Description

I am recommending a long equity position in Chemtura (CEM) which presents a compelling near-term event-driven risk / reward proposition (predicated on a high-probability event that will occur in the next 1 - 3 months - of which I think there are 3 / 4 high-probability levers of unlocking value), with total return potential of >300% over the next 1 - 3 months (based on probability tree matrix further below). Chemtura is an asset-rich chemicals company (>$1Bln of AR + inventory and ~$900MM of PP&E ) that trades for less than 2.7x trailing EBITDA (TEV is approx currently at ~83% of book value). The Company's market cap is currently ~$180MM (down from ~$2.2Bln 7-mths ago) driven primarily by a near-term / July 2009 $370MM debt maturity (company is currently in discussions w/ lenders).

Given Mr. Market's "hyper-focused" / "fear-induced" myopic view on bankruptcy risk, the equity (currently trading at ~$0.70 / share) is priced at a level that almost fully factors in both (i) limited near-term business visibility (pent-up fear around comparable chemical-related businesses - like Lyondell / Ineos / etc - that have fallen off a cliff) and (ii) bankruptcy risk. While Mr. Market is pricing the equity based on worst-case assumptions, the reality is that Chemtura has a handful of levers / alternatives that should help them get reduce or eliminate the "perceived" credit risk (top of which is selling one of their premier assets - Crop Protection or Consumer Products). While I realize it seems fool-hardy to rely on an asset sale especially in this environment (the merits of this statement are debated further below - I'd argue the odds are 80%+ in our favor given the high quality of these particular assets and, more importantly, the high quality / capitalization of the strategic bidders who I believe are involved in the respective auctions), there are three other alternatives which the company can pursue (including amending the current 2016 / 2026 bond maturities to re-finance out the near-term maturity w/ an asset-backed-loan) that will unlock value.

Overall, I'd label this opportunity as a low risk / high uncertainty (apologies for borrowing Monish Pabrai's investment "formula"). The downside to the long CEM equity trade (which I'd argue is largely priced in at this point) is $0.25 - $0.40 / share (i.e. assuming a Chapter 11 filing, I think the equity will trade in the $0.20 - $0.40 / share range given the optionality of the security - noted in more detail w/ the capitalization / valuation work below). The upside to the trade is $3.00 - $5.00 / share (which I'd label as a 90% probability). Given this dynamic (90% * $4.00 - 10% * $0.40 = $3.50 - $3.60), I'd argue the 5/6-to-1 optionality is an attractive risk / reward opportunity (the remainder of this write-up is focused on providing information / clarity around the probability weighting above).

While we don't have to get into too much detail on the business (company filings / research does an adequate job of covering), its worth noting the history of Chemtura. For the past 2+ years, Chemtura has been the perennial "value trap" (in my humble view - largely driven by an inept CEO at the helm - Bob Wood ... NOTE that Wood was replaced in late December 2008 w/ Craig Rogerson - a capable "turnaround" expert cut his teeth successfully turning around / selling Hercules). Chemtura generates >250MM in EBIT ($430 - 440 in EBITDA) and operates through four business units (in a nutshell, 2 of which are good / 1 decent / 1 very shaky). More pragmatically, Chemtura has two crown jewels (Crop Protection and Consumer Products - that combined yield >200MM of EBIT / FCF proxy before allocating corporate overhead) that are highly coveted by strategic / "well-capitalized" bidders (including Arch Chemicals, DuPont, FMC, Monsanto in particular): 

SUMMARY BUSINESS OVERVIEW:

