Olin Corp. (OLN)


Stock Price: $17.24
Market Cap: $2.9 billion
EV: $5.9B
Thesis:
A golden rule of thumb is to try to find at least 5 uncorrelated reasons to buy:
1.     Management is expecting a continued recovery in caustic prices: At global operating rates of 88% to 90% the chlor alkali industry would be effectively sold out by 2021 - supply and demand balances will continue to tighten, creating additional upward pricing momentum.
2.     Debottlenecking expansion: There is the potential in the longer-term to augment chlorine capacity by 20%. Approximately 200K tons of expansion is expected to come online in the next 1-2 years. For Olin, this presents itself as low cost incremental growth across multiple locations. Global EPI and LER supply and demand is projected to be tight by 2021 (ex-China). Current operating rates have invited room for supply growth. High-cost EPI and BPA act as deterrents to capacity additions for non-integrated producers. In the near-term, Olin has the ability to grow EPI and LER capacity through low-cost debottlenecking. Farther out, Olin has the optionality for brownfield investment in EPI and LER capacity.
3.     Heavy insider buying: There has been significant insider buying during the past quarter alone. At least five directors have purchased amounts upwards of $120,000 worth of stock.
4.     Major refinancing opportunity in 2020: Using $1.2 billion delayed draw term proceeds from its bank credit facility, Olin is expecting to pay down existing high cost acquisition-related bonds when they become callable in October, 2020. This will result in a potential $50-$70 million in savings of interest expense.
5.     Accelerated Buybacks: The board authorized accelerated share repurchases (Aug. 2019) of up to $500 million ($50 million worth has already been repurchased).

Brief Reasons for Current Undervaluation:
1.     Mid Caps are overlooked
2.     Misconception that most of Olin’s business is tied to the economy: Fears of US and global GDP slowdowns have negative effects on the stock price
3.     Misconception that Olin is affected by the trade war: Olin has minimal exposure to Chinese exports and to China (less than 2% of international operations are concerned with China)

Business Overview:
Olin Corp. is a low-cost producer of chlorine, caustic soda, and epoxy chemicals. It is the leading integrated global producer of chlorinated organic products, and a major global fully integrated epoxy producer with access to key low-cost feedstocks and cost-advantaged structures, making it among the lowest cost producers in the world. It is the leading vertically integrated global manufacturer and distributor of chemical products and a leading US manufacturer of ammunition.

Olin Corp’s revenues are divided between 57% generated in the US, and 43% generated internationally. In terms of sales generated internationally, this includes 35% of Chlor Alkali’s sales, 68% of Epoxy’s sales, and 10% of Winchester’s sales. DowDuPont is the largest customer with 14% of sales. No other customer accounted for more than 5% of sales. The next largest customer is the US, with 2% of total revenues.

Segment Information:
Chlor Alkali Products & Vinyls (57% of total revenues)
This segment manufacturers and sells chlorine and caustic soda and other chlorine chemical compounds. Bleach is a fairly substantial part of the business (15-20% approximately; 22% CAGR sales volume) and is not cyclical unlike other chemicals. The segment has end markets in water treatment (9% of chlorine; 18% of caustic soda), pulp and paper (19% of caustic soda), vinyls (26% of chlorine), and urethanes (35% of chlorine; 16% of caustic soda). Products are delivered via pipeline, marine vessels, deep-water and coastal barge, railcar, and truck. In terms of logistics and terminal infrastructure, the segment has a private fleet of trucks, tankers, and trailers. Its product sites are integrated with deep-water access. Due to a strong relationship with DowDuPont as both a customer and supplier, it can purchase raw materials such as electricity (generated from natural gas sources), salt (besides the 69% met by internal supply), ethylene, and methanol for a much lower cost than competitors.

Epoxy (33% of total revenues)
This segment produces and sells a full range of epoxy materials and resins, in upstream, midstream, and downstream products.

