Description
I propose taking a significant position in OM Group (OMG). OMG offers investors a very special situation. OMG is currently trading at the value of its Working Capital, plus the value of a recently completed (and readily saleable) acquisition. The market is currently ascribing almost no value to the continuing operations or fixed assets of OMG. As the world’s largest producer of refined cobalt-based chemicals, the demand for which is growing annually at +10%, we believe the ongoing operations of OMG are highly attractive, however, the market is valuing them as virtually worthless. The company has a pristine balance sheet, has almost no debt, and has ~$4 in cash per share. This is not a distressed situation or cash-burning company. The company earned $5.68 in 2007 and is estimated to earn $6.49 in 2008 (consensus). To summarize, by initiating a position in OMG we are able to acquire the world’s largest producer of materials whose demand is growing at a strong double-digit level (see Appendix), has ~$4 in cash per share and significant earnings power, for the value of the company’s Working Capital, plus its recent acquisition. Ben Graham would be proud.
-Majority of revenue tied closely to price of cobalt (+ a premium), and cobalt markets look tight at least through 2009; 90% of the cobalt-based revenues are tied to such contracts, with pricing lagging the spot market moves by a month or less
-Cobalt is increasingly being controlled by fewer suppliers, namely Glencore, and most of the supply exists in the DRC and other regions with political risk: supports the case for sustained high prices going forward
-Following the sales of its nickel assets and the call of certain debt, the company has $115.4mm of cash on hand, against $54.5mm in balance sheet minority interest and almost $26.3mm in debt; liquidity is ample and enhanced by a $150mm revolver + accordion
-Share buyback (see analysis below) or instituting a dividend could provide major upside to shares, and create a further stable investor base (the company indicated on their 2Q call they were actively investigating all options, including buyback)
-REM acquisition gives OMG ability to cross-sell/bundle sales to customers in the electronic chemicals line, particularly printed circuit boards and electroless nickel plating to memory disk manufacturers in Asia (higher growth); REM also allows OMG to become less exposed to the cobalt market and pricing generally
-Misunderstood company, more analyst coverage possible—only 3 “minor” shops cover currently
OM Group’s business primarily consists of refining cobalt (and other metals) to make over 1,300 value-added specialty products which are sold into a variety of end markets. In 1H08, ~85% of total sales were derived outside the Americas. The company has two segments:
Advanced Materials (70% of 1H08 sales) includes chemicals sold into the battery, powder metallurgy, chemicals, and ceramics/pigment markets, as well as revenues from its JV cobalt smelter in the DRC and cobalt metal re-sales. This line has a strong presence in Asia and products typically contain cobalt; as an example, the lithium ion batteries market is expected to grown 7%-10%/year. For almost all its cobalt-based products, OMG contractually buys cobalt at some discount to spot, and sells product later at a premium to the prevailing spot price. Thus, quick sharp cobalt price declines hurt margins while similar rises aid margins. Note: OMG is not a miner of cobalt.
Specialty Chemicals (30% of 1H08 sales) includes chemicals sold into the tires, coatings, and chemicals markets, in addition to ultra pure chemicals, photomasks, and electronic chemicals primarily for the memory disk market. The advanced organics products represent a mature growth market, but electronic chemicals are growing around 20%/yr. The products in this segment do not contain cobalt.
OMG has historically sourced most of its cobalt from the DRC (Democratic Republic of the Congo) and from Norilsk. Their primary refining facility is located in Kokkala, Finland. The company also owns a 55% interest in a cobalt smelter in the DRC, which it consolidates into its financials. This JV consists of the Big Hill plant in Lubumbashi (Katanga province), which is a smelter literally situated next to a large pile of mining waste-product—largely cobalt, built up over many years; OMG claims to have 10+ years of supply here. Groupe George Forrest (an important figure in the DRC) is the 45% minority owner of the JV. The company has excellent government relationships in the DRC and was not even subject to the review of mineral activities that is currently affecting some operations in the DRC. All of the smelted cobalt here is sold to OMG for further refining. OMG records its partner’s share of the profit generated here, as minority interest expense on the income statement, as incurred. However, OMG only records its share of the profits after the products have been shipped, refined and put into its inventory—this can take 3-5 months, thus leading to some timing mismatches which can impact quarterly earnings. OMG sources a “major” portion of its cobalt between this JV and its supply contracts with Norilsk (see below).
