My apologies but the charts have not come out on here - if anybody would like to see them or the model then let me know and I will send them.

Quick History & Business Primer

 

They are a Swiss industrial Chemicals manufacturer based in Basel that came into being in 1995 when spun out from Sandoz, a larger Swiss group that has been around since the end of the 19^th century. Over the next decade or so they built up their existing portfolio, acquiring BTP in 2000 (in a highly-leveraged transaction that badly overstretched the company), Ciba Masterbatches and the speciality chemicals business of Hoechst.

 

The Clariant portfolio is a complex one, comprising Industrial and Consumer specialties, Pigments, Masterbatches, Textile Chemicals, Leather Services, Oil & Mining Services, and Performance Chemicals, which is itself comprised of three former units that have been merged (Detergents, Paper Chemicals and Additives). Briefly the various units can be described as follows:

 

Industrial & Consumer Specialties

They make speciality ingredients for skin and hair care (for example wet wipes), along with household cleaning fluids and disinfectants. This division also produces products for industrial applications, including adjuvants, solvents, dispersing agents and other performance fluids. Finally, they hold a global position in aviation de-icers. This is the largest division by sales, with 1,526m sales (of the group's 7,120) in 2010 at a 13.5% EBIT margin. Competitors include BASF, Croda and Evonik.

 

Masterbatches

They make colour and additive concentrates and technical compounds for the plastics industry, with end markets being autos, electrical, consumer goods and packaging. Main competitors are Ampacet, PolyOne and Schulman. Sales in 2010 were 1,260m at a 9.5% EBIT margin.

 

Pigments

They make organic pigments, preparations and dyes used in coatings, printing and plastic that are then used in many industries including autos, industrial, paints, printing, cosmetics and other HPC applications. BASF and DIC/SUN are the key competitors. Sales in 2010 were 1,168m at an excellent 17.3% EBIT margin, by far the highest in the group.

 

Textile Chemicals

They make chemicals for pre-treatment, dyeing, printing and finishing of textiles used in apparel, home textiles, technical textiles and carpets. Sales were 821m in 2010 at a margin of just 9%. Competitors include BASF, Dystar, Huntsman and Long Shen.

 

Oil & Mining Services

They make explosive emulsions, fertiliser stability improvers and dust controllers, competing against Baker Petrolite, Champion, Cytec and Naico. Sales in 2010 were 604m at a margin of 11.9%.

 

Leather Services

They make leather chemicals for tanning, retanning, dyeing, fatiguing and finishing used in autos, luxury goods, furniture and clothing. Key competitors are BASF, Lanxess, Stahl and TFL. Sales in 2010 were 326m at a margin of 11.7%, making it the smallest division.

 

Performance Chemicals

This division is actually the second-largest in the group with sales of 1,415m at a margin of 11.4% and was formed through the merger of three formerly independent divisions - additives, paper chemicals and detergents and intermediates. Additives products include non-halogenated flame retardants to protect buildings and equipment along with textiles used in planes, trains and automobiles; waxes used in polishes, coatings, plastics; antioxidants; light stabilisers and antistatic agents. In detergents they supply raw materials for laundry detergents and household cleaning products. Finally, in paper they produce chemicals for whiteness, colour, coating and strength. The product portfolio is quite large but they generally compete with BASF, Dow Chemical, Ashland, Kemira and Organic Kimya.

 

Recent Years

 

The last few years have been a frustrating experience for the shareholders of Clariant. The businesses in which they have traditionally operated have been characterised by intense competition, low capacity utilisation and low profitability. Competition became more intense in recent years as Chinese players entered the market and Clariant's initial response was to be aggressive on pricing so as not to lose volume, the reason being they saw it as important to keep the order books full so as not to suffer from negative operating leverage with falling volumes.

 

Various half-hearted attempts were made to restructure the business to make it fit to compete with lower-cost peers, mainly through the divestment of certain unprofitable units in the period 2001-2006 but in general the company seemed happy to muddle through. Around 2007, the onset of the financial crisis encouraged the company to take more decisive action. Project Clariant was announced, the key points being a reduction in working capital from 24% of sales in 2008 to 16% by 2010, reduction of full-time employees by 20%, some site optimisations and a focus on price over volume. These improvements were achieved by 2010 year end.

