CHMT - Can they repurchase 50% of the market cap in 1 go?

Chemtura (CHMT, $22.38, $2.1 Bn Mkt Cap, $2.5 Bn EV)

Idea source: Divestitures, PAH acquisition, biggest recent daily drop.

Potential source of dislocation:

·         Event fatigue: CHMT had been a “special-sit” for 3-4 years counting – topics include the emergence from bankruptcy circa 2010-11, incentives to hit 2011 EBITDA guidance, and continuous divestiture of non-core assets.

o    On April 17^th, CHMT announced the sale of its Agrochemicals business to PAH for $1 Bn, or roughly 9.8x 2013 EBITDA. This price-tag is below the 11-12x or $1.1-1.2 Bn most expect. The $200 mm difference (or ~$2 / share) is immediately baked into the stock and pressures share downward amidst general market weakness.

o    Post this catalyst, there exists no obvious event path. Hence stock is in the limbo of neither special-sits nor long-only value (given lack of bulge-bracket coverage)

·         Train-wreck avoidance: Given the extreme cold weather of El Dorado, Arkansas in Jan-Feb 2014 (often below 20F, where Bromine’s freezing point is 12’ F), ~60% of CHMT’s Bromine capacity was hindered (~15-20% of total sales post Ag divestiture) and will negatively impact 1Q result. Funds may attempt to avoid exposure ahead of such.

·         Poor screen-test: Due to declining top-line (divestitures), stagnant EBITDA margins (cyclical weakness in 1 of its segments), and recently negative FCF (capacity expansion & divestiture), CHMT may not screen well.

Company description: CHMT is a specialty chemicals company that has 4 lines of businesses:

1.     Makes additives into fuel (grease and chemicals that go into gasoline to make cars run more efficiently and cleanly) and lubricants (like Lubrizol)

2.     Urethanes (basically plastic that goes into golf balls, solid tires for heavy equipments, etc),

3.     Bromine & derivatives (flame retardants that go into foam insulates in buildings, circuit boards, etc, also mercury control, and as drilling fluid), and

4.     Organometallics (catalysts that help create more complex chemical compounds)

Thesis: 2:1 risk/reward w/ potential for 30-40% IRR, playing for sized (50% O/S) stock repurchase.

·         Upon closure of Ag-segment sale by 2015YE, CHMT will obtain ~$850-900 mm in cash. Along with (a) the ~$ 150-200 mm FCF it generates in FY14 and 15, (b) $549 mm of cash, and (c) ~$900 mm of total debt, CHMT is set to have ~$650 mm net cash position in 2015. With the management vocal about 2x net debt / EBITDA in leverage, on $220 mm pro-forma EBITDA, CHMT has roughly $1.1 Bn of firepower, or roughly 50% of market cap, to return capital to shareholders. Management is very vocal about the subject and will likely pursue the tender-offer path.

·         Assuming the slump of Bromine continues (flat margin and top-line) and CHMT remains around the current price ($22-23), management can repurchase ~9 mm, 31 mm, and 12 mm shares in 14, 15, and 16, effectively bringing EV down to ~$1.4 Bn and market cap down to $1 Bn.  In such a scenario, CHMT is being valued at ~6.4x FY2015 EV/EBITDA, below virtually all specialty chemicals comps (7.5 – 12 x) at arguably depressed earnings (12-13% EBITDA margin vs. 15-30% peers).

·         The downside scenario we have is around $18.50 / share (5.5x our FY2015 EV/EBITDA). Even during the down-turn circa 07-08, CHMT still manages to squeeze out 9-10% EBITDA margin. While the mix is different now, it would take sizably lower additive and lubricant demand (suggesting economic downturn) and another cyclical hit to Bromine (all amidst the mercury policy lift, potential European recovery, and O&G ramp in clear-brine fluids) to get us there. But in such a case, the stock price will then be situated around CEO’s 1 mm option strike zone ($15-$20) all with CHMT’s massive cash infusion. We believe the price may also be tempting to many investors with ~10-11x 2014 P/FCF.

·         The upside case is $30+ with multiple ways to win: (a) Oil additives & Lubricants out-perform as transportation fires in all cylinders, (b) Bromine pricing turns for various host of reasons, and CHMT drives towards 20% EBITDA margin in this segment, (c) Announced stock-tender jump-starts immediate upside, although time-line is uncertain.

·         Ultimately, CHMT is a bit of a grinder-stock: we do not see any immediate catalyst that makes the stock work, but it generates good free cash-flow, has an incentivized CEO at the helm that cares about shareholders, and will receive a pile of cash within the next 18 months. The current setup provides 2:1 risk-reward with potential to 30-40%+ compounded returns over the next 2-3 years should every box checks out. Barring another recession, the current 5-7% FCF yield can easily bail an investor out over time.

 

Risk:

·         Bromine-based flame-retardant could be in secular decline as major electronics manufacturers phase out given toxicity – certainly, yet such dynamics (1) places premium and barrier of entry on firms that have non-toxic products an (2) comfortably dissuades new entrants. Additionally, if the rise of cloud computing takes hold, given (a) the segregated nature of these clusters from consumers, (b) heightened risk to a shut-down due to fire hazard, and (c) the favorable economics of bromide products, the rise here should help offset consumer-driven slumps.

·         Continuously weak Bromine price alongside weak traffic could cause downside volatility: see chart below. Guangdong bulk Bromine pricing shows no sign of slowing down and, while it is more commoditized than CHMT’s specialty derivatives, the decline nonetheless causes my concern.

·         CHMT was and continues to be a crowded idea – sell-side is all over this name w/ $30+ PTs and a lot of event-driven buyside firms know the name. 2 problems with this point: (1) I am a generalist who only looked at this name for <1 week, while the seller arguably knows the space and has been very involved. While the conclusion of event may have led to event-funds forced selling, the feeling that I have an informational disadvantage is incredibly strong. (2) With buy-back further shrinking the size of the company, one may wonder who the last buyer to print the blue-sky PT may be.

 

What will make me change my mind / reassess thesis?

·         If Bromine prices in Guangdong shows no sign of reversal – a far bigger problem may be brewing in China alongside unbridled capacity add.

·         If management changes tone about its capital-return plan and decides to hold it on balance-sheet. In which case they may be preparing themselves for winter/uncertainty.

·         If the additive/lubricant side of the business shows strong signs of weakness – meaning economic recovery is hitting a strong speed-bump.

·         If a powerhouse comes up with a flame retardant that is superior in all spectrums.