Tickers in this Article: OMG, FCX, SOA, ALB, GB, STP, SCCO, AMSC
Though I have not owned it in many years, I've been a fan of OM Group (NYSE:OMG) for some time, particularly as the company's management tries to diversify the business and steer it away from such heavy reliance on cobalt. Although this is not a well-followed company at all, is still quite dependent on cobalt prices, and has not proven that it can deliver consistently strong returns on capital, today's valuation seems to expect far too little from this specialty materials company.

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Crosscurrents in Q3
Given that there is only one published earnings estimate for OM Group, the question of whether the company disappointed with its third quarter results, is largely irrelevant. Nevertheless, it was a quarter that seemed to be mixed with good and bad news.

Reported revenue rose 40%, but that growth was overwhelmingly due to an acquisition. Organic growth was more on the order of 4%. The company's Engineered Materials business saw 75% reported revenue growth, with 7% underlying volume growth in advanced material sales. Given the weakness in semiconductors and PCs, specialty chemicals was surprisingly strong, with 6% revenue growth, while battery technology sales were down 3%.

Profitability was heavily influenced by the VAC acquisition, as well as some accounting charges. The company said that its adjusted gross margin actually rose more than a point, while adjusted operating income rose 38%, from the year-ago period. (For related reading, see Biggest Merger And Acquisition Disasters.)

Weaker Metals a Challenging Backdrop
Much has been made of the weakness in copper prices and the resulting weakness in the share prices of major copper miners, like Freeport McMoRan (NYSE:FCX) and Southern Copper (Nasdaq:SCCO). While some speculate that this is warning of economic troubles on the way, others point to more challenging markets in areas like construction, autos and electronics.

What doesn't get much attention is that cobalt prices have been traveling in roughly the same direction. Although OM Group is working hard to become a more diversified industrial materials company, cobalt prices still move profits here.

Waiting on a Chip Pick-Up
Some of the low valuation on OM Group shares is likely due to the ongoing weakness in semiconductors and consumer electronics; one of the major sectors that the company has targeted with its diversification in specialty chemicals. Look at other specialty chemical players, like Solutia (NYSE:SOA) and Albemarle (NYSE:ALB), and there's a fair bit of uncertainty and inconsistency on the Street.

Curiously, the chip business seems to be relatively solid right now, at OM Group. Management pointed to good results this quarter, as opposed to weakness in printed circuit boards and memory disks, and photomask volume was up about 23%. Perhaps, then, OM Group is gaining share in a stagnant market and could really start benefiting when companies like Micron (NYSE:MU) start posting better results.

Diversification Needs to Pay Off
OM Group has had mixed success, so far, in its efforts to broaden its base. While it has a solid business in supplies components and materials for batteries (it provides materials for the batteries that go into the Nissan (Nasdaq:NSANY) Leaf, for instance), it's own efforts to compete with the likes of Greatbatch (NYSE:GB), in markets like medical batteries, have not been transformative yet.

Now the company has committed another $1 billion to diversification in buying the highly European-focused Vacuumschmelze and its specialty magnetic components business. Certainly this business has promise, as it generates a lot of revenue from solar converters, wind power components, auto and security. However, a quick look at the likes of Suntech Power (NYSE:STP), Vestas or American Superconductor (Nasdaq:AMSC) highlight that these are some challenging markets at present.

The Bottom Line
OM Group's valuation suggests that it was, is, and will continue to be a mediocre metals company. OM Group is not exactly alone, as investors are likewise not excited about Materion (Nasdaq:MTRN) today, either; another specialty metals company that has diversified itself with more component-oriented businesses. (For related reading on metals, see A Beginner's Guide To Precious Metals.)

It would seem that the worst-case scenario is that this remains a cobalt-centric story and these diversifying acquisitions go down as a waste of money. There would not seem to be such disastrous downside in that scenario. On the flip side, if these moves pay off, today's price will ultimately look like a bargain and risk-tolerant investors should give this one a look, as it tries to transition from a commodity business to a value-added components company.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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