Description

Short Framework

Leveraging balance sheet to buy an organic decliner during the late stage of an industrial cycle + trading at peak multiple (30x + 2020E EPS) + technical selling pressure to come from large non-strategic shareholder + free optionality on this deal falling apart (which will make the valuation even more egregious)

Short Thesis

KWR trades at a recurring-revenue-software-like valuation despite beng an industrials company with stagnant end markets and late cycle risk. Meanwhile, it is in the "middle" of closing a transformative deal that will load up the company with debt to acquire a deteriorating asset where no financial disclosure has been given for the past ~2.5 years. Most KWR shareholders are long-only's, index-closeters, or momentum chasers who are complacent about the financial trajectory of the asset being acquired -- they could very much face a day of reckoning when management gives the true picture of the acquired asset if and when this deal ever closes. There is also a chance that this deal falls apart given how much of a struggle it has been to get approval from FTC and EC, and that outcome will further demolish the stock given KWR wouldn't be able to reap the pro-forma cost synergy benefit associated with the deal. 

Background

Quaker Chemical is a global manufacturer and marketer of specialty chemical products for the automotive and steel industries. For more background information on 1) what this company does and 2) why it decided to acquire Houghton, please see HoneyBadger's write-up from almost 2 years ago here:

https://www.valueinvestorsclub.com/idea/QUAKER_CHEMICAL_CORP/5235816999

HoneyBadger also pitched it as a short back then, with the thesis focusing on 1) potential over-earning (on gross margin %) as KWR was benefiting from key input price declines in a low oil price environment and 2) expensive valuation paired with a leverage-inducing transaction while end markets were showing signs of slowing.  

The stock has rallied ~60% since then, as KWR demonstrated its margin resiliency across a full commodity cycle (the over-earning short hypothesis is broken by now and management fully believes it can maintain current GM % level if not improving it slightly going forward given ability to raise price to offset any input cost headwind (lubricant is a small cost as % of metalmaking process so the customers don't push back on price much). Further, KWR showed it could grow at above end market growth rates over the past 2 years given its high-touch sales model allowing it to further gain market share. Multiple has only expanded even more to outrageous levels. I believe this backdrop actually sets KWR up as a timely short RIGHT NOW.

Elaborated Short Thesis Points

1) A decent amount of Quaker's recent operating strength came from Houghton. Yes, legacy Quaker/KWR has been growing at above its end market growth rates (KWR has been churning out ~MSD % organic revenue growth for the past 2 years compared to end market volume growing at LSD %, but I believe this very much came from taking share from Houghton, the company it is levering up to acquire. Essentially the company is "taking share from itself", but shareholders aren't exactly aware of this dynamics given Houghton's (target) financials haven't been updated for more than 2 years. From speaking to industry consultants and former executives at Houghton, I believe Houghton's own operating performance has been deteriorating over the past 2 years. Here is what I have gathered:

• Houghton was purchased by the Hinduja family (Indian conglomerate) from private equity in late 2012, and it was flat organic growth at best pre-Hinduja deal, built with a lots of bolt-on M&A (typical PE playbook)
• Hinduja's investment angle wasn't operational enhancement but rather they are traders/financial engineers, levering up the company hard during a time economic recovery was soft. Frankly, Hinduja's deal due diligence was all wrong around raw material cost synergy opportunity with Gulf Oil (another asset owned by Hinduja) -- nothing ended up materializing there
• During Hinduja's ownership, Houghton further shrank (both revenue and EBITDA) globally and lost a few critical accounts in various market segments
• After the announced acquisition by KWR, Houghton has lost further business and has been bleeding a bit. Sales process created frustration and insecurity such that Houghton has had major salespeople leave, and definitely lost market share

2) There could be revenue dis-synergy, leading to a slowdown in market share gain

• Previously, KWR and Houghton were the two major players who were focused in this industry. Customers want some form of competition so they can keep each other in check. Since this deal got announced, big key customers are not thrilled at the idea of getting stuck with one big supplier
• The pro-forma entity is likely vulnerable to hold onto its current market share as it gets viewed as the "big evil giant", customers may start seeking out alternatives to maintain competitive tension
• Mgmt has been pitching the story of revenue synergy (unquantified amount) given KWR has some accounts that Houghton has never worked with and vice versa, but mgmt has given no indication of potential dis-synergy
• Case in point, Houghton needs to divest a portion of its business (slightly less than 10% of its revenues) to a buyer in order to get through anti-trust process. As a result of this, even legacy Quaker won't be able to compete with the buyer of that divested business for some time

3) There is a more than 10% chance that this deal ends up breaking -- in which case all that "EPS accretion" will be thrown out of the window

• This deal has been taking a really long time to close -- originally it was scheduled for 2H 2017 and it had since been postponed again and again and again. Why? Well, KWR says securing anti-trust approvals had been more challenging than expected and it ran into further delays as it was asked to divest a piece of Houghton's business. According to the merger agreement, either KWR or Hinduja (existing owner of Houghton) can walk away from this deal with no break up fee whatsoever. So in the scenario that Houghton's asset has deteriorated to level that makes it no longer worth KWR's effort to try to close this deal and reap the cost synergy, KWR would simply give up (free option). I'm not saying this is base case, but this is possible. 
• In the scenario KWR breaks this deal, it would be trading at an enormously high multiple on its stand-alone earning power. To put it in perspective...if this deal breaks, KWR would trade at 35x 2019E non-GAAP EPS and low 20x forward EBITDA by my estimate -- easily double the multiple of many industrials peers. Sure it would have a great balance sheet if this deal breaks, but 35x?

