A Botched Deal that Could Lead to Big Gains

No bride or groom likes to be left at the altar.

The same thing applies to investors in companies about to be acquired. One moment, it may look like shareholders will get a hefty premium, and the next, the bottom falls out of the deal and the shares to tumble when investors flee for the exits.

But wise investors should take note: this is often when a rare opportunity presents itself. If the business is still solid and its prospects are promising, investors should strike.

This is what happened to chemical maker Huntsman Corp. (NYSE: HUN) when funding for a proposed 2007 acquisition by privately-held Hexion for $28 a share dried up. To make matters worse, Huntsman was unable to win back the affection of a prior suitor, which had offered to buy Huntsman for $25 a share a few months earlier. Two suitors, and nothing to show for it.

Don’t feel too bad for Huntsman, though. The company sued the deal’s financial backers for the bungled Hexion deal, netting a cool $2.7 billion for its troubles. That enabled Huntsman to sharply build its cash balances up to $1.7 billion while paying off some of its long-term debt.

Three years later, Huntsman has fallen out of the spotlight, and its shares fetch roughly one-third of that $28 a share buyout offer. Shares are now the cheapest among the publicly-traded chemical companies, right at a time when Huntsman should start delivering robust cash flow growth.

Huntsman makes a wide range of chemicals that are used in insulation, detergents, adhesives and inks. Polyurethane is its most important product, accounting for 40% of sales and 55% of its EBITDA. Demand for the plastic, which is used in appliances, autos, shoes and most importantly, construction, is finally on the rise. Many industries are using increasing amounts — except for the still-moribund construction industry. Analysts expect Huntsman to post improving results this year as many industries increase their orders, and it points to further sales gains in 2011 and 2012 as the dormant construction sector finally springs to life.

By the time we hit the next peak in the economic cycle, Huntsman’s results should look starkly different than the previous peak. In the last few years, Huntsman has sold off the chemical divisions that yielded the lowest profit margins. Now, the sales mix — especially the all-important polyurethane segment — offers a more attractive profit margin. Moreover, the company now has more plants operating in China, and is considered to be the low-cost producer in most of the niches where it operates.

But one couldn’t take note of a better margin from recent financial results. During the past few years, pricing and volume have both been depressed, dampening Huntsman’s profit margins. Gross margins fell from about 16% in the middle of the last decade to the 12-13% range the past two years. Gross margins should bounce back above 16% this year, and they could hit 18% by next year, according to a recent presentation given by management to analysts.

That should really boost Huntsman’s cash flow. The company should post a +35% to +40% jump in cash flow this year to about $700 million to $750 million. Assuming low single-digit sales growth in 2011 and again in 2012, cash flow should approach $1 billion by 2012. (In Hunstman’s case, cash flow is a more important metric than net income, as the company has a very high degree of amortization being expensed from acquisitions and plant expansions).

While rivals such as Dow Chemical (NYSE: DOW), BASF, LyondellBasell and Bayer all trade for more than seven times projected 2011 EBITDA, Huntsman trades at just five times projected 2011 EBITDA, and 4.5 times projected 2012 EBITDA. Over time, the valuation gap between the company and its peers should dissolve. If and when shares trade back up to seven times projected 2012 EBITDA, the stock should be able to move up more than +75% from current levels to around $15.

That’s a far cry from the $25 and $28 offers the company received back in 2007, but still a nice dowry for this bride left at the altar.