly more downstream integration, the transaction will create meaningful synergies.  Olin expects cost synergies of $200 million per year and potentially another $100 million per year in revenue synergies.  Given the size of the combined company and the nature of the business, the synergy targets strike us as being rather conservative.  We understand the company hired McKinsey consulting to give them an estimate of the cost synergies alone, and McKinsey’s estimate was at least $250 million, compared to the company’s estimate of $200 million.  As I am generally more skeptical of revenue synergies, I only give them credit for the $200 million of cost synergies in my estimate.  Before we assume any growth, 2014 PF EBITDA, including only the cost synergies we arrive at $1.200 Billion in EBITDA.  Given the cyclical nature of all of their businesses, it is important take a close look at where each one of the segments relative to its cyclical average. Here are my conclusions:

-          Chlor-Alkali: We have much more data for Olin’s Chlor-Alkali’s division that we do Dow’s, but given Dow’s greater downstream integration, Olin’s Chlor-Alkali business should be more cyclical. In 2014, EBITDA margins were 17.9%, vs. the average over the last 10 years of 27.1%. The 17.9% margin in 2014 is the lowest margin over the last 10 years, which margins peaking in 2005 at 43.0%. This is consistent with the management and industry commentary that we are at the trough of the Chlor-Alkali cycle.  The reason for the weak conditions in the chlor-alkali industry is that the biggest end users of chlorine is the vinyls market, which is primarily driven by constriction. It is no surprise that the higher margins were achieved in 2005 / 2006 when the US housing market was at its strongest.  Capacity utilization in chlor-alkali is in the low to mid 80% today consistent with little pricing power and trough margins.  This is due to the combination of weak housing demand as well as growth in supply over the last few years.  Fortunately, there is virtually no new capacity coming on, while demand should accelerate nicely as the US housing market recovers.  Olin has stated they believe that their own chlor-alkali business is likely to see a $200 million in increase in EBITDA as the industry recovers.   While Dow’s business is larger, its greater downstream integration makes the business less cyclical. Discussions with the company suggest there may be $100 million upside as the market recovers.

-          Global Epoxy:  As this business comes purely from the Dow side we have less historical data for this division, but analysis of the Epoxy businesses of Hunstman (within their Advanced Materials division) and Hexion suggests this business a. Is below average cycle (Hexion did 8.3% margins in 2014 compared to a 10 year average of 11.9) b. Dow’s Epoxy business’ margins are meaningfully below peers. We cannot find any structural reason as to why it should be lower margin that Hexion, so we suspect once it is run as a standalone business within OLN, that there is upside to margins regardless of the cycle. Dow’s conference calls from a few years back discuss this business having the potential to achieve 20% EBITDA margins, a far cry from the current fully adjusted 5% margin.  Epoxy is used for a number of end markets, but construction and infrastructure remains an important end market.  Given that Epoxy is a global market and the weakness in infrastructure in emerging markets, we are not assuming much of a cyclical recovery here, but believe the margin gap with Hexion can be closed, providing 50% upside to Global Epoxy EBITDA from current depressed levels (79 million of EBITDA upside from closing margin gap). Huntsman’s margin are significantly higher still, but their Advanced Materials division includes other businesses that could be even higher margin than Epoxy.

-          Ammunition (Winchester).  Sales of firearms and ammunition have seen significant growth over the last number of years in the US.  The reasons for this growth are growth in active sport shooting, increased demand for home protection and concerns about further regulatory changes.  While we have no specific reason to think fear around home security should decline or that the growth in sports shooting should reverse, we think fears around further regulatory changes may subside if there is a change in the White House.  This has to some extent already happened, as sales have been declining since the 2013 peak.  While recent government registration data for guns suggest a reversal of the declines, it is too early to tell what the true normalized levels for this business is.  In 2014, revenues for this business were about 40% higher than the 10 year average and almost 100% higher than the levels we saw under the Bush Administration.  The company has improved the profitability of this business independently of the growth in revenues over the last few years, so we assume the 144 million in adjusted EBITDA for 2014 is above normalized levels by 44 million. 

-          Chlorinated Organics. This is the business we have the least amount of detailed historical data on. It is clearly not at peak, given that EBITDA for this business was 160% higher in 2012 than it was in 2014. We use the average level of the last three years as average to come up with 16.7 million of upside to normalized levels. The chlorinated organics division produces chemicals for cleaning applications, construction, refrigeration and water treatment.

-          Chemicals distribution.  This business generally does not have much commodity pricing exposure as it largely a logistics business, but can still be impacted by pricing lags and inventory changes. The business has EBITDA of 21 million in 2014 compared to historical averages of 30 million, so we assume 9 million of EBITDA increase to normalized levels.

