|Shares Out. (in M):||62||P/E||15.2||13.8|
|Market Cap (in $M):||3,940||P/FCF||20.0||22.0|
|Net Debt (in $M):||906||EBIT||440||484|
Investors on VIC are familiar with the carbon black industry that have been discussed on previous write ups on OEC (Orion Engineered Carbons) by jet551 on Feb 17, 2017 and again by juice835 on Apr 11, 2018. CBT operates in the same businesses that OEC does, although CBT has a smaller mix of specialty carbon black and a larger mix of rubber carbon black. Since the OEC write-ups, there have been several positive data-points that confirm the positive tailwinds that the carbon black industry is facing and an emerging theme could potentially benefit carbon black producers going forward.
Carbon black utilizations remain tight (>90% globally) and demand has been extremely robust, evidenced by tire manufacturers starting contract negotiations early among other examples. These tight market conditions and a healthy demand backdrop is likely to lead to continued pricing and margin improvement, which have the potential to be sustainable long-term. Separately, the IMO 2020 fuel spec change is also likely to leave the high sulfur fuel oil market in over supply, which the carbon black industry uses as a feedstock.
The evidence to support strong carbon black fundamentals are currently coming to light, which will likely lead to higher pricing and margins (after accounting for raw material lag) through 2018 and 2019, with the potential for cheap feedstocks to further boost those margins beyond 2019. CBT’s consolidated multiple of 8.2x is undemanding compared to pure-commodity chemical names that average 7.5x and specialty chemical names that average 11.5x. I think a SOTP approach better values the Performance Chemicals segment, which is more like a specialty chemical business and values CBT at $76/sh, without even considering more upside to 2019 and 2020 numbers.
I think CBT is currently mispriced because:
1) Investors miss the rate at which industry fundamentals are inflecting positively and how this inflection has the potential to be structural
2) As CBT (and OEC) show sustainably strong margins, the market will value the Performance Chemical business with a specialty chemical multiple, leading to an attractive SOTP valuation
3) There is a possible tailwind from the IMO 2020 fuel spec change that could benefit the carbon black industry
CBT’s primary businesses manufacture rubber and specialty carbon blacks, similar to OEC. Within Reinforcement Materials (45% of 2017 EBITDA), CBT manufactures rubber carbon black that is primarily used in the tire manufacturing. Within Performance Chemicals (45% of 2017 EBITDA), CBT manufactures specialty grade carbon blacks that go into a variety of end-markets that utilize black pigments among other uses. CBT also has two legacy businesses which they are trying to exit from, Purification Solutions, which is an activated carbon business and Specialty Fluids, which is utilized in oil and gas completion fluids. Both segments comprised 10% of 2017 EBITDA but that ratio is expected to shrink dramatically in 2018 and will continue to shrink until they are exited. Management has been explicit about their desire to exit those businesses, which should simplify the business structure and narrative for CBT going forward.
Thesis Point #1 – Rate of Industry Inflection and Structural Nature
Reinforcement materials (aka, rubber carbon black) has driven CBT topline and margin beats over the last two quarters and I expect those trends to continue given the tight market environment.
As further evidence of positive industry fundamentals, tire manufacturers have started to negotiate 2019 contracts, almost 6 months earlier than usual as a sign that they are concerned about supply given the current tight utilization dynamics, which sits at or above 90%. In light of recent price increases, this implies that tire OEMs are more concerned about supply than price.
There are several datapoints that suggest that these industry improvements could be structural. In the US, recent EPA compliance standards have increased the cost of new greenfield production, making new build economics more challenging, coupled with a multi-year ramp in tire OEM manufacturing capacity laid out in Jet551’s write-up. In China, at least half of the shut downs over the winter of 2017 due to stricter environmental restrictions are unlikely to return to the market, and new builds face more stringent environmental restrictions, creating more headwinds to new build economics.
The industry has also acted more rationally with regards to capacity adds and recent expansions announced by OEC and CBT only constitute 2-3% of total global production, where those largely serve to absorb growing demand as opposed to displacing supply.
Thesis Point #2 – Performance Chemicals Deserves a Premium Multiple and SOTP is Attractive
Performance Chemicals basically operates in an oligopoly (OEC, CBT and Birla make up ~75% of market) and the process is more specialized than a pure commodity chemical. The ability to add new capacity also extends beyond just economics because many of the end-products have a level of intellectual property associated with them. A long qualification process ranging from 3 – 12 months (OEC’s 3Q17 transcript) speaks to the IP involved and those factors may prevent or delay the addition of new capacity adds.
