There's A Lot of Potential Upside for This Industrial Smallcap Stock

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At first glance, OM Group (NYSE: OMG) doesn’t look like it would be too interesting to investors. The company generated -$39 million in losses, or -$1.22 EPS in 2012. In one month, OM Group has experienced an 8% decline in its stock price. However, what investors might not notice is its recent business restructuring. The company divested its cobalt metal commodity business at the end of March for around $325 million to concentrate on higher-margin business. Let’s take a closer look to see whether or not we should get into OM Group after this divestment.

Business snapshot

OM Group is a diversified industrial growth business serving global markets such as automotive systems, electronic devices and renewable energy, operating in four main business segments: Magnetic Technologies, Advanced Materials, Specialty Chemicals and Battery Technologies. The majority of OM Group’s revenue, $631.6 million, or 38.6% of the total 2012 revenue, was generated from the Magnetic Technologies segment. The Advanced Materials segment ranked second, with $447 million in revenue in 2012. The Specialty Chemicals and the Battery Technologies contributed $417 million and $143 million, respectively, in 2012 sales.

Divesting a low margin business

Among the four segments, the Specialty Chemicals seems to be the best segment with nearly $38 million in operating profit. The worst segment was Magnetic Technologies, with more than $22.2 million in losses, while the Advanced Materials had a very low profit margin with only $6.4 million in operating profit. However, OM Group announced that it would exit its Advanced Materials business, including the downstream portion of the segment such as cobalt refinery assets in Kokkola, Finland. The total transaction value is around $435 million, including the initial cash consideration of $325 million and future payments of up to an additional $110 million when the business could achieve certain revenue milestones in the next three years. Joseph Scaminace commented on the deal:

The divestiture of our cobalt business is the final step in exiting our legacy commodity businesses and is consistent with our strategy to move up the value chain into technology-based businesses with attractive growth prospects and more predictable earnings profiles.

Stronger balance sheet with share buyback after divestment

What I like about OM Group is its conservative capital structure. As of December 2012, OM Group had more than $1.2 billion in total stockholders’ equity, $228 million in cash, and only $467 million in both long and short-term debt. OM Group would repay its debt with the total cash on hands of more than $500 million. In addition, OM Group would return cash to its shareholders in a form of share buybacks. The value of share buybacks is up to $50 million of its common stock.

OM Group seems cheap at its current price

At $23 per share, OM Group is worth around $739 million. The market values OM Group at 7.1 times EV/EBITDA. OM Group expected to generate around $120 - $140 million in EBITDA, and the balance sheet would turn to a net cash balance after all the debt was paid off. Thus, the current trading price would value OM Group at around 5.2 to 6.1 times EV/EBITDA.

Indeed, its peers KMG Chemicals (NYSE: KMG) and Koppers Holdings (NYSE: KOP) are trading at a comparable level to OM Group’s current valuation. KMG Chemicals, at $18 per share, has a total market cap of $208.4 million. The market values KMG Chemicals at 7.34 times EV/EBITDA. Koppers Holdings is trading at nearly $42 per share, with a total market cap of $858 million. It is valued around 7.4 times EV/EBITDA. After exiting the Advanced Material business and paying off the debt, OM Group would have a much stronger balance sheet than KMG and Koppers. While the debt/equity ratio of KMG is around 0.2, Koppers is the most leveraged company with the highest debt/equity ratio at 2.

Currently, Koppers pays investors the highest dividend yield of the trio, at 2.3%, while KMG’s dividend yield is only 0.7%. Although OM Group hasn’t paid out any dividends, a $50 million buyback would yield as much as 6.7% for shareholders. Furthermore, with a stronger overall business with higher margin, OM Group might pay shareholders some dividends in the next year.

My Foolish take

Investors should have a closer look at OM Group. With a recent business restructuring, its plan for share buybacks and substantial debt reduction, OM Group is a decent investment opportunity for investors now. If OM Group is trading at the comparable valuation to its peers, it should be worth nearly $1 billion on the market. Thus, OM Group’s potential upside would be more than 35% in the next year.

Anh HOANG has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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