Description

Executive Summary

You can take the blue pill or the red pill. With net debt equal to 196x LTM adjusted FCF, PAH’s $3 billion equity value almost entirely reflects speculative value. An informed buyer would not pay more than $0.50 per share for PAH (95% downside).    

PAH was written up 3 times on VIC; twice as a long and once as a short. 

Company Description

PAH is a specialty chemicals company whose revenues are split evenly between its two segments: Agricultural Solutions and Performance Solutions. Its end markets include agriculture (50% of revenues), electronics (20%), automotive (10%), industrial (10%), consumer packaging (5%) and offshore energy (5%). Note that the vast majority of its end markets are cyclical. PAH started out as a SPAC, and IPO’d in the U.K. in May 2013. With the $881 million it raised, in addition to subsequent debt and equity offerings, it quickly went to work buying 6 specialty chemical companies for over $9 billion in total.

There is a simple demarcation between the bull and bear case on PAH; bulls look at the income statement, and bears look at the cash flow statement and balance sheet. I will lay out the bull and bear cases in as neutral a fashion as I can, given my obvious bias.

The Bull Case (aka the “blue pill”, aka blissful ignorance)

PAH is collection of good businesses. The Company is an asset-light/high-touch specialty chemicals provider. Its products make up a small fraction of the cost of the end products they go into, and the company does not typically face pricing pressure (however, it does not benefit from pricing power either). In 2017, PAH generated 4% organic constant currency revenue growth and 7% Adjusted EBITDA growth. For 2018, management gave guidance for low-to-mid single digits revenue growth and 6% to 9.5% Adjusted EBITDA growth.    

Largely due its high leverage of 6.2x net debt/2017 Adjusted EBITDA, PAH trades at just 9.9x EV/2017 Adjusted EBITDA and 9.2x 2018 Adjusted EBITDA. Management paid between 10x and 14x EBITDA for the 6 acquisitions that make up PAH, so one can buy these assets at a discount to private market value.  PAH’s undervaluation is confirmed by the public and private market valuations of its peers. FMC Corp. (FMC), which trades at 11x EBITDA, is the closest public comp to its Agricultural Solutions segment. While there are no good public peers for its Performance Solutions segments, the best comp was recently LBO’d. In late 2016, Carlyle Group announced that it would purchase Atotech, a division of Total S.A., for 11.5x EBITDA.

PAH’s Chairman, Martin Franklin, generated strong returns for shareholders at Jarden Corp. through a similar leveraged M&A strategy. Assuming 8% Adjusted EBITDA growth in 2018 and 2019, just $100 million in FCF per year, and a valuation of 11x EV/EBITDA at the end of 2019, PAH offers 85% upside, or a 42% IRR over the next 1-3/4 years. Management has taken steps toward a partial IPO of the Agricultural Solutions segment in order to accelerate deleveraging and unlock shareholder value; although, on the most recent call, management somewhat backed away from pursuing this transaction.    

Every value investment has some degree of hair on it, otherwise a large value gap wouldn’t exist. In PAH’s case, the only negative is the leverage, as the business and management are strong. PAH’s leverage will diminish over time, making PAH an attractive investment for long-term investors.

The Bear Case

PAH falls into the investment category I call financial statement arbitrage. The income statement looks great, while the balance sheet and cash flow statement are quite ugly. Before I get into the two financial statements that the sell-side and the bulls ignore, I’d like to take a step back and talk about the income statement, and why it can be misleading in some cases. 

EBIT Blah

A company’s FCF generation can often be jagged—up one year, down the next—making financial analysis difficult. GAAP accounting was developed to make analysis easier by matching revenues and expenses, and essentially smoothing out the lumpiness of FCF. Since the only difference between the accounting of items and their actual cash inflow/outflow is timing, cumulative FCF and GAAP net income should match each other rather closely over long periods.

Using GAAP net income instead of average FCF works fine in the vast majority of cases, but the leeway GAAP gives to management in making assumptions can sometimes lead to large differences between net income and FCF which never true up. This is probably the #1 flag for an accounting fraud.

EBITDA was introduced in the 1980s by investment bankers in LBOs to make leverage multiples appear lower. The use of EBITDA has subsequently expanded far beyond its original use and is virtually ubiquitous today. Munger and Buffett have expressed strong views against using EBITDA, with colorful Charlie calling it “bullshit earnings” and diplomatic Warren writing, “When Wall Streeters tout EBITDA as a valuation guide, button your wallet.” (BRK 2013 annual letter).