While there is near-term risk on raws pass through, I believe that CBT will be able to achieve EBITDA margins in the low 30%’s after G&A which compares to specialty chemical peers like in the comp table below. I think as Performance Chemicals laps the raw material headwinds assuming crude does not go much higher from here, margins will gradually improve into the 30%s and can sustainably hold those levels.
Thesis Point #3 – IMO 2020 Fuel Spec Change
A recent theme that has been discussed extensively across energy is the fuel spec change to take place in 2020 where ships will be required to shift from burning high sulfur fuel oil (HSFO) to low sulfur alternatives, commonly known as IMO 2020. IHS estimates that the maritime industry currently accounts for 80% of high sulfur fuel oil supply and that demand is expected to fall off a cliff in 2020, which would leave the HSFO market in very large oversupply. While it is debatable whether the supply of HSFO will shrink as refiners have the option to convert HSFO into a low sulfur alternative via cokers and hydro-treaters, my view is that there is insufficient coking capacity globally to convert all the HSFO and refiners are also unlikely to build new coking capacity given the cost and time ($500m to $1bn over 3-5 years) given uncertainties around how structural the low sulfur diesel spread could be.
There is also another debate around the capability for the carbon black industry to use HSFO in a meaningful way. My checks indicate that the raised US EPA standards that have mandated the installation of scrubbers could facilitate HSFO in US plants, with a small extra cost. I estimate that HSFO needs to be discounted by over $4/bbl to a similar feedstock for carbon black producers to be incentivized to use HSFO and with current forward curves showing around a $12-$16/bbl spread to similar feedstocks, carbon black producers are likely to benefit from the spread based on the conversion ratios of around 1.5-2.0 of feedstock to product. A potential risk in this analysis is that rubber carbon contracts could directly pass these costs through, but the index is a basket of over 15 commodity feedstocks across many part of the globe. On specialty rubber, the carbon black producers are likely to keep that spread, although they might give up some yield due to the lower quality feedstock.
Assumptions and Valuation
I think that CBT is likely to get to 2018 EBITDA of $605m slightly above the top end of their guidance range of $575-$600m. While CBT does not generally provide much guidance around volume, pricing, raws and margins, I believe that their business dynamics are quite similar to OEC, with the exception that CBT has a bigger Asia rubber spot market presence. I believe that it is reasonable to assume that the price/raws dynamics are similar at both companies, where raws pass through are majority contracted in Reinforcement with little time lag and not very contracted in Performance with 3-6 month lags on pass through. From a topline perspective, I am assuming the current YTD trajectory continues in Reinforcement, which loosely ties to a low double digit increase in price and GDP growth in volumes. In Performance, I expect HSD increases in volume and MSD increases in price, although margins could see some near-term pressure as the price of crude-linked raw materials remain elevated, although the near-term upward momentum has stopped, which helps sentiment.
My SOTP valuation conservatively assumes 2018 EBITDA as a base case, but I expect the earnings momentum to continue into 2019, which would bias valuation higher as Performance margins improve. Comparable specialty and commodity chemical multiples form the basis of my valuation.
Risks & Mitigants
Large-scale capacity additions is a risk to the current narrative, although the top two producers (OEC and CBT) have already announced capacity adds and the market has digested them fairly well.
Right now, tire manufacturers appear to be willing to absorb price increases and are appear more concerned about supply certainty. If tire manufacturers start to push back on price, we could see a ceiling to profitability, but their pricing power is weaker since carbon black is largely a regionally localized industry and where utilizations currently stand.
The rate of crude prices increasing from here, less so the absolute price, could hinder raw material pass through that could delay the margin improvement story, however, Russia, US and OPEC have been vocal about limiting the upward trajectory of crude prices, making it a lower probability event.
Further environmental regulation could add more pressure to maintenance costs but most of the plants have become more environmentally compliant and more costs should also ultimately impact new build economics.
I think the carbon black industry is at a multi-year inflection and IMO 2020 could increase the tailwinds to profitability. While I am equally positive on OEC, I think CBT will also benefit from the same tailwinds over time. I think there is about 20% upside to the stock currently, and I think that 2018 and 2019 estimates are likely biased higher if pricing continues and management gets better at maintaining margins / passing raw material costs through.
Continues to beat and raise expectations through 2018 and 2019.
Exit of non-core businesses should simplify the narrative.
