Description

Kraton Performance Polymers (“KRA” – $31)

KRA is a leading producer of commodity and specialized rubbers and chemicals for use in adhesives, coatings and sealants in the personal care products, medical products, oil/gas and roofing/paving end markets (please refer back to previous KRA write-ups on VIC for more detail on the business operations of the company). While the negative sentiment around this company and its management team is partially self-induced, today is a compelling moment in time as the market is focused on what we believe are temporarily depressed earnings. We believe that stabilization in the supply of KRA’s key input commodity could drive Adjusted EBITDA growth of 20% in 2018 versus current consensus for 2017, and effect a re-rating of the stock. Our view is that the risk/reward today is skewed asymmetrically to the upside and that this could be a $50 stock a year from now.

Market’s View

A failed 2014 acquisition and the execution of the Arizona deal as fundamentals in its markets were about to deteriorate have led to skepticism around management credibility and put the company in the proverbial “penalty box.” The bull thesis surrounding the company’s acquisition of Arizona Chemical (now KRA’s Chemical segment) is certainly interesting as that business has potentially reached a cyclical trough, but we believe there’s much easier money to be made in the near/medium term.

The most significant fundamental misperception that has driven down KRA shares is the impact of the price of KRA’s most important commodity input in its Polymer segment – butadiene (a byproduct of the ethylene cracking process). From the beginning of Q4 2016 through early March 2017, the spot price of butadiene in the U.S., for example, went up by 164%. KRA stock saw a decline from $35 to $27 during that period, as the market assumed the company’s COGS were spiking and earnings proportionally deteriorating. Investors also apply a lower, commodity business type of multiple to KRA given the “volatility” in the input cost.

Further aggravating the market’s negative view is the fact that KRA chooses to report its numbers using an inventory adjustment called ECRC, the goal of which is to reflect the true fundamentals in the business. Bears believe KRA’s Adjusted EBITDA is just another example of non-GAAP shenanigans, and point to the fact that for the last several years this adjustment has only increased the company’s EBITDA when it should be decreasing the EBITDA at times as well. Therefore, say the short sellers, this Adjusted EBITDA is fraudulent.

Our View

We believe that a) butadiene is not as volatile and unpredictable as perceived, b) KRA does not eat the impact of the higher commodity pricing for more than a month and c) the Adjusted EBITDA the company reports is actually the most accurate way to value the business on a going forward basis.

The fast move in the price of butadiene is understandable and, we believe, likely going to reverse (it actually recently began to correct). Due to several major ethylene cracker outages, from producers such as LyondellBasell (“LYB”), the price of butadiene began to spike late in 2016. The shortage of supply was further exacerbated by a large spike in natural rubber pricing, causing some tire manufacturers to start using butadiene instead of the natural rubber. We expect that as cracker capacity restarts following temporary closures, the supply and price of butadiene will correct.

But what generally matters to KRA Adjusted EBITDA is not whether the price of butadiene is up or down, but that it remains stable. For 40% of the Polymer segment, the spike in commodity prices is immediately passed through to the KRA customer. For the remaining 60%, there is a lag of 30 days before KRA can increase the price of its synthetic rubbers/chemicals. Therefore, KRA does not need butadiene pricing to drop to return to normalized earnings – the company just needs it to stop going up. Even if the price remained stable at these high levels, the company would regain the earnings power investors expected to see in 2017. Obviously, a sharp correction in the price of butadiene would likewise benefit KRA, with windfall earnings during the reverse lag scenario, allowing KRA to recoup the lost profits during the spike. In fact, spot pricing in the U.S. has begun to come down, dropping ~30% recently as supply returned to the market.

Finally, we believe that the inventory adjustments to EBITDA made by KRA are warranted. Conventional EBITDA for KRA would reflect the price the company is getting for products sold with related COGS reflecting butadiene purchases made months prior. This metric could be very deceiving if the price of butadiene has changed significantly in the interim and cause investors to get an inaccurate picture of what is currently happening in the business. Therefore, KRA presents to the market what EBITDA would be if the units sold were produced using butadiene purchased at current spot pricing. Over time, the 2 metrics would yield the same numbers, the only difference being the Adjusted EBITDA is much less volatile in the interim from quarter to quarter. That allows an investor to see the true earnings power of the business in a given quarter and value future earnings properly.

For good measure, it’s worth noting 2 points. The first is that Q1 2017 guidance for KRA is for Adjusted EBITDA in the range of $60 million - $65 million. Had the company guided EBITDA in the conventional manner, it would have been $90 million to $95 million, driven by selling prices being very high for KRA products that were made with butadiene purchased months ago at much lower prices. So the theory that Adjusted EBITDA is always higher than conventional EBITDA is incorrect. In fact, the slide below (follow the link to a 12/01/2015 8k, see slide 37) illustrates that KRA’s Adjusted EBITDA achieves precisely what management intends.

http://phx.corporate-ir.net/phoenix.zhtml?c=220948&p=irol-SECText&TEXT=aHR0cDovL2FwaS50ZW5rd2l6YXJkLmNvbS9maWxpbmcueG1sP2lwYWdlPTEwNjA0OTY0JkRTRVE9MiZTRVE9NDImU1FERVNDPVNFQ1RJT05fUEFHRSZleHA9JnN1YnNpZD01Nw%3d%3d

Over the course of 15 years from 2001-2015, the delta between conventional EBITDA and Adjusted EBITDA was just $38 million, or just $2.5 million annually. The view that KRA’s adjusted EBITDA is a “fraud” just does not hold water. In fact, it is the best metric to assess fundamentals in the business and value the company.

Valuation

As a diversified chemical producer (with both commodity and specialty/value-add products) with Adjusted EBITDA margins of ~20%, but with 4.4x leverage, KRA is in our view worth at least 7x-8x EBITDA. Using 7.5x our 2018 Adjusted EBITDA estimate of $423m, the stock is worth $50 per share.

Catalyst

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