Description

** See Notes Below Table

(** NOTE: excludes extraordinary maintenance, and extraordinary turnaround 1/10 years and 1/30 year. Includes working capital benefit as guided by management)

Summary - Cyclical Bottom…Again - We Believe 2020 is Trough Year for Trinseo, and we will see a pronounced acceleration in 2h2020 and as we head into 2021.

We first wrote about Trinseo in late 2014 for VIC (https://www.valueinvestorsclub.com/idea/TRINSEO_SA/6660291449), and in addition to being a contest winner, the stock went up 5-fold. (We recommended selling the stock a bit early after it nearly tripled.) Today, Trinseo is a much better story, with better financials, improved balance sheet, better positioning, better set-up, and at the bottom of the cycle. When the TSE IPO was completed, there was no dividend and the company was heavily levered. Even at very depressed levels of profitability, the company pays a dividend north of 8% yield while the company continues to buy back stock.

Recent Incremental Sell-off for the Group – TSE Stock Sold off Disproportionately More Aggressively When it Should have Rallied. We are seeing examples of completely irrational behavior in stock action during the past six weeks.

In addition to the sell-off COVID-19 to the market-wide due to COVID-19, US Chemical names were hit especially hard on the backdrop of the breakdown of discussions between Saudi Arabia and Russia in the oil market. Most US chemical names benefit from higher oil prices as global chemical companies mainly use oil as feedstock, so lower oil prices reduces the typical US chemical company cost advantage from the use of natural gas. Thus, due to the price war driving oil prices to collapse, chemicals have been hit particularly hard. TSE has been hit more than the other players, despite having no gas business in the USA. Trinseo’s business is predominantly European, so lower oil not only does not hurt them; it helps them as companies using crude oil, vs. Chinese companies using thermal coal.

Trinseo - Stock-Specific Idea vs. General Opportunity to Pick-up Some Cheap Stocks

After a massive three-day rally finally seeing a bounce after weeks of massive relentless selling/de-risking, with the futures indicating down 3% for Friday morning, we considered the timing and waiting for Monday to submit this idea. We felt however even with the modest bounce in TSE, that the dislocation is still so enormous, that we wanted to put this idea back again in front of the VIC Community, as we believe this aberrational pricing dislocation will correct quickly. Thus, if TSE sees any weakness today, we would encourage investors to buy aggressively as any entry-level below $20 is going to look silly a few months from now. We see a lot of names (particularly in chemicals) that excite us, but TSE is our highest-conviction idea. And even though I am not due for a submission to VIC for about another month, I did not want to potentially miss what I believe is likely to be a big move between now and May.

We believe this is perhaps a once-in-a-lifetime opportunity to pick up a good company at such a cheap level. We have all heard numerous investment luminaries highlighting the fact that we do not see a coronavirus often, and that despite the short-term economic impact, we will get on the other side of this event, and see some ridiculous opportunities to pick up some good names for outsize gains. TSE is our bet.

On a normalized basis, TSE is trading at a 46% FCF yield with the stock trading at ~2.2x normalized free cash flow per share.

Trinseo is now ~32% below where the CEO just bought significant stock in the open market last August ($29) and the stock ran up over 60% in the following two months.

M&G Investment Management recently filed with a 20% ownership and activist intentions to unlock value. The stock is well below levels at which they purchased. Trinseo is at the most compelling levels we have seen. We thought in December 2014, when we wrote about Trinseo shortly after their broken IPO, that the stock would never see these levels again. It did. And while it has bounced the past two weeks since mid-March when the stock went just under $15 per share, at $19.71 per share, we think it is just getting started and should have never reached the teens. When the street and investors finally figured out this story, it continued to run to the mid-$80s in 2018, long after we had closed out the position. We again see that asymmetric opportunity and encourage investors to buy aggressively at current levels. At below $20 per share, we see over 400% upside to $100 per share. The inefficiency of the markets is astonishing in our view, as sell-side analysts simply have not done the work. Wholesale de-risking from economic fears and the coronavirus is causing stocks like TSE with solid business models and consistent earnings and executions to be sold to extreme levels.

A shareholder activist (M&G Investment Management) just sent a letter (Trinseo 13D Filing reflecting letter from M&G) to Trinseo demanding changes. Clearly, M&G recognizes there is enormous value and as a shareholder, wants it to be recognized. If TSE sells its worst division for what OMN sold to Synthomer ((Details of OMN sale to Synthomer)) the rest of the Trinseo is effectively kept for free. Selling engineering plastics for what LYB bought Shulman, provides investors tremendous upside ((Details on LYB purchase of Shulman)). The sum of the parts easily justifies over $100 per share. In the meantime, investors collect an 8% dividend yield and an 8% share buyback while waiting for the story to play-out.

