Description

Executive Summary:

AdvanSix Inc. (“AdvanSix”, “ASIX”, or the “Company”) is a commodity chemical business which produces the lowest cost Nylon 6 globally including China. More broadly, ASIX is an integrated manufacturer of Nylon 6, caprolactam, ammonium sulfate fertilizers, and chemical intermediates used in the building and construction, packaging, agriculture, and paint/adhesive industries. The business is the lowest cost producer and operates in a duopoly with BASF in the US with diverse end-markets which should secularly grow at GDP.

ASIX’s competitive cost advantage is not understood by the markets and only two sell-side analysts cover the stock. Previous cycles have led to a margin range of 1,000 basis points from peak to trough. Since ASIX only has a short operating history as a public company with no direct public comps, the potential cyclical upswing over the next few years is being overlooked providing an opportunity for 100%+ upside from current share price over the next handful of years.  

AdvanSix stock has performed well since the 2016 IPO yet recently pulled back from highs near ~$44 to $27 due to disappointing performance and fears from an FBI raid in their Hopewell facility. We feel these issues should not impact the long-term value of the business and ASIX has significant upside trading at ~5.2x our 2019E EBITDA. In addition, current growth / de-bottlenecking investments and the majority (85%) of end markets performing well, the Company could generate more than $250 million in EBITDA over our investment horizon which would value ASIX at ~4.0x EBITDA. This is an extremely low multiple for a business that is the global low-cost producer, has a strong balance sheet, and generates growing free cash flow despite increased capital expenditures. Importantly, revenue is widely variable based on pass-through contracts that are correlated to oil prices. Revenue growth is not the important factor, it is EBITDA generation that will increase from improving yields and pricing spreads. The bull case for ASIX can be summarized by the following points:

Cost Advantage:

ASIX is the low-cost producer of caprolactam in the world. Caprolactam is a chemical compound used in the production of Nylon 6 resin which can be used in plastic packaging, carpet, electrical components, and automotive parts. The reason ASIX can produce at such a low cost is (1) backwards integration that provides feedstocks that act as netbacks to production costs and (2) industry leading 4:1 Raschig technology. The Company is able to sell 100% of all excess products that are not necessary for the core operations. ASIX produces their own phenol (only 15% of the world does this) which is more efficient in the conversion of benzene to caprolactam then from buying cyclohexane as over 600 million pounds of acetone is produced as a bi-product along with other chemical intermediates. In addition, ASIX facilities have a Raschig process that allows them to produce four ammonium sulfate pounds for every one caprolactam pound. The ammonium sulfate fertilizers are valued at a premium in the US and Latin America due to high sulfur yields (American soil is sulfur deficient). This was not historically the case, as rain had been more acidic and thus had higher sulfur content. As government regulations increased, the acidic content in the rain decreased and with it the sulfur content. This is why most competitors operate at a two to one ratio as the technology was not valued. With strong tailwinds for ammonium sulfate fertilizers, this is a very important advantage and should help generate strong EBITDA and cash flow over a 3 to 5-year horizon.

Scale also provides an advantage for ASIX. As the largest US producer of caprolactam, ASIX can purchase raw materials (mainly cumene, 75% of COGS) at favorable prices and is also able to ship and transport more efficiently. In addition, the Companies position in the US provides access to low cost natural gas which makes up 10% of cost of goods sold. The US also provides higher value end-markets in comparison to their European and Asian competitors. The supply chain limits the ability for the US to import caprolactam as it is a molten supply chain which is shipped in heated trucks and rail cars. In order to ship overseas, it must be exported in flake form then melted upon arrival. This lengthens the supply chain from a couple of days to potentially weeks or months if importing from Asia.

Overall, the low-cost advantage allows the Company to operate at utilization rates much higher than industry levels (95%+ vs. 75%) as they are able to make profits on any amount of caprolactam and Nylon 6 they produce.

