Description

I am long the shares of Azelis (ticker AZE BB).   It is a specialty chem / ingredient distributor.  Azelis trades at a 6% FCF yield, but has a reliable long-term runway to compound FCF at 10%+ rates, with half of that coming organically and half from continuing to roll up the fragmented M&A targets (for which Azelis is frequently the preferred buyer).  Azelis is a well-managed business and has the hallmark characteristics of a compounder.   Profits are relatively predictable and annuity-like.  I expect a mid-teens long-term %IRR from holding the shares, which I think is attractive given the risk-profile of the business. 

One of the relatively under-appreciated business models in the public markets is the distribution business model.   Companies with local oligopolies / monopolies providing a relatively small but critical / hard-to-replace part of their customers' process tend to be decent ponds to fish in.   They often earn attractive returns on capital over the business cycle.   Examples of sectors where one can find quality publicly-listed distributors are industrial gases, construction / industrial equipment rental (e.g. Ashtead was recently written-up by another member), plumbing distribution (e.g. FERG, one of my prior write-ups), and chemical distribution (the subject of this write-up).  

Azelis is a pure-play specialty chemical distributor.   It has 3,800+ employees, 60+ labs, 2,700+ suppliers and 59,000 customers across 63 countries.   About 2/3rds of the business is HPC / healthcare / CPG.  The company has a $6 bil market cap and $1 bil of LTM gross profit.  Cash conversion and quality of earnings is quite high.   Compared to commodities, specialty distribution is less capital intensive, grows faster and is more predictable.

By most metrics (market cap, staff count, gross profit), Azelis is c.15% smaller than the largest pure specialty player, IMCD.   The general market perception is that IMCD is the creme-de-la-creme player and Azelis still has some way to go to match IMCD.   Even if there is some truth to that perception, I believe Azelis is closing that gap.  

See below the historical speed of gross profit growth for Azelis, which is not too dissimilar from IMCD.   In recent years, Azelis also has pulled off larger M&A deals (relative to its size) than IMCD.  

Azelis is really a well-managed 'people business'.   There’s a virtuous cycle at work here.   Suppliers like dealing with Azelis due to the professionalism and knowledgeableness of its staff, tenured relationships, and global reach / market reputation among customers.  Among customers, Azelis has a good reputation thanks to customer service, staff caliber, and an attractive product portfolio (which Azelis was entrusted with by the suppliers thanks to Azelis’s reputation, thus the virtuous cycle).  And among M&A targets - smaller distributors who look to sell their business - Azelis is frequently the preferred bidder, due to its reputation with suppliers and customers, and perception that Azelis management truly understands the specialty business better than any other competing buyer.   

The ‘sales cycle’ to win a supplier (aka ‘principal’) is long and intricate, but once Azelis is in, it is in.  Relationships are sticky and churn is rare.  Supply agreements are frequently exclusive, i.e. Azelis is the only distributor who carries a certain ingredient or enzyme in a certain geography, etc.  Unless Azelis badly bungles on execution, it is very unlikely that the supplier will drop Azelis.  When a new supply agreement is spun-up, Azelis and the supplier undergo a certain degree of integration in IT and operations, which furthers the stickiness.  Azelis will then try to leverage this relationship to “grow with the supplier”, i.e. if a supplier wants to become bigger in a certain new geography, Azelis will eventually enter that geography (often through M&A) and will serve that supplier there, too.  

Customers are usually mid-sized / small businesses, i.e. areas of the market that are uneconomical for the supplier to serve directly.  Unlike the commodity chemical space where price and speed / proximity are often the deciding factors for the customer, in specialties the customer's objectives are far more technical, and this gives Azelis an opportunity to foster a solid, consultative relationship.  Azelis frequently helps the customer with formulation; Azelis has 60+ formulation labs scattered around the world.  Azelis’s corporate motto is “innovation through formulation”.  Azelis is perceived by the customer as an important partner in helping achieve a certain performance, e.g. in achieving a certain flavor, color, consistency, longevity, etc.  I.e. Azelis sells performance and service, not chemicals.  Another way to look at this is to recognize that Azelis plays the function of outsourced R&D.   The sales-cycle for a new customer can be lengthy;  Azelis might invite a prospective customer to one of Azelis’s 60 labs to demonstrate product performance.  But once the customer has been landed, Azelis’s customer relationships are sticky and income is basically recurring.   As long as the customer stays in business and keeps selling the products which use the ingredients / chemicals provided by Azelis, Azelis essentially gets an annuity-stream of gross profit from that customer.  An average customer buys more than 1 chemical / ingredient from Azelis. 

