Olin: Chemistry and Cash Flows - [Business Breakdowns, EP.132]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of Breakdowns, check out joincollossus .com. All opinions expressed by hosts and podcast guests are sole their own opinions. Hosts, podcast guests, their employers, or affiliates, may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell and today we are breaking down Olincorp. If you ever wondered when that high school chemistry class would come in handy, now is the time. Olin is a key player in industrial chemicals, but many of those chemicals are used in products that we interact with or see on a day -to -day basis. To break down Olin, I'm joined by Yinen Zau from Zina Investment Management. Together we cover the Chlor Alkalai market. What it means to be the lowest cost producer of a given commodity.

1:24And how Olin has shifted its business model and shifted its operational model to help sustain earnings through cycles. Please enjoy this breakdown of OlinCorp. All right, Enon, thank you for joining us on business breakdowns today. Olin is not a household name by any means. and I will admit to having absolutely no familiarity with this business prior to doing some research. So I think the best place to start is with a lot of background on the business, just a level set before we get into operational and financial dynamics. So maybe we could start with the very high level view, the 30 -second elevator pitch for who Olin is and what they do.

2:04Sure. So I think like you, most of your listeners probably have never heard of Olin, The only consumer -facing product that Olin does have in its portfolio that some of your listeners may be familiar with is Winchester, and that's the brand under which Olin manufactures and sells ammunition. But outside of Winchester, Olin's portfolio primarily consists of non -consumer -facing industrial chemicals, and so it's certainly not a household name. I think what's underappreciated about Olin is that the industrial products that it does manufacturer are really critical in the production of many goods and services that we use on a daily basis.

2:45And that list of applications, ranges from everything including plumbing and siding and windows and doors that are found in homes to the foam that's in mattress or furniture to the aluminum in your car, the soap and detergents. It's also used to help keep the water that we drink clean and safe. I think something like 90 % of the tap water consumed in the US is treated with oil and products. So it's definitely not one of those companies that most people have never heard of, but that has a pretty meaningful impact on our lives every day. It reminds me of business breakdown that we did on DuPont in that way.

3:27Is it right to think about the investors that are looking at DuPont are likely the ones looking at oil and from a subsector perspective. So there may be some overlap, but as you probably learned on the DuPont podcast, Dow and DuPont merged, I think it was back in 2015 and 2016, and then the idea of that merger was to separate those three businesses into three more focused businesses with Dow owning the commodity upstream part of the assets, DuPont owning the downstream specialty assets, and then Corteva owning the crop science and ag chemicals businesses. is I would put Olin more in the commodity part of that value chain.

4:08And so it's more like a commodity chemical company like the Dow than it is like a dupent. Yeah, I probably should have been specific about which part of that business because it looks a lot different today than it did when we did that breakdown. Maybe we can go back in time here. I know there is a rich history in terms of how everything came together. So maybe you can walk us through that history of the business. Sure. Absolutely. So, Olin has a really long history. In fact, the founding of the company dates back to the late 19th century. Franklin Olin founded, at the time it was called the Equitable Powder Company in 1892.

4:44An equitable really started as a blasting powder supplier in Illinois. The primary customers were mining and construction companies. And over time, he expanded into various adjacencies, including ammunition manufacturing. I mean, he did that through the Western cartridge company, the Western cartridge company in 1931 acquired Winchester, which was a firearm manufacturer, out of bankruptcy. Around the same time that equitable powder was founded, Mathis and Chemical was founded in Virginia. And Mathis and Bill, the first chloralculi plant in the US in South Bill, Virginia. And then they went on to build more chloralkyly plants in various locations across the country, including Niagara Falls and upstate New York, Lake Charles, Louisiana, Macintosh, Alabama.

5:33And a lot of those early chloralkyly plants were built either near salt deposits or near cheap sources of electricity. And this is because as we'll get into later, salt and electricity are the primary feedstocks for the chloralkyly industry. And so Niagara Falls was chosen because of access to cheap hydro, salt, villa, macintosh, and we're both near -salt deposits. And if you fast forward another 50 years from the founding of equitable powder of Matheson to 1954, that was the year when Olin, which is the the Blastin powder ammunition inside of the company, merged with Matheson Chemical, the Chloralchlide business.

