Calgon Carbon: An Environmental Growth Stock With High Risk And Reward

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By Luis Sanchez :

Company: Calgon Carbon Corporation

Ticker: NYSE: [[CCC]]

Stock Price: $16.44

Market Cap: $903 million

Debt: $50 million

Beta: 0.78

Competitor Companies: [[CBT]], [[DHR]], [[HWKN]], [[MWV]], [[XYL]]

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. Equipped 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.

Business Segment Analysis

Calgon Carbon Corporation is a specialty chemical producer and industrial equipment maker that provides environmental cleaning solutions for water purification, air pollution ballast water systems (or "BWS") for ships and other environmental cleaning solutions. The company is US-based and serves global customers primarily in developed markets that have robust environmental laws and seeks to partner with its customers to meet increasingly onerous environmental standards with its specialty chemicals and engineered solutions.

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

The Following Tables Show Projected Revenues and Operating Assumptions for the Business Segments. Read below for commentary.

Revenue Build:

(click to enlarge) Revenue Build

Operating Assumptions:

(click to enlarge) Operating Assumptions

Activated Carbon and Services (or "ACS") is the core business of the company and contains the specialty chemical product lines for water purification and air pollution clean-up and is 86% of company sales. The business unit had 2012 sales of $485.7 million with operating and EBITDA margins of 10.15% and 14.80%, respectively. The unit is expected to post moderate growth with a projected 6 year compound average growth rate 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 which comes in a variety of forms (granularized, powered, pellets, etc.). Calgon currently produces over 100 types of activated carbons which have over 700 distinct applications. When the activated carbons are discharged, they absorb organic and inorganic matter depending on the particular chemical formula used to make the carbon. Activated carbons are customized for specific cleaning tasks which represent both an opportunity and a challenge for the ACS business. The opportunity is that the product can be highly differentiated. The challenge lies in the complexity of manufacturing 100 variations of the basic products and dealing with very specific regional environmental regulations which cover everything from commingling raw materials to regular chemical testing. In 2012, the company experienced difficulties in managing its supply chain due to supplier deficiencies - these interruptions hit gross margins by approximately 2%. The company must constantly innovate and tweak carbon formulas to compete and find new applications. Calgon runs several R&D centers which cost the company 1 - 2% of sales.

Activated carbons are made primarily from coal, but can be made from numerous other forms of ash or chemicals. The carbon is "activated" through a high-temperature baking process or through a chemical impregnation. The coal required to make the most potent product is meteorological bituminous coal. After activated carbon has been spent, it can be "re-activated" through another cooking process. The reactivation service is a major part of the company's business (20% of segment sales) and the company actively transports carbon between sites for reactivation.

The ACS unit's primary customers are municipal water utilities and coal power plants. 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. In addition, 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.

Although municipal budgets are strapped for cash in the US and Europe, the market for water treatment services is resilient and gradually growing with population. Water purification volumes are growing and municipal water systems do not face significant sequester or political risk because of the basic need for the service. However, municipals do not have the budget to upgrade their equipment or technology which hurts Calgon's other businesses. 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 outcomes. The EPA has proposed new environmental standards for mercury emissions which are expected to hit enforcement in 2015. In January of 2013, a binding UN resolution passed which commits its 140 members to implement mercury emissions standards by 2020 - this mostly impacts concentrated manufacturing nations like India and China. There are also resolutions in the EU which may raise emissions standards within the next 3-5 years.

In the US, several utilities are running full scale mercury scrubbing trials ahead of the ramp up in regulation. These trials are expected to wind down over the next year - explaining the short-term decline in air pollution sales. There are a few competing solutions to the mercury emissions issues, but Calgon's wet scrubbing activated carbons are well positioned to be the industry leader. Currently the market for mercury emissions clean-up in North America is approximately 160 mm pounds per year due to random local and state environmental laws; however, once the new EPA standards take effect, the market is expected to grow to 800 million annual pounds. These estimates of future market size were used to project revenue growth in the product line. Air pollution revenue is expected to grow from $95.6 million in 2012 to $207.7 million in 2017. There is potential upside to these figures because the current assumption is that most of the growth will come from North America with some incremental growth in Europe and little growth from other markets based on Calgon's current competitive position.

