Description

Introduction

We are long shares of Brenntag (BNR), the world’s largest chemical distributor. Following the reset of 2016 EPS expectations from €3.00 to €2.42 and a tumultuous trading year in Europe, German-listed shares of BNR are now listed at €51 and 15x FCF, a low multiple for this high ROIC distribution business with a demonstrated ability to maintain margins and earnings through an economic cycle. Though commonly colored as an indirect participant in depressed energy markets, North American oil & gas makes up just 9% of Brenntag’s gross profits – and while the sharp contraction in North American E&P spending reduced BNR’s consolidated growth over a few quarters, resilient demand from the pharmaceutical, coatings, personal care, and food markets should lead to a growth inflection in early 2017, allowing Brenntag to exit 2017 generating more than €800m of EBITDA and €500m of FCF. Even within a secularly slow-growth world with 2% organic growth, Brenntag shares should attract a FCF multiple of 18-20x once year-over-year comparisons stabilize in 2017 – at that multiple, shares would be worth €60-65, representing a 20-30% premium to today.

The typical Brenntag customer is a small-to-medium sized business purchasing less than €100k of chemicals a year -- these smaller suppliers rarely have direct relationships with suppliers like Dow and BASF, and when they do, they purchase in non-bulk quantities. This customer base is diversified across industries and geographies: Europe represents 44% of gross profit, North America 41%, Latin America 7%, and Asia 7%. Producers also rely on Brenntag to reach the higher-growth small business segment -- less-than-truckload (LTL) shipments aren’t economic without scale. Consequently, producers rely on scaled distributors like Brenntag that can buy large quantities and efficiently repackage them to smaller customers.

While distribution creates value for both the customer and the producer, markets remain highly fragmented. Brenntag’s global footprint and renowned management team, known for maximizing asset efficiency and accountability at the regional level, result in a highly efficient platform to consolidate smaller peers. Over the past year, Brenntag redeployed capital into ten announced acquisitions at an average of 6.7x EV/EBITDA (vs. Brenntag’s currently 11.9x EV/2016 EBITDA multiple), adding 14m of EBITDA to Brenntag’s 800m run-rate. And yet Brenntag still only accounts for 6% of the global market, leaving it with years of bolt-on growth opportunities, especially as current net debt/EBITDA resides at historical lows of ~2x.

Following a weak Q1’16 earnings, shares sold off significantly as a result of underperformance in North America due to weakness in the Oil & Gas segment, which accounts for ~9% of total gross profit. Management expects that business to stabilize over the next few quarters. While shares have recovered since the 52-week lows earlier this past summer, Brenntag still trades at 15x FCF, an attractive valuation for the industry’s largest distributor and for a company that has shown resilience through economic cycles. Given the high value proposition of Brenntag’s business combined with the attractive financial profile and consolidation opportunity, we expect to make a compelling return on our investment.

Distributors serve as critical intermediaries between large suppliers and a fragmented SMB customer base

Chemical distributors play a very pivotal role in the highly fragmented chemicals industry for both suppliers and customers. Brenntag estimates that ~80% of their gross profit is generated from SMB customers who spend on average less than EUR 100k a year on acquiring chemicals. So from the perspective of a supplier, it doesn’t make sense to have in-house logistics to serve a very fragmented customer base. You can imagine how much of a headache it would be for a large supplier like Dow Chemical to service thousands of SMB customers in a particular region. The return on investment on having an in-house operation just wouldn’t make sense to service that segment of the market.

In terms of the value added to the customer, Brenntag can be viewed as a one-stop shop. Customers typically are purchasing multiple chemicals at once, making it more efficient to buy from one seller (as opposed to sourcing directly from multiple suppliers). The chart below depicts BNR’s value in the chemicals industry. But imagine what the chart would look like if you had 5,000 suppliers listed on the left side of the chart and 180,000 customers listed on the right.

Brenntag benefits from scale as the largest distributor in the industry

Similar to other distribution businesses, scale is very important for chemical distribution. As the world’s largest chemical distributor, Brenntag and its customers and suppliers benefit from attractive economies of scale. One obvious benefit is the purchasing power Brenntag gains from scale with its suppliers. Brenntag can realize significant bulk volume discounts, reducing the pricing delta between what customers can source directly from suppliers vs. Brenntag.