1. Crop Protection generates >$80 - $85MM of EBIT: products used for quality / strength in agriculture end-markets (this is ultimately the crown jewel and will likely be sold in the next 1 - 2 months to a large / well-capitalized strategic player for >$500MM) ... 
2. Consumer Products generates >70MM in "normalized" EBIT (currently around $55MM of LTM EBIT): products are used in cleaning fluids in the home as well as pool cleaning fluids (generally an annuity stream given the large base of pools already in use - but in this environment, I'd anticipate the products to be more discretionary in nature given consumer is tightening their belt on pretty much everything 
3. Performance Specialties generates $125MM of EBIT: products used for lubricants in engines / machines and durability mostly to transportation and construction end-markets (I'd label this business as good but exposed to the vagaries of heavy industrial / transportation capex cut-backs)
4. Polymer Additives generates approx $87MM of LTM EBIT (this has been the "value trap" division as investors have been awaiting a restructuring that would effectively take EBIT margins from the low single digits to the high single digits - i.e. extracting $50 - $100MM of EBIT improvement ... to date, this has NOT yet happened thus the "value trap") ... comps include ALB, FOE and Behr 

While Chemtura has arguably been the perfect "value trap" over the past 2+ years, this long equity thesis / write-up is NOT contingent on the any "fundamental turnaround" / nor recognition of business fundamentals (in full disclosure, I don't profess to be an expert in CEM's business, but I've done enough channel checks into industry experts who have helped give me clarity on probability weighting the various scenarios). Also, while there is near-term mark-to-market downside risk (i.e. $0.25 - $0.50 / share in a bankruptcy filing), I'd argue that given the various levers (discussed further below), the upside optionality of >$3 / share adequately rewards us for the near-term risk. One final point ... I'd also argue that these types of "event" names that provide "hyper-call options" are more interesting now (especially in light of the environment we're currently trying to navigate through) as these types of 5 / 6-to-1 event trades offer a near-term catalyst on "value" realization that are totally independent of beta-risk.

The rest of this write-up will be focused on (i) a punitive / conservative view of the company's valuation ... (ii) ultimately using #1 to prove out the fact that the equity is already trading w/ bankruptcy risk baked in (i.e. downside to any bankruptcy filing is arguably $0.25 - $0.35 / share given the call option nature of capturing any value through a bankruptcy process - especially given the rich asset base / various levers of business unit value), (iii) highlight alternatives the CEM mgmt team has at their disposal (and why I think the top 3/ 4 will relieve the bankruptcy risk on the company) and (iv) ultimately provide a probability tree of upside / downside (and prove out why taking a 5 / 6-to-1 bet on a call option that's trades purely off of a near-term event is compelling)

CAPITALIZATION /VALUATION:

The graph below takes a punitive approach of the company's valuation using punitive / conservative multiples to each of CEM's 4 businesses (note that I have assumed Q4 EBITDA falls by 50% YoY and that 08E EBITDA is $380MM. This view is largely driven by other chemicals businesses that have "fallen off a cliff" in Q4 - Q1 09E period given end-market inventory de-stocking (extrapolating this view through the duration of 09E would put EBITDA at >$225MM ... I'd argue that demand / inventory will start re-stocking during Q2 - Q3 and will likely put EBITDA at around $300MM by YE 09E ... even in the scenario by which EBITDA falls to $225MM, the company should generate >$50MM in FCF and that's NOT taking into account $200 - $300MM of working capital improvements especially given inventory will come off driven by commodities falling ... but again, NOTE that the trade / thesis is NOT contingent on taking any view on the overall business ... just taking a view on the alternatives around the near-term event below.

It's worth noting that the company is currently trading at 0.8x book value (based on Friday close - book value as of Sep 08 is ~$1.5Bln vs TEV of approx $1.2Bln).

