Description

Summary thesis

Recent market selloff combined with a weak Q3 for the company created the opportunity to invest in a quality compounder at fire-sale valuation multiples. Recent volatility in the shares distracted investors from the long-term opportunity created by the recently announced merger with Nexeo. We believe the shares offer c. 150% upside in a base case scenario over the next 2 years with minimal downside in a bear case scenario.

Business description and investment highlights

Following the merger with Nexeo (which should close in Q1-19), Univar will become the world’s largest chemical and specialty chemical distributor, followed by Brenntag. We believe chemical distribution is a fundamentally good business with numerous desirable characteristics and Univar in particular appears the most attractive company in the space:

• Exposed to a secularly growing market
• Market leader in most geographies in an otherwise fragmented market
• High operating leverage
• High return on invested capital
• High barriers to entry
• Whilst cyclical, it’s relatively resilient during recessions
• Deploys capital very effectively in accretive acquisitions
• Disintermediation is highly unlikely

Barriers to entry are massive. It’s nearly impossible for a new small distributor to enter the market because it requires a large and efficient asset base to generate economies of scale. Specialty containers, warehouses, specialty trucks and equipment are needed to operate in this industry. Furthermore, given the hazardous nature of the materials transported, many rules and regulations are in place making it very hard for new players to enter the industry. This is not an industry easily disintermediated by the likes of Amazon Business / AmazonSupply, something that happened to other verticals (e.g. electrical equipment distribution). The Amazon vans are useless in distributing chemicals and there are zero synergies with their B2C business.

The chemical distribution industry is very fragmented, with the top 3 players (Brenntag, Univar and IMCD) representing some 10% of the global industry. Even in the US, the most consolidated market, the top 3 distributors represent less than 40% of the market. Because of high barriers to entry and high fragmentation, the industry has seen numerous M&A  transactions in recent years. These transactions tend to be very accretive as cost synergies are huge. If the acquired distributor has a warehouse near the acquirer, it will be shut down and all volumes consolidated in one distribution network, thereby increasing capacity utilisation.

The chemical industry is a GDP growth industry but the chemical distribution one is growing faster, c. 1-2% faster than GDP. This is because only 10-15% of the industry today has outsourced its distribution and the secular trend is towards more outsourcing. It’s a slow but inexorable trend with very few exceptions (Croda being one – they have been vocal about their strategy to internalise distribution). Over the last decade, the industry has grown c. 4-5% p.a. and we assume a modest 3% growth going forward.

Univar has an incredibly diversified customer base, with over 100,000 customers and none representing a material percentage of sales. No vertical represents more than 15% of sales so it’s also diversified from an end market perspective. The suppliers’ concentration is higher – while Univar has nearly 10k suppliers, the large ones like DowDupont are indeed material to the group.

The industry is remarkably resilient to recessions. This is because the most volatile element in recessions is pricing, not volumes. Distributors typically charge based on volumes distributed. The underlying volatility of the chemical sold is typically passed on to the customers with a lag. In recessions, prices of chemicals sold typically fall but $ per volume is relatively constant, so that both gross margins and EBITDA margins typically increase in recessions. Furthermore, the other very interesting characteristic of this industry is that free cash flow is highly counter-cyclical. C. 80% of the business is buy-to-sell, which involves an important element of inventory build-up (c. 20% of the business is pure distribution where Univar takes no inventory risk, it simply distributes the supplier’s product to customers). This means that if volumes increase, which happens in normal growth years, working capital movements are a drag to free cash flow generation. Vice versa, in recessions, there is a large working capital unwind that generates strong free cash flow generation.

For this reason, chemical distributors were historically able to support large piles of debt. Univar, Brenntag and IMCD, all had net debt to EBITDA as high as 6-7x in the past precisely due to this characteristic: the business delevers in downturns.

The typical economics of the business are as follows:

• Gross margins for chemical distributors are typically in the low 20s. The more specialised the underlying chemical sold, the higher the gross margins. Univar offers specialised services like chemical waste removal and ancillary services, on-site storage of chemicals for its customers, and support services for the agricultural and pest control industries. These services typically generate higher gross margins
• Freight and handling costs represents c. 4% of sales and there are economies of scale since the incremental chemical on a truck costs very little to the distributor
• Warehousing and selling and admin costs represent c. 8% of sales. These costs are relatively fixed so the incremental margin on these costs is quite high
• Resulting EBITDA margins are around 8%. Univar’s management team believes it can deliver EBITDA margins in the double-digit range

Incremental margins are high, typically in the high-20s. All the publicly listed chemical distributors have exhibited margin expansion over time. Combined with strong organic growth, high free cash flow generation (CAPEX is very low) and opportunities to deploy capital in accretive M&A, these businesses have traditionally attracted relatively high valuation multiples as well as Private Equity capital. Brenntag was IPO’d in 2010 by BC Partners at approximately 10x EBITDA. Univar was taken private in 2007 by CVC again at c. 10x EV / EBITDA. CVC sold a minority stake to CD&R in 2010 at a similar valuation and then IPO’d the business in 2015 again at similar valuations. IMCD was IPO’d in 2014 by Bain Capital at a forward valuation of c. 13x EBITDA. These are businesses that financial sponsors are very familiar with and attracted to, given their desirable characteristics described above.

Why Univar?

