Description

Investment Overview

• Distributors are highly variable cost businesses, require minimal capex, and enjoy countercyclical working capital benefits which boosts FCF in a downturn. Equates to highly resilient businesses with good ROIC

• Nexeo has underperformed distributor peers on profitability, but business was starved under ASH ownership. TPG invested in the business to improve profitability and we are now at the inflection point of earnings

• Street has not given much credit to future profitability prospects, essentially ignoring progress to date (~250 bps of gross margin expansion since 2012) and large delta to peers leave long room for improving profitability and earnings growth

• Past 2 years of earnings have been negatively impacted from price declines in major key products such as polyolefins (specifically polypropylene) and hydrocarbon derivative chemicals that have declined with crude. As we lap these declines & witness some inflation or even just more volatility in raws, Nexeo should benefit

• Nexeo trades at a steep discount to peers. Improved performance will allow for valuation gap to close.

• I see 77% upside on the stock using 10x my 2018e EBITDA, but see ~250% upside on the warrants (granted, illiquid). The warrants obviously offer the most leverage to Nexeo closing gap to peers.

 Note: in the table above I use the warrants out and the price. Market cap, etc. are all based on the common stock. 

Background

Nexeo is the plastics and chemicals company from Ashland (ASH) that was bought out by TPG. It sits at #3 globally in chemicals and #1 position in plastics

• ASH completely starved this business.

• While allocated $27MM of capex from ASH, mgmt. told us that $3mm was spent on 40+ facilities upkeep per annum.

• New mgmt. told us they visited warehouses that were marked “At capacity” when in reality they just didn’t have vertical stacks for pallets and inventory was so jammed in there that nothing else would fit. In reality, they were less than a third utilized.

• TPG bought the business in 2011 but needed to invest in the business from a) a facility standpoint and b) an IT infrastructure standpoint

• As an aside, mgmt. and primary contacts point to ASH’s systems as the best. I just have indigestion with that since they have the lowest margins compared to UNVR and Brenntag

• Wilbur Ross has now entered the picture when his SPAC acquired the company for 9.1x 2016 EBITDA.

• Pitch for the acquisition was i) hugely fragmented industry which can be consolidated ii) opportunity to get new supplier wins to expand distributions share of the market for chemicals (~10% today vs. 35% for steel, 90%+ for roofing materials, 85%+ for pharma, etc.), and iii) high ROIC business.

• Yes, Wilbur will leave the board with the Trump nomination, but has installed a solid board.

Investment Thesis

• Nexeo has underperformed distributor comps on profitability, but street is ignoring improvement to date (it hasn’t been a straight line and Q-to-Q can be a challenge)

• Opportunity comes from missing estimates early on while also being a SPAC, which are notorious for underperformance.

• Despite having a good mgmt. team coming into place, investors initially were sold much higher EBITDA targets on the deal.

  • Chemical and plastic numbers have remained low and that is largely out of mgmt’s control.

  • Possible that higher #’s were put out so that the deal would be voted for by SPAC shareholders.

  • First time as a public company with guidance. “Ambitious” with putting 2017 numbers out in early 2016

  • In reality, a distributor does not have much visibility into his order book a year out & raw material pricing is important, so just take guidance with a grain of salt. (Doesn’t change the fact that the stock is too cheap! Which I am getting to…)

• Fiscal year 2016e EBITDA was projected to be $195MM and 2017e was $213MM.

• We were in May when this came out with a 9/30 fiscal year, so actual results of $173MM vs. $195MM was a big miss.

• The stock declined and now sits ~$9.2 vs. the SPAC price of $10. Nexeo now trades at 8.4x ’17 EBITDA vs. 11.7x for UNVR and 11.7x for Brenntag and 11.7x for the median of my distributor comp set listed below. As can be seen, distributors in other sectors also trade at 11x+ EBITDA. This is a major value discrepancy.

• Street has not given credit for margin improvement to date. Given how much mgmt. had to reinvest the business over the past few years, it is optimistic to see the GP margin increasing. EBITDA margins too have stepped up from the 2-3% range to the 5-6% range.

• While there has been good improvement, Univar and Brenntag’s GP margins exceed 20% so there is still a long runway ahead.

• Improvement in margins to date has been achieved DESPITE major price declines in products. Recall most of these products are a crude derivative and most have fallen 40-60%, like crude. And as we all know, distributors are most profitable in inflationary markets.

• The ability to manage GP spread in declining price cycles is very important and the street has given no credit. Importantly, profits in general should improve more in an inflationary market, which I expect given where prices have trended recently.

• Taken from the 4Q earnings call: “we are starting to experience some pricing volatility and demand is showing some signs of improvements as year-over-year cost of oil and gas improve. The return of volatility and improvement in overall industry dynamics is a very positive trend.”

• One other thing to mention is that sales declined 12.5% and 13.8% for FY’15 and FY’16, respectively mainly do the price declines plus volume given the industrial recession we were in.

• What the street typically misses is a V-shaped recovery. An industrial recovery doesn’t typically have a decline like that and then 2 years later have flat growth. Typically, cycles see “snap backs” (even oil doubling off the bottom in February 2016 should make for easy comps in Q1). However, that’s a finger in the air and hard to justify with hard figures except for history.

• There should eventually be a recovery, like oil in my view and 2017 could be an inflection point

• http://www.plasticsnews.com/article/20170130/NEWS/170139979/pp-prices-start-2017-with-a-big-increase

• However, being rather conservative using ~4% CAGR over the next 2 years for the top line, plus a 80bps of gross margin improvement (still well behind peers), I can easily see this business getting to $232MM of EBITDA for FY’2018.

• Using a 10x multiple, I see the stock trading up to $16.4 for 77% upside, which foots to a 6.1% FCF yield.

• I use 89mm shares + 12.5mm founder shares, 1.5mm PSU awards + 10.6mm from warrants for a total share count of 113.9mm

• Note that I do not give much credit for chemical distribution gaining share, which is a major talking point - major chemical players (LYB, DOW, DD. among others) have said they were not looking to increase distributed products.

• I will say that all the mergers and spin-offs of chem companies (Dow/DuPont will create 3) does create an opportunity for more CEOs to turn to distribution, however.

• While I like the stock, I like the warrants better, however. The stock at $16.4 implies a warrant value of ~$2.45 for 255% upside from todays levels.

• Each warrant is for half a share. So $16.4-$11.5 / 2 = $2.47 vs. current price of $0.69

• The warrants do not expire until June 6, 2021

• You can argue, but I don’t use a Black Sholes model for these.

Why does this opportunity exist?

• SPAC trading typically is poor after close of a deal. Acquisition accounting with stepped up inventory, amort, predecessor / successor accounting can cause some confusion from underlying results.

• Mgmt sold the deal on lofty targets

• Still trading on depressed earnings

• Sell side missing upside opportunity in margins + progress to date

• One sell side report even cited Nexeo’s leverage was 7.8x. Totally incorrect! Its under 4.5x on mgmt’s numbers.

Catalyst

• Continued improvement in profitability metrics tightens valuation gap with peers
• Raw material environment provides for improved earnings above street expectations