2023-05-22 15:17:04 ET
Summary
- Cyclical plays are a bad bet at this stage of the cycle, and Olin’s heightened sensitivity to the broader markets is even more concerning.
- The Epoxy division is in a bad way.
- FCF generation is under pressure.
- FY23 estimates look underwhelming and make forward valuations look pricey.
- On the charts, we don’t like the risk-reward on offer.
Company Snapshot
Olin Corporation ( OLN ) is a Virginia-based chemical company with long-standing expertise in the chlor-alkali space (130 years of experience and 54% of group sales). Some of the company's chief products include caustic soda, chlorine, hydrogen, bleach products, epoxy materials, aromatics, industrial cartridges, and ammunition (both sporting and military) OLN's products are utilized primarily by industrial and commercial entities across the globe (39% of group sales come from outside the US).
We believe there's a time to pursue stocks such as OLN, but that time isn't now. Here are a few reasons why we are not ready to jump on the OLIN bandwagon at this juncture.
Cyclical impact and high sensitivity to broader markets
At this stage of the business cycle, it is unwise to get too cozy with commodity chemical plays, given the inherently pronounced sensitivity to global GDP. The IMF was already previously expecting real global GDP growth to decline from 3.4% in FY22 to 2.9% this year, but this has been scaled down once again to 2.8% as per its most recent forecast in April.
These underwhelming GDP numbers will no doubt leave a mark on chemical volumes. Statista believes that FY23 chemical volumes in important regions such as North America (1.9% vs 2.7% in FY22) and Europe (1.6% vs 1.3% in FY23) will fail to keep pace with what was seen in FY22 whilst no region is expected to see an improvement in these growth rates.
On account of difficult industry-related conditions expect pressure on both the topline and operating level (according to Fitch, revenue growth will be subdued at 1.6% while margins look poised to contract by 40bps) whilst financial leverage pressures will inch up on account of weak operating leverage and a tight monetary policy environment. The only thing that may stay resilient is FCF conversion, but as you'll see later on in this piece, Olin is likely to struggle here as well.
A weakening growth dynamic should weigh on the performance of broader markets, and it doesn't help that Olin's stock is hyper-sensitive to the movements of the benchmarks. As you can see from the image below, Olin's beta has increased over the past year, and currently stands at an elevated reading of over 2x!
Epoxy division concerns
Olin's second-largest division - the division which produces epoxy materials and precursors (~29% of group sales) is in a bad way, and it would be unrealistic to expect a quick turnaround.
Demand in the American and European markets continues to be weak, and management has also acknowledged that they resorted to overpricing in some of these markets, which impacted their positioning. Note that Chinese producers have also ramped up the supply position, and because demand in the Asian markets isn't resilient enough, one is facing an overdose of supply in the export markets.
If you're affected by either one of volume or pricing challenges, Olin could perhaps be better positioned for a rapid bounce back, but when you're hamstrung by both sides of the equation, it becomes even harder to recover. For context, out of the 54% YoY revenue decline of this division, 25% was from lower volumes, and 5% was from weak pricing. FX impacts and the closure of certain units also left a mark. Olin is currently in the process of making adjustments to its global epoxy asset footprint and will incur additional restructuring costs linked to the closure of certain units (management expects another $30m of fresh restructuring charges)
Ongoing free cash flow pressures could weigh on buyback momentum
OLN management takes great pride in their fidelity towards buying back the stock, but if recent FCF pressures were to persist, it could put a spanner in the works. Besides, also note that buyback trends have already been slowing over time. A year ago, the company was deploying around $400-$450m of cash per quarter on buying back stock; these days it has halved.
Coming back to the FCF, we can see that the company failed to generate a positive number in the March quarter (-$24m), and whilst weak profitability played a part, Olin also didn't do a great job in managing its working capital well enough.
The cash conversion cycle gives you a sense of how long cash is tied up with working capital, and we can see that it recently hit 5-year highs of 65 days in the March quarter (Olin typically keeps it at less than 50 days).
The prime culprit here was the heightened amount of inventory build-up which came in at 64 days, a 10-year high, and ended up sucking out $146m of cash!
Weak market and demand conditions for caustic soda, vinyl intermediates, and epoxy materials are expected to linger for the foreseeable future, so don't expect a rapid decline of those heightened inventory levels. Needless to say, this could be a drag on cash generation. Cash gen could also be pressurized by upcoming international tax payments of $50m-$100m for the company's power assets in the Gulf Coast.
Underwhelming sell-side estimates for FY23 leave an adverse mark on forward valuations
Olin has been incurring heavy margin pressure for over a year now (the image below highlights how the EBITDA margins have been sliding on a trailing twelve-month basis), and that is unlikely to abate as we progress through this year.
As per YCharts estimates (the average estimates of 12 sell-side analysts) group revenue in FY23 will slump by -17% YoY, but the EBITDA impact will be even more pronounced at -30% YoY (this would imply that margins drop to 22%, almost a 400bps YoY impact)!
In the Q1 presentation, Olin's management suggested that EBITDA in FY23 could be in the ballpark of $1.6-$1.9bn. Consensus currently is a little lower than the mid-point of that range, at $1.71bn. On that EBITDA number, the stock currently trades at a pricey forward EV/EBITDA of 5.6x, which would constitute a 20% premium over the 5-year average multiple of 4.68x . Even if we assume a drastic turnaround in H2 (which looks unlikely) with the company hitting the upper end of the range, that would still point to a pricey EV/EBITDA of 5.1x, which is still above the long-term average.
Unappealing technical landscape and limited support from institutions
If one considers the weekly price imprints of OLN over the last two years or so, we can see that things have been rather choppy, with the stock making large swings within the $43 to $61 range. We are yet to see any price range where the stock has managed to stabilize, and thus it becomes even more pertinent to play the two boundaries and take positions accordingly. In that regard, if one were to kick-start a long position at the current price point, the risk-reward does not work in your favor. You typically want to take positions where the reward-risk equation is over 1x. But at the $54 level, the equation works out to a sub-par number of 0.84x
The other thing to note is that Olin is unlikely to benefit from any mean-reversion interest for those fishing in the materials sector, as its relative positioning versus the Vanguard Materials ETF is still quite elevated (~48% higher than the mid-point of the long-term range).
Ideally, you also want to see the guys with deep pockets, to turn more constructive on your stock, but that theme is yet to be reflected with Olin. Both the total number of institutions that pursue Olin and the net shares owned by them have been sliding every single month since the turn of the year. For context, on a YTD basis, the former metric is down by 11% and the latter metric is down by 18%.
For further details see:
5 Reasons Why We're Avoiding Olin At This Juncture