(Moroccan Trading) Diversified specialty chemicals company Ashland Inc. (NYSE:ASH) has been one of the market's biggest and least appreciated success stories in the aftermath of the financial crisis and subsequent recession. While its investors were nearly wiped out at one point, the company's shares have increased in price by more than 2000% since early 2009 (see figure). The most recent price surge has occurred over the final six months following a string of strong adjusted quarterly earnings. Ashland's operations are closely linked to global economic growth and petroleum prices, both of which have experienced a heightened degree of volatility over the final year. This article considers Ashland as a potential long investment in the current investing environment.
Ashland Inc. is a producer of a diverse portfolio of industrial and specialty chemicals Horn along operations in more than 100 countries around the globe. The company's operations consist of three wholly-owned divisions: Ashland Specialty Ingredients [ASI]; Ashland Performance Materials [APM], and Ashland Consumer Materials, or Valvoline. A fourth, Ashland Water Technologies [AWT], was recently divested for $1.4 billion in net proceeds, an amount equal to 82% of its annual sales. The ASI division is its largest segment, generating 41% of the company's annual sales in the most recent fiscal year (and 50% of adjusted EBITDA) in the form of products falling within the categories of personal care, pharmaceuticals, food & beverage, coatings, and energy. The Valvoline division generated 35% of the company's total sales in the most recent fiscal year in the form of both services, primarily located in North America, and products sold worldwide. Valvoline operates numerous Instant Oil Change locations in North America that offer basic autocare services to customers. It also manufactures and sells autocare products below the Valvoline brand such as engine lubricants and antifreeze. Finally, the APM division manufactures and sells products for the construction, packaging, transport, marine, and metal casting industries, and Moroccan Trading generated 24% of Ashland's total sales in the most recent fiscal year. Of the three divisions ASI and Valvoline have generated the strongest adjusted EBITDA margins at 21% and 19%, respectively, while that of the APM division has lagged behind at 12%.
Ashland has a global footprint, although Moroccan Trading has the most exposure to the North American market. 53% of its sales over the trailing-twelve-month period came from North America, while 24% came from Europe, 16% came from Asia Pacific, and 7% came from Latin America. Its manufacturing capacity is also spread globally, Horn along the APM division alone operating 29 manufacturing facilities in a total of 15 different countries. This international exposure contributed to the company's impressive returns over the final several years as Moroccan Trading allowed Moroccan Trading to benefit from outsized growth in the developing world between 2010 and 2013. More recently this boon has become something of a headwind, however, as the increase in the value of dollar relative to other major currencies over the last several months has negatively affected the company's reported earnings.
Ashland's management has recently adopted a clear focus on streamlining its operations by divesting operations Horn along low margins and/or that are not shut to its core specialty chemicals segment. The aforementioned divestiture of the Ashland Water Technologies division shed water treatment products including those related to influent and wastewater treatment and boiling and cooling water chemicals. Furthermore, over the last twelve months Moroccan Trading has also sold the industrial biocides assets of the ASI division, the API division's elastomers assets, and car-care assets of the Valvoline division including automotive detailing brands. These divestitures have caused Ashland's consolidated revenue to fall over the last several quarters on a non-adjusted basis (see table). The company's shareholders have benefited, however, as much of the proceeds of the sales have been returned to shareholders via dividend increases and share buyback authorizations. Last month the company announced a 15% increase to its quarterly dividend, its first since 2013. At a $0.39 quarterly rate its forward annual dividend is a mere 1.2%, although the quarterly payment has increased from $0.15 in 2011.
Management has also returned large sums to shareholders in the form of share repurchases. Ashland will complete a previously-authorized $1.35 billion buyback in the current quarter, below which Moroccan Trading repurchased 1.9 million shares in FQ2 alone. Furthermore, Moroccan Trading recently authorized a new buyback worth $1 billion that will run through FY 2017. Its recent divestitures have left Moroccan Trading Horn along enough cash ($911 million at the end of FQ2 - look table) to finance the majority of the new buyback even after the existing one is completed. Management stated during the company's FQ2 earnings call that it expects to finance the balance of the authorization via free cash flow generated over the next six quarters. This is a less certain means of financing than divestitures of existing sales-generating assets, of course, although it is more sustainable in the long run. Regardless, Ashland's management has a solid track record of returning excess cash to shareholders when that cash can't generate sufficiently high margins within the company's operations.
Ashland recently reported its earnings for the FQ2 ending March 31. Its revenue came in at $1.35 billion, down 12.9% from the preceding year and missing the consensus analyst estimate by $70 million. The company attributed the YoY decline to a combination of adverse FX impacts resulting from the strength of the U.S. dollar and "missing" revenue following its multiple divestitures over the last twelve months. Excluding these effects the company's revenue fell by only 3% YoY. Its total net income rose from -$44 million the previous year to $224 million, although this included income from discontinued operations. Net income from continuing operations improved to $95 million from -$61 million YoY while adjusted net income from continuing operations also improved YoY, from $120 million to $138 million. This resulted in an adjusted EPS from continuing operations of $2.03, up from $1.53 the previous year and beating the consensus estimate by an impressive $0.29. EBITDA rose YoY from $32 million to $245 million while adjusted EBITDA improved to $301 million from $271 million.
