NEU - NewMarket Corporation

[WneverLOSE]

NewMarket Corporation is a specialty chemical company that engages in the petroleum additives businesses through their Subsidiaries Afton Chemical Corporation and Ethyl Corporation.

 

Basically they make some of the chemicals that other chemical producers use to create all of the end products such as driveline oils, engine oils and so on.

 

First of all I was wondering if someone is familiar with the industry and would care to explain a little about the industry dynamics.

Some questions that come to mind are :

1) How come that both Lubrizol (A Berkshire Hathaway subsidiary and a major competitor to NewMarket) and NewMarket have such a high return on equity ? How come other chemical companies don't enter the market with such lucrative returns ?

2) What changed in the era post 2008 that made both companies more than double their ROE ? (ROE for 2006 - 20%, 2008 - 43%, 2016 - 50%)

 

[BG2008]

I want to bump this thread as I'm currently looking at the specialty chemicals space as well

[BG2008]

This is me being an amateur in the specialty chemical space.  I've heard from some IR folks that specialty chemicals is done is small batches and requires a lot of hand holding.  The pie is also small.  It's not worth the time and effort for the larger guys like Exxon etc. 

 

ROE doubling perhaps tied to US shale revolution?  No idea.  Just speculating here.

[WneverLOSE]

It's not really about the big guys not being interested, they are, Infineum (a joint venture between ExxonMobil and Royal Dutch Shell) and Chevron Oronite are 2 out of the big 4 players in the industry.

 

The jump in profitability is much more pronunced with Lubrizol and the fact that Warren paid 13 times earnings in 2011 means he was pretty sure that this is the new norm.

 

Year	2004	2005	2006	2007	2008	2009	2010
Revenue	2,864.4	3,622.2	4,040.8	4,499.0	5,027.8	4,586.3	5,417.8
Net Income	91.8	187.2	103.6	283.4	(66.1)	514.2	748.7

[Guest Schwab711]

The increase in gross margins started in 2009. I looked at their FY2009 10-k and they mention "increased pricing".

 

Again in 2010, "When compared to 2009 operating profit levels, the 2010 results are higher across the lubricant additives product lines, but lower across the fuel additives product lines."

 

In FY2013 10-k: "Petroleum additives operating profit increased $3 million when comparing 2013 to 2012 and $24 million when comparing 2012 to 2011. The increase from 2012 to 2013 resulted from improved results in the lubricant additives product line, which was partially offset by a decrease in the fuel additives product line. The increase between 2012 and 2011 was across both of our major product lines, lubricant additives and fuel additives."

 

This continues through present.

 

Pre-2009:

 

US EBT margins are roughly 4% - 9%, which is essentially in-line with foreign EBT margins.

 

Post-2009:

 

US EBT margins explode to 20%-30%+, foreign EBT margins are essentially unchanged.

 

 

What happened?:

 

Pre-2009:

Engine Oil Additives – The largest submarket within the lubricant additives marketplace is engine oils, which we estimate represents approximately 65% of the overall lubricant additives market volume, but a much lower percentage of the overall market profitability. The engine oils market’s ultimate customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

Post-2009:

Engine Oil Additives—The largest submarket within the lubricant additives marketplace is engine oil additives, which we estimate represents approximately 70% of the overall lubricant additives market volume. The engine oils market’s primary customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

 

I'd bet you quite a bit there was a regulation passed in or around early 2009 (possibly an emissions/mileage-based regulation?). I am new to specialty chemicals/Lubrizol/NEU as well, so I don't know what that regulation(s) is/are and what the current status is. A very large proportion of the increase in profitability and every other metric for the past 10 years or so though.

 

I believe Lubrizol/NEU were handed a pretty awesome monopoly in 2009.

[BG2008]

The increase in gross margins started in 2009. I looked at their FY2009 10-k and they mention "increased pricing".

 

Again in 2010, "When compared to 2009 operating profit levels, the 2010 results are higher across the lubricant additives product lines, but lower across the fuel additives product lines."

