Chemtura: Major Restructuring With Earnings Growth On The Horizon

Summary

• Chemtura's management team has begun to streamline non-core businesses and to transform their portfolio into a pure play industrial company. This will drive margins, pricing and volume.
• Chemtura has a major asset (agriculture business) for sale that could be worth more than the market is expecting.
• Chemtura has $600M in NOLs that they can use against capital gains when selling their AgroSolutions business.
• Once they receive the proceeds from the AgroSolutions business, they will have the ability to accelerate their buyback program, pay-down debt, and have substantial earnings power.

Chemtura (CHMT) historically has operated as an industrial conglomerate. Chemtura's divisions had little operational overlap, and this complexity could early have led to a lower valuation within the marketplace. In response to slower growth and pricing pressures, Chemtura's management team has begun to streamline noncore businesses and to transform their portfolio into a pure play industrial company. Over the past year, Chemtura has completed the sale of two divisions, raising $406 million of capital, and is in the process of selling a third division, which I believe will generate in the range of $900 million to $1.2 billion in net proceeds. With this substantial chunk of capital, the company is going to be restructuring their balance sheet through debt reduction and aggressive stock repurchases. I feel that the full impact of the capital restructuring has not yet been reflected in the price of the stock. Moving forward, their focus will be on their industrial performance and engineering segments as they aim to improve pricing, margins and volume. By 2015, I believe they could earn in the range of $2.30 to $2.35 and trade with a multiple of 15 to 16.

Business:

Industrial Performance Products

Industrial Performance Products include petroleum additives that reduce friction and offer corrosion protection, polyurethanes used for finishing floors, high-gloss paints, and antioxidants that improve the durability and longevity of plastics used in food packaging, auto components, and electrical components. These products are sold directly to manufacturers and through distribution channels. Management's strategy is to shift out of commodity products and into specialty products.

CHMT has added additional capacity that will serve as a tailwind in the back half of 2014 and 2015. During the second half of 2013, CHMT completed the construction of 2 new plants. They opened their new multi-purpose manufacturing facility in Nantong, China, and commenced operation of its synthetic grease unit. In 2014, the synthetic lubricant facility will commence operation, and be followed in 2015 by its urethanes unit. The facility provides a platform for their next phase of growth in the Asia-Pacific region.
The second facility is the Ankerweg facility in the Netherlands, which is their high viscosity polyolefin plant. This will commence production for customer qualifications in the fourth quarter of 2013. Commercial production is expected to begin before the end of the first half of this year, following the completion of these qualifications.
For 2013, strength in sales of petroleum additives and certain synthetic lubricants was partially offset by the weaker demand conditions for their urethane products in mining and electronics applications. The segment performance was impressive considering CHMT had to cover the additional fixed cost of their 2 new manufacturing plants in China and the Netherlands.

Industrial Engineered Products

Chemtura is one of the three largest producers of brominated performance products, such as flame retardants and organometallics. Their Great Lakes Solutions brand manufactures and engineers specialty chemicals utilized in plastics, agriculture, fine chemicals, oil and gas, building and construction, insulation, electronics, mercury control, solar energy, pharmaceutical, and automotive industries. Products include brominated performance products, flame retardants, fumigants, and organometallics. Customers include polymer manufacturers, metal fabricators, chemical manufacturers, and oil service companies. Organometallics are used in solar cells, pharmaceuticals, and LED displays, and represent a growth driver along with their mercury control business.
Demand for flame retardants using insulation foam declined sharply in the first half of 2013, and selling prices also fell. Management remains optimistic, as they saw improvements in the second half of 2013. The segment has started to see a recovery in sales volume for products used in insulation foam applications. CHMT anticipates the new product adoption will accelerate and they will start to see the newer products start to replace the lower margin older products in 2014. Their Emerald Innovation 3000 product line that produces flame retardant products in a greener, more sustainable way, is one example of a product line gaining traction in the marketplace. Management indicated that they will see some price improvements in the first quarter and then more in the second quarter. They anticipate the largest move will result in the second half of this year as industries ramp up their need to comply with the U.S. Mercury and Air Toxics Standards (MATS) that go into effect in 2015.
Offsetting demand for flame retardants, CHMT saw solid growth in products for mercury control; fine chemicals, that is bromine-based intermediates; and clear brine fluids, as well as organometallics used in metal vapor deposition applications. I expect demand for bromine products to continue to grow at a solid pace, as orders will increase prior to MATS regulations, which go into effect in 2015. The demand for mercury removal will continue to grow at a rapid pace for many years as regulations begin to be implemented next year. In addition, management expects 2014 to be significantly better than 2013 because of substantial cost reduction efforts at their primary manufacturing plant.

