Description

Investment Thesis

Company Overview

Back in 2000, KKR LBO’d the business from Laporte Plc (KKR currently owns 9%). Since then, the company has acquired several new business lines and divested underperforming units.

Rockwood is an inorganic specialty chemical company comprised of four main segments (Specialty Chemicals, Performance Additives, Titanium Dioxide Pigments and Advanced Ceramics) discussed below. Its products typically account for a small percentage of total customer costs. There is limited customer concentration as the largest customer comprises 2% of sales. End-markets include metal treatment and general industrials, chemicals and plastics, automotive, life sciences, construction, specialty coatings and electronics and telecom, among others.

The Specialty Chemical segment accounts for 36% of sales and 37% of EBITDA (ytd). Within Specialty Chemicals, there are two main business lines - surface treatment and fine chemicals. Surface treatment chemicals are used to protect against corrosion, ease forming and machining, ensure coating adhesion, provide a more sterile environment and aid in cleaning. The fine chemicals consist of the lithium, special metals and metal sulfides product lines. The lithium side is focused on battery applications, performance greases and elastomers.

The Performance Additives segment accounts for 22% of sales and 16% of EBITDA (ytd). This is comprised of three main business lines – color pigments, wood treatment and clay-based additives. In color pigments, the principal product is iron oxide used for the coloring of concrete and in paints, coatings and plastics. The wood treatment line protects wood from decay, mold, parasitic attack, water and fire exposure. Finally, clay-based additives are used to help control viscosity, flow and keep solids in suspension across various industries (oil field applications).

TiO2 accounts for 26% of sales and 27% of EBITDA (ytd). TiO2 is a whitener and opacifier used in paints, paper, plastics, fibers, etc. The company’s focus is on the anatase side (unlike rutile at DuPont or Tronox) produced using the sulfate process. This is more of a niche product. Functional additives are also captured in this segment, which improve shine, mechanical strength and prevents degradation in coatings, plastics, paper, etc. In 2008, Rockwood entered into a JV with Kemira, a Finnish company, which combined both companies TiO2 businesses and Rockwood’s functional additives unit. Rockwood owns 61% of the JV and consolidates the operations.

Advanced Ceramics accounts for 16% of sales and 20% of EBITDA (ytd). The ceramics business is focused on medical applications, electronics, cutting tools and other products. Notable characteristics are high wear resistance, biological inertness and high melting points. Almost all advanced ceramics are made to order, taking into account specific customer requirements.

As Rockwood is not a petrochemical business, its raw materials are not tied to oil-based derivatives. As a percentage of costs of goods sold, raw materials are 46%, while energy costs are 9%. Variable costs consist of raw materials, packaging, energy costs, certain shipping costs and transfer costs, whereas fixed costs include manufacturing overhead (headcount, maintenance, inspection and other) and other distribution costs (i.e. warehousing).

As a diversified player, Rockwood has many competitors across its several operating segments.

Specialty Chemicals – Henkel, Nihon, PPG, Nippon Paint, FMC, SQM, Dow Corning, Cabot, Sigma Aldrich, etc.

Performance Additives – Akzo Nobel, Sherwin-Williams, Evonik, Arch, BASF, Elementis, Cytec, Amcol, etc.

TiO2 – Fuji Titanium, Kronos, DuPont, Cristal, Huntsman, Tayca, Ishihara, Evonik, Solvay, Sakai, etc.

Advanced Ceramics – Kyocera, CoorsTek, Ceradyne and NGK Insulators.

Capital Structure

Revolver ($180 MM)                           $0 MM

Term Loan                                        $846

TiO2 Term Loans                               $274      

Capital Leases & Other                       $68

7. 5% Senior Notes                            $200

7.625% Senior Notes                         $326

Total Debt                                        $1,714

Kemira Note                                     $10

Cash                                               $358

Net Debt                                          $1,346

Minority Interest                               $311

Equity Mkt Cap                                 $2,900

Enterprise Value                               $4,557 MM

*TiO2 business operated through joint venture with Kemira. Rockwood owns 61%, but consolidates the business.

**Pension/OPEB of $421 MM. Most of pension underfunding is in Germany where funding is not legally required or customary.

***US federal NOLs of $461 MM and state and local NOLs of $399 MM, respectively.  

Recent performance has been strong, specifically the core specialty chemical business – lithium and surface treatment. The lithium segment is growing (and expected to grow going forward) at a 10% rate. Additionally, a pricing increase of 20% was instituted in 3Q which should see traction starting in 2012. This business has huge upside if the electric car penetrates the new car market. The company’s overall market share is 40%. On the surface treatment side, business is tied to industrial production, but the company has been winning market share.