 

In FY2013 10-k: "Petroleum additives operating profit increased $3 million when comparing 2013 to 2012 and $24 million when comparing 2012 to 2011. The increase from 2012 to 2013 resulted from improved results in the lubricant additives product line, which was partially offset by a decrease in the fuel additives product line. The increase between 2012 and 2011 was across both of our major product lines, lubricant additives and fuel additives."

 

This continues through present.

 

Pre-2009:

 

US EBT margins are roughly 4% - 9%, which is essentially in-line with foreign EBT margins.

 

Post-2009:

 

US EBT margins explode to 20%-30%+, foreign EBT margins are essentially unchanged.

 

 

What happened?:

 

Pre-2009:

Engine Oil Additives – The largest submarket within the lubricant additives marketplace is engine oils, which we estimate represents approximately 65% of the overall lubricant additives market volume, but a much lower percentage of the overall market profitability. The engine oils market’s ultimate customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

Post-2009:

Engine Oil Additives—The largest submarket within the lubricant additives marketplace is engine oil additives, which we estimate represents approximately 70% of the overall lubricant additives market volume. The engine oils market’s primary customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

 

I'd bet you quite a bit there was a regulation passed in or around early 2009 (possibly an emissions/mileage-based regulation?). I am new to specialty chemicals/Lubrizol/NEU as well, so I don't know what that regulation(s) is/are and what the current status is. A very large proportion of the increase in profitability and every other metric for the past 10 years or so though.

 

I believe Lubrizol/NEU were handed a pretty awesome monopoly in 2009.

 

Why not just call Neumarket IR and ask them about this?  You don't have to believe everything they say.  But, they'll likely shed some half truth and half spin. 

[WneverLOSE]

I will call if I still don't understand it in the next few days of research.

I don't think regulation explains the returns unless the law says "all products must use Lubrizol or NewMarket formulas".

Even than I would expect Lubrizol to drive NewMarket to the ground in order to stay the only player in the game.

 

If the regulation is about pollution or safety the usual capitalistic dynamics stay intact, other companies would like to enter the market (even more after returns have gone up so much) by so lowering prices / increasing supply and driving returns to a much lower equilibrium.

 

I think any Charlie Munger fan should be researching this company hard ! it brakes any economical model I had of the world.

I must develop new ones now  :-\

[Guest Schwab711]

@BG2008: I've looked at NEU for 1 hour. Otherwise I think that it is a good idea. I'm just sharing what I see. You all asked for comments and I responded.

 

@wnever: please share if you talk to them (in this thread or by pm). I think it's a cool idea. Edit: meant to add, great post/idea! Thank you to BG for bumping so I actually looked at it.

 

I don't mind paying 2x WEB's price if I know he's right.

 

In general, I don't mean to imply govt monopoly is bad, if that's how it was taken. I have had 40%-50% of my PA in MCO. I love govt monopolies. I just want to understand how the music stops, if that's a possibility. I'm a big fan of WEB. If he bought Lubrizol, his mouth probably watered for the same reasons mine did. It's so much easier to be a business genius if you own an oligopoly/monopoly.

 

Look forward to sharing more ideas about this with y'all.

[DooDiligence]

 

Pre-2009:

Engine Oil Additives – The largest submarket within the lubricant additives marketplace is engine oils, which we estimate represents approximately 65% of the overall lubricant additives market volume, but a much lower percentage of the overall market profitability. The engine oils market’s ultimate customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

Post-2009:

Engine Oil Additives—The largest submarket within the lubricant additives marketplace is engine oil additives, which we estimate represents approximately 70% of the overall lubricant additives market volume. The engine oils market’s primary customers include consumers, service dealers, and OEMs. The extension of drain intervals has generally offset increased demand due to higher vehicle population and more miles driven. The primary functions of engine oil additives are to reduce friction, prevent wear, control formation of sludge and oxidation, and prevent rust. Engine oil additives are typically sold to lubricant manufacturers who combine them with a base oil fluid to meet internal, industry, and OEM specifications.

 

 

I'd bet you quite a bit there was a regulation passed in or around early 2009 (possibly an emissions/mileage-based regulation?). I am new to specialty chemicals/Lubrizol/NEU as well, so I don't know what that regulation(s) is/are and what the current status is. A very large proportion of the increase in profitability and every other metric for the past 10 years or so though.

