Azelis’ current share price provides a great entry point in a high quality company operating in an industry with long-term secular tailwinds with a very resilient earnings profile. I believe that Azelis could grow EBITDA >15% p.a. through the cycle for quite some time. A rerating of the current multiple (11x EV/EBITDA on my FY24e) on the previously mentioned growth makes for strong compounder material.

mike126 wrote Azelis up roughly a year ago, and it offers a good base on specialty chemical distributors. I highly suggest to read the write-up. I’ll be providing a bit of a background and colour on the difficult FY23 and the challenging current environment, which imo provide for a great opportunity.

Specialty chemicals and ingredients are chemical products that provide a wide variety of specific, targeted effects. These chemicals are a fundamental part of the end-product, providing it with important characteristics. Their composition sharply influences the performance and processing of the product and are generally applied in customer-specific formulations and are fundamental key inputs; they cannot be easily replaced, except with other specialty chemicals in some cases.

The label ‘specialty’ in chemicals is a much abused term. Producers have a tendency to exaggerate the gamma of true specialty chemicals in their portfolio because specialty chemicals tend to generate high(er) growth, higher margins and more sticky earnings. So producers love to market their ‘specialty chemicals’ exposure, even though many times these are not true specialty chemicals. As an interesting anecdote, I once had the CFO of IMCD crack up from laughter when I mentioned the ‘specialties’ part of Solvay (now within Syensqo Materials). He clearly had another opinion about the specialty character of Solvay’s solutions.

What exactly makes for a ‘specialty’ chemical is not precisely defined, but besides the above attributes its important to note that with respect to specialty chemicals volumes one generally does not talk about ‘utilisation rates’ or ‘gross margin / tonne’ (or even about ‘tonne’ in general). Sales of specialty chemicals go in very, very small sizes; a purchase of $5-10k is pretty average. 

 

There’s also little discussion and visibility on pricing. You won’t find price charts and the ones that you find do not truly reflect specialty chemicals prices. There generally are no online price lists. The market is extremely opaque. That’s part of the whole opportunity and an important value add of distributors. 

 

 

Distributors of specialty chemicals sit between the producers (e.g. IFF, Givaudan, BASF, Symrise, etc.) and thousands of smaller clients servicing a wide variety of end markets, products and customers.

 

One of the attractive aspects of the specialty chemicals market is that it’s still a relatively young market, with lots of ongoing developments driven by overall growing demand, but also the increasing need for customisation and efficiency improvements. Depending on the geographical region and market vertical, the market for specialty chemicals generally exhibits GDP+ kind of growth. 

 

A big, secular driver of growth is the outsourcing of the sales, marketing and distribution activities of producers to the distributors. The specialty chemicals distribution market didn’t exist ~30 years ago. As the market grew, it became increasingly challenging for the producers to service the smaller clients (which many buyers of specialty chemicals are). But it remains a key market, given the importance of the chemicals in the final product but also as a reflection of clients’ needs.

 

Depending on the source, outsourcing is estimated to be roughly 15-20% penetrated, growing at roughly 0.5% per year, though there are geographical differences (EMEA and Americas are more penetrated, APAC less so). Overall, my rough estimate is that this translates into c. $3bn extra revenues pa to be divided amongst specialty chemicals distributors. 

 

Also, according to the pure play distributors, the outsourcing trend has been accelerating. Producers generally want to work with as few distributors as possible – ideally 5-7 per region instead of 30-50 currently. End-markets are extremely fragmented, not only because of the geographical differences in end-costumers’ wants and needs, but also because specialty chemicals generally don’t travel. The volumes sold are so small that the cost of handling and logistics could easily become very large in comparison to the value. That’s why production (and distribution) of specialty chemicals tends to be relatively local.

 

That is also an important reason for the extremely fragmented character of the industry, and why acquisitions are a large part of the growth. Inorganic growth is a natural part of growth for distributors and should be taken into account when projecting future growth. Over the past decade, in the year with the lowest amount of revenues acquired, IMCD acquired +6.3% of revenues (I’m using IMCD as an example given the longest public track record) – that’s a lot.

 

While estimates vary – though not a lot – the top 10 commodity and specialty distributors (ao Brenntag, IMCD, Azelis, Caldic, Barents, Univar, Sinochem and Kolmar) are estimated to have roughly 15% of the chemical and ingredients distribution market. This number has actually not changed a lot over the years as the growth of new local distributors continues to be strong.

