1) Pricing power - NEU's relationships with customers allow them to raise prices to pass on costs of raw materials. There is, however, no requirement to lower prices. Given the oligopolistic nature of the petroleum additives business (NEU is top 4), NEU has the chance to participate as prices continue to rise, even in 2013. The (minor) competitor listed, Chemtura, cited raw material price increases. If smaller players are able to raise prices, what does that say about market leaders such as NEU?
That doesn't necessarily show the full story, however: gross margins have been increasing steadily in the past decade:
(Source: Morningstar)
Price don't necessary follow costs, usually to NEU's benefit! The four top producers (90% total market share) form an oligopoly which compete on services/value-add versus price. Industry competition and pricing power with customers/suppliers all favor NEU. However, this is just the beginning, in my opinion.
2) Cost advantage due to USA oil & gas renaissance. In the past few year years, raw material prices for NEU have been rising, yet cost of goods sold have remained consistent (see 10-k pg 28). NEU's relationships and market allow them to pass on cost increases. Now, what if those costs decrease?
NEU lists "base oil (byproduct oil refining), polyisobutylene (isobutylene component is of component of nat gas/crude oil refining), antioxidants, alcohols, solvents, sulfonates, friction modifiers, olefins (byproduct of oil refining), and copolymers" (parentheses mine) as the inputs needed.
Most of these inputs are the result of oil/gas production, and oil output/refining capacity has been increasing dramatically:
Should those oil/gas products lower in price, NEU and the market leaders are not pressured to lower prices to compete because of the oligopoly. They might lower, but after a lag and usually conservatively. This scenario may not last forever, but as long as competitors focus on service rather than price, NEU will continue to earn economic profits.
Now, how does NEU protect itself from new entrants who would undercut? Customization and the same customer relationships above ("oil companies and refineries to original equipment manufacturers (OEMs) and other specialty chemical companies" from 10-k pg. 3) preclude an easy switch. A customer-stickiness combined with technological know-how (from the limitless types of additives) will at least severely delay new entrants. New entrants or substitutes would therefore be difficult to make.
3) Steady secular growth - requirements from the US government for increased fuel mileage force continued reliance on additives for that extra boost of efficiency. Because of sufficient barriers to entry from 2), NEU and its competitors can participate in the steady (albeit slow) growth.
4) ROC-focused management - from reasonable buybacks, special dividends (e.g. in 2012) and a conservative capitalization, NEU is run by management-like owners because they are, in large part owners (13%/$550mm of equity owned by insiders, per Morningstar). That is how NEU manages double-digit ROA/ROIC for past 5 years, even in 2008 when many firms were trying to stay solvent.
Risks: the main risks to this thesis include 1) the beginnings of price competition given years of solid profits 2) lack of growth from end-user demand related either to engine/machinery usage and/or regulatory changes. If, for example, government lowered fuel mileage/composition requirements, then NEU's products would not be as useful. This is not a fast-growing market, so revenue growth even in the best cases would not be high and decreases could definitely re-rate NEU and its peers lower on a multiples' basis.
These risks, however, I believe are mitigated by the above four points, and as such I have added more to NEU.
Careful investing to all,
-Stanley
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