This Chemicals Company May Be Small but It's Got Potential

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

Axiall (NYSE: AXLL) is relatively small in the world of integrated-chemical companies. Worth only $3.1 billion at its current stock price, Axiall is 6% of the size of peer Dow Chemical (NYSE: DOW), but I believe the company is an undiscovered diamond.

Previously known as Georgia Gulf, the merger with PPG's chemicals business earlier this year created the new entity Axiall. However, despite almost doubling in size, Axiall is still valued as if it had not grown at all.

In particular, Axiall produced EPS of $1.03 for the second quarter of this year, the company's first full quarter of earnings after the acquisition. On an annualized basis, this indicates that the company will produce EPS of $4.12, excluding the $100 million in annual costs savings the company's management expects to achieve over the next two years.

Even at current rates, Axiall is trading at a forward earnings multiple of 10.8, which is below the chemicals sector average of 14.2 and significantly below the forward earnings multiple of sector leaders DuPont (NYSE: DD) and Dow Chemical, which trade at forward earnings multiples of 13.9 and 13.3, respectively.

Axiall has sector-leading qualities

It would be easy to assume that Axiall is trading at a lower valuation than its peers because the company is less profitable/efficient. However, the opposite is true.

Taken as a average over the last three years, Axiall has achieved a return on assets similar to that of its larger peers:

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>ROA</p> </th></tr> </thead> <tbody> <tr> <td> <p>Du Pont</p> </td> <td> <p>6.7%</p> </td> </tr> <tr> <td> <p>Dow Chemical</p> </td> <td> <p>3.3%</p> </td> </tr> <tr> <td> <p>Axiall</p> </td> <td> <p>5%</p> </td> </tr> </tbody> </table>

Furthermore, over a similar period, Axiall has achieved a similar return on shareholder equity:

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>ROE</p> </th></tr> </thead> <tbody> <tr> <td> <p>Du Pont</p> </td> <td> <p>30%</p> </td> </tr> <tr> <td> <p>Dow Chemical</p> </td> <td> <p>10%</p> </td> </tr> <tr> <td> <p>Axiall</p> </td> <td> <p>12%</p> </td> </tr> </tbody> </table>

Cash generation is strong

What's more, Axiall is highly cash generative as shown by the company’s cash- conversion ratio. (The cash-conversion ratio is the net operating cash flow, minus Capex spending divided by EBITDA; the higher the ratio, the more income that is converted into cash, which is good for increasing investor returns and boosting shareholder equity/assets.)

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>Cash-conversion ratio</p> </th></tr> </thead> <tbody> <tr> <td> <p>Du Pont</p> </td> <td> <p>60%</p> </td> </tr> <tr> <td> <p>Dow Chemical</p> </td> <td> <p>21%</p> </td> </tr> <tr> <td> <p>Axiall</p> </td> <td> <p>63%</p> </td> </tr> </tbody> </table>

Other valuations appear low

Apart from the basic forward earnings multiple, Axiall appears cheap on other metrics, for example the EV/Revenue and EV/EBIT valuations. Compared to Dow and Du Pont, Axiall trades at a EV/Revenue figure of 0.9x and its peers trade at 1.1x and 1.8x multiples, respectively.

Additionally on a EV/EBIT basis, Axiall trades at a ratio of 7.3x, Du Pont trades at a ratio of 16x and Dow a ratio of 38x.

But what about the company's outlook?

The company's valuation is low and Axiall is standing up well in comparison to its peers, but what about the outlook of all concerned?

Well, Axiall's free cash flow is strong, which has allowed the company to begin reducing net debt - down 3% from Q1 to Q2. The company paid down debt from cash in the first quarter, resulting in a charge taken on the working capital side of cash flow; however, without this charge, free cash flow would have been $75 million. On an annualized basis, this would allow the company to pay down its $1.5 billion of debt over five years.

Indeed, Axiall has a history of strong cash generation. For the last three years, (un-merged) free cash flow has averaged $133 million a year, or a 50% cash-conversion ratio.

Axiall operates in a relatively defensive sector, producing plastics used in everyday items such as cars, flooring and pharmaceuticals, much like DuPont and Dow. However, Dow has recently been branching out, as the company's international operations note softening demand from Europe.

Indeed, during the first quarter of the year, Dow noted a 4.2% and 2.6% decline in sales within its performance materials and performance plastics divisions, respectively. Meanwhile, the company's agriculture-sciences division grew 14.4% - this is obviously where the money is for the company. 

Unfortunately, while Dow is befitting from agriculture, DuPont is not. The company suffered from a 10% decline in first half earnings after the firms agriculture, nutrition and health segments came under pressure from  “unseasonably cool, wet weather across North America and Europe.”

What's interesting here is that far from helping Dow and DuPont, diversification and international expansion have actually hampered earnings growth. Domestic, plastics-focused Axiall is still growing. 

Still, DuPont and Dow's size put them ahead of Axiall as they are able to achieve better economies of scale. That said, as I have shown, this has not translated into stronger shareholder returns. Moreover, analysts are less optimistic about Dow and DuPont, predicting that Dow's adjusted EPS will expand only 10% this year and 12% in 2014. Du Pont is expected to notch growth of 8.6% this year and 5% the year after. In comparison, Axiall is expected to generate adjusted EPS growth of 140% this year and then 25% in 2014.

Foolish summary

This is a brief summary of Axiall's strengths in comparison to its larger peers. However, even in this short space, it is easy to see how strong the company is in comparison to its larger peers -- especially when taking into account the company's size.

Axiall is growing rapidly. The managements cost-cutting activities should only increase earnings by $100 million a year, or 10%, at the end of the two-year program, which will ultimately lead to stronger cash generation and a better return for investors.

If you're looking for some long-term investing ideas, you're invited to check out The Motley Fool's brand-new special report, "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so simply click here now and get your copy today.

Fool contributor Rupert Hargreaves owns shares of AXIALL CORPORATION. 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!

blog comments powered by Disqus