POL or PolyOne is a relatively new position for me. I got the idea from Zacks Reitmeister Letter. PolyOne is a chemical company, which has transformed its business from a commodity, high volume, low margin company, to a specialty, high margin company. They now have 21 successive quarters of double-digit year-over-year growth in adjusted earnings (usually much more than 10%). I entered it about 15 weeks ago at $32.75 and fairly quickly took an average or full position in it roughly at that price. It got up to $39.00 a month ago and was at $36.00 at yesterday’s close.
Here’s what their adjusted earnings growth has looked like. You’ll note that their December quarter is always sequentially lower, but up substantially from the year before.
2012: 24 30 24 18 = 96
2013: 31 37 36 26 = 130
2014: 44 51 49 36 = 180
Note that adjusted earnings were up 35% and 38% year over year. Revenue, on the other hand, has been flat as they predicted, as they are exiting acquired lines of unprofitable commodity products from a recent acquisition.
Trailing earnings look like this on a quarterly basis, from Dec 2012 to Dec 2014
96
103
110
122
130
143
157
170
180
At $36 they are exactly at a PE of 20.
In October they raised their dividend by 25%. They have lots of Free Cash Flow, and they repurchase lots of shares
Declared a quarterly cash dividend of ten cents ($0.10) per share, representing a 25% increase and the fourth consecutive year of annual dividend growth.
We have increased our annual dividend 250% since we initiated it in 2011. This underscores the confidence we have in our ability to continue to achieve accelerated earnings expansion into 2015 and beyond.
Here’s a January public article from Seeking Alpha that I found interesting and useful
Jan 2015 –- PolyOne’s Transformation Is Ongoing And Will Drive Profits Further
Summary
• The shares have stumbled in recent months, likely due the risk surrounding the change of CEO. But this is a healthy consolidation after a strong run.
• The transformation to a specialty company is not complete and the firm, through organic growth and acquisitions, will drive specialty to 75% of revenue in 2 years.
• We think sometime in 2015 the firm’s debt will be upgraded to investment grade, which could propel the equity along with the debt.
PolyOne has undergone a massive transformation that has re-positioned the company as a specialty polymer provider from a commodity player less than a decade ago.
The Transformation Is Ongoing - When Stephen Newlin became CEO of PolyOne back in early 2006, the company was largely a commodity producer. The business model relied on volume to drive sales and they were heavily tied to cyclical end markets which created boom and bust cycles.
The shift in the business model has been nothing short of dramatic going from a low-margin commodity plastics company to a high-margin specialty engineered products business with a much more diverse end-customer.
In 2005, the specialty business accounted for just 2% of operating income but now is nearly 64%. Earnings have grown at a massive 22% compound rate since 2005. Most other metrics show similar strong results including return on invested capital which has risen from 5% to over 10% in 2013.
The on-time delivery rate was just 81% back in 2006, which was actually in line with the industry average. But Newlin got it up to 94%.
We think the market has recognized this transformation and boosted the share price accordingly. From late 2011 through the end of June last year, the shares have risen by a whopping 348%! Since June, however, the shares have given back nearly 15%. We would argue that the consolidation that the shares have undertaken since June has been healthy and is likely to set up the stock for a resumption of gains in 2015.
In early 2014, PolyOne announced a CEO succession as Mr. Newlin was preparing to retire. Robert Patterson took the helm of the firm in May of last year serving as both President and CEO. Mr. Newlin is remaining on as the Chairman of the Board. Mr. Patterson was previously the COO and executive vice president. We think the new CEO will continue where Mr. Newlin left off.
Levers of Further Growth Will Continue To Drive Shares
The company laid out their bridge to 2015 EPS of $2.50, up from $0.82 in 2011 for a 32% CAGR over the period. The company is now much more diversified and no end market now accounts for more than 18% (transportation). Most of the growth is likely to come from innovation as the company continues to invest in R&D ($53 million in 2013 versus just $20 million in 2006). The firm has invested heavily in their pipeline as well in marketing, technology and sales teams.
Today, the innovation pipeline has $1.7 billion of market potential new products, the largest it has ever been. We think some of these products could be significant game changers that can quickly expand their presence in higher margin applications within markets such as healthcare, consumer and packaging. The firm has a vitality index which measures the percent of sales from products introduced in the last five years. The index has risen to 43%, well above their goof 35% or better. These new products carry much higher margins and returns on capital.
We think this is the first of many levers that the company is using to grow EPS at double digit rates. They are also still realizing synergies from their Spartech acquisition, conducted two years ago, which is also likely to aid the bottom line. Just recently, they disclosed that they shuttered a former Spartech facility and are still rationalizing and integrating back office function. In addition to the synergies from that past acquisition, management has given hints that they will continue to conduct some additional acquisitions to further augment their product portfolio and boost underlying growth.
Other avenues to get to that $2.50 include a strong share buyback program that has been reducing outstanding shares by approximately 2% per year but has been accelerated as of late. In the trailing twelve months, diluted shares outstanding has been reduced by over 5%. The company has 10.3 million shares available for repurchase under the current authorization with plenty of free cash flow to support a continuation of the current pace of buying.