 

I believe Lubrizol/NEU were handed a pretty awesome monopoly in 2009.

 

I've had this on a watchlist for a while now but never understood the high ROE's until you explained it.

 

How will EV's & the supposed, death of ICE, affect this?

[MrB]

@BG2008: I've looked at NEU for 1 hour. Otherwise I think that it is a good idea. I'm just sharing what I see. You all asked for comments and I responded.

 

@wnever: please share if you talk to them (in this thread or by pm). I think it's a cool idea. Edit: meant to add, great post/idea! Thank you to BG for bumping so I actually looked at it.

 

I don't mind paying 2x WEB's price if I know he's right.

 

In general, I don't mean to imply govt monopoly is bad, if that's how it was taken. I have had 40%-50% of my PA in MCO. I love govt monopolies. I just want to understand how the music stops, if that's a possibility. I'm a big fan of WEB. If he bought Lubrizol, his mouth probably watered for the same reasons mine did. It's so much easier to be a business genius if you own an oligopoly/monopoly.

 

Look forward to sharing more ideas about this with y'all.

 

Schwab do you think Davita is a government monopoly albeit indirectly?

You should start a thread on goverment monopolies.

[oscarazocar]

This is a very interesting topic, the question of what changed in the specialty chemicals/additives market in 2008-2009.  I looked at it a bit back then and didn't really figure it out.

 

Buffett talked a bit about Lubrizol at the 2011 annual meeting transcript, but his comments didn't really explain why the business improved so radically in the few years before.  If you look at the history of the BRK/LZ acquisition (ex-all the Sokol trading stuff), Buffett was not hot on the deal and then he met with Sokol, who had just had lunch with the LZ CEO, and immediately changed his mind.  My theory was that the LZ CEO explained to Sokol that the industry had shrunk to the point where it was now an oligopoly and pricing dynamics had changed significantly, which made the business structurally much more attractive.  I believe the industry had been quite profitable in the 1990's before entering a down decade in the 2000's due to overcapacity.  Understandably, the companies didn't really comment on this publicly and all kept their cards pretty close to the vest.

[WneverLOSE]

OK did the reading, the bottom line, this is a new oligopoly.

 

Since the 1990s the industry started consolidating and it picked up even more in the 2000s.

This consolidation rationalized the industry a bit bringing return on equity for the sector from single digits over a cycle  to low double digits, a return much more appropriate with returns achieved by the average US corporation.

 

The additives companies sell their products as part of a package, a package is a blend of all the specific additives needed and the blenders combine it with the base oil to create the finished product.

The nature of the business is that high R&D is needed to produce a new product so the sector naturally attracts to scale and unlike technology R&D that is obsolete after 5 years, a good formula can be used for decades.

That means that long running history is also valuable and after 90 years of operations many patents are held by the current players. This makes it hard for new players to enter the market, much R&D is needed in advance to catch with the current lineup of products available with no guarantee of any successes (even more when you consider that fact that they need to not only find 1 good formula but all of them to create the right package).

 

One aspect of the pricing power is the fact that the additives are a small part of the cost of making the finished product.

Add this to the fact that the end users use only a small amount of the product once a year (when maintenance dictates oil changing is necessary) and that it is a very small expense relative to the cost they put into their car makes it that they are not very price sensitive so the makers of the end products pass costs to me and you.

 

By the 2008 crisis the sector was already made up of the big 4 (controlling about 90% of the sector) and the fear that came during that crisis made all of them behave very rationally, the result was that all of them made tons of money and everyone understood that keeping competition at bay would benefit everybody. (Mainly focusing on profits and not "Market share growth")

 

2 of the big 4 are owned by the oil giants, making the additives they use themselves. No prospecting competitor will fool themselves into thinking they can take business selling to Exxon from Exxon so if a new competitor is to enter the market, his market opportunity is only the revenue of the independents, Lubrizol and NewMarket.

This makes the R&D calculation even worse for them.

 

Those are the big factors that caused those business to achieve VERY high returns with very little volatility, and make it last.

 

[Guest Schwab711]

OK did the reading, the bottom line, this is a new oligopoly.

