The Official Winston Kotzan Website

NewMarket Thrives in an Old Market

Related Stocks: NEU, LZ, BASFY.PK

09/17/2007: NewMarket (NEU) serves as a holding company for two businesses: Afton Chemical and Ethyl Corporation. Ethyl primarily produces and sells tetraethyl lead led (TEL), a gasoline additive that reduces engine “knock.” Tetraethyl lead is known to be a deadly chemical hazardous to the environment and has been gradually outlawed in the United States through legislation beginning in the 1970s.

Ethyl’s primary source of sales is to countries other than the United States where tetraethyl lead is still permissible. Management and industry analysts widely accept that this business is in decline and revenues from this source are expected to shrink.

The bread and butter of NewMarket’s business is Afton Chemical. Afton produces various lubricants and gasoline additives. The lubricants it develops are for engines and other complex machinery with moving parts. Additives improve energy performance, and help keep remove dirt particles from engines.

Catalysts

NewMarket’s additives and lubrication business seems well positioned to benefit from the global economy as more people around the world will be driving cars. Just over half of its business originates from outside North America.

The gasoline additives business is in constant flux as chemicals are replaced with less environmentally hazardous substitutes. With the revival of ethanol, gasoline producers are now looking to ethanol as a safer means to boost octane. It seems that Afton Chemical is jumping on this ethanol trend with the introduction of a new product named BioTEC.

To stay ahead in this market, the company makes a notable investment in research and development. In 2006 it invested $70 million for R&D. Development and improvement of products appears to be a key to NewMarket’s long-term strategy.

Financial Analysis

Since it is difficult to accurately predict long-term growth trends for this industry, ratio analysis seems most appropriate for valuing this company. It trades near a Forward Price/Earnings ratio of 11.

When comparing to its competitors, I used the Enterprise Value / EBITDA multiple. This metric is similar to Price/Earnings, but can be used more effectively between companies of varying debt structures. According to Yahoo!, NewMarket currently trades at about a 6.7 trailing EBITDA multiple. This is lower compared to the 8.6 multiple of its competitor Lubrizol (LZ), but higher than BASF (BASFY.PK). Looking at the information on the BASF website, I calculated their EBITDA multiple just above 5.

Looking at Return on Equity, NewMarket seems to be good at generating value for shareholders. In recent years, the ROE has improved and for 2006 was 19.1%.

I tried to relate ROE to the cost of capital (financial jargon for the opportunity cost of an investment). The company recently issued senior notes at 7.125%. Adding a risk premium of about 4-5% would give us a cost of capital in the low teens. Because the ROE is above the cost of capital, it implies that NewMarket has the potential to generate profitability for shareholders.

Finally, NewMarket has a strong balance sheet with a manageable debt load and consistently positive free cash flow. The strong financial condition and high ROE might make NewMarket an attractive takeover target for private equity or another specialty chemicals company.

The financial strengths may have caught the attention of Renaissance Technologies, a renowned quant hedge fund. Looking at the latest 13-F holdings, Renaissance owns 3.46% of the outstanding shares. They also have a 4.22% stake in its competitor Lubrizol.

Please also note that as of September 6, 2007, the BASF ADR was de-listed from the NYSE and now trades on the Pink Sheets market under a new ticker. The Pink Sheets market typically carries riskier securities, but since value of these shares is related to their counterpart shares on the heavily traded Xetra market in Germany, I expect arbitrage to mitigate the trading risks associated with the Pink Sheets.

Risks

According to the 10-Q’s, most of the improved financial performance of late 2006 and early 2007 is attributable to the introduction of new products with higher operating margins and price increases on existing products. Whether this is a trend that can be sustained for very long is uncertain.

Another threat is that since this is a small company, its customers have significant influence over sales volume. In 2006, over 10% of revenue came from two customers: BP plc and Royal Dutch Shell plc.

NewMarket is also a small player compared to its competitors. Its products directly compete with some of the larger oil conglomerates and chemical companies such as BASF AG.

Conclusion

NewMarket appears to be a great holding for speculation. The possibilities of a takeover and benefits from global growth make it appealing. However, consider the risk and volatility of the stock. With few guarantees on future performance or safety, a few bad cards can send this company in either direction.

As a safer alternative for investing in the additives and lubrication industry, I suggest BASF. Aside from a more diversified business, BASF also has a tremendous stock repurchase program and the stock price stands to gain from the appreciating Euro.

Full Disclosure: At the time of this writing, Winston does not hold positions in the discussed stocks.