2023-07-05 11:44:03 ET
Summary
- Net sales have recently increased thanks to product price raises, but volumes remain weak.
- Profit margins are depressed due to inflationary pressures, but cash from operations is high enough to cover interest expenses and capital expenditures.
- The company's long-term debt is manageable despite rising interest expenses, but the management should materialize its intentions to reduce it.
- Share buybacks have significantly reduced the total number of shares outstanding since 2020, but they should slow down soon as cash from operations is weakening.
- The recent share price decline represents a good opportunity for long-term investors with enough patience to wait for the current macroeconomic landscape to improve.
Investment thesis
Ingevity Corporation ( NGVT ) is a highly profitable chemical company that is not having a good time due to the current macroeconomic landscape. The slowdown of the world economy, the slower-than-expected economic recovery of China, and rising product prices due to inflationary pressures are causing a drop in volumes. To this, we must add that customers are not replenishing their inventories as much as would be expected due to increased prices and growing concerns of a potential recession due to recent interest rate hikes. These volume declines, as well as rising production costs, are keeping profit margins below recent years, and interest expenses have risen to high levels as a consequence of higher debt due to recent acquisitions, as well as rising interest rates. For these reasons (declining volumes, declining margins, increased interest expenses, and fears of a potential recession), investors remain on the sidelines as the company's prospects have worsened for the short and medium term.
Even so, the company continues to generate enough cash from operations to cover current capital expenditures and interest expenses and generate some excess cash despite such a complex macroeconomic context, so reducing current debt levels should not be a major problem. In addition, the management plans to reduce capital expenditures to offset declining cash from operations. Furthermore, profit margins were improving before the current headwinds, boosted by key acquisitions. For these reasons, I strongly believe that the recent share price decline of 51% represents a good opportunity for long-term investors with enough patience to wait for the current macroeconomic landscape to improve and offer more optimism to investors.
A brief overview of the company
Ingevity Corporation is a global developer, manufacturer, and seller of a wide range of chemical solutions for a wide range of industries and markets, including automotive components that reduce gasoline vapor emissions, asphalt paving, road striping, oil exploration and production, agrochemicals, adhesives, lubricants, publication inks, coatings, elastomers, and bioplastics. Until 2016, the company operated as a division of Westvaco Corporation and its corporate successors, including MeadWestvaco Corporation and WestRock Company ( WRK ), and was then separated as Ingevity, which has a current market cap of $2.13 billion.
Until now, Ingevity operated under two main business segments: Performance Chemicals, and Performance Materials. Under the Performance Chemicals segment, which provided 67% of the company's overall net sales in 2022, it mainly manufactures specialty chemicals and engineered polymers, and under the Performance Materials segment, which provided 33% of the company's overall net sales in 2022, it provides high-performance activated carbon that reduces vehicle gasoline vapor emissions. It's important to note that, in 2023, the company separated its recently acquired Capa caprolactone business (from the Performance Chemicals segment) into a single segment, which will be called Advanced Polymer Technologies from now on.
The company doesn't pay a dividend but performs aggressive share buybacks in order to reward shareholders by reducing the total number of shares outstanding, which means per-share metrics improve over time as results are divided among fewer shares.
Currently, shares are trading at $58.62, which represents a 51.32% decline from all-time highs of $120.41 on February 21, 2019. This decline responds to the current macroeconomic situation as volumes are declining due to a slower-than-expected economic recovery (especially in China) and weak customer restocking, and these lower volumes coupled with higher production costs due to inflationary pressures are causing a strong negative impact on profit margins amidst growing concerns of a potential recession and rising interest expenses. In this regard, investors remain on the sidelines as their projections are currently pessimistic. Nevertheless, I strongly believe this represents a good opportunity for long-term investors as the company has carried out some major acquisitions that have helped boost sales and profit margins (despite current margin contraction) since the spin-off, and current headwinds are, in my opinion, of a temporary nature due to their direct link to the current macroeconomic context.
Recent acquisitions
In March 2018, the company completed the acquisition of Georgia-Pacific’s pine chemicals business, which manufactures and sells pine-based tall oil fatty acids, tall oil rosin, and tall oil rosin esters used in adhesives, cleaners, paints and other coatings, inks, metalworking, mining, oilfield, packaging, and rubber processing, for $310 million. Later, in August 2018, it also acquired the remaining 30 percent interest in the joint venture Purification Cellutions, which manufactures honeycomb scrubbers, which are key components of Ingevity’s technology used by the automotive industry, for $80 million.
