The largest single allocation of capital during the quarter was made to Axiall Common (AXLL). Axiall is a company formed in January of this year with the closing of a merger between publicly-listed Georgia Gulf, a PVC resin and building products company, and the commodity chemical business of PPG Industries, primarily chlor-alkali (chlorine and caustic). PVC resin and PVC building products are economically sensitive and closely linked to construction; however the past few years have seen a partial de-coupling as a surfeit of domestically produced natural gas and derivatives have lowered energy and raw material costs, thus advantaging U.S. chlor-alkali and PVC resin production relative to most global capacity and promoting exports.
Georgia Gulf, Axiall's predecessor, is a company we first investigated in 2007.It was a peer of Westlake Chemical, a portfolio holding that we exited earlier this year as the valuation exceeded our estimates of intrinsic value. From our standpoint, Georgia Gulf was poorly capitalized. Our sister fund, Third Avenue Focused Credit Fund would go on to make a successful investment in Georgia Gulf's distressed debt in late 2009, following the ejection of prior management and a capital restructuring. Were-sharpened our pencils in January of 2012 when Westlake made an equity investment and a hostile bid for the company – the former proving successful while the latter not – but ultimately lacked comfort in an improved, but still unsuitable, balance sheet per our standards for an equity investment.
In July 2012, Georgia Gulf management engineered a reverse Morris Trust transaction1 with PPG that would exchange cash and an equity stake for PPG's commodity chemical business, a deal that ultimately closed January 28, 2013. The combination of the two sets of assets would benefit from:
• Vertical Integration – control of chlorine production, a major ingredient in the company's PVC resin production,should allow more efficient production of both chlorine and PVC resin as production can be coordinated and optimized;
• Improved Balance Sheet – the size of the transaction and the use of shares as currency reduced the company's debt relative to the operating earnings of the combined businesses;
• Reduced Cyclicality – prices for caustic, a saleable and unavoidable byproduct of most chlorine production, tend to be counter cyclical as chlorine demand follows economic activity and is scarcer in slower periods.
PPG, in turn, offered Axiall shares to its own shareholders as consideration in a share buyback timed with the combination close; those PPG shareholders who accepted Axiall Common would appear to have been sorely disappointed, however, when Axiall's March quarter results fell short of Wall Street's expectations, creating selling pressure on the shares and an attractive entry point for the Fund's investment.
The Fund's cost basis equates to less than six times the pro forma,mid-cycle, pre-tax cash flow of the combined entities or about nine times earnings and an approximately 35% discount from a conservative estimate of replacement cost, valuations suggesting a wide margin of safety in the investment. Analytically, there are a number of items that could throw investors off the scent, at least temporarily. For one, the historical reported numbers for Axiall are not meaningful in isolation given the absence of PPG's assets prior to January 28, 2013. A little digging through corporate filings revealed, however, that the operating results for the PPG assets were available to those taking the time to do the necessary work. Fair value accounting and expenses related to the merger further muddied the waters for those analysts dependent on historical reported results rather than existing assets.
Axiall management would appear to have multiple avenues to create shareholder value over time, from efficiencies achieved through the businesses combination, to attractive reinvestment opportunities via further vertical integration into ethylene(the other key ingredient for PVC) or capacity expansions, or a sale of the business as an attractive set of assets to a strategic buyer looking for its own vertical integration. A protracted disconnect between U.S.domestic natural gas prices and global energy prices—solidifying a feed stock cost advantage—could be a pleasant surprise;while industry capacity additions pose potential risks, they will likely require a number of years to materialize.