|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.