6:14And that really laid the foundation for what we know is Olin today. After that merger, the combined company continued to enter into adjacent chemical and industrial businesses, but over the years they spun off or sold most of those businesses to pair back down to the Cloralcola business, plus a smaller, less core, but still very cash -generative Winchester ammunition business. And if you fast forward another 50 years to 2015, well, a particularly important transaction occurred that year as well. And that was when and Olin acquired Dow Chemicals, Chloralkylion, Chlorine, Derivatives, businesses.

6:53And Dow had initially only wanted to sell part of the business, specifically to downstream Chlorine Derivatives businesses. The Olin said they were interested, but only if Dow were to include a larger portion of the portfolio, including the upstream Chloralkylion assets, And ultimately the deal that got done saw Olin getting the majority of Dow's chloralculi assets. And that transaction really was transformative for Olin because it made Olin the leading chloralculi producer in North America. And I think just as importantly, it added significantly to the number of different chlorine derivatives that Olin was able to produce.

7:36And that will become an important point as we dig into the change in operating philosophy at Olin. Yeah, it's always interesting with these businesses that have 100 plus years of history where they typically have these errors of becoming diversified conglomerates. And there's usually some relation to the product offering, but then over time they start to actually divest a lot of those assets and become more focused. It certainly sounds like the case here where even the future transactions kept them focused in the Chloralcholide business. I do think I'll need 101 on chloralkylis. So as much of a rundown as you can give in terms of what's happening within that market, the inputs and the outputs of how chloralkylis used, it's something I know of, but I don't know well.

8:23So whatever primer you can give us is going to be helpful here. Sure, absolutely. I think at a high level, it refers to the production of chlorine and caustic soda. And that's done through a chemical reaction involving salt, water, and electricity. So pretty simple when you put it that way, but much more complicated in practice. The two molecules that are produced, chlorine and caustic soda, are in fact coproduced. And they're coproduced from the same electrolysis process. Generally speaking, in all electrolysis processes, what you're doing is you're running an an electric current to drive a chemical change that wouldn't naturally occur under normal conditions.

9:10And in this particular electrolysis setup, you're running an electrical current through a mixture of NaCl, aka salt, and water, H2O. And out of that chemical reaction, you get a reformulation of the NaCl and the H2O into three things. So, CL, which is chlorine, NAOH, which is more commonly known as caustic soda, sodium hydroxide, as well as a small residual amount of hydrogen. But people don't really talk about hydrogen that much because in most setups, the hydrogen is just released into the atmosphere. Now, generally speaking, because chlorine is difficult to transport and store due to its toxicity, the chloralculide production is set up to produce chlorine with caustic soda treated as a byproduct.

10:06And so it's imperative to have outlets for the chlorine that you produce since that can be a limiting production factor. In terms of the various outlets for chlorine, you can further process that chlorine into a range of derivatives, or you can sell it merchant, and the various chlorine derivatives all have various use cases. But the largest end market, by far, is residential housing construction, where you'll find it in the form of PVC. And that's Polyvinyl Chloride, which is a type of rigid plastic that can be used to make, as I said earlier, vinyl siding, doors, windows, and pipes for plumbing.

10:49The other molecule that's produced is caustic soda. And caustic soda is generally not processed any further by the chloralkylic producer. It's just sold as is, but it does have a wide range of industrial uses as well, including as a processing aid for the production of alumina, various other metals, pulp and paper, just to name a few industries. It can also be used as of raw material in general manufacturing for things like soap and super absorbent polymers, like diapers, feminine hygiene products, etc. As a result of the different end market applications for the two molecules, what's interesting about the chloralkylide business is that one side of the molecule, chlorine, demand tends to be driven by housing construction and the other side, the other molecule that's co -produced, caustic soda is driven by general industrial activity and And the two can move together, but often move at different rates.

