Description

PQ Group Holdings ("PQ") is an orphaned IPO with significant potential upside from a few different alternatives - partial or full sale, equity growth via debt reduction and more investor recognition. The stock is down 20% from its 2017 IPO and 15% year-to-date. At current prices, shares trade at 8.9x EBITDA and 11.3x EBIT (maintenance capex) on 2018 numbers. The FCF multiple is ~12x on full capex or ~9x using maintenance capex.

After a few LBOs, the company came public in late 3Q 2017 at a price of $17.50, below the initial range of $21-$23/share. This compares to a current share price of $14.02. The public float here is small as the sponsors (CCMP and INEOS) and other investors continue to own ~70% and management holds ~5%.

Business Description

Previously, PQ and Eco Services combined to create a leading global producer of inorganic specialty materials and catalysts. Both were portfolio companies of CCMP. PQ is split into two segments: Environmental Catalysts and Services (38% of sales / 50% of EBITDA) and Performance Materials and Chemicals (62% of sales / 50% of EBITDA).

Environmental Catalysts and Services ("ECS") produces catalysts for refineries, emissions control (for engines) and petrochemical players. These catalysts are highly technical and customized and often require long lead times to develop. Within this segment, there are three sub-segments - silica catalysts, zeolite catalysts and refining services.

Silica catalysts aid in the production of HDPE (high density polyethylene) which is used for strength and stiffness in packaging films, containers and other molded applications. PQ also produces a catalyst for MMA (methyl methacrylate) which is used to make acrylic plastics or scratch-resistant plastic that is substituted for glass and used in cell phones, tablets, furniture and for automotive components. Demand here is tied to chemical production.  

The Zeolite unit operates via a joint venture with Shell. Zeolite catalysts target diesel emissions (removes NOx) in both on-road and off-road diesel engines through selective catalytic reduction. This allows customers to meet stringent environmental standards. Other catalysts within the Zeolite group include hydrocracking, aromatic catalysts and paraffin isomerization (upgrading olefins to high octane blending components).

Lastly, ECS provides recycling services through regeneration plants (8) to refiners who use sulphuric acid in their alkylation units (increases octane in gasoline while lowering vapor pressure as required by turbo charged engines to meet efficiency standards). These facilities are often integrated with customer sites with contract duration of 5-10 years. This allows refineries to cost effectively manage spent acid for reuse. This unit process also produces virgin sulphuric acid and sodium bisulfate for water treatment, mining and general industrial uses. The company estimates market share in excess of 50% in the US.

Competitors include WR Grace, BASF, UOP (Honeywell), Albemarle, Tosoh, Axens and Haldor Topsoe plus Chemtrade and Veolia in refining services.

Performance Materials and Chemicals (“PMC”) consists of silicates and specialty materials used in cleaning products, fuel efficient tires, surface coatings and food & beverage.  There are two sub-segments within PMC – Performance Chemicals and Performance Materials.

Performance Chemicals includes sodium silicate products and derivatives used as absorbents, clarification agents, precursors and additives to enhance product performance. Silicates are derived from industrial sand and soda ash for use in consumer products, cleaning products, construction materials, food & industrial products and tires. The sodium silicate market is regional as high water content increases the cost of shipping long distances. PQ estimates its market share is ~3x the nearest competitor.

Performance Materials captures the company’s specialty glass products. These microspheres (engineered glass beads) are used as reflective markings on roads and runways to improve visibility at night and during periods of bad weather. PQ is a leader in the highway safety market with 4x the market share of its nearest competitor. Other products in this sub-segment include additives in plastics for light-weighting and cleaning, in paints and coatings for thermal insulation and to improve lubrication and in oil drilling fluids.

Competitors include OxyChem, PPG and Evonik.   

The total business is split between North American (60% of sales), Europe (22%), Asia (10%), ROW (4%) and South America (4%). Sales by end-market are as follows: Fuels & emission controls (21%), consumer products (16%), highway safety & construction (17%), packaging and engineered plastics (17%), industrial process chemicals (21%) and natural resources (8%).