The acquisition activity intensified in February 2019 when the company acquired the Capa caprolactone division of Perstorp Holding AB, the global market leader in the production and commercialization of caprolactone and high-value downstream derivatives, including caprolactone polyols, caprolactone thermoplastics, caprolactone lactides, and hexanediol (HDO) with annual revenues of ~$175 million at the time of the purchase, for $653 million. These products are essential for adhesives, bioplastics, coatings, elastomers, and resins, and Capa delivered around 35% of adjusted EBITDA margins at the time of the purchase, which means it is a highly profitable business that should generate strong cash from operations for Ingevity.
In April 2021, the company announced a partnership and investment in GreenGasUSA Holdings, an integrated renewable natural gas ((RNG)) solutions provider helping customers reduce their environmental impact, and now Ingevity owns a minority stake of less than 50% as a result. A year later, in August 2022, the company also invested $60 million in the acquisition of an equity stake in Nexeon Limited, a UK-based lithium-ion anode materials producer, in order to enter the electric vehicle industry.
And the latest acquisition took place in October 2022 when the company announced that it completed the acquisition of Ozark Materials, a leading producer of pavement marking materials, including thermoplastic pavement markings, waterborne traffic paints, and preformed thermoplastics in the United States and Canada for $325 million.
Net sales have grown significantly boosted by acquisitions and price raises
The company has managed to increase sales in the past few years through acquisitions, facility expansions, and operation diversification in Europe, as well as product launches and price raises to offset current high inflation rates. Although sales declined by 5.94% in 2020 due to coronavirus-related disruptions, these efforts have translated into an increase of 14.42% in 2021, and a further 19.89% increase in 2022. Still, it is very important to note that paying down the company's huge debt pile is becoming more necessary over time, which means sales growth should soon slow down. Over half of the company's net sales take place within the United States, but it also has a strong presence in Asia-Pacific and Europe.
Nevertheless, net sales kept increasing during the first quarter of 2023 as they increased by 2.56% year over year, but volumes remain lower due in part to a slower-than-expected recovery in China (as the company has high exposure in Asian markets), and weak customer restocking due to a slower than expected global economic recovery and growing recessionary fears. In October 2021, the company announced an over 20% manufacturing capacity expansion of caprolactone monomer at its facility in Warrington, U.K. through optimization projects, and in September 2022, it expanded its facility in DeRidder, Louisiana in order to increase its global polyols manufacturing capacity by 40% due to increased demand. In this regard, net sales are expected to increase by 8.98% in 2023, and by a further 4.40% in 2024.
But the recent share price decline coupled with increasing sales has caused a sharp drop in the P/S ratio to 1.318, which means the company currently generates net sales of $0.76 for each dollar held in shares by investors, annually.
This ratio is 35.82% lower than the average since the spin-off and represents a 70.04% decline from all-time highs of 4.399, which reflects growing pessimism among investors as they are placing less value on the company's sales due to weaker cash generation capacity and an uncertain short and medium term. Still, profit margins should soon stabilize as inflationary pressures fade.
Profit margins are expected to improve by the end of 2023 as raw material prices stabilize
After the coronavirus pandemic crisis in 2020, the company has adopted a relatively aggressive cost-cut program in order to offset subsequent inflationary pressures, but these have not been enough to offset them as both TTM gross profit and EBITDA margins declined to 33.53% and 26.12%, respectively, during the past quarter due not only to higher production costs but also more unabsorbed labor (from lower volumes). Also, temporary production shutdowns in China in order to control inventories amidst weak demand is currently causing some EBITDA weakness.
This decline in profit margins took place also despite a series of product price raises that the company implemented in order to offset higher production costs. In this regard, after a product price raise that took place in March 2022 due to escalating natural gas prices, in July 2022, the company raised again the price for tall oil fatty acid, distilled tall oil and derivative products, and for rosin-based resins associated with its industrial specialties portfolio due to supply and demand imbalances and the impact of biofuel regulations. Still, if we look at years prior to the coronavirus pandemic in 2020, we can see that the long-term trend was positive thanks to the acquisition of companies whose products enjoy leading positions and broad differentiation.
More recently, in February 2023, the company announced again a 10% price raise for its specialty grades of tall oil fatty acid (after another raise that took place in November 2022), which should enable some stabilization of profit margins from the second quarter of 2023 despite ongoing supply chain and inflationary headwinds.
Thanks to these raises, both gross profit and EBITDA margins showed a strong recovery during the first quarter of 2023 as they reached 33.21% and 29.50%, respectively. Nevertheless, profit margins are expected to finally start stabilizing at more acceptable levels by the end of 2023 as the price of CTO (Crude Tall Oil), which is the main raw material of the Industrial Specialties segment, stabilizes. Still, its price is expected to keep increasing (albeit at a slower pace) during the second half of 2023. Nevertheless, the company has more than tripled the use of non-CTO raw materials and products in order to offset higher CTO prices and expects to continue extending their use in the future, which should eliminate some margin volatility in the long term.
