I like distributors. It’s usually a low margin business, as distribution is just a cost-plus business model, but it’s also high return on invested capital. In some cases, a distributor is putting product on a truck and parking it elsewhere for a fee. Distributors are also “asset-light” with highly variable cost structure. There are pros and cons with that. The con is that when the market grows, they don’t have the same operating leverage as someone with a higher fixed asset base would. The pros come from downturns, where distributors can flex their cost highly variable cost structure, lower inventory and generate cash. Even in good times, the low capital intensity of the business leads to high free cash flow despite low margins.
I think Nexeo (ticker: NXEO), a chemical and plastics distributor, has 60% upside over the next 12-18 months.
So what is Nexeo’s background?
Nexeo was originally the chemical and plastic distribution arm of Ashland, a major specialty chemical company that has undergone a significant portfolio transition. It divested Nexeo to TPG as part of that transition. Ashland was also starved for capital at the time after it acquired Hercules in the crisis. As such, Nexeo was starved for capital and it probably best that the business be put in new hands. TPG acquired the business in 2011 and was owned until Wilbur Ross’s SPAC, WL Ross, acquired majority share of the business.
Nexeo is the 3rd largest chemical distributor in North America behind Brenntag and Univar. It is also the #1 plastics distributor. It suppliers are the Dow, DuPonts, and Lyondells of the world, it breaks down products into smaller batches and then supplies over 22,000 products to over 26,000 customers. Univar and Brenntag are its main competitors but the industry is extremely fragmented. The market is extremely fragmented, so while Nexeo is #3 in chemicals, the number 4 players is about a fourth of the size of Nexeo (which provides bolt on acquisition opportunities). Barriers to entry are not only supplier and customer relationships, but also regulatory aspect of transporting chemicals which can be dangerous.
Why has the stock traded poorly recently?
I can’t say for certain, but I’ve tried to come up with a list of reasons. The first is that when Nexeo first went on its roadshow, it put out 2-year EBITDA target (see page 17). No one does that, especially not brand new public companies. And at the time, mgmt. could not have predicted what was going to occur in early 2016 when oil went to the mid-$20 range, which made their targets near impossible. So I think some people lost trust or thought they were signing up for something different.
Next is the SPAC dynamics, which often trade poorly post acquisition. I don’t have a any historical data proving this, but just in my experience I see it occur and it may be due to shareholder turnover.
Lastly, there is limited float in Nexeo with only ~50% float outstanding of a $800MM market cap company. If someone wants out and someone doesn’t step up to buy, it can disproportionately drive the price down (which I personally like, because I get the same asset at a better price). Big funds typically like a lot of liquidity, so they won’t usually take a big position without a large float. When that occurs for Nexeo (which would occur if TPG exited, which I assume they will at some point in the next 3 years) that could be a catalyst for the stock.
Why is Nexeo an attractive investment?
For one, I like the macro backdrop. Nexeo and other chemical distributors have seen considerable top line pressure given the industrial recession we’ve witnessed from the O&G sector and commodity downturn. If you are positive on the industry returning eventually like I am (even over the long term) then the top line (and earnings) may be able to compound at a higher rate than GDP.
Nexeo’s operating metrics have lagged its peers, but they are improving which I think is being missed by street analysts. Brenntag and Univar maintain significantly higher gross profit margins (~20% vs. Nexeo’s 10%) & EBITDA margins (7-8% vs. low 5%s
As can be seen in the table below, Nexeo’s operating metrics have improved. Remember this was a starved business. It takes time to improve and I think we’ll continue to see that.
Third, the stock is dirt cheap. Nexeo now trades at a full 2.5x discount to its peers and to the distributor comp set.
This is an appropriate time to highlight another catalyst for the stock: MISINFORMATION
There are actually 2 problems here:
- “Predecessor / successor” reporting. That is the financial reporting requirement to split the company’s results pre & post acquisition. I’m sure it has a purpose, but it only added to confusion. Lots of investors today use Bloomberg, FactSet or CapIQ to screen for stocks, quickly look at financial results and decide if its worth their time. Predecessor / successor information splits Nexeo’s results, which makes it look like it did not generate cash last year. It did. And a good amount too which is shown in the FCF walk in the last section of this post.
- Street estimates. Everyone looks at these to see where the stock trades on forward estimates. The major services show that Nexeo’s 2017 EBITDA estimates are $174MM so the stock trades at 9.5x 2017e EBITDA (note: this is 9/30 year end). Wait – Nexeo’s guidance is for EBITDA to be up 10%+, so why is the street expecting flat growth this year? Well, these services are reporting the wrong. For some reason, even though analysts are around guidance for Nexeo, the number is wrong, which is an advantage to us.
I can’t be sure either of these are the reason for Nexeo’s discounted valuation, but I think it can at least contribute.
Based on peer multiples, I think Nexeo’s stock should trade at 9-12x EBITDA, a lower multiple if they can’t execute and a higher multiple if they start to accelerate margin improvement which implies faster earnings growth (therefore warranting a higher multiple).
Therefore, my near-term price target is $11 with upside to $13 over the next 18 months, as shown, which foots to 30% upside and 60% upside in 6 to 18 months, respectively. Also, to handicap what sort of risk reward we have here, the sensitivity tables attempt to show the downside, which I think is pretty good.
How does valuation foot to free cash flow?
Yes, I am using EBITDA which is common in the industry, but let’s see how that all foots to free cash flow. Working capital is the tricky part with distributors, as in downturns they release W/C (source of cash) and in upswings they build (use of cash). Given the unofficial industrial recession we were felt in 2016, FY2016 generated a ton of cash for Nexeo, so therefore I expect they will need to re-build some in the next year. However, as the FCF walk below shows, I still think 2018 FCF yield will be enough to get people’s attention. I feel very comfortable with my target price since it foots to an 8% FCF yield.
What are your thoughts?
Full disclosure: I hold a material investment in Nexeo’s securities. I encourage you to do your own research before making any investment. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of without notice for any reason at any time.
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