 

Since the 1990s the industry started consolidating and it picked up even more in the 2000s.

This consolidation rationalized the industry a bit bringing return on equity for the sector from single digits over a cycle  to low double digits, a return much more appropriate with returns achieved by the average US corporation.

 

The additives companies sell their products as part of a package, a package is a blend of all the specific additives needed and the blenders combine it with the base oil to create the finished product.

The nature of the business is that high R&D is needed to produce a new product so the sector naturally attracts to scale and unlike technology R&D that is obsolete after 5 years, a good formula can be used for decades.

That means that long running history is also valuable and after 90 years of operations many patents are held by the current players. This makes it hard for new players to enter the market, much R&D is needed in advance to catch with the current lineup of products available with no guarantee of any successes (even more when you consider that fact that they need to not only find 1 good formula but all of them to create the right package).

 

One aspect of the pricing power is the fact that the additives are a small part of the cost of making the finished product.

Add this to the fact that the end users use only a small amount of the product once a year (when maintenance dictates oil changing is necessary) and that it is a very small expense relative to the cost they put into their car makes it that they are not very price sensitive so the makers of the end products pass costs to me and you.

 

By the 2008 crisis the sector was already made up of the big 4 (controlling about 90% of the sector) and the fear that came during that crisis made all of them behave very rationally, the result was that all of them made tons of money and everyone understood that keeping competition at bay would benefit everybody. (Mainly focusing on profits and not "Market share growth")

 

2 of the big 4 are owned by the oil giants, making the additives they use themselves. No prospecting competitor will fool themselves into thinking they can take business selling to Exxon from Exxon so if a new competitor is to enter the market, his market opportunity is only the revenue of the independents, Lubrizol and NewMarket.

This makes the R&D calculation even worse for them.

 

Those are the big factors that caused those business to achieve VERY high returns with very little volatility, and make it last.

 

Thanks for the update, this is awesome! Can you share the sources you read to get to this point? Or at least what the sources were if you can't post them? This is really interesting.

 

Is there any particular reason the profit expansion for the industry is generally limited to the US?

[gndsville]

See page 24 for more on the backstory:  https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/GDNewsletterWinter2011.pdf

[WneverLOSE]

See page 24 for more on the backstory:  https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/GDNewsletterWinter2011.pdf

 

WOW great source !

If we ever meet the drinks are on me.

 

Schwab711 - I didn't save everything but some of the links are :

 

http://archive.fortune.com/2011/03/15/news/companies/buffett_lubrizol_investment_oil.fortune/index.htm

https://www.wsj.com/articles/SB10001424052748703328404576207040639038696

https://www.quora.com/Why-is-the-additives-industry-an-oligopoly

 

I was also reading the annual reports from 2000 - 2010 of Lubrizol (but it didn't help much) and reading the comments of an analyst that did a good job covering the story - Michael J. Sison.

 

 

 

[Guest Schwab711]

See page 24 for more on the backstory:  https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/GDNewsletterWinter2011.pdf

 

WOW great source !

If we ever meet the drinks are on me.

 

Schwab711 - I didn't save everything but some of the links are :

 

http://archive.fortune.com/2011/03/15/news/companies/buffett_lubrizol_investment_oil.fortune/index.htm

https://www.wsj.com/articles/SB10001424052748703328404576207040639038696

https://www.quora.com/Why-is-the-additives-industry-an-oligopoly

 

I was also reading the annual reports from 2000 - 2010 of Lubrizol (but it didn't help much) and reading the comments of an analyst that did a good job covering the story - Michael J. Sison.

 

You guys are awesome. Thank you

[Guest Schwab711]

As an update. I did end up reaching out to the company's IR group. I sent an email and left a few voice messages over the last week. No response yet.

 

I think everyone covered in the thread so far is the answer. What is the main driver, I still don't know, but I think regulations had a big contribution. Results in the industry changed so quickly during 2009 that it seems odd to me that improving industry dynamics was the main cause. I was able to find what Lubrizol thinks though.

