18:52 PM | September 20, 2010 | Robert Westervelt in Wickliffe, OH
Lubrizol (Wickliffe, OH) not only survived the downturn but managed to grow margins and profits through the global recession. Strong performance in additives—which account for about three-quarters of the company’s revenues—has led the way. Now the company is looking to maintain margins at a higher plateau and grow its two segments: additives and advanced materials.
Excluding charges, Lubrizol posted earnings of $7.55/share in 2009 compared with $4.09/share for 2008. Cash flow from operations was $951 million last year compared with $223 million for the year ended 2008. Revenues decreased 9% to $4.59 billion as raw materials prices dropped sharply.
“Our performance over the past 18 months is based on the team’s hard work over several years,” says Lubrizol chairman and CEO James Hambrick. “I am pleased by our performance, but I am not particularly surprised.”
Earnings have grown dramatically in recent years, led largely by a sharp recovery in once-moribund additives margins. The company set a 2012 earnings target of $10/share in February, and is already approaching that target this year on stronger-than-expected volume recovery. The current median analyst estimate for 2010 is $9.97/share, according to ThomsonOne (New York).
Management is clear about the focus of its current strategy. “It’s all about sustaining margins and we’re so far doing a great job at it,” Hambrick says. Management is confident that the higher margin and profit levels can be maintained. “We’re trying to strike a balance of adding great value for customers and delivering good returns to shareholders,” Hambrick says. “If we do that well, I tell the team the fruits of that will come back to us as well. We need to manage in a sustainable, long-term way.”
The company’s share price has climbed more than fourfold from March 2009 lows, and analysts remain upbeat as margins demonstrate resilience. “Following Lubrizol’s fifth straight earnings beat [in second-quarter 2010], we believe the focus is shifting from the sustainability of mid-20s additives margins to 2012 earnings power,” David Begleiter, analyst with Deutsche Bank (New York) said in a report last month. “With second-quarter margins of 22% already surpassing the company’s 2012 target of 18%-19% and substantial leverage on accelerating volumes we believe Lubrizol is on-track to earn $12 in 2012.”
Lubrizol’s additives division, which includes engine additives and driveline and industrial additives, accounted for about 72% of revenues last year. The advanced materials unit—which contains three specialty chemical segments: engineered polymers, consumer specialties and performance coatings—accounts for the remaining 28% of sales.
Lubrizol pioneered the development of lubricant additives 80 years ago, and has the leading market share in additives for transportation and industrial lubricants. Additives competitors have been whittled down to just four, compared with more than a dozen 20 years ago, the result of consolidation in the oil sector as well as the extended period of poor profitability that started in the 1980s. The profit decline has been quickly reversed in recent years.
Lubrizol’s additives segment generated revenues of $3.3 billion and segment operating income of $787.8 million. Operating income has grown for six straight years.
“We took a fresh look at our overall strategy in 2003 and made some adjustments that have paid off,” says Lubrizol president/additives Dan Sheets. “It comes down to picking the right partner customers and executing on the value proposition. It involves bringing great technology, supply reliability, and marketing and customer support.”
The resurgence in profits is notable following a 20-year period that lasted until the early 2000s when profit growth in additives was hardly a given. Lubrizol’s operating income during the period essentially flatlined in what was viewed as a no- to low-growth business (chart, p. 25).
It was just through sheer tenacity that the company managed to maintain profitability in its core operation through the 1990s and early 2000s, Hambrick says. He remembers the upbeat mood at headquarters when he was a young manager at Lubrizol when the company’s revenues hit revenues $1 billion in 1980 and the entire business was additives. Twenty years later, revenues were $1.75 billion. “But, if you discount for inflation over 20 years, that $1.75 billion from 1980 actually was only worth $750 million in 2000. We were actually shrinking. We had to do something. And we have.”
The company’s own perception of the market was partly to blame. “People saw this as a no-growth business,” Hambrick says. “For short periods of time it can be 0%-1%, and other times it can jump up to 4%-5%/year. But if you look at it over reasonable time periods this is a business that grows 2%-3%/year.
Hambrick, who was named president in January 2003 and has been CEO since April 2004, was confident the business could be turned around. “I always knew that there was inherently more value here than we were delivering.”
The message that had to get across the employees, and customers, was that margins needed to improve or the business would not attract reinvestments. “In order to sustain the technology that we are delivering, you need to earn a reasonable return on, not only our capital, but also our technical expenses,” he says. “And failure to do that means we cannot continue to operate this business.”
In additives, and specialty chemical businesses in general, there are two key components to success. “One is skill at performance chemistry. We have to be able to differentiate on performance,” Hambrick says.
Second, he acknowledges, it helps to be in a defendable market with few competitors. “If I am delivering performance but doing it against ten competitors, there is always somebody who can deliver two-thirds of that performance at half the cost,” Hambrick says. “You can survive, as we did in additives, but you will never become prosperous.” Specialty chemical makers should prefer to build in spaces with a small number of competitors. “Then, if you deliver value, you will probably get paid for it,” he says.
The other competitors in additives are Newmarket’s Afton Chemical unit, Chevron’s Oronite business, and Infineum, a 50-50 jv between ExxonMobil and Shell.
The additives division has become “less about production capacity and more about know-how,” Hambrick says. Margins have returned to a high level. And those margins are sustainable, he says. “This shift in the additives business happened over two decades,” Hambrick says. “It took a long time for the pendulum to swing. To the extent that competitive forces will come into play, and they eventually may, it will also take a very long time to shift back again. I fully expect profitability will stay for quite some time, It has reached a new equilibrium.”
