Arch Chemicals Spinoff Sets Its Sights on Costs and Growth

15 February 1999 00:00  [Source: ICB Americas]

By Joseph Chang

Arch Chemicals Inc. is coming out of the gates with a plan to boost its operating performance and build on its growth prospects as an independent entity following its spinoff from Olin Corporation on February 8. The global specialty chemicals company employs about 3,000 and recorded sales of $863 million in 1998 within three business segments: microelectronic chemicals, water chemicals and performance chemicals.

In the spinoff, Olin shareholders received one share of Arch Chemicals for every two shares of Olin, bringing the total number of Arch shares to 23 million. Shares of Arch Chemicals started trading on the New York Stock Exchange on February 9 under the symbol "ARJ." They closed up 6 cents to $18.81 in the company's debut.

"We are fortunate to be starting life as a new company with global leadership positions in key growth markets and a heritage of close strategic relationships with customers who are world leaders in their fields," says chairman and CEO Michael E. Campbell. "With minimal debt and strong cash flow from operations, we have the financial flexibility to aggressively pursue growth opportunities at the same time we focus on reducing costs and improving our returns."

Arch Chemicals will start out in a relatively strong financial position. The company is assuming $75 million of Olin's debt in connection with the spinoff, bringing its debt/capital ratio to about 16 percent. Interest coverage (cash flow/interest expense) stands at a robust 11x. On the other side of the spectrum, Monsanto spun off Solutia in September 1997 with more than $1 billion in debt--a debt/capital ratio of 86 percent.

Wall Street's initial expectations for Arch Chemicals are fairly low, as the company is coming off a fourth quarter operating loss of $1.4 million and a 29 percent decline in full-year 1998 earnings to $40 million. However, Merrill Lynch analyst John Roberts says this gives the company a good opportunity to exceed expectations.

"Arch Chemicals will likely beat what I think are relatively low expectations coming out of the spin," says Mr. Roberts. "The semiconductor sector is showing signs of turning, the pool chemicals business will benefit from very low customer inventories and the company, as a smaller entity, will be better able to focus on costs."

The analyst adds that historically, "the vast majority of chemical spinoffs have created significant value early on." Case in point was Solutia, which ran up from $19.19 on September 2, 1997, to a high of $32 by late March 1998 before returning to a current $19.75.

"Like many spinoffs, we believe these businesses did not get the attention they required when combined with Olin's more cyclical and capital intensive brass and chloralkali operations," Mr. Roberts says.

As is the case with most spinoffs, Arch has outlined a substantial restructuring program to enhance its operating efficiencies. The company is targeting $20 million in pretax cost savings by 2001, realizing $5 million in 1999, $10 million in 2000 and $5 million in 2001.

"This will come about as a result of reorganizing and eliminating layers, supply chain re-engineering, and raw material and energy cost reductions stemming from cycle time reduction," says Arch Chemicals CEO Mr. Campbell.

The restructuring encompasses sharing plant oversight between the company's hydrazine business and its catalyst sulfuric acid business, taking advantage of the close proximity of their manufacturing sites. Arch will also centralize research and development functions across business units into two main sites in the US and reduce the number of distributors of its water chemicals and microelectronic chemicals.

"In microelectronic chemicals, the company had seven different distributors," notes Merrill Lynch's Mr. Roberts. "Now they're consolidating that into one national warehousing and distribution system."

Arch's Mr. Campbell anticipates that the company's earnings per share will increase 19 percent to $1.85 in 1999 (assuming 4 percent sales growth) and 12 to 15 percent thereafter. Merrill Lynch's Mr. Roberts expects EPS to grow another 14 percent to $2.10 in 2000. Executive management compensation is linked to 12 to 15 percent target EPS growth as well as improvement in both operating (EBIT) margin and return on assets (ROA).

Franklin Mutual Advisers analyst Timothy Rankin calls Olin's spinoff of Arch "a move in the right direction." However, he adds that management's EPS targets are "relatively unaggressive." "Clearly, $1.85 is not an overly ambitious estimate for this year's earnings," he notes.

Arch's businesses posted an operating margin of 6.6 percent in 1998, down from 8.5 percent in 1997, leaving room for improvement. US specialty chemicals operating margins typically range from 10 to 15 percent. "When you look at Arch's peers, there are very few businesses with single-digit operating margins," Mr. Rankin says. "Arch should certainly be able to achieve 12 to 13 percent."

Institutional investment firm Franklin Mutual Advisers, which had a 10.6 percent stake in Olin (and now Arch as well) as of its last filing in April 1998, has been pressuring the company to pick up the pace of its restructuring. In April 1998, Franklin advocated a spinoff of Olin's brass and ammunition businesses (CMR, 4/20/98, pg. 1) to enhance shareholder value.

Arch Chemicals' performance chemicals segment has strong market positions in biocides, performance polyols, hydrazine propellants and solutions, and sulfuric acid. It has plants in Rochester, N.Y., and Swords, Ireland, and plans to open one in Suzhou, China, in 2001.

The water chemicals segment is the leading producer of calcium hypochlorite for sanitizing swimming pools. It has production sites in Charleston, Tenn., as well as in Brazil, South Africa and France.

The residential swimming pool market in which Arch operates grows at about 4 percent annually. However, the company is expanding into the commercial and municipal pool business (health clubs, universities, YMCAs) to double the size of its water chemicals markets. Mr. Campbell expects this initiative to boost growth in 2000 and 2001.

Arch Chemicals' microelectronic chemicals segment supplies a range of advanced photoresists, wet process chemicals and total chemical management services to the semiconductor industry. Primary manufacturing sites are in Mesa, Ariz.; East Providence and North Kingstown, R.I.; and Zwijndrecht, Belgium. The company also has a joint venture with Fuji Photo Film.

Merrill Lynch's Mr. Roberts says the microelectronic chemicals business "should return to profitability even without an industry recovery since all three new plants are now up and running, comparisons are easier for the Japanese JV, and R&D costs will be lower due to the rationalization of overseas programs into the US."

Although Arch enjoys leading positions in niche markets, some question whether the company can survive as an independent company in a rapidly consolidating specialty chemicals industry.

"You're looking at an undersized, severely underperforming asset that would certainly make sense for a number of these acquisitive companies to gobble up," says Franklin Mutual Advisers' Mr. Rankin. "Aside from the fact that Arch shares are ridiculously cheap today, one way or another, shareholders are going to make out. Either the company is going to outperform or be bought out."

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