11:51I'm going to oversimplify here, but it sounds like there's similarities to a crude oil refining process where the oil is taken, the hydrocarbons are then refined through some process involving a lot of energy to create various types of fuels and some byproducts, which may or may not be used jet fuel and just traditional gasoline. is it safe to make that comparison just in terms of, from a very high level, the overall process of what's going on? So I think that's a fair analogy for the chlorine side of the chloralkylic production process. Since the chlorine is often processed further into various chlorine derivatives, and you have some flexibility in terms of which derivatives chain to direct the chlorine molecules to in order to maximize value.

12:40but the degree of flexibility really varies from producer to producer depending on their setup. And I'm going to ask the question that I assume a lot of listeners will be wondering themselves, which is, is this chlorine ever used within a residential pool or for any pool purpose? Or is that a completely separate chlorine? It is. That's right. This is the type of chlorine that would be used in a pool. I'm not sure that you would be buying it directly from a brand name that Poland produces, but they'll be selling it to someone who produces chlorine that might end up in your fool. I think we can talk a little bit about how that operation actually works and specifically for Poland.

13:21How do they access the chloralkali? How is it transported in terms of making its way through that process and then distributed to whoever the buyer is who I assume is the manufacturer of that broader manufacturing process? Can you just go through a little bit of what that looks like in terms of the operations and which part Olin is controlling versus what's outsourced and how the dollars are changing hands in this particular value change? As I mentioned the two key feedstocks are salt and electricity When Matheson in 1890 I think was 97 built the first plant in saltwood, Virginia They built it in salt bill because there was a salt dome in salt goes as cheap access to salt I think the same with Macintosh.

14:08In Niagara Falls, I believe they have access to salt, that's maybe 50 miles away. So you want to be close to a source of salt, and ideally you want to have a stable, steady, and cheap source of electricity. Post the Dow acquisition, Olin in addition to the legacy, Mathis in sites in Niagara Falls, in Macintosh, And they also have a site in Charleston, Tennessee. They acquired two large plants in the US Gulf Coast, in Placameen and in Freeport. The interesting thing about the US Gulf Coast is that it's actually the most cost advantage region in the world due to cheap self -encheeb electricity. And the reason for that is that really goes back to the Shell Revolution in the early 2010s Because of a revolution in the way we're able to access shell formations and drill oil and gas, natural gas became really abundant in the US.

15:14And most of the electricity that we consume in the US is generated from natural gas. And so, all in at some of their sites, they have cogen facilities that they own and operate producing electricity for their plants. In some sites, they have access to the co -gen plants site partner that provides a source electricity. And in other regions, they are able to buy electricity from the grid. The grid is strong enough to support the quantity and volume of electricity that they need. And then with salt, the US Gulf Coast, and particularly in Texas and Louisiana area, there are lots of underground salt formations that Poland has access to with very abundant sources of that salt.

16:04Beyond Poland's portfolio, there are a lot of other companies in the US that are also concentrated in that region like West Lake, like OxyCam for most Asian tech. and then in terms of what they produce, as I said, there's a wide range of products that they can produce, and depending on what it is, the distribution and the end customer is different. I think what's unique about Olin versus their peers is that unlike their peers, Olin is not as forward -integrated into the vinyl chain, which is the PDC chain. In fact, before the Dow merger, Olin was somewhat of a one trick pony and it only sold chlorine in the merchant market or in the form of hydrochloric HCl and bleach.

16:51Following the down merger, it acquired a more diversified chlorine envelope with the addition of some vinyl exposure plus some epoxy resin exposure and some chlorinated organics exposure. As I said, depending on what you're selling, the distribution is different. If it's merchant chlorine, Olin is primarily shipping that via rail car into the interior of the country and then that's getting consumed by industries like TI02 and DINTDI, which are two of the precursors used to make various types of foam. And then the HCL and bleach are typically sold to municipalities who use it for water treatment.

17:31That's bleach. HCL is sold primarily to oil, natural gas and steel producers. And then on the vinyl intermediate side, Poland doesn't actually produce any PVC. It does produce some vinyl intermediates like EDC or VCM, which are the precursors that end up becoming PVC. For EDC, Poland is actually the world's largest merchant producer. Most of the rest of the world's EDC is forward and integrated into VCM and then ultimately PVC. And then, Poland does also produce some VCM to one large customer. That's Shintek. And then on the epoxy business, again, when the oil and reports that they report epoxy as a separate business, but it's really just another chlorine derivative.

