Cabot Corporation – Why I Just Doubled My Position

In this article, I'm taking a look at one of my recent purchases - Cabot Corporation (NYSE:CBT). I will show you as to why I believe you really should check this undervalued cyclical company and why you should consider investing in the stock despite our current economic cycle and future potential volatility.

I will inject a bit of European-investor-thinking here, a bit of an international profile to the considerations as to why I think CBT, despite its nature, presents a fairly safe stock for investment.

Let's get going!

Bildresultat för Cabot corporation

(Source: Cabot Homepage)

Cabot Corporation - A cyclical company with recession-resistant character

The company was founded over 130 years ago and is headquartered in Boston. It's in the business of developing and manufacturing chemicals and performance materials for industries all over the world. A quick glance at the business tells us the following:

(Source: Investor presentation)

The company is divided into four areas, two of which make up for a very large portion of EBIT, and two end-market sectors making up over 75% of the revenue. CBT has a 50+ year history of dividend payouts, a seven-year streak of consecutive increases, and many years without a dividend cut (Source). Its current yield is roughly 3.25%. At 4,500 employees, this is smaller than the companies I usually have in my portfolio, but I believe CBT, despite its smaller market cap, warrants a second look.

During 2018, the company delivered on several key goals and metrics, among other things, showing investors a record adjusted EPS increase of 14% vs. FY17, increased CapEx and plant openings to better compete with a stronger international footprint, and a share repurchase program during times of low valuation.

(Source: Q4/FY18 Results)

The company delivered on what it considers to be its core strategy and further positioned itself through investments for capturing the global GDP growth.

Cabot Corporation is a strong player in China, making an investment in the stock an equally interesting one with exposure to our Asian neighbors. Cabot sees continued demand for its products here and considers itself a preferred supplier to industries it serves in China (Source).

The company primarily produces performance chemicals and reinforcement materials, making up almost 96% of its FY17 EBIT. In terms of reinforcement materials, we're looking at rubber black/carbon black, a business with a 19% EBITDA margin and where the company is the #1 manufacturer in the world, using its 20 facilities worldwide for production (Source).

Cabot is also near the top in specialty carbons, fumed metal oxides and similar products in its performance chemicals segment, with an even more appealing 27% EBITDA margin.

(Source: Investor presentation)

The remaining two segments are very minor in relation to the larger two, but they still manage to capture excellent margins. While its specialty fluids segment is small, the company is #1 worldwide for cesium drilling and completion fluids - the entire segment is marketed to extremely high-margin niche products as opposed to (among other things) carbon black which is used in everything from common tires to inkjet/printing inks. What's more, as of January 2019, Cabot is selling its specialty fluids segment, achieving what can be considered a greater focus away from an asset that wasn't necessarily related to its core products.

(Source: Investor presentation)

The company argues that its position is excellent to meet global demand in all key areas, with production and facilities moving outside of the US and to regions with more demand/production. Cabot also points to important macro factors, such as mobility (and electrification), the growth of the middle class, emerging market growth, and higher sustainability demands, as key growth drivers for its products (Source).

(Source: Investor presentation)

The company considers future outlook appealing and guides towards volume and EPS growth during 2019-2021. As of 2018, it seems to be capitalizing on this outlook and delivering what can be considered acceptable results, though the Q4 was considered borderline as volumes declined.

(Source: Investor presentation)

Regardless of single-quarter results, the company has achieved impressive fiscal-year results for the last few years, managing double-digit compound annual growth rates during this time - and this during a time when it's shifted production and reacted to shifting market trends by diversifying and changing production towards new products. The company's investments into fumed silica and alumina plants have been ongoing for years, with new plants coming online in the coming fiscal years.

(Source: Investor presentation)

In terms of debt, the company has an attractive investment-grade rating with a net debt/EBITDA ratio of below 2.5X, which among other things, is the preference for several rating services (such as SimplySafeDividends). The company has deleveraged quite nicely from its 3.22X level back in 2012, and no planned M&As are announced as of the writing of this article.

So, in short, Cabot Corporation is a global leader in terms of production of key materials for many applications/products we use on a daily basis. The demand for these products is unlikely to wane/decline because they include things like tires, auto weather-stripping, belts/hoses/seals, consumer products, fibers, fumed silica, carbon black for displays, molded plastic, batteries, structural adhesives, building sealants, epoxy adhesives, automotive coatings, and semiconductor polishing.