Winchester (10% of total revenues)
This segment produces and sells sporting ammunition, reloading components, small caliber military ammunitions and components, and industrial cartridges. It is the leading US producer of ammunition. The principal raw materials used in the segment are lead, brass, and propellent, which is purchased through multi-year contracts to counteract commodity volatility. Winchester submit a proposal for operation and maintenance of Lake City Army Ammunition Plant in December, 2018. Lake City Plan is the US Army’s primary manufacturing location for small caliber ammunition, with the expected decision to take place in Q3 2019. It presents itself as a long-term opportunity of the Winchester brand. In September, 2018, the US Immigration and Customs, Department of Homeland Security awarded Winchester a $12 million, 5-year contract. In April, 2018, the FBI awarded Winchester a $5 million, 5-year contract.

Macro Trends Affecting Segments:
Debottlenecking Growth Opportunities
94% of EDC volume is dedicated capacity to be used by integrated producers to make PVC, leaving only 6% for merchant. Global supply is projected to decline by 500KT as swing suppliers expand their own PVC capacity. This will be coupled with extensive demand growth from non-integrated PVC producers. The estimated new merchant requirements are roughly 2 MMT.

Olin management has contemplated new PVC plants in Asia, since existing ones are non-integrated. Olin currently has low cost US Gulf Coast assets integrated to chlorine and ethylene.

However, management has decided against investment into building PVC plants. Their current rationale is as follows:
2030 demand growth will require 21 integrated world scale plants to satisfy half of currently forecasted caustic demand growth. World scale CA-PVC integrated facilities built in North America would produce 1 MMT of PVC per year, would take 4-5 years to build, and require $5-6 billion of capital.
While it makes the most sense to build in China, using a basis of $500/MT caustic and $800/MT PVC, the IRR for the world scale facility would be less than 10%. At this time it wouldn’t justify that kind of investment, but should product prices increase it will be revisited.

Chlor Alkali
Chlorine demand has exceeded capacity growth since 2013, and is forecasted to accelerate through 2030 if additional capacity is not added. The increase in chlorine demand is forecasted to be 21 million metric tons between 2018 and 2030, with half coming from vinyl alone. Caustic demand is forecast to increase by 23 million metric tons between 2018 and 2030. PVC demand is expected to increase by 21 million metric tons between 2018 and 2030.

Other growth opportunities for chlorinated organics includes refrigerants and solvents. They are projected to grow rapidly and require carbon tetrachloride. Fortunately, Olin has the largest capacity for carbon tetrachloride in the world, and is the only producer with assets on two continents.

Olin is also positioned to capitalize on Latin American demand growth by directly serving growing regional consumers. Imports are expected to grow to 3.5MM dry metric tons per year by 2030. Membrane demand is forecasted for 200-300K dry metric tons. It has end markets in pulp and paper, home, and personal care. The primary transport is through trucks, which Olin is more than equipped to handle with its truck fleet and logistics network across the Americas.

During 2018, North American caustic soda price contract indices increased $40 per ton while the caustic soda export price indices increased $270 per metric ton. During the second half of 2018, both domestic and export price indices experienced declines. The price of natural gas influences demand for chlorine and caustic soda pricing. If natural gas prices increase, this increases their customers’ costs, and depending on the ratio of crude oil to natural gas prices, could influence them adversely.

In Q2, 2019, the segment experienced a lower demand for chlorine. In addition, caustic soda pricing experienced a decline during the quarter. Towards the end of the quarter, the segment saw positive developments from an upward turn in caustic soda prices, which occurred later than management had anticipated. Additionally, management incurred $40 million higher in maintenance turnaround costs in the chemical business. While the peak turnaround costs for the segment was $176 million in 2018, for 2019 it is forecasted that it will drop to $125 million.

