Olin Shares (NYSE: OLN) held up quite well in a year that was unforgiving for cyclicals. Its business is clearly deteriorating and management will be put to the test as to whether it be able to maintain as much free cash flow as they committed to during a recession. As the company enters a significant downturn, even if management guidance is warranted, there are better stocks to hold in this environment.
Just a few months ago, Olin’s results were very strong, but the cycle in commodity chemistry can turn extremely quickly. In the company’s second quarter, it earned $2.76 compared to $2.17 last year. This represents approximately $422 million in net income. With those strong results, it generated $856 million in free cash flow in the first half, enabling $690 million in buybacks, including $426 million in the second quarter, or about 5% of all shares outstanding. Its number of shares has fallen nearly 10% over the past year to 153 million. Management also initiated a new $2 billion authorization alongside second-quarter results that would be funded by free cash flow.
Along with strong free cash flow, Olin also paid down $800 million of debt to $2.58 billion, up from $3.38 billion last year, and that stronger balance sheet should help the company better withstand slowdowns. In its major units, results were strong in the second quarter, although there were signs of a weakening cycle.
Chlor-alkali and vinyl sales increased 45% despite lower volumes, driving EBITDA up 65% to $467 million. Prices were an extraordinary tailwind, and they started eating away at demand, but still a great result. Epoxy sales fell 9% to $773, leading to some loss of operating leverage primarily due to high energy costs in Europe with EBITDA down 14% to $160 million. Winchester increased sales 9% to $440 million and EBITDA to $125 million, mainly due to price increases. Winchester, as an ammunition supplier, is the least economically sensitive business unit while the others supply chemical inputs and adhesives for PVC piping, and 70% of PVC is used in construction. As you can see, Olin was able to jack up prices on almost all of its products.
After the second quarter, management reached $2.5 billion to $2.7 billion in EBITDA for the full year. In the first half, the company generated $1.44 billion, so management expected a slowdown in the second half. Indeed, after generating $727 million in EBITDA in Q2, management was moving toward $615-620 million in Q3, down 15% sequentially.
In mid-September, however, the company cut its third-quarter EBITDA guidance to $530-550 million, about 13% lower than previous guidance, indicating a sharp turn in the cycle. This follows the announcement in August of the permanent closure of a facility in Texas as it continues to focus on shrinking its footprint and exiting low-margin operations to raise prices, even at the expense of volumes. It is difficult to separate the decision to close the plant from the drop in demand and the reduction in forecasts.
Explaining the reduction, management said there had been an “accelerated deterioration in European and North American demand” for epoxy and vinyl. This has been made worse because Chinese demand is so bad that it is exporting more to Western markets, creating supply gluts in Europe and the United States, hurting local producers. Ultimately, there will be a need to rationalize supply, such as the closure of Olin in Texas. Worse. There are also excess ammunition stocks, which weigh on Winchester. Olin concluded by warning that he was entering his “recession scenario”.
This is an important statement because in a recession, management estimates that it can still generate $1.5-2 billion in EBITDA compared to the $636 million generated in 2020. This would translate to approximately $1 billion in free cash flow. Management shut down excess capacity, became more willing to reduce volume to meet price, and increased Winchester licensing revenue to create more sustainability through the business cycle. Now, until we actually go through a recession, I suspect the market will express some skepticism that Olin has reduced its cyclicality so much. A sequential decline in EBITDA of $200 million just above its recession rate of $400-500 million as economic activity around the world still appears to be slowing puts Olin squarely in the “show me when the company releases its third quarter results on October 27.e. I am concerned about further guidance cuts.
Olin is already feeling the shift in the economy due to its geographic and product mix. 17% of its activity is located in Europe, mainly its Epoxy unit. Its exposure to the rest of the world is 21%. I would highlight this disclosure: “A significant percentage of our Euro-denominated sales are for products manufactured in Europe.” Natural gas prices in Europe are trading much higher than in the United States as the continent scrambles to buy LNG to make up for the loss of Russian imports.
Since natural gas is a significant input cost for chemical manufacturing, these facilities face high costs and risk losing their competitiveness to China’s exported epoxy. In the worst-case scenario, European natural gas supplies are being rationed this winter to ensure consumers have sufficient heat. I would expect the profitability of this unit to drop significantly.
In addition to Olin’s adhesives and PVC products exposed to the cyclical construction industry, China accounts for at least 50% of global epoxy consumption, which is why their shift from importer to exporter as disappointing domestic demand has forced such deep cuts. China’s real estate market continues to be weak, with no signs of improvement given the continued COVID-zero surplus. As a result, volume and prices are expected to weaken further. With headwinds from China and Europe, third-quarter earnings are unlikely to bottom.
While management had previously guided to $2.6 billion in EBITDA and $1.6 billion in free cash flow, the next twelve months will be much weaker. Given that this quarter will be around $525 million, I would expect EBITDA for the next twelve months to be closer to $1.5 than the $2 billion side of its “recession range. “. With the company likely to reduce investments in a weakened environment, this indicates free cash flow of $800 million.
Right now, the stock is trading at 8.5 times that free cash flow, so the stock isn’t expensive. Even with a 10% free cash flow yield, the stock could reach $60. There’s no doubt that the stock is cheap, as long as management is able to deliver on its promise to keep EBITDA above $1.5 billion during a recession. Over the next few months, if you own OLN, you will struggle with sequentially declining earnings and skepticism about where earnings will bottom out and whether the recession forecast holds. While you may be right in the end, I suspect it will be a grueling journey with the remaining stock stubbornly cheap.
At this multiple, OLN is not an outright sell. However, I encourage investors to look to the energy sectors. Companies like ConocoPhillips (COP), EOG (EOG) and Ovintiv (OVV) offer similar cash returns to OLN without the severe cyclical headwinds (indeed, if a deterioration in the European energy situation hurts OLN, it helps the energy companies). Rotating OLN into the energy sector is a way to stay in a low multiple stock while creating near term upside potential and would be my recommendation.