More recently, Adjusted EBITDA, which adds back all one-time charges, including stock-based compensation in some case, became the norm, making it ever “easier” for investors to understand the underlying earnings power of a company. What a tangled web we weave…

If I sound like a purist who calculates FCF over the prior 10 years and inflates the average to incorporate future growth…well, I’m not. While I prefer FCF, I actually use Adjusted EBITDA for valuation purposes in many cases. However, I’m very aware that it is a short cut for reality, and I make sure that it is backed up by FCF.  I’ve found that using EBITDA in such cases is fine. After all, the name of this game is to be approximately right rather than precisely wrong.    

What happens when popular Adjusted EBITDA tells a rosy story, while orphaned FCF is sounding alarm bells that no one hears? This is the story of PAH.         

EV/Adjusted EBITDA vs. EV/FCF

What if you were born in a world where everything was the same as in this world, with one exception: everyone drove their car in reverse. People drove down streets and highways in reverse, looking through the rearview mirror. When people would “back it up” they’d put it in drive. There would be far more accidents in this world, auto insurance rates would be much higher, there would be a lot more injuries and deaths, but life would go on. Now let’s say a friend, without telling you where he’s taking you, brings you to a secret meeting of the Forward Driver’s Society. These people drive in drive. But they only do it at night or on empty streets because driving in drive means you’re crazy and a menace on the road. The Forward Driver’s Society has lots of statistics proving that driving in drive is far safer and results in much fewer accidents, but they’ve convinced very few and are seen as the crazies of this fictitious world.    

Using EV/Adjusted EBITDA is a lot like driving backwards; it can work but it results in a lot more accidents. Enterprise value, the sum of net debt and equity market value, is a cash number. Adjusted EBITDA is a non-cash number. This apples and oranges valuation metric is a bit problematic. But just like the reverse driving world, life can still function. 

EV/FCF uses two cash numbers. The denominator can be used to reduce the numerator by paying down debt or by buying back stock (I have yet to see a company do the same with Adjusted EBITDA). EV/FCF results in fewer accidents. It’s logical. It’s apples and apples. Welcome to your first meeting of the Forward Driver’s Society.   

The “red pill” (aka the brutal truth)

Let’s look at PAH’s cash flow statement.  In 2017, PAH generated $182mm in CFFO. We need to make a few adjustments to see how much cash the business actually generated.

(1)   In 2Q17, PAH factored $43mm in receivables in Europe (the company has continually factored U.S. receivables, which I’ll assume were flat in 2017 and 2016, but European factoring was newly implemented).  I subtract this number from CFFO. 

(2)   In 4Q17, PAH made a $44mm make whole payment to refinance debt.  I add this back.

(3)   PAH did three debt refinancings, from late 2016 to early 2017, which reduced its cash interest expense by $37mm in 2017 ($323mm in cash interest) vs. 2016 ($360mm). Meanwhile, net debt actually increased at year-end 2017 ($5,071mm) vs. year-end 2016 ($4,913) as there was little FCF and the USD value of European debt increased as the USD declined. I subtract the $37mm in interest savings from CFFO because this savings was generated through debt refinancing, and I’m trying to isolate how much cash flow the business produced.

(4)   In June 2017, a division of PAH settled litigation with DowDuPont and received a $20 million payment which was booked in CFFO.  I subtract this non-operating number out.

Adjusted CFFO was $126mm, and after subtracting $100mm in Capex and Product Registration expense, 2017 FCF, generated by the business, was just $26mm or $0.09 per share.

When looking out at 2018, I add back the interest savings from debt refinancings as this savings is real and will benefit FCF going forward. Starting with $126mm in 2017 Adjusted CFFO, I add back the $37mm in cash interest savings in 2017 and an additional $23mm in savings in 2018 from the most recent refinancing (in other words, 2018 FCF will be $60mm higher than in 2016 due to 4 debt refinancings). Management now has to continue factoring European receivables, as it does in the U.S., or cash flow will drop. I’ve assumed they do $43 annually, so I add this back as well. Capex and product registrations should remain at a combined $100mm annually. 2018 cash taxes are expected to be $10mm higher at the midpoint of guidance. All told, this results in 2018 FCF of $119mm, or $0.40 per share. This is a best-case scenario as working capital is a use of cash as PAH grows revenues, and I have assumed flat w/c.

