It's an open question as to whether corporate executives really take their duty to shareholders seriously, but that becomes an even more relevant issue when a potential takeover comes into the picture. Georgia Gulf (NYSE:GGC) management may well be right that Westlake's (NYSE:WLK) buyout bid undervalued the company's potential, but a great deal of that potential is tied to both a housing recovery and an improvement in the company's cost structure.
While the long-term potential value of Georgia Gulf definitely exceeds the Westlake offer, it may be hard for the company to surpass that offer in the short term.
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Three Major Drivers to Watch
As I see it, there are three primary factors that investors should watch as it pertains to Georgia Gulf's future. These are the direction of natural gas prices, the direction of the housing market and the company's ability to further integrate its production.
Natural gas is a major input in chloralkali and PVC production, and the declines in U.S. natural gas prices have actually made North America the low-cost producer. While major producers like Dow Chemical (NYSE:DOW), Olin (NYSE:OLN), Westlake and Georgia Gulf have varying degrees of EBITDA sensitivity to natural gas, the significant price declines tied to shale gas exploitation have very clearly helped the industry.
The question is whether or not this theme is played out. The last peak in the market (around 2006) occurred with nearly $7 natural gas, and I don't think U.S. natural gas prices can go all that much lower. Numerous producers have switched from gas production to oil/liquids and those that can't switch are curtailing production and drilling as current prices just don't support further production at these levels.
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Georgia Gulf often operates its PVC facilities at higher-than-industry rates, and it looks to be no different now. The question, though, is whether the company can and should move to further integrate its production.
Right now, the company buys about half of its chlorine and all of its ethylene, which clearly reduces its ability to control costs. While the prices of inputs like chlorine and finished products generally track in similar directions, there's a big difference between "similar" and "identical" and those differences can seriously squeeze the already narrow margins of this business.
The question is how the company may go about this. As of the company's investor update back in March, a $400 million "self-build" option was on the table, as were other options like a partnership or long-term supply agreements. Frankly, I'd hope the company considers the partnership route or some hybrid option that gives the company the freedom to own and control more of its own supply in the future.
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The Big Housing Unknown
Far and away the biggest delta for Georgia Gulf is the recovery of the housing market. Something close to 75% of Georgia Gulf's final sales are tied to the housing or construction markets in some fashion, whether through the PVC used in products like pipes or its own vinyl siding business.
The downturn in the housing market has pushed one-time rivals like Alcoa (NYSE:AA) and Owens-Corning (NYSE:OC) out of the business altogether, though the company still has to deal with huge rivals like Shin-Etsu, Occidential (NYSE:OXY) and Formosa Plastics. Here, of late, the positive same-store sales increases at Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), particularly in professional product segments, have raised hopes about the housing market, but we've heard this more than once in the past few years.
Sooner or later housing will recover, but "sooner or later" can cover a lot of time. While Georgia Gulf's balance sheet is in much better shape than it was a few years ago, investor patience with this company may not hold throughout a prolonged slow recovery.
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The Bottom Line
Based on near-term earnings potential, Georgia Gulf shares probably ought to trade in the mid-$30s (on the basis of a forward 6x EBTIDA multiple). If management is right, though, and the company's now structured to produce EBITDA of $400 million in the good times, shareholders could certainly see solid gains as that housing market starts to show real signs of recovery.
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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.