Description
Huntsman (Ticker: HUN) is a chemical company that is a combination of commodity and specialty chemical assets. Originally focused on the commodity chemical space in the seventies and eighties, the company has used the cash generated from the cyclical assets during the good times to diversify into stable, higher returning businesses. Even though 65% of its trailing EBITDA comes from these high quality assets, HUN has been awarded a valuation in line with commodity players such as Lyondell or Nova Chemical. The company is currently trading at 5.2x ‘05E EBITDA, 6.0x ‘05E EBITDA – maintenance capex and a 21% FCF yield (Note: HUN is currently not a cash tax payer, so trailing FCF is overstated). Dow Chemical, a more appropriate comparable, trades at approximately 8.5x 2005E EBITDA. Even assuming a 25% discount to this multiple to account for the Dow’s superior assets and better balance sheet gives me a price target of $25 for HUN, a 50% premium to the current level.
The Business:
The Huntsman family has been acquiring companies in the chemical industry for the past thirty years. Prior to the IPO in February, 2005, Huntsman was one of the largest privately held chemical companies. The company ran into liquidity problems in 2000 as its commodity business locked in unfavorable contract rates. At this time, MatlinPatterson lead a balance sheet restructuring, which gave MatlinPatterson joint-control of the company with the Huntsman family. HUN completed its IPO on February 16, 2005, selling its initial shares at $23. The company issued 55.6 mm shares and selling shareholders sold 13.6 mm shares. A mandatory convertible preferred due 2/18/08 was issued at the same time as the IPO. The preferred has a 5% yield and converts into either 10.2 mm shares or 12.5 mm shares of common stock in 2008, depending upon HUN’s stock price. As the stock price is currently below $23, the mandatory convertible preferred represents 12.5 mms hares of common stock. Post IPO, MatlinPatterson and the Huntsman family jointly control 59% of the common stock through HMP Equity Trust.
There are six business units: base chemicals, polymers, pigments, polyurethanes, advanced materials and performance products. Base Chemicals, polymers and pigments are commodity chemicals. The remaining three segments all have the same characteristics: expected growth of 2-3x world GDP, leading market positions, and higher margins. These segments are substantially less cyclical than the commodity segments mentioned before. Note: all segment sales and EBITDA numbers mentioned below are prior to intersegment elimination and corporate expenses.
Basic Chemicals: LTM Sales $4,450 mm, LTM EBITDA $340 mm
The company sells ethylene, propylene and other aromatics/co-products. The company’s worldwide ethylene capacity is approximately 50% from natural gas feed and about 50% from a naptha feed (oil derivative). Only 35% of the company’s ethylene capacity is currently being used internally, which is a short term positive in today’s ethylene pricing environment. HUN’s natural gas feed capacity is in North America, a long term disadvantage if gas prices stay at the current level. However, tight industry capacity for the next few years will allow HUN to continue to operate these plants very profitably until at least 2007/2008 when the Middle East capacity comes online. While Street analysts all seem to agree we are near peak pricing conditions (if not already past), there is little focus on what I believe to be the more important point: sustained profitability for the next few years.
There are three main plants, two in the US (Port Arthur and Port Neches) and one major facility in the UK (Wilton). The US assets are considered to be average. The Wilton facility is a flexible cracker in an excellent location. Abiding by its philosophy of using cash from the up-cycle to fund growth in more stable, higher return businesses, HUN is building a LDPE plant in Wilton, UK. This will make it the lowest cost producer of LDPE in Europe, as well as allow HUN to use more of its ethylene capacity internally, reducing its exposure to this perpetually low margin market. (In order for ethylene producers to operate efficiently, they need to run their plants between 95-100% of capacity. As most producers of ethylene are also producers of the down-stream products, there is generally excess ethylene on the market, leading to perpetual pricing pressure.)
Note: The US business and the European business operate off of different pricing contracts, with the US business resetting their prices on a monthly basis and Europe, setting pricing on a quarterly basis. As a result, third quarter results were dramatically affected by the large increase in oil prices in the quarter, hurting European margins. In addition, Q4’s base chemicals results will be impacted by plant shutdowns and delayed restarts post Hurricane Katrina. Both Port Arthur and Port Neches were down for a significant part of the quarter.
Polymers: LTM Sales $1,700 mm, LTM EBITDA: $160 mm
HUN’s sales are levered to polypropylene and polyethylene prices. Polypropylene was 60% of the segments EBITDA in 2004, with 20-25% from polyethylene. Historically, HUN’s average polymer prices has been 11% above its commodity mix, mainly due to its value added position. HUN is levered to LDPE rather than LLDPE/HDPE, both of which are suffering from two types of future competition. First, as polyethylene costs are driven higher due to natural gas prices or capacity constraints, polypropylene may be used as a substitute. Second, the capacity that is being built in the Middle East is focused in this area. In contrast LDPE, the older plastic which goes into products such as toys or saran wrap has no replacement risk and little capacity is being built. If you look at the prices of LDPE contracts over the last year, one can see that downward price corrections have been less dramatic than LLDPE or HDPE. A similar story is true for polypropylene. As propylene is a derivative of “heavy” crackers, less capacity is being built as the new crackers in the Middle East are all light crackers. With less capacity coming online there should be slightly less pricing pressure, though the option of replacement is always there.