What would an informed buyer pay for PAH?

PAH is clearly over-leveraged. Any buyer of the entire business would have to allocate a large percent of FCF toward debt reduction, with the remainder being the only return the buyer would get. FMC’s maximum leverage over the past 10 years was 3.5x (before making its most recent acquisition, which took it to 4.5x). 3.5x may be on the high end but is a relatively safe leverage target for a business like PAH. 2017 results for PAH are close to a cyclical peak, but since the business has long-term growth let’s assume 2017 results reflect mid-cycle earnings going forward. PAH’s net debt/2017 EBITDA is 6.2x. In order to get it down to 3.5x, net debt needs to come down by $2.9 billion.

While PAH has benefitted from the recent debt refinancings that lowered cash interest, the reverse will likely be true in the future. After a 30-year bull market in bonds, it would not be smart to bet that PAH can continue to refinance its debt at current rates. Cash interest expense likely has an upward bias looking out longer term. For this reason, a buyer of the business would want to deleverage the balance sheet as quickly as possible and allow a margin of safety for higher interest rates down the road.

Assuming the $119mm in 2018 FCF is sustainable (we’re calling this mid-cycle FCF), and debt needs to be reduced by $2.9 billion, a smart buyer would allocate around $100mm annually toward deleveraging and would take home $19mm. (Assuming 2017 EBITDA is mid-cycle, deleveraging through EBITDA growth will not happen). This $100mm in cash flow needs to be applied toward debt reduction for the next 29 years.

Over this time frame, interest rates will likely rise, possibly substantially, resulting in higher cash interest expense and lower FCF. The 2 biggest pieces of PAH’s debt structure ($1.1 billion each) mature in 2022 and 2023. There is the real possibility that higher cash interest expenses will cut into FCF, prolonging the 29-year deleveraging period, or even cutting into the $19mm annual cash return to the owner. To incorporate a margin of safety for this potential, a buyer would want to capitalize that $19mm FCF stream at a conservative multiple. 5x would fit my risk tolerance, but let’s say PAH can find a buyer with a higher risk tolerance who pays 8x FCF. PAH’s fair value, to an informed buyer, would be $152mm, or $0.50 per share.       

An inch away from a covenant violation

PAH’s covenant Adjusted EBITDA incorporates future synergies however, PAH is far along into the integration of its acquisitions and has just $10mm in synergies left to capture. Adding this $10mm to LTM EBITDA, results in covenant leverage of 6.1x, compared to a maximum requirement of 6.25x.    

PAH’s seasonality is such that it burns cash in Q1 and spends the rest of the year digging out of the hole. In 1Q17, PAH burned $148mm in FCF. I expect the 1Q18 burn rate to be higher given w/c expansion. Assuming 10% Adjusted EBITDA growth in 1Q18 (I think management will pull all the stops to maximize this number; in other words, low earnings quality), PAH’s LTM covenant EBITDA would be $850mm. At 6.25x, PAH’s maximum net leverage would be $5,314, compared to $5,071 at 4Q17, for headroom of $243mm. Assuming PAH burns $150mm in Q1, its headroom falls to just $93mm. $1.8 billion of PAH’s debt (36%) is euro-denominated, and the euro weakened by ~3% in 1Q18 against the dollar, giving PAH an additional $60mm in headroom, so it looks like they’ll survive Q1. But a modest strengthening of the euro against the dollar going forward will put PAH in violation.

This is why management back-tracked on the partial IPO of Agricultural Solutions on the Q4 call, as IPO proceeds would be a restricted payment and PAH would need permission from its lenders, possibly in the context of a covenant violation discussion, to move forward. I’m indifferent as to which path management takes as there’s no free lunch: a partial IPO of Ag. would accelerate deleveraging, but at the expense of substantial shareholder dilution.     

Risks

PAH is heavily shorted at just under 9 days. Squeezes have occurred in the past and can occur again. However, I don’t see how PAH gets out of the deep leverage hole that it is in, other than through a reorganization process.

Catalyst

-  

-          1Q18 cash burn.

-          Potential covenant violation later in the year.

-          Cyclical decline in PAH’s end markets.

-          Mr. Market finally comes to a meeting of the Forward Driver’s Society.