M&A is a big long-term driver of growth and value creation for Azelis.  Here, Azelis’s relatively smaller size vs public peers works to the investor’s advantage.  It is easier for acquisitions to ‘move the needle’ in Azelis’s EBITA growth.   Azelis is also significantly less likely to be faced with supplier conflicts.  Azelis believes there are 20,000 small distributors out there, and it can eat into that base through M&A for many more years, with Azelis doing about a dozen acquisitions every year.  Some of the acquisitions are given more autonomy than others, with the acquired brand retained, which speaks to Azelis’s more decentralized structure, e.g. Azelis’s local unit heads have more pricing discretion compared to some peers that set prices centrally.

Given that Azelis trades around 14.5x EBITA currently and tends to pay 10x or sub 10x for its acquisitions (and sometimes closer to 8x), deals are significantly value creative.   Immediately after closing a deal, Azelis works to enable the acquired unit to offer a wider array of products to that unit’s existing customers.  And if the unit is based overseas, Azelis works with existing large global suppliers to help them expand into that new geography.  The technical staff of the target get access to Azelis’s global formulation expertise and also contribute to it.  In a way, Azelis is a ‘network’ business and adding a new ‘node’ is beneficial for many of the other existing nodes.    Azelis’s deals create significant value through these synergies, and they take some time to unlock post-acquisition.   The synergy enables an acquired unit to gradually improve its EBITA margin towards Azelis’s group average.   The company recently raised EUR200 mil (representing c. 4% dilution), signaling confidence in the near-term M&A pipeline.  

It is easier for Azelis to win new mandates when it is bigger, by virtue of a larger footprint, bigger product portfolio and improving reputation.   Overall, the long-term organic growth opportunity is likely sizable.  See chart below from BofA / BCG suggesting that the outsourced specialty distribution market currently is still a fraction of what it could be if suppliers decide to outsource more of their distribution.  A lot of that growth is likely to come from emerging markets like Asia.

There are some economies of scale.  As Azelis grows, management believes they can improve gross margins by 100-150bps and also deliver some small annual EBITA margin improvement from fixed costs absorption.  Note that unlike Brenntag and commodity distributors, Azelis is significantly more capital-light.  As referenced a few paragraphs above, Azelis positions itself as selling the technical know-how and the customer experience.  As a result, Azelis outsources many of the steps that are lower value-added in the specialty context, such as trucking, labeling and mixing.  Azelis also owns very few of its warehouses, and leases the vast majority.  I consider these as advantages for a growth-oriented business.

Valuation / returns

Azelis’s current TEV is c.€6.8 bil (net of the €200 mil recently raised) and trailing 12-month EBITA is €475 mil, or a 14.5x EBITA multiple.   The company has €1 bil of net debt, and I think Azelis could handle more than double that amount (as demonstrated through prior industry LBOs).   Azelis closed more than a dozen acquisitions in 2022 (spending more than half a billion) and closed at least 4 more in 2023 already.  It takes Azelis some time to fully integrate an acquisition and reap the synergies.  Because Azelis is constantly doing deals, I believe reported EBITA for any given period underestimates the company’s true earnings power.   Another reason reported EBITA underestimates earnings power is because when a new supplier / mandate is won, there are some front-loaded costs and investments incurred before revenue can be generated.  This is particularly true in EM regions, where it can take years for a performance ingredient to achieve acceptance among the customer base.  Pharma is also a segment where costs are much more front-loaded than revenue, due to years-long regulatory approval processes.  

In recent years, organic EBITA growth averaged 11% but this included a favorable Covid period (when life sciences / HPC product consumption increased significantly).  In the future, I model gross profit and EBITA organic growth to be closer to % MSD rates, driven by GDP-linked consumption growth, increased product cross-selling to customers, and new mandate wins (as % outsourced distribution penetration increases).  After adding bolt-on acquisitions, I think EBITA will grow by 10% CAGR.   In my view, the entry price (14.5x EV/ EBITA, c. 6% forward FCF yield) is too low for the annuity-characteristics of the business as well as the long runway to productively reinvest capital.  Assuming there’s no change in exit multiple, I expect a mid-teens IRR and hopefully there will be no reason to sell.  

