Description

Aceto Corp. (ticker: ACET) is one of the largest and most unique independent specialty chemical distributors in the world.  At its recent closing price of $7.00/share, Aceto is being valued at a mere 1.3x net working capital and 5.9x trailing EV/EBIT with average returns on invested capital of 23% over the past decade and a normalized free cash flow yield of ~11.5%.  With several company-specific and industry related growth opportunities on the horizon (mentioned in detail below) and a compelling absolute valuation profile, we believe the risk adjusted return profile of Aceto to be attractive at today's levels. 

Founded in 1947, Aceto engages in the sourcing, quality assurance, regulatory support, marketing and distribution of chemically derived generic (not patented) pharmaceuticals, biopharmaceuticals, specialty industrial chemicals and crop protection products. Among its many unique competitive advantages is the Company's unparalleled low-cost chemical sourcing network in China & India, where Aceto sources 2/3^rd's of its chemical supply from over 500 independent chemical manufacturers. This unique sourcing network, coupled with the largest and most extensive regulatory and quality assurance services offering in the industry, allows Aceto to source and qualify the lowest cost active pharmaceutical ingredients (API's), intermediaries, chemicals and nutritionals from China & India, enabling these manufacturers to bring products to market that they would not otherwise be able to. Aceto's 'virtual manufacturing' model enables them to generate high returns on invested capital with minimal capital requirements and above average operating margins relative to other distribution companies.

Aceto operates in three segments: Health Sciences (59% of sales), Chemicals & Colorants (36%) and Crop Protection (5%).  The following is a brief description of each of the Company's three main segments:

Health Sciences: Within this segment, Aceto primarily sources and distributes generic API's (bulk ingredients used to make drugs), pharmaceutical intermediates (chemicals used to make API's), nutraceuticals (think vitamins) and generic biopharmaceuticals. Aceto typically works on behalf of their pharmaceutical customers in order to identify sources of specialty chemicals from their low-cost Chinese & Indian manufacturing network for mature drugs that have already witnessed a steep decline in price since coming off patent. Aceto does not attempt to distribute 'blockbuster' generics, choosing instead to focus on niche chemicals for drugs that typically generate less than $100 million per year in revenues and have little to no distribution competition. Aceto currently distributes over 200 API's and has over 100 API's for potential distribution in the pipeline. As prices continue to get squeezed in the generic pharmaceutical market, high cost domestic chemical manufacturers are unable to compete with their Chinese and Indian counterparts, creating a huge opportunity for Aceto to leverage their sourcing network to deliver an affordable source of supply to their customer base. Over the course of a nine year cycle, the Health Sciences segment has averaged gross margins of ~18%. No one customer or product is greater than 10% within this segment.

Chemical & Colorants: Similar to their Health Sciences segment, Aceto leverages their low-cost chemical manufacturing base to distribute mainly specialty industrial chemicals within this segment. The Company distributes thousands of chemicals used in dyes, pigments, coatings, inks, plastics, food, aroma & flavor, electronics and other. As expected, this segment is the most cyclical of Aceto's divisions but also hosts the most upside potential in the event of an economic recovery. Full cycle gross margins average ~16%, and have ranged from a low of 13.5% to a high of 18%.

Crop Protection: This is one of the most attractive segments of the chemical industry and one of Aceto's largest growth opportunities. Aceto distributes chemicals used in herbicides, fungicides and insecticides to customers primarily in the U.S. and Europe. The Company sells mainly to major agro-chemical marketers and distributors. They work extensively with their agro-chemicals customer base in order to determine which products are of high demand and do not currently have a generic equivalent.  After proving to the FDA that the generic formulation manufactured by their overseas network is equivalent to the existing product on the market, Aceto utilizes their distribution network to bring the product to their customer base. Aceto has been able to grow this business from essentially nothing a few years back to over $20MM in revenues in fiscal year 2009 with only two main products under distribution. Sales are growing at ~40%, and the Company is currently awaiting approval from the FDA on three additional chemicals that are expected to be ready for distribution in the 2010 growing season. Several others are currently in the pipeline. This segment has the highest gross profit margin of all the Company's segments, in the range of 25% to 30%.  

The importance of Aceto's regulatory and quality assurance platform is paramount to the firm's success and perhaps the single largest differentiator between their business model and other distribution models. Their ability to qualify Chinese and Indian manufacturing facilities and facilitate FDA approval of their production processes and quality control is unique to the industry.  The marriage of their regulatory services and low-cost sourcing capabilities is the core functionality of their business model.  With 28 full-time regulatory employees in China and 15 in India, Aceto's Global Assurance & Regulatory Support team is the largest in the industry and has enabled the Company to prosper as several of their competitors with undifferentiated distribution models have fallen to the wayside. 

While defining the competitive landscape is a challenging exercise given the consolidation in the industry and their unique product offering, several companies that Aceto partially competes against have recently filed for bankruptcy, including private company JLM Industries and public competitor Chemtura. This has created a welcomed source of new customers for Aceto as companies look for a stable source of supply for their specialty chemical needs. The primary cause of these bankruptcy filings was the combination of excessive leverage and an undifferentiated business model, neither of which pose a threat to Aceto. 

