Description

Hawkins, Inc. (“HWKN”) is a regional distributor of bulk commodity chemicals and value-added derivatives of industrial and water treatment chemicals. Over the past four years, the company has experienced rapid growth in earnings, with EBITDA increasing from $65 million in FY 2020 to $143 million in FY 2024. This substantial growth has driven the stock price up by over 300%, reaching its current all-time highs. I believe HWKN has been benefiting from elevated earnings due to temporary, highly favorable supply issues that allowed the company to raise prices significantly above raw material costs, resulting in record profit spreads per unit sold. My research suggests that HWKN’s earnings should revert lower as supply begins to normalize, competition increases, and customers push back on prices with demand slowing. In fact, the company’s most recent earnings results showed a material fundamental decline in earnings which were obfuscated by a favorable uplift from the decreased LIFO reserve. Due to its small size (<$2bn mkt cap), limited sell-side coverage, lack of quarterly conference calls, and low earnings transparency, this was overlooked, and the stock price has since increased another 15%. 

At current prices, I believe HWKN offers a compelling short opportunity with 33% to 50% downside.

Summary of the Business

HWKN has three operating segments: industrial, water treatment, and health & nutrition. 

• Industrial: supplies industrial chemicals to a diverse customer base serving multiple industries such as agriculture, chemical processing, electronics, energy, food, pharmaceutical and plating. This group’s principal products are acids, alkalis and food-grade and pharmaceutical salts and ingredients.

  • Manufactures derivative commodity chemical products such as bleach (sodium hypochlorite), certain food-grade and pharmaceutical products (including liquid phosphates, lactates and other blended products), and agricultural products

  • Receives, stores and distributes various chemicals in bulk quantities, including liquid caustic soda, sulfuric acid, hydrochloric acid, urea, phosphoric acid, aqua ammonia and potassium hydroxide.

  • Repackages water treatment chemicals for their Water Treatment Group and bulk industrial chemicals to sell in smaller quantities to customers

The majority of the industrial segment revenues are generated from manufactured, blended, or repackaged chemicals or “specialty products.” While the company uses the “specialty chemicals” terminology for many of its products, they are commodity chemicals and derivatives blended or created from base chemicals that are readily available.

• Water Treatment: specializes in supplying chemicals, products, equipment, services, and solutions for potable water, municipal and industrial wastewater, industrial process water, non-residential swimming pool water and agricultural water.

  • Supplies full line of general water treatment chemicals targeting small rural towns / municipalities and small industrial companies

  • Utilizes delivery route sales / service business model on a regional basis supplying lower volume deliveries of water treatment chemicals. 

This segment has grown meaningfully in the last five years from acquisitions and continues to be a key aspect of their growth strategy going forward. Since FY 2021, the company has completed nine acquisitions spending ~$150mm in total. Management has stated they pay, on average, 7-10x EBITDA implying those acquisitions have added ~$15mm to $20mm EBITDA. The company has done a good job of executing the roll-up strategy and from channel checks, they are well regarded in the industry for their service and niche market focus on smaller customers. 

• Health & Nutrition: specializes in providing ingredient distribution, processing, and formulation solutions to manufacturers of health and wellness products. Types of products include: minerals (e.g. magnesium, manganese, calcium, etc), excipients, natural B vitamins, amino acids, enzymes, etc. 

The core business model for vast majority of HWKN’s business is essentially purchasing commodity chemicals in bulk (such as caustic soda, chlorine, and sulfuric acid) then repackaging or blending to create derivative products that are sold in smaller quantities to end users and earn a $ spread per unit. The company is a regional distributor focused primarily in the Midwest and operates in a mature, fragmented, and highly competitive industry where customers, in a normal operating environment, have multiple sources of supply. The company’s 10-K, “We operate in a highly competitive industry and compete with producers, manufacturers, distributors and sales agents offering products equivalent to substantially all of the products we offer.” 

From conversations with competitors and the company, the industry tends to perform best during periods of volatility in commodity prices when distributors enjoy temporary surges in profitability from expansion in spreads. Post-COVID 2020 to 2023 were far and away the most profitable years for the entire industry. 

