Description

I have a book value of $1.42/share.  In the last 6 months I have generated $145 million in EBITDA and $90 million in free cash flow vs a market cap of $230 million.  In Q3 I reported positive GAAP earnings on record margins.  My unsecured bonds trade above par.  Hi, my name is Chemtura Corp, and I'm currently in chapter 11.

Chemtura was written up by Todd1123 in February, since which time the company filed for chapter 11 bankruptcy protection.  Todd's analysis was straightforward and accurate and I'd encourage a quick readthrough of his writeup and the Q&A.  The thesis here is pretty simple: Chemtura is a solvent company that has found itself in bankruptcy from being the victim of a liquidity crunch.  It's equity value is far from worthless and there are several catalysts to get us out of bankruptcy and to a normal valuation.  This is not your typical bankruptcy and I think it's possible to realize a 400-500% return on an investment at current prices.

Company

The company was renamed after Great Lakes Chemical and Crompton Corp merged in 2005.  Their business is simple enough: they operate about 40 plants around the world that produce specialty chemicals.  About half of all sales are outside of North America.  The company has averaged EBITDA margins in the 9-10% range although GAAP earnings have been extremely choppy and negative due to a number of impairment, restructuring, and legal charges.  Generally, selling chemicals - even the "specialty" kind -  is a notoriously difficult business sometimes akin to oil refining.  The company is divided into four segments:

Consumer Performance products are pool products and household cleaners.  The segment is currently about 20% of sales and has above corporate average EBITDA margins around 13.5%.  The pool products make up most of sales; it's an oligopoly market with nice margins.  Sales are down 10% from 2008 because of the economy, but probably more so because the 2009 summer was uncharacteristically cold and rainy.  I think it's reasonable that this business will see sales rebound to 2007-2008 levels in 2010-2011.  This is one of the few products where Chemtura is selling the final good and owns the brand.

Industrial Performance products are additives for motor oils, lubricants, flooring and paints.  The segment is currently about 35% of sales and has above average corporate EBITDA margins around 11.5%.  Sales are down substantially, about 30-40% from 2008, although margins have actually improved and are at record levels due to cost cutting and lower input costs.  The standout business is the petroleum additives business.

Crop Protection makes seed treatment chemicals such as herbicides, fungicides, and insecticides for high value crops like fruits and vegetables.  This is the most valuable business that Chemtura owns, but it's also the smallest, representing about 15% of sales with good 20% EBITDA margins.  Sales here are typically steady at worst, although revenues have managed to be down 20% from 2008.  Many farmers internationally have been having a difficult time accessing credit (a listen to any number of ag related companies' conference calls will confirm this) which has led to lower plantings but I think a return to the 2008 revenue run-rate is reasonable for this business.

Industrial Engineered Products sells chemical additives that usually have specific property enhancement capabilities like flame retardation, UV protection, etc.  Sales go into a wide range of applications, everything from PVC pipes to electrical equipment.  This segment is about 30% of sales and has weak EBITDA margins in the 5-10% range.  These businesses have gotten hammered in the last year, sales are down over 40% and continue to look downright ugly.  Margins collapsed in the first half of the year into negative territory, but have picked back up in Q3.  The profitability of these businesses is stabilizing although it's anyone's guess as to what the new normalized level of sales is.  A lot of the products go into construction materials which continues to be very weak, while things like electronics are showing signs of life.

Going Broke

By September 2008, Chemtura was a moderately levered company at 27% debt/assets and 2.7x debt/EBITDA.  Business in 2008 had been okay, with sales about flat in the first half of the year but gross margins lower because of rising energy costs.  The plunge in industrial demand (all demand, really) hit Chemtura hard.  By the middle of Q1 2009, sales were down almost 45% while cash flow had begun to dry up.  The real problem for the company was liquidity - there was almost none.  Chemtura's debt is as follows (as of September they also had $228 million in cash):

There were two big problems here.  First was that the $370 million in unsecured notes issued by Great Lakes was coming due in July 2009.  This was a huge concern and those notes still haven't been paid off (obviously).  Second, and more importantly at the time, the Senior Credit Facility got renegotiated to a lower amount.  As of 12/31/08 the facility was $180 million and it was backed by their accounts receivables.  A ratings downgrade in Q4 2008 triggered all kinds of issues which are detailed in the 10Q.  To make a long story short, the facility was restricted by the lender, Chemtura was forced to take back AR, and eventually the tap was shut off completely thus killing a much needed source of capital.  Throw in suppliers tightening trade credit and the accounts receivable collection process taking longer than usual because of the economy and voila, chapter 11.

The original plan to avoid bankruptcy had been to sell the crop protection and/or petroleum additives businesses, both of which are the most profitable businesses Chemtura owns.  The company received several low-ball offers but turned them down, as it became apparent that things were so bad that even a sale of these units wouldn't solve their problems.  So instead they hung on to them and filed for bankruptcy in March.  Refinancing or renegotiating the debt was off the table due to market panic. 

Bankruptcy Through Now

Chemtura managed to file for bankruptcy about two weeks after the S&P bottomed.  I'm not saying their business has had the same 50% rebound as the stock market, but it has undeniably improved, and while it's a lot smaller than it used to be, that doesn't necessarily mean it's less profitable.  Sales hit bottom in Q1 and have rebounded sequentially.  The major theme from most chemicals (and many other firms) is that the inventory destocking jolt that began in Q3 2008 has now passed its anniversary.  The good news is that sales will probably be at worst, flat from here.  The bad news is that customers are still running in "inventory lite" mode, and it's anyone's guess as to how long this will go on.  Personally I have no clue myself, except that I know it wont go on forever, and at some point volumes will surge at some multiple of typical GDP growth.