Capital Structure

As a consequence of its LBO history, the capital structure is debt-heavy, although debt should continue to decline. Total leverage is ~5x in 2018. Management’s targeted goal is 3.0x-3.5x. Furthermore, the company should be able to refinance its 6.75% senior secured notes at a lower interest rate as the bonds trade at 105. At 75 bps cheaper and $125 million lower from debt repayment, I calculate savings of $12 million annually.

Shares outstanding total 135 million. Ownership is split between CCMP (45.8%), Ineos (24.3%), other investors (3.3%), management (5.2%) and public float (21.4%).

Guidance

For 2018, management is guiding to sales and EBITDA growth of 5%-7% and 4%-8%, respectively.

Free cash flow is bracketed at $120 to $140 million and the company intends to repay debt, invest in high growth projects and look for tuck-in acquisitions. I think this guidance will prove conservative.

Thesis

As an orphaned and somewhat unknown IPO trading well-below the initial price, I think you have the opportunity to create a good business at a discount to competitors and cheap on absolute basis. PQ generates ~90% of revenue from products with #1 or #2 market positions. These leading products consist of mostly additives, catalysts and services that constitute a small portion of customers’ overall end product costs yet are critical to performance. Oftentimes, PQ develops these complex formulations in concert with customers and over the course of many years.

Growth at 2x GDP is targeted due to existing end-market expansion, secular demand trends (emissions control and fuel efficiency, plastic mix gains, environmentally-friendly products and highway safety) and new initiatives. PQ is in the early innings in harvesting the benefits from new products with promising growth characteristics as evidenced by its vitality index measure (sales from products <5 years old) which was up 30% in 2017.

There are several tailwinds at play in ECS that should drive growth. The global transportation network (trucks, rail, ships and air transport) is targeting lower sulphur fuels across the board. In anticipation of this ongoing trend, the Zeolite JV has two new plants coming line in late 2018 and early 2019. The silica catalyst outlook benefits from new HDPE capacity starting up over the next several years. Lastly, the regeneration services sub-segment should see incremental demand from new alkylation projects in 2020-2022 and increasing premium gasoline consumption. Mix benefits from accelerated growth in the ECS segment relative to PMC should drive overall margins higher over time.

Within silicates, there are several positive trends. These include environmentally-friendly personal care products and increasing demand from developing countries for products such as whitening additives for toothpastes. Additionally, there is growth in precursors for green tires which improve fuel efficiency by enabling lighter vehicles, allowing tires to roll and engines to run with less friction. Finally, the ThermoDrop product in the road marking business provides a superior alternative ($0.5 billion market) and the recent Sovitec deal adds European and Latin American exposure.

Management is focused on de-levering which could result in multiple expansion as leverage appears to be an overhang. Recent investments + synergies (Sovitec acquisition) and new product development should show up in 2018 and 2019 numbers. Additionally, we should see some benefit from a lack of ThermoDrop start-up costs (end in 2017), announced pricing increases (silica +6% from a competitor) and hopefully not a repeat of Hurricane Harvey which negatively impacted sales and EBITDA by $8 and $7 million,.

Valuation

Based on my numbers, PQ trades at 8.9x EBITDA, 11.3x EBIT (using maintenance capex) and ~12x FCF. Rolling these numbers forward to 2019, I calculate ratios ~8x, ~10x and ~10x. This screens cheap for a business growing mid-single-digits and a potential take-out candidate. The sponsors could easily seek a sale down the road as performance improves and if the shares continue to trade at a discount to intrinsic value.

For reference, specialty chemical names trade at ~10x forward EBITDA. In terms of private market value, WR Grace recently purchased Albemarle’s polyolefin catalyst business for a reported 12.8x EBITDA (or 9.6x with expected run-rate synergies). At 10x 2019 estimated EBITDA, I calculate a low $20s share price or even higher in a takeout assuming the buyer pays for some of the potential synergies. This is before factoring in the value of NOLs of $383 million and intangibles from business combinations (stepped up basis at Eco Services pursuant to 2014 acquisition) of $671 million as of the end of the 2016.

Catalyst

-Takeout

-Debt reduction

-Cash generation