Innospec has the opportunity to leverage self-help and growth markets – innospec inc. (nasdaq iosp) seeking alpha la gasolina in english


Small and not widely followed, specialty chemical company Innospec ( IOSP) has a pattern of nearly annual sharp pullbacks that give investors another chance to get into what has been a pretty good growth and quality story over the years. There are a lot of moving parts here, and management needs to work on the profitability of the Oilfield segment, but I like management’s track record as well as the growth prospects for a specialty chemical company focused on products that offer important performance enhancements to markets that will pay for them. Strong Growth, But Choppy Margins

There’s always going to be a certain amount of volatility in Innospec’s margins, as the company always has to deal with input cost volatility, mix shifts, and other consistently inconsistent margin-moving business factors. I also believe the relative lack of coverage (Reuters lists two analysts following the company, Yahoo! Finance lists four) plays into stock volatility, as this isn’t a particularly well-covered company and there is a record of substantial deviation from estimated earnings.

In any event, the first quarter saw Innospec grow revenue at a 23% reported rate, with three out of the four businesses performing ahead of the company’s long-term plan. Fuel Specialties grew 5% in constant currency on weak (up 1%) volume, Performance Chemicals grew 19% with good balance (volume up 10%, price/mix up 9%), and Oilfield was up 40% on very strong volume (up 33%). Octane revenue plunged, with the company generating almost no revenue in this legacy (but still absurdly profitable at scale) business.

Margins were less impressive. Overall gross margin declined about two points, with three out of the four businesses seeing margin erosion. The company continues to integrate the assets it’s acquired from Huntsman ( HUN) and leverage value-added product sales, leading to almost three points of margin expansion. Fuel Specialties, though, saw close to three points of margin erosion on higher input costs, and Oilfield saw more than four points of erosion on higher input costs and transportation costs. Octane gross margin went negative (and was the highest-margin business a year ago) as there was virtually no revenue to absorb fixed costs.

While Innospec did have higher corporate costs, the segment-level profit margins didn’t show as much erosion as at the gross margin line. Fuel Specialties saw about two points of EBITDA margin erosion and less than two points of operating margin erosion, while Oilfield saw a little less than four points of EBITDA margin erosion and less than two points of operating margin erosion. Performance Chemicals saw expansion at both lines, though profitability is still below pre-Huntsman levels. There’s Work To Do

The Oilfield business needs to generate better margins and management is working on this. Lags in passing along higher input prices are always going to be part of the business, but management needs to figure out how to lower transportation costs. I’d also note that this isn’t an optimal time in the cycle. While drilling and production activity have rebounded in the U.S. onshore market, those benefits aren’t being shared equally with energy service companies yet and there’s still enough excess capacity on the service side that E&P companies can push hard on pricing.

With the Octane business, there’s not as much that management can do. The company booked an order for the second quarter and I expect management to live with the volatility and uncertainty so long as there still appears to be enough demand to drive worthwhile profits here on an annual basis. Given that decision, this may well prove to be the segment that drives more volatility relative to expectations.

The Fuel Specialties business is more about sticking with a model that works. The company had some volume weakness outside of the Americas due to new product reformulations, but the company remains a leader in this market alongside peers like NewMarket ( NEU), Chevron’s ( CVX) Oronite, and Berkshire Hathaway’s ( BRK.A)( BRK.B) Lubrizol. While gross margins are suffering from higher input prices, the business should recapture those as pass-throughs kick in later.

Performance Chemicals is likewise about continuing with a strong operating model. Companies in the personal care products space continue to invest in new product formulations to cater to customer demand for products that are greener, more convenient, and offer better product features (like thick/rich lathers). Further integration and reinvestment efforts into the acquired Huntsman assets can still generate benefits from here, and management has talked of looking for add-on expansion opportunities into the ag and mining sectors that would leverage existing capabilities. The Opportunity

Management has said that they would like to add more businesses/products through M&A, but the multiples are simply too high right now. Consistent with prior comments on the subject, management doesn’t think there’s much to buy in the Fuel Specialties space, but still a lot of things they could do in the Performance Chemicals area. Oilfield could also get some M&A attention, particularly as the company would like to expand from its North American focus into the Mideast.

The numerous moving parts at Innospec do create some modeling challenges, but I continue to believe that the company can generate long-term revenue growth in the mid-single digits, with Performance and Oilfield leading the way. Fuel Specialties is likely to be a slow-growing business from here, but one that generates good margins and is largely protected from the rise of hybrid/electric vehicles by its focus on commercial/heavy-duty diesel vehicles.

In my model, I have Innospec returning to double-digit operating margins in 2019 and then largely staying there with EBITDA growth in the high-single digits over the next five years and mid-single digits over the long term. I’m looking for double-digit FCF growth, but that is largely a product of an abnormally low starting point from 2017.

On the subject of valuation, management commented that it believed 12x multiples on EBITDA were too high for potential M&A targets, but the shares are presently trading for about 11.5x my forward EBITDA estimate. Discounting my estimated future cash flows, I believe Innospec shares are currently priced for a double-digit total expected return.