Trinseo S.A.

Description: Trinseo is a leading global materials company operating through five divisions:

1. Engineering plastic, which produces highly engineered compounds into the following end markets: medical, electrical, lighting, building and construction, automotive and appliances. This division benefits from secular growth in lightweight plastics for automotive and is, therefore, a key beneficiary of the move to electric cars as well as the transition to the global 5G communications network. This division generated $137 million of EBITDA in 2019, significantly below its normalized EBITDA of $185MM. Both volumes and profitability per ton were depressed in 2019 due to a perfect storm in the automotive end market, where demand in China fell by over 25% while production was also disrupted in Europe due to the transition to the new emissions standards. Looking at profitability per ton we are at new lows and over 35% below normalized levels.
2. Latex, which produces latex products serving diverse markets from carpets to graphic paper, artificial turf and building and constriction end markets. The segment is a relatively mature cash cow where 50% of the sales are indexed to raw materials, thereby reducing the risk of sharp swings in the underlying feedstock prices. This division generated 81 million in EBITDA in 2019, depressed due to the significant amount of destocking on the back of the trade war. The normalized EBITDA for this division is $110 million. Profitability per ton is currently just over 20% below normalized.
3. Synthetic Rubber, which produces specialty grades of synthetic predominantly going into the high-performance tire market. Over 2/3rds of the revenue and even more of its profits go into the replacement tire market, versus the OEM channel. This division has significant secular growth coming from the move towards electric vehicles as tire wear is higher due to the higher amount of torque. Additionally, this is one of the few areas within the automotive end market that will benefit from ride-sharing and self-driving cars as the number of tires being used will show substantial growth despite a potentially smaller car market. EBITDA for this division was $48 million in 2019, very depressed compared to normalized levels due to significant destocking due to the trade war, deferred purchases due to the economic uncertainty and the weakness in the OEM markets (China cyclical decline, and Europe’s emissions change). We estimate conservatively that normalized EBITDA is $100 million, with the current earnings being a historical low, while the division generated close to $200 million when the business was healthy.
4. Polystyrene, which produces a number of specialized grades of polystyrene going into appliances, packaging, consumer electronics, and building materials. Due to its specialized nature, the earnings in this business have been remarkably stable and its 2019 EBITDA of $53 million is very close to its normalized level. The outlook for this business is quite exciting as its main market, which in Europe has just seen the announcement of 7% of supply being taken off the market by competitors, which should allow pricing to be firm despite a choppy economic environment.
5. Styrenics, which has two pieces to it: American Styrenics and the Feedstock segment (mainly European styrenics). American Styrenics has been remarkably stable and generated $119 million in EBITDA in 2019, versus the 5-year average of $132 million (10% below normalized). The North American styrenics market has proven much more stable and insular which in part explains the stability of this business compared to the company’s Feedstock division which has been more volatile. The feedstock division is seeing historically low levels of profitability due to the combination of new capacity additions combined with historically low levels of industry maintenance. In 2019, the Feedstock division basically broke even ($3 million in EBITDA), while we estimate normalized EBITDA to be $70 million (so currently we are 96% below normalized). We are seeing clear signs of the trough in styrene in Europe as a portion of the industry is now bleeding cash with some of the higher cost players having or being in the process of taking capacity offline. While there is still some capacity coming on in styrene, this is likely to be more than offset by the industry going back to normalized maintenance levels.

Taking a step back, since Bain Capital took the company public in 2014 (they had carved it out of Dow Chemical a few years earlier), the company has generated an EBITDA of $590 million on average from 2015 – 2018 before the sharp contraction in 2019 ($355 million). The consensus has EBITDA falling to $331 million in 2020, which is $6 million above what we estimate the absolute trough is assuming all divisions trough at the same time. In addition investing heavily to improve the growth profile and the profitability of the portfolio (which has meant CAPEX above $100 million due to a number of specific projects, which are now ending), the company has been a good allocator of capital paying a healthy dividend while reducing the shares outstanding by close to 5% per year (despite much higher prices).

