Description

As we are already in December, we wanted to include 2016 estimates to illustrate the likely upside in this story.

2016 Estimates

EPS:    $3.02

P/E:      5.2

P/FCF:   3.7

EBIT:    299.0

TEV/EBIT:  6.6 

TSE – Trinseo

Trinseo S.A is a global chemicals business that Bain Capital took public in June of 2014 after having acquired the business from Dow Chemical in 2010. Bain did not sell any stock in the IPO and all proceeds were used to repay debt. Having already been priced at a discount to its global peers due to its substantial exposure to Europe, the stock has fallen a further 16% on the back of continued negative European macroeconomic news flow. While the headline multiples are already very attractive, the valuation becomes extreme once we normalize for the abnormally high capital expenditures the company is incurring over the next 24 months. While some of the higher capital expenditures are for growth projects, some relate to new IT and cost optimization systems, the benefit of which we have not factored into our earnings or working capital figures. The valuation metrics are as follows:

The company states specifically in its S1 filing that maintenance capital expenditures are $35m to $40m per year, and this seems to be consistent with the historical data. Taking the reported capital expenditures for the last few years and backing out the specific growth and conversion projects (which should result in either higher volumes, higher EBITDA/ton or both) leaves a capital expenditure number of approximately $40m. After the company completes the growth projects it has planned for 2015 and 2016, we believe the portfolio will be in line with management’s objectives and we expect capital expenditures to decline materially.

In this context, we find the current valuation extremely compelling and believe the stock has 150%-200% upside in our base case.

The company currently has four operating divisions:

Synthetic Rubber: Accounting for approximately 34% of 2015E EBITDA, the synthetic rubber division is structurally the highest growth business within the portfolio. The division makes synthetic rubber predominantly for specialty tires. Beyond selling into the steadily growing global car park as approximately 75% of the tire market is for replacement, the secular trend towards higher performance or specialty tires provides an end market that should enjoy structural growth for many years to come. While the broader synthetic rubber industry has been suffering from overcapacity for the last 2 years, the company has continued to see healthy margins due to: 1) over 80% of the business is based on long-term contracts 2) the majority of the division’s end markets are for very high-end, specialty products. In addition, the company is not involved in butyl rubber, which is one of the grades that has seen the most competitive pressure.

Styrenics: At 29% of EBITDA, the styrenics division manufactures polystyrene, acrylonitrile butadiene styrene and styrene acrylonitrile products. Broadly speaking, these products are used in consumer electronics such as mobile phones and tablets as well as appliances. The styrenics industry has suffered from significant overcapacity, but recent capacity shutdowns combined with healthy demand growth are driving steady improvement in utilization from a recent trough. Still below mid-cycle levels, we expect utilization in the industry to cross 90% in the course of 2016. It is important to note that the assets in this industry are relatively old, so outages are increasingly common, causing periods of high utilization for months at a time. As an example, in Q3 of 2013, industry outages drove higher spreads in this business thereby generating EBITDA of $67m, as opposed to the $22m generated in Q3 of 2014.

Latex: At 24% of EBITDA, the latex division produces styrene butadiene latex, styrene acrylate latex as well as other performance latex products. While the challenges faced by some segments of the latex industry from the decline in coated paper in developed markets are well known, a combination of product mix and geographic exposure has allowed this division to remain remarkably steady quarter in and quarter out. This is true both of volumes as well as profitability. While upside exists in markets such as construction which have significant cyclical upside, we have assumed this business remains flat.