Pigments: LTM Sales $1,050 mm ~ LTM EBITDA $150 mm
HUN is the largest producer of TiO2 (titanium dioxide) in Europe. This is a pigment used to in paints to increase the brightness, whiteness and opacity to paints and coating, paper and plastics. Capacity in the industry is highly consolidated with the top five producers accounting for 75% of global capacity. Despite the relative consolidation in this industry, pricing has been abysmal historically. This segment has underperformed due to softness in Europe. However, Lyondell has recently announced pricing increases in North America for TiO2.
Polyurethane: LTM Sales: $3,400 mm, LTM EBITDA: $680 mm
Considered by many to be the crown jewel of HUN’s business, 70% of the business is from MDI. Again, in line with its strategy to focus on higher return, more stable businesses, HUN divested its TDI business a year ago. TDI is basically a commodity chemical in which HUN’s assets were both non-competitive and its share in the business was well behind that of the market leaders, preventing it from reaching a competitive cost position. As a result, HUN is now the only global urethane producer focused solely on MDI. HUN and Bayer are the market leaders with approximately 24% share in MDI each. Effective barriers to entry in the MDI business have created an oligopoly which has increased both pricing power and stability. Historical demand growth has been 2-3x GDP, with capacity growth tracking demand. Tight capacity in the last year has lead to substantial pricing leverage (growth being driven by substantial demand from China). Bears focus on the pricing power being derived from Chinese demand for exports. With a large Chinese MDI plant to come online in 2006, they believe there is a potential for a substantial pricing correction. While I agree that there is likely to be pricing pressure in the next year, I believe that global MDI demand will remain strong. Therefore, any correction should be viewed as temporary. In addition, HUN through its joint ventures in China will have gained a leading market position in the fastest growing MDI market.
To give you a little more detail about HUN’s Chinese investments, HUN entered into two JV’s to build MDI production facilities near Shanghai in 2003. One is an unconsolidated manufacturing JV with HUN owning 35%. The JV partners are HUN, BASF and three Chinese Chemical companies. The partners are building three plants manufacturing MNB, aniline and crude MDI. In the second JV, HUN is teaming up with foreign investors to build an integrated MDI plant ~ HUN will own 70% of this JV. These facilities are expected to come online mid-way through 2006 and 100% of production is expected to be sold in China.
Advanced Materials: LTM Sales $1,200 mm ~ LTM EBITDA $190 mm
Advanced Materials can be described as the hidden jewel in HUN’s portfolio of assets. This is the former CIBA epoxy business that was purchased by MatlinPatterson in June, 2003. Since its purchase, HUN’s management has dramatically reduced costs by exiting unprofitable contracts and selling off low margin businesses. Today, 80% of the business is either #1 or #2 in its market. There are three main sub-segments: Coatings, Construction and Adhesive (50% of sales), Power and Electronics (25% of sales), and Design Composites & Engineering (25% of sales). Coatings, Construction & Adhesives have a full portfolio of products in a fragmented industry, making it the one stop shop for its customer’s needs. As a result the company has gained more expertise, scale, and technology than any of its peers. HUN focuses on the higher margin products, leaving low end markets such as decorative paint to others. Power and Electronics has two distinct set of products: polymers for insulating electronic components and materials for use in power plant components. Design, Composites and Engineering basically is a structural composite business geared towards aerospace, high performance, wind turbine and general industry. It’s estimated that this business has 20-25% EBIT margins, making it one of the most profitable business lines owned by Huntsman.
Overall, Advanced Materials has excellent sales and margin growth opportunities. This segment is rarely mentioned in Street reports as it has been undergoing restructuring programs for the past two years. As we end this period, the Street should recognize the superior opportunities Huntsman enjoys in this space, supporting my argument that HUN deserves a diversified chemical valuation multiple.
Performance Products: LTM Sales: $2,050 mm ~ LTM EBITDA: $230 mm
Approximately ½ of the EBITDA is from what Huntsman defines as a strong niche specialty chemical business in amines. HUN has been increasing capacity substantially in this segment, and maintains the low cost, market leader position. The other half of revenues is from basically ethylene glycol, which is a commodity market. This segment suffered in the past six months in the wake of Hurricane Katrina.
