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My dear long-term readers surely now that I have high hopes for a few chemical heavyweights that have been heavily impacted by the recession this year. The list includes prominent names like Olin Corporation (OLN) and Dow Inc. (DOW) that fared quite well since the publication of my most recent notes on them, as Olin is up ~27.8% since August 20, while Dow has climbed ~11% higher since July 24.
Today, I would like to take a closer look at Trinseo S.A. (TSE), another chemical industry player that has fallen out of favor with investor due to the pandemic-induced challenges, thus the share price has materially corrected, and its yield is now hovering above 6%, assuming a recently declared $0.4 DPS.
As the rock-bottom interest rates coupled with a great dividend reset have significantly complicated the portfolio-building and rebalancing for income-focused investors, high-yield names that are in a relatively sound shape to maintain the payout and that also have observable prospects of recuperation do deserve deeper analysis.
To begin with, the stock has lackluster grades that influence its Quant Rating. With the Bearish QR, TSE is at the very bottom of the commodity chemicals industry, which signals investors should act with extreme caution given the precarious risk-reward profile.
The only grade that is standing out is A- Value. Due to the valuation reset precipitated by the ripple effects of the pandemic, a few of its trading multiples are deeply below the sector medians and the 5-year averages, while others are skewed due to margin compression.
But does this value-profitability asymmetry indicate that TSE is a value trap and a short candidate? I would not say so. And there are a few reasons for that.
The top line
Being a global materials company, Trinseo has a vast and complicated portfolio structure; the company operates via the Latex Binders, Synthetic Rubber, Performance Plastics, Polystyrene, Feedstocks, and Americas Styrenics segments.
Among its key end-markets are the automotive, tires/rubber goods, and building & construction sheet. As comes from the 2019 data (page 5), combined, these end-markets accounted for 38% of net sales last year. Even without a thorough examination, it is evident that the company is exposed to the ups and downs of the economic cycle. Trinseo does have some exposure to non-cyclical end-markets like packaging (7% of the 2019 net revenue), and that bode well for the Polystyrene segment in the choppy second quarter, but most of its sales are from the industries that bear the brunt of the recession, thus, it was anything but surprising that the Q2 revenues dipped by more than 40% to $569.7 million, as none of the divisions escaped the contraction. Synthetic Rubber, the segment most exposed to the tire industry, was the most battered, as its revenues slid 68% due to a profound reduction in volumes sold (a 56% impact), unfavorable selling prices (11%), and also some FX headwinds (slide 8). With revenues being 25% below 2Q19, Polystyrene, the flagship segment with the highest contribution to the top line, was the most robust (if ‘robust’ is apt in this context), as the demand was not as drab as in the cases of the other divisions.
It is not mere coincidence that the recession crashed Trinseo’s margins and taken its toll on capital efficiency, the parameters that dividend investors should watch closely. TSE’s Profitability Grade is D+, only slightly better than the worst result possible. For example, Trinseo’s EBITDA margin is now ~2.2%, while operating and net margins are both negative.
However, I was positively surprised when I calculated its trailing-twelve-months Cash Return on Total Capital (ROE does not make sense here, as TSE uses materially more debt than equity), which stood close to 9% as of end-June vs. 17% in 2019. Though the ratio did compress, for the bottom of the cycle, it looks quite solid.
The cash flow statement holds some clues: as the demand dropped like a stone, TSE kept working capital at bay. It quickly adjusted production in order to mitigate the effect of cratered demand on cash flows. As a result, it received a $123.1 million inflow from the reduction in inventory, and despite a close to $165 million net loss, it generated positive cash flow and even delivered FCF of $27.6 million in the first half of the year.
While the Q2 was a calamity with no doubt, the prospects for the second half of the year and 2021 are much brighter. For example, the demand for tire bottomed in April, and since then, has been consistently improving. For instance, though the industry heavyweight Continental (OTCPK:CTTAF) reported a ~42% revenue decline in the June quarter, the effect of the lockdowns evaporated in Q3, thus analysts are expecting only a 2% revenue contraction in the September quarter, almost flat sales in Q4, and a 19% uptick in Q1 2021.
And though TSE’s revenues will likely remain weak in H2 (Wall Street is forecasting a 24% and 14.7% contraction in Q3 and Q4, respectively), there are visible prospects of recovery in 2021, as analysts are expecting close to 11% growth.
That means one thing: the worst is likely behind, and if TSE did not scale down the payout amid the toughest days in April, it will likely not slash the DPS when revenues inch higher bolstered by the broad economic recovery.
More on the dividend
For those investors who would like to see a prolonged history of consistent dividend payments (that were tested by the economic doldrums, maybe even a few times), Trinseo will clearly not be a stock of choice, and they perhaps should look at dividend aristocrats instead.
TSE was listed in 2014; since 2016, it has been paying a regular quarterly dividend. DPS was increased only twice: in 2017 and 2018. In the last twelve months, dividends paid required million $63.1 million. As free cash flow during the same period amounted to $54 million, the dividend coverage was adequate and stood at 86% (vs. 323% in 2019).
Regarding 2020, I am not confident cash surplus will be high enough to cover the rewards fully, but it might still cover a significant portion of it, assuming that TSE will keep costs and working capital at bay, and also considering that H2 capex will be lower than in H1 (slide 14).
Risks to consider: financial position
It is common knowledge that a gargantuan debt pile can be a permanent threat to dividend sustainability. First, the debt must be serviced. Second, it must be repaid. The risk to face issues with meeting both obligations can force a company to improve liquidity at the expense of shareholders and eliminate the dividend.
TSE has a hefty Debt/Equity of over 281%, which already makes a gloomy impression. The silver lining here is that 45% of the debt is covered by cash & cash equivalents, which stood at $581.8 million as of end-June. Another bright spot is that the significant maturities are not looming both in the short- and medium-term (see Contractual obligations on page 51).
I believe the market is too bearish on Trinseo, as it is ignoring the obvious positives and focusing on negatives that are gradually disappearing, like the softness in the tire market that was precipitated by the lockdowns and that will likely not return to the critical levels seen in April unless the situation with the second wave across the globe entails a reintroduction of draconian measures that will hibernate the economy and spell trouble ahead.
Anyway, multiples’ compression is a boon for dividend investors, who can consider buying the stock that has a bottom-cycle valuation and enjoy a ~6% yield going forward. Moreover, as revenues will likely continue gradually recuperating buoyed by the recovery of the end-markets, I reckon the market will re-rate TSE, pushing valuation closer to a mid-cycle level.
And finally, TSE is not a value trap, as I do not see any signs of business model erosion or headwinds stemming from the impending decline of the industry it operates in. It supplies materials that are critical for the modern economy, and even for a greener version of it (clearly, not only ICE vehicles need tires).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.