Other benefits include the following:

• Having a large distribution network reduces the marginal cost of adding new customers on an existing distribution route. Increasing the density on its routes allows for Brenntag to bring down fuel, driver wages and other delivery-related costs, resulting in increased operating profit

• Large distributors like Brenntag with multi-location distribution networks are attractive to large, multinational customers. These customers may prefer to reduce logistics costs by relying on one distributor with a large network to service multiple sites with uniform pricing

Protected from underlying commodity price swings

Brenntag is somewhat protected from commodity price volatility. A chemical distributor’s sole purpose is to move goods from point A to point B. So the market value of the goods moved is irrelevant as the distributor is being paid for logistics and other services like repackaging and blending. Brenntag earns a fixed dollar amount for its role as the intermediary moving the product. That dynamic is reflected in the chart below. We would note given there could be swings in the value of goods moved, gross profit is the appropriate top-line metric as opposed to revenue. So in the industry, profit margins are measured as % of gross profit.

Further, commodity price volatility is less of a concern as Brenntag’s inventory has historically turned over 9-11x a year.

Brenntag’s performance during the financial crisis illustrates the resilience of the business model and its protection from price swings. In 2009, despite seeing a 14% decline in revenue, gross profit declined by only 2%.

Extremely diversified business across end markets, suppliers, products, customers and geographies

Brenntag benefits from diversification in all aspects of its business. Whether it’s customers, products or suppliers, Brenntag’s large scale helps to cushion it against times of weakness in certain geographies or industries. This was certainly evident in 2009 when gross profit declined by only 2% as certain end markets like personal care, food and pharma were less susceptible to economic downturns.

The sell-off of the stock after Q1 earnings was mostly due to Brenntag’s exposure to the oil & gas sector in North America (note oil & gas exposure is limited to only North America). O&G accounted for ~37% of North American gross profit and 14% of total gross profit in 2014 but has significantly declined. Beginning in Q1’16, O&G accounted for just 22% and 9% of North American and total gross profit, respectively. Going forward through 2017 and beyond, management gave guidance that O&G gross profit should remain at the EUR 54 million level on a quarterly basis.

Fragmented industry allows for continued M&A

While Brenntag is the largest player in the chemical distribution industry, it accounts for just over 6% of total market share. Brenntag estimates that there are over 10,000 distributors in the industry which should allow for plenty of M&A opportunities. Since 2010, Brenntag has done more than 30 acquisitions for EUR 1.3 billion and did 550 million in 2015 alone.

Historically, Brenntag allocated most of its excess capital to M&A. As the industry remains fragmented, we expect management to continue its path on making thoughtful and accretive acquisitions.

Below is the list of Brenntag’s acquisitions since 2015.

Consistent feedback from calls that mgmt. team is among best in industry

There was consistent feedback during our channel checks that Brenntag’s management team was among the best in the industry, especially when compared to Univar which has seen significant mgmt. turnover under its PE ownership. In addition to the feedback, a comparison of the historical financial performance highlights Brenntag’s superior metrics. Brenntag looks better on any metric (EBITA/EBIT margins, capex intensity, and FCF conversion).

Valuation and final thoughts

Brenntag operates with high margins, generates significant cash flow and trades at 15x free cash flow. We think shares are very attractive at these levels, especially when considering the fragmented nature of the industry which should allow for Brenntag to continue on its M&A path (averaged 155 million of acquisitions a year for the last 8 years and did 550 million in 2015). Before entering 2016, Brenntag traded between 20-30x FCF and we think 18-20x (at a minimum) is an appropriate valuation for this outstanding business. We also looked at valuation by doing a DCF and layering in upside from making additional acquisitions. Under this scenario, we estimate shares are worth at least 65-70 a share, implying at least 25%-35% upside. As Brenntag grows away from the issues related to the underperformance of Oil & Gas seen in 2016, we believe valuation will re-rate to historical levels and we will earn an attractive return on our investment.

Catalyst

Continued accretive bolt-on acquisitions

Recovery of Oil & Gas segment in North America