Capacity Rationalization:

Up until 2010, the industry was very rational in terms of capacity which led to ASIX being able to operate at much higher margins than current levels. In 2010, China began adding significant capacity at a time when demand growth was steady. This put pressure on spreads and reduced earnings power of the producers. Beginning in 2015, the industry has started to see favorable tailwinds of capacity rationalization. Fibrant shut down their US plant which was about 25% of US capacity, and BASF took down a 100,000-ton line in Europe. This reduced global supply by ~5% in one-year. End markets in North America continue to show strong demand and with ASIX and BASF operating in a duopoly, these trends support long-term supply and demand dynamics.

Currently, pricing is at the marginal cost of production levels and the supply/demand dynamics should be favorable for the foreseeable future. In addition, China has implemented environmental controls that have lowered utilization rates in the regions, increased costs for producers, and had an impact on feedstock spreads. There is also increasing talks of forcing plants in China to move to industrial parks to reduce pollution. With 1/3 of global capacity in areas of environmental scrutiny and utilization rates low, this could lead to many plants shutting down altogether over the next several years and increase spreads above the current levels. Discussions with management leave estimates for maintenance capital expenditures at $55-$65 million or ~2% of the replacement value of $3 billion. With ASIX trading so far below replacement value, it seems unlikely that additional capacity will be built and there is a possibility that many plants will shut down if forced to relocate.

Pricing Cycle:

There are three main spread equations in understanding the variable margin. The first is used to estimate profitability for nylon and can be tracked with the benzene to caprolactam (BNZ-CPL) spread. The BNZ-CPL dropped ~70% from 2011 to the trough in 2016 according to our discussions with management and former employees. These spreads have now recovered to ~$1200/MT which is near the marginal production cost, but still well below peak levels. With strong North American demand trends, these levels should stay relatively stable with upside if Chinese supply is reduced. Current levels are near 2012 levels where we estimate ASIX generated ~$290 million in EBITDA.

The second spread can be used to estimate profitability for the chemical intermediates and is the large buyer acetone price and the acetone to refinery grade propylene spread. Acetone represents ~1/2 of chemical intermediate sales with over 600 million pounds sold annually. Phenol is the second most important chemical intermediate as over 200 million pounds are sold annually. Acetone prices have come under pressure due to recent over supply in China and inflation in propylene has reduced spreads to 5-6 cents in the most recent quarter vs. 9-10 cents historically. We feel these levels will rationalize as well, but do not include this upside in our EBITDA estimates.

The third is the corn belt ammonium sulfate price which drives ammonium sulfate segment profitability. ASIX produces over three billion pounds of ammonium sulfate fertilizer and prices are currently at ~$250 per ton. These prices were near $400 in 2012 so we see considerable upside to current levels. Recent tailwinds such as limited nitrogen supply and increasing urea prices suggest upside to ammonium sulfate fertilizer. Even a small increase in price would be significant with the current production levels.

Internal Investments:

Since the spin-off, management has taken on multiple capital investments that have depressed free cash flow in the near term but will strengthen the long-term value of the business. Management has said a strong pipeline of $150-$200 million in growth opportunities with 20%+ IRR’s remain and with a historically underinvested business, these provide considerable upside. Capital expenditures in 2018 and 2019 will be ~$50 million and ~$45 million above normal levels ($55-$65 million of maintenance) as management is investing in debottlenecking the production process and building specialty product capabilities. These projects increase intermediate chemical buffer storage capacity that will mitigate unfavorable impacts of routine maintenance and unplanned outages. In addition, initiatives are aimed at increasing plant productivity and lowering costs through procurement improvements. The investments will also work on building a system for competitive bidding and supplier diversification to reduce raw material costs. These investments will contribute meaningfully to production capacity.

Additional spend includes $10-$15 million for relocation of the R&D plant and $8-$10 million in for health, safety, and environmental reasons. As these investments start to flow through in the second half of 2019, the Company will be in a strong position to continue to allocate capital in high return growth investments, pay down debt, return shares, or pursue opportunistic M&A. It is worth noting that in the LTM ASIX has generated $164 million in cash from operations and $72 million in free cash flow (8.6% yield) despite increased capital expenditures.

