Riding Caustic Higher
• Olin’s 3Q results suggest that our constructive thesis on US chlor-alkali is playing out. We expect caustic soda prices to continue to rise in 4Q17 and beyond, supported by steady demand growth and a dearth of global capacity additions, exacerbated by a regulatory regime change in Europe (mercury process phase out) and ongoing environmental-related supply constraints in China. As the US trade balance continues to improve, Olin now exports 20% of its caustic with room to grow to 25%. There is an offset however. As chlor-alkali producers maximize production to capitalize on higher electrochemical unit (ECU) margins, they need to “move” co-product chlorine, which has a different demand function that happens to be weaker at the moment. This “moving” of chlorine is accomplished principally in the form of derivatives, such as ethylene dichloride (EDC) and epoxies, both of which remain under pressure. Elsewhere in Olin’s portfolio, demand for Winchester’s commercial ammunition continues to trend down by 20% y-y such that profit was halved in 3Q17 on lower prices and margins. With regard to the stock, we are encouraged by improving FCF prospects in 2018+, notwithstanding an incremental $250mn earmarked for various IT projects through 2020. However, Olin will need to address its financial leverage at some point. Despite a robust cyclical upturn in caustic soda prices, net debt of $3.49bn has trended flat in the 7 quarters since Olin acquired Dow’s chlor-alkali business.
• Top 10 takeaways: (1) adjusted 2Q EPS of $0.37 was in line with consensus, and a touch below our $0.39E; (2) EBITDA likewise trended lower than expected at $265mn in 3Q vs. our $275mn as earnings came in below our forecast in both Epoxies and Winchester; (3) hurricane Harvey was a headwind of $42.7mn in 3Q, essentially in line with the ~$40mn OLN had indicated on 29 September; (4) the company anticipates an additional $10-15mn in Harvey-related pressure in 4Q17, less than the $30mn we had expected; (5) Olin sees 4Q17 EBITDA of $280mn plus or minus 5%; (6) the company will face incremental cash flow headwinds in 2018 due to an ERP rollout which will require $250mn in capex through...
• We shift a nickel to 2018 from 2017. We trim our 4Q17 EPS estimate modestly to $0.49E from $0.53E on incremental weakness in Winchester and Epoxies, partially offset by a lower projected tax rate. This makes $1.05E for 2017. In 2018 however, our EPS estimate rises by a nickel to $2.40E from $2.35E. The incremental $0.05 is due to higher earnings expectations in Chlor-Alkali, partially offset by diminished earnings expectations at Winchester, and somewhat higher interest expense as cash flow for deleveraging is instead directed to a new ERP system.
• We maintain our Hold rating and raise our target by $1 to $31. Our price target suggests shares are rather fully priced at this juncture. As a reminder, our OLN price target is based on an average of two valuation frameworks; a relative EV/EBITDA multiple and a relative normalized P/E multiple. Our relative EV/EBITDA multiple for 2018 uses a 2.5x discount to the group average and suggests a warranted stock price of $33. Our normalized P/E methodology suggests a warranted value of $29, based on our normalized EPS estimate of $2.19 and a 25% discount to the group average multiple applied thereto.
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