18:16And so I would think of it as one of several options that oil and can direct chlorine too. And the epoxy side of things, they can choose to sell the molecule upstream in the form of epichlorohydrate or process it further downstream into epoxy systems and formulations. and then sell a more processed version of that to customers. Can you give the quick snapshot just in terms of percentage of whether you measure it by revenue or if they break it out by EBITDA even better when it comes to the Chloralculide business, the ammunition business, they split out the epoxy business. Just what the snapshot is for each of those businesses within Olin?

19:00The answer to your question is it kind of depends Because it's a cyclical commodity business, at the peak of the cycle, the cyclical commodity piece is going to account for a larger percentage of your EBITDA because you're at peak earnings. And at the trough of the cycle, it's going to account for a lot less versus the ammunition business, which is comparatively much more stable. 2021 and 2022 were both peaky years for the chloralkalye business. is and each of those years the Chloralculi business accounted for over 80 % of the EBITDA, but in a trough year, it's going to account for much less than that.

19:39Okay. And for context, how low would that possibly go from 80 % to 50 % or I know you're not going to be exact in terms of those forecasts, but I'm just wondering how cyclical this cyclical commodity actually is. Let's just do some quick mental math here. Winchester will probably end the year at around $250 ,000 to $300 million of EBITDA. And total EBITDA for the entire company is probably close to $1 .4 billion this year. So they'll still 70 to 75%. But in this case, it's just because the Chlorocloid business doors winchester in terms of EBITDA contribution. But going from close to 90 % to 70 % is a big swing for the commodity piece.

20:30Absolutely. And that can bring us back to one of your earlier points just in terms of how they involve themselves in the overall value chain and not being as integrated with the of INALS business. How does that shift the profile? I assume it just gives more pure commodity exposure, but is there anything else that goes into that thinking in terms of through the cycle normalized rates of return and how you as an investor would think about them being more or less integrated with some of the end markets? What's interesting, I'm sure we'll get into the change in operating philosophy later, but before 2020, I would say Olin's business was always more levered to the fortunes of the cost -except of the business.

21:23That was because it was not as forward -integrated into PVC like its peers. What you had was a situation where when housing and construction were strong, PVC demand would be strong and because PVC demand was strong there would be a pull on chlorine and so all of Olens peers who are more integrated into PVC on the chlorine side of the business they would produce as much material as they could and as we talked about earlier what's unique about the chloroclyceric process is that it's a co -production process and so when you are producing for chlorine, you also have to produce caustic soda. And what ended up happening in that type of environment is there would be excess caustic soda.

22:13And because Olin's fortunes were more levered to the caustics out of the business, they would benefit from some of that chlorine strength. But it was not more than offset, but it was offset to an extent that wasn't optimal for their setup, even in the year like 2018 where the industry was going through a peak, Olens EBITDA topped out at around 1 .3 billion. And I think this was the key insight that Scott Sutton, who took over as CEO, had in 2020 when he changed the operating philosophy. Yeah, there's some similarities again to tie back a little bit to the group process of associated gas being produced or even NGLs where it can depress the price of those commodities because they are just simply being produced along with the crude oil.

23:04And that can have a massive impact on some businesses that have that diversified exposure and aren't pure play crude oil producers. Let's get into Scott Sutton what he's done where he came from prior to Olin and some of the changes that he made for the business, he mentioned the chain in operating philosophy. What did he do to adjust for that impact that you were mentioning before? Only just back up one or two years to give some context before Scott joined. So as I said earlier, there was a cyclical peak in the industry in 2018. Poland earned about 1 .3 billion, which is good but not great. 2019 was a tough year for that was the year when the stock had our radar screened and we learning about Nolan.

23:512019 was a weak demand year for caustic just driven by general industrial economy weakness. As I said, Poland has always been historically more levered to the fortunes of caustic and so caustic being weak was not a good macro situation for them.