The chemicals these guys produce, they're everywhere.

So why is the company appealing/undervalued?

Sounds like things are going well - so what exactly is going on?

(Source: 1Q19 Presentation)

As other manufacturers, such as car manufacturers have noted, lower auto production is a pattern worldwide now. This results in a drop in demand for CBT's products. The declining polymer prices have led to customers waiting and destocking in expectation of the prices flattening as well, further impacting Cabot's earnings. The rapid decline in feedstock prices, combined with the lower demand from automotive/polymer prices, has led to further EBITDA and EBITDA margin compression/higher costs in 1Q19 in almost all of the company's business segments.

As of now, we have the following share price development to look at:

(Source: Google)

Cyclicality and China

So, we have a company active in a very cyclical business. With some of Cabot's largest customers in the automotive industry, the fate of the company's short-term stock price is linked intrinsically to the cyclicality of the world economy (much like car companies/other cyclicals). This gives us a company where the stock price development can be said to be somewhat more volatile than in more defensive/consumer staple names.

Cabot's business in China, the Asian empire, is also something to be taken into consideration, as the results are notoriously difficult to predict. The company itself said it that it did not expect a slowdown or destocking, and explained the material challenges:

As we sit here today, we're definitely seeing the China environment in the near-term is a bit more challenging than we expected and the destocking and automotive slowdown has been a bit more pronounced as we sit at this point in the year. - (Source: 1Q19 Earnings Call)

This isn't just related to the automotive slowdown, but it's also related to coal tar pricing indices, which the company in the same earnings call noted are hard to predict due to the underlying steel/alumina drivers in China. In short, the company expects significant headwinds in both Q1 and Q2 in China, but the biggest risk is if these headwinds continue beyond Q1 and Q2, or other factors that might be in play here that the company has not yet considered.

China is, simply put, not the easiest country to do business in or to predict, and this has nothing to do even with the potential trade war. It's simply hard to predict, which can cause both short-term and long-term headwinds such as these. The trade war could amplify these concerns and risks, but even should these disappear entirely, it wouldn't erase the risks of doing business in China, the company's international customer/production base.

Trade War

The other thing that needs to be mentioned when considering Cabot Corporation as an investment is that Trump has his eyes on China. Initially, analysts were very positive about the Trump administration and the policies they would enact. The belief that the deal-maker would improve things...well, they may materialize still, but the fact is that short term, his policies have been pretty negative/volatile for companies like Cabot and their outlook for doing business in China.

Trump did what he said he would do (though some may argue this). He has been tough on China and demanded better terms, and the risk of a trade war is still ongoing.

Like any company with a customer base in China, or even large parts of its production, Cabot Corporation will suffer when/if things heat up between these two parties. And that's not something to sneeze at.

So, in short, we have:

  • Macroeconomic tendencies leading to destocking from customers and soft demand for automotive parts, including the company's flagship products.
  • The risks of a cyclical business.
  • The risks of China.
  • The risks of an approaching trade war.

But not much else, in my opinion.

The positives outweigh the negatives

We went through some of the positives in the introductory portion of the article already. The fact is we have a company producing products where we can see continued global demand, unimpeded by, for instance, the electrification of the automotive industry or the changing tendencies in many sectors. In fact, the demand for the company's products and the fact that the products are higher-quality will only increase.

This gives the company a moat, as the barriers to entry into this industry are quite high.

Elastomers, composites, specialty carbons/formulations, activated carbon and metal oxides are, simply put, a core of virtually any modern manufacturing process today - and Cabot Corporation is the largest manufacturer of many of these things. It's been around for over 130 years, and it has a large customer base, including an already-established presence internationally.

(Source: Q4/FY18 Results)

The company has proven itself capable of adapting to a changing world and manufacturer base, with much of its manufacturing now being located outside of the US.

(Source: Q4/FY18 Results)

As we can see, the company's goal of remaining competitive in this landscape is well underway. It will, among other things, be the first chemical company in China to be certified in accordance with the RC14001 (Source). The company is also initiating strategic partnerships in China.

Macro trends speak in favor of this company

The world is:

  • Growing more mobile.
  • Absorbing an increasing portion of a growing middle class.
  • Growing more developed, even and especially in immature/emerging markets.
  • Characterized by increasing sustainability demands.

