CAP STRUCTURE:
COMPANY OVERVIEW
Rockwood Holdings (ROC) is a US based global specialty chemicals company operating 81 facilities in 23 countries across five business segments (recently expanded from 4 as seen below):
1) Specialty Chemicals (37% of 2011 net sales) includes leading global supplier of surface treatments products and solutions for metal processing industries and leading global producer of lithium products.
NOTE: as of Q1 ’12 the company separated surface treatments and lithium. For Q1 ’12 these segments were 20.7% and 12.6% of net sales. Previous annual levels should be updated upon the filing of their next K.
2) Performance Additives (21% of 2011 net sales) includes color pigments for concrete products, paints, and a leading provider of a new generation of alternative timber treatment chemicals, and clay based additives used for coatings, inks, household products and other applications.
3) Titanium Dioxide Pigments (25% of 2011 net sales) operated as a 61% owned JV with Kemira Oyj and includes a leading producer of specialty grade TiO2 produced through the sulfate process, rather than the chloride process, which allows production of both anatase products and rutile products rather than only rutile. Most global production is rutile, but anatase results in less wear and tear on application machinery, and is typically used in synthetic fibers, rather than coatings, inks, plastics etc where rutile is used.
4) Advanced Ceramics (16% of 2011 net sales) a leading global producer for end markets including medical, electronics, industrial, and automotive focusing on niche applications. Almost all advanced ceramics products are made to order based on specific customer requirements.
The company provides products that they believe are generally critical to the success of their customer’s final products, but account for a small portion of the total cost of the final products. No single customer represented more than 2% of sales in 2011.
While the company is economically sensitive, this is somewhat mitigated by the fact that the company has more than 60,000 customers across a variety of end uses as demonstrated by the following breakdown of 2011 net sales by end use markets:
INVESTMENT HIGHLIGHTS / CATALYSTS
1) Demand growth for Lithium is expected to remain strong
The runway for iPhones, tablets, and other consumer products that depend on lithium based batteries remains long as global consumers continue to upgrade their mobile devices. Additional demand comes in the form of portable power tools and other consumer electronic items.
The real step change will come from the eventual adoption of hybrid / battery powered vehicles, with some analysts expecting a 500% increase in demand for lithium associated with vehicles in the coming years.
Today batteries represent ~30% of total lithium demand. Sell side estimates put battery demand at 50% of total demand by 2020. Other uses include ceramics, glass, and lubricants.
Currently, lithium producers enjoy an oligopolistic pricing environment and have been able to consistently raise prices (up 300% since 2000) as demand increases. Of course, global supply is increasing as demand increases, but with a 3-4 year lead time before new mines/plants can become operational, the current pricing structure will remain in place for some time.
Additionally, when new entrants are able to come online, ROC should be able to maintain their status as a low cost producer. Unlike lithium used for ceramics, glass, etc, battery grade lithium must undergo significant refinement through techniques which ROC has been perfecting for years, and new entrants will have to attempt to replicate.
While the trend will likely be for battery grade lithium to drift toward a pure commodity pricing structure over time, I believe ROC will enjoy customer loyalty for some time. For example, historically a major complaint from AAPL users has been related to battery life. This hurdle seems to have been cleared in recent years, but the company is likely aware that customers remain suspicious of battery life, and AAPL will likely want to stick with a known and proven source of high quality lithium.
2) The company has long noted that TiO2 is not a core business, and has engaged a bank to examine strategic options for the TiO2 business.
While management contends that their Ti02 business is adequately specialized to demand a higher multiple than other Ti02 businesses, market perception is that Ti02 is a straight commodity business, and thus less valuable than ROC’s other business lines. On the Q1’12 conference call management announced that they had engaged Lazard to examine strategic alternatives for the business, with the likely outcome being either an IPO or a sale. Regardless, this business is probably worth somewhere around $900M to ROC (4.1x 2012 EBITDA, with minority interest backed out) – money which can be used to pay down debt, or returned to share holders. The pro forma business should command a higher multiple as claims that other product lines enjoy oligopolistic pricing are easier to justify than the Ti02 business.
