Innospec Might Be A Name To Watch In Specialty Chemicals

 

It seems a little strange that a specialty chemicals business with $750 million in annual sales and strong returns on capital would be a virtual unknown, but that's the case for Innospec(Nasdaq:IOSP). Although this is a company with input cost exposure and somewhat volatile free cash flow, investors may want to keep an eye on this name as a potential value in the sector.Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.
Addressing Huge Markets for Specialty ChemicalsBroadly speaking, the markets for fuel additives and chemicals used in personal care products are huge. While there are many competitors, including major chemical companies like DuPont(NYSE:DD), Dow (NYSE:DOW) and BASF, this is nevertheless a market where offering the right proprietary product can drive premium pricing and reliable business.
The fuel additive market is a multi-billion dollar market, as these additives include detergents that control (or reduce) engine deposits, as well as other products that inhibit corrosion, reduce separation and improve performance in cold weather. With the opportunity to increase engine life, improve performance and reduce emissions, a host of manufacturers like Honda (NYSE:HMC), Toyota(NYSE:TM) and GM (NYSE:GM) have taken particular interest in working with chemical and petroleum companies to support these additives. For related reading, see our Industry Handbook on Automobiles.
Specialty fuel products represent more than 70% of Innospec's sales, not including its octane additives business. Royal Dutch Shell (NYSE:RDS-B), one of the largest oil companies in the world, is a major (10%) customer for Innospec.
Plenty of Opportunities in Consumer ProductsAlthough Innospec's "active chemicals" business is substantially smaller than the fuel businesses, there's reasonable growth potential here as well. Many of the lotions, soaps, fragrances and so on sold by the likes of Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG) are veritable specialty chemical stews, with a variety of ingredients added to improve absorption, feel, performance and so on.
Competition does limit the sort of premiums that Innospec and its rivals can charge, making this as much a story about cost leverage as product development. Input costs (often basic chemicals like ethylene) can be erratic, but those periods where lower costs combined with better volume often produce very attractive margins.
The Bottom LineInnospec is considerably more profitable (at least on an incremental basis) than most chemical companies and the company works both as an independent and as a potential tuck-in acquisition for another chemical company. I think it's also highly significant that through all of the ups and downs of the market cycles, Innospec has a long record now of positive free cash flow. With good cash flow and a clean balance sheet, non-strategic buyers could also come into the picture (as with Berkshire Hathaway's purchase of Lubrizol).
On the basis of continuing long-term mid-single digit cash flow growth, Innospec is worth a look. With the company seeing some pressure on margins in 2011, 2012 could be a year where the comps are somewhat easier and the financial results look better. Although Innospec does carry a premium relative to the broader chemicals sector, the company's long history of solid (albeit erratic) returns suggests that's not entirely out of line.


Posted: Mar 13, 2012  by Stephen D. Simpson, CFA