Chemtura AgroSolutions

Chemtura AgroSolutions develops and sells agricultural chemicals formulated for specific crops to enhance quality and improving yields. It has six different product lines: seed treatments, fungicides, miticides, insecticides, growth regulators, and herbicides. These products are sold directly to growers and to major distributors in the agricultural sector. Management indicated they are seeking to sell this division and had a great deal of interest from multiple bidders. At the present time, they are in the second round of bidding. Management indicated that they expect to announce a sale by the end of the first half and close sometime in the second half. In my valuation below, I assume they announce at the end of Q2 and sell by Q3 2014.

Discontinued Operations (Consumer Products)

In October 2013, they entered into a definitive agreement to sell their Consumer Products to KIK for $315 million in cash. The deal is done and they have received the cash.

Hidden assets

Having accounted for the tax effects of the sale of their Consumer Products business and considering the 2014 annual release of their NOLs capped by their change of control in 2010, CHMT enters 2014 with approximately $600 million of U.S. federal NOLs, of which $357M can be used in 2014, while the balance can be used against future earnings. They can use these NOLs against capital gains when selling their AgroSolutions business.

Valuation:

In 2013, they successfully refinanced their debt capital structure, reduced their cost of capital, extended maturities, and increased flexibility. The repayment of the Senior Secured Term Loan will reduce interest expense by almost $4 million on an annual basis. In January 2014, they repaid $110 million of their Senior Secured Term Loan with proceeds from the Consumer Products divestiture. Below, I have laid out their current capital structure.

The 2018 Senior Notes are redeemable at any time prior to September 1, 2014. As these notes carry a higher interest rate, it would make economic sense to pay down the remaining balance on this note with any proceeds from the Agro business.
In valuing what the potential proceeds from the AgroSolutions business will be: I compiled a list of two comparable names in the space. On average, I believe, based on the comps, CHMT could sell the business for $1B on the low end. Permira, who is a private equity firm, acquired Arysta LifeScience Corp. (2007), which was in a similar agro business, for a takeout value of 12x EBITDA. A comparable company in the space also is FMC, who is a diversified chemical company that provides solutions, applications, and products for agricultural and industrial markets. They currently trade at an 11x EBITDA multiple. Using the low end of the range gets me a potential takeout value of $1B. Although this may be aggressive, an industry player could possibly pay this multiple given the synergies that might be available through the merger.

Pro Forma Income Statement:

Within my pro forma income statement, the main valuation drivers of revenue growth for Chemtura are volume increases y/y and price increases y/y. For IPP, I estimate that volumes will remain in the low single-digits for the first half of 2014, as they will take on additional orders and prepare their two new plants in the Netherlands and China for increased volume. I expect volume to improve in the back half of this year and especially in 2015, as the plants will have a year run-rate of production while generating order growth. I anticipate volume to grow 8% y/y in Q3 and Q4 of 2014. Within 2015, I expect volume to remain in the high single-digits and reach low double-digits in the back half of 2015.
For IEP, I expect that pricing will continue to be pressured in 2014 as they transition their strategy away from more cyclical (commodity) areas. I estimate that pricing will grow low single-digits for 2014. I assume 2015 will be a stronger year, as less cyclical areas like Pharma, Fine Chemical, Mercury Control, Clear Brine Fluids, and Fumigants will drive volumes and enable price increases. I estimate pricing will be up mid-single in 2015. I estimate that volume will be up high single-digits in the first half of 2015 and up 10% in Q3 and Q4 of 2015, assuming mercury control standards come into effect and CHMT sees a ramp in less cyclical areas. Management does not currently expect that its revenue will fully return to 2012 levels ($896M) in 2014.
I assume they pay the remaining $100M of the 7 7/8 Senior Notes and have the ability to buy back 20% of the stock at an average price of $30 by the end of 2015. I only expect Chemtura to pay down this much debt because the company has stated that their target leverage ratio is to be at 2X. Interest payments on the remaining debt should be ~$8M per quarter after they pay down the $100M of debt by September 2014. In my pro forma income statement, I estimate that the sale of AgroSolutions will be complete in Q3 2014. Moving forward from Q3 2014, every quarter represents results just from the Industrial businesses.
I believe in 2015, CHMT can do in the range of $2.30 to $2.35 in EPS. My assumptions are that operating expenses will remain relatively flat and they will see GPM leverage as they focus CapEx spend on ramping capacity and improving margins. Applying a 15X multiple to my 2015 EPS estimate gets me a PT of $34 to $36. The 2015 multiple is based upon the comparable companies, like FMC that trades at 19x 2015 estimates and Albemerle (ALB) that trades at 15x 2015 estimates.
CHMT introduced a 2016 revenue target of $2.5 billion without the AgroSolutions segment ($3.1 billion including it), and a 2016 adjusted EBITDA margin target "near" 20% with or without AgroSolutions. The revenue target represents a CAGR of about 12%, which I consider aggressive considering the growth prospects and competitive environment for the end-markets served by CHMT's Industrial businesses. I expect revenue for 2016 to be in the $2.4B and adjusted EBITDA margins closer to 18%.
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Sum of the parts:

