|Shares Out. (in M):||42||P/E||23||20|
|Market Cap (in $M):||2,331||P/FCF||0||0|
|Net Debt (in $M):||381||EBIT||0||0|
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NGVT presents an opportunity to invest in company with a near monopoly in a highly profitable niche market that has the potential to double over the next 5 years due to regulation implementations. The company also provides a call option on recovery in drilling activity, increased infrastructure spending, and growth in general industry activity. Based on regulations already on the books and no assumption of recovery in these end markets I calculate 40%+ upside from current levels.
NGVT is a leading global manufacturer of specialty chemicals and high performance carbon materials. The company spun out of WestRock (WRK) in May of 2016. NGVT operates two segments, performance chemicals (~70% of revenue, ~40% of EBITDA), and performance materials (~30% of revenue, ~60% of EBITDA). In performance chemicals, the company produces tall oil fatty acid, tall oil rosin, and other crude tall oil distillates for use in applications such as pavement technologies, oilfield technologies, and industrial specialties. The reason to buy the stock is the performance materials segment. NGVT has a near monopoly on the high margin activated carbon market for auto emissions control. The company’s product is installed in the gas tank canister and reduces gasoline vapor emissions. Emission regulations are expected to double the market with majority of the benefit accruing to NGVT.
Niche-market suppliers in a large industry can be fertile grounds for attractive investments. In some ways, these types of companies function as toll-roads. They extract a small piece of the economics from every unit in a large industry but make up only a small piece of the overall industry cost structure. These markets are frequently characterized by mini-monopolies with substantial barriers to entry due to customer relationships, product assurance benefits, and domain expertise. NGVT’s performance materials segment is an embodiment of these attractive forces.
NGVT engineers, manufactures, and sells chemically activated carbon products for use in gasoline vapor emission control systems in cars, trucks, motorcycles, and boats. The finished goods look like little black pellets and cylindrical blocks and sit inside a vehicle’s gasoline tank. The activated carbon absorbs gasoline emissions that would otherwise be released into the atmosphere as volatile organic compounds (VOCs) and contain hazardous pollutants. These are different than tailpipe emissions. Gasoline vapor emissions are released during refueling and when the fuel tank is exposed to heat- both from vehicle operations and sitting in the sun. NGVT’s activated carbon products capture the vapors and redirects them to the engine as fuel. The measurement of the carbon’s ability to capture the vapors is called butane working capacity or BWC. BWC is the yardstick used by regulatory organizations around the world. The company’s direct customers are auto part manufactures (Delphi, Futaba, Mahle, and others) who supply to auto OEMs.
The company’s essentially sells 3 solutions sets of its activated carbon product with each corresponding to a regulatory “tier.”
EPA Tier 0. BWC of 5-11, contains 0.5-1 liters of activated carbon, and generates revenue of ~$1/vehicle
EPA Tier 1 and 2. BWC of 11-15, contains 2-3 liters of activated carbon, and generates revenue of ~$8/vehicle
EPA Tier 3. BWC of 15-17, contains 2-3 liters of activated carbon and NGVT’s patented honeycomb scrubber device, and generates revenue of ~$20/vehicle
Market share, industry structure, and barriers to entry
To say NGVT’s market share is dominant would be an understatement. Its global market share is close 90%. The competition that does exist is primarily in the less profitable tier 0 and tier 2. The company essentially has 100% market share in the tier 3 standard. The company has maintained this position while implementing low-single digit annual price increases. NGVT possesses several barriers to entry which have enabled this dominance and should continue to insulate the company’s positioning going forward. First is a technological advantage. As a result of decades of innovation and production experience, NGVT’s products are unmatched in terms of BWC effectiveness. Due to a proprietary design and process, NGVT’s solution achieves higher BWC with less physical activated carbon. This allows for a smaller and less costly canister in the emissions system. The company’s specialized honeycomb scrubber, which is utilized in the tier 3 solution is patented through 2022. NGVT’s product is cheaper and better.
Second, the company’s long standing customer relationships and reputation for compliance serve as a substantial competitive advantage. Given the relatively low cost of NGVT’s product versus the total cost of a car, the significant risks that come with emissions-noncompliance make switching to an unproven competitor not worth it. No one wants to be the next Volkswagen. Furthermore, there are switching costs. Because gasoline vapor control systems are certified as “environmental devices,” it is challenging and costly to replace with a competing product during the life of the vehicles model’s production due to the expensive recertification process.
Lastly, I would argue that NGVT benefits from efficient scale. While increased regulation provides an opportunity for the performance materials segment to double in size over the next 5 years, the overall automotive activated carbon market is not big enough for a new entrant to make the capital investment needed to compete with NGVT. Also, given the length of OEM design cycles, a company developing a competing product today would lose out of much of the regulation-driven growth over the next few years.