Long-term debt is manageable, but rising interest expenses are becoming a concern
As a consequence of the recent acquisitions mentioned above, as well as aggressive share buybacks, long-term debt has skyrocketed to $1.50 billion, which means the company will eventually need to reduce its debt levels in order to continue improving its operations and results in the long term. Also, cash and equivalents are currently very limited as they stand at just $77.90 million.
Luckily, the company is still highly profitable despite ongoing headwinds as the current trailing twelve months' cash from operations of $294 million should be enough to cover current capital expenditures of $140.30 million and interest expenses of $63.20 million. Nevertheless, total interest expenses increased to $19.60 million during the past quarter due to higher debt exposure and interest rates, so the company is expected to pay around $80 million in annual interest expenses from now on.
Cash from operations was -$20 million during the first quarter of 2023 as the company typically builds working capital during the quarter for the rest of the year. In this regard, inventories increased by $26.4 million during the quarter and accounts receivable by $15.4 million while accounts payable declined by $0.9 million, which means the company remains profitable but cash generation is weakening due to margin contraction. In this regard, the management stated, during the earnings call conference of the first quarter of 2023, that it plans to reduce capital expenditures and focus on debt reduction.
As far as inventories are concerned, they currently stand at $361.40 million, so the management should eventually take advantage by converting them into actual cash with which to reduce current debt levels in order to reduce interest expenses. Even so, the current macroeconomic context marked by weak demand (and a potential recession) suggests that it will not be an easy task and that it will be necessary to drastically reduce manufacturing capacity without it affecting (too much) profit margins as a consequence of even more unabsorbed labor as we have recently seen in China. In this sense, it should not surprise investors if the cash generated through the emptying of these high inventories is lower than expected.
Buybacks continue at full speed but should slow down soon
In March 2020, the company announced a $500 million share repurchase program, and the total number of shares outstanding has declined by 13% since then. This means that each share represents a growing size of the company, which improves per-share metrics as they are divided by fewer shares. In this regard, share buybacks provide more flexibility than dividend payouts as they can be regulated based on operating performance without a share buyback reduction causing a significant drop in the share price.
The company bought back $33 million worth of shares during the first quarter of 2023, which means share buybacks continue in force, but declining cash from operations, higher debt exposure, rising interest expenses, and growing economic uncertainty suggest that the company will soon need to slow down the pace of share repurchases. After all, I don't think it would be wise, for the long term, to reduce capital expenditures but maintain the current speed of share buybacks (even if the share price has fallen so much).
Risks worth mentioning
Overall, I consider Ingevity's risk profile to be relatively low thanks to relatively high cash from operations (despite ongoing headwinds) and a highly manageable debt pile thanks to very high inventories. But even so, there are certain risks that I would like to highlight, especially regarding the short and medium term.
- If inflationary pressures continue to pressure the company's operations, profit margins could remain depressed for longer than expected despite recent product price raises. This is especially true if the CTO (Crude Tall Oil) price increases more than expected during the second half of 2023 and beyond.
- The company could have a hard time emptying its inventories due to weak demand, and this risk could increase significantly if a global recession finally materializes.
- If a recession does finally materialize, the company's operations could weaken further. In such a scenario, volumes would likely decline even further, which would have a direct impact on profit margins (due to unabsorbed labor), and thus, on cash from operations.
Conclusion
First of all, it is important to note that the current 51% decline in the share price (from all-time highs) reflects a growing pessimism among shareholders that is, in my opinion, justified. Demand for the company's products has fallen and profit margins have failed to recover (despite aggressive product price raises) as a consequence of strong inflationary pressures and lower volumes, and although sales have been boosted by these price increases, cash from operations is declining due to lower profit margins. To this, we must add that if a potential recession finally materializes as a consequence of the recent interest rate hikes, the company's operations could weaken even more. All this is happening at a time when interest expenses are increasing as a consequence of higher debt exposure and rising interest rates.
Even so, I consider that the current headwinds through which the company is navigating (and even a potential recession) are of a temporary nature as they are directly linked to the current macroeconomic context and that, in addition to having a sufficiently high cash from operations to cover current capital expenditures and interest expenses, the company has high inventories that should allow for stronger cash from operations in the foreseeable future. Furthermore, capital expenditures are expected to be reduced in the coming quarters, and the management is determined to reduce current debt levels in order to improve the company's long-term sustainability by reducing interest expenses.
For these reasons, I believe that the most patient investors holding the company's shares will be rewarded in the long run and that the current fall in the share price represents a good opportunity to obtain relatively high capital returns when the macroeconomic context offers better prospects for the company and optimism among investors flourish again.
For further details see:
Ingevity Corporation: Headwinds Are Temporary