Description

Important Disclosures: Certain funds and accounts managed by us and our affiliates are currently long Orion Engineered Carbons (OEC).  We may buy and/or sell shares of OEC in the future for the funds and accounts managed by us without notice, and we are under no obligation or agreement to take, or not take, any action or restrict our actions in any manner.  This is not a recommendation to buy or sell shares. Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this investment thesis.  The information below is from public sources. We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information. We undertake no obligation to update any information below.

Orion Engineered Carbons (OEC) was written up in February 2017 by jet551. Since then the stock is up 26% through April 9th, while the S&P has been up 13% over the same period. Despite this performance, we believe OEC still trades at less than 10x 2018 guidance FCF and is an even more attractive long today due to recent favorable shifts in competitive dynamics. We believe that these shifts are leading to a sustainable high double-digit increase in pricing, which could result in up to a 5-7x 2019 FCF multiple based on the current stock price.

I will refer readers to jet551’s February write-up for a business description and will focus on competitive trends and valuation here.

2017 Business Snapshot

Source: OEC Investor Presentation dated March 2018

Rubber Black Segment

Rubber Black is fundamentally a commodity business with global competition driven by regional feedstock costs. Pricing is cyclical due primarily to trends in supply; demand is largely stable as 75% of volume is replacement tires. Base pricing (net of feedstock pass-throughs) typically fluctuates by +/- 1-2% per year. Industry supply / demand is currently tight and pricing increased slightly in 2017 as a result. Since the last pricing upcycle in 2010 - 2012, the competitive dynamics have shifted in three meaningful ways, and we have received indications from industry sources that pricing in 2018 potentially could be up as much as 10% compared to 2017 pricing in North America and the EU as a result:

1. Increased cost of environmental mitigation: Starting in 2013, the EPA has focused on reducing emissions in the Carbon Black industry, requiring costly environmental mitigation to be put in place. While there has been no greenfield capacity in the US in the past 30 years, the increased mitigation cost makes adding brownfield capacity uneconomic at current pricing levels. As a result, we believe total capacity in the US has been flat since 2008. There is one Birla plant in Canada with a permit to add capacity; however, we understand Birla is not adding under the permit as it waits to see whether Canada follows the EPA, which we believe is highly likely. Similar dynamics have played out in the EU where we believe capacity has only shrunk over time as nations seek to end production of this highly polluting chemical within their borders.

2. Tire mix shifts have lowered actual capacity vs. stated levels: Rubber Black capacity estimates are based on initial plant assumptions about grade mix. As end demand for tires has shifted towards high value tires, so too has the grade mix for rubber blacks. Production of higher grades lowers the throughput of the plants, thus reducing effective capacity. Full utilization under current grade mixes is therefore believed to be only around 90-95% of stated capacity, which is where we believe the industry currently sits in North America and the EU.

3. Decreased competitiveness of imports: In general, we believe that imports of rubber blacks are limited by the material’s low value to weight ratio. That said, feedstock cost advantages in China and Russia had historically led to imported supply, lowering any potential price increases. This time, however, it is different as China has lost its feedstock advantage as described in the prior write-up.  That, combined with environmental shutdowns in China has actually led to shortage conditions for Carbon Blacks in Asia. As a result, imports from China into the US and EU have collapsed to near zero in the past few months. Russian exports will remain at maximum capacity assuming current plans for expansions, limiting incremental import pressure in Europe for the foreseeable future.

But what about new supply?

Given the commodity nature of this business, as prices rise, new supply coming online is not a question of if, but when? There are 3 main sources of new supply:

1. Greenfield: We believe that new greenfield plants will take over 2 years to build from permitting to production, assuming no unexpected issues arise. It is safe to assume no greenfields in North America or the EU due to environmental concerns, and China’s crackdown on pollution makes new projects less likely there as well. There is currently one new plant coming online in Belarus and one in Russia – both of which are expected only to keep industry utilization stable at full production. Most new projects coming up are in India where production will be consumed domestically.
2. Brownfield: Significant additions at existing plants still require permitting and costly mitigation which we believe makes them uneconomic and highly unlikely in North America and the EU. These projects would take 12-18 months to complete and even considering all announced projects we still see likely tightening of supply / demand over the next 2-3 years.
3. Debottlenecking / engineering / yield improvement: All-in, we expect that these potential sources of “shadow” supply should only add ~1% to global supply per year at most. Again, we are already factoring this into the above conclusion of continued tightening conditions.

Taking all of the above into account, we believe that it is possible that conditions are in place for a sustainable step-up in pricing levels that is not currently factored into the stock price or guidance. Industry contacts have indicated that they believe this could result in 10%+ pricing in 2018; with conditions remaining the same in 2019, even further pricing upside could exist. Even without a significant step up, we believe that this business is pre-midcycle with respect to pricing and deserves a commensurate multiple, which we will outline in the valuation below.

Specialty Black Segment

Our diligence supports much of what jet551 has already written here. The Specialty Black segment is as good as it gets when it comes to Specialty Chemicals businesses.  It is a GDP++ grower driven by increasing penetration / applications within vehicles, batteries, consumer products and industrial products. Specialty blacks are a low percentage of total end-product cost, meaningfully impactful end-customer experience and requires customized formulations – all leading to low risk of switching and 30%+ EBITDA margins in 2016 and 2017. We believe this is an oligopoly market with only 3 real players -  Orion, Cabot and Birla. Numerous checks with customers have helped underscore our belief that there is limited direct competition and almost no switching (the only instances we heard of were due to lack of availability).

Valuation

European and US Specialty Chemical comps with similar margin and growth profiles to Orion’s Specialty segment trade at around 12x+ 2018 EBITDA. To be conservative, I have taken a haircut to that number in the valuation below and only assume a 10x forward EBITDA multiple for the Specialty business.

A commodity chemicals business is more difficult to value. Historical trading ranges indicate a 6x -9x forward EBITDA range depending on where the market currently is in its cycle. Current supply / demand conditions in Rubber Blacks indicate that we are closer to trough than midcycle, in our view warranting at least a 7.5x forward EBITDA multiple, which is what we have used below.

These estimates are based solely on our subjective analysis and should not be relied upon.  Actual results will vary significantly from these estimates.

Certain Risks

The risks we have identified in connection with an investment in OEC include, among others:

Macro and new supply announcements

Catalyst

Catalysts

Continued strengthening of the business

OEC management has confirmed a switch to USD reporting in Q1 2018 and GAAP in H2 2018. This could lead to index inclusion by Q2 2019, which OEC management believes accounts for 30% of demand for peers’ shares.