In the late 1990s, Lubrizol started seriously looking to develop a specialty chemicals component to add a growth element to offset the low organic growth in additives. The company made some small acquisitions in the late 1990s, but most of advanced materials was brought in as a result of its acquisition of Noveon in 2004. Last year, the advanced materials business generated revenues of $1.3 billion and segment operating income of $168.7 million.
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Lubrizol is looking to build critical mass in each of its advanced materials businesses, and is eyeing acquisitions to help achieve that goal.
Hambrick stresses that the company is not looking to add another segment in advanced materials “because we already have ample growth space within the portfolio.” Hambrick is also cautious about getting too big and says he does not believe in a conglomerate structure nor a mix of different businesses. “We don’t think they add value to customers or to shareholders,”
Additives Ebitda margins are highly attractive, in the mid-20 percent range. Advanced materials are generally in the mid-teens Ebitda range, and Hambrick says further scale, or “critical mass,” in the advanced materials business will bring them to additives-like returns. Acquisitions and organic growth are being sought to achieve that size.
“The gross profit at the unit margin level in advanced materials, the unit selling price minus unit raw material costs, shows that these businesses are at least as profitable as additives,” Hambrick says. “They do not have as much volume and do not have the same economy of scale. Mid-teen margins are nothing to cry about, but they cannot get to that 25% operating income level until each of three businesses are at least $1 billion in size.”
In a bid to quickly gain scale, Lubrizol bid on specialty chemical maker Cognis earlier this year. The company bid aggressively, nearly $4 billion for the business, but Cognis’ private equity owners sold to BASF. “It had very nice personal care and coatings components that were a good fit. It did not really have engineered polymers, but there was an industrial business that could have fit well” in that segment.
Lubrizol was the highest bidder but Cognis’ private equity owners went with BASF. “Could I have put another €200 million on the table and changed the outcome? Maybe,” he says. ”But, I also had to be disciplined, and there is a fine line beyond which you’re being foolish.”
There is also strong organic growth potential in the business. Advanced materials heritage traces back to BF Goodrich, the original owner of Noveon. “Polymer synthesis has historically been a strength for the company,” says Eric Schnur, president of Lubrizol Advanced Materials. The company has worked in recent years to balance with improved application development capabilities. “We are not just thinking about supplying the molecule but what we can contribute to the overall finished formulation.”
The company is working to develop products that help customers differentiate products in the marketplace, he says. “It is a fundamental change in mind set away from volume to value,” Schnur says. “If customers are successful, your margins are going to be more sustainable.”
In 2008, the company created a program to accelerate product innovation by encouraging the cross-fertilization of technology, people and information between the additives and advanced materials operating segments, says Robert Graf, corporate v.p./R&D who heads the effort. Researchers in lubricant additives now sit on teams with personal care scientists and vice versa. The technology used to make its Carbopol personal care polymers is showing promise in some specialized lubricant applications, he adds.
Noveon has given the company an attractive growth platform. But the 2004 acquisition also likely shook the additives business from its complacency, Hambrick says. “Noveon allowed me to demonstrate that I am serious in saying that if we cannot figure out how to grow additives, it is not worth reinvesting in. It was a signal to the outside world, including our customers, and it is going to send a huge signal to my organization. And if there is any way to ever jar the inertia of the organization, that was it.”
The deal clearly recharged the additives business as it has posted record operating income for six years straight. “The team would probably rather not admit it to me, but I am telling you, Noveon was an ‘Oh my gosh!’ moment at the company.”
Margins and return on capital are at strong levels in the additives division and Hambrick says the company will reinvest to maintain leadership in the business now that it has demonstrated it is worth reinvesting in. It has also committed to invest $1 billion over the next 10 years to upgrade and expand additives capacity, including a wholly owned greenfield plant in Zhuhai Gaolan, China.
Construction will start on the project in October. “We are going to phase capacity in as needed,” Sheets says. “We are matching it with our projections of demand. We are expanding our footprint in what is becoming the largest market in the world.”
Lubrizol currently has more than $1 billion on its balance sheet, up from $200 million at end of 2008. That amount has attracted some investor concern about how it will be deployed. Hambrick says the company will be disciplined about putting it to use.
The company deliberately began to build cash in second-quarter 2009 in anticipation that Cognis could become available. Cognis’ private equity owners were working toward a 2010 initial public offering, and were reportedly open to preemptive bids. “We started working on that in June of last year,” he says. “We knew what was coming but obviously I didn’t want to tell the world what I was planning.”
Hambrick thought the timing could be ideal for Lubrizol. Two possible large suitors for Cognis—Dow Chemical and BASF—had just completed large specialty acquisitions in Rohm and Haas and Ciba, respectively. “I thought I might be able to sneak in there as these companies were distracted with integration,” he says. BASF, however, had been stalking Cognis as well and won the bidding.
After Cognis, the company announced plans to repurchase up to 10% of its total outstanding shares, over the next 18-24 months as part of an expanded share purchase program.
“I am very hopeful that I will soon be able to make an acquisition in the $200 million-$500 million range,” Hambrick says. “If that happens, I will slow down buybacks. If those acquisitions do not work out, we are going to continue to buy back shares.”
Hambrick says that the right acquisitions would be the best use of cash. “If you are a short-term investor and your time horizon is 18 months, you love the share buybacks. But, if you are a shareholder like me, who is going to own those shares for a long, long time, I am not interested in share buyback beyond the fact that I own a little bit bigger portion of the enterprise. I am really interested in acquisitions that will add to net present value growth. That’s what I’m tying to accomplish.”
Hambrick, who is 54, has time left to carry out his ambitions. “A $10-billion company split equally between additives and advanced materials is the aspiration that I privately have. I won’t put a time limit on it, but that’s what I’m working toward.”