Description

Orion Engineered Carbons (“OEC”) is a little-known specialty chemical company with excellent free cash flow, a prized specialty black segment, and several unrecognized positive catalysts.  OEC has had a tough start as a public company, has misunderstood ties to oil, and underappreciated near-term catalysts.  It trades at 8x EV/EBITDA, which is more than a turn below comparable specialty chemical companies and compelling given the high barriers to entry that exist in its business.  Execution on several fronts should draw more attention to the name in the near-term. Currently trading at $21, the stock is worth at least $30/share, in our view, with significant additional upside potential.

Business Description

OEC makes a specialty chemical called carbon black.  Carbon black is a very fine black powder made of carbon.  Carbon black is in practically everything that is the color black; your pen, calculator, phone, computer, printer ink, car, clothes, shoes, etc.  Specific batches of this powder have different chemical properties and get used in a wide array of end markets.

Orion is one of only three global carbon black players.  The Company segments its business by two carbon black types: specialty black and rubber black.  Specialty black (60% of profit) is used in plastics, coatings, cables, wires, and inks. This segment has some very interesting characteristics that we believe are not fully recognized by the investor community.  Rubber black (40% of profit) is primarily used in the tire market. More than 70% of OEC’s rubber black volume is used as a raw material in the predictably-growing replacement tire market.  

Why it is Mispriced

1)       Unknown name with rough start as a public company

2)       Misunderstood tie to oil

3)       Unrecognized near-term positive catalysts

Unknown name with rough start as a public company

OEC was acquired in July 2011 from Evonik, a large German chemicals company, by two PE firms for a 7x TTM EBITDA purchase multiple.  OEC was an orphaned division within Evonik, and under private equity ownership, benefited from a new management team and a clear business plan.  Three years later, the Company had grown EBITDA by nearly 40% and OEC was taken public in July 2014.  Originally anticipated to price at $21-$23 (8.5x TTM EBITDA multiple), OEC actually priced at $18 (7.7x TTM EBITDA multiple).  The Company then proceeded to miss guidance in three out of its first six quarters as a public entity, with management lowering guidance for the full year 2015 as oil prices fell starting in second half of 2014.  It was a rocky start.

The Company is based in Luxembourg, reports in Euros, trades in US dollars, is an international filer, and is (loosely) covered by a mix of US and European analysts.  There are many things that make this company easy to pass-by at first glance which are all contributing to the current opportunity.  

Misunderstood tie to oil

Carbon black is made using a feedstock derived from either petroleum or natural gas, so the business is tied to oil.  However, OEC’s two segments have opposing dynamics to oil price changes, which creates a natural hedge.  We believe this is misunderstood to some extent. To be clear, declining oil prices are a negative for OEC’s results and increasing oil prices are a positive, but oil prices are less impactful than investors assume at first glance.  The hedge is evident when you compare the trailing EBITDA of each business line over time as oil prices have fallen.  OEC has experienced a steady upward EBITDA trajectory with the mix shifting between rubber black and specialty as oil prices have changed.

In the rubber black segment, price is the sum of a fixed component “base price” and a floating component indexed to oil.  In theory, this floating piece acts as a pass-through for changes in feedstock costs which are oil based, so even though price fluctuates significantly, gross profit per ton will be steady.  However, in practice, because this is only a percentage change pass-through, in a scenario where oil is falling consistently (i.e. late 2014 through early 2016), absolute feedstock costs do not fall as much as absolute rubber black price, hurting gross profit euros.  Similarly, when oil is rising consistently, it is a benefit to the rubber black segment (i.e. early 2016 to present).

Additionally, feedstock markets have their own supply/demand characteristics which don’t always mirror the supply/demand dynamics for oil.  This occurred in Europe from the end of 2015 until the middle of 2016; one of the feedstocks used to make carbon black declined less than oil.  The rubber black floating component of price, which is indexed to oil prices, declined dramatically while feedstock costs fell less, and thus margins were squeezed.  Management calls this out as the “differential” in conference calls and this accounted for a significant part of the profit euro decline in the rubber segment from the 9/15 quarter to the 6/16 quarter.  Oil prices have improved, and the feedstock supply/demand dynamic has reverted to a relatively stable differential for the last six months. In response to this differential, OEC’s implemented a surcharge in Q316, increasing price at a high single digit rate sequentially in rubber black.  We expect the surcharge to hold through Q416, are monitoring this differential monthly, and we expect differential stability to continue as long as oil prices remain flat or increase.