Today, at the bottom of the cycle even at very depressed levels of profitability, the company pays a dividend of 8.1% while the company continues to buy back stock. While in 2020 stock buybacks are tempered by the completion of the elevated CAPEX, and two large turnarounds, one needed once every 30 years and the other needed once every 10 years, the free cash flow will still be 15.2% (if you add these extraordinary turnarounds back your FCF yield will be 27%, which means price/FCF yield will be 3.7x as highlighted in the table at the beginning of this write-up. We expect the free cash flow to accelerate significantly over the next few years as businesses recover from the cyclical trough, while CAPEX declines and the share count continues to shrink. On a normalized basis (2022) we expect the FCF per share to be $9.00 per share (assumes $510 million of EBITDA, 35.9 million shares outstanding and $75 million of CAPEX). This means that currently, the stock is trading a 46% FCF yield. Said another way, the stock is trading at less than 2.2x normalized free cash flow per share.

For a company with a conservative balance sheet (2.2x leverage on 2020 (trough), but closer to 1.4x leveraged on normalized EBITDA), at the trough of the cycle (the economy is not in recession but key end markets are which combined with the amount of destocking has gotten us to trough profitability), with an 8% dividend yield, this should be plenty for value investors to get excited. However, there is more.

In the middle of the coronavirus paranoia, the company mentioned on its earnings call on February 6, that M&G PLC, a UK based activist fund had sent the TSE board of directors a letter to discuss options to create value. Within hours, their 13D filing hit Bloomberg showing that M&G had amassed a 20% stake in the company becoming its largest shareholder. While we don’t know exactly what they plan to do, the stock is so grotesquely undervalued, that there seems to be a number of relatively straightforward ways to create value.

We generally think the company has done a good job relative to capital allocation, with the exception of spending too much on capital expenditures. While the company is already planning on significantly lower CAPEX, I suspect M&G may be able to reduce it further (a lot of room from $100 million down to their true maintenance level of $45MM), to buy back more stock. However, there are other ways to create even more value.

While selling the entire company is clearly at option (valuation today is cheaper than the valuation Bain Capital paid back in 2010 even though valuations for the market are dramatically higher), you can create even more value by selling some of the individual divisions. We know there has been significant financial and strategic interest in these types of assets over the last 24 months, with Synthomer buying OMN (key competitor for the Latex division) for 11x normalized EBITDA, Lyondell buying Shulman (key competitor for the Engineering Plastics division) for 12x normalized EBITDA and Saudi Aramco buying Lanxess’s synthetic rubber business for 8.5x EBITDA.

Trinseo currently trades at 4.6x trough EBITDA, but at 2.9x normalized EBITDA. This does not include several hundred million of NOLs that a buyer may pay for, which would reduce the current EBITDA multiple further. The latex division, which while low growth, is quite stable and mature, which in a low rate environment can attain a good multiple as we have seen in the case of the OMN deal. However, I would still consider it to be the lowest multiple segment of the company. Yet at the same multiple at $110 million of normalized earnings, this would yield $1.2 billion of value. Assuming the stock still trades at 2.9x normalized EBITDA, this would create $891 million in equity value (11-2.9)*110, or 118% upside to the current stock. The stock remaining earnings stream would likely re-rate after such a transaction, so simplistically if you think it goes to 6x normalized EBITDA for the remaining piece, that would be another 164% (6-2.9)*400. If you instead, or as well, decide to sell the engineering plastics business, which at $185 million of normalized EBITDA, would be worth over $2.2 billion (by the way this is $745+ million more than the current Enterprise Value), you would create 223% of equity upside (185*(12-2.9). if you do both, then you can add them together, and if the rest rerates to 6x normalized EBITDA you would get another 88%, for a total of nearly 429% upside. Of course, if you sell the synthetic rubber division for more than 6x (Saudi Aramco deal was 8.5x) you would get another 33% (8.5-6)*100. This would mean a total of around 462% assuming the remaining polystyrene and styrenics businesses cannot trade above 6x EBITDA. As we have seen, it seems to make more sense to sell these divisions by pieces, than selling the company as a whole. Again, we don’t know which path they will take, but at 46% normalized free cash flow yield and 8.0% dividend while we wait, we are happy to wait and see how this plays out.

Catalyst

1.) Activist investor M&G pushes for a sale for one or more components of TSE's business units to unlock value for shareholders. 

2.) PE decides TSE is so cheap again that it is worth taking private and doing another IPO in the future. 

3.) Investors or the sell-side figure out the story from speaking with management and industry experts and recognize this valuation is unsustainable and scramble to buy the stock sending it vertical

4.) A larger chemical company looks at TSE and its assets and recognizes how cheap the assets are, the fact that it is trading at historic low valuations and trough earnings with a large cycle in front of it, and decides to make a highly accretive acquisition offering shareholders a huge return in a short period of time.