Univar is not the only publicly listed chemical distributor. Brenntag and IMCD are both listed comparable companies. However, we believe the opportunity today is the greatest in Univar for the following reasons.

First and foremost, Univar is currently the cheapest chemical distributor, even on 2018 numbers, trading on 7.5x EBITDA Vs Brenntag on 8.5x and IMCD on 15x. Univar had a relatively weak Q3 where results were affected by temporary weather-related issues in their Canadian business. The stock fell 14% on the day and this was before the Q4-18 market rout that caused the stock to fall over 40% in the quarter.

The second reason is that Univar is about to complete a strategically sound and financially accretive acquisition. On September 17th, 2018, Univar announced the agreement to acquire Nexeo, the 3rd largest chemical distributor in the US. The deal is an incredibly attractive one that seems to have been overlooked by the market. From a strategic perspective, it creates North America’s largest chemical and ingredients sales force with the broadest product offering and most efficient supply chain in the industry. Financially, it’s a very accretive deal. Univar will pay approximately 8.5x 2019 EBITDA for Nexeo excluding synergies. With synergies, quantified at $100m, the implied multiple paid compresses to c. 6x EBITDA. We note that current sell-side consensus doesn’t factor in the benefits of the merger as it hasn’t closed yet. Consensus earnings estimates for 2020 are therefore significantly depressed compared to our expectations.

The third and probably most important reason is that Univar offers significant self-help upside which should more than offset any macro related weakness. Our thesis is that the US business has been greatly mismanaged by the previous management team and therefore offers substantial margin upside. Erik Fyrwald served as CEO from 2012 until 2016 and pushed a “volumes at all costs” strategy that turned out to be disastrous for the group, especially in light of the Oil and Gas recession that hit the US in 2015. He was succeeded by Stephen Newlin, a seasoned executive that in 2017 launched a turnaround plan. The key architect of the plan was David Jukes, the then COO that became CEO in May 2018. David is a Univar man through and through and before becoming the company’s COO / CEO, he successfully led Univar’s EMEA business. Under his leadership, the EMEA business dramatically improved. EBITDA margins went from 2% in 2013 to 8% in 2018, in a context of weak underlying market growth. Over the period, Univar’s margins went from a 400bps deficit to market leader Brenntag to 50bps premium. This is all thanks to David’s commercial strategy combined with sharp focus on operation excellence.

In 2017, David tried to replicate the European playbook to US operations and, as part of the plan, issued very ambitious targets for 2019 and 2021 which, by now, nobody believes in. Reported results for the US business did improve but the pace was not the one that management originally envisaged. In our view, those targets have become an overhang to the stock as everyone knows that they will have to be retracted and nobody wants to be invested ahead of management lowering the guidance. In our view, this is a red herring.

The reason the plan did not work as originally envisaged has very much to do with Univar’s IT systems. The European IT infrastructure is new and agile, it’s based on SAP S4. The US one is antiquated, c. 35 years old. The commercial initiatives that were supposed to be implemented in the US were hindered by the old and inflexible IT. Management faced the tough choice of going through a new risky IT implementation or being stuck with an old IT system. The solution came with the Nexeo deal. Nexeo’s IT is the same as Univar’s one in Europe. It will allow Univar to move its ERP onto Nexeo’s in a relatively seamless way with limited risks. This will allow management to implement in the US the same commercial initiatives that worked so well in Europe. We believe the US will exhibit margin expansion over the coming years irrespective of market conditions. Sell side analysts seem to have given up on the margin expansion opportunity which, we believe, remains very realistic.

Valuation considerations and return scenarios

In terms of valuation, we assume an exit valuation multiple of 9x EBITDA for our base case. It represents the low end of the 9-10x valuation range where chemical distributors traded over time. In terms of financial assumptions, we assumed the following:

• 3% organic top line growth
• 15bps of annual EBITDA margin expansion, which is well below the 40-50bps target laid out by management
• $100m in synergies from the Nexeo deal, which is likely to be conservative
• 5.5% cost of debt

We note that half of the Nexeo business, representing c. 1/3 of acquired EBITDA, is in plastic distribution and will be disposed shortly after the acquisition. We believe this business could fetch as much as $500m which will help Univar to delever significantly. We haven’t factored that in our base case scenario.

Applying a 9x multiple to our estimated 2021 EBITDA of c. $1.1bn results in a fair share price of c. $47, for a total return of over 150% and over 50% IRR over 2 years.

Summary return scenario (including Nexeo from 2019):

In our bear case scenario, we assumed a valuation multiple of 7x EBITDA, which is the absolute trough valuation Brenntag traded at very briefly in 2011 in the midst of the European sovereign debt crisis. In terms of financial assumptions, we assumed the following:

• 3% top line decline in 2020-21, implying a full-blown recession
• 20bps of annual EBITDA margin compression. We note that Brenntag margins remained stable in 2009
• $75m in cost synergies from the Nexeo deal, below management targets
• Cost of debt of 6.5%

Even with these draconian assumptions we still get to a double-digit IRR over the next 2 years:

We therefore see the investment as highly asymmetric and compelling.

Catalyst

• Nexeo deal to close in Q1-19
• Plastic business disposal expected in Q2-Q3 2019
• Investor Day with new financial targets for the merged company in Q4-19 expected