As highlighted above (and assuming the multiples are conservative), the bonds are covered in every scenario and the equity has significant value (>$1.75 - $5 / share) once the bankruptcy risk is removed. The assumptions / multiples above are NOT Herculean and my view is that Mr. Market will apply a 4x+ EBITDA multiple once the July 2009 maturity is dealt with. The equity option value is largely driven by the fact that >50% of the Company's overall profitability is generated through "high quality" / high cash flow businesses that I'd argue are worth >7x EBIT ... and the Company trades for less than 3x LTM EBITDA (I'd be the first one to agree that given 09E could put this valuation at a less exciting 4.5x valuation - but nevertheless cheap) and the remaining 50% of CEM's profitability is effectively trading for $0 (call option value)

VALUE UN-LOCKING ALTERNATIVES:

I believe there are a handful of alternatives management is currently pursuing (I'd label the first option as a 60 - 70% probability event, the 2^nd option as 20 - 30% and the last 2 options as the remaining 10%)

OPTION 1 - ASSET SALE: most likely - crop protection or consumer products division ... feedback from industry sources has highlighted that bids are on the table for both divisions from well-capitalized strategic players (Arch w/ a bid on foreign Consumer Products division and DuPont w/ a bid on domestic Consumer Products division ... and a couple parties w/ bids on the Crop Protection division ... w/ talk on the Crop Protection division in the >7 - 7.5x (including corp expense) EBIT range 

 Note that any sale that yields greater than $370MM would relieve the bankruptcy pressure on the equity (and unlock value) ... my view is the Crop Protection division will be sold for around $500 - $550MM ... and the Consumer Products division will be sold piece-meal and will likely yield around $400 - $450MM. In total, this would result in paying off most of the company's debt and create the remaining PF Chemtura business for approximately $180MM (market cap) w/ >$100 - $150MM of PF EBIT

OPTION 2 - AMENDMENT: Seek amendment to 2016 / 2026 bonds to free up collateral and complete ABL (AR of 287MM + inventory of 720MM = ~1Bln) 

Reason why they need lender approval is that 2016 / 2026 have negative pledges against majority of collateral pool

Notable that there are significant un-encumbered assets in the Chemtura network that are NOT guaranteed by any of the existing bonds ... as a result, there is significant asset value that could be used for an asset-backed-loan (the one caveat is that the Company will need to get an amendment - 66% approval) from the 2016 / 2026 bond maturities to free up this collateral ... while the Company would have to pay both the bond maturities for this, this could be done (and my view is that the price would be a couple hundred basis pts given the these relationship bondholders have only one other alternative - bankruptcy filing - and should be willing to play ball)

OPTION 3 - RE-FINANCE OUT THE RISK: Approach to 2016 / 2026 bonds and pay-up for them to rotate into new / larger 2nd lien (i.e. pay up but fight another day approach - NOTE that even assuming a blended ~15% interest rate on~$1Bln of total debt, the company should still generate >$100MM of FCF based on 08E EBITDA - assuming 08E is "normalized" longer-term which I think is very likely 

This approach is NOT preferred but it would effectively take care of the near-term maturity (and as we've recently seen in the past couple weeks, there have been new issuances - just a matter of price)

OPTION 4 - CONVERTIBLE NOTE SECURITY: Seek out a creative solution w/ deep-pocket party via convert note, etc (we've heard there are multiple parties in the hunt) - given the "competitive" dynamic, I don't think the terms will be that egregious (i.e. the equity optionality on a solution will be significant for current / existing shareholders as long as the company gets the infusion) 

 While this is not the preferred route, we know of a handful of parties who are looking to work w/ the company (who know / have been following the company for the past 2+ years and who see value in splitting up the business and extracting value)

UPSIDE / DOWNSIDE:

My view is that in a bankruptcy filing, the equity trades to $0.25 / $0.50 / share given the call option of the equity security (i.e. there are >$1Bln of AR / inventory + >$1bln of PP&E on the balance sheet and there are 4 business units that could be sold in an auction that would yield significant value to the equity). I've weighted this scenario at ~10%. The various scenarios below have been equally weighted at 1/3 of the remaining 90% probability.

