The Weekly Pitch: CCC, An Environmental Growth Stock

Greetings. I will be starting a new blog on WSO where I will focus on putting together quality equity research pieces. My goal is to get practice at writing ER and to hopefully generate some investing discussion on the boards in the process. I'll be starting a sister blog here: (http://seekingalpha.com/user/13500742/profile) where I will post more detailed versions of these articles. I will do my best here to be concise while still providing key details. I am hoping for some discussion/constructive criticism.
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Company: Calgon Carbon Corporation
Ticker: NYSE:CCC
Stock Price: $16.44
Market Cap: $903 million
Debt: $50 million
Beta: 0.78

Investment Thesis

Calgon Carbon Corporation is a specialty chemical producer and industrial equipment maker that provides water purification and air pollution cleaning services to utilities, the shipping industry and other industrial applications. The company partners with its customers to meet increasingly onerous environmental standards in water purification and emissions and is expected to show strong long-term revenue and earnings growth due to the impending implementation of several environmental laws and a current restructuring effort. Equip with both high potential growth and high expectations, investors need to ask themselves if the company can deliver on its promises and if Calgon’s newly appointed CEO can execute accordingly.

The social trend of increasing eco-awareness is long standing and is now making a global footprint. New environmental laws at both the national and transnational level are set to hit developed and developing countries alike over the next 5 to 10 years. For better or worse, Calgon Carbon is a pure-play environmental cleaning company with the world’s largest activated carbon specialty chemical business geared towards municipal water purification. By leveraging the stable cash flows from its water purification business, the company seeks to expand into the key emerging environmental markets of mercury emissions cleaning and ballast water treatment for large ships.

The resulting investment story is one of potential high rewards paired with high risk that should keep investors cautious until Calgon achieves key milestones in its business plan. The upside could see as much as 65% 5-year revenue growth and 75% 3-year EBITDA growth which could translate to greater than 50% upside in the equity. However, a colossal valuation with heightened uncertainty over management’s ability to execute a turnaround and successfully expand into new markets unfavorably tip the risk/reward balance for the time being.

Please refer to the attached file which contains the financial model outputs while reading through the analysis.

Business Segment Analysis

The company is organized into three reporting units: Activated Carbon and Services, Equipment and Consumer Products.

Activated Carbon and Services (or “ACS”) is the core business of the company is and contains the specialty chemical product lines for water purification and air pollution clean-up and had 2012 sales of $485.7 mm or 86% of total sales. The unit is projected to have a 6 year compound average growth rate (CAGR) of 5.67%. The top-line growth will be driven by price increases, a modest increase in volumes to existing customers and robust growth in the air pollution cleaning market in response to new regulations. Operating and EBITDA margins are expected to expand from 10.15% and 14.80% currently to 15.00% and 19.65% within 5 years driven by price increases and a restructuring program.

Activated carbon is a specialty chemical used for water and air purification. Calgon produces over 100 types of activated carbon which are highly differentiated patented chemical products. The key raw material is bituminous coal and the manufacturing process is complicated by specific regional environmental regulations which cover everything from comingling raw materials to regular chemical testing.

The ACS unit’s primary customers are municipal water and coal power utilities. The water treatment customer base is very stable and typically engage in 10 year contracts for activated carbon services. Calgon Carbon is the world’s largest seller of activated carbon services and has relative pricing power over its customers because of its partnerships with localities to customize carbons for specific cleaning needs and to meet regional regulatory requirements. Its customer base is highly fragmented (each municipality is basically independent of each other) and has high switching costs due to the customized nature of products and services. The purification business is experiencing modest top line growth due to recent anti-dumping actions placed against Chinese competitors allowing Calgon to successfully raise its prices (estimated by management at 5% per year until the tariffs expire after 2017).

