2023-05-17 15:27:39 ET
Summary
- Huntsman could be a better company in 5 years as it has exited some poorly performing segments and is trying to focus on those with high ROIC/margins.
- They are also shareholder friendly, as evidenced by their growing dividends and large share buybacks.
- And they are also cheap on an EV/EBIT multiple basis, with room to expand their multiples once the market recognizes the improved business.
Thesis
Whilst screening for companies that have a low P/E ratio, buy back shares aggressively and also pay a dividend, I found Huntsman ( HUN ), which I am quite familiar with as they have a plant in my town. And this company has many of the characteristics that could make it a very rewarding investment.
They have improved their future prospects by exiting low-margin businesses and trying to focus on higher-margin ones, while returning a lot of cash to shareholders and offering the possibility of multiple expansions. And with earnings currently depressed by economic conditions, this could lead to big paydays for shareholders in the future as earnings normalize.
Analysis
The difficult situation in Europe and global inflation are having a big impact on Huntsman at the moment, but this should be temporary as the economy should improve at some point in the future. Lower sales volumes put real pressure on revenues and margins, resulting in a suboptimal performance in the last quarter. However, they have improved their sales mix and therefore had higher average selling prices in some cases, which should lead to good earnings improvements as demand normalizes.
The 26% year-on-year revenue decline is a big hit , but things should improve in late 2023 or early 2024 as Europe and China are on the road to recovery. Huntsman is working hard to improve the outlook for the company, and the problems they are having at the moment are more due to the wider economic environment.
New Corporate Structure
Huntsman's new structure after exiting businesses that did not generate acceptable returns is as follows:
- Polyurethanes (~ 61% of sales)
- Advanced Materials (~18% of sales)
- Performance Products (~21% of sales)
And this new structure should lead to margin improvement as economic conditions change and business normalizes. The sale of the Textile Effects division will generate approximately $500 million in net cash while divesting its lowest-margin business. And with the new mix, they are not as exposed to volatile commodities as they were in the past. They are also working hard to improve their cost structure in the remaining businesses by redeploying staff and closing underperforming facilities, with a particular focus on Europe .
At present, however, it is uncertain how long low demand and destocking will continue to put pressure on margins as there is no clear guidance. Nevertheless, the recovery in China should be felt in the coming quarters. In addition, German economic data is showing signs of improvement and the European Central Bank may pause on raising interest rates at some point this year. Lower costs and more stable conditions in the future should lead to normalized business conditions for Huntsman.
And the strong demand for energy-efficient solutions in Europe is likely to drive the Polyurethanes business there in the near future.
And with $2 billion in cash + borrowing capacity and a net debt leverage of around 1, they should be able to weather the hard times.
Free cash flow for the last 3 months was negative $168 million, but as noted above, cash and debt capacity should be sufficient for more than 12 months. And although there have been some quarters of negative FCF in the past, the really strong Q4 usually turns the full year FCF into positive.
Shares Outstanding
As you can see from the chart above, they have put capital to good use by buying back shares that are likely to be undervalued, creating value for existing shareholders, and they have stated that they will continue to buy back shares as they plan to use $400m for this purpose in 2023. And that would be almost 10% of today's market capitalization.
Historically, the number of shares outstanding has been reduced by 2% each year , increasing the ownership of existing shareholders. So I would argue that the capital used for buy-backs creates value for existing shareholders at the rate of 2% per annum.
Multiple Expansion
And with a P/E ratio of 12.98x, which would be in the single digits on normalized earnings, there is room for multiple expansion, where I would argue that a doubling of the multiple is possible in the long term as the market recognizes the positive changes following the economic downturn. But for a more conservative approach, I would use 1.8x instead of 2.0x as the multiple in the calculation, to have more of a margin of safety.
Dividends
In addition, we see dividends being increased in most cases, further enhancing the total return to shareholders. And the dividend yield is currently around 3.75% . In the Q1 call , management also noted that capital allocation will continue via dividends and buybacks, with attractive mergers and acquisitions also a possibility.
The dividend yield is relatively high at the moment, but with a higher earnings multiple, the dividend yield is likely to be lower in the future and to be a bit more conservative with the assumptions, I would use 2% shareholder value creation per annum in my calculation through dividends.
And EV/EBIT also shows that the company is cheap relative to pre-tax earnings. So the biggest question will be whether they can grow their profits and defend them against the competition.
And this is one point where I have to say that I do not think they have a big enough competitive advantage because this is a very competitive market. Competitors such as BASF ( BASFY ) or Dow ( DOW ) are heavyweights with far greater financial resources and larger R&D departments.
Valuation
But despite having no competitive advantage, this could still be a very rewarding investment as many investors underestimate the compounding effects of dividends + buybacks + multiple expansion. Even if they only grow earnings by 5% a year, while adding 2% each in buybacks and dividends each year, and move from a single-digit P/E to a double-digit P/E (normalized), the annual return will be fantastic, even if the numbers alone look average to most.
- Earnings: 1.28 (5% p.a for 5 years = 1 x 1.05^5)
- Multiple: 1.80
- Shares Outstanding: 1.10 (2% p.a for 5 years = 1 x 1.02^5)
- Dividends: 1.10 (2% p.a for 5 years = 1 x 1.02^5)
1.28 x 1.80 x 1.10 x 1.10 = 2.79x over 5 years, or 22.78% per year.
The cheap valuation with room to grow makes this a potentially exceptional long-term investment, and there is also the possibility that Huntsman could be taken over or finds interesting acquisition targets.
And the cheap valuation combined with the balance sheet also acts as a safety net, as the downside is protected, but the upside is potentially huge.
Risks
There is a risk that the market will not recognize the improved business metrics and that the exited low-margin businesses will not be the catalysts we had hoped for.
Furthermore, there is also the possibility that the difficulties will continue for a much longer period, but that is why I have chosen a time frame of five years, because I think that is enough time for the temporary difficulties to disappear.
Other than that, I don't see much risk with Huntsman as I believe it is likely to generate high free cash flow later this year, coupled with a low valuation, which should be a big safety net for investors plus demand for polyurethanes is expected to pick up again, and the market is forecast to reach $100bn by 2028 , with a CAGR of 5% until then.
Conclusion
Huntsman is a really interesting idea at the moment, but I am not quite sure if this is the right time to build a position or if it is better to wait and see how things develop after the economic difficulties. But by then it could be too late if earnings surprise and the attractive multiple is gone. Because what makes this a fantastic opportunity, rather than just a good investment, is the potential for multiple expansion.
However, I believe the improvement in their business should bear fruit in the near future, and the metrics could even increase by more than I have calculated. So at the moment I am a bit torn between pulling the trigger or waiting a bit longer, because normally I would like to have some sort of competitive advantage, because I feel more confident when investments have one.
For further details see:
Huntsman Corporation: This Could Be An Excellent Investment Because It Has The Right Characteristics