In March 2007, OMG sold its nickel assets to Norilsk Nickel for $490mm. Primary assets included a Finnish nickel refinery, Australian nickel mine and leaching plant, and two equity stakes in nickel properties. The company wanted to reduce its exposure to nickel price volatility, and nickel segment sales had accounted for just over 50% of total OMG sales. In conjunction with this deal, OMG entered into 5-year supply agreements (max. volumes) with Norilsk for cobalt and nickel raw materials, some of which it re-sells and/or distributes. The company is able to purchase these materials from Norilsk at a significant discount to the cobalt spot price, thus enhancing profitability.
On January 2, 2008, OMG completed the acquisition of the Electronics chemicals business from Rockwood Specialties Group, Inc. (REM) for ~$321mm in cash. The businesses supply customers with chemicals used to manufacture semiconductors and printed circuit boards, and also photomasks primarily for semiconductor and photovoltaic manufacturers. It had sales of ~$200mm in 2007. This deal should be accretive in 2008 and will increase the portion of sales coming from OMG’s non-cobalt line of business. In 1H08, this represented just over half of the Specialty Chemicals segment sales.
OMG has stated it wants to reach $2 billion to $4 billion in revenues by 2010 and rank in the top quartile of specialty chemical/materials companies by EBITDA margins, etc., through organic growth and continued M&A.
This metal is not particularly rare, and is mostly sourced as a by-product of copper and nickel mining. It has a high melting point and retains strength in high temperatures. On the demand side, China leads the way, with cobalt use up 10%/year over the last 5 years (accounts for >20% of global demand, and growing). Cobalt is considered a strategic metal by the US, and South Korea considers it the same, recently announcing that they would stockpile it (in addition to other minor metals). The U.S. Defense National Stockpile Center recently announced plans to limit the sales of six metals, cobalt being one. The Cobalt Development Institute (CDI) projects global demand for cobalt to increase 14% by 2010, led by China. The size of the cobalt market is over 60k tons (demand) and growing.
The main uses for cobalt are in batteries (consumer electronics), superalloys (aircraft engines), ultra-strength tools (used in mining and oil & gas), and catalysts (used in the energy/petrochemical industry). Demand continues to be robust for these applications, especially in batteries, which the CDI estimates is growing at 10-15% per annum, driven by the consumer electronics market (more gadgets, the cellularization of China) and the growing use of rechargeable batteries in automobiles (hybrid cars). Lithium ion batteries and hybrid electric vehicle batteries contain significant amounts of cobalt, and should be a large driver of demand going forward.
According to industry estimates, the DRC accounts for almost 40% of cobalt mine production and 50% of global reserves. Zambia and Australia are also big producers, while Australia and Cuba hold large reserves. Supply disruptions have been common over the last few years, with the latest coming from the DRC in the form of mining license disputes, power problems and general political unrest. Cost inflation, poor infrastructure, declining ore grades, and potential labor strikes pose a persistent threat to production as well going forward. China sources ~90% of its cobalt from the DRC and Zambia. Further, OMG’s contract supplies with Norilsk represent about 8% of the total cobalt available in the market, further squeezing supply.
In early November 2007, the DRC’s Katanga Mining Ltd. agreed to buy Nikanor Plc (~$2 billion), creating the world’s largest cobalt producer. Even before this deal, Glencore owned the rights to sell Nikanor’s production as well as Katanga’s. Glencore controls about half of the projected global cobalt production. There is also chatter that Glencore is in talks to buy Camec’s DRC cobalt output as well; in November 2007, Camec formed a cobalt development venture in the DRC with rival Prairie International. Thus, Glencore could control a substantial portion of the cobalt market in the very near term, thereby effectively reducing the number of ultimate suppliers even further. This resulting supply-demand picture is the bull case for continued strong cobalt prices at least through 2009. New cobalt supply is set to come online starting in 2009-2010, if all goes according to plan. However, this is not a given since most of the planned capacity is in the DRC, which has been rife with project delays. Note that much of the planned cobalt supply is by-product from primary nickel or copper mines.
Currently, the cobalt price has been under some pressure due to excess supplies in China being dumped on the market and usual seasonal weakness. The metal is very thinly-traded right now, even though the market remains in deficit this year (even cobalt bears agree on this). Shorting activity on the metal has increased of late. This is not an exchange-traded metal, and is quoted by various sources; OMG’s reference price is the low-grade (99.3%) cobalt price quoted by Metal Bulletin. The price is widely believed to recover in September, and there is industry speculation that a couple of large traders are “manipulating” the price down right now, in order to restock and ramp it back up in the fourth quarter (buy low, sell high). This type of gamesmanship has precedence in this particular market.