The coal power plant customers are clients in the air pollution product line which is currently a growth area for Calgon with several recent positive regulatory tailwinds in the US and internationally. The market for mercury emissions clean-up in North America is currently 160 mm pounds per year; however, once the new EPA standards take effect, the market is expected to grow to 800 mm pounds per year. Air pollution revenue is expected to grow from $95.6 million in 2012 to $207.7 million in 2017 based on growth in the market and the company’s current competitive position.

The Equipment unit has two primary product lines: equipment for water purification and the ballast water systems (BWS) for ships and had 2012 sales of $66.0 mm or 12% of total sales. The unit is expected to post a 6 year CAGR of 25.75%. The growth will be driven by a ramp up in sales of BWS. Operating and EBITDA margins are expected to expand from 1.06% and 3.11% currently to 16.00% and 18.05% within 5 years driven by a product mix shift towards the more profitable BWS.
The water purification equipment represents engineered solutions for advanced purification needs in a variety of applications. Sales have been stagnated because of strapped municipal budgets as well as a lack of resources for Calgon to take on large scale infrastructure projects – typically losing those contracts to industrial conglomerates.

Ballast water systems represent the company’s single biggest growth opportunity. New regulations will take effect in the US and a growing number of other countries which require all ships to have ballast water cleaning systems installed. Ballast water discharges have been found to cause environmental contaminations when ships release water collected in one ocean in a different part of the ocean. The potential market size is 95% of all large ships (anywhere from 50-80 thousand ships) and Calgon has a ready-made BWS that is already compliant with the new regulations. Calgon uses a UV disinfectant solution. UV systems are currently two thirds of BWS sales and Calgon’s market share has been 10-15% of UV BWS sales. Ships are required to install a BWS during their next dry dock and because a ship dry docks on average every 5 years, the next 5-10 years is a multi-billion dollar opportunity. Calgon expects a majority of its sales to be generated from existing ship installs; however, so far, its 200 plus sales have almost entirely been generated from new ship constructions. The fact that Calgon has not gained traction in existing ship installs is a worrying sign. The business line is expected to drive annual BWS sales in upwards of $100 – 500 mm as US and international regulations phase in between 2014 and 2018.

Finally the Consumer Products segment represents a very small piece of the overall company (1-2% of total sales). There are numerous applications of activated carbon which can be embedded into other materials such as carbon cloth for gas masks or wound dressing. Other applications include food processing and Brita water filers, just to name a few. The consumer division does not appear to be on the top of mind of management. Segment sales are assumed to maintain current operational characteristics.

Corporate Initiatives

In August of 2012, Randall Dearth was newly appointed as CEO. Since joining as CEO, Mr. Dearth has already made shareholder friendly moves in announcing a $100 mm share buyback program (11% of shares outstanding) and initiating a restructuring program. The restructuring aims at cutting 30 million in annual costs by consolidating manufacturing facilities, reducing product types by as much as 50% and investing in factory automation and improved IT systems. The restructuring moves seem sensible and given that for the last 3 years top line growth has been 15% with no earnings growth, there are likely many low hanging fruit.

Sales and marketing is carried out through a direct sales force with offices based in the US, Canada, Mexico, Brazil, UK, Belgium, Germany, France, Sweden, Denmark, Japan, Singapore, China and Taiwan. As part of the current restructuring, the sales staff has been reorganized into teams supporting specific product lines as opposed to the sales function being a stand-alone division of the firm. This new sales model may allow better focus and improved client service which may incrementally improve sales.
The company drives sales growth both organically and inorganically by gradually opening offices in new geographies (1-2 per year) and periodically engaging in small acquisitions (less than $50 million) of regional activated carbon businesses to win relationships.

Key Risk Considerations and Mitigants

Key risks include regulatory uncertainty, macroeconomic conditions, competing solutions, and management execution risk.

The company’s growth is concentrated in areas where regulation is expected to create demand. Outside of these areas, the firm’s products are expected to grow at GDP-like rates. Calgon has no control over the regulatory process and can only anticipate when enforcement will begin. Because Calgon has already invested in engineered solutions, late adoption of regulations would give its competitors time to develop solutions and will hurt Calgon’s cash flow due to the fact that its newly acquired overhead would operate below capacity.