Higher Margin Products:

Management has put an emphasis on optimizing mix to include higher margin products that have 1.5x-2x the gross margin of normal Nylon 6. One example is copolymer resins that provide enhanced characteristics such as toughness and strength and are used in value-added products. These resins currently compose 8-10% of sales, and conversations with management mention that these will be a meaningful growth contributor going forward. We are not including these in our $250 million EBITDA estimate, but provide significant upside.

FBI Investigation:

The FBI raid in March of 2018 caused a reduction in market capitalization of ~$225 million. We feel this overreaction is severely overblown when looking at comparable situations. Historical fines and environmental projects imposed on defendants have been minimal outside the three large cases of Volkswagen (2017), Duke Energy (2015), and BP (2013). Taking out the impact of Volkswagen in 2017 leaves an average of $1.3 million in fines to defendants. ASIX had a previous environmental air emission problem at the Hopewell facility in 2013 that resulted in a $3 million fine. Even if these numbers are multiplied significantly, it would not result in any significant impairment to the value of the business.  In addition, the investigation has had no impact on operations which would lead one to believe they will not be forced to shut down the plant for any time period.

Furthermore, on the recent 3Q18 quarter call management mentioned the approval of a 5-year growth plan permit from the Virginia Department of Environmental Quality. We toured the Hopewell plant on 11/15/18. CEO Erin Kane mentioned that it is a normal part of the business to have drop-in inspections and 2018 has had 2x the number of visits and not a single problem was found. We believe that these scenarios would not be allowed if there was a material issue with environmental compliance.

Company Overview:

AdvanSix was spun-off from Honeywell on October 1st, 2016. Honeywell shareholders received one share of AdvanSix for every 25 shares of Honeywell. Honeywell chose to spin-off AdvanSix to focus on their core business in higher growth markets with differentiated technology and software capabilities. The spin-off has allowed management to optimize the core business, add financial flexibility, and enhance its offerings and service to customers.

ASIX is an integrated manufacturer caprolactam, a chemical compound which is used in the production of Nylon 6, a polymer resin used in production of engineered plastics, fibers, filaments, and films. These are in turn used for automotive and electrical components, carpets, sports apparel, fishing nets, and food and industrial packaging among other things. Because of the backward integration, ASIX produces ammonium sulfate fertilizer and chemical intermediates as bi-products. Over 90% of sales come from North American markets.

The scale that ASIX has allows them to produce caprolactam at a lower cost per pound than competitors and also provides benefits from procurement activities for raw materials and services. Scale is also intriguing to customers as the stability of supply is important for meeting end-market needs.

Inputs:          

Cumene, an oil derivative, is produced by reacting propylene and benzene. 98% of all cumene produced in the world is used as a chemical intermediate in the production of phenol and acetone. Cumene makes up 75% of ASIX’s raw material costs. Input price increases are highly correlated with oil prices. The phenol is then used in the production of caprolactam, the main component in Nylon 6 resin. This process also produces acetone and ammonia, among other chemicals, as byproducts that can be used in production of ammonium sulfate or sold to customers. This gives ASIX a competitive advantage as the byproducts act as netbacks which reduces their overall cost of production.

Natural gas is the second largest input at 10% of raw material costs. ASIX has an advantage over foreign producers as the US has the lowest cost natural gas. The third main input is sulfur at 8% of sales. ASIX scale also allows them to have lower handling, storage, and transportation costs as they are able to invest in software and other capabilities that improve their ability to produce and store the products.

ASIX’s vertical integration is provided through four main plants.