All of these trends directly correlate with Cabot's products and in a way that doesn't require the company to change the fundamental things about its manufacturing. It's not an engine manufacturer - EV cars needs tires as well - and the higher demand for new cars will benefit a company like Cabot. Increased construction, alternative energy sources, tire development, all of these things will ultimately have a positive impact on the company's products, short-term market trends notwithstanding.

Long-term outlook positive

(Source: Q4/FY18 Results)

Long term, this company expects to grow impressively while continuing to return 50% of DCF to shareholders.

As we went through in the initial parts of the article, key reasons that make a company interesting to dividend/value investors are present. We're talking dividend growth/appealing payout ratio, net debt and excellent earnings growth in the long term. Combine this with a company that's proven it can handle changing market demand and structural changes in the value chain/sales mix, and we have a case to make right there.

(Source: Q4/FY18 Results)

Proving themselves is a theme here. The above graphic shows an EBIT that's more than double despite the production capacity for carbon black being almost identical.

So, we have a company producing products the world needs and will continue to need. We have a company well-positioned to capitalize on the macro trends and changes, and we have short-term headwinds resulting in a deterioration of the company's share price.

Where are we in terms of valuation?


(Source: F.A.S.T. Graphs)

Now, as usual, the valuation is my reason for looking and investing here. And the current company valuation, given all of these factors we've mentioned, is very appealing indeed.

Trading at a blended P/E ratio of 9.7 means the company hasn't been valued at this level since 2011 - and that's taking into account that its economic situation in '11 was much worse than it is today. We can see certain cyclicality in the share price, given that, you know, it's a cyclical stock. However, the undervaluation according to the fundamental metrics here is as undeniable as in many of the appealing stocks I look at.

The market would historically prefer valuing this company at a blended P/E of 15.7. I'm going to be conservative here and use 15.0 when I do my forecasting in terms of return to offset some if not all of the macro risks involved with this company.

(Source: F.A.S.T. Graphs)

I try not to be prone to hyperbole, but the return rates even at a return to normal valuations of P/E 15.0 are quite amazing until 2021. At this entry price, the price could even deteriorate to a blended P/E of 7.5 - lower than it was during the global recession - and you'd still be making almost 5.5% annual rates of return until then. Even should it stay at a blended P/E of 10.0 until 2021, your investment would generate annual returns of almost 20%.

The numbers tell the story here - and the story is one of an excellent investment opportunity. The company has some hits and misses in terms of earnings from the roughly eight analysts who follow it, but more than 50%, it manages to hit expectations with a fairly low margin of error. There haven't been any major (more than 40% off) misses for the past 10 years in this department.

(Source: F.A.S.T. Graphs)

Bottom line here is the fundamental numbers tell us that based on historical performance and expectations of future performance, even in the very long term, Cabot Corporation has a good possibility of delivering market-beating returns for the value-conscious dividend investor.

(Source: SimplySafeDividends)

The 52-week numbers and ratio comparisons show us that the company is valued at a historically low price in terms of P/E and dividend yield. Taking into consideration the risks presented in the article, Cabot seems very well positioned for an investment.

The question becomes of course at what price?

Wrapping up

Cabot Corporation is attractively valued. Despite being active in segments that routinely suffer from depressed valuations due to the cyclicality of related industries (such as automotive), I view the company's current valuation as excessively negative. I first had my eyes on the company at the beginning of this month and initiated a position at ~$43. Hindsight proved this to be somewhat too high, and I increased my position at $40.9.

Now, because I don't believe the company warrants a recession-level valuation, my recommendation is purchasing the stock in the company. Today's valuation is appealing as it is, but given the short-term trends here, I believe the stock may fall even further, at which point one could increase their position (as I will do if it falls below $38).

At the end of the day, I believe there's little arguing about Cabot's appealing valuation here, meaning my recommendation begins at the current prices. As usual, I don't recommend that you overexpose yourself to this position initially, but remain prepared for further drops in the stock price.

My recommendation

At this price and below $40 at a blended P/E ratio of 10.0, I rate Cabot Corporation a "BUY". You should own this company for its position in the value chain related to its line of products which will be needed now and in the coming decades, and its proven history of adapting to a changing market both nationally and internationally.

I will update this article or publish an updated thesis should things change and/or in conjunction with future earnings updates.

Thank you kindly for reading.

Disclosure: I am/we are long CBT. 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.