 

During 2009, numerous states adopted CARB standards, which essentially forced all auto manufacturers to comply with CARB (since all their major markets mandated it). Eventually the EPA adopted them as well. It seems like fuel additives were one of the cheaper solutions to help companies meet requirements. Thus, the sudden, huge pricing power despite terrible macro economic conditions. I think certain additives are still currently priced based on the value they add relative to meeting these regulations (which seem to be passed by both Bush & Obama and have fairly wide-support - I don't want to make this political, just thinking through sustainability of margins).

 

There were also other emission standards that were going to kick-in in 2010 and the industry pricing dynamics were already improving by 2008. I think the combination of these two reasons + the huge boost from national CARB regulations led to the explosion in margins.

 

Here's some sources I found helpful:

https://en.wikipedia.org/wiki/United_States_emission_standards#Phase_2:_2004%E2%80%932009

https://www3.epa.gov/otaq/fuels1/ffars/web-dies.htm

http://articles.latimes.com/2009/may/19/nation/na-emissions19

https://www.epa.gov/air-pollution-transportation/timeline-major-accomplishments-transportation-air-pollution-and-climate

 

https://www.sec.gov/Archives/edgar/data/60751/000119312509216931/dex991.htm

[DTEJD1997]

Hey all:

 

NEU continues to hit new all time highs.

 

No doubt this is a high quality company...but I'm a little concerned about the price & valuation.

 

The company derives the vast majority of it's sales & income from gasoline/petroleum additives.  I think the phase in of electric vehicles is going to take longer than most people think, but will EVENTUALLY happen.  In 15 years, I can see the majority of road vehicles being electric.

 

When the stock is trading for a P/E of well over 20, something happening 10-15 years from now that is going to damage their sales is a concern.

 

My strategy is to sell out of the money covered calls.  For example, today NEU is trading at $472.  Sell the December $500's for something like $13.00?

 

I've had success twice now selling out of the money calls and then buying them back to cover at a lower price on trading volatility.

 

Anybody have any thoughts on this?

[Gregmal]

Hey all:

 

NEU continues to hit new all time highs.

 

No doubt this is a high quality company...but I'm a little concerned about the price & valuation.

 

The company derives the vast majority of it's sales & income from gasoline/petroleum additives.  I think the phase in of electric vehicles is going to take longer than most people think, but will EVENTUALLY happen.  In 15 years, I can see the majority of road vehicles being electric.

 

When the stock is trading for a P/E of well over 20, something happening 10-15 years from now that is going to damage their sales is a concern.

 

My strategy is to sell out of the money covered calls.  For example, today NEU is trading at $472.  Sell the December $500's for something like $13.00?

 

I've had success twice now selling out of the money calls and then buying them back to cover at a lower price on trading volatility.

 

Anybody have any thoughts on this?

 

Ive admired this business from afar for awhile but never owned it. I remember looking at this maybe 5 years ago, with the price actually not being too far from where it is today. If anything it seems like its consolidated a bit and grown into 2014-15's valuation.

 

I think 20x for a high caliber company like this with a conservative balance sheet is fairly reasonably, especially if we're talking about 1% targets on the 30 year. I dont think there's much growth here though and from previous looks at it, probably not a ton of G&A left to trim.

[Spekulatius]

I think 20x for a high caliber company like this with a conservative balance sheet is fairly reasonably, especially if we're talking about 1% targets on the 30 year. I dont think there's much growth here though and from previous looks at it, probably not a ton of G&A left to trim.

 

Why do people continue to put up LT bonds as an alternative? Makes no sense to me. The alternative is SPY (probably 5% FCF yield) or just other value stocks.

 

For example, look at GRA, in a somewhat similar business. Their main business is sell catalyst to refineries and Polyethylene and polypropylene plants. IP Rich business, high profit margins (25% EBITDA margin and higher ) which i think has pricing power. GRA trades at 10x EBITDA (roughly). No position yet, but  closely.

[Gregmal]

For one, because if long term rates continue to go down, much of the stock market is quite undervalued. And two, as an investor, if not looking at stocks, you need to look at alternatives and the alternatives would need to be more appealing(unless you’re one of those doomsdayers, in which case you should look at buying an Armageddon bunker, even though those historically have no FCF yield)