-The company has laid out aggressive operating goals by 2010 (see above) and will use M&A to get there, thus overpaying and re-levering are risks; OMG has stated it is not averse to doing another deal like REM in the near-term, and feels comfortable taking leverage up to the 40% Debt/Capital area (implying ~$770mm in additional debt), however, the company has explicitly said that any deal must be accretive in the first year
-Though not expected to affect cobalt supply in the near-term (i.e., before 2009), a number of cobalt projects are slated to come online from major companies like Freeport and Camec in the DRC and Formation Capital and Sumitomo outside the DRC
-Cobalt prices have been volatile in the past and are currently trading off recent historic highs
OMG’s 2007 sales growth was primarily driven by strong cobalt prices (MBCOFM.3 is the ticker for low-grade cobalt, per Metal Bulletin, on Bloomberg). Assuming pricing is sustained at ~$38/lb in 2008 and demand grows lower than YTD levels, supported by China, Advanced Materials sales should hit almost $1.3 billion. Modeling in 8%/yr growth on FY07 Rockwood sales, while very conservative given they serve “high growth” markets, results in total pro forma OMG sales of ~$1.9 billion in 2008. Using 24% gross margins in FY08 (was 30.7% in FY07)—to reflect the current declining cobalt price environment—and assuming some increase in SG&A from Rockwood, results in ~$6.50 in EPS and $290mm in EBIT. (For comparison, in 1H08 OMG already achieved Net Sales of ~$1 billion, EBIT of $178.1mm, and EPS of $3.76.) This corresponds to 4.4x P/E (’08) ex-cash, and 3.3x EV/EBIT (’08), given the company’s current capital structure. Of course, since the company is in acquisition mode, the actual “cheapness” hinges upon closing accretive deals going forward. The stock is trading below last year’s price, despite cobalt having been up substantially y/y until 3Q08.
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Capital Structure (6/30/08) |
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Cash |
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$115.4 |
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Long-term Debt |
26.3 |
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Minority Interest |
54.5 |
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Equity |
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1,151.8 |
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Total capitalization |
$1,232.6 |
Tangible book value/share is ~$25. The company has $3.80/sh in cash, and almost no debt. Pertinent metrics also show a compelling investment case.
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Stock Price: |
$32.52 |
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P/E ex-cash ('08): |
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4.4x |
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FD shares out (mm): |
30.3 |
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EV/EBIT ('08): |
3.3x |
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Market Value ($mm) |
$985.8 |
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MV/Tangible BV: |
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1.3x |
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Net Debt/Min. Int.: |
-34.6 |
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ADV (3-month): |
1,015,250 |
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Enterprise Value (EV): |
$951.2 |
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Short Interest (7/31/08): |
4,453,962 |
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% of float short: |
14.7% |
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Days to Cover: |
4.4 |
As value investors, we do our best to follow the principles of Ben Graham. Graham had a golden rule that he used as a backstop for many of his investments. He looked for companies that were trading at approximately the value of their Working Capital (Current Assets-Current Liabilities). Graham’s view was that if he could purchase a company for only the value of its working capital, the market was valuing the company’s ongoing operations and fixed assets at zero. If Graham believed there was value to the ongoing operations or fixed assets, he would buy the stock as he was essentially getting that portion of the business for free.
OMG is currently trading at such a valuation.
Please see the analysis below. OMG’s working capital at the end of 2Q08 was $608m. If you add to that the value of the REM and Borchers acquisitions, which have a lower working capital intensity and could likely be sold at a similar value the company paid for them, that value increases to $950m.
The current market value of OMG is $986m. Thus the market is valuing the ongoing operations and fixed assets of OMG at $36m or $1.17 per share.
Initially, we were concerned with adjusting our analysis by adding in the value of the recent acquisitions, however we have justified this with the knowledge that those businesses have a very low working capital intensity and the acquisitions have recently closed so prices are likely reflective of reasonable valuation in today’s markets. We believe the assets could be resold at the same value or higher, given their highly specialty nature. Anecdotally, we have learned there were other bidders prepared to offer more for the assets, but for strategic reasons Rockwood did not want to sell to those other buyers.