If we start with 2014 Pro Forma EBITDA of $1.200 Billion and make the following adjustment to get to normalized levels: +150 million in Chlor-alkali (assumes mid-point of cycle, not the full 300 million the company has highlighted as “recovered earnings), +79 million from Epoxy, -44 million from Ammunition, 16.7 million in chlorinated organics and +9 million in chemicals distribution. This add up to a total of 211 million on top of the 2014 figure for a total PF EBITDA of 1411. To be clear, this is to arrive at normalized, or through the cycle levels. As we are moving off of a trough in every business with the exception of the ammunition business, we expect EBITDA to go beyond average cycle and towards peak of the cycle over the next few years as housing in the US recovers from its abnormally low level of housing starts. Peak EBITDA is closer to $1.650 Billion.  In the company’s form S-4 filed you can find the individual projections of the two companies. Once you add in the synergies plus the benefit of the ethylene supply contract you will find a number just north of our peak estimate for 2017.  While earnings are likely to go above average cycle in the medium term, we will focus on the normalized earnings for the purposes of our valuation analysis.  After the investments make over the last number of years, capital expenditures are expected be lower on a recurring basis going forward.  In addition, we expect Olin to close down some of Dow’s older chlorine capacity which will bring down capital expenditures further. However, just using the company’s estimates of capital expenditures, they are expected to be $300 million per year for the foreseeable future.  Depreciation and amortization however, will be higher at 477 million per year, which means cash EPS will be higher than reported EPS by $1.06 per share. PF interest expense will be 153 million and there are 167 million shares outstanding PF for the deal. This means that using our normalized figure of $1.411 Billion of EBITDA, the business generates $4.09 in cash EPS, while reported EPS will be $3.04.  Because book EPS reflects abnormally high D&A relative to normalized capital expenditures, we focus primarily on the cash EPS figure.   While chemical multiples are currently depressed due to the fears around global growth, there are many strong arguments in favor of Olin deserving a higher multiple that your average specialty chemicals company: 1. Almost 20% of the business comes from ammunition and chemical distribution, where the peers trade between 17X and 20X EPS, 2. Olin is now the dominant market leader in chlor-alkali globally with an advantaged cost position due to its exclusively US manufacturing footprint and its advantaged access to low cost North American natural gas. Nevertheless. Let’s assume that the business receives a paltry 12x EPS multiple. Even using this multiple, the stock is worth $49 per share or 160% upside to its current price of $19. I suspect the stock will trade above fair value as the chlorine cycle recovers. As we move towards the peak, cash EPS will be well in excess of $5 per share, which at a 15x normal specialty chemicals multiple warrants a $75 share price.

The two obvious pushbacks are:

1.       If the stock is worth between $49 and $75, how can it trade at $19 today? It is really a combination of a few things:

a.       When the stock was announced in late March, the stock immediately popped from $27.19 to $32.41 as people realized the power of combining these assets. However, as fears around a Chinese slowdown intensified and multiples of chemical companies compressed, Olin’s multiple compressed with the rest of the group. Several high profile funds filed significant ownership in the mid to high 20s but this only made things worse as several months of weak hedgefund performance forced many of the holders to reduce or exit their position as the stocks fell, exacerbating the move down

b.      The merger arbitrage community have been putting an abnormally large amount of pressure on Olin stock as they have shorted Olin and bought DOW. Not only are there a number of large funds what like the DOW standalone story post deal, but there are also funds doing to pure arbitrage based on the uncertainty around the final ratio

c.       Olin is still a mid cap stock, so it does not yet have the size to gain the support of the larger asset managers of the sell side community. Once the deal closes and the large banks will have little choice but to cover it, we expect the deep dislocation in its stock price to be corrected. While the stock could be volatile for the next few weeks, given how tight the borrow has become in Olin, I suspect the shorting pressure from the arbs will be largely behind us. 

2.       Isn’t China slowing and doesn’t that mean that I can’t own anything in materials? Yes, China is slowing, but no, we don’t think it will impact Olin much if at all. Why? Because Chlorine is a national and not a global market. This is not true for Soda Ash, but Chlorine drives the cycle and if pricing for soda ash falls too far, producers will cut chlorine capacity further thereby stabilizing pricing for soda ash, and pushing price up for chlorine.  China has had overcapacity for soda ash and PVC for many years. For reference, their export capacity (on the coast in China) is running at 55% utilization. Needless to say the Chinese are not making any money on this, but they do provide a pricing umbrella for the US producers that use natural gas (ethane) instead of crude oil (naptha).  It is clearly true that the pricing umbrella has come down since the spread between natural gas and crude oil has come down. However, the cost curve has not flattened nearly as much as people think because the co-product prices in the naptha process have fallen so significantly. Please note that we are not assuming any recovery in crude oil prices, but there is clearly more upside fundamentally to crude oil prices over the next few years, despite the near term glut. If oil prices recover, the margin cost of soda ash and pvc will move higher which will increase the pricing umbrella for US producers like Olin. However, given the current spread, with brent crude oil at $47, there is plenty enough spread for utilization and pricing in the US to recover with US housing to get to normalized levels and beyond before Chinese products become competitive. Case in point, with crude oil where it is today, and with Chinese export capacity at 55%, the Chinese are far from being able to compete on cost relative to the US manufacturers like Olin.  The flip side to the current overcapacity in chlor-alkali is that there is basically no capacity coming on for the next number of years. Actually close to 3.5% of capacity will have to leave the industry by 2018 / 2019 due to regulatory reason in Europe (mercury based capacity).  In addition, we think it is likely that Olin takes out Dow’s old capacity in the US.  While sentiment around commodities and emerging markets could hardly be more bearish, there is a plausible scenario where, US housing recovers, European housing recovers, China doesn’t crash and burn but just grows as a slower rate from hare, India accelerates its infrastructure plans, while Brazil slowly recovers from its recession.  All of this happens while oil stabilizes and gradually grinds higher, while there is no new supply and a portion if the installed capacity in Europe is removed for regulatory reasons. If this scenario plays out, then Olin will be worth a lot more than what we have in our base case.

Catalyst

The closing of the deal at the end of this month.

Some other investors/analysts figuring out this story and publishing it in the next month of so.  (I am skeptical there are any sell-side analysts with the ability, but perhaps I will be surprised.)