They also see additional cost savings from their Lean Six Sigma (LSS) program, which achieved strong cost savings across their infrastructure, especially related to G&A expenses. They have over 70 Lean Six Sigma projects underway focusing on safety, quality and value.
Credit Upgrade Likely Coming
Since 2008, the company saw their pension funding go from 60% funded status, to over 100% as of the end of the third quarter. Meanwhile, leverage continues to decline with net debt-to-EBITDA dropping from over 4.0x in the first quarter of 2013, to below 1.9x currently. The company has a small debt issue maturing next year amounting to $48 million. The next issue is not due until 2020 and amounts to $317 million. The coupons on these two issues are in excess of 7% (one is a legacy issue from an acquisition) and are likely to be called and/or refinanced at much lower rates. The lower interest expense and likely lower net debt level and leverage, will boost their credit rating to investment grade. We think this could aid the equity in addition to the debt issues.
Four Megatrends Aligned with Key End Markets
One of the initiatives that management has pushed is aligning the firm in key end-markets to take advantage of megatrends that they see growing those markets at higher rates. They believe the four megatrends are 1) improving global health and wellness, 2) protecting the environment, 3) Globalizing and localizing, and 4) decreasing dependence on fossil fuels.
In the beginning of December, they acquired an Accella unit for $49 million. The unit is a specialty polymer coating producer which Polyone management noted would expand their offerings in consumer products, automotive parts, outdoor recreational equipment and food packaging. Management noted that the acquisition is congruent with their megatrend philosophy.
Valuation
Despite the incredible run, valuation remains cheap even using modest future assumptions for growth. The shares trade at 16x ntm earnings, just ttm 8.5x EBITDA, and at a PEG of 0.83x. We think the company can grow the top line conservatively at a mid-single digit rate while continuing to expand further into specialty products, boosting operating margins and profitability.
Free cash flow last year grew to $137 million, up from just $74 million the year before. We think the company has reached an inflection point whereby cash flow from operations is growing at exceptional rates while the cash needs to maintain and grow the business are growing much slower, leaving more to hit the free cash flow line. We think free cash flow this year could rise to 4.4% of revenue or $185 million and $230 million in 2015, or 4.8% of revenue. On 2016 estimates, the company has a 5.5% free cash flow yield- quite a value for a company that is growing at such a high rate.
As we noted above, the company has expanded their specialty platform to 65% of operating income in 2014, up from 43% in 2010. Given the new acquisition, we think the firm can achieve 70% in 2015 and forecast them expanding to approximately 75% by 2016. At that level, the firm should be generating EBITDA of at least $550 million.
Under our base case scenario, we think the shares are worth approximately $50, compared to the $36.00 they trade at today. Any short term declines in the price should be viewed as excellent opportunities to enter the name or accumulate more shares.
Conclusion - PolyOne has undergone an exceptional transformation from a commodity producer to a specialty supplier of polymers. We think the industry is likely to experience strong growth over the next few years due to a shift towards specialty engineered products that are more cost effective in their end-markets.
Finally, their last quarter report:
Adjusted earnings increased 38% to 36 cents
Achieved 21st consecutive quarter of strong double-digit adjusted EPS growth
Full Year Results
Adjusted earnings up 37% to a record $1.80
40% EPS CAGR driven by relentless focus on specialty transformation and mix improvement
Adjusted earnings per share increased 38% to $0.36 from $0.26
Revenue was $869 million, down from $924 million. As expected, the revenue decline resulted from ongoing mix improvement, including the exit of unprofitable products associated with the Spartech acquisition and certain operations in Brazil, weaker business conditions in Europe, and unfavorable foreign exchange.
For the full year, revenue was $3.84 billion, up 2% from $3.77 billion. This growth, combined with significant profitability expansion, led to adjusted earnings expanding 37% to an all time record $1.80.
“2014 was yet another great year in our company’s history, underpinned by our unwavering commitment to our four pillar strategy and achieving our aggressive goals. Three of our businesses have already reached their 2015 margin targets with DSS and PP&S having line of sight to getting there this year,” added Mr. Patterson. “Innovation and mix improvement continue to be at the heart of our specialty transformation as 44% of our specialty platform sales were from products introduced in the last five years.”
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"Our strong free cash flow for the year enabled us to repurchase 6.3 million shares of common stock and increase our annual dividend 25%. We also completed the acquisition of Accella, thereby accelerating growth in our Specialty platform. With liquidity of $475 million and a net debt to EBITDA of 1.9x, we have ample financial capacity to pursue strategic acquisitions, invest in innovation and continue our share repurchases and dividends. We see tremendous growth opportunities to pursue and capture regardless of economic conditions. I am confident that we will deliver another year of strong double-digit adjusted EPS growth in 2015.
Conclusion: Good results
This company won’t tear up the world, but they have excellent growth at a very reasonable price.
Saul