Description

for write up w/graphs:     http://drop.io/qjvfbf9

• Stepan Chemical presents a compelling short opportunity with limited downside risk. It is a sleepy, family controlled commodity chemical company with almost no analyst coverage and a long history of low margins and low returns on capital that is suddenly experiencing surging gross margins as a result of several factors which are likely unsustainable.
• Stepan is a global manufacturer of specialty and intermediate chemicals used in consumer products and industrial application. Stepan is a leading merchant producer of surfactants, which are the key ingredients in consumer and industrial cleaning compounds. Manufacturers of detergents, shampoos, lotions, toothpastes and cosmetics depend on surfactants to achieve the foaming and cleaning qualities of their products. Over 75% of Stepan's sales come from surfactants used in laundry detergent.
• SCL reported gross margins for the quarter ending 3/31/2010 of just under 19%.
• Going back to 2000, Stepan's quarterly gross margins have a distribution that looks like this: (median of 12.9%, mean of 13.5%)

• The reasons for the decline in gross margins since 2000, shown in the chart below, are pretty simple:
  • Chronic over-capacity in the surfactant industry.
  • Increasing input costs, particularly petrochemical feedstocks such as benzene, increasing electricity and natural gas prices used in the manufacturing of the product, and increased shipping costs.
  • Sluggish domestic demand growth for surfactants (estimated at around ~.5%/yr).

• Because the margins in the business were so bad for so long, it got to the point where, to quote one industry participant (Dan Howe of Uniqema) in 2004: "Most of the industry has not had reinvestment economics in the past several years. This has resulted in capacity rationalization and lack of investment." This sentiment was echoed by Francis Sherman, the surfactants manager for Azko, who said in 2005 "Profitability of this industry, however, is below reinvestment levels, and we don't see financial justification for capacity expansion until margins improve," There plenty of examples of plants that were shut down:
  • In 2005, "Akzo disclosed that it would shut down its McCook, Ill., cationic surfactants plant".
  • "During 2005, Huntsman Corp. wrapped up a restructuring of its surfactants business that included the closure of plants in Whitehaven, England, and Guelph, Ontario."
• If we go all the way back to 1990, we can see that one of the key drivers for gross margins in the surfactants business is crude oil, and more specifically, derivative petroleum products such as benzene.  This is because benzene is a primary ingredient in LAB, along with normal paraffin; however, benzene is the only ingredient in LAB with a readily observable market price. LAB is the feedstock for LAS, which is made using a simple conversion (sulphonation) process. LAS is the most common surfactant used in detergents and household cleaners, and the primary product sold by Stepan.
•  The graph below shows the normalized spread between LAS (the white line), and Benzene (orange line). Note that this spread was negative for much of the period from '91 through '99. This is partly due to the significantly higher domestic demand growth for surfactants during this period as consumers moved more to liquid soaps/detergents and away from powders, which requires a lot more surfactant. This transition is basically over in the US. More importantly, notice the dramatic change in spread that began in Q4 of 2008. This was the start of Stepan's miraculous margin expansion.

• It turns out that the average price of benzene with a 4 month lag is an excellent predictor of Stepan's gross margins.  The scatter plot below shows Stepan's quarterly gross margin versus the lagged benzene price. The red marker in the scatter plot is Q4 2010 quarter, and the green one is Q3 2009.

If we put the current lagged benzene price of 275 into the regression equation, it implies a gross profit margin of 20.05-0.0262*275 = 12.8%.

More importantly, if we take the current actual benzene price of 337, it implies a gross profit margin of 20.05-0.0262*337 = 11.2%.

• Clearly there is something going on here with the margins. Is this a result of the industry finally becoming attractive again? How can we explain this?
• We already covered the first part-- massive capacity was taken out and either temporarily shut down or used to produce other kinds of chemicals.
• The real story is that, while Stepan had struggled for years in an oversupplied market to pass on own increased input costs, when the price of its inputs suddenly plummeted at the end of 2008, Stepan was able to hold relatively firm on its pricing because capacity suddenly became tight for surfactants. Because most surfactants end up in household cleaners and laundry products, a segment which is recession resistant, demand for surfactants did not have anywhere near the same decline as feedstock prices. Combined with the recently rationalized surfactant production capacity, this was the perfect storm for allowing Stepan to make outsized margins.
• The high price of surfactants has driven detergent makers and large consumer products companies like P&G and Unilever to look for alternatives to LAS and to decrease the concentration of surfactant in their products.
• One of the reasons why Stepan was able to hold the line on pricing is that the primary substitute for LAS that is made in commercial quantities is not based on petroleum, but on palm and coconut oil. Palm oil was on a huge tear at the beginning of 2009 (for totally separate reasons) just when the benzene vs. surfactant spread was out of whack, so pricing stayed high on both.