 

At the time the market was not willing to give the company much credit for the restructuring of the business for the reason that Clariant was seen as structurally challenged with restructuring being a fact of life rather than a one-off in such a business. The company had already put through some 475m CHF in restructuring and impairments in the two years leading up to Project Clariant, and there seemed to be little appetite amongst market participants to look another two years out beyond the latest bout of restructuring. In my view there is still a little bit of this mentality in the market today - from 2006-2010 the company has cumulatively reported 1,229m of clean EBIT but 1,395 of restructuring and impairment charges. The valuation of the company, at 4.3x EV/EBITDA 2012 against 5.2x for industrial chemicals peers and 7.9x for speciality peers implies that the market does not believe the company has really changed and that the same problems of old will resurface in the coming years.

 

Other factors that have hindered the progress of the shares in recent years have been rising oil prices and the financial crisis, which put paid to organic growth just as pricing momentum began to improve, an overly leveraged balance sheet (this has since been improved with negligible net debt position pre-deal) and shareholder-unfriendly management. As an example, in 2008 I tried to meet with the company to talk about the restructuring with a view to taking a position as a value restructuring play and was told I had to go through various presentations and go through a pre-screening process with the IR before I would be approved to be put in front of the management. After I had done this and met with the management, I then dialled in to a presentation they were doing with other investors and found the management were not communicating effectively - for example they had been discussing the price over volume strategy with me and then in the group meeting were emphasising the importance of volumes. As it turned out the price over volume strategy was not in any jeopardy, but in my view they don't communicate all that well with the market. This hasn't really changed - for example the recently-announced Sud-Chemie deal was not all that well-flagged and was done at a meaningful premium to their own multiple.

 

Recent Years In Numbers

 

As previously noted, pre-2008 the company struggled to generate much growth beyond volumes, which track GDP. A difficult competitive environment led to round after round of restructuring and portfolio reshuffling and the company battled to generate acceptable margins, even pre-exceptionals. On a reported basis the company never beat their cost of capital in the 2005-2009 period and was loss-making post minorities every year. 2010 seems to have been the turnaround year, with EBIT pre-exceptionals at record highs for the portfolio and net profit at the highest level in about 10 years:

	2006	2007	2008	2009	2010
Income Statement
Sales	8,150	8,533	8,071	6,614	7,120
Cost Of Goods Sold	-5,664	-6,045	-5,757	-5,057	-5,133
Gross Profit	2,486	2,488	2,314	1,557	1,987
Selling, General & Admin	-1,729	-1,775	-1,637	-1,162	-1,177
Research & Development	-209	-211	-184	-150	-135
Associates	39	38	38	25	21
Restructuring & Impairment	-211	-262	-302	-290	-330
EBIT	376	278	229	-20	366
Restructuring & Impairment	-211	-262	-302	-290	-330
Other Exceptionals	8	1	1	0	-28
EBIT Pre-Exceptionals	579	539	530	270	724
D&A	271	273	253	225	177
EBITDA Pre-Exceptionals	850	812	783	495	901
Net Interest	-110	-71	-138	-101	-123
PBT	266	207	91	-121	243
Tax	-145	-99	-119	-73	-52
Net Income Continuing Pre-Minorities	121	108	-28	-194	191
Discontinued	-199	-103	-9	0	0
Net Income	-78	5	-37	-194	191
Minority Interest	-7	-7	-8	-12	-11
Net Income Post-Minorities	-85	-2	-45	-206	180

 

Over the time period the company has de-levered from a peak net debt of 1,832m in Q207 (2.1x EBITDA) to just 126m net debt as at 2010 y/e pre-acquisition of Sud-Chemie. There are no significant debt maturities until 2013. The improvement in the position has mainly come about through an increased focus on operating cash flow:

	2006	2007	2008	2009	2010
Cash Flow Statement
Net Income	-78	5	-37	-194	191
Non-Cash Items	571	496	738	511	362
o/w Depreciation & Amortisation	271	273	253	225	177
Changes In Working Capital	-163	29	-132	488	147
Other	-46	-32	-178	-48	-58
Cash From Operations	284	498	391	757	642
Capex	-358	-312	-270	-135	-224
Other Investments	-9	-121	55	-31	-753
Sale of PPE & Subsidiaries	104	26	34	52	16
Cash From Investing	-263	-407	-181	-114	-961
Changes In Debt	268	47	-263	132	28
Dividends	-7	-9	-5	-10	-11
Other	-62	-65	-63	19	-79
Cash From Financing	199	-27	-331	141	-62
Currency Translation	0	2	-32	1	-43
Change In Cash	220	66	-153	785	-424
Beginning Cash	223	443	509	355	1,140
End Cash	443	509	355	1,140	716