In the specialty black segment, price is not significantly tied to oil, which is largely misunderstood.  The Company highlights that 37% of volume is indexed to oil in this segment.  However, it is the lower margin products of this segment that are indexed to oil.  The higher margin products are extremely specialized, with high switching costs and significant price inelasticity.  Some of these products are priced at upwards of 20,000 euros/ton (versus rubber black which is closer to 800 euros/ton).  These higher margin products are the real drivers of profitability in this segment as roughly the top one-third of volume makes up nearly 70% of profits.  Price in this segment, therefore, is somewhat fixed while feedstock costs fluctuate with oil prices.  Thus, when oil prices rise, it is a negative for profitability in this segment.

It is difficult to quantify the impact of oil price changes precisely but here is our best attempt. The majority of the profit per ton changes since 2014 have occurred because oil prices have changed. Oil prices started falling in Q214 and surcharges in rubber black were implemented in 3Q16.  Thus we choose to compare today’s volumes at the 2Q14 profitability per ton levels against  today’s volumes at the 2Q16 profitability per ton levels.  As shown below, brent at a $110 price would generate about an additional 10% of EBITDA in 2016.  This is clearly an oversimplification; we are ignoring base price changes, mix shifts, cost cuts, etc.  However, we believe that this is a decent proxy for quantifying the impact of oil price changes on OEC’s profit levels.



To summarize, the net effect of oil price changes matters, but it is not the key factor driving performance because the two segments are natural hedges for each other. That said, it is important to note that the volumes in rubber black outweigh the volumes in specialty black by almost 4x, so the net effect for OEC is that a rising oil price increases profit a bit.

Unrecognized near-term positive catalysts

We think a lot of things are going right for OEC that are not fully reflected in its stock price:

1.        2016 differential surcharges in Europe will positively impact 4Q16 results.  From 2015 through mid-2016, oil prices fell but feedstock prices rose in Europe.  As a result, the Company enacted a “surcharge” on rubber black prices in Europe which the management team credits for the bulk of the gross profit per ton increase in 3Q16 in Europe.  We expect this profit level in rubber black to hold for at least the 4Q16, which should positively impact results next week when the Company reports its 4Q.  But rather than being a short term, temporary surcharge, our call work suggests that this is likely to be replaced by a more permanent base price increase in Europe beginning in the 1Q17, which brings us to our next catalyst.

2.        Europe and Asia 2017 pricing increases in rubber black.  The industry announced spot market rubber black price increases in the 4-6% range on base prices around the world during 2016, with the intent that these increases roll-forward to tire contracts for 2017.  In Korea, OEC announced an up-to-9% price increase.  Price increases stick when industry utilization is above the mid-80%.  Our call work indicates that utilization in Europe is above 90% and Korea is strong right now as well and thus these pricing increases were accepted for 2017.  In North America, our understanding is that industry price increases did not hold and pricing was flat yoy – utilization is hovering in the low-80%.  We are assuming base price increases of 2%, 2%, 1% and 0% in Europe, Korea, ROW (ex-North America), and North America, respectively, implying a ~1% base price increase for the company overall.  A 1% base price increase equates to roughly a 2% increase in gross profit beginning in January 2017:

Note that Cabot, OEC’s closest competitor, reported last week and commented that rubber black negotiations were generally “quite positive” providing further confidence in these base price increases, which may prove conservative.  Additionally, Michelin, Goodyear and Continental all announced 2017 price increases on their tires during their 4Q conference calls, citing raw material cost increases, including rubber black.  

3.        Oil prices have risen since Q3 2016 and the futures curve is projecting current prices to hold.  Brent averaged $47 a barrel during 3Q16, then ticked up to $51 a barrel during the Q4 2016 quarter.  In the 1Q of 2017, prices have averaged around $56 a barrel and the futures curve is projecting that this $56 price holds through our 2018 time horizon.

4.        Worldwide pricing increases in specialty black.  In July, OEC announced price increases in specialty of 5-8% worldwide.  Price increases are harder to quantify in specialty because the segment is more opaque, but this is generally a positive tailwind.

5.        OEC continues to take market share. Recent volume performance combined with our call work suggests that OEC may be able to continue taking market share in both rubber and specialty black.  In particular, we have heard consistently that OEC has been stealing share from Cabot, with one of our contacts pointing out that, “you go to any plastics conference and you will hear about how OEC is taking share from Cabot.”

6.        North American new tire production going on-line.  Tire manufacturers have announced new tire capacity coming online during 2017-2020 in the North American market. This anticipated demand is a function of a mix shift away from imports, an increase in tire tariffs on China imports, increasing miles driven, record vehicle ages, and a shift towards higher-value added tires (which use more carbon black).  Note that we see no evidence of related factory closings here.  This appears to be incremental capacity predicated on future demand, so it is another positive tailwind for OEC.

7.        Capacity rationalization in Europe. In Europe, Birla closed its Hanover factory and OEC closed its Ambes factory during 2016.  These factories had 100K tons of capacity, were older facilities and our call work suggests that volumes were being produced at a loss.  Utilization rates in Europe were already high so these closures should provide further support for price increases in 2017.  For OEC specifically, the Company has identified 6M euros of cost savings and an additional 2M euros of capex savings starting in 2017 from the Ambes plant closure.