Better understanding of IMO 2020 impacts will help quantify the real potential benefit to carbon black producers.
|Entry||06/14/2018 12:47 PM|
How meaningful do you think the IMO change could be / how much do you think it could add to EBITDA?
|Subject||Re: IMO impact|
|Entry||06/15/2018 07:59 PM|
I used the following broad assumptions based on industry checks and they are very approximate:
1) Residual oil as a feed stock is only applicable in the rubber black process and 2 ton of feedstock will yield 1 ton of rubber black
2) Feedstock subsitutability is probable in the US, where scrubbers are already installed or are in the process of being installed per the EPA settlement and possible in Europe depending on the plant setup and availability of residual oil
3) The incremental cost to dispose of the sulfur and associated waste products range from $10 to $40/ton (of product) excluding new scrubber costs. New scrubber costs are are likely to double the cost per ton
4) The rubber black producers can keep the cost savings unless the contracts are re-written to include the residual oil in the index, where they would give up part of the feedstock cost savings
I assumed a $10/bbl discount to the carbon black oil index (undisclosed basket of feedstocks globally), although some industry experts estimate a discount as wide as $20/bbl+ is possible. Based on those assumptions and a 6.7 conversion from 1bbl to ton (http://www.cmegroup.com/tools-information/calc_refined.html), CBT would effectively get a $135/ton (of product) cost saving, but offsets that with a $25/ton (midpoint) extra cost, implying $110/ton of cost savings.
CBT sold about 1.65 million tons of rubber carbon black in 2017 and their geographic mix is about 35% US, 40% Asia, 25% Europe. Between the US and Europe, I think it is safe to assume CBT can utilize the discounted feedstock in 40% of their rubber sales or 65kmt. That would imply a $72m cost saving to CBT, ~10-15% of annual EBITDA, depending of your view of future EBITDA.
There are many variables in the set of assumptions I outlined that you can play around with, but that was how I looked at it. Open to debate or comments on this methodology.
|Subject||Carbon Black Price Increases|
|Entry||06/28/2018 09:21 PM|
I recently got a chance to meet with OEC on a roadshow and wanted to share some of my takeaways from the meetings. As expected, I was most focused on where we were in the cycle and the response I got gave me higher confidence that we're not close to the end yet.
OEC was quick to point out that on top of customers coming early to negotiate contract prices for 2019, they were having little problem passing on price increases, especially in the Europe and the US, where utilization is known to be above 90%. As confirmation of those price increases, I included links to both CBT and OEC price increases, both within the last month, in hyperlinks below. The price increases were in EMEA of about $100-$120/ton and according to my conversations, those are very likely to fall right down to the bottomline, since raws are more or less indexed/pass-through. OEC also suggested that those prices are likely to be a good indicator for 2019 contract base price levels. Furthermore, the company also said that they are turning away new customers/volumes because of where utilization sits. Lastly, while profitability is on an upward trajectory, environmental regulations continue to push greenfield economics higher, likely leaving 2019 per ton economics still below greenfield economics.
While all those signs point to a longer cycle and we're no where close to the end yet, I believe that CBT might actually be a nearer-term benefactor than OEC because of their higher spot volume mix in Performance Materials, which I estimate to be ~40%. For illustrative purposes, I estimate CBT's rubber black annual sales to be about 1.6 million tons and assuming a $100/ton EBITDA improvement and a 40% spot mix, that implies about $64m of spot volume (annualized) tailwind for the remainder of calendar year 2018 and $160m of full year benefit once the new contract cycle goes into effect. The caveat is the exact location of the spot volumes are difficult to figure out based on CBT's disclosure and the assumption is that the EMEA tightness and pricing is very likely to occur in the US and is also possible in Asia. I believe that given the current tightness in utilization and the lack of ability to export high volumes of the product and increasing environmental regulations, the carbon black cycle could go into extra innings.
|Subject||Upsized Share Repurchase Program Hints at Solid Underlying Fundamentals|
|Entry||07/16/2018 07:48 PM|
This morning, CBT announced that they increased their current share repurchase authorization by 10m shares to 11m and increased their target repurchases to $400m over the next 3 years.
This is above CBT's targets laid out during the recent analyst day of $200-$350m, where management committed to returning 50% of FCF to shareholders based on $300-$400m of annual FCF and includes an $85m annual dividend.