Below is a sum of the parts evaluation to give another perspective of what each business could potentially be worth in 2015. CHMT has been trading at a significant discount to both its specialty chemicals peers and comparable transactions. CHMT trades for 6x 2015 EBITDA, whereas public comparable companies trade in the 6.5x to 9x range. For example, Albemarle, a key competitor in bromine products, trades for 9x 2015 EBITDA. In terms of comparable transaction, there was a relevant deal in the IPP segment in 2011 worth noting. Berkshire Hathaway acquired Lubrizol, a competitor in the lubricant space, for 6.5x forward EBITDA in March 2011. A sum of the parts analysis (which yields a blended 7.5x 2015 EBITDA multiple) suggests 45% in additional upside, or $38 to $40 per share. The model takes into account the proceeds from the AgroSolutions business and subtracts it out from the 20% stock buyback and $100M paydown on debt.

Downside:

To evaluate a downside scenario, I assumed that CHMT's annual EBITDA returns to 2013 levels of $260 million. In addition, I only assume they buy back $10M shares by end of 2015. I used a conservative 6x blended multiple in comparison with my 7.5x upside blended multiple. I believe this case is highly unlikely given the fact that the company is seeing stronger pricing and product demand, in addition to the fact that they have expanded capacity and expect costs to reside as these facilities to come online. However, at the most downside case, I would expect CHMT to trade at the $21 to $22 range.

Risk:

1. Rising raw material costs are a major issue that CHMT may not be able to fully offset with price increases.
2. The company's bromine-based flame retardants business is most at risk due to demand sensitivity to overall macro economic conditions, as well as its fixed supply cost.
3. Additional investments by competitors in bromine supply could eliminate the favorable supply tightness/strong pricing in the market today.
4. Operational issues could arise from new capacity built delaying output.

Catalyst:

1. Ability to sell the AgroSolutions business at a reasonable discount and offset a majority of the costs with NOLs.
2. Faster-than-expected recovery in pricing.
3. Demand continues to grow in their end-markets.
4. Potential acquisition.
5. Larger stock buyback than previously announced.

Investment Thesis:

Chemtura's portfolio optimization has been moving along nicely. Going forward, CHMT will focus on margin expansion in their core segment, pay down debt, and accelerate their share buyback. I anticipate with the sale of their consumer business and the expected sale of their agriculture business, CHMT will have the ability to buy back 20% of their stock and pay down $100 million in debt. The bulk of future CapEx will be allocated to their industrial businesses to drive volume, price, and margins. Over the past two years, CHMT has spent significant CapEx to ramp their capacity. Now that the capacity will soon be online, the elevated CapEx will go away and they will have substantial cash flow to buy back stock. I believe CHMT is an attractive investment according to several metrics, with near-term and long-term potential catalysts for capturing value. I expect CHMT could trade in the $36 to $40 range sometime in 2015.

Source: Chemtura: Major Restructuring With Earnings Growth On The Horizon

Additional disclosure: We may trade in these securities dependent upon market movements.


Chris Bunge, Manalapan Oracle Capital Management (95 clicks)

Hedge fund analyst, long/short equity

Source:seekingalpha.com