The Olin Illusion

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 6th, 2016

The Olin Illusion

  • OLN appears to be a clear buy on our framework that looks at normalized return on capital, but this position becomes far less clear when we account for a number of important factors
    • The large intangible component of the asset base – most of which came with the Dow deal
    • The state of the balance sheet – OLN has the highest debt/EBITDA in the group
    • The possible permanent impairments in the margin structures of the chemical business lines because of a more global market, slower growth and overcapacity
  • OLN does not appear cheap on a value versus Return On Tangible Capital (ROTC) basis – Exhibit 1
    • Its ROTC is only 6%, and it is less than 4% when you add back the intangibles
    • OLN has as much as 60% EV downside to hit the trend line, which would put the stock price at zero!
  • Today OLN’s EV is close to 50% debt, similar to HUN, and the only companies in worse shape are CC and TROX – the high component of debt results in very volatile equity
    • Cash flows are not high enough to make much of a dent in debt and OLN may be forced to sell assets (as CC has done) to get on a better footing
  • The company has consistently guided above actual results in every quarter since 2014, and the trend is worsening
    • This is partly a function of the very bullish outlook presented by Dow about the chlorine products business at the time of sales and partly a result of some poor trends in all of OLN’s businesses which have not improved as expected
    • We remain very concerned about a slowing World, outside of the consumer (Chinese consumers specifically) negatively impacting PVC (through to chlorine/caustic) and epoxies
  • We believe that estimates remain too high for OLN for this year and for next and that some of the downside to the stock suggested in Exhibit 1 is real (perhaps as much as 30%).

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

Return On Capital and Earnings

Our normalized valuation framework is driven by an expectation that companies in cyclical industries have earnings that cycle around either an average Return On Capital (ROC) or, in some deteriorating industries, around a declining trend – rarely an improving trend.

In the case of OLN we have a consistent history and a recent decline, which could be part of an historical pattern, or might be something different – Exhibit2. We have seen sharp declines in the past associated with lows in the chlor-alkali market and the recent low would have been worse had it not been for low natural gas prices in the US, helping keep costs low, and a strong Winchester business. We would caution on the more recent data points as they pick up consensus forward estimates, which we believe are too high, based on very poor recent guidance from the company and a level of optimism that is getting worse – Exhibit 3. We are very skeptical about the recent uptick in estimates for 2016 and 2017 – Exhibit 4 – although we would expect some benefit from the Q3 jump up in ethylene margins. We think other negatives will quickly offset this after Q3. Exhibit 5 shows just how poor quarterly estimates have been.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Free Cash Flow and Debt

The Dow deal was expensive, and OLN now carries a lot of expensive debt. In Q2 2016, interest expense was greater than operating income and in the last 12 months, cash from operations barely covered capital expenditure and dividend payments. Of the larger companies in our universe OLN has the highest debt/EV level (with Huntsman) Exhibit 6 and the highest debt/EBITDA ratio – Exhibit 7. Returns on both total and tangible capital have taken a beating with the combination of market weakness and the Dow acquisition – Exhibit 8. The step change in capital employed, associated with the Dow deal is shown in Exhibit 9.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Further Risk – No Cash – No Debt Repayment – Dividend Cut?

OLN has no free cash flow to begin to address its debt burden and without a recovery in the global PVC and caustic markets (which we believe is at least 24 months away) we believe that cash from operations will struggle to pay more than capex and the dividend. We do think that there might be a small (Q3 and possibly early Q4) windfall from higher ethylene margins (on the ethylene purchased from Dow) but this will only make a small dent in debt. We are not optimistic about the epoxy markets given the weaker global industrial economy and China competition, and attempts by several majors to gain share, which can only result in price pressure.

OLN’s debt was downgraded to BB in July by S&P and then given a stable rating, but further negative revisions and lower cash flow expectations for 2017, should they occur, might cause another negative revision and result in the company questioning its dividend policy.

OLN could try and sell assets, but it is restricted by the reverse Morris Trust deal for much of the asset base and it is not obvious that a divestment of Winchester makes sense, given what would likely be a very low valuation in proportion to the cash generated – Exhibit 10.

Exhibit 10

Source: Capital IQ and SSR Analysis

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