 

Ignoring the inorganic growth component would be a mistake. As mentioned, inorganic growth is a natural part of this industry and will continue for years to come. Both the management of Azelis and IMCD are strongly of the opinion that inorganic growth going forward should reflect the level of the past, and potentially even accelerate going forward. 

 

It is important to keep in mind that acquired companies are generally very easily integrated. Most of the assets acquired are intangibles, i.e. customer and client relationships, the network, geographical and/or product exclusivity, know-how, the salesforce. Acquisitions can generally be divided into platform acquisitions, which form a new base into a new geography, and smaller add-ons. Platform acquisitions are generally executed at low-teens EV/EBITDA multiples, while add-ons at mid- to high single digit multiples.

 

One important factor that sets Azelis (and IMCD) apart from the rest is their ability to quickly integrate acquisitions. I cannot understate the importance in this industry of having a core ERP and CRM system throughout the entire companies. Both Azelis and IMCD have state-of-the-art IT, built from the ground up with the specific vision that in the future (that is, today) this would be a key differentiator. Peers like Brenntag and Caldic did not directly integrate their acquisitions, which was fine when they were smaller, but are now paying the price. This is a major reason of the relative underperformance of Brenntag and why splitting the company is so difficult.

 

Besides the above factors, there are other factors that will continue to drive specialty chemicals distributors’ growth: customer needs are becoming more differentiated, increasing demand for (more) customised solutions and thus specialty chemicals; there’s growing complexity from increasing regulation; the industry is increasingly pressured to digitise.

 

As a consequence of all the above specialty chemicals distributors tend to have very strong and resilient financials. I believe that Azelis and IMCD will grow earnings through the cycle at roughly ~mid-teens % p.a. 

 

 

How it generally works for pure play distributors like Azelis or IMCD is that a producer, eg Givaudan, regularly provides them with a pricing list of all the specialty chemicals that they are allowed to distribute in certain geographies. The prices on this list are pretty secret and a reason why producer-distributor relationships tend to be exclusive and long-lasting. The distributor is then free to pursue whatever margin it can get on these prices. 

 

That’s why gross margin is an important metric in the specialty chemicals distribution industry, as it basically reflects the value proposition of distributors. The gross margin will of course reflect a compensation for the distribution activities, but also other factors such as a finder’s fee element (which blew up during covid) and other value added activities such as formulation advice. The latter is important. Given the myriad of specialty chemicals, Azelis’ clients often do not know what other, better solutions are out there. They might not even know what they want and/or need. It is up to Azelis to try to sell to clients an entire ‘package’, or better – a full solution. That’s why Azelis and IMCD have been investing over the past decades to set up many formulation labs to help and assist clients find new, innovative solutions that fits their needs.

 

2021 and 2022 where BIG years for specialty chemicals distributors on the back of covid induced tailwinds. The distributors enjoyed extremely high demand on the back of relatively low supply, pushing up prices and gross margins and conversion ratios (ebitda / gross profit). The big question in the industry was ‘how much will results normalise and how long will it take?’

 

In terms of volumes, there was still very good demand in Q1 23. This was different in Q2 and Q3 where demand weakened strongly. Demand stabilised in Q4 (at very low levels) and this was recently also confirmed in the Q1 24 results of the companies.

 

While top-line growth normalised in 2023, many were surprised by the resilience of gross margins. 

 

 

 

 

An important reason for these sustained margins has been that the pressure in the market mainly impacted the Industrial segment and less so Life Sciences. Distributors generally split their operations into the more cyclical Industrial part (e.g. Coatings & Construction, Advanced Materials, Lubricants & Energy, Industrial Solutions) and the more resilient Life Sciences (Pharma, Food & Nutrition, Beauty & Personal Care). The correction in the market mainly pressured Industrials while prices and volumes were relatively sustained at the higher gross margin Life Sciences, thus improving the mix. 

 

In addition, demand corrected more rapidly than pricing. The volume correction was fierce; customer inventory levels came off very high levels and destocking was strong. This was further exacerbated by the impact of China, which was a double whammy in the chemicals markets: deteriorating Chinese demand not only pressured local demand but also led to the dumping of product in Europe and the US by Chinese producers, leading to a strong oversupply in the markets. This was again mostly the case within Industrials. It is unclear when exactly destocking faded and shifted into low market demand, but overall most producers are currently seeing clear signs of volume stabilisation since Q4 23. While basically no producer is yet speaking of a restocking trend, customer inventory levels are at such low levels that demand is slowly increasing off this low base. This is an important reason why many producers are positive about an improving market environment in H2 24 (i.c. improving demand and better comps).