Ø  The Frankford plant is the second largest producer of phenol and acetone in North America

o    The plant has capacity to produce 1.1 billion pounds of phenol and 680 million pounds of Acetone annually

o    ~75%-80% of phenol produced is transported to the Hopewell facility

Ø  The Hopewell plant is one of the world’s largest single-site producers of caprolactam and ammonium sulfate

o    The plant has capacity to produce 795 million pounds of caprolactam, 3.3 billion pounds of ammonium sulfate, and 600 kilo metric tons of ammonia annually

o    60% of caprolactam produced is shipped to Chesterfield to be polymerized into Nylon 6 resin, the rest is sold

Ø  The Chesterfield plant is one of the world’s largest sites for Nylon 6 production

o    The plant has capacity to produce 440 million pounds of Nylon 6 resin annually

Ø  The Pottsville plant produces nylon films used for packaging

o    The plant has capacity to produce 17.5 million pounds of film annually

Caprolactam:

Caprolactam is the chemical compound used in the production of Nylon 6 resin. Caprolactam production for ASIX starts with cumene, an oil derivative, and goes through reactions to create phenol. This is an important advantage to ASIX as the conversion from phenol to cyclohexanone produces more than 600 million pounds of acetone along with other chemical intermediates that are used as netbacks to production costs. Only 15% of the world produces their own phenol. Once the phenol is converted to cyclohexanone, it is reacted with ammonia and oleum to produce caprolactam. During the conversion process, ammonium sulfate fertilizer is created as a byproduct and ASIX has more than 3 billion pounds of production capacity due to the 4:1 Raschig production process.

60% of the 795 million pounds of caprolactam produced at the facility in Hopewell is shipped to Chesterfield and used in production of Nylon 6. The remaining is sold to other nylon fiber/film producers. 20% of overall production is sold in the US and the other 20% is sold in Europe (10%) and Asia (10%).

Nylon 6:

The Company sells 440 million pounds of Nylon 6 globally under the Aegis brand name. The overall Nylon 6 segment has a $9 billion addressable market and shows steady growing demand with end markets of carpets, plastics, packaging, building products, and textiles. ASIX has put an emphasis on engineered plastics and packaging which provide higher margins and are generally faster growing end markets. For engineered plastics, Nylon six provides excellent molding and extrusion characteristics that can be used for automotive parts, electronics, and shoes. The Nylon exhibits strength, stiffness, toughness, and heat/chemical abrasion resistance. The flexible and rigid packaging provides tear and puncture resistance for meats, cheeses, and other packages having sharp edges. In addition, they help extend product shelf-life and preserve flavor, color, and aroma.

ASIX has also been investing in copolymer resins. The copolymer resins exhibit magnified characteristics of Nylon 6 and generate double the margin of the rest of the business. These currently make ~8%-10% of sales, so even a small increase as a percentage of sales can provide considerable upside.

Ammonium Sulfate Fertilizers:

Ammonium sulfate fertilizer is derived from the production of caprolactam. The Hopewell plant is one of the world’s largest single-site producers. Over 70% of North American sales are to co-ops and integrated retailers. The access to both North and South America gives ASIX a year-round growing season to push products. ASIX boasts a >60% granular conversion rate which command a premium in the markets. This is a $3.5 billion market that is impacted by farmer profitability, crop prices, and stock-to-use ratios. Ammonium sulfate fertilizers provide a premium over urea fertilizers due to the sulfur nutrients that increase crop yields.

Generally, fertilizer pricing declines in 3Q with new season fill and strengthens in the spring planting season. ASIX boasts industry leading Raschig technology that produces four pounds of ammonium sulfate for every one pound of caprolactam. This is a cost advantage for ASIX as they are able to get netback products that are a result of the production of caprolactam and Nylon 6. Recent industry trends are providing tailwinds for ammonium sulfate fertilizer pricing. With annual capacity of 3.3 billion pounds, even small price increases provide attractive upside.

