Monday, February 01, 2010

Lubrizol (NYSE:LZ): Downgraded to Sell at Citigroup

Citigroup is out downgrading Lubrizol (NYSE:LZ) 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.

Notablecalls: This is a substantial call from Citi's Specialty Chemicals team as it highlights a potentially significant future margin cliff.

The stock has been a kind of an analyst darling of late and with Citi turning a cold shoulder, there will be more sellers today.

I'm not saying shorting LZ today will be easy. It was down 7pts on Friday & will have #'s out this week that are expected to be 'OK'. Plus, the futures are firmly in the green this morning.

But all in all, I foresee up to 3pts of downside in the name. I don't see it piercing the $70 level but it will likely come close.

1 comment:

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