Oil-Dri Corporation Stock: Alternative Energy Innovation And Superior Margins (NYSE:ODC)

Investment thesis

Our current investment thesis is:

• ODC appears to be an attractive proposition for exposure to alternative energies, with good innovation and production capabilities positioning ODC to rapidly increase its scale. Management appears talented, with a keen eye for innovation. Following operational improvements and an increase in unit economics, ODC is in a better position to reinvest in future growth with the view to raising distributions.
• Even if this does not succeed, or plays out slowly, the fundamental operations are sold, with a market-leading position and limited cyclicality.

Company description

Oil-Dri Corp of America (NYSE:ODC) is a prominent player in the absorbents and cat litter industry. The company has built a strong reputation for providing innovative absorbent solutions for industrial, agricultural, and pet care applications.

Share price

ODC’s share price performance for much of the decade has been disappointing, broadly trading flat. In the last year, however, the shares are up almost 100%, on the back of an impressive development in its financial performance.

Financial analysis

Presented above are ODC’s financial results.

Revenue & Commercial Factors

ODC’s revenue has grown at a CAGR of +5% during the last decade, with a clear acceleration post-FY21. A similar trajectory is observed with EBITDA (+11%), which was broadly flat between FY14 and FY22.

Business Model

ODC specializes in developing and manufacturing absorbent and adsorbent products. These include cat litter, industrial absorbents, and agricultural products. The company has an international reach, tapping into diverse markets and capitalizing on opportunities in different regions. This has been possible due to the establishment of a strong reputation for quality and reliability in the markets it serves.

The company offers a diversified range of products catering to different markets, targeting both consumers and corporations across its many segments. In the consumer sector, it provides cat litter under various brand names. In the industrial sector, the company’s products are used for various purposes, including spill cleanup, oil and grease absorption, and moisture control in agriculture.

Despite the market-leading position it holds and the steady nature of its market, ODC places emphasis on innovation and product development. The company is seeking to improve its long-term growth trajectory through exploiting higher-growth avenues, while leveraging its key capabilities in production and scale.

The segments ODC has chosen include Vegetable Oil, Jet Fuel, and Biofuels (such as renewable diesel), with a number of products across these segments. This aligns with the broader clean energy, ecological trend, without necessarily entering high-competition segments that are dominated by much larger players.

This is the reason for ODC’s increased Capex spend since FY20, as ODC builds out the infrastructure necessary to service these markets. This has yet to materially impact the company’s financials but the expectation is for a considerable increase in capacity during 2024/25, implying full-ramp up in the years following this.

Financial progress

As we have touched on previously, ODC’s revenue growth in recent years has been impressive, with a clear uptick in the company’s trajectory relative to prior years. As the above illustrates, this growth has been experienced across all its core segments.

This implies a transformational improvement in the company but we are not wholly convinced this is the case. As the following reflects, the company has seen a gradual increase in Tons sold, which is expected given the slow-moving nature of its industry (+1.7% CAGR).

This means the key driver has been price, with net sales per ton increasing at a CAGR of +8.7%. Now, this is highly impressive and reflective of ODC’s strong competitive position and the inherent nature of its industry (sticky customers), contributing to inelastic demand.

This said, it does not mean its commercial position has materially improved to drive this. We highlight this because it implies the current trajectory is not sustainable, as inflationary conditions soften and quantity begins to decline (which is the case in FY23).

ODC has been able to maintain operational excellence throughout this period, allowing its GM% per ton to increase. Again, we are hesitant about the sustainability of this, particularly if price p/t reverses and declines.

Competitive Positioning

We consider the following to be key competitive advantages of ODC:

• Innovation Leadership – Management’s commitment to innovation ensures that it stays ahead of competitors and grows shareholders’ value incrementally. Management is not satisfied with its existing position.
• Adaptability – ODC’s ability to adapt to changing market conditions and regulatory environments has been critical, with the recent expansion into Biofuels likely to support its existing segments through the creation of eco-friendly solutions.
• Brand – Effective marketing and branding efforts have helped ODC maintain visibility and generate a strong reputation in the market.
• Scale and expertise – ODC has substantial scale and expertise in its production, allowing the company to branch out and develop related products and services rapidly. Its expansion into alternative energy segments is the perfect example of this, with capacity expansion already its key focus.