Risks and potential mitigants

Key man risk.  As a people-business, I think a company like Azelis will always have key man risk.  This applies both to leadership and all the way down to relationship managers and technical staff.  The C-suite team (led by Dr Mueller) is well regarded and appropriately credited for Azelis’s success.  When Mueller came in as CEO c.10 years ago, Azelis was being mismanaged and was struggling under the ownership of 3i (the financial sponsor).  Mueller remained with the company as Azelis then twice changed hands, with the company first bought by Apax and then by EQT.  I think Mueller is an impressive operator and him retiring or moving on to other things would be a loss for the investors (and I do not know who is the logical successor, at this time).  Given that Mueller is 63 years old, I hope this will not be a factor for at least a few more years.  Mueller (along with the CFO Thijs Bakker) also recently bought some shares in the open market.  By American largecap public mkt standards (or even by Univar standards), his pay package ex the LTIP is relatively modest at €2m, though no doubt Mueller has already made a lot of money during the 3i / Apax / EQT ownership period.   Note that there is also an LTIP (active through 2024) which focuses on organic (instead of total) EBITA growth and % relative TSR versus peers.   

EQT overhang.  There’s a significant perceived overhang from PE sponsors holding the stock post IPO.   EQT (the PE sponsor) acquired Azelis in 2018 through fund EQT VIII.  EQT and its co-investor PSP jointly continue to hold 50.6% and 11.6% of Azelis’s stock, respectively.  Since the IPO in 2021, EQT and PSP have been selling small amounts of their holding, last jointly selling about 1.5% early this year.  But then 2 weeks ago Azelis issued €200m of new shares (4% of capital), likely for M&A, and half of that (€100m, or 2%) went to EQT.   With this move in May, EQT spent more on buying stock than what they raised the last time they sold stock in January, which suggests they see compelling value in the shares.  Also, given that EQT sits on the board, EQT is likely supportive of the M&A targets Azelis management has in mind for the fresh €200m that was raised.   Because of this, I am more relaxed about the PE overhang than most people. Note also that the EQT position sits in the fund ‘EQT VIII’, which is a 2018 vintage fund.  There is no burning pressure to sell out; I’d be more concerned about this if it was a 2012 vintage fund, for example.  I also think PE sponsors nowadays are a lot more cognizant of the merits of holding on to the truly great assets for longer.  Note also that the co-investor PSP Investments is a Canadian pension fund, so I think their time horizon is likely even longer. 

Capital misallocation.   As a highly FCF-generative business with a thesis that rests on productive M&A-driven reinvestment (though they do pay out a dividend and they have done some small buybacks), there will always be a risk that Azelis overpays for the wrong targets or wades into trouble through tricky integrations and loss of business through under-estimated supplier conflicts.  There are no clear mitigants to this risk other than faith in the management and governance setup (where I like that the board is small and consists of shareholder-aligned voices through EQT).  Mueller’s LTIP emphasizing organic growth and Azelis’s use of earn-outs when structuring deals also make me feel better on this front. 

Competition.   IMCD lost some of its ‘scarcity’ luster as the only public pure-play specialty distributor in chemicals after Azelis went public.  I think Apollo’s plan for Univar is to split it into specialties and commodities, and then IPO the specialty part.  I think Univar and Brenntag would be more formidable competitors for Azelis and IMCD if they were each broken up (see the PrimeStone activist letters on Brenntag for some convincing arguments as to why the integrated model operates worse).  So if Univar is soon broken up and Brenntag is also broken up in the future, I think competitive intensity in the specialty market would rise.   The other competitive risk is commoditization in the long-term, particularly from China/Asia, whereby Chinese chemical producers can move up the value-chain and supply the global markets with gradually more sophisticated / specialty chemicals at discount prices, pressuring Azelis's suppliers (and thus pressuring Azelis).  

Why not the alternatives?

Brenntag:  I’ve posted a Brenntag write-up and comments previously.  Brenntag offers a different risk-return profile.  A bigger part of the Brenntag thesis rests on the low entry valuation and the short/medium term re-rerating prospect if the company was to be broken up into parts.  Several activists are on the scene, with two directors proposed, a shareholder vote (where I cannot predict the outcome but expect the activists to lose due to specificities of the German electronic voting process) and an imminent AGM.  The actions taken by Brenntag in response (such as getting a friendly European shareholder to increase their stake to 5%+ stake and vote with the company, threatening to sue the activists, and omitting the activist slate director CVs from shareholder communications) are lowering my enthusiasm for Brenntag.  So, although Brenntag is a lot optically cheaper, in its current form I do not expect it to compound organic or inorganic profit at the same rate as Azelis.  So, the longer your time horizon, the more likely you are to be right owning Azelis over Brenntag. 

IMCD:  I think it’s a perfectly valid and reasonable investment but I like that Azelis is 15% cheaper on forward numbers and I like that Azelis is also 15% smaller in terms of size, which hopefully will mean it will grow faster.  I also liked the recent Azelis insider purchases by CEO/CFO and EQT.   That said, I think IMCD is also likely a fine LT investment, too. 

Catalyst

Organic growth

Acquisitions

Dividends and buybacks