Description

The company's typical customer is a small business with about $7MM of revenues. It buys roughly E2,000 worth of chemicals from Brenntag every week or about E100K per year.  Brenntag supplies its customers with chemicals that are critical to their day-to-day operations but make-up only a small proportion of overall expenses.   As result, Brenntag’s typical customer cannot afford to hire dedicated procurement personnel with expertise in chemical markets and consequently suffer from limited visibility into sport price trends and sourcing options.  This unique combination of small dollar ticket, high operational importance and opaque pricing, allows Brenntag to charge a nice spread for its services and earn returns on capital in access of 20%.  It also enables Brenntag to pass along swings in chemical prices and protect the amount of absolute gross profit dollars it earns through fluctuations in commodity prices.

The market in which Brenntag operates benefits from structural tailwinds that work in favor of large independent distributors at the expense of smaller competitors.   The chemical industry is in the midst of a long-term phase of consolidation amongst producers.  Consolidation is a result of the ever increasing pressure on manufactures to offset raw material inflation through economics of scale.  As producers expand in size their appetite to directly serve small customers diminishes. Shipping minor amounts of volume of chemicals in less than full truck loads is less economically profitable versus serving large buyers who can absorb bulk transports in full trucks or better still through train car loads; also maintaining a large sales force to serve many small customers becomes unattractive relative to operating an account team that handles a limited number of large buyers (the ratio of revenue per sales person is favorably skewed to working with big customers in a commodity oriented business such as chemicals where price premium is hard to come by for manufactures).  Consequently, producers have been steadily outsourcing their distribution towards independent players such as Brenntag, who can aggregate small quantities of product from different manufacturers into efficient scale.  Over the last 15 years the market for 3^rd party chemical distribution has grown in High Single Digits in real economic value-add terms (that is, excluding the effect of chemical price inflation).  We believe there is still ample growth ahead, as the percentage of 3^rd party distributors has reached only 30% of the small customer segment in 2010 versus about 15% in the mid-1990s, representing about 1% of market share gain every year. 

As OEMs grow in size, they are consolidating their 3^rd party distribution relationship to reduce supply chain complexity and costs.  Producers are therefore gradually deprioritizing their cooperation with small distributors that operate on a local basis and buy small quantities.  These small distributors cannot gain access to products at the same price and operational flexibility afforded by manufactures to large players such as Brenntag.  Small 3^rd party providers are therefore likely to lose share to big distributors that can offer end customers more flexibility in product delivery at quicker response times, two of the elements most critical to small end customers, even before price.  As a top player in each of its geographical regions of operation, Brenntag is well positioned to gain share from local competitors.

We estimate that the combination of attractive market growth rates and improving competitive dynamics will allow Brenntag to grow gross profit at mid-single-digit rates over the next business cycle and beyond.  With growth we expect the company to drive operating margin expansion from several sources within its internal control. Net, EBITDA should compound at 8-9% over the cycle. Combined with ~33% financial leverage, we see Brenntag compounding value at around 12-13% before redeploying its cash.  The company’s business model is well suited to handle acquisitions of smaller players that lack scale and can expand their margins to reach Brenntag’s corporate average once consolidated.  Brenntag’s past M&A performance supports our favorable view on capital deployment.  We estimate that with tuck-in acquisitions and buybacks, Brenntag will be able to compound value at a yearly rate of around 20% over the business cycle.  At the current price of Euro 71 per share, we own the business for ~9X our 2012 cash earnings estimate.  We view this as an attractive entry multiple for a defensive business with good long-term compounding ahead of it, and in which time works in our favor as owners. 

The key risks for permanent impairment of capital stem from the potential for intensifying competition between large independent chemical distributors, possible misuse of capital by management and a prolonged economic recession. 

On the competitive front we currently find little signs of intensifying competition as the largest players focus on regions and product sets with limited overlap.  Brenntag and other large players are spending most of their attention on share gains from smaller ‘mom-and-pop’ competitors and on wining more distribution volume from OEMs.  We estimate that they do not have a rational reason to compete directly for at least the next two business cycles. That is, the large distributors have a rationale incentive to avoid direct competition with each other and instead focus on the meaningful sources of profitable growth from low penetration rates for 3^rd party distributors and natural advantages for large players versus sub-scale ‘mom-and-pop’ operators.  In regards to management’s use of capital, we have not found any reason for concern, and find comfort in the Brenntag’s M&A model which relies on small tuck in deals.   On the macro front we view the key risk as Brenntag’s exposure to Europe, which contributes about 40% of the company’s earnings.   During the last recession Brenntag has proven its resiliency to economic downturns with gross dollar profits declining only about 4% in 2009 in the midst of a uniquely challenging economic crisis.  This resiliency stems from Brenntag’s pricing power over its end customers, which allows the company to maintain the required spread it need to earn good returns on its operational assets (in other words Brenntag was able to charge customers almost the same amount of dollars for distribution regardless of the lower volume of chemicals it delivered during the downturn).  We believe Brenntag will be able to cope well with future economic downturns.  

Catalyst