Chemicals and ammunition manufacturer Olin Corporation
(NYSE:OLN) is in the danger zone this week. Olin is a classic value trap. With a P/E of 13, the stock may appear cheap, but a closer look reveals earnings, quality issues, and major growth is still priced into its valuation.
Significant non-operating income hidden in operating earnings distorts OLN's EPS figures, which overstate profitability and undermine the validity of the stock's P/E.
OLN is entering a tough economic climate for all of its business segments and should struggle against larger, more efficient competitors. The market's expectations of future growth for this company are unrealistic.
Red Flags Hidden in the Footnotes
Two significant items rear their head on page 101 of Olin's 2013 Form 10-K
. A reduction of costs of goods sold due to a favorable contract settlement, and a reduction to selling and administrative expense due to the recovery of legacy legal costs, boosted OLN's pre-tax income by $25 million, or 10% of its reported pre-tax earnings.
My firm's patented research system flagged these items for our analysts, which allowed us to remove this non-operating income from after-tax operating profit (NOPAT). One could also have found these items in Olin's 3Q13 earnings announcement and conference call, but based on the number of recent articles I've read that refer to OLN's unadjusted EPS, it appears that many investors are not accounting for these items.
There are also two smaller, but still significant items that investors could only find deep within the financial footnotes. A $5 million
decrease to LIFO reserves artificially boosted pre-tax earnings, and $200 million in off-balance sheet debt in the form of operating leases was buried on page 100
Investors need to look past the reported numbers to understand true profitability. You have to do more than pay close attention on the company's conference calls. You have to do serious digging through its filings.
Our NOPAT excludes financing costs such as interest expense, as well as unusual costs like write-downs and restructuring expenses, so NOPAT should usually be higher than GAAP net income. For OLN, however, its $172 million NOPAT was actually 4% lower than its reported net income of $179 million.
Heavy Competition Dampens Growth Potential
Olin's two segments, chemicals and ammunition manufacturing, are heavily commoditized. Companies with higher margins and returns on invested capital (ROIC) can crush less efficient competitors, like Olin. Higher ROIC companies can offer lower prices and still make money than the lower ROIC counterparts. Olin has the lowest NOPAT margins and ROIC of any of its competitors.
Figure 1 compares Olin to six competitors that it specifically names as its peers
in its 10-K.
Figure 1: Falling Short of the Competition:
Sources: New Constructs, LLC and company filings
Olin is close to Dow Chemical
(NYSE:DOW) and Axiall
(NYSE:AXLL) in terms of ROIC and NOPAT margin but far behind all other competitors. OLN also is at a scale disadvantage, as it has the lowest revenue in its peer group.
There are signs that OLN competitors are already taking market share away from it. OLN reported a slight decline in volume from its Chlor-Alkali segment in Q1, while DOW reported flat volumes in its Chlor-Alkali segment for the same quarter. DOW's superior margins, return on capital, and scale give it an advantage over OLN when prices fall, as they are this year.
Poor Secular Trends
Both of OLN's primary businesses face major headwinds over the next year. On the chemicals side, OLN faces falling commodity prices that are significantly diminishing sales. Revenue for the Chlor-Alkali segment fell 6% year over year in 1Q14, while the Chemical Distribution segment saw a 37% decline in revenue. Management has guided to further year over year declines in the coming quarters.
In the Winchester ammunition segment, OLN has experienced extraordinary sales in the past two years due to unusually high demand. Fear over potential restrictive gun legislation led to a frenzy to stockpile ammunition, and OLN saw near-record sales.
Going forward, the Winchester business is not necessarily in trouble, but it will likely experience a year over year decline as demand returns to a more normal level.
The reason these short-term economic headwinds are so troubling for OLN is that the stock is still priced for significant profit growth. In order to justify its current valuation of ~$27/share, OLN must grow NOPAT by 5.5% compounded annually for 35 years
. If we keep the same growth forecast but lower the growth appreciation period (GAP) to 15 years, the stock is worth only $21.50/share, a 20% downside to the current price.
The DCF model above factors in the expected decline in NOPAT for 2014. Any scenario where OLN justifies its valuation in a reasonable GAP requires a growth scenario that ignores the expected profit decline this year and gives OLN credit for more growth than a company producing commodity products can expect. 10% NOPAT growth compounded annually for 6 years would justify $27/share, but that does not seem likely. Given OLN's inferior profitability metrics, long-term decline seems more likely than double-digit profit growth.
OLN is a classic value trap. The low P/E multiple makes it look cheap, but really the stock is still overvalued. The accounting earnings are not a reliable indicator of the underlying cash flows of the business. This company is priced for profit growth that it does not look likely to achieve.
Insider Trading Activity
Insiders at OLN purchased a significant number of shares recently, but those purchases came on the heels of several sales. Over the past six months, net sales of insider shares stand at 101,000, or 13% of insider shares held. Despite the recent purchases, the trend is still towards selling rather than buying.
Avoid These Funds
Investors should also avoid ETFs and mutual funds that allocate heavily to OLN. The following two mutual funds in particular should be avoided due to their 3+% allocation to OLN and Dangerous-or-worse rating.
Sam McBride contributed to this report.
Mr. Trainer is a Wall Street veteran and corporate finance expert. He specializes in reversing accounting distortions on the underlying economics of business performance and stock valuation. He is author of Modern Tools for Valuation (Wiley Finance 2010).
Touchstone Small Cap Core Fund (MUTF:TSFCX): 4.1% allocation to OLN and Dangerous rating.
Homestead Funds: Small Company Stock Fund (MUTF:HSCSX): 3.6% allocation to OLN and Dangerous rating.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.