The performance additive business via color pigments has exposure to the US housing market so near-term growth is expected to be limited. Volumes are down 40% from 2006-2007. Management is pointing towards 2014 growth. Partially offsetting this is the clay-based additives business used in natural gas drilling.

The ceramic business has benefitted from strong German luxury car demand (export market) and increased penetration (currently 35% of sector) on hip joints due to metal-to-metal issues. The company’s market share of ceramic hip joints is 95% worldwide. This sub-segment shows higher margins than the auto business and has been growing at an 8%-10% rate.

The TiO2 business is sold out, so volume growth is off the table, but I expect continued tightness to offset higher ore prices, so EBITDA should be flat. 4Q pricing is expected to be at least 8% higher.

Add all the up and I think we see decent growth going forward, albeit at a lower rate than over the past 12 months.

Guidance

Since 2002, Rockwood has grown EBITDA from $317 MM to $820 MM as of LTM 9/30/11. Going forward, Rockwood plans to invest in organic growth (5% per year) and look for bolt-on acquisitions (3% per year). US NOLs may skew acquisitions towards the US. EPS growth of 20% is the goal. Management expects to paydown debt in 2012 and look very closely at instituting a dividend.

Valuation

Specialty chemical names trade around 7x EBITDA compared to 5.4x for Rockwood. If I strip out the non-owned JV component, the multiple moves to 5.8x. From a private market standpoint, Nalco was recently purchased for >10x 2011E EBITDA. Nalco likely has superior growth prospects than Rockwood and merits a premium, but a 4x spread is too wide. Similarly, earlier in the year, Rockwood sold its plastic compounds business for 9.0x LTM EBITDA.

The TiO2 business is for sale as Rockwood views the segment as non-core. Another way to look at the valuation is to strip out this segment. Using a 4.0x multiple for TiO2, the remaining entity trades at 6.1x EBITDA.

The current valuation prices in a lot of weakness in Europe and a very low multiple on the TiO2 business. Note that most of the European exposure is to German manufacturers who sell into export markets, so weaker EU demand will not have as pronounced of an effect. Approximately 25% of sales are in cyclical end markets including electronics, automotive and construction.

The current plan is to paydown the high yield notes in 2012, which will reduce interest expense by $40 MM going forward. This alone should add 35+ cents/share to EPS/FCF on a run-rate basis. On a 2012 basis after stripping out the non-owned TiO2 component and assuming cash is used to pay down debt per management’s guidance, I calculate around $4.50-$5.00 of FCF. At a 12x multiple, this results in $50-$60/share price. This compares to an average PE of 15x over the past five years.

Management

KKR installed the current CEO, Seifi Ghasemi back in 2001. Despite recent sales by KKR, the CEO continues to own 2 MM shares, nearly all of his net worth. Read through some of the transcripts and conference presentations. The CEO is straightforward and says the right things, although I would like to see share buybacks at current prices.

Over the past eight years, the company has paid down close to $2 BN of debt. Currently, capital allocation is focused on growth (capital expenditures > depreciation) and debt repayment. Near term, the plan is to call the high yield notes in 2012, pay them down with cash on hand and then start returning cash to shareholders (initiation of dividend in 2012).

Risks

-Slowing growth. The market is preoccupied with volume growth (-1.9% in 3Q - outages) as 3Q was driven more by pricing (+12.3% in 3Q). Tougher comps in 4Q

Concerns Include: Chinese demand, general industrial production – autos, steel and aerospace, battery demand (electronics slowdown), continued weakness in US housing business hurting performance additives segment and de-stocking; DuPont noted destocking across polymers and certain industrial supply chains

-European exposure

Concerns Include: Weakening Euro (61% of sales denominated in Euros) although Euro-denominated debt and cross-currency interest rate swap will help offset, recession, 54% of sales in Europe, but this refers to sales to mainly German manufacturers who then sell into the export market so it is misleading; export market is most appropriate indicator

-Higher ore prices for the titanium business.

Concerns Include: Titanium-bearing slag is largest raw material, Iluka reportedly raised prices 80% and Tronox/Exxaro merger could change dynamics of raw material procurement

-KKR owned 21% of stock last year, but now only 9%. Do they know something I don’t know? Probably

-Overpaying for an acquisition

-Enterprise value to EBITDA multiples are overstated due to consolidation of TiO2 and Viance JVs. I adjust for this when I run my numbers

Catalyst

-Sale of TiO2 business

-FCF generation and continued debt reduction

-Initiation of dividend in late 2012