Description

Quaker Chemical
Short Thesis

Quaker Chemical (Ticker: KWR) is a major supplier of chemical specialty products (oils, greases, and lubes) to the global automotive and steel industries.  The Company has benefited significantly from the seven year upward gains in global automotive and steel production, coupled significant gross margin expansion from key input price declines (primarily crude & mineral oils) that we believe has allowed the business to over-earn over the past two years.  The stock is up about 4x since 2010, versus +2x for the S&P.

Despite potential headwinds from end market slowdowns and price compression, KWR trades outside of its typical valuation multiple band (albeit less so when fully accounting for the in-process acquisition of a sizeable competitor).  We believe the potential from a Trump infrastructure plan has buoyed the outlook for the company, which saw its forward EV/EBITDA multiple increase from ~10-11x EBITDA to +16x post-election through March 2017.  We believe the underlying end market fundamentals and business cash flow characteristics suggest a base case stock price decline of 25-30%.

Furthermore, historically KWR has been underlevered with minimal net debt or even net cash on the balance sheet.  Pro forma for an in-process sizable transaction announced April’17, the business will be ~3.7x levered (~3x levered with fully baked synergies).  This may put unexpected strains on a management team that is relatively inexperienced managing such a high debt burden on top of a major integration with stated synergies representing 40% of the acquired company’s EBITDA.  In addition, should the steel or auto markets truly turn over (think peak SAAR or the subprime auto issues finally coming to a head), or should valuation multiples contract due to a reversal in investor sentiment, this will accentuate the negative share price impact and KWR could quickly become a levered equity with a share base that is long only and not typically prone to loving leverage on cyclical businesses.  

Business Summary

KWR develops, produces, and markets a broad range of formulated chemical specialty products and offers chemical management services for various heavy industrial and manufacturing applications in a global portfolio (North America 45% of sales, EMEA 27%, Asia/Pacific 24%, and South America 4% of sales).  Because the business is global, shifts in regional production are less important (excluding FX impacts) than changes in total global production and demand.  

The Company is the market leader in a variety of industrial niches serving the steel and metalworking markets such as: 1) rolling lubricants (rolling oil) used by steel and aluminum makers; 2) machining/grinding compounds for the metalworking market; 3) corrosion prevention chemicals, and; 4) hydraulic fluids for the steel market.  According to analysts, KWR has a 60% market share in cold rolled steel segment.

The principal products and services in Quaker’s global portfolio include:

1. rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel and by manufacturers of aluminum in the hot rolling of aluminum);

2. corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment);

3. metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing);

4. machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process, achieve closer tolerance, and improve tool life);

5. hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment.

Key Performance data

KWR has demonstrated positive performance since 2010, with EBITDA up ~60% and volumes / sales up ~40%.  With that said, KWR’s market cap and EV have increased about 4.0x / 3.4x, respectively, over the same time frame due to significant multiple expansion.  We point to a few ways KWR has grown outside of organic growth rates across the auto / steel sectors:

1. KWR has pursued a variety of tuck-in transactions ranging from a few million to +$50mm (for a total of nearly $200mm).  Assuming a 6x-8x purchase multiple for these deals, that would add an incremental $25 – +$30mm of EBITDA and would explain a significant % of the incremental EBITDA.  We show the purchase history below (excludes recently announced Houghton transaction), and further we note part of KWR’s strategy is to leverage its distribution channels post-acquisition in a 1+1=3 framework.

2. KWR has benefited greatly from lower input costs over the past 24-36 months, primarily mineral oils (crude-based), vegetable oils, and animal fats.  The chart below illustrates the benefit in margin that KWR experienced starting in Q3/Q4’14.  Gross margin creeped up to +38%, and this has recently started to fall.  KWR previously stated that their long term gross margin target was 35%, however the CEO noted 37% on the last earnings call.  For reference, a reversion to a 35% gross margin would have reduced 2016a EBITDA by 15-20% based on constant sales.  It’s important to note, however, that in a deflationary input cost environment with pushback from customers around pricing, the impact would be much more pronounced as top line would actually fall.  Part of the margin benefit is from crude oil prices contracting, although other inputs are less correlated.

Stock Price & Valuation

Post-election, KWR’s stock price rallied from about $108.00 to nearly $140.00 per share, and then moved to +$150.00 per share following the announcement of a cash/share acquisition of Gulf Houghton Lubricants, Ltd (“Houghton”).  

We show KWR’s historical EV/EBITDA below, which averaged at 10.4x before moving to +16x post-election (note: this excludes multiples after the Houghton deal was announced in early April).  

Houghton Combination

Our hat goes off to KWR’s management, as they capitalized on KWR’s the skyrocketing stock price to get a pretty sizeable deal completed with a comparably sized business and plan to use ~40% stock as currency.  For reference, KWR’s stock is up 60% since June 2016 (50% through March ’17, to eliminate the impact of the Houghton deal)!  

Below are some relevant slides from KWR’s recent investor deck regarding the combination.  Among other items, KWR expects to realize $45mm of synergies.

KWR is issuing 24.5% on a PF basis to Houghton shareholders (unhedged), and assuming Houghton’s outstanding debt. Houghton was previously an LBO with a very different resulting leverage profile.  At current prices, and including assumed debt (based on recent KWR public filings) and $172.5mm of cash paid out to Houghton shareholders, we estimate a 12.6x purchase multiple (ex-fees), or about 9.2x including all synergies (ex-fees and ex costs to achieve those synergies).  

Valuation targeting

To summarize, our premise in this short is that:

1. global auto / steel growth expectations are both relatively lackluster,

2. KWR’s valuation multiple expansion reflects growth expectations that will likely not come to fruition and moreover the business may be overearning based on margin benefits that are not sustainable, and

3. KWR is taking on a lot of debt to swallow a competitor, which may come back to haunt management if the synergies aren’t easily achievable or if suddenly the business falls off the rails and becomes a levered equity with anxious shareholders.

KWR could continue to rally, but in our mind we think the downside potential from here outweighs the upside.  We show a few cases below:  to keep us honest, we show a case where KWR sees a 3% topline growth, some margin expansion, interim CF generation and a 13x multiple.  This clearly isn’t good for the short, resulting in a +20% gain from current, although it requires a fair amount to go right including a full realization of synergies.  

In our base case for the short, we are targeting a 10.5x multiple with a slight decline in margins (essentially on par with Q2’17 margins, which management thinks are low).  We think topline is up slightly, and EBITDA is down about 9% vs. the PF #.  This leads to a stock price comparable to where KWR traded prior to Trump being elected.  In our bull short case, we see a 10x multiple, flat top line vs. ’16 PF, and a nearly 18% decline vs. PF’16 EBITDA through lower margins.  This results in a +60% gain on the short (with a stock price that basically returns to where it was last summer).

Possible Kicker: We believe a portion of the growth has been seen due to taking competitor share. We think some of that share may have come through Houghton possibly cutting off an avenue for incremental growth. If this is the case we could quickly see this revert even further to multiples significantly below our chart (again the leverage here will most likely help as well on the way down).

Comps

Catalyst

Mainly its an earnings deceleration story which we believe will most likely be tied to SAAR