3) Continued Debt Reduction / Return of Cash to Share Holders
Management has consistently stated that cash use priority would be 1) expanding Li production capacity, 2) paying down debt, and 3) returning cash to share holders. They have been true to their word, aggressively paying down debt, and implementing a dividend (3.3% yield) for the first time in the most recent quarter.
Net Debt/LTM Adjusted EBITDA Source: Presentation at DB Industrials Conference, 6/13/12
4) Motivated Management
Not only is management excellent from an operational standpoint, but they own more than 9% of the company (#2 holder KKR has 2 board seats). Conference calls indicate a clear preference for profit over revenue growth, and margin maintenance against a difficult macro background and rising input cost environment has been impressive. They have consistently stated that priority use of FCF would be to expand the lithium business, pay down debt, and return cash to share holders. Debt has been significantly reduced, and a dividend was instituted for the first time in Q2’12.
RISKS / WHY IT IS CHEAP
1) European Exposure
Approximately 63% of 2011 net sales were denominated in Euros, and current share prices reflect continued macro / European concerns. However, it is important to recognize that while production takes place in Europe (primarily Germany), sales are largely generated via exports, meaning that continued weakening of the Euro may help accelerate sales to some extent.
Additionally, a substantial portion of the company’s total debt is denominated in Euros (448.2 Euros), allowing the company to more easily pay down debt in the event of continued Euro weakness.
Worst case scenario would be a return to the Deutsch Mark, which would likely be the strongest currency in the region, and thus negatively impact exports.
In summary, despite very real Euro related concerns, demand for ROC’s products will continue to rise over time independent of the macro outcome in Europe, and patient investors will be rewarded.
2) The Ti02 Business Is Seen As A Drag By The Investment Community
Ti02 demand remains strong, but input costs are rising faster than producers can raise prices leading to margin squeeze. Additionally, Ti02 is not as specialized as ROC’s other business units, leading to a lower multiple. However, the company intends to divest the Ti02 business. Short term this may lead to dilution, but longer term, it will lead to a stronger pro forma company.
3) Asian / Luxury Exposure
Many of the company’s products are sold into the German luxury auto market, with an eventual destination of Asian buyers. Recent commentary from luxury retailers has indicated a softening in demand from Chinese buyers as the Chinese economy cools and as new government rules meant to reduce bribery in the form of luxury gift giving are set to go into effect.
However, over the course of the global recession luxury sales have proven to be resilient, and I believe luxury auto demand is independent of luxury demand attached to gift giving, which is more likely focused on smaller, less conspicuous items like watches and other fashion accessories than automobiles.
While I believe that continued slowing in China is a likely scenario in the near term, I believe luxury spending will remain robust on a longer time line.
VALUATION
ROC is a business with strong growth in front of it that is currently trading at historically low multiples.
Historical EV/Consensus forward EBITDA, and P/Consensus forward Earnings:
Assuming growth in line with recent performance and multiple expansion to levels in line with historical performance, ROC is currently priced with a large margin of safety, and should significantly outperform indexes over the next 2-3 years.
Given the high quality mix of ROC’s business, and based on comparative multiples for other specialty chemical companies, I believe a 7.5x EBITDA multiple is appropriate, indicating significant mispricing.
On an EPS basis, the mispricing is more pronounced. While like most industrials there is some variability in ROC’s earnings, their record of strong growth, excellent management, and long runway likely deserve at least a 14x multiple.
KICKERS
The company has consistently made it clear that lithium and surface treatments are their primary focus. However, while not central to the thesis, other business lines are well run and should add value on a longer time line. Additionally, ROC would make a nice tuck in acquisition for a larger competitor in the chemical space.
1) ROC is one of the more likely takeover candidates in the chemical industry
2) The performance additives business is tied to construction, and an eventual rebound in the housing market will be a strong tail wind.
3) The advanced ceramics business is tied to solar panels, and has suffered due to uncertain subsidy environment globally. However, longer term increased production of solar panels seems likely.
4) The advanced ceramics business is FDA approved for ceramic hip joints – as metal on metal joints face increasing criticism, and the global population ages, demand for this high margin business should improve.
SUMMARY
While European concerns are weighing on all investor’s minds, ROC is a solid company with an excellent operating history, long runway of growth, and a motivated management team. Patient investors that can look past near term European uncertainty will be rewarded by significant EPS growth and multiple expansion.