Chemical Intermediates:

The Company also is able to manufacture and sell other chemical products derived from the processes in the backward integrated supply chain. The most important chemicals are acetone and phenol. Other byproducts include alpha-methyl styrene, cyclohexanone, methyl ethyl ketoxime, cyclohexanol, acetaldehyde oxime, 2-pentanone oxime, sulfuric acid, ammonia and carbon dioxide. This is a $12 billion market with steady growing end markets.

Acetone accounts for half of chemical intermediate sales and is used in the production of adhesives, coatings, paints, engineered plastics and solvents. Oncoming acetone supply in Asia as well as inflation in propylene prices has compressed the spreads and had a negative impact on EBITDA. Historic prices have ranged between 9 and 10 cents per pound, and recent issues have reduced these spreads to ~5 cents per pound. With annual sales greater than 600 million pounds, this is a headwind that will impact the business. We feel this issue may take some time to resolve, but favorable trends in the remaining 85% of the business should offset the acetone issues and rationalization would be an incremental bonus to our current projections.

Phenol is used ~75% internally for caprolactam production with the rest sold to customers for the use in resins and epoxies. ASIX has the capacity to produce 1.1 billion pounds of phenol, of which ~275 million are sold externally. Phenol and the other chemical intermediates pricing remain strong and has helped to offset some weakness in the Acetone markets.

Customers

Revenue generation is volatile due to 50% of revenue being tied to formula/index pricing linked to raw materials or published industry indices. These contracts do not have a significant impact on the absolute EBITDA number. The other 50% of revenue is based on market pricing that is decided by supply/demand, marginal producer economics, and underlying raw materials. These contracts generally have a 30-60-day lag. The impact to EBITDA is determined by the adders or spreads that are separately negotiated. Ammonium sulfate has no formula contracts, while about 2/3 of the Nylon 6 and Chemical Intermediates segments have formula contracts. This has been steady historically and will be the mix going forward.

Most customers are on 1-2-year contracts, with the largest customer Shaw Industries (22%, 17%, and 16% of sales) being on a longer-term contract. Since there are only two suppliers, there is very little turnover, and customers feel that the stability ASIX provides as the largest producer of Nylon 6 is important. The top ten customers compose 44% of sales with an average relationship lasting 20 years. These relationships help keep utilization rates high and provide both operating and purchasing leverage.

Significant customers include:

Ø  Nylon: Shaw, Lexmark, Toray, Hyosung, Bemis, DuPont

Ø  Ammonium Sulfate: Heringer, Growmark, CHS, Nutrient Ag Solutions

Ø  Chemical Intermediates: Eastman, Hexion, Dow, Univar, Monument, Lucite

Executive Management:

We have met with management multiple times and feel that they are the right team to grow the business after spending the last few years correcting material under investment in the business over the past decade or so of Honeywell ownership. CEO Erin Kane has excellent experience and has been part of the business since 2014. We feel she is a great operator and is making the right decisions to grow the long-term value of the business. CFO Michael Preston seems like an excellent capital allocator and is using a disciplined approach to choose investments that will have the highest returns for the business. Long-term incentives are based on cumulative EPS and ROI, and we feel that the incentives are aligned with shareholder value creation.

Conclusion/Valuation:

There are numerous tailwinds that support our estimate of $250 million annual EBITDA over the next 2-3 years. The capacity rationalization discussed above, tailwinds to pricing spreads, and increased investment should be meaningful contributors. With past EBITDA generation near $300 million in 2011 and 2012, we feel we our estimates are conservative and leave significant upside. In a base case scenario, ASIX can generate $250 million of EBITDA and at 8.0x EV/EBITDA would value the business at $2 billion, with an equity value of $1.8 billion. This gives a target price of $58 vs. the current share price of $27, over 100% upside.

Risks:

Ø  Unplanned turnarounds affecting EBITDA

Ø  Planned turnaround execution

Ø  End market cyclicality

Ø  Pricing/Spreads

Ø  Internal investment execution

Ø  Change in supply/demand dynamics

Catalyst

Conclusion of FBI investigation, growth projects, pricing tailwinds, capacity rationalization, impact of high margin products