While the sales decline has tapered, margins have expanded.  The main driver of this is input costs, notably energy (oil, natural gas).  Other cash expenses, primarily SG&A and R&D (but also capex) have flattened out after cost cutting plans which have been in place since well before serious troubles arose.  Management feels that they can keep these expenses flat in the short-term even if they see sales improve.  Chemtura managed to file for bankruptcy at about the apex of the panic, and things have obviously improved quite a bit since then.  I'm not going to pretend that business is great, but it's good enough that they're generating nice FCF and EBITDA. 

As for the courts, the most notable item so far has been the increasing pressure on the judge to form an equity committee.  The US Trustee recently rejected the formation of one but I'd be surprised to see equity continue without formal representation.  I think it's looking more and more likely because of a few things.  Most obvious is that the bonds are trading above par - this fact should attract any reasonable investor's attention.  The Witco notes are only trading at $78.50 but (a) they're not guaranteed by any of the subsidiaries whereas the other two notes are and (b) the current price of the Witco note is still higher than the prepetition price.  Then there's the little bit about the $345 million in shareholder equity ($1.42 per share) as of September.  Management has run their own stress tests on the remaining goodwill ($235 million) and does not foresee any additional impairments (in fact, nothing got impaired in Q3).  And as mentioned before, they happen to be generating quite a bit of cash, had positive earnings in Q3 despite $20 million in bankruptcy expenses, and have $228 million in cash on hand.  None of these facts are indicative of a company that is hopelessly insolvent.

Another encouraging sign is that we recently saw a somewhat unusual shareholder step in.  On October 8, Strategic Value Partners (SVP) filed a 13D stating that they had acquired 21 million shares (8.6%) of common stock at an average price of $.89.  SVP is a highly regarded distressed debt fund that rarely takes equity stakes in companies.  While their intentions aren't totally clear yet, they've formed an ad hoc committee and I believe they are going to push for a rights offering which would at least pay off the Great Lakes 2009 notes.  What's more is that I've recently been informed that the SEC has begun talking to the court about the reasons why an equity committee has not been formed yet.  Apparently they have noticed some of the same things I've laid out and it's not sitting well with them either.

Besides that, case has been pretty uneventful so far other than a few relatively minor skirmishes between the company and creditors.  Some shareholders have decided to form a shareholders alliance in order to file formal objections to various motions, and they've already been helpful in identifying some billing shenanigans from Kirkland & Ellis (debtor council) and Deloitte (debtor auditor).  Chemtura was recently granted an extension for their exclusivity period to February 11, 2010, so it'll still be a few months before we see a  plan filed.  I doubt that a debtors plan will include a sale of business units unless they feel they can get a good price for the assets. 

Naturally, bankruptcy has been and will continue to be expensive.  Normalized, legal expenses associated with the bankruptcy will be $20-25 million per quarter, or about $.40/share in EPS annually.  This is a relatively complicated case, with 26 subsidiaries and a lot of international operations.

Valuation

My valuation isn't a whole lot different than in Todd's original writeup - I still get about $4-6/share for the stock.  Below is my basic earnings model.  By 2011 I think that $.30-.40 in EPS is easily achievable, in which case they would also be generating about $350 million in EBITDA.  My revenue estimates assume that business returns to about the midpoint of where it was in the 2007-2008 period and the brutal recession times of 2008-2009.  This is fairly consistent with what some industry contacts have told me they expect. 

A 10-15x forward P/E multiple was normal for the stock prior to the recession, and it's a fair multiple that's common among other specialty chemical companies with similar margins (ARJ, OLN, FUL, SEH, WLK, PENX).  So it seems reasonable that by the end of 2010, even assuming $50 million in bankruptcy litigation expense in 2011, Chemtura could earn about $.35 and trade at a 12.5x multiple for a price target of $4.37/share.  On an EV/EBITDA basis, they would be generating about $335 million, which at a 7.0x multiple would be a price target of $4.80/share.  You can plug in whatever multiples you want though.

A sum-of-the-parts analysis yields similar valuation using normalized EBITDA and reasonable multiples. 

There could be upside to some of these numbers depending on what SVP wants to do.  It's possible that they could lead a rights or straight equity offering sooner rather than later, which could pay off the 2009 notes.  They could also apply some of the cash towards the DIP, and possibly arrange some other financing if necessary.  This could be a quick fix for bankruptcy and would be a good way to put an end to the litigation expense. 

Anyway, I believe that all of the proper elements are in place for a recovery in the equity.  Positive book value?  Check.  Profitable?  Check.  Strong cash flow and FCF?  Check.  Sophisticated investor stepping in?  Check.  Mounting pressure for an equity committee?  Check.  Even at the current run-rate I think they will be modestly profitable in 2010, and if there's any kind of meaningful recovery the stock has significant upside leverage.  I also think that the formation of an equity committee will push the shares up significantly when it's announced - it'll be a big catalyst. 

Catalyst

Equity committee formed

Rights/equity offering led by SVP

Paydown of debt

Exit bankruptcy