Valuation: (Note: most balance sheet numbers are from the latest 10-Q)
Stock Price: $17.50
Shares: 233 mm (including conversion of preferred)
Equity Value: $4,078 mm
Total Debt: $4,441 mm
Receivables securitization: $193.8 mm
Minority Interest: $125 mm (Market value ~ Company just signed an agreement to buyout the minority interest in its Advanced Materials segment)
Cash: $200.1 mm
Net Operating Loss cash value equivalent: $480 (assumption, total NOL value $3,600 as of the end of 2004, assuming a tax rate of 35% and that $300 mm in cash taxes were avoided in 2005 ~ applying a 50% discount)
Enterprise Value: $8,156 mm
2005E EBITDA: $1,565 mm
2006E EBITDA: $1,924 mm
EV/2005E EBITDA: 5.2x
EV/2006E EBITDA: 4.2x
EV/(2005E EBITDA-Maintenance Capex): 6.0x
Maintenance CapEx $200 mm
(Note: current capex is running substantially above this due to the building of the MDI plant in China and the LDPE facility in Wilton, UK, both projects which will run several hundred million dollars to complete)
2005E EPS: $2.21
2006E EPS: $2.93
2005E P/E: 7.9x
2006E P/E: 6.0x
LTM FCF/share: $3.76
FCF yield: 21%
(Note: the company is making a large pension contribution in Q4 of this year as well)
The market continues to value this company in line with its commodity peers (LYO, NCX, etc). As a result, the polyurethane, advanced materials, and performance chemicals business are largely unappreciated. Given these segments represent approximately 65% of the trailing EBITDA and have organic growth of 2-3x world GDP, giving HUN a commodity chemical multiple seems ludicrous.
However, even if you disregard my argument as to the appropriate valuation of these assets, Huntsman’s de-levering over the next year should give you some comfort. The company should generate over a $1,000 mm in FCF in 2006, which would translate into $4.30 in additional equity value by the end of next year. Given the commodity nature of the business, many argue that you should value this off of normalized EBITDA, a number that is difficult to predict given the amount of cost cutting which has been done in this business. However, given a variety of assumptions, I get to a “normalized EBITDA” of about $1.2 to $1.4 bn. At the low end, I’m assuming that ½ the North American assets are stranded and worthless come the next cycle, reducing EBITDA by approximately $100 mm. Assuming 7x normalized EBITDA for the company gives you an enterprise value range of $8.4 to 9.8 bn. Accounting for the $1,000 in debt paydown over the next year gives you an equity value per share of $23-$29.
In conclusion, one can argue for years about the appropriate method to value a chemical company, and I by no means claim to be an expert in this space. At $17.50, depending upon how you look at it, you are either buying the specialty chemical assets at ½ their value or you are getting the commodity chemicals segment for free. Either way, the stock is dirt cheap. Given inside ownership of 60%, if the market continues to fail to realize the company’s value appropriately, it’s hard to believe that MatlinPatterson/Huntsman family will not begin to explore value-enhancing alternatives such as initiating a share buyback, selling off segments, or perhaps splitting up the company.
Catalysts:
1) End of tax-loss selling come January 1, 2006
2) Payment of debt ~ should be up to $1,000 mm in FCF in 2006.
3) Reduction in North American natural gas prices
4) Opening of the MDI plant in China ~ HUN has been investing in this for the last two years and will only start realizing income midway through 2006.
5) Potential split between commodity business and specialty chemicals business post debt paydown. ~ this would allow for a more appropriate multiple to be placed on the polyurethane, advanced materials and performance chemicals business.
Risks
1) Substantial increase in US natural gas prices from current levels and a decrease in respective oil prices. If this pressure continues, the North American ethylene and polyethylene plants could be unprofitable once the capacity in the Middle East comes on line. They should be shut down at that time. As a result, ½ of the commodity business could be worth nothing in a few years. However, the stock market already seems to be reflecting this scenario.
2) Lower than expected pricing power for polyethylene, polypropylene and the base chemicals. While difficult to predict, HUN may be slightly insulated from any drawbacks due to its concentration in LDPE and polypropylene, areas where less capacity is being added. In addition, they should start internally using more ethylene with the Wilton LDPE plant comes online, potentially avoiding some of the pressure on ethylene prices from the increase in capacity in the Middle East.
3) Global recession
4) Overhang from MatlinPatterson/Huntsman family joint 59% ownership.
Catalyst
1) End of tax-loss selling come January 1, 2006
2) Payment of debt ~ should be up to $1,000 mm in FCF in 2006.
3) Reduction in North American natural gas prices
4) Opening of the MDI plant in China ~ HUN has been investing in this for the last two years and will only start realizing income midway through 2006.
5) Potential split between commodity business and specialty chemicals business post debt paydown. ~ this would allow for a more appropriate multiple to be placed on the polyurethane, advanced materials and performance chemicals business.