The company operates several activated carbon manufacturing and reactivation plants. As part of an ongoing restructuring to drive profitability, the company is consolidating several of its manufacturing facilities, increasing factory automation and reducing the activated carbon product portfolio by as much as 50%.

The Equipment segment represents approximately 12% of total company sales. The unit has two primary product lines: equipment for water purification and the ballast water systems (( BWS )) for ships. The business unit had 2012 sales of $66.0 million with operating and EBITDA margins of 1.06% and 3.11%, respectively. The unit is expected to post strong growth with a projected 6 year compound average growth rate of 25.75%. The top-line 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 including the purification of industrial chemicals for pharmaceuticals, food packaging, and natural gas installations. Key equipment includes the ultraviolet light disinfection (UV) and the ion-exchange technologies. The equipment unit is underperforming because of strapped municipal budgets as well as a lack of resources for Calgon to take on large scale infrastructure projects. While Calgon has key engineered components of industrial water systems, it does not have end-to-end design, engineering and construction capabilities to win major contracts; these big engineering contracts are usually taken by industrial conglomerates such as GE or Siemens. Currently, growth is projected to persist at GDP-like levels along with the water treatment industry as a whole; however, there is potential upside in the segment's growth if infrastructure development efforts in developed markets gain steam.

The ballast water systems side of the unit represents 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 the competition is open for engineered solutions. 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. 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, but management remains confident that sales patterns will reach an inflection point in the near future. The business line is expected to drive annual BWS sales in upwards of $100 - 500 million. Initial US Coast Guard regulations covering BWS will take effect between 2014 and 2016 and other international regulations representing 30-40% of navigable water ways will likely phase in between 2015 and 2018.

Growth for the ballast water system sales are projected to grow from $20 million in 2012 to $210 million in 2017 or from 68 units to 700 units sold at an average price of $300,000. There is a high margin of error in this calculation and sales could easily surprise to the upside or down side depending on how industry conditions develop. The unit sales were conservatively projected as follows:

  1. 50,000 total ships which use US waterways will need to install a BWS beginning sometime between 2014 and 2016.
  2. Ships will install their BWS on their next dry dock which happens on average every 5 years. Therefore when installations peak (2016), roughly 10,000 BWS will be installed per year.
  3. UV Disinfectant BWS represent two thirds of the current systems sold (6666 per year).
  4. Applying forward Calgon's current market share of roughly 10% of the UV BWS market (666 units sold per year) and an average selling price of $300,000, represents a potential annual revenue of $200 million per year during the peak installation years between 2016 and 2019.

As mentioned, there is significant room for error in this calculation as it is built on the assumption of regulation hitting at certain times, UV technology remaining popular, and Calgon's market share remaining constant. If phase-ins were to be pushed back or if Calgon's market share were to increase (just to mention two of many possible scenarios), the projected value of the BWS opportunity could significantly decrease or increase. Holding all other assumptions constant, if Calgon were to only reach peak BWS sales of 300 by year 2017, the implied share price (from the DCF) would drop to approximately $12.60. On the other hand, if sales managed to peak at 1,000 units per year by 2016, the implied share price would be $16.70 or 16% upside from the current DCF-implied share price.

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 filters, 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 grow at GDP-like levels and maintain current operational characteristics.

Firm Management and Initiatives

In August of 2012, Randall Dearth was newly appointed as CEO. Dearth was CEO of the chemicals subsidiary of German conglomerate Bayer and has been a board member of Calgon Carbon Corp. since 2007. Since joining as CEO, Mr. Dearth has already made shareholder friendly moves in announcing a $100 million share buyback program (11% of shares outstanding) and initiating a 3 year restructuring program to shore up profitability. The restructuring aims at cutting 30 million in annual costs; a Chief Operating Officer position was created to help refocus organizational efforts.

