Orion's Carbon Under Regulatory Thumb

Investors have been reluctant to come to terms with the environmental harm caused by their favorite companies.  Criticism of corporate leadership could put stock price and even dividend payments in jeopardy.  Even when state and federal governments play the role of ‘party pooper’, shareholders often argue against regulatory efforts.  Near-term returns are more important to than clean air, water and soil in the future.    

Among those feeling the pressure of environmental regulation is Orion Engineered Carbon (OEC:  NYSE), a leading producer of carbon black.  The product name itself should be tip off to Orion’s problems.  Carbon black is used in a variety of industrial and commercial products.  It puts the ‘very black’ into your printer ink and paint.  Because it is a good conductor of electricity it is also used as an antistatic additive in plastics piping and coating for electrical wires.  Plastics, films and adhesives hold up better with a good dollop of carbon black in the mix.  Most importantly carbon black is used as a reinforcing agent in vehicle tires.     

Carbon black is produced by injecting a limited supply of air at high temperatures into coal tar or ethylene cracking tar.  The combustion process is deliberately incomplete, leaving unburned carbon in the form of fine black fluffy particles.  The particles are then collected and packaged for each particular application.

It is important to differentiate between ‘carbon black’ and ‘black carbon’.  The two names are frequently  -  and incorrectly  -  used interchangeably.  ‘Black carbon’ is a fancy name for ‘soot’ that is the unintended by-product of ordinary combustion.  Soot results from the incomplete burning of gas, oil, wood or other fuels that leaves small, dark particles in the atmosphere.  Home fireplaces, summer camp fires, forest or grassland fires are just a few of the sources of black carbon or soot.  Diesel engine emissions are among the worse culprits for soot generation.  The second most important man-made source of climate change, soot is causing as much damage to as carbon dioxide.  Of course, there is a laundry list of ailments triggered by particulates in the air such as heart attack, asthma and bronchitis to name a few.

Orion’s manufacture of carbon black is controlled, but that does not mean its production plants are pristine.  Indeed, Orion was among three carbon black producers that were found to have violated the Clean Air Act.  An industry wide investigation begun in 2008 by the Department of Environmental Production found that the company had failed to apply for permits and maintain emissions control systems at four of its facilities in Louisiana, Ohio and Texas. 

In December 2017, Orion management entered into a settlement with the Department of Justice, agreeing to install pollution control technologies to reduce emissions of harmful air pollutants.  Orion also had to pay a fine and cover the costs of environmental mitigation projects to clean up the mess made by its facilities.  Similar settlements were made with two other carbon black producers:  Sid Richardson Carbon and Energy Company and Columbian Chemicals Company.

Its shareholders might not have liked seeing the consequences of the                             settlement in the company’s income statement and balance sheet.  The pollution control equipment was expected to cost as much as $140 million while the settlement and clean-up projects were estimated at $1.3 million.  The work was expected to require six years to complete beginning in early 2017.

Orion is still working on its commitments.  In July 2020, the company announced it has completed an upgrade of its emissions controls at one the offending plants in Texas.  The most recent system upgrade is estimated to pull 2,300 metric tons of nitrogen oxide and sulfur dioxide out of the plant’s chimneys each year.

At the beginning of 2018, when shareholders and analysts had a couple of months to absorb the settlement news, Orion shares were trading at 20.89 times trailing 2017 earnings of Euro 1.10 (US$1.35).  This compares to a multiple of a multiple of 26.73 time trailing earnings just a year earlier.  It would be too simple to conclude the slippage in valuation over that time period was due to the regulatory action.  The company staged a capital raise in December 2017, just as it was coming to terms with the EPA.  The successful sale of common stock suggests investors were taking the EPA regulatory action in stride. 

Indeed, the impacts of the regulatory action had likely long been incorporated into investor sentiment as early as 2008 when the EPA investigation was first disclosed.  An even greater adjustment in valuation sentiment probably took place in November 2013, when the EPA made public its plans to take legal action against Orion.  Unfortunately, net losses in 2012 and 2013 make it difficult to compare earnings multiples over time.

Orion has actually become more profitable under regulatory scrutiny.  In 2012, with the EPA breathing down its back, Orion was posting gross profits of 20.2% and its operating margin was a measly 6.3%.   As the years have gone by Orion has installed all manner of pollution abatement equipment such as selective reduction reactors.  Rather than drag on earnings the regulatory scrutiny may have brought home a new level of discipline to Orion’s operations.  In 2019, the gross profit margin was 26.4% after peaking at 32.9% in 2016.  Likewise the operating margin has improved to 10.0 in 2019,  after a peak of 11% in 2015.

A look at the Orion’s balance sheet tells the most interesting part of the regulatory tale.  The company appears to have escaped having to report any liability whatsoever for its pollution transgressions.  Indeed, the various costs appear to have been absorbed quarter by quarter as incurred.  No exceptional bite was taken out of earnings and a dividend has been paid without interruption through the end of 2019.  Dividend payments have been reduced in the current fiscal year, but that has been as a consequence of a conservative cash management strategy to cope with the uncertainty associated by the coronavirus impact.

Thus investor regulatory anxiety has been largely unwarranted where Orion Engineering Carbons has been concerned.  The stock more than doubled in the years following the EPA enforcement action.  It took an economic threat from an invisible virus to bring the stock to heal.  The shares set a historic low in March 2020 when the broader U.S. equity market staged a deep correction.  The shares have since partially recovered. 

We note Orion’s stock is currently priced at 0.89 times trailing sales.  The company converted 16% of sales in the most recently reported twelve months to operating cash flow  -  a plus when there are critical capital investments in the budget.  Based on the sales multiple, the stock should be trading at 5.6 times operating cash flow.  Instead we find the stock is priced at 5.4 times cash flow.  This is not much of a difference.  Nonetheless there is a suggestion of undervaluation.  This should provide investors with a reason to at least look at OEC. 

A company producing carbon black is never going to wear an environmental halo.  However, the company has made some progress in working its way out from under the EPA’s regulatory thumb  -  at least from management’s perspective.  The true costs of producing carbon black may remain understated on   For those who actually care about the environment, Orion has also taken an important step in transparency by publishing an annual sustainability report.  The company published its second annual sustainability report in early December 2020.   There is room for improvement but a start to more responsible production of a very dirty product.    

 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.