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OMG Margin of Safety - Value Analysis |
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ASSETS |
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Cash And Equivalents |
115,388 |
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Accounts Receivable |
232,245 |
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Inventory |
473,550 |
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Other Current Assets |
76,032 |
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Total Current Assets |
897,215 |
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LIABILITIES |
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Accounts Payable |
202,007 |
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Accrued Employee Costs |
29,536 |
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Short-term Borrowings |
- |
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Current Portion of LT Debt |
121 |
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Current Income Taxes Payable |
27,553 |
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Other Current Liabilities |
30,136 |
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Total Current Liabilities |
289,353 |
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Ongoing Operations Valuation |
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Per Share |
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Current Assets |
897 |
$29.60 |
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Current Liabilities |
(289) |
($9.55) |
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Working Capital |
608 |
$20.05 |
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REM Acquisition |
321 |
$10.57 |
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Borchers Acquisition |
22 |
$0.72 |
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Total Value of Non-legacy OMG Assets |
950 |
$31.35 |
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Current Market Value of OMG |
986 |
$32.52 |
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Implied Value of Ongoing Operations of OMG |
36 |
$1.17 |
Management can generate strong returns from a share repurchase as well, even without a re-rating of its trading multiple:
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OMG: Share buyback scenarios |
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Amount of buyback (100% debt-financed, $mm) |
$100 |
$150 |
$200 |
$250 |
$300 |
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Price for buyback (current Px) |
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$32.54 |
$32.54 |
$32.54 |
$32.54 |
$32.54 |
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Shares bought (mm) |
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3.1 |
4.6 |
6.1 |
7.7 |
9.2 |
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Pro Forma shares outstanding (mm) |
27.2 |
25.7 |
24.2 |
22.6 |
21.1 |
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Interest rate |
12.00% |
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Additional Interest Expense ($mm) |
$12.0 |
$18.0 |
$24.0 |
$30.0 |
$36.0 |
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Statutory Tax Rate |
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35.0% |
35.0% |
35.0% |
35.0% |
35.0% |
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After-tax effect on Net Income |
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-$7.8 |
-$11.7 |
-$15.6 |
-$19.5 |
-$23.4 |
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Consensus Net Income (2008E) |
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$216.0 |
$216.0 |
$216.0 |
$216.0 |
$216.0 |
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Pro Forma Net Income (2008E) |
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$208.2 |
$204.3 |
$200.4 |
$196.5 |
$192.6 |
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Pro Forma shares outstanding |
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27.2 |
25.7 |
24.2 |
22.6 |
21.1 |
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Pro Forma EPS |
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$7.64 |
$7.95 |
$8.29 |
$8.68 |
$9.13 |
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Maintain current forward P/E (consensus) |
4.7x |
4.7x |
4.7x |
4.7x |
4.7x |
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Pro Forma Price |
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$36.29 |
$37.74 |
$39.37 |
$41.23 |
$43.35 |
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Price today |
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$32.54 |
$32.54 |
$32.54 |
$32.54 |
$32.54 |
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% Upside |
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11.5% |
16.0% |
21.0% |
26.7% |
33.2% |
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Pro Forma Total Debt/EBITDA ('07): |
0.6x |
0.8x |
1.0x |
1.2x |
1.4x |
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Pro Forma Price |
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Size of buyback |
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$100 |
$150 |
$200 |
$250 |
$300 |
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4.25x |
$32.48 |
$33.78 |
$35.24 |
$36.90 |
$38.80 |
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Potential |
5.25x |
$40.13 |
$41.73 |
$43.53 |
$45.58 |
$47.93 |
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Fwd. P/E |
5.75x |
$43.95 |
$45.70 |
$47.68 |
$49.93 |
$52.50 |
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6.25x |
$47.77 |
$49.68 |
$51.83 |
$54.27 |
$57.06 |
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6.75x |
$51.59 |
$53.65 |
$55.97 |
$58.61 |
$61.63 |
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% upside |
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Size of buyback |
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$100 |
$150 |
$200 |
$250 |
$300 |
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4.25x |
-0.2% |
3.8% |
8.3% |
13.4% |
19.2% |
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Potential |
5.25x |
23.3% |
28.2% |
33.8% |
40.1% |
47.3% |
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fwd. P/E |
5.75x |
35.1% |
40.4% |
46.5% |
53.4% |
61.3% |
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6.25x |
46.8% |
52.7% |
59.3% |
66.8% |
75.4% |
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6.75x |
58.5% |
64.9% |
72.0% |
80.1% |
89.4% |
Furthermore, a simple LBO analysis reveals at least 20% IRR is achievable in 2012 on a transaction with the following conservative assumptions:
-$60/share offer price (significantly higher than today)
-42% of transaction financed with equity; balance of financing includes: $110m of the cash on hand, $250mm of first lien debt at L+500, and $750mm of HY bonds at 11%
-$58mm of fees
-Net Sales grow 10% in 2009, but stay flat the following year and decline in 2011 and 2012 by 5% each year
