The Future Of Industrial Oil
The Sargasso “free call” approach described through SKF and RecondOil
Sargasso’s Approach is Well-Suited to the Current Environment
Many environmentally oriented ESG funds tend to invest in businesses that have few or no material environmental issues [1]; these businesses often are found in the technology sector and can include more speculative cleantech.
The approach and philosophy at Sargasso led to a different place in the market. Because our approach emphasizes identifying and investing in businesses that have demonstrated performance in addressing material environmental issues, our approach diverges from that of many ESG/green-fund. This approach prioritizes businesses with proven track records in tackling environmental challenges rather than focusing solely on growth stocks. Additionally, we prioritize diversification across economic sectors to manage risk effectively.
There is no question that new technologies and ways of doing business will be central to the transition to a more sustainable future and will play a larger and larger part in the global economy, be it IT, fintech, or cleantech. Sargasso is committed to capitalizing on this long-term promise, particularly in cleantech initiatives. However, we aim to minimize our clients’ exposure to the inherent risks associated with early-stage technologies and products.
One of the principal ways we seek to capitalize on earlier-stage products and technologies without assuming more risk is through “free calls.” [2] Our approach’s primary objective is to avoid the permanent impairment of capital. For that reason, we start our process by gaining an understanding of the financial position and risks associated with a business with the aim of preserving capital. Next, we assess how our client can make an attractive return on the investment over a three-to-five-year investment horizon. Finally, we seek out “free calls”. We define “free call” as an underappreciated aspect of a business (a new product, a hidden asset etc…) that has a reasonable chance of developing and could add substantial value to the company but is not currently imputed into the share price. “Free calls” therefore can further skew the risk-reward profile of an investment in our favor. For Sargasso, these “free calls” often take the form of new environmental products or technologies.
In several of companies we have identified green products or business lines that could prove transformative from an environmental and financial perspective, but currently have little or no value ascribed to them. One such company is SKF.
“Free calls” can materially enhance the risk-reward profile of a fund’s investments
SKF and RecondOil: An Environmental Leader with a Large Cleantech “Free Call”
Within SKF sits RecondOil, an innovative cleantech solution that uses a filtration and biochemistry-based chemical process that gives industrial oils (used for lubrication, hydraulic processes, and cooling in metal working machinery) a virtually infinite life leading to dramatic savings and higher product quality. RecondOil obviates the need to dispose of used oil that today is typically dumped or burned after use, with severe environmental consequences.
SKF is a global leader in ball-bearings, seals, and other solutions that are critical to keeping machinery in operation. Machine downtime can be costly, and ball bearings are a critical but relatively low-cost item. SKF has maintained or grown its share in key markets, a reflection of the strength and reliability of its products and the reluctance of purchasing managers to change what works.
SKF’s environmental operations are excellent. The company targets zero scope-1 and 2 emissions by 2030. Building on a near 47% emissions reduction between 2016-2022, SKF is methodically transforming its manufacturing facilities to zero carbon. For example, their Tudela, Spain factory couples Solar PV electric with geothermal heating and cooling systems to reach zero carbon without offsets. The company is also addressing emissions related to purchased steel (where a substantial portion of their carbon impact lies) by partnering with leading organizations such as Climate Group STEELZERO and Responsible Steel. SKF’s environmental excellence meaningfully enhances their relationships with customers by helping them decarbonize their own supply chains.
Beyond its environmental leadership, SKF generates substantial free cash flow and pays a 3.75% dividend. We believe the business is well positioned to accelerate growth, in part because of its exposure to the secular trend of electrification which will require more and higher-spec ball bearings. In the coming years we expect SKF to meaningfully enhance its operating margins as it continues to consolidate and automate its manufacturing footprint. This should lead to significant growth in operating earnings through an economic cycle. Finally, the business is attractively priced with shares trading at ̴̴6x 2022 EBITDA, making SKF a compelling long-term investment before giving any consideration to RecondOil which we think could prove transformative to the business.
Over time, industrial oils become contaminated and oxidized making machinery less efficient and effective, leading to machine downtime, increased scrappage and a deterioration in product quality. SKF estimates that 40% of maintenance costs in industrial processes could be related to contaminated oil. RecondOil solves these issues by keeping industrial oils in a virgin state. Environmentally, 90M barrels of oil a year are used in the production of industrial oil and the disposal of used oils can have severe environmental consequences.
The industrial oil market is estimated to be of $60 billion in size. Each 5% of the market captured by RecondOil would yield $3 billion in revenue and an estimated $450 million in operating income. The entire SKF business today generates around $9 billion of revenue and $990 million in operating income. Obviously, the financial implications could be very large.
The company will sell RecondOil through service contracts, making this earnings stream annuity-like. Therefore, we think it could command a very attractive valuation, especially because RecondOil has no competition to speak of, and its environmental attributes should give it a premium in the market.
We believe there is a good probability that RecondOil develops into a transformative product for SKF. But, if it doesn’t, SKF will remain an attractive ball bearings business that should grow earnings over time at an attractive rate while paying a growing dividend. Identifying a “free call” like RecondOil is our preferred way to invest in cleantech solutions.
As philosopher-catcher Yogi Berra noted, “It’s tough to make predictions, especially about the future.” We do not know how the current sell-off in growth stocks will resolve itself, or what the future course of interest rates will be, but as equity prices decline our confidence increases that we can find discrete opportunities across sectors which represent excellent risk-rewards from tech and cleantech, to consumer goods, to industrials, to hidden gems like SKF and RecondOil.
We welcome your comments and questions, which can you send to lbony@sargassoenvironmental.com.
Reference:
[1] Klasa, Adrienne. “Sustainable funds face threat from tech sector turmoil.” Financial Times, January 18, 2022.
Footnotes:
[2] When used by SAM in describing its investment philosophy “free call” refers to a future event or transaction that may or may not occur, the value of which is not reflected in a company’s share price. For example, it could be the potential appreciation of intellectual property or increased demand for a product. This event or transaction, when realized serves as a catalyst for the share price and will, in SAM’s estimation, add value to the company that will be reflected in a higher share price as the market recognizes this. SAM is not implying that an investor receives securities or options in securities for no cost by use of the term “free call.”
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