Opportunities

We consider the following to be key opportunities in the coming years:

• Eco-Friendly Innovations – Continuing to capitalize on the demand for sustainable products, while inherently branching out into the alternative energy segment.
• Expansion into Emerging Markets – Tapping into growing markets with absorbent needs.
• Diversification of Product Line – Continuing to introduce new solutions for evolving industries.

Economic Consideration

A key selling point for ODC we feel is its limited cyclicality. Despite considerable economic disruption and changing conditions, ODC has performed exceptionally and marched on. The company’s diversification is a key reason for this, limiting specific exposure.

We are expecting economic conditions to worsen in the coming year, although we believe this will not have a considerable negative impact on ODC.

Margins

ODC has broadly boasted flat margins, with a recent improvement coinciding with a change in economic conditions, with the company benefiting from the inflationary conditions.

This said, it is worth crediting Management for operational improvements. The company has invested in an improvement in its infrastructure and manufacturing capabilities, contributing to greater efficiency.

Quarterly results

ODC’s top-line performance continues to be strong, with growth of +16.6%, +22.9%, +15.3%, and +13.1% in its last four quarters. In conjunction with this, margins have considerably stepped up.

The primary factors driving this have been discussed above, namely pricing action and operational efficiencies, with inelasticity allowing for growth despite quantity sold declining.

Management also notes the benefits of its recently completed alternative energy investments are beginning to be realized, primed to contribute to a higher long-term growth rate.

Further, Management has stated it is willing to pursue potential acquisitions that align with its growth strategies, likely feeling it is lacking the necessary expertise to execute effectively. This is particularly the case given Management sees significant investment opportunities ahead. We will discuss subsequently if this is possible.

Balance sheet & cash flows

ODC has occasionally generated negative FCFs, but usually due to one-off items, with broadly consistent FCF generation in line with profitability. Management’s capital allocation policy has been conservative, with limited debt utilization (ND/EBITDA ratio of 0.2x) and a declining payout ratio.

This positions the company well to finance expansion, although it would be wise to await a decline in rates to have further flexibility before attempting M&A.

Outlook

We are expecting ODC’s growth rate to decelerate in the coming 3 years relative to the last 5 years, as the benefits of price hikes subside. This said, with investment in growth segments, we are expecting an offsetting impact, although this is currently difficult to quantify.

We are expecting a similar trend with margins, although not greater uncertain. Management is certain much of the gains are from operational improvements, whereas we are less convinced. If Management is correct, a slight improvement is likely before stabilization, while we see a near-term softening before a small step down.

Industry analysis

Presented above is a comparison of ODC’s growth and profitability to the average of its industry, as defined by Seeking Alpha (12 companies).

ODC performs respectably relative to its peers, although is lacking in key areas. The company’s growth has been considerably better than its peers, implying superior execution and competitive positioning. Offsetting this, however, is margins, which despite an improvement is still below average.

Valuation

ODC is currently trading at 8x LTM EBITDA and 20x NTM FCF. This is a discount to its historical average.

Ordinarily, we would suggest a discount to its historical average is justifiable, owing to the company’s strong financial development and current commercial expansion. This said, as we have highlighted, the company is facing margin risk, which has the potential to cause multiple expansions.

For the purpose of estimation, If we assume EBITDA-M declines to 12% and the company achieves revenue growth of ~5% in FY24, ODC is trading at an implied NTM EBITDA multiple of 10x, which is actually a premium of 8% to its historical average.

Given the commercial development ahead and margin risk (as opposed to certainty), we consider the stock slightly undervalued based on this.

Further, ODC is trading at a deep discount to its peers, with a ~100% LTM EBITDA discount and ~144% on an NTM P/E basis. We consider this attractive in our view, as although the company is underperforming financially, this is not sufficient to justify the size of the current discount.

Key risks with our thesis

The risks to our current thesis are:

• Market competition affecting pricing strategies, particularly if economic downturn negatively impacts demand.
• Regulatory challenges, namely in the growth verticals, impacting product development.
• Unsuccessful innovation in growth verticals currently being invested into.
• Greater than expected decline in growth or margins.

Final thoughts

ODC is a high-quality business in our view. The company has seen an improvement in performance, which we question the sustainability of, but importantly ODC is reinvesting proceeds to improve its long-term trajectory.

Progress appears to be strong, with Management now focused on scaling its capabilities through capital investment. We expect its contribution to increase over the coming years, increasingly “moving the needle”.

At a small premium to its historical average, upon the assumption of a decline in margins, we consider ODC attractively valued.