Furthermore, based on the recent disclosure in the 10-Q, CBT had 1.5m of remaining authorization from the 2015 program and today's announcement indicated that there is 1m left of that authorization. That implies that CBT repurchased 0.5m of shares since the end of fiscal 2Q. For reference on the pace of share repurchases historically, CBT repurchased 2.3m, 0.8m and 1.1m shares in 2015-2017 and 200k in fiscal 1H18.
I think the upsize in repurchases and the pick up in the pace of buybacks highlights the current strength in business fundamentals as I had described before and expect a very robust fiscal 3Q result. This also sends a very powerful message from a management team on their confidence in the industry fundamentals and that management will take a very judicious approach to M&A and/or capacity additions.
|Subject||Fiscal 3Q18 Update|
|Entry||08/06/2018 08:03 PM|
CBT had a strong quarter even though the headline EBIT/EBITDA masks the real underlying strength of the Reinforcement Materials business and the current rubber carbon business. CBT's fiscal YTD Reinforcement Materials generated $215m of EBIT, well ahead of the $250-$270m guidance. On the flipside, Purification Solutions segment weighed on EBIT, losing $6m for the quarter and CBT remains committed to strategic alternatives for the business.
Other notable positives was that CBT organically generated $95m of discretionary free cash flow and repurchased $43m of stock and paid a dividend of $21m making whole on the promise of returning >50% of discretionary free cash flow to shareholders.
While CBT did not update guidance on the press release, they may update guidance on the slides ahead of the call and I think guidance is likely biased higher.
|Subject||2019 Contract Pricing|
|Entry||10/03/2018 07:53 PM|
I wanted to provide an update on CBT. Last week, there was a major carbon black industry conference where producers, buyers, feedstock providers congregated (Carbon Black World in Germany). The takeaways from the conference was that the rubber black market remains extremely tight in NAM and Europe and 2019 contracts are very likely to settle with price increases 2-3x the size of price increases in 2018. These price increases are very consistent with spot rates in the US and Europe (whatever small spot market is left) and both CBT and OEC have commented that spot rates are likely to set the bar for 2019 contracts.
These datapoints also confirm CBT and OEC’s prior comments about how the 2019 contract negotiations started early as rubber black buyers are becoming increasingly concerned about securing supply. This also validates CBT and OEC comments that they are basically sold out on volumes in Europe. Contract negotiations have also wrapped up early for 2019 and I think CBT will be in a very good position to provide color on those contracts at their upcoming F4Q18 call, while providing guidance for FY19.
Anecdotally, 2019 contracts are asking for 6-7c/lb increases, compared to 2-3c/lb increases in 2018. Furthermore, the US contracts have negotiated a surcharge to incorporate increased scrubber costs, which helps preserve the gross profit margin as scrubber investment rolls out over the next 1-2 years.
Given the pricing dynamic of contracts, I think CBT is set up for a very strong 2019 guide and EBITDA of $700m is not out of the realm of possibility. As a guide, CBT’s EBITDA is 55% rubber black and about 75% is contracted (25% is China which is a spot market).
Some considerations to the bull case is that China is still a spot market and still the most opaque to me. Carbon black spot prices have come off early 2018 highs but remain well above 2017 averages. Coal tar pricing has also declined, which helps preserve the margin. The large unknown is how China environmental regulations that tightened the market in late 2017 will play out in 2018. I have seen articles about China relaxing steel and coal regulations to help economic output, which should theoretically keep coal tar (feedstock for CBT) supply ample but the unknown is whether they regulate carbon black production.
The other consideration is how specialty black performs given the increase in crude pricing. That said, both OEC and CBT have been surprisingly resilient in getting price and not giving up too much margin while crude prices have steadily gone up for the last 12-18 months.
Ultimately, I think 2019 is setting up very well for CBT (and OEC too), with increases to contract pricing expected to fall straight to the bottom line. Not many chemical companies can claim large upward increases to 2019 estimates - TiO2, polyolefins, MDI, etc. are all likely going to plateau or decline. Also, as mentioned before, I do not think we’re close to the peak of the cycle for carbon black as utilization remains above 90%, contracts are being signed early with large prices increases and scrubber surcharges being accepted holistically. I remain of the view that carbon black is a bright spot of the chemicals sector while other chemical companies are concerned about global trade flows and China growth.
One point to note is that after more work and conversations with carbon black producers, it appears that IMO 2020 is unlikely to be a windfall for them. The producers have discussed passing any cost savings from low HSFO prices to the buyer while it also protects them if it goes the opposite way. I think this is a reasonable action to take as a carbon black producer and they can focus on providing a value add product to the tire companies who are happy to let them earn the margin.