 

There was also a non-sustainable benefit of about 90m in 2009 achieved through reduced capex (depreciation and amortisation was about 225m that year)

 

Reasons To Believe Now

 

The first thing to say is that they have done what they said they would do on price over volume, as the following chart shows:

 

 

Prior to the announcement of Project Clariant, pricing was flat, with organic growth driven entirely by volume. After the announcement of the restructuring, one can see that pricing clearly picked up, going as high as +8% on a trailing 12m basis. Volumes were impacted a bit by this but pricing more than offset this and organic growth was in fact picking up slightly before the crisis hit. Pre-exceptional EBIT margin had risen to 7.3% by Q308, up from 6.3% at the end of 2007.

 

The financial crisis then crushed volumes and EBIT margin fell far below these levels but I note that pricing held up quite well and has in fact turned positive again. I would hope that this signals that the company are more focussed on pricing and profitability now - the company reported record trailing 12m EBIT margins pre-exceptionals in Q410m for example.

 

 

 

The company also stated in the last report that 2010 was the last year where we would see significant restructuring. I think that in the past, the huge gap between profitability pre-exceptionals and the reported number had been part of the reason for the discount. The company have, I think, been fairly clear that this gap should close, which I think will help the valuation. A quick look at the trailing 12m restricting charge shows that they seem to be backing up their words with numbers:

 

 

The charges peaked in Q110 and have fallen about 20% since then.

 

The other thing I think it is worth noting is that while I cannot say that I really have a strong feeling that the company now communicates better with investors than they did in the past, I think they are at least a bit more focussed on delivering what shareholders should be interested in - namely cash flow. Prior to the restructuring, free cash flows were generally very poor, peaking below 200m on a trailing 12m basis (market cap was around 5bn at the time). Post the restructuring I think that management have done a much better job, with free cash flow peaking at about 650m with the working capital reductions before stabilising recently at about 420m. The 420m is still with around 147m of working capital inflows which are probably not sustainable, but also includes a 50m excess of capex over depreciation, so I model free cash flow stabilising at 320m before rising somewhat with operating profit.

 

 

On a standalone basis that puts the normalised equity free cash flow yield comfortably around 8%, with scope for a bit more upside from EBIT pickup. The pushback here would be that none of this cash was ever returned to shareholders, with it first being used to reduce leverage and then to fund an expensive deal.

 

One final thing to be aware of for the patient investor is that the management talked on the recent conference call about potential portfolio rationalisations. The sense that I got was that now the restructuring has been completed, the divisional heads are on watch for the next year or two, and unless they can deliver numbers that make a compelling case for the divisions staying within the .group, they would be for sale. I think that the obvious candidates here would be Oil & Mining Services, which have not shown much margin pickup in the last few quarters, and perhaps Textile Chemicals or Masterbatches - Textile Chemicals because it is a small part of the group, has not had much margin improvement and is vulnerable to Chinese competition, and Masterbatches because profitability is quite low despite Clariant's attempts to consolidate the industry in the past. I think the proceeds could eventually be fairly meaningful - for example Oil & Mining Services could raise about 500m in a sale scenario I think - but I would hope that the spectre of trade sales would focus divisional management more on delivering results.

 

The Standalone Value

 

Assuming the EBIT margin settles at 10% (currently 10.2% pre-exceptionals), growth slows to around 2% and WACC is 8.1%, I get to a DCF of 28.6 before considering the Sud Chemie deal - around 65% upside. Applying peer group multiples, the standalone value is about 23-24 (33%-40% upside), depending upon the year under consideration. The I use a mixture of P/E, EV/EBIT and EV/EBITDA to value the company, with peers from both the Industrial chemical and speciality chemical space. See model for details.