The developed world’s public sector has shown soft demand due to tightness in government budgets which is expected to persist. Core water purification and air pollution services should not be greatly impacted because of their essential societal purpose; however, equipment sales have already experienced multi-year demand softness which will likely persist. Because of macroeconomic conditions, further increases in environmental standards may be deferred because of the additional cost they put into the system.

Competing solutions remain a significant risk as there are many competitors in all categories. In the core activated carbon markets, the industry is highly fragmented and many regional competitors exist. Competition is especially difficult in regions where Chinese anti-dumping duties are not in place or where patents are not effectively enforced. Industry consolidation and the rising trend in trans-national fair trade treaties are mitigating factors.
In emissions reduction, there are alternative products (notably dry scrubbing); Calgon’s wet scrubbing solution is currently the most effective and environmental and is a category leader.
Calgon faces intense competition in ballast water systems. However, of the few dozen BWS on the market, Calgon is one of the few (less than 10) with regulatory approval and has one of the longest industry track records.

Management execution risk is a major concern due to the challenge of the restructuring and hitting aggressive growth targets. While there is some traction in the air pollution sales, BWS sales are still flat over the last three years. A snapshot of the board of directors shows experiences aligned with the chemicals and energy industries – no shipping industry ties. Further, while the company expects a majority of its BWS sales to come from existing ship installs, almost all past sales are from new ship constructions. Most of the company’s BWS competitors have long standing shipping industry ties which highlights the question of whether Calgon can make inroads in the industry which is currently out of its comfort zone. Until BWS sales to existing ships gain traction, growth projections for the company as a whole look optimistic at best. Because the valuation is reliant on heavy growth from BWS sales, the high risk currently associated with the growth strategy seriously calls into question the current valuation.

Valuation and Key Assumptions

Because of the high-growth nature of the company, a comparables analysis of relative valuation and growth should better reflect what investors are willing to pay for CCC shares. Using the ‘Valuation Statistics’ table in the accompanying financial schedules, CCC is currently trading at the high end of all near term multiples: P/E 19x vs. 16x median, EV/Sales 1.6x vs. 1.4x median and EV/EBITDA 10x vs. 9x median. However, CCC also has the absolute highest projected growth of the comparable companies with three year top-line growth 35% vs. 14% median and three year EBITDA-growth 76% vs. 25% median. When applying projected long-term growth to the 2013 trading multiples, Calgon actually has the cheapest multiples: 2013 EV/Sales/Growth 0.05x vs. 0.10x median and 2013 EV/EBITDA/Growth 0.13x vs. 0.39x median.
In addition to higher projected growth, Calgon has a significantly lower beta than its peers with average LTM margins. The lower beta is a function of having less leverage and a more stable business model due to its long term municipal contracts. The peer companies have varied business models with some focusing on equipment sales and other focusing on specialty chemicals. If CCC’s restructuring efforts are successful, its margins will be near the high end of its peers and will validate the company’s premium multiples.
The comparables analysis shows that if Calgon meets or exceeds expectations for growth and profitability then the shares are quite undervalued in the long-term. Using the implied valuations from the EV/Sales/Growth and EBITDA/Sales/Growth multiples, the 3-5 year target share price should appreciate by 1.6x or reach approximately $26.5. Alternatively, if one were to apply the current EV/Sales and EV/EBITDA multiples to 2017 projected financials, the implied share price would also be approximately $26.5. Of course, these share price approximations do not account for the risk in the projections.

Conclusion

Calgon has a promising business model with significant regulatory tailwinds. If the company delivers on current expectations, then its shares could easily see greater than 50% upside. However, significant risks and questions over execution unfavorably tip the risk/reward tradeoff and make the current equity valuation appear overdone. Investors would be wise to wait for early milestones that the company is executing and pay particular attention to signs of growing traction in equipment sales.