• About 60% of North American surfactant production capacity (in terms of nameplate capacity) uses oleochemicals (basically palm oil and coconut oil) as the feedstock; the other 40% is based on petrochemicals (crude oil and benzene derivatives). Most of Stepan's production is based on petrochemicals. The comparitive economics of petrochemicals versus palm/coconut oil were extraordinarily favorable recently to Stepan compared to the historical levels. Thus, the "economically rational" surfactant production capacity was reduced during this period as it didn't make much sense to produce surfactants from palm/coconut oil during this period because it was so much cheaper to use benzene/crude derivatives. This is apparent in the following chart, which shows the ratio of coconut oil to benzene prices:

• The last time benzene and surfactants were at the current price levels was at the start of 2008. Stepan's average gross margin for Q4-07 and Q1-08 was 10.9%.
  • If we apply this margin to their  Q1-2010 annualized sales of ~$1,350 we would get a gross profit of $147mm.
  • Operating expenses were running $128mm in 2009, with Q1-2010 operating expenses up 33% year-over-year, so run rate operating expenses of $165mm are a reasonable estimate.
  • One can argue that Stepan is currently
    • Conservatively capitalized, with approximately zero net debt, and
    • Not very well run in terms of fat at the corporate level.

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  • So, we can give Stepan credit for an additional $200mm of net debt at a 6% rate, and suppose that this cash is dividended out. Also assume for argument's sake that management can cut operating expenses by 25% from the current run rate of $165mm/yr.
  • The table below shows what this leaner version of Stepan would look like using the 13% median historical gross margin:

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  • Even if we gave Stepan credit for 16% gross margins, which would be historically unusual given current benzene prices and the lower comparative advantage of crude oil feedstocks versus palm/coconut oil feedstocks, the stock still looks pricey-- even if they lever it up and cut costs (which is unlikely to happen unless the controlling family sells the company):

• Besides rising input costs and the demonstrated historical difficulty for Stepan of passing those costs onto its customers, the key risk for Stepan is that new capacity for manufacturing surfactants in the US comes on line, attracted by the currently high returns on capital and favorable margins. The question then becomes, where is this new capacity going to come from? The most likely answer to this is that the US market will come to more closely resemble the surfactant market in Europe. What happened in Europe was that the manufacturers of LAB, a benzene derivative that is essentially what Stepan converts to LAS, were going through a tough time. Industry overcapacity and low utilization rates drove LAB makers to fill up their plants by going downstream and making LAS (surfactant). This is has led to low gross margins in Europe ever since and is the main reason why Stepan does not actively participate in the European surfactant market.
• Currently, the two major  manufacturers of LAB in the US are Sasol and Petresa (a division of CEPSA). Huntsman also makes LAB in the US. Right now there is a glut of LAB capacity, and margins are now significantly below re-investment economics for LAB makers. This state of affairs will likely lead to either one or both of the following:
  • LAB makers will rationalize production, which will put pressure on Stepan's margins.
  • LAB makers in the US, rather than shut down their plants, could instead investment a few tens of millions of dollars into surfactant production and "go downstream," which there is clear precedent for in Europe. In fact, the two major LAB producers in the US are active producers of surfactant in Europe, and so have the know-how and marketing ability to make and sell surfactant in the US. The expert we spoke with on surfactants, Neil Burns, estimated that an investment of $100mm in surfactant production in the US by either LAB maker would significantly change the market dynamics and pricing for US surfactants. I am currently trying to talk to someone from either LAB maker to see what their plans are in this regard.
• The vast majority of incremental world demand is coming from Asia and Latin America as they also go through the power-to-liquid soap/detergent conversion. That's why there is a huge amount of new investment in China, India and other countries to manufacture surfactants. Given how inefficient it is to ship the stuff (although shipping rates were also somewhat low in the past 2 years), it makes a lot more sense to produce it locally, even though America has been a large net exporter of surfactants over the past few years. The problem with local production in emerging markets is that they don't need Stepan-- the basic chemistry behind the vast majority of Stepan's products has been around for decades.
• The insider trading activity at Stepan suggests that managment is seizing on this opportunity to unload stock at favorable prices, with selling patterns that are quite different from those of the recent past.

• Just because a company never earned very much for a long time and is suddenly earning a huge amount doesn't mean that it is a good short. But Stepan has certain characteristics that make its current level of earnings more likely to be unsustainable.
• Stepan has plant and equipment for converting its feedstocks into surfactants.  So Stepan's results, and those of its competitors, fundamentally depend on two prices-- the price it has to pay for its inputs, and the price where it can sell its output. If these relative prices get out of whack, like they are now, Stepan will feel pressure on both sides:
  • For example, suppose benzene prices fall to their levels from early 2009. In that case, Stepan's sophisticated customers, the consumer products companies, will demand price cuts. Especially as more surfactant manufacturing capacity comes on line (attracted by the current blow-out margins), Stepan will have a tough time holding the line on prices. Ultimately pressure will come from the Walmarts of the world, who will want lower prices to drive sales of household cleaners and detergents.
  • Alternatively, suppose benzene prices continue to increase (which seems to be the more likely scenario at least in the short term). Then Stepan will be put back into the situation it found itself in during 2004-2007-- trying to pass through price increases just as the new surfactant manufacturing capacity is coming on line. On top of that, increasing benzene prices, if they are perceived by large surfactant customers in the marketplace to be driven by longer term, sustainable trends, will lead to increased substitution and development of new alternatives.
• Also observe that the current situation is truly unprecedented for Stepan-- it's not as if the company used to earn close to this much and the market is just getting to the high part of the cycle-- the company never experienced anything remotely like this level of earnings, which suggests that the circumstances today have no direct analogue in the past.

Catalyst