Tsikhan Kuprevich
It’s been a while since I’ve followed up on my coverage of Innospec (NASDAQ:IOSP), a small specialty chemical company competing in the fuel additive, performance chemical, and oilfield chemical markets. While the shares had done alright for a while, climbing about 20% and outperforming much larger rivals like Clariant, DSM Firmenich, Evonik, and Lonza, the stock has sold off sharply from the end of July and is roughly flat with where I last covered it.
There are a lot of moving parts with Innospec given the company’s diverse end-markets, and it doesn’t help that a lot of its largest direct competitors are private or buried within larger conglomerates that don’t provide a lot of detailed information to provide easy comparable figures. Speaking generally, I believe Innospec is largely holding its own in its markets, if not gaining share in some cases, but the entire specialty chemical space has derated as investors have seen that the businesses aren’t quite as independent of overall macro trends as previously believed.
I’m still bullish on Innospec, but investors have to make their peace with a stock that is basically uncovered by the Street, doesn’t provide a huge amount of information to investors, and is sensitive to a number of macro drivers. I think investors can reasonably expect a high single-digit to low double-digit long-term annualized return from today’s level, but this likely won’t be the most exciting stock to own from quarter to quarter.
Weak Oilfield Results Dragged Down Results
Innospec reported significantly mixed results in the second quarter, with better performance in Fuel Specialties and Performance Chemicals offset by surprisingly weak results from Oilfield Services.
Overall revenue declined 9% as reported, missing by about 7%. Fuel Specialties revenue rose 8% on 20% volume growth and 12% adverse mix/pricing. Performance Chemicals rose 18% in organic constant-currency terms, with volume up 29% and price/mix down 11%. Oilfield Services was down 45%; while management doesn’t provide volume and price breakouts here, commentary in the press release and conference call would suggest meaningfully lower volumes on lower production chemical sales (and particularly with a large Mexican customer that ran down inventories substantially).
The gross margin declined about two points as reported to 29.2%. By segment, Fuel Specialties improved 230bp to 34.6% on an adjusted basis, with margin now at the end of management’s range on improved mix and catch-up price/cost. Performance Chemicals saw a big rebound after a very poor year-ago result (driven by weak volume and operating leverage), up more than five points to 22.6%. Finally, the Oilfield was definitely hit by operating deleverage, with margin down more than 11 points to 30.6%.
Adjusted EBITDA rose 14% (with margin up 250bp to 12.4%), while operating income rose 19% (21% on an adjusted basis), with margin up close to two and a half points to the mid-9%’s. Segment profits declined 5%, with margin up 50bp to 13.5%. Perhaps not surprising given the gross margin figures, Fuel Specialties was the leader, with 21% adjusted growth and 18%-plus segment margin (up almost two points), while Performance Chemicals more than doubled, with margin up six points to 13.2%. Oilfield Services profits fell three-quarters, with margin down more than seven points to 6.7%.
End-Market Dynamics Remain, Well, Dynamic
Given a variety of end-markets ranging from commercial trucks (diesel fuel additives) and commercial aviation (jet fuel additives) to shampoo (personal care), concrete admixtures, drag reducers for pipelines and various drilling, production, and stimulation chemicals (Oilfield Services), the macro outlook for Innospec is always at least a little complicated.
With Fuel Specialties, air travel demand remains healthy, with global revenue passenger miles up 9% year-over-year in June (as per IATA). Trucking has not been as strong, with the Cass Freight Index shipments number down 1% in July (not a perfect proxy for trucks-on-roads volume, but still directionally useful). I do have some concerns about weakening economic conditions driving lower demand later this year, but I also think trucking is nearing a bottom. A bigger question is whether the segment could outperform on gross margins a little while longer, as the price/mix comps aren’t so tough in the second half.
Performance Chemicals is likewise a complex case. This business got hit last year by destocking and weak pricing/mix, but has been rebounding so far this year and larger players in this space (Clariant, et al.) have signaled that destocking pressures are largely over.
One of my bigger concerns in the near term is how customers have “traded down” from name brands to store brands across a wide range of categories, and I wonder whether this has had some impact on volumes for premium-products (sulfate-free and so on). New contracts have helped drive volume growth, though, and I still like the company’s leverage to higher-value “natural” and premium products.
End-market conditions for Oilfield Services are mixed. Rig counts in the U.S. are down about 9% year over year, but U.S. oil production recently hit another record high and OPEC production has been steady. Management did talk about issues with a specific large customer in Mexico, and it sounds as though that customer (I would assume Pemex, but that’s just a guess on my part) has been running down inventory to an unsustainably low level. All of that should argue for stable-to-better sequential volumes in the second half of the year, but management sounded pretty cautious about this business.
