RealMoney Silver - Wallflowers: Inspect Innospec

Wallflowers: Inspect Innospec
By Bill Trent
RealMoney.com Contributor
5/8/2008 11:00 AM EDT

This is the next entry in an ongoing series of stories focusing on companies that have little or no Wall Street following. These firms are often referred to as "wallflowers." Many times, shares of these companies are quite undervalued, as most portfolio managers do not get a chance to hear their story. Today, we're looking at Innospec, which is followed by just two analysts.

Innospec (IOSP) is a small-cap with scant Street following, but it has the potential to make big strides as it scales out of a diminishing business segment. The company's growth and free cash flow make it one to watch in the quarters to come.

Innospec makes fuel additives and other specialty chemicals that are sold primarily to oil refineries and other chemical and industrial companies. The company operates in three segments: fuel specialties, active chemicals and octane additives.

Fuel specialties growth has been driven by legislation, population affluence, and energy price and availability. The segment's sales grew 20% in 2007 and accounted for 62% of total revenue.

Active chemicals provides technology-based solutions for customers' processes or products focused in the personal care; household, industrial and institutional; fragrance ingredients; plastics and polymers; and pulp and paper markets. This segment accounted for 22% of total sales in 2007 and grew 11%.

Getting the Lead Out

Innospec's third business segment, octane additives, has the inauspicious distinction of being the world's last remaining supplier of tetraethyl lead (TEL) additives for the automotive market. Beginning with the 1973 Clean Air Act in the U.S., use of leaded gasoline has been declining worldwide. In recent years, the company has experienced annual sales declines ranging from 10% to 25% in this business.

According to Standard & Poor's, the octane additives segment accounted for 53% of total company revenue as recently as 2003. With such a large portion of the business declining at a rapid rate, it is probably no surprise that only two analysts cover the company. However, things are changing.

As noted, the declines in TEL have been under way for many years. Recognizing this, the company has diverted the segment's profits into its other business lines, developing or acquiring new products for which demand is growing. As a result of the declining TEL sales and growth in the other segments, the octane additives segment accounted for just 16% of sales in 2007. As a result, total sales from continuing operations have managed to grow each year but one since 2003. The smaller the octane additives segment gets, the less it matters.

The most significant risks relate to regulation and legal issues. A legal suit regarding the UN Oil for Food program hangs over the company. Furthermore, as the TEL business demonstrates, regulatory changes can have a dramatic impact on fuel additives. However, the regulations can cut both ways, providing opportunities for new growth as well.

Room to Grow

Innospec trades near the average price-to-book ratio for the industry despite having one of the highest returns on equity among its peers. As a result, I think the multiple can at least hold steady if not expand. Although sales have grown just 5% annually over the last five years, the diminished impact from the octane additives business suggests that future growth could be much higher. Based on the high ROE, I estimate a sustainable growth rate in the 16% range.

In 2007, Innospec generated $47.9 million in cash from operating activities and $35.7 million of free cash flow. Its free cash flow yield of 6.8% is more than double the current yield on five-year Treasuries and the 3.3% average free cash flow yield of the companies that pass my screens. The company has been using that cash to reduce its debt. Although there have been share repurchases the total share count has remained fairly stable over the last couple of years, which suggests the repurchases are mainly offsetting option issuance.

With the potential for growth to pick up, I could see the free cash flow yield tightening a bit, to perhaps 6%. That level would still offer a significant risk premium beyond that provided by growth. The timing of all this remains uncertain given the volatility that remains in the ethanol business. However, over the next five years, I believe renewed growth and the modest valuation expansion could combine to total a 20% average annual return.