Orion Engineered Carbons

[alexjonPSR]

Has anyone spent time on Orion Engineered Carbons (OEC) or Cabot (CBT)? Meryl Witmer has talked about OEC numerous times in Barron's at prices much higher than today over the last three years.

 

Carbon black is primarily a commodity industry but within OEC, the specialty division is a world class asset with high margins and pricing power. The overall business has a good return on capital overtime and can generate strong cash flow.

 

I would love to compare notes and see what others think if they have done any research, specifically on the US rubber black division where OEC's new CEO is trying to change on contracts are structured in the industry.

 

Below are some comments that help summarize the thesis today:

 

OEC Overview/Thesis

 

Rubber Black: #4 in the world with a 7% global market share. Within any region market share is closer to 15%. 80% of demand is for replacement tires and OEC over indexes to more complex, premium tires. Pass through contracts that benefit from higher oil prices. (Contributes 75% of volume, 54% EBITDA)

Specialty Black: #1 player in $2bn sub industry with > 24% market share. OEC has unique process applications (6 vs 2 for avg. competitor) that allows for more refined, high value carbon black required in specialty applications including coatings and pigments. High specification, long term contracts for low volume, high value products leads to high margins and ROIC. Benefits from lower oil prices (Contributes 25% volume, 46% EBITDA)

 

The rubber black division is not earning its cost of capital (according to management: 2019 about 8.5%) but there is a path to get there. The division is global with the US segment (40% of assets) under earning due to mandated EPA regulatory cap-ex. In the near term this is a negative as OEC is unlikely to generate excess free cash flow over the next 12-18 months. However, over the long term, industry dynamics and actions management is taking should allow the division to earn its cost of capital and create a more stable base of revenue and earnings.

 

Carbon black is difficult to transport, and local economics are dictated primarily by access to feedstocks. As a result of the EPA mandated compliance capex, the cost to supply rubber black in the US has increased, limiting capacity additions. OEC and competitors have been able to take base price increases over last 3 years. With demand for tires set to improve cyclically, but also because of additional tire capacity that has been onshored to the US, demand for tires is set to continue to outpace carbon black supply. The supply demand imbalance along with a higher cost of EPA capex favors carbon black suppliers who need to ensure rubber black prices are high enough to guarantee supply. Against a positive cyclical recovery in pricing, OEC CEO’s Corning Painter, who joined in August 2018, is working with suppliers to change how rubber black is priced and supplied in the US. Painter wants to move from 1-year contracts that are pass through and adjust for price increases and differential surcharges, towards 5-10-year contracts with a base reservation fee + variable/pass through pricing. These contracts are like those he structured at Air Products (APD) in their industrial gas business. Margins rose > 1000bps following their implementation. This type of supply agreement will remove some of the upside to the rubber black division but also limits the downside. Together with base price increases these actions should allow the rubber black division to earn its cost of capital and provide for more stable earnings and cash flow.

 

At cost of capital pricing in the rubber black division and stability in specialty, OEC can go from a $250-$275mn EBITDA business to $350-$400mn business assuming little to no growth in specialty. Maintenance cap-ex is $70-$80mn (including $40mn for growth) and OEC is a highly cash generative. OEC has historically traded at average multiples of 7X EV/EBITDA and 12X EPS. Public competitor Cabot (Ticker: CBT) consistently trades at 1X turn premiums. OEC can earn > $2 /share in EPS and > $2/share in after tax cash flow/share. At average multiples, OEC is $25-$30 stock. There is also potential for significant upside from a re-rating if OEC can improve the structural ROIC of the rubber black division. Since taking over in 2018, CEO Painter has purchased 250,000 shares in the open market at an average price of $14. Other executives including many lower level executives have also purchased shares in March/May 2020. Executive comp metrics are based on a ROCE and relative TSR.