Opportunities To Grow And Leverage M&A
Innospec’s markets aren’t exactly fast-growing, but the company has used internal product development, market share growth, and M&A to grow revenue at around 8%/year over the last 15+ years. I don’t think that’s a fair expectation for future growth, but I do still believe Innospec can outgrow the overall specialty chemical markets in which it competes.
In Fuel Specialties, demand for more efficiency and lower emissions from diesel engines should support demand and I expect ongoing growth in global air travel to support high-margin jet fuel additives (and jet fuel, too, is getting looked at more closely by governments as a target for emissions regulation). Innospec also has some leverage to passenger vehicles here, as the growth in gasoline direct injection drives more gasoline additives demand.
With Performance Chemicals, management has made a big push in “better for you” areas like sulfate-free and 1,4-dioxane-free offerings, as well as “customer experience” products that improve the texture, smell, appearance, and performance of personal care products (like soaps/shampoos that produce higher-quality lathers, deodorants that don’t feel tacky, and so on). At the same time, the company has continued to slowly build up its capabilities in areas like agricultural chemical additives (adjuvants, emulsifiers, et al.), construction (mortars, admixtures, et al.), and mining (flotation, hydrometallurgy).
I have less to say about Oilfield Services, but management continues to invest in new product development here, with more of a focus on products that are water-compatible (as opposed to many traditional oilfield chemicals that are petroleum-based) and less environmentally problematic.
I do have some modest concerns about the company’s overall level of R&D spending. Innospec historically spends around 2% of sales on R&D, which is below what larger comps like Clariant, Evonik, Lonza, and Wacker Chemie (generally around 3%-4%), and Innospec’s revenue base is far smaller. This may be a little deceiving, though, as a lot of Fuel Specialties and Performance Chemical revenue comes from legacy products that don’t require major R&D support. I’d also note that Innospec is quite disciplined and focused with its R&D spending, so I think there’s an argument that it gets a lot of “bang for its buck” despite being unable to match its large rivals dollar for dollar.
With around $240M in cash on the balance sheet, I expect Innospec to be on the hunt for M&A. The company did a modestly sized deal last year (QGP Quimica, a Brazilian specialty chemical company), paying about $35M upfront (with another $23M contingent on performance through the end of June 2026) for what appears to be around $40M in annual revenue. I expect deals similar to this in size and scope – complementary deals that add either specific products/end-market exposures and/or geographic exposure (QGP will help the company’s efforts in Brazil’s Performance Chemicals markets).
The Outlook
With destocking having hit the Performance Chemicals business harder than I’d expected and Oilfield Services encountering some sharp headwinds, my 2024 revenue estimate is now about 15% lower than it was before (the company basically met my FY’22 expectations and missed FY’23 by about 5%). I expect a rebound next year on easier comps for Oilfield Services, and I’m expecting around 4% long-term revenue growth.
I’m expecting EBITDA margin to improve about a point this year (to just under 12%), and I look for further improvement to 15% over the next five years. That’s not a particularly conservative assumption given historical margin performance, but I think scale, operating efficiencies, and ongoing mix improvement toward higher-value specialty products can do it. For free cash flow, I expect free cash flow margins to bounce around in the “mid-to-high” single-digit range for the next three or four years, heading toward the high single-digits to low double-digits over time and supporting around 8% annualized FCF growth.
Discounting those cash flows back, I think Innospec is priced for a long-term annualized return in the high single-digits to low double-digits. I also use an EV/EBITDA approach based on what the market has historically paid for growth, margins, and returns, and on that basis I believe Innospec can trade at around 11.5x (or around $120 on my 12-month EBITDA estimate). I want to note that while Innospec’s margins, returns (ROIC, et al.), and growth compare favorably to the wider specialty chemical group, there has been a de-rating here over the last few years, so my target multiple does represent a premium to many of its comps today.
The Bottom Line
Given how little-followed these shares are, I do see some risk that the market will basically just forget about the stock for stretches of time and/or overreact to quarterly results given the lack of breadth of analyst estimates. I do also see risks that the company fails to maintain its market position versus rivals, given their ability to simply outspend Innospec.
Taking those risks into account, I still think there is a reasonable case for owning the shares. I wouldn’t call it “can’t miss” cheap, and I do think there are risks of weaker demand from personal care companies and energy E&P customers, but on balance I think there’s still a case for owning the shares over the longer term.
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