Commodity Price Volatility Creates Temporary Favorable Environment for Distributors

The primary factor driving the earnings surge at HWKN over the last four years has been the supply disruption and shortages that resulted from COVID-19 and the subsequent curtailment of chlor-alkali production capacity. This led to a historic spike in the cost of chlorine and caustic soda from 2020 through end of 2023. These supply shortages created panic among customers who were concerned about availability of products, allowing distributors like HWKN to charge prices well in excess of cost increases. This drove a surge in margins and profits for distributors despite selling lower volumes. Peers consistently remarked on the record profits achieved, citing a "once in a lifetime" environment created by the combination of hyperinflation and product shortages. For example, multiple distributors explained that if they were facing 20-30% raw material price increases, they were able to get at least 50% price increases from their end customers. 

Large chemical distributors, such as Brenntag and Univar, revealed that there has been a change from historical norms in profitability between two distinct chemical product groups: organic solvents (e.g. ethanol, acetone, methanol, etc) and inorganics (caustic soda, chlorine, sulfuric acid, ammonia, etc), which is the only type of chemicals that HWKN works with. For decades, distributors earned higher spreads in organic solvents versus inorganics and viewed the organic solvents business as more attractive. The market changed after the pandemic and inorganics became much more profitable due to the shortages. Larger distributors have since been shifting their mix towards inorganics where they were previously under-indexed. 

Since the end of 2023, market conditions have deteriorated as supply and availability of raw materials has significantly improved and is normalizing to pre-pandemic levels. On top of that, demand has been softening and commodity prices are stabilizing below peak levels. Recent channel checks suggest that distributors are shifting their strategic priorities towards market share and volume gains, versus pricing and spread expansion. The result is increased competition which will make it hard for companies like HWKN to defend recent spread levels. This is a return to normalcy for an industry that operated this way for decades prior to the pandemic.

HWKN – Recent Results & Valuation

HWKN was an outized beneficiary as its strong regional presence with smaller customers resulted in less competition from larger distributors, who were focused on supplying larger clients in an environment with limited supply. Also, HWKN is almost exclusively exposed to the inorganic chemicals, such as caustic soda and sulfuric acid, that experienced much larger spikes in both demand (used as disinfectant and coagulant) and supply shortages from decline in capacity as well as supply chain disruptions. Prior to the pandemic, HWKN averaged ~$60mm EBITDA from FY ’16 to FY ’20 versus $143mm on an LTM basis. The primary factor behind the >$80 million increase in EBITDA was the expansion in profit per unit sold, despite significantly lower volumes. The company has historically refrained from disclosing specific financial impacts from changes in volumes and pricing, except in its FY 2023 10-K. In this report, for the first and only time, they revealed the magnitude of the price growth and its contribution to the surge in profits.

• In the Industrial Segment, net revenues and gross profits (ex LIFO reserve) grew from $387mm in FY ’22 to $471mm in FY ’23 and $70mm in FY ’22 to $80.4mm in FY ‘23, respectively. The increase in sales was driven by +36% increase in ASPs but total sales volumes declined -11%. 

• In the Water Treatment Segment, net revenues and gross profits (ex LIFO reserve) grew from $228mm in FY ’22 to $305mm in FY ’23 and $60mm in FY ’22 to $73.4mm in FY ‘23, respectively. The increase in sales was driven by +28% increase in ASPs while total sales volumes increased only 4% due to acquisitions.

A careful examination of HWKN’s recent earnings results show profits of the underlying business being much lower than the reported numbers and very different to what the positive headlines would have you believe. The company fails to mention that Q4 earnings were boosted by $11.5mm from the decrease in the LIFO reserve, which does not reflect actual earnings. The only mention of this accounting impact is in the MD&A section of the 10-K. The company touts the 20% growth in FY ’24 Reported EBITDA but excluding the earnings impact from changes to the LIFO reserve, EBITDA actually declined by 1.5%. Upcoming earnings results should have minimal impact from changes to LIFO reserve and will finally reveal the declining profitability in the underlying business. 

LTM reported earnings are conservatively estimated to be at least 25 – 40% above normalized levels which will come to light in future earnings releases. The combination of lower earnings and valuation multiple, which is currently well north of the company’s historical average of less than 10x, results in ~33% to 50% downside to HWKN’s current stock price. 

Catalyst

- Future earnings release