 

More recently (Q4 23 and Q1 24) distributors have also been experiencing pricing pressure on a part of their volumes. Overall, 20-30% of Azelis’ and IMCD’s product portfolio consists of ‘more commoditised’ chemicals (hard to define with precision). This segment is now (finally) experiencing pricing correction, or ‘normalisation’. This is the more cyclical and commoditised part of the portfolio; prices are much less sticky compared to the rest of the portfolio. 

 

There is no certainty about how long this pricing pressure will last, but I imagine another quarter or two. Also, both Azelis and IMCD noted that they only see this pricing pressure in the more commoditised part of the portfolio and expect the rest of the portfolio to exhibit resilient pricing.

 

In short, specialty chemical distributors are finally seeing a healthy return to a more normalised environment after a few extremely good years. The best way to show this normalisation is the yoy ppt development of the important conversion ratio (EBITA / gross profit). IMCD shows this dynamic better given the longer history.

 

I expect another quarter or two of relative weakness, but I’m nonetheless interested in the sector today. Comps will strongly improve going forward. Also, as mentioned, the consensus among producers is that demand bottomed, with many mentioning (pockets of) green shoots. 

 

 

 

Barring exceptional market circumstances, I do not expect gross margins to revert to pre-covid levels. Both Azelis and IMCD closed several large acquisitions in the few years before covid, with still needed to be integrated; (large) acquisitions generally tend to pressure gross margins until they are fully integrated and brought to group levels. There’s also been a strong push over the years towards the APAC region, the most promising and rapidly growing region. APAC exposure grew strongly within the mix, although this region still has relatively lower gross margins. 

 

Over the longer term, I believe Azelis should continue to grow on the back of the previously mentioned trends (industry growth, outsourcing and M&A) as well as the relatively larger focus on the APAC region, which is less mature - hence higher organic and inorganic growth potential - and has relatively higher EBITA margins despite having lower gross margins. The latter is more a sign of immaturity; there’s no reason to assume that APAC gross margins will not move towards the level of EMEA and the Americas. I believe this combination will allow Azelis to grow EBITA 15-20% on average for many years.

 

 

I’m keeping it simple here. Azelis is trading at ~11x EV/EBITDA on my FY24 estimates. IMCD is trading at ~15.5x. This discount is mainly the result of relatively lower liquidity and the shareholder overhang. As the overhang disappears and liquidity improves, I believe that the discount should fully close.

What’s a good multiple for a company operating in an industry with long-term secular tailwinds and a very resilient earnings profile? Not 11x in my opinion. Keep in mind that despite the strong market pullback, Azelis’ EBIT(D)A was relatively stable over FY23.

 

As mentioned, I believe that Azelis can grow EBITDA >15% p.a. through the cycle for quite some time. A rerating towards a more ‘normal’ multiple (15-20x) and DD% earnings growth provide the base for Azelis to be a secular compounder. 

 

 

Roughly a month ago, main shareholder EQT put out the news that they had been approached by several parties interested in acquire (a stake of) Azelis. At the same time EQT also mentioned to be discussing the potential of taking Azelis private again given the substantial discount to intrinsic value vs IMCD. Just a month later, EQT placed a big stake. What’s more, the CFO sold a few weeks before. 

 

This action doesn’t look great; saying ‘it smells’ would be a nice way to put it. But while I don’t like how EQT and the CFO behaved, I do believe that a lasting discount of Azelis’ valuation will attract attention from PE. As mentioned, this is a growing industry, with a resilient earnings profile and plenty of consolidation potential. PE could easily take Azelis off the market, lever up 7x (which both Azelis and IMCD were a few years before going public) and grow the heck out of it.

 

 

There’s no reason not to prefer IMCD over Azelis in my view. I believe that Azelis’ upside is higher over the medium term as the liquidity and shareholder overhang discount disappears. But I see no reason why these two companies shouldn’t have comparable performance over the longer term, if execution remains the same. IMCD is the leading best pure-play specialty chemical distributors and execution has been great, though Azelis has done a great job catching up.