|Shares Out. (in M):||155||P/E||10.4||11.3|
|Market Cap (in $M):||10,400||P/FCF||0||0|
|Net Debt (in $M):||2,500||EBIT||0||0|
|TEV (in $M):||12,900||TEV/EBIT||0||0|
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The last write up on VIC on Brenntag is from December 2016 by Kerrcap. It is an excellent piece and provides ample background on the business and the industry.
Over the period 2014-19 the company significantly lagged global indexes and was mis-managed. In 2020 the Board named a new CEO who appears to be implementing a sensible strategy aimed at restoring organic earnings growth.
The market fears current earnings are unsustainable; I believe that the stock offers an attractive risk/reward on a 3-year time horizon, with little risk of permanent capital impairment.
Brenntag (BNR GY, €10bn market cap) -
Summary investment thesis
Brenntag is the largest independent chemical distributor globally; it operates in a growing and highly fragmented industry, providing essential services to both large chemical manufacturers and its more than 200,000 customers around the world.
Brenntag competitive advantages are numerous and hard to replicate: its leading scale and dense global network drive both a purchasing cost advantage and a lower cost to serve customers than competitors; its reputation, long-lasting relationships with suppliers and wide product range further ensure better availability than peers, which is particularly valuable in today’s age of supply chain disruption.
The business model is extremely resilient: EBITDA grew both during the Great Financial Recession of 2008/09 and during the 2020 Covid-19 pandemic.
The financial algorithm can be thought of as c.+4% organic profit growth, augmented by +1-3% of annual bolt-on acquisition growth; EBITDA compounds +7-9% (since 2005 EBITDA compounded at +10%) and the dividend yield is 2.5%; Brenntag low capital intensity business model leads to returns on capital consistently in the low-teens.
The stock trades on a discounted multiple of 10x P/E, as the market fears current earnings are boosted by exceptional pricing linked to product shortages; these concerns appear overstated as even if exceptional market conditions fully revert, Brenntag would generate normalized EPS just shy of €6 in 2025; applying a reasonable 15x P/E multiple (in line with the market) would lead to a mid-teens IRR with a low risk of terminal value impairment.
Over the past decade TSR averaged +9% p.a; since the new CEO took over in 2020 the stock compounded at +15% p.a.
Company and industry context
Brenntag is the largest third-party chemical distributor in the world operating 700 locations in 72 countries; the company is highly diversified across customers (200,000), products (>10,000) and suppliers (thousands), with no single material exposure to a particular end market or client (top-10 account for 5% of gross profit).
The business benefits from a very low risk of technological disruption: chemicals are bulky and hazardous materials that are difficult to transport and require efficient network and extensive regulatory licenses to handle them; furthermore, high level of service to customers (in the form of repackaging, mixing/blending, reformulating, technical knowhow support) and a track record of safety and reliability with chemical suppliers make it extremely difficult for a potential new entrant to disrupt the incumbent.
The business reports in 2 segments: Essential (60% of group EBITDA), Specialist (40% EBITDA):
In Essential, Brenntag distributes primarily bulk chemicals in high volumes through its best-in-class global network; this division is infrastructure intensive and logistics arrangements and availability are what matter to customers.
The Specialist division distributes formulations that are proprietary for customer specific applications and are therefore produced in smaller volumes; this is an asset light business, relying on technical advice and high level of customer service.
According to the Boston Consulting Group, independent chemical distribution industry growth is around +4% p.a; chemical manufacturers intend to rely more on third party independent distributor in the future, thus the outsourcing penetration rate is likely to continue to increase over time from its current low level estimated around 10%.
The market is extremely fragmented with more than 10,000 distributors operating globally; whilst Brenntag is the #1 or #2 operator in all major geographies, the top-4 players control only 10% of the market.
A core part of Brenntag strategy is to actively consolidate the market through value accretive M&A without stretching its balance sheet (targets net debt/EBITDA 1.0-2.0x): since 2010 the company spent €2.5bn in M&A through 89 acquisitions with an average multiple paid lower than its own; on average Brenntag’s acquisitions contributed between +1-3% point of gross profit growth per annum.
Why is this a good business
Brenntag fulfills a vital role in the chemical supply chain as it provides the logistics and sales platforms to sell chemical in small quantities: the typical customer is a small to medium size business purchasing less than €100k of chemicals per year, making it uneconomical for large chemical manufacturers to serve them directly.
Through its leading scale and extensive network density, Brenntag benefits from purchasing power with suppliers and a lower cost to serve customers than peers.
Brenntag operates through a series of hub and spokes network in each of its major region of operations, serving both small customers through a deep local presence, but also large multinationals requiring a consistent pan-regional or one-stop shop global offering.
