By Notable Calls: Monday February 1, 2010
Citigroup is out downgrading Lubrizol to Sell
from Hold whole lowering their target to $67
(prev. $78).
Citi notes there was a new data point in
lubricants that came out on Friday from
NewMarket, one of Lubrizol's main
competitors. NewMarket's lubricant additives
margins dropped sequentially from 23.3% in
3Q'09 to 16.4% in 4Q'09 as raw material base
oil prices went up faster than lubricant
additive prices. They think this is the first
crack in the lubricant industry. Lubrizol's
Lube Additive margins had skyrocketed from a
historical average of ~12% to ~28% in both 2Q
and 3Q 2009. They are downgrading LZ despite
the 7% drop in the stock on Friday for three
key reasons:
- Firm notes they have seen similar examples
of margin erosion in other chemical products
such as Monsanto's Roundup and the fertilizer
potash. In both these products, margins
skyrocketed after having been stable for
several years. In the case of Roundup, the
Chinese entered the market and crushed
margins in 2009. Recently in potash, the
oligopoly structure did not hold up well,
dragging down profitability. The reasons may
be different in each case, but the outcome
was the same.
Lubrizol's lubricant margins hovered between
11%-13% for most of the decade before moving
higher in 2009. The reason for the margin
expansion was that raw material base oil
prices collapsed in 2009, while final
lubricant prices did not fall as much. As a
result, there was an unprecedented margin
expansion, when margins reached 28% in 2Q'09
and 3Q'09. Lubrizol may post good results in
4Q'09 when it reports on Thursday (2/4), but
NewMarket's results have shown the
vulnerability of these margins to higher raw
material costs. Can lubricant prices go up
from here even if they did not go down in the
recession? Citi thinks there could be
pushback from customers such as engine oil
and other lubricant manufacturers, quick lube
chains, retailers such as AutoZone and
Wal-Mart, or OEM players in the automotive
and construction industry.
Given that Valvoline is one step downstream
from Lubrizol, the firm expect its margins to
be a leading indicator for LZ. Valvoline's
margins peaked in 2Q'09 and have declined for
the last two quarters. NewMarket's margins
peaked in 3Q'09 and declined from there,
roughly one quarter behind Valvoline. Firm
expects Lubrizol to broadly follow the same
pattern in the long run. LZ may post a good
4Q due to its cost cutting initiatives, but
Citi's call today is not about the fourth
quarter; it is more about the next 12-24 months.
- Citi thinks high operating margins of 28%
could attract new investments by existing
producers or new players to the industry.
Lubrizol has already announced a new $1B
capital program over the next 10 years to
upgrade existing operations and to build
capacity in additives. The centerpiece of the
initiative is a greenfield expansion which
involves an investment of over $200 mm over
the next three years in building a new plant
in Southern China. Lubrizol plans to break
ground in late 2010 and would likely export
products throughout Asia. Citi notes they
wouldn't be surprised if Chinese oil
companies or others enter this business given
attractive margins and China's growing
passenger car market and industrial lubricant
needs.
- Citi is lowering their Lube Additives
margin assumption from 23.5% in 2009 to 18.5%
in 2010 and 16% in 2011. Our long-term margin
assumption of 16% is higher than Lubrizol's
historical margin range of 11%-13%. A 1%
change in Lube Additives margin impacts EPS
by roughly 40¢/share, so there is significant
sensitivity to Lube Additives profitability.
Firm estimates that the Lubricant Additives
segment accounted for ~85% of total company
profit in 2009, while historically the
segment was 60%-70% of total profit.
Firm is lowering their earnings estimates for
2010 (by $0.23 to $6.74) and 2011 (by $1.27
to $6.07) to account for lower operating
margins in the Lubricant Additives business.