Epoxy
In Q2, 2019, the liquid epoxy resin pricing stabilized after prices having increased 30% over the previous two months due to tightening epichlorohydrin supply from ongoing supply distributions in China. The previous tight supply had resulted in upward pricing momentum for liquid Epoxy resin in China. As an aside, management noted that export pricing is still downward relative to contract pricing, and there is still significant capacity that has been offline on the export side. In terms of turnaround costs, going forward they are expected to decrease by half from $66 million to around $30 million.

Business Model:
Olin Corp has three integrated sites: Freeport, TX, Plaquemine, LA, and Stade, Germany.
Its Freeport plant is the largest chlor alkali complex in the world, has access to deep-water, brine reserves, and low cost power via owned co-gen power plants.
Plaquemine has over 1 million tons of chlorine capacity, access to brine reserves, deep-water & Mississippi river, and low cost integrated power, while being the key asset for GCO’s Perc business.
Stade is an attractive platform to sell into Europe and Asia, has an integrated and flexible epoxy asset design, and deep-water access. It is also a low cost GCO asset that supports customers on multiple continents.

Competitive Advantage:
Olin Corp. is the largest, low-cost global chlor alkali producer, making it the #1:
·      Merchant EDC, merchant chlorine supplier
·      North American bleach producer
·      Chlorinated organics, epoxy producer

Why is it mischaracterized as a cyclical business?
There are several factors as to how the New Olin has been lowering its cyclicality. Since 2016, it has reduced its exposure to merchant chlorine and caustic soda pricing to less than 20% of revenue, from 40% in its Legacy business. At the same time, it has boosted its industrial bleach business, increases the non-cyclical component to other parts of the chlor alkali business. Similarly, caustic soda itself is a counter cyclical buffer to chlorine. Lastly, the segment relies on LT contracts with Dow DuPont to provide stable cash flows.

With an advantaged position in terms of raw material purchases, Olin reduces the cyclical nature of its business. 85% of its electricity is generated from natural gas and hydroelectric sources. 80% of its brine purchases comes from internal supply, from owned facilities. For ethylene, Olin has a 20-year supply agreement with Dow. Its Dow contracts automatically renew, namely those related to wastewater and ground water treatment services.

Dow serves as both a buyer and seller to Olin. Contracts to sell to Dow have a minimum term of 7-years. To enumerate those sales contracts, Olin sells chlorine, aromatics, GCO, and VCM (contract through 2025, pipeline customer available in 2021). Contracts from Dow that Olin buys serve to further the logistical advantages of pipeline integration. These include contracts for ethylene, propylene, and benzene.

The ethylene contract is a series of three supply agreements that provide pipeline supply without operating or start up risk.
Tranche #1: acquired at closing of Dow asset acquisition, provides up to 180,000 MT and costs $300-350M
Tranche #2: available since 12/31/17, provides up to 160,000 MT, and costs $270-290M
Tranche #3: available starting 12/31/2020, provides up to 300,000 MT, and costs $500-540M

Chlor Alkali: Global chlorinated organics business replacement asset value of $1 billion. For a competitor to replicate this, it would take significant scale, and from management’s opinion, at least 4-5 years to build a single plant alone. Suffice to say, there’s not going to be much disruption from competitors.

Epoxy is positioned at the low-end of the industry cost curve. It is the only EPI and LER producer, in North America (location: Freeport, TX), and globally. It is the lowest cost producer in Europe for EPI and LER. Olin has 48% epoxy resin capacity in North America and 38% in Europe. It’s exposure to China is minimal with only 3% of the country’s capacity.

Valuation:
Olin is currently trading at 5.6x TTM free cash flow, 8.9x TTM earnings, and roughly 1x book. We will be valuing it by putting EBIT multiples on each segment, and then cross-referencing it with a simple FCF multiple.