UPSIDE: assuming ~6x 08E EBITDA (we've assumed Q4 08 EBITDA down 50%) and ~5x "normalized" (i.e. we've assumed no improvement in Polymer Additives - i.e. the "perennial value trap" portion of the biz = $5 / share (vs current of $0.75 / share or approx 550%+ upside)

BASE: assuming ~5x 08E EBITDA (we've assumed Q4 08 EBITDA down 50%) and ~4.3x "normalized" (i.e. we've assumed no improvement in Polymer Additives - i.e. the "perennial value trap" portion of the biz = $3.33 / share (vs current of $0.75 / share or approx 345%+ upside)

DOWNSIDE: assuming ~4x 08E EBITDA (we've assumed Q4 08 EBITDA down 50%) and ~3.5x "normalized" (i.e. we've assumed no improvement in Polymer Additives - i.e. the "perennial value trap" portion of the biz = $1.75 / share (vs current of $0.75 / share or approx 135%+ upside)

RISKS:

Mgmt team puts all their eggs into one basket (i.e. the asset sale) and it does not go through ...

- mitigant is that there are multiple parties hovering around this situation that would likely provide a convertible note infusion to solve the near-term maturity (while this would dilute existing shareholders, the equity would trade up 2 - 3x the current amount on the clarity that the business will survive)

- mitigant: we've had constructive dialogue w/ the CFO and he is aware of all of the alternatives ... and he understands the time-frame (i.e. next 1 - 5 months) he's operating in

- mitigant: we've interacted w/ Rogerson (new CEO) in the past and we think he has a good handle on this situation (i.e. he understands that there are 3 / 4 levers to value creation)

CATALYSTS:

NEAR-TERM (1 - 2 months): Company sells the Crop Protection division or Consumer Products division (anything >$400MM would deleverage the business dramatically and allow the Company to pay down the n-term $370MM maturity) ... the market realizes that the next bond maturity is 2016 (so no near-term triggers)

LONGER-TERM (3 - 6 months): Mgmt gets a new ABL / credit facility (only needs $200MM max in my view) that effectively extends for 3 - 5 years (and NOTE the next bond maturity is 2016)

LONG-TERM (6 - 12 months): Company regains credibility (we'll see how much of a turnaround expert Rogerson is) and Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power ("homerun case" ignored above is Street takes "normalized" earnings power of $0.50 - $0.75 / share and applies a 10x "market" multiple to get to a $5 - $7.5 / share valuation

FINAL PT:

while the 2026 bond maturity (trading at 20 / 25 cents on the dollar) is an alternative way to approach the situation (given its seniority to the equity in a waterfall / recovery), I'd argue that the equity offers greater risk / reward given the following pts: (i) equity is the fulcrum security and has 5/6-to optionality versus ~2-to-1 optionality for the 2026 maturity (i.e. the CY of 27.5% trades back up to the mid-teens which implies 15 - 20 pts of upside on a 20 / 25 entry). As a result, I'd rather buy the equity that offers greater liquidity and more optionality (and longer-term - assuming the new CEO / Rogerson is a strong turnaround expert - could be worth >$7 / share under more "normalized" conditions so approx 10x upside). 

Catalyst

NEAR-TERM (1 - 2 months):  Company sells the Crop Protection division or Consumer Products division (anything >$400MM would deleverage the business dramatically and allow the Company to pay down the n-term $370MM maturity) ... the market realizes that the next bond maturity is 2016 (so no near-term triggers)

LONGER-TERM (3 - 6 months): Mgmt gets a new ABL / credit facility (only needs $200MM max in my view) that effectively extends for 3 - 5 years (and NOTE the next bond maturity is 2016)

LONG-TERM (6 - 12 months): Company regains credibility (we'll see how much of a turnaround expert Rogerson is) and Street recognizes the underlying earnings power of the biz model and applies a "market" multiple to earnings power ("homerun case" ignored above is Street takes "normalized" earnings power of $0.50 - $0.75 / share and applies a 10x "market" multiple to get to a $5 - $7.5 / share valuation