8.        China substitutes on the sidelines.  China announced coal production cuts in 2016 of 250m tons (8% of 2015 capacity) and, in January 2017, announced another 300M tons of cuts (10% of 2016 capacity).  Coking coal is used to produce coal tar, which is the feedstock used in China to make Chinese rubber black.  Thus coal tar supply has decreased and pricing for it has increased by roughly 50% yoy, which flows through to Chinese rubber black and tire pricing.  At these prices, it is likely no longer economical for China to ship their rubber black.  These increases started towards the end of last year so the impact is still unclear.  China is estimated to be ~2-10% of the total market supply of rubber black in both the US and Europe.  If this supply stays on the sidelines, demand and pricing in the US and European markets will increase.    

9.    Continued execution and capital allocation.  TTM EBITDA has had a consistent upward trajectory.  This strong execution dovetails with a very clear capital allocation plan to maximize cash flow and pay down debt until the Company’s net debt/EBITDA is below 2x and to maintain a 40M euro annual dividend (3% yield).

10. Take-out potential.  Almost every industry contact we spoke with highlighted the potential for OEC to be acquired.  The low relative valuation combined with a private equity ownership period of close to 7 years makes that certainly plausible.  The most frequently cited acquirers are Birla, Omsk, or “one of the Asian players,” with Tokai or Hyundai highlighted among other much smaller players.  A purchase price multiple of EBITDA of 8-10x is often suggested as reasonable.  Birla acquired a 1M ton carbon black producer (i.e. about the same size as OEC today) for 8.7x EBITDA in 2011.  This is not a perfect comparable as the target (Columbian) produced more rubber than the more valuable specialty black, but it is a reasonable price floor to use for a private market transaction for OEC.

Valuation

Assuming no multiple expansion, current EV/EBITDA of 8.0x implies a price target of $26 by year-end 2018.  Assuming some slight multiple expansion to 8.5x, we have a price target of $30 by year-end 2018.  Note that this 8.5x multiple is still below Cabot’s current 9.3x multiple.  Cabot is the closest direct public comp.  We think OEC is a more attractive business because 60% of its profit comes from specialty versus Cabot’s roughly 40%, and thus should be trading at a premium to Cabot, not the discount we are conservatively using here.  Additionally, OEC shareholders today will receive another 1.36 euros per share from the dividends paid over the next two years, which is not reflected in our price target below.  

Risks

Falling oil prices.  While the Company has demonstrated the ability to navigate through a failing oil price environment successfully, this would be a net negative for OEC.

EPA capex.  There is significant capex required by the EPA for OEC’s US operations.  However, Evonik indemnified OEC against this capex spend in the 2011 acquisition and thus has agreed to pay for most of it.  Based on conversations with management, this will be a $10M capex spend for OEC annually for the next six years, starting in 2017.  However, there is some risk that this cost could be higher than anticipated.

Pension expense.  There is a pension liability on the balance sheet of about 60M euros.  Our understanding is that there are no or very minimal ongoing cash outflows tied to this pension and that the pension liability is a function of different IFRS accounting required for some specific European benefit plans.

PE overhang.  The PE owners still own the majority of shares outstanding.  We believe they are not sellers at today’s price point and they are actively looking for a takeout, but there is a potential overhang if the share price ticks up and the PE owners become more willing sellers in the public markets.

Recession.  Carbon black is widely used and sales are driven by stable replacement volume year in and year out.  More than 80% of profit is replacement demand.  The management team estimates that in a repeat of the 2008 financial crises, EBITDA would be 20% lower than today.

Appendix: More on the Business Segments

Specialty Black

Specialty black volumes are growing at mid-single digit rates.  Management has consistently shifted the product mix towards higher value products and costs have fallen (with oil), so gross profit per ton has increased over time as well.  The Company operates as part of an oligopoly, with only two other significant players.  Cabot is publicly traded in the US and Birla is privately held by an Indian conglomerate.  OEC has 25-30% market share here (#1 share) and these top three players have about 70% market share all together.  Roughly 80% of products are dual-sourced, so each player is aware of competitor pricing actions and there is generally very rational pricing.  