Valuation: Aceto has 24.8 million shares outstanding and currently trades for $7.00/share for a market cap of ~$170 million. The Company has $40 million of net cash and an Enterprise Value of $130 million. Aceto trades for a slight premium to tangible book value and a mere 1.3x net working capital, which is primarily comprised of cash and inventories (inv turns ~ 5x per year). The Company requires less than $500k per year in maintenance capex, rents their distribution facilities around the world, and carries only $4.2 million worth of PP&E on their balance sheet. The asset light nature of the business has enabled Aceto to generate average returns on invested capital of 23% over the past decade. The business is extremely scalable given the low fixed cost nature of the business so a significant ramp up in revenues will not require the equivalent growth in SG&A. Full cycle gross profit and operating income margins are 18% and 5.3%, respectively, but we expect margins to expand in the upcoming cycle due to distribution mix shifts from lower margin industrial chemicals to higher margin agro-chemicals and nutraceuticals. The Company currently trades for an 9x PE ratio excluding cash and at a trailing EV/EBIT multiple of 5.9x. 

While we expect earnings to modestly contract after the Company releases their FY4Q09 (fiscal year ends 6/30) results in early September given that they will be comparing against an unusually strong FY4Q08, we believe the Company's aggressive growth initiatives and margin expansion opportunities will drive revenues and profitability higher in the upcoming cycle, and that any sell-off related to their upcoming earnings announcement should be looked at as an opportunity to add to our position. Assuming no growth and a normalized revenue base of $350 million, Aceto can generate approximately $15 million in free cash flow, equating to a free cash flow yield to their enterprise value of ~11.5%. The Company's dividend yield is currently 3%, and their policy going forward will be to return 30-40% of net income to shareholders in the form of dividends. 

Favorable Industry Dynamics: As it relates to Aceto's largest business segment, Health Sciences, the outlook remains bright on several fronts. For starters, over the next four years (2009-2012), more than $60 billion of branded (patented) pharmaceuticals in the U.S. will be exposed to generic competition as a consequence of patent expirations, significantly expanding Aceto's distribution opportunity set. The number increases to $139 billion if you include the top eight world markets. Generic's share of total prescriptions (volume) has risen from 53% in 2003 to 68% in 2008, and most industry prognosticators expect this number to continue to rise as a result of the lackluster branded pharmaceutical pipeline, increased demand given the aging population of the U.S., and the Administration's focus on finding a way to insure the 50 million American's without insurance in the U.S. which would further expand the market for generic drug use.

Cost containment initiatives within the pharmaceutical industry currently being contemplated in Congress could prove to be a boon for Aceto. More pricing pressure for the pharmaceutical companies means more opportunity for Aceto, seeing as though their modus operandi is to source from the lowest cost suppliers in the market, which more and more companies will be seeking to do as declining price points create margin pressure. 

As governments around the world seek to stall the rise in healthcare spending, emphasis has been placed on the anti-competitive conduct of branded pharmaceutical companies and its impact on depressing the growth of the generic pharma market. For example, it's almost certain that tactics such as "pay-for-delay" settlements to generic drug makers from branded pharma companies will be banned. This practice is commonly used by big pharma to create a financial incentive for generic drug manufacturers to keep their cheaper equivalent off market. Other tactics likely to be restricted include exclusion payments and product hooping (trivial modifications to existing drugs). All told, proposed healthcare reform is a net positive for Aceto. When economic conditions stabilize, Aceto expects organic growth to be at least 10% per annum.

In addition to the favorable industry developments on the horizon, Aceto is currently pursuing several additional growth prospects.  A brief list is as follows:

• The Distribution of finished dose vaccines for companion animals, sourced from China, which should receive USDA approval by year end. The first product expected to be delivered, a four-way combination vaccine for dogs which is currently in tight supply within the U.S., is currently controlled by only two pharma companies who have been reluctant to drop prices. This is a $200 million market that Aceto expects to capture at least 10% of. Gross margins will be in the 25% range.
• Globalization of the nutraceutical business, which generated $40 million of revenue over the trailing twelve month period for Aceto and is expected to grow at 10+% per year.
• Penetration of the Japanese pharma market, the second largest in the world. Several companies have attempted to distribute to the Japanese market and failed over the years, but if Aceto is successful this would be a game changer. Recent talks with Aceto's CEO Len Schwartz lead us to believe that the Company may slowly be making progress on this initiative.

Concluding Points: With a significant amount of tangible downside protection in the form of liquid net asset value and an extremely well capitalized balance sheet, not to mention the unreflected intangible asset values of their sourcing and regulatory networks, we believe the downside risk of Aceto is relatively limited. Coupled with the Company's high returns on invested capital and abundant growth opportunities, we believe the risk/return profile of Aceto is attractive for shareholders with a longer term investment horizon.

Risks:

• FY4Q09 Earnings Release: As mentioned above, Aceto is likely to announce that their results for the quarter ending 6/30/09 were below those of the previous year, largely attributable to their significant inventory build ahead of the 2008 summer Olympics in Beijing when chemical manufacturers were forced to idle facilities and a substantial source of supply was taken out of the global chemicals market. Aceto's foresight and long inventory position enabled them to temporarily raise prices and deliver product at higher than normal margins.
• Uses of cash: Like any Company with a significant net cash position, there is a risk that Aceto makes a foolish acquisition. Given our extensive dialogue with management, we see this risk as relatively minimal given management's commentary that they believe private market valuations are still too rich, and their policy of only making acquisitions that would be accretive to earnings in the first twelve months.
• Risk of Customers Going-Direct: While this is an inherent risk for any distributor, several factors have enabled Aceto to eliminate this threat historically, including their regulatory and sourcing expertise in the low-cost Chinese and Indian manufacturing network, intimate knowledge of the chemical supply chain, lack of concentration with any one customer or manufacturer, and the niche products and relatively small market sizes of the chemicals they distribute.

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