Not many North American companies want to be in the commodity chemicals business anymore, and more and more of that business has migrated to countries such as China, India and Brazil. So, like many other chemical companies, Cabot (NYSE:CBT) has worked hard to remake itself into more of a specialty chemical company with differentiated products. Global sluggishness isn't helping the business at the moment, and the combination of elevated debt and historically unimpressive margins are risk factors, but changes in how the company does business could lead to better long-term results.
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The New Black Is Still Black
Cabot has long had a strong market position in carbon blacks, particularly rubber black (used as a reinforcing and binding agent in tire production). Cabot holds more than 20% share, with rivals like Birla and Evonik not exactly household names among investors. As you might imagine, the fortunes of this business are broadly tied to those of major tire manufacturers such as Goodyear (NYSE:GT) and Michelin, and to a lesser extent, commercial vehicle tire companies like Titan (NYSE:TWI). With the tire business largely on the decline in North America, Cabot has moved more and more production to Asia, where it can not only leverage its strong technology with cheaper access to materials, but also take advantage of emerging market vehicle growth.
Norit Brings Opportunity...at a High Cost
Not unlike Huntsman (NYSE:HUN) (and following in the long tradition of DuPont (NYSE:DD)), Cabot has been spending considerable resources on building up its capabilities in more advanced and higher value-added products. A major step in that direction was the acquisition of Norit.
Norit is a global leader in activated carbon, a key component in purification and filtration applications. Norit is a leader, along with Calgon Carbon (NYSE:CCC), and it would seem that there should be good demand in the years to come from applications such as mercury removal at coal-fired plants (more than one-third of Norit's sales are tied to utilities). On the other hand, environmental regulations concerning mercury have had a long and tortuous path from the government, through the courts and into industry. What's more, more renewable energy or gas-fired utility usage could limit some of the upside in North America.
None of that is to say that Norit is a bad business. An EBITDA margin of roughly 25% is nothing to sneeze at and is nearly double that of pre-acquisition Cabot. That said, Cabot paid about 11 times EBITDA and I'm not sure the deal can earn its cost of capital over the next three or four years. Then again, sometimes companies have to pay a high price to improve their margin prospects and growth.
SEE: A Clear Look At EBITDA
Small Opportunities Add up
While carbon blacks, fumed metal oxides and activated carbon are the dominant businesses at Cabot, there's a host of other products that can add value as well. Along with DuPont, Cabot is a leading player in inkjet colorants, and it's one of two major producers of aerogel - a thermal insulator useful in demanding applications such as skylights and undersea pipes.
The Bottom Line
I find the current sentiment around Cabot to be interesting. On one hand, most analysts go out of their way to praise Cabot's market position and technology, and likewise believe the company has made good moves to improve long-term margins and returns. So even though the current state of the tire industry isn't great, it's a cyclical business and likely to get better. Why, then, do analysts think that the stock ought to carry a sizable discount to historical EV/EBITDA multiples and other chemical/specialty chemical companies?
If some of the problem is debt, I can understand - the company did stretch its balance sheet to do the Norit deal, and further financing to add capacity in Asia will likely be necessary. Even still, Wall Street usually loves margin leverage stories and Cabot still has what should be a lucrative emerging market growth angle (even if the emerging markets aren't so strong today). I'm fine with assigning some discount to Cabot's valuation, but what's fair?
Go with a multiple of around 6.5 times 2013 EBITDA, a number that many analysts are using, and you get a target of about $49. That's better than 30% potential from here; not bad for a company where it seems like Wall Street has taken a "show me" attitude for now. That said, this is an economically sensitive stock, so investors shouldn't just throw caution to the wind.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.