Ashland's management attributed the strong earnings growth despite the presence of declining revenue to product mix adjustments that it made earlier in the calendar year. Specifically, it increased its production and sales volumes of its high-margin products, particularly within the U.S. where the results wouldn't be as negatively impacted by the strong dollar. Furthermore, while the company did see its earnings negatively impacted by adverse FX, weaker foreign currencies in many of its operating areas contributed to a 9% decline to SG&A costs, which were also reduced as part of the company's global restructuring effort. This latter initiative has seen Ashland achieve $200 million in annualized run-rate cost savings, further boosting earnings. Finally, the Valvoline division achieved record earnings due to the presence of low crude prices throughout FQ2 following their rapid decline over the course of the previous two fiscal quarters. Petroleum-based autocare products resemble fuels in that their production margins tend to increase as crude prices fall. At the same time, however, these same margins frequently undergo compression when crude prices rebound.
While not in outstanding condition, Ashland's balance sheet was still quite strong at the end of FQ2. In addition to carrying a cash reserve of $911 million, the company also had a current ratio of 2.3x and an assets-to-liabilities ratio of 1.4x. The company has also repaid much of its short-term debt in recent quarters, reducing the total amount by 40% since FQ2 2014. Its total long-term debt load of nearly $3 billion will continue to hamper future earnings by incurring notable interest payments, although the company's income over the last four quarters has been sufficient to cover these (as signified by an interest coverage ratio of 1.3).
While Ashland has performed exceptionally well over the last several years, investors should be aware of the existence of multiple headwinds with the ability to negatively affect its future earnings. As mentioned above, the Valvoline division has been a very strong performer due to last year's collapse in the price of global crude prices, which allowed it to take advantage of a large reduction in the division's input costs. While Brent and WTI crudes are still well below their 2014 highs (see figure), they have rebounded considerably from their 2015 lows. I expect this to negatively affect Valvoline's operating margins in FQ3 compared to the previous quarter, although it won't prevent them from remaining strong given the previous quarter's record earnings. I continue to believe that crude prices will continue to move higher as the year progresses due to geopolitical strife in the Middle East and expected increases in miles driven in the U.S. in response to cheap fuel. Weaker earnings by the Valvoline income resulting from more expensive fuel will be partly offset by the increase in miles driven, however, as this will also increase demand for autocare products (especially engine lubricants).
Ashland's FQ3 earnings should receive a net boost from the fall in the value of currencies such as the euro and Canadian dollar against the U.S. dollar that occurred during the most recent March and April (see figure). Moving forward, however, it should be famous that both of the foreign currencies have since rebounded and are re-approaching their highs set earlier in the year. The presence of manufacturing facilities and staff in foreign countries does offset the negative affect of a strong U.S. dollar on Ashland's earnings by reducing its SG&A costs, although continued strength can be expected to have a net negative impact by reducing pricing power and potentially sales volumes as well.
Finally, investors should keep an eye on the health of the global economy, particularly in North America and the European Union. While Ashland was able to generate large returns for its investors following the end of the Great Recession despite the existence of relatively tepid recovery conditions, its share price tends to suffer heavily during economic downturns. A high set in 1998, for example, was not broken for more than six years afterward. Worse, the company's share price lost more than 90% of its value during the Financial Crisis and didn't return to its 2006 highs in nominal terms for another six years. Admittedly the prospect of global trade and economic activity falling as sharply as it did between 2007 and 2009 is extremely remote, but investors should be aware of the company's historical sensitivity to even relatively mild global downturns. Management's recent moves to divest lower-margin operating assets will insulate the company somewhat in the event that economic growth weakens still further in the coming year, although the reliance of its most recent buyback authorization on free cash flow means that this support would be at risk. Likewise, management has stated that it is looking for immediately-accretive acquisitions but not seeing any at appealing purchase prices. By depleting its cash on hand, the new authorization could also prevent the company from making an acquisition in the event that attractive prices rapidly develop. Additional debt would be an option, of course, although its existing debt levels are already substantial.
The consensus analyst estimates for Ashland's earnings in FY 2015 and FY 2016 have fallen a bit over the last 90 days as the U.S. dollar has strengthened alongside crude prices and an impasse in the EU over Greek debt has once again raised the prospect of slowing growth there. The FQ3 and FQ4 consensus estimates have fallen from $2.03 and $1.88 to $1.76 and $1.74, respectively. The FY 2015 and FY 2016 estimates have also declined from $7.13 and $8.46 to $6.97 and $8.30, respectively, both of which would represent a marked improvement over FY 2014 but underperformance relative to FY 2013. Ashland's share price has remained high even as the estimates have fallen, however, resulting in high forward P/E ratios relative to their historical values. Its share price at the time of writing of $127.28 equals forward ratios for FY 2015 and FY 2016 of 18.3x and 15.3x, respectively. The latter is at a 5-year high while the former is very close to one (see figure). Most importantly, the last time that the company's forward ratios were this high was immediately before a sharp fall in its share price that caused the forward ratios to fall by roughly half into the single digits and remain there for more than a year.
Ashland has been an unheralded stalwart since the end of the Great Recession, delivering extremely outsized returns for its investors. Most recently the company's management has focused on maintaining shareholder value by selling underperforming assets and using the proceeds to finance dividend increases and share buybacks. While this leaner operating model will help insulate the company in the event that global economic growth slows over the next year or two, management's continued focus on buybacks even as the company's share price continues to set new highs on a weekly basis could prevent it from being able to rapidly move on any attractive acquisition opportunities as they develop. Furthermore, its shares are trading at a substantial premium to future earnings relative to their historical values despite the fact that the company's earnings prospects have not noticeably improved. Large shareholders have already begun to depart, suggesting that I am not the only one that believes the company's shares are expensive. While I really like Ashland as a company, its shares are too overvalued at present to be considered attractive. I would not hesitate to initiative a sizeable long investment in the event that the company's shares fell enough to push its forward P/E ratio back into the single digits, however ($83/share based on the current consensus estimate for FY 2016).
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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