Description

Kraton is an underfollowed specialty chemicals company in the midst of closing a transformative M&A deal, which is expected to result in $4 of FCF per share, implying a PF trading multiple of [5x] 2014E EBITDA including cost synergies.  Sell side analysts have largely ignored the stock due to its smaller size and historically volatile GAAP earnings.  The Company uses a FIFO method of accounting, which masks the true profitability of the Company due to volatility in raw materials pricing which are passed through to customers.  However, normalizing for FIFO accounting, the Company generates significant cash flow on a stand-alone basis and trades at 7x EV/LTM EBITDA or 10x FCF.  PF for the transaction, at $4 of PF FCF per share and a valuation multiple of 12x suggests the stock is a close to a double at current levels

Kraton was written up on VIC by Marlowe in June ‘11.  Our thesis today is different today -- namely, (a) we believe that investors need to look at normalized earnings (adjusting for FIFO) to understand the true earnings power of the business; and that (b) the acquisition of LCY is highly accretive and adds the scale required to put KRA on the radar

Business Overview:

Kraton Performance Polymers (“Kraton” or the “Company”) is the world’s largest producer of styrenic block copolymers (SBC).  The Company has a broad portfolio of polymers that are used in a wide variety of applications including the following:

• Adhesives, Sealants and Coatings (~36% of sales): tapes, labels, non-woven and industrial adhesives, clear sealants and industrial coatings, protective films for industrial and consumer applications and lubricant additives

• Advanced Materials (~27% of sales): Consumer disposable and consumer durable soft-touch products, engineering thermoplastics, personal care items, PVC alternatives for medical packaging, wire and cable, automotive interiors, coated fabrics and flooring disposable food packaging and closures, highly engineered polymer modification

• Paving and Roofing (30% of sales): Asphalt modification for performance roadways, bridges and airports, asphalt modification for roofing felts and shingles

• Cariflex Isoprene Rubber (7% of sales): Surgical gloves, condoms, catheters, medical stoppers and needle shield covers, consumer products, cold-seal adhesives for food products, electronic industry applications

Kraton’s products are broken into two categories, unhydrogenated stryenic block copolymers (USBC) and hydrogenated stryenic block copolymers (HSBC):

• USBC (59% of sales): Represents the majority of worldwide SBC production.  Primarily used in paving and roofing, adhesives, sealants and coatings and footwear applications

• HSBC (31% of sales):  Significantly more complex and capital intensive to manufacture than USBCs.  Primarily used in applications such as soft touch and flexible materials, personal hygiene products and medical products

Standalone KRA -- and the impact of BD on normalized margins:

KRA is a former Shell spin-off and has since been owned by Rippewood, TPG and JPM.  KRA went public in 2009 and has successfully changed its pricing strategy to take advantage of structural changes in the butadien market -- Marlowe’s write up does a great job explaining this

The company’s primary COGS is butadiene, which is a by-product of the steam-cracking process used to produce ethylene and is closely correlated with crude prices.  Butadien has experienced significant price volatility driven by supply disruptions, which has played havoc with KRA margins.  The reality is that KRA is able to pass on the majority of price fluctuations to customers, and its margins are nowhere near as volatile as GAAP results suggest.  While top-line growth has been spotty, the big driver of earnings is gross profit on a LIFO-adjusted basis.  As an example:

Although the sell-side generally understands the volatility of FIFO accounting, the general view is that the company is too small and under the radar to bother forecasting out the LIFO spread, and as a result, the street and investors typically focus on GAAP / FIFO earnings

Transaction Overview -- strategic and accretive deal that will put KRA on the radar:

Kraton is merging with the 3rd largest global SBC producer to to create an industry leader in SBC with $2+ billion in revenue.  The deal is effectively structured as an asset for equity swap, with LCY Chemical Corp. (“LCY”), a Taiwan-based and listed chemical company combining its SBC operations for 50% of the newly formed combined entity

LCY is a large specialty chemicals company with 6 other BUs in addition to the SBC business being merged with KRA.  LCY’s SBC business has ~$600M in revenue and operates at a cost advantage  in the industry due to a low-cost operations footprint and material sourcing capabilities.  LCY recently completed a 100KT expansion of nameplate capacity in China in June 2013 to drive further scale efficiencies, which represents over 20% of the Company’s total capacity now at 490KT.

Pro forma for the transaction, the Company is expected to generate $4 of Free Cash Flow per share.  The merger provides Kraton with a cost-efficient manufacturing base with strategic sourcing of raw materials in Asia, a high quality asset base with 100 kT of nameplate USBC capacity, and better access to fast-growing markets (~33% of revenues in APAC vs. ~10% today).  The deal is expected to be accretive to KRA, with Kraton targeting $65 million of cost synergies to be captured within 3 years (3.5% of target revenues).  We believe this is conservative relative to ~7%+ of revenues typically targeted as cost savings in other chemicals M&A.  Furthermore, Kraton will receive the full year benefit from the recent capacity expansion at LCY.  The Company is expecting accretion of $0.75-$0.80 of additional EPS in the first year. .  The merger is expected to lose in Q4 2014

KRA has a pretty good presentation laying out the details of the merger: http://www.kratonasia.com/wp-content/uploads/2014/01/Kraton_LCY-SBC-Investor-Deck.pdf

Risks:

-- Holdup to LCY transaction

-- Further butadien volatility with negative impacts to margins

Catalyst