 

The Sud-Chemie Deal

 

On 16^th February, together with announcing Q410 results, Clariant announced the acquisition of Sud-Chemie, a German speciality chemicals producer with a global footprint. Their portfolio spans six divisions - Adsorbents & Additives, Foundry Products & Speciality Resins, Performance Packaging, Water Treatment, Catalytic Technologies and Energy & Environment. The portfolio is quite complex but basically is exposed to clean technology with a particular focus on emerging markets. IN additives they produce an organic stabilising agent that can replace lead in the production of PVC, in Foundries they make emission-reduction solutions, while in Catalytic Technologies they make products that allow chemicals to be made from cleaner energy like gas and biomass rather than oil along with fuel cell technology. 40% of sales are to Asia, the Middle East and Africa.

 

The company's sales CAGR from 2005 to 2010 has been about 7%, while EBI margins have grown from 7.7% to 11.4% over the same time period despite extensive investments. The margin improvement has been as a result of greater capacity utilisation. Absolute sales in 2010 were €1,225m. Cash flow generation has been limited (just 36m in 2010) due to extensive investment (capex has averaged 160% of depreciation, R&D 5% of sales vs. 1.9% at Clariant). The company had about €460m of net debt including unfunded pension liabilities at 2010 year end. They guide for €1.35bn of sales in 2011 and an improving margin, with capex €110m - free cash flow will thus be limited again. I include five years of financials of the acquired company in the model.

 

The total EV of the deal is €2bn (CHF 2.63nm), valuing the equity at €1.4bn. Private equity owns 50.41% of the business, for which Clariant have offered €121 per share. Various families own another 46% of the company and will exchange their shares for new Clariant shares at a ratio of 8.84:1. At the current exchange rate that works out at about €115.4 per share.

 

In terms of financing, Clariant recently received shareholder approval to issue up to 75m new shares but confirmed that only 71.2m shares will be issued, 48m as part of the share swap (implied value CHF 827m, and an additional CHF 400m via a rights issue. CHF 500m of Clariant cash will be used to finance the deal, with the balance financed through debt:

 

Financing
Deal EV CHF	2,630.1
Share Exchange	827
Clariant Cash	500
Rights Issue	400
New Debt	903.5
Total	2,630.1

 

The market initially baulked at the deal for a couple of reasons. First, valuation appeared unattractive at trailing multiples of 1.6x sales, 9.7x EV/EBITDA and 14.3x EBIT, premiums to Clariant's own valuation of 160%, 96% and 132%, respectively. Additionally, the rationale for the deal seemed to be in contrast to the 2008 strategy of simplifying the operation to improve transparency. The deal adds another six divisions to the existing 8 reporting divisions (more divisions than GE or Siemens) along with 19 R&D sites over the world together with dozens of production centres.

 

In the days after the deal the stock sold of around 20%, with the market cap reduction in euros being nearly 600m, implying Clariant had grossly overpaid for the asset. As people did more work on the deal they realised that the production sites were required to be close to customers and that the structural growth offered by SC should somewhat reduce concerns over Asian competitors eating their lunch in the traditional business areas.

 

Using very modest assumptions (about 10 years of mid-teens EBIT margins followed by rapid evaporation of profitability and terminal growth of 3%), at most I think the deal is about €200m value destructive, but in fact at 9.8% ROIC the deal is actually value neutral so I think there is some optionality on the structural growth of the business. As a bullish example, if the business could entertain 5% top line growth for a couple of decades due to the structural growth and defend margins at low to mid teens, the fair value of the asset could be as high as €3bn.

 

On a more superficial level, EPS accretion by 2012 could be low single digit.

 

Conclusion

 

The market is putting the combined entity on a valuation of, in the most pessimistic scenario, 7.3x 2012EV/EBIT, a 20% discount to the sector. The standalone value of Clariant post the deal is also supportive in my view. The market has not really rewarded Clariant during the global recovery in the same way that it has done peers:

 

 

But I hope that evidence that the margin improvements are sustainable, together with a closing of the gap between reported and adjusted margins, together with appreciation of the reduced cyclicality of the group, would allow the stock to outperform meaningfully over the medium term. The stock currently has 8 buy ratings, along with 6 holds and 4 sells, with nobody having a price target above 23, so I don't think anybody has really gone out on a limb in terms of giving them much credit for a sustainable improvement in the business. Clearly there is room for upgrades.