Albemarle Shares Offer Quality Growth at a Reasonable Price

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When investors think about the chemicals industry, they often envision a highly cyclical industry where companies compete primarily on price, selling commoditized chemical products. Painting the entire chemicals industry with such a broad brush, however, would gloss over exceptions to the industry rules, including specialty chemicals manufacturer Albemarle (NYSE: ALB).

Over the past decade, Albemarle has successfully executed an efficient business strategy centered on a few core niches where it enjoys strong competitive advantages and only a small number of competitors, including petroleum catalysts and bromine chemical products. At its current price, I also believe Albemarle’s stock offers value to investors looking for quality growth at a reasonable price.

Minting cash by selling catalysts and bromine

Although not a huge company by any stretch, with a market cap under $6 billion, Albemarle is nevertheless a heavyweight in two of its three main segments, catalysts and fine chemicals, which together comprised roughly 68% of the company’s 2012 sales. The catalysts and fine chemicals segments generated very attractive operating profit margins of 27% and 21%, respectively, in 2012, greatly exceeding the average operating margin within the chemicals sector. So, how is Albemarle able to generate such attractive profit margins in these segments?

In its catalyst business unit, Albemarle makes the bulk of its money by designing, manufacturing, and selling refinery catalysts. There are only four or five other major players within the refinery catalyst space, including Albemarle, as developing and selling refinery catalysts requires significant research spending as well as close relationships with the end customers -- refineries -- who may have individualized needs depending on the specifications of each refinery.

Within the refinery catalyst space, which Albemarle estimated to be a $6.3 billion market in 2011, Albemarle only competes with W.R. Grace (NYSE: GRA), Chevron (NYSE: CVX), Royal Dutch Shell, and a few other privately held companies.

The relative scarcity of competitors within the refinery catalysts space has allowed Albemarle to consistently enjoy good pricing power and therefore, attractive profit margins. For example, even in 2009, during the worst of the global recession, Albemarle’s catalysts segment still generated a solid 16% operating margin.

The advantages of this oligopolistic competitive structure also extend to other players besides Albemarle such as W.R. Grace, which generated an eye-catching operating margin of over 30% in its catalyst segment in 2012.

I believe the refinery catalyst sector will enjoy strong growth over the next several years as more stringent pollution standards necessitate the development and use of more advanced catalysts that can help remove more potential pollutants during the refining process. The increasing use of “sour” crude with high levels of contaminants as the world shifts away from “sweet” Middle Eastern crude can also help drive increased refinery catalysts consumption, in my opinion.

These trends will certainly benefit Albemarle and its competitor W.R. Grace, which generates roughly 40% of its revenue through selling catalysts. W.R. Grace generates the remaining 60% of its business from various construction and industrial products such as cement additives, concrete mixtures, and can sealants. These other businesses help W.R. Grace to diversify its operations away from the energy and refining industry, which is the dominant end market for the firm’s catalysts segment.

For a big integrated company like Chevron, however, any incremental gains in catalyst sales will likely be an insignificant drop in the bucket. Chevron is an integrated energy company with exploration, production, and refining operations worldwide. It is the second largest oil company in the U.S., boasting production of 2.6 million barrels of oil equivalent per day, as well as 11.3 billion barrels of oil equivalent in proven reserves. As such, Chevron’s fortunes will be more shaped by how it can increase its total oil production and reserves, and not really by its much smaller catalyst operations.

In its fine chemicals segment, Albemarle primarily sells chemical derivatives of bromine, which are used in a wide range of applications from flame retardants to oil and gas drilling fluids. Albemarle’s key competitive advantage here is its internal, low-cost supply of bromine. The company sources its bromine from low-cost wells in Arkansas brines as well as from the Dead Sea, where the inherently high concentration of bromine in the source water reduces the overall cost of extracting the bromine.

The company competes in this space primarily with Israel Chemicals, which also has access to low-cost bromine from the Dead Sea. Because both Israel Chemicals and Albemarle enjoy access to low-cost bromine, they own significant competitive advantages over competitor bromine product manufacturers, allowing these companies to enjoy healthy profit margins within their bromine segments and dominate the competition.

Thoughts on valuation and conclusion

Albemarle is certainly no ordinary chemicals manufacturer as it enjoys strong competitive advantages in its core catalysts and fine chemicals segments, as well as a healthy growth outlook, especially in its catalysts business. Compared to its closest peer and competitor in the catalysts space, W.R. Grace, Albemarle also looks relatively undervalued.

For example, as of market close on July 11, 2013, W.R. Grace was trading for 70.9 times 2012 earnings, while Albemarle’s trailing price to earnings ratio was a more reasonable 18.7 times.

To be fair, Chevron, another major player in the catalysts space, was trading for 9.3 times 2012 earnings at the end of July 11, 2013. However, Chevron is also a sprawling integrated energy company that is not a good comparison for Albemarle and W.R. Grace. In my view, paying less than 19 times trailing earnings to purchase shares in a high-quality company such as Albemarle with strong competitive advantages in its core businesses and healthy growth prospects is a strategy worth considering.

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