Engineering Polymers: At 13% of EBITDA, this is currently the company’s smallest division but has significant upside over the next few years. This division has two businesses, a polypropylene compounds business and a polycarbonate business. In 2013 this business was EBITDA breakeven with the compounds business generating about $75m while the polycarbonate business was losing approximately $75m. Industry consultant estimates suggest the losses in the polycarbonate business will decline to about $60m in 2015, although this is still a very meaningful amount for a company generating $355m in EBITDA in that year. And while utilization is expected to gradually improve in polycarbonate, we have assumed EBITDA is relatively flat after 2015, as it is hard to estimate with precision how much EBITDA is likely to lift as utilization increases but remains below levels usually associated with strong pricing power. However, we hold Trinseo management in high regard, and thus assume that if they believed the $60m in losses to be more permanent, we would expect them to shut this business down, at least temporarily, thereby increasing EBITDA by $60m. In addition, the company has taken restructuring actions that are expected to add $35m in EBITDA for 2015.

Balance Sheet

Turning to the balance sheet, the company has Net Debt / EBITDA of just under 3.0x based on our 2015 estimate. Additionally, the majority of the debt carries a hefty 8.75% coupon. Despite the temporary higher capital expenditures, we expect the company to continue to repay debt as well as refinance a portion of the debt at lower cost during the course of 2015. The current run rate interest expense is $120m and the company recently stated that they expect interest expense exiting 2015 to be $35m lower than at the end of 2014. This alone increases EPS by 50 cents, which is significant for a company that we expect will earn $1.53 in adjusted EPS in 2014 (adjusted for non-cash inventory revaluation).

Geography

In terms of geographic mix, 60% of company sales are in Europe, 23% in Asia Pacific, 13% in the US and 4% in the rest of the world. While many investors have aggressively sold the shares over the last few months due to its exposure to Europe and to some extent Asia, we think these exposures are somewhat misleading.  Firstly, on the synthetic rubber side, much of the business goes to premium European auto OEMs whose cars are sold throughout the world, while the tire replacement market in Europe is relatively stable.  Secondly, the styrenics business sells into manufacturers of mobile phones and tablets in Asia, but the end product is sold globally. As for the underlying exposure to Europe, while things could always get worse, it seems likely that on a cyclical basis, the European economies have more upside than downside. Finally, investors have understandably been concerned about the translational impact of a weaker EUR since the company reports in USD. However, the company has specified that the earnings sensitivity is $1.5m for each 1% change in the EURUSD exchange rate. This currently represents an $11.5m headwind in 2015, or 3.1% of EBITDA.

Conclusion

In conclusion, we think the risk / reward for Trinseo is extremely compelling on the back of a very low valuation combined with embedded earnings growth from new projects, as well as the significantly accretive impact of deleveraging and refinancing.  To the extent that the European economy finally starts to improve, we should see further upside, while also retaining the optionality of an upcycle in styrenics as well as polycarbonate.  In particular in polycarbonate, we think the opportunity is very asymmetric, as either utilization improves and the $60m in losses turn into profits, or the management will be under increasing pressure to exit this business. That said, with $60m in losses from polycarbonate, the stock is still trading at a 21% FCF yield for 2015 and 27% FCF yield for 2016 based on normalized capital expenditures. 

We understand that people are concerned about Europe, chemicals, and leverage. However, the contractual nature of a large part of the business, the replacement nature of many of the company’s markets, and significant cash flow generation should more than offset these concerns. We believe the stock provides 150% to 200% upside in our base case, with further significant upside if the styrenics or polycarbonate markets see an upcycle, or alternatively if the polycarbonate business is exited or sold.

Catalyst

• Expansion of margins from upgrading of synthetic rubber portfolio
• Accretive impact of debt repayment
• Accretive impact of debt refinancing
• Cyclical uplift in styrenics and/or polycarbonate - Capacity is coming out and demand is growing
• Increased Management Visibility to Institutional Investors - (Having been owned by Private Equity since June 2010, it has not been necessary for management to communicate well with a broad group of investors.)   Since the IPO, management is having to acclimate to "playing the game" of telling their story to investors and to analysts.
• Expanded Sell-Side Research coverage - Since the recent IPO, TSE management will be attending more conferences and participate in more sell-side roadshows, and we are likely to see expanded research coverage, and consequently - greater awareness among investors.