The business is also extremely defensive: during 2008/09 recession and the 2020 pandemic EBITDA actually grew year-on-year, as customers are willing to even pay a premium price for certainty of supply in period of uncertainty.
Furthermore, the business is highly cash generative, it has low financial leverage and working capital is counter-cyclical, releasing cashflow at time of economic contractions as generally both volumes and chemical prices fall.
Most importantly Brenntag business is insulated from the price swings in the underlying commodities it distributes: Brenntag earns a fixed fee for its role as intermediary moving the product; thus, inflation tends to be comfortably passed-on to the end customers.
In summary, Brenntag meets all the key characteristic of a best-in-class distribution business: it is by far the largest intermediary connecting a deeply fragmented customer and supplier base; it offers consistently high levels of service, distributing bulky and difficult to handle materials; it has pricing power and its earnings are unaffected by swings in chemical prices; it consolidates actively the market, further enhancing its scale and network effects, which it partially shares with customers, gaining market share.
Management and Remuneration
The business IPOed in 2010 and performed relatively well until 2014; thereafter, a series of ill-timed acquisitions (North America Oil & Gas verticals) and a deterioration of operational performance led to a consistent decline in conversion margins, eventually leading to former CEO retirement at the end of 2019.
In 2020 the Board named Christian Kohlpainter as new CEO who presented to investors a sensible new strategy aimed at reinvigorating organic EBITDA growth, forging a culture of greater accountability and streamlining the business through a cost savings program.
The new CEO has consistently over-delivered through implementing some key changes:
Separating organizational structure and salesforce into Specialist and Essential divisions;
Announced new remuneration criteria based on organic EBITDA growth targets;
Changed divisional leaders and CFO;
Achieved targeted €220mn savings (“Project Brenntag”) ahead of schedule; a new plan “Horizon 2.0” will likely be announced in November 2022 at the Capital Markets Day;
Announced a revamped ESG strategy.
Management remuneration criteria appear sensible, moderate in magnitude and in line with shareholders interests: short term bonuses are awarded based on organic EBITDA growth (60% weight), WC turnover (20%) and EPS growth (20%); long-term remuneration is based on two different equally weighted measures of relative TSR.
The financial algorithm is relatively straightforward: organic growth should average around +4% p.a. with the Specialist division slightly outperforming, and Essential division slightly slower. Bolt-on acquisitions should contribute an additional +1-3% of growth per annum, so overall gross profit should grow between +5-7% p.a.
Operating leverage and cost savings related to “Project Brenntag” and “Horizon 2.0” should lead to EBITDA growth of +6-9% (in the last decade it averaged +10% p.a), further complemented by a dividend yield of 2.5%.
Cash conversion has historically been lumpy due to swings in working capital related to chemical prices volatility; nonetheless in the last decade FCFE averaged 85% of net income.
The business is modestly capital intensive (capex/gross profit c.6%, WC turns c.8x) and consistently generates ROIC in the mid to low-teens, well above its cost of capital.
FCF has historically been equally split between paying dividends (payout c.45%) and spending on acquisitions (average EBITDA multiple paid 7-10x).
The new CEO stated that its M&A strategy will sensibly tilt more towards mid-size targets and higher growth area such as the Specialist segment and the APAC region.
Why opportunity exists & Valuation
The stock trades on a discounted multiple of 10x P/E, as the market fears 2022 earnings are unsustainable, as product shortages led to exceptional pricing; indeed EBITDA in 2022 is likely to be 85% higher than pre-pandemic levels (€1bn in 2019).
These fears appear excessive: assuming EBITDA compounds at c.7% p.a. over 2019-25, and adding +220mn of Project Brenntag savings, gets me to 2025 EBITDA of €1.65bn and EPS of €5.6; applying a conservative 15x multiple, would imply a mid-teens IRR to 2025 with very low risk of permanent impairment of capital.
Under the new CEO the company recently revamped its ESG disclosures and targets: the ambition is to reduce emissions faster and better than the industry average and reaching carbon net zero by 2045
On the Social front, Brenntag aims to become the employer of choice in the industry, reduce incidents to zero and reach 30% of women in management below C-level by 2030.
Importantly, adjustments to the board remuneration based on ESG are expected by 2024.
SUMMARY INVESTMENT THESIS IN CHARTS FORMAT
Chemical distributors offer value added services that are hard to disintermediate; furthermore, the business is defensive and offers counter-cyclical FCF characteristics.
The company is highly diversified by geography, suppliers, products and customers.
As the largest player in a heavily fragmented industry, Brenntag consolidates the market through value accretive M&A.
Consensus fears current earnings are unsustainable; I estimate 2025 EPS of nearly €6, which on a 15x P/E multiple implies mid-to-high teens IRR.
Further execution of the current sensible strategy.
Capital Markets Day in November should announce an update on potential savings having completed Project Brenntag ahead of time.
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