Phase I of the restructuring involves consolidating manufacturing and R&D facilities. Phase II involves reorganizing the sales force into product teams, reducing the number of carbons produced and upgrading factories to increase scale and efficiency. Phase III involves improving the company's IT infrastructure and further facilities improvements to increase efficiency. Given the supply chain issues Calgon faced in 2012 and the fact that the company has seen top line growth of 15% with zero bottom line growth over the last 3 years, the restructuring effort is long overdue and likely to hit some low hanging fruit. The product line rationalization and manufacturing consolidation make a great deal of sense and Calgon has already shown cost reduction progress in its 2013 Q1.

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: Disinfection Byproducts in Drinking Water (or "DBPs"), mercury emissions standards, ballast water systems. 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 simply sit idle.

There is more certainty around the DBPs rule as well as the US Mercury emissions rule which is reasonably expected to begin enforcement in 2015; however, more definitive hearings over emissions standards will take place during the second half of 2013. There are no firm dates put on the likely enforcement of EU Mercury emissions standards. The BWS rules are more complex because they are international and have multi-year phase-in periods depending on ship size. The US coast guard is firm on a January 2014 enforcement date. Other BWS rules such as the IMO rule covering 36 countries or 30% of global waterways are also expected to phase-in over the next five to ten years and are already factored in the valuation of CCC's stock price.

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. Also, 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, many small regional competitors exist around the world as the industry is highly fragmented. Further, in some international markets, chemical patent protection and fair trade (anti-dumping) enforcement is not actively enforced putting Calgon at a distinct disadvantage in select markets. The rising trend of multi-national fair trade pacts is a mitigating factor to these risks overtime and as Calgon continues to develop its international brand as a leader in activated carbon services, it may better compete.

In the Air Pollution market, 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. A quick search will populate a list of at least 20 competing BWS; however, Calgon has one of the few products (less than 10) that has already achieved major regulatory approvals. Also, Calgon and its predecessor company, Hyde, have a 10 year track record selling over 300 BWS which is amongst the greatest track records in the industry.

Management execution risk is a major concern due to the complexity of the ongoing restructuring and the current goals of expanding into new markets and industries. There is elevated skepticism on whether Calgon can achieve its aggressive growth targets: double air pollution sales and a tenfold growth in BWS. While the company has gained some traction in the air pollution market, 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

The following table shows the DCF model. Please read below for commentary.

(click to enlarge) DCF

The DCF implies a current fair value for the minority interest in the equity at $14.41. Key assumptions in the DCF include a 9.5% discount rate based on the weighted average cost of capital developed from the comparable companies, an 8.0x exit multiple used to determine the terminal value which is based on recent relevant transactions, the assumptions for revenue growth (explained in segment overviews) and assumptions for margins which were estimated based on historical financials, management expectations and analysis of comparable companies.

Because the company has high-growth projections and cash flows are not expected to normalize within the scope of the projection period (and are hard to predict beyond the projection period), the DCF does not adequately reflect the long-term value of the equity. However, using the sensitivity tables to the bottom right of the DCF, a valuation range of $13 to $16 appears to be a reasonable short-term value range. Because the equity is currently trading around $16.50 at the time of writing, the shares appear to be fully-valued to slightly over-valued.

The sensitivity tables highlight potential areas where shareholder value can be created. 1) The company can warrant a higher exit multiple if growth milestones are achieved or exceeded. 2) The company can reduce its cost of capital by decreasing risk or utilizing more debt. 3) The company can increase equity value by reducing share count by either out of free cash flow or using debt. If all of three of these scenarios simultaneously occur, the calculated fair value of equity should exceed $25.

The following table shows a comparable company's analysis. Please read below for commentary.

(click to enlarge) Comparables Table

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 of 35% vs. 14% median and three year EBITDA growth of 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.

Disclosure: I am long [[CCC]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

See also Cramer's Lightning Round - Green Mountain Is Too Complicated (7/23/13) on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BWS , CBT , DHR , HWKN , MWV

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