4) Once this deal closes, there will be significant technical selling pressure by the Hinduja family to come

• Let's say this deal closes (which is still the more probable scenario despite the MARATHON), KWR is going to fund the deal with a mix of cash and stock. Hinduja (the seller) will own 24.5% of pro-forma KWR equity and KWR did not hedge this equity mix ratio -- that is A LOT OF stocks owned by a financially-minded investor that will very likely exit as soon as a (short) lock-up period expires
• That amount of volume is ~1/3 of existing float --> good luck finding buyers to absorb that selling pressure
• I think it's a no brainer for Hinduja to exit its stake once this deal closes given its relatively low cost basis and nose-bleeding multiple KWR paid. At today's price, the effective transaction value represents 15.2x Houghton 2016A EBITDA (last reported number and it could be lower by now). This compares to the 11.8x EBITDA deal multiple at the time of the transaction announcement. The difference is driven by KWR's stock appreciation since then.

5) KWR's EBITDA multiple on Bloomberg is flat-out wrong, making some think the valuation is reasonable. On the screen, KWR actually looks "reasonable" on Bloomberg/Capital IQ on EV/EBITDA metric because sellside analysts have already included Houghton EBITDA in their forward estimates, yet the capital structure is a pre-acquisition capital structure with net cash (compared to the net debt situation it would be in once the deal closes)

• This type of situation is rare and can only happen when deal takes a LONG time to close. Typically, sellside analysts wait to publish their pro-forma models/estimates until deals close. In this case, KWR mgmt repetitively told sellside this deal WILL close yet the delay has been incredible
• On the "screen", it looks like EV/EBITDA multiple of 9.6x for 2020E EBITDA and 8.4x for 2021E EBITDA, not bad at all for a MSD% grower! It's actually 15x.
• I think it's entirely possible that some quants have been partially responsible for driving up KWR's stock given the "on-the-screen cheapness"

6) End market is even slower now compared to 2 years ago, making KWR a solid macro edge in a long/short portfolio

• Both KWR's end markets (auto and steel) are in the later stage of current expansion cycle. Growth forecast for global light-vehicle production is between 0% and 2% in 2019 depending on who you ask, and global steel demand is expected to grow ~1.5% this year. Imagine if macro condition starts rolling...
• If the cycle turns, this business WILL decline. It is NOT a WD-40 or Rollins (both of which also trade at nose-bleeding multiples but are more justified compared to KWR) when it comes to recession proof-ness
• In 2009, KWR volume was down 20% YoY with decreases across all regions and market segments except Asia Pacific

How does this all play out?

If this Houghton deal indeed closes, KWR would finally have to give updated financials for the first time in 2.5 years. If we are right about Houghton's deterioration, it would imply that sellside analysts' pro-forma models are wrong. By my estimate (accounting for modest Houghton share loss and a dilutive business divestiture), KWR would print pro-forma non-GAAP 2020E EPS of $7.4 (vs. analyst consensus of $8.3 as of today) implying the current valuation at 30x P/E multiple. I think people would balk at the lack of organic growth at Houghton and assign no more than 22x P/E on this combined business (I feel like I'm being generous). Specialty chemicals comps trade at ~16-17x fwd P/E and ~10x fwd EBITDA on average (Axalta, WR Grace, PPG, Ferro, Fuchs, Albemarle, Valvoline, HB Fuller, RPM International, GCP Applied Technologies, etc)

At 22x my 2020E EPS, this would be a $162 stock, close to 30% lower from here (and this would happen quickly to the extent the deal closes soon and we get to see the numbers). This $162 price target triangulates into ~12.5x EV/2020E EBITDA and ~17x P/2020E FCF, which are fair multiples within comps' range in my opinion.

In the downside case, I wouldn't be surprised by more multiple compression especially if the cycle starts to roll

If the deal falls apart...sweet.

I struggle to see how you lose material money shorting this stock given it trades at 27x 2020E consensus non-GAAP EPS and (adjusting for capital structure) it trades at 15x 2020E consensus adj EBITDA (PF to Houghton's closing). 

Disclaimer: 1) shorting is hard. 2) this is not a bad industry

Catalyst

1. Houghton deal closes and people get to see its underwhelming financials under the hood

2. Houghton deal gets scratched