-EBIT margin decline from 19.2% in 2007, down to 14.3% in 2012
-Steady capex in line with historical spending (~$30mm/year)
-7.0x EBITDA exit multiple
Catalysts
-Share repurchase
-Management marketing in September and October – attending the KeyBank Industrials Conference (Sept 10-11)
-Initiation of new sell side coverage
-Cobalt prices resuming their rise in September/October
-Potential M&A
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Advanced Materials |
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70% of 1H08 Total Net Sales |
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90% of 1H08 Advanced Materials Net Sales were outside of the Americas (44% Asia, 46% Europe) |
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Sales volumes +30% in 2Q08, ex-cobalt metal and copper by-product resales |
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End Market |
% of 1H08 sales |
2Q08 Revenue growth |
Description |
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Battery |
40% |
93% |
Improve electrical conduction of rechargeable batteries used in a variety of products |
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Other |
31% |
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Includes cobalt metal resale |
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Powder Metallurgy |
11% |
106% |
Strengthen and add durability of to diamond and machine cutting tools/drilling equipment |
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Chemicals |
14% |
58% |
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Ceramics |
4% |
47% |
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Specialty Chemicals |
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30% of 1H08 Total Net Sales |
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71% of 1Q08 Specialty Chemicals Net Sales were outside of the Americas (38% Asia, 33% Europe) |
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Net Sales down by 3%, ex-acquisitions, which added $77mm in revenue (2Q08) |
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End Market |
% of 1H08 sales |
2Q08 Revenue growth |
Description |
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Semiconductor |
22% |
+17x |
(see below) |
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Coatings |
20% |
129% |
Faster drying of paints, inks and coatings; other performance enhancers |
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Tire |
15% |
28% |
Promote adhesion of metal to rubber in tires |
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PCB |
16% |
+11x |
Oxide treatments, electroplating additives, etching technology and electroless copper processes used in PCB mfg. |
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Memory Disk |
11% |
-33% |
Electroless nickel solutions and preplate chemistries for HDDs used for memory/data storage apps. |
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Chemical |
11% |
30% |
(see below) |
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General Metal Finishing |
3% |
14% |
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Other |
2% |
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Segmentation |
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Description |
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Electronic Chemicals |
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Products for electronic packaging, memory disk, general metal finishing, and PCB finishing markets |
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Ultra Pure Chemicals |
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Used in manfacture of components such as semiconductorswafers, and LCDs |
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Photomasks |
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Photo-imaging masks and reticles for the semiconductor and microelectronic industries |
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Advanced Organics |
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Tire, coatings and inks, additives, and chemical markets |
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1H08 vs. 1H07 |
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1H08 |
1H07 |
? |
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Net Sales |
$991.6 |
$447.5 |
$544.1 |
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Components: |
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Pricing (Adv. Mats.) |
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199.8 |
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Volumes (Adv. Mats.) |
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41.9 |
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Cobalt Metal Resale |
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148.4 |
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REM/Borchers |
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143.9 |
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Pricing (Spec. Chems.) |
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27.0 |
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Volumes (Spec. Chems.) |
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-12.1 |
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Other |
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-4.8 |
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Total |
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544.1 |
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Segment Analysis: |
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Net Sales |
1Q07 |
2Q07 |
3Q07 |
4Q07 |
2007A |
1Q08A |
2Q08A |
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Adv. Materials |
$151.40 |
$154.90 |
$193.30 |
$222.30 |
$721.90 |
$332.40 |
$359.10 |
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Specialty Chems. |
66.7 |
78 |
71.9 |
87.2 |
303.9 |
149.1 |
152.5 |
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Operating Profit |
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Adv. Materials |
$47.20 |
$52.40 |
$48.60 |
$64.50 |
$212.60 |
$95.30 |
$79.50 |
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Specialty Chems. |
8 |
10.1 |
4.7 |
3.1 |
26 |
8.5 |
12.4 |
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Operating Margin |
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Adv. Materials |
31.20% |
33.80% |
25.10% |
29.00% |
29.50% |
28.70% |
22.10% |
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Specialty Chems. |
12.00% |
13.00% |
6.60% |
3.60% |
8.50% |
5.70% |
8.10% |
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Avg. Cobalt Px |
$25.82 |
$28.01 |
$25.84 |
$32.68 |
$27.99 |
$46.19 |
$45.93 |
Catalyst
1)Share repurchase
2)Management marketing in September and October – attending the KeyBank Industrials Conference (Sept 10-11)
3)Initiation of new sell side coverage
4)Cobalt prices resuming their rise in September/October
5)Potential M&A