For these reasons, I believe NGVT will maintain their market position at the high end for the tier 3 product over the intermediate term. Any share loss will most likely come in the less profitable tier 0 and tier 2 markets. The company’s main competitors are Cabot Corp and Calgon Carbon.
Regulation in Canada and the US is already on the books and has a phase in schedule running until 2022. As of 2015, every new car sold in the US and Canada must meet at least tier 2 standards. Beginning in 2016, 20% of new cars sold had to meet tier 3 standards. That increases to 40% in 2017, 60% in 2018, 80% in 2020, and 100% by 2022. The most significant Ex-US regulation is China. In January, China published the final guidelines for “China VI” which will go into effect July 1, 2020. The regulation requires all vehicles sold to meet tier 2 standards and allows for provinces to adopt early. While acknowledging that Chinese policy is not without its risks, previous government action and language suggest that pollution reduction and emission control is a legitimate priority. For what it is worth, the Chinese auto analysts and policy experts I have spoken with saw limited risk to China VI being adopted on time and thought there was potential for early adoption. Other regulatory proposals include: South Korea tier 3 starting 2018, Brazil tier 2 proposed starting 2019, Japan tier 2 proposed starting 2020.
Putting it together
Using the revenue/vehicle figures, regulatory phase-in schedules, and some assumptions around market share and global SAAR (US/Canada down slightly, China +3%/yr), you can ballpark segment revenue growth.
This aligns with management’s expectation for the performance materials segment to double over the next 5 years.
The segment’s 2016 EBITDA margins were an attractive 40%. That included a planned factory outage which negatively impacted margins by ~250bps in 2016. Management has said publicly that the segment’s cost structure is 80% fixed and 20% variable. Margin drivers going forward are product mix and increased plant utilization. The regulation-drive growth is coming from the significantly more profitable tier 2 and tier 3 products. The company produces activated carbon in two plants in the United States and opened a third plant in China in late 2015. As the 3rd plant ramps, NGVT should benefit from better utilization. Management believes these three factories provide sufficient supply to meet the growing demand over the next 5-10 years. I haircut management’s cost structure comments and model 65% incremental margins for the next three years and then fade to 50%.
The PC segment will likely drive near term volatility in the stock. NGVT converts crude tall oil (CTO) into higher value derivative chemical products. The segment’s end markets, market position, and competitors are below:
Pavement technologies, 24% of 2016 segment revenue. NGVT supplies specialty asphalt additive products used in road construction and resurfacing. They are the #1 or #2 player and compete against AkzoNobel, Arkema and ArrMaz.
Oilfield technologies, 10% of 2016 segment revenue. NGVT sells well service additives for oil-based drilling fluids and corrosion inhibitors for equipment and pipes. The company says they are “top tier” in market positon and compete with Georgia-Pacific, Lamberti, and Arizona Chemical (owned by Kraton).
Industrial Specialties, 66% of 2016 segment revenue. NGVT produces various specialty chemicals used in industrial settings. (Examples: adhesive tackifiers, agrochemical dispersants) They are #1 or #2 in the relevant product categories and compete with Eastman Chemical, Kraton, Georgia-Pacific, and Respol/Forchem.
The segment has been challenged. Revenue in 2016 was down 13.7% due to a 25% drop in oilfield technology revenue and a 16% drop in industrial specialties revenue. Oilfield technologies has been negatively impacted by both lower overall drilling activities and low oil prices making hydro-carbon based substitute products less expensive. Industrial specialties was hurt by lower demand from weak general industrial production and pricing pressure in their generic CTO products.
Despite the revenue headwinds, the company has taken steps to improve profitability and rationalize market supply. In 2016, NGVT implemented a cost reduction program which yielded $30m savings in 2016. Additionally, the company announced in November that they were closing a CTO refinery in Palmeira, Brazil. The facility represented approximately 10% of the company’s refining capacity and was its highest costs refinery. I view this as a decision favorably. It demonstrates the company’s focus on profitability and desire to improve the supply side of the market.
The PC segment revenue drivers are largely macro related (drilling activity, road construction, general industrial activity) which makes modeling sales largely a shot in the dark. Below are what I believe to be conservative estimates. (ie. not betting on an oil recovery or major acceleration in GDP growth or infrastructure spending)
Historically EBITDA margins in the PC segment have been as high as 20%+. Management has said they believe a return to the 18-20% range is achievable over the next 24 months with half of the improvement coming from self-help cost reductions and half from market recovery. I give them credit for the self-help half but only to the bottom of the 18-20% range. This equates to 125bps annual improvement over the next two years:
NGVT has a 10-year supply agreement with WestRock for CTO. The contract has a price floor which has prevented roughly half of the segment’s raw material costs from failing by the same magnitude as selling prices. In mid-2017 the floor starts to adjust on a quarterly basis, which will provide a lift to margins if selling prices remain depressed.