It is difficult to get much transparency into the specific customers and product mix in this segment.  There are hundreds of customers in many different industries.  We believe that plastics are the highest volume products sold but are very low margin.  These are items like black garbage bags, pipes, or the black plastic molding for your keyboard, mouse, office chair, etc.  We think the customers here are primarily “masterbatchers,” who mix carbon black with resin to create pellets that ultimately get used to make bags, pipes, product molds, etc.  Conversely, coatings are a smaller piece of volume but the majority of profit.  Coatings include the black paint on an automobile, which is made by Akza, Axalta, BASF, PPG, etc.  Depending on the special properties associated with these coatings (UV resistance, rustproof, sheen, etc.), the carbon black prices can be extremely high.  Specialty segment product pricing on average is 1,600 euros/ton, but coating prices can be anywhere from 3,000 to up to 20,000 euros/ton for some niche applications (in small volumes).  Cable and wire product volumes are between the volume and margin of plastics and coatings.  Cable and wire can have specialized properties like flex, rigidity or conductivity that generate higher margins.  Customers include Borealis, Dow and General Cable.  Inks are also a very profitable niche.

Some of the attractive business dynamics in this segment include:

-          Customers have very low price sensitivity.  The carbon black spend is minimal compared to the other component costs of a car, phone or household product, so customers focus less on price.  As one of our procurement contacts put it, “we never really did any price discovery.”

-          The more specialized (and expensive) the product, the higher the customer switching costs.  Carbon black formulations are “designed in” to products in this segment and typically require 6 months to 2 years of testing, depending on the application.  Even when supply chain issues occur, “we will try hard not to switch and give the vendor many chances to redeem themselves.”  Switching just does not happen frequently, according to our research, although share shifts between suppliers of a particular customer can occur.

-          About 20% of specialty products have patents, so OEC is the sole provider in the marketplace.  We believe that these products are “super unique,” as one of our calls put it, and have particularly high margins.  These products span all different product categories but all have some sort of specialized manufacturing process that makes them unique and desirable – these are characteristics like electrical conductivity, polarity, special sealing qualities, extreme rigidity or flexibility, low grit, etc.

-          Barriers to entry are quite high.  Patents on production processes, high cost factories and long-term customer relationships are all barriers to entry.  As a competitor pointed out, “some of their customers, they have had them for 70 years and it’s highly unlikely the customers will ever change.”  There is very limited risk of seeing new entrants in the specialty black market.

The margins in this segment reflect these favorable business characteristics; in the mid-high 30% range.  If oil and thus feedstock costs rise, we expect margins to compress but to remain healthy (this margin compression will be offset by a net positive impact from the rubber black business for the Company overall).  When oil prices were high in 2013 and 2014, the segment had margins in the mid-20% range.

Rubber Black

More commoditized than the specialty black segment, volumes in this segment grow at low single digit rates annually.  The market consists of three large global players (OEC, Cabot, Birla) and several regional players in each major market.  These top three rubber black producers hold roughly 30% market share globally and then each regional market share differs.  This business tends to form regional oligopolies because shipping costs are disproportionately high for such a lightweight item.

There are five major global tire customers (Bridgestone, Goodyear, Michelin, Continental, Pirelli) and then many smaller regional tire customers.  Some of the attractive business dynamics in this segment include:

-          Replacement demand is 70-75% of volumes.  Replacement tires are higher quality and higher margin products for OEC than OEM tires.  As a result, we believe that replacement demand is an even greater proportion of profitability.  Our calls suggest replacement demand is around 80% of profit in this segment.

-          Regional oligopolies mean generally rational pricing.  Historically, this has proven to be true, although we understand that OEC has dropped their price to gain market share in the last year or two in North America.  While generally not a great dynamic, it is likely favorable for OEC’s utilization and relative profitability since OEC can spread their fixed costs across more volume than their competitors can.  Thus far, OEC’s competitors have not followed suit, ceding some market share and rejecting a “race to bottom” price war.

-          Large and consistently growing installed base of vehicles in use.  While the US is a mature automobile market (there are 250M cars for 250M people above the age of 18), China and other emerging markets are at nowhere near the same maturity.  China alone has 100M cars with 1.3B people today.  Commercial vehicles add another 35% or so units to the total addressable market and have a similar maturity profile.  We have seen steady 3-5% growth annually in automobile sales worldwide, and experts expect that to continue going-forward.  This is a helpful tailwind for demand for OEC’s products, particularly in the tire business.

-          Barriers to entry are high.  While easier to enter the rubber black market, it is still a challenge as factories are expensive and customer relationships are long-term.
-          Customer switching costs are high.  Tire formulations are tested for 1-2 years in order to ensure that they meet certain performance specifications, so customer switching costs are fairly high.  Like the specialty business, most customer have 2-3 rubber black sources, so share shifts within an existing customer are the biggest risk to overall market share.

Catalyst

Surcharges stick for 4Q16

Rubber black price increases stick beginning in Q1 2017 for Europe, Korea, and the rest of the world, ex-North America

Recent oil price increases flow through to the bottom line

Specialty black price increases worldwide

OEC continues to gain market share

Additional tire demand comes online driving (no pun intended) incremental rubber black demand

Ambes savings improve 2017 profitability

China competition is sidelined by higher coal tar pricing

Continued execution and smart capital allocation

PE owners exit via a sale of the company