24:12The one thing like producers are forward integrated in the PVC is not just because we have cheap access to electricity, but we also have access to cheap ethylene. And the way you make PVC is by combining chlorine with ethylene. And ethylene, just to give your listeners another primer on another commodity chemical, is the basic building block molecule that is produced from various fossil fuel derivatives. is. The marginal producer in Europe and Asia is producing that ethylene from NAPTA, which comes off the refinery. And as a result, it's tied to the price of oil. And then US producers, because of the shell revolution, have primarily shifted from NAPTA to ethane, which is a natural gas liquid that is a byproduct of shell oil and gas drilling.

25:05And because of that, ethane is generally tied to the price of Henry Hill natural gas prices and on a barrel of oil equivalent basis US natural gas is a lot cheaper than the Brent oil that Europe and Asia producers are using as feedstock and So for that reason the ethylene that we produce in the US Gulf Coast is also a lot cheaper US PVC producers just have a huge cost advantage and so in 2019 even though cost it was weak, the PVC producers were still producing, still running very chloroaclasts, like crazy, to take advantage of the cheap effluent cost position of the US. This drove a huge oversupplying cost that resulted in a decline in oil and zebra stock from 1 .3 billion that they earned in 2018 to just 900 million in 2019.

25:57Then what happened was COVID hit in 2020. Because the global economy shut down, you're demand for Olin's products, especially on the cross -six side fell off a cliff. In 2020 was a really tough year for them. I think the Rebeta fell from the 900 million in 2019 to just over 600 million. Now, I think the other unexpected event in 2020 that happened in addition to COVID was a change in leadership at the company. Scott Sutton became CEO in 2020 and upon taking the reins, he instituted a major change in the operating philosophy at the company. Essentially, he flipped the old model on its head and he switched to a model in which Olin would manage to the weak side of the model, or as he called it.

26:49Essentially, it was a value over volume strategy. And he wasn't entirely new to the business. He'd been on the board for a number of years. So he had an idea of, I think, how this operating model could work. Many had also previously run the acetacetic acid business at Celenies in a similar fashion. I think what made Cloralkyli uniquely suitable to this operating model was the fact that the Cloralkyli industry, unlike the acetacetic acid industry, and for that matter, most other commodity chemical value chains produces, as we've said multiple times, two different molecules through one process operating at one operating rate.

27:35And if you are always managing to the weaker of the two molecules that are co -produced, and otherwise only producing as much product as there is demand for the weaker of the two, effectively your under -supplying the stronger side of the market can therefore push pricing in that market to enhance value. At the same time, instead of pushing excess product into the weaker market, which would depress margins even more, you're preserving value by not oversupplying the weaker market. It's a win -win. On paper, it makes a lot of sense from that 10 ,000 -foot view, but executing is pretty complicated.

28:17under the hood, what you're essentially having to do is every day determining Olin's participation rate based on a three -step decision tree. The first decision node is the simplest and that's is caustic cheaper or is chlorine cheaper a weaker and once you determine that then you set your production to the weaker side of the market. The second decision node on the chlorine side of things is which chlorine derivatives chain do I want to participate in? Is it a Do I want to produce more merchant? Do I want to produce more vinyls and remediates? Or do I want to produce more chlorinated organics? And then the final step is determining how far up and down each of those chlorine derivatives chains, do you want to manufacture?

29:04Do you want to let the epoxy out at the chlorohydrate? Or do I want to process it further into epoxy systems? So essentially just became a very simple volume over value low cost commodity strategy to a much more complex commercial model where you're moving with more agility to maximize the overall value of the Chloralki molecule. So basically an interesting optimization problem. Super interesting. The amount of variables that are going into that, just fascinating to me. And I want to unpack a few of those. From the start, the idea that you're going to push less volume into the cheaper market, therefore you should see some improvement on price.

29:55How confident have they been that that optimization is actually going to play out to their benefit? I think you can make the case as well that you would want to push onto the market. And if you're the low -cost producer, push out some of the higher -cost competitors, but in this approach, you might actually be letting them survive. In terms of the early results, how have they proven to be just in terms of implementing this strategy to success and not losing share or whatever it might be from competitors? We asked ourselves that same question when Scott took the reins, because I think the knee -jerk reaction is if it's so simple why hasn't it ever been done.