Capex spiked in 2015 to ~$100m due to the construction of an activated carbon manufacturing facility in China. With this new plant completed, the company believes they have sufficient manufacturing capacity to meet the increase in regulation demand over the medium term. 2016 capex was $57m reflecting a more normalized maintenance spending environment.
The company has guided to $80-90m in FCF in 2017 and >$100m in 2018. With its most recent quarterly results, the company announced its first share repurchase authorization for $100m. Other near term capital uses could include paying down debt (currently 1.9x net debt to EBITDA) or strategic M&A. Management stated future acquisitions would likely come in the PC segment and align with the company’s strategy of moving towards higher margin/higher value-add chemical products. Over the medium to longer term, management has alluded to the possibility of instituting a dividend.
It is worth noting that the company pays a full 35% tax rate. Any corporate tax reform would help cash flow and earnings.
Given the differences in margin profile and growth, I believe it is appropriate to value the segments separately. I apply an 8.4x multiple on 2018e performance chemical EBITDA based on average of specialty chemical peers CE, EMN, and CBT. On performance materials, I use ALB’s 15.4x 2018 EBITDA multiple. This sum-of-the-parts valuation derives a share price of ~$76 which equates to 43% upside from current levels.
Another way to look at valuation is the market implied performance chemical segment value. I argue that, on a standalone basis, NGVT’s performance materials segment deserves at least ALB’s multiple. NGVT’s PM segment has 2x ALB’s EBITDA margins and better growth but to be conservative I’ll use ALB’s 15.4x. This multiple on my 2018 estimates implies a negative value for the performance chemicals business:
The stock is too cheap based on what I believe to be very conservative assumptions. There is potential for upside in both of my segment estimates. The current price, in my view, provides ample margin of safety versus the fundamentals of the business. To emphasis this point, I consider upside and downside scenarios with the following assumptions:
Performance chemicals: Revenue continues to decline low-single digits. Management is unable to extract further cost benefits and margins stay flat from 2016.
Performance materials: NGVT losses ~20% of tier 3 market share over two years. Segment revenue grows 5% in 2017 and 6% in 2018. Margins stay flat from 2016 ex-plant outage.
Valuation: 20% discount to comp group
Performance chemicals: Segment revenue is flat in 2017 but returns to growth in 2018 with 7.5% revenue growth. Leveraging the topline and continued cost reduction EBITDA margins return to 16%.
Performance materials: Same revenue growth as base case but I give full credit to management’s cost structure comments
Valuation: 20% premium to comp group
In sum, NGVT provides a very favorable distribution of outcomes with 91% upside in the bull case, 43% upside in the base case, and -15% downside in bear case.
Risks to thesis
By far the biggest risk to the thesis is if the gasoline emission regulatory implementation schedule does not proceed as expected. I believe this risk in the United States and Canada is relatively low for a couple of reasons. First, the regulation is already on the books and is already being implemented without problem or major push back from auto manufacturers. That is not to say that it could not be rolled back, but that is less likely than the risk of a new piece of regulation not being approved. Second, compliance can be achieved at a relatively low cost for auto OEMs versus the total production cost of a vehicle. Including a gasoline emissions device is hardly an onerous regulation. The regulatory risk in China is harder to evaluate because 1. Implementation is still multiple years away and 2. It’s China. Government commentary and action suggest that pollution reduction is national priority however this is a risk that deserves close monitoring.
Intellectual property in Performance Materials
NGVT’s dominant market share in activated carbon was achieved due to the company’s superior proprietary process to maximize BWC. If another company were to discover NGVT’s trade secrets or innovate its own more effective process it would be a significant risk to NGVT’s market position.
Global Automotive Sales
NGVT’s performance materials segment is dependent on auto production. A recession or prolonged period of economic weakness leading to a significant reduction in auto sales would negatively impact the company’s results.
Electric vehicles do not need gasoline and thus have no need for gasoline emissions systems. While today electric cars make up a very small percentage of global sales, a significant increase in electric car penetration would be a negative for NGVT.
Macro risks in performance chemicals
NGVT’s performance chemicals segment is exposed to several macro factors. The pavement technology business is largely dependent on government infrastructure spending. Oilfield applications depends on drilling activity and is thus reliant to some extent on the price of oil. Industrial specialties depends on general industrial activity. Slowdown in any of these end markets would negatively impact NGVT.
CTO price exposure and relationship with WestRock
CTO accounts for ~20% of all costs of goods sold. Major price swings can affect profitability. The company has a 10-year supply contract with WestRock to source ~50% of the company’s CTO needs. If WestRock were to go out of business, filling that supply from other sources could be a challenge.
Additional countries implementing gasoline emission regulations.
Increased drilling activity.
Higher CTO prices.
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