For each segment, we took a three-year average EBIT, and placed a multiple we deemed appropriate. Chlor Alkali had an average EBIT of $430 million. We placed an 8x multiple considering it exists in a commodity industry, but also keeping in mind that the segment’s EBIT has been growing quite consistently over that period. That gets us a composite of $3,444 million.
For Epoxy, the average EBIT was $34 million, with a multiple of 8x (same assumption as Chlor Alkali), getting us a composite of $271 million. Lastly, we have Winchester with an average EBIT of $38 million, with a multiple of 4x. The reason being for a multiple at a liquidation level is that Winchester has been experiencing declining sales, which leads to a declining bottom line. As such, we believe 4x is representative of that situation. That would get us a composite of $153 million.
Taking the aggregate of the three, you get $3,868 million, which amounts to a per share value of $22.97 per share. This will serve as our low end.

Next, we considered free cash flow. We believe this is more representative of Olin, as EBIT does not account for working capital changes or capital expenditures. Olin exists in a capital-intensive industry, and FCF takes better account of that. For the past 10 years, free cash has been growing at a CAGR of 24%. Because Olin experiences the effects of the caustic cycle, we decided to take a 3-year average for FCF which gets us $424 million. Putting a 12x multiple considering growth gets us a composite of $5,087, or $30.21 per share.

Financials:
On the surface, Olin exhibits the characteristics of a mediocre company with its commodity-like return metrics: ROIC (6%), ROTC (6%), ROA (7%), ROE (12%).
But does a mediocre company produce hundreds of millions of cash flow?

Free cash flow has been growing consistently since 2015, increasing by almost five-fold. In terms of OCF, the increase has been three-fold. In 2018, Olin generated a whopping $522 million of free cash, and $907 million of operating cash flows. 10% of free cash flow went towards buybacks, and 26% towards dividends (uninterrupted for 92 years).  72% went towards long-term debt repayment, after taking into account what borrowings matched.

2019 cap ex is expected to be in the $375-425 million range.

Olin is on the heavy side with debt. Its net debt/EBITDA was 2.39 in 2018. Interest charges have been around $200 million for the past couple years, which is much greater than the $30 million they used to be pre-2015. Interest coverage by free cash flow and OCF has risen to 2.35x and 4.35x in 2018 from 1.6x and 3x in 2016. Debt maturities are far off in the future: $200 million due in 2022, $720 million due in 2023, $500 million due in 2025, 2027, and 2030 each. Roughly $824 million of long-term debt is variable rate. In addition, Olin has $325 million of operating lease liabilities.

In mid-July 2019, Olin completed $750 million bond offering and a new $2 billion bank credit facility. It issued $750 million in 10 year senior unsecured notes and used the proceeds to immediately prepay the Term Loan A facility and outstanding borrowings under accounts receivable securitization facility. By year-end 2019, Olin is expecting a $100 million increase in working capital, and plans to use cash from refinancing to discontinue sale of receivables under factoring agreement. Debt repayment was in effect lowering debt burden in advance of the ethylene payment that was going to be done at the end of 2020. Management’s goal is to build cash over the next 1.5 years to be in a position to pay down debt.

So, in 2019, they have a commitment to pay down $250-300 million. Taking into account the downside risk of a $90 million hit to EBITDA, there is still ample free cash of $400 million.

From a recent presentation:
Cash generation boosted by $200 million annually, beginning in 2021
1.     Lower interest expense ($50-70 million)
2.     Wind down of IT integration project ($90-100 million)
3.     Initiation of new VCM contract ($75 million)
4.     Total incremental cash generation = $200 million

Other liabilities that stand out are related to pensions. In 2018, Olin had a pension deficit of $439 million. The expected return was egregious: 7.75%. The discount rate for periodic benefit cost has decreased to 3.6% from 4.4% in 2016, and the discount rate for benefit obligation has risen slightly to 4.2% from 4.1% in 2016. The yearly benefit obligation size is roughly $37 million, which is slightly smaller than in previous years.

However, we expect greater obligations in the future, despite the company not thinking so.

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