Description

I’m sure you all are looking for more levered, beaten-up small-cap chemicals companies. However, we believe Kraton presents a unique opportunity to purchase a niche chemical company embarking on a strategic cost reset and transformational acquisition at ~2.5x Pro Forma “cash” EPS. Peer multiples would translate to >4x upside over the next three years. Although the company will be significantly levered upon closing its recently announced acquisition, we find the risk / reward attractive given the potential upside.

Even excluding the benefits of the cost savings and the deal, the company still trades at a double-digit unlevered free cash flow yield. Additionally, we have not given the company the benefit of repurchases in any of these cases. Management anticipates generating $450 million of free cash flow over the next three years against a market cap of $500 million.

Kraton, which has been written up a couple times on VIC, manufactures styrenic block compounds (SBC’s), a synthetic elastomer and rubber alternative used in a variety of stable end markets like baby diapers and surgical gloves.  Kraton has historically traded at a substantial discount to specialty chemical peers for what we think are four main reasons:

·      While Kraton contractually passes through almost all commodity costs, it reports GAAP earnings on a FIFO basis, leading headline earnings to appear much more volatile than its stable underlying cash flows.

·        As Kraton has dominant share in its niche business, the company has no real publically traded comps and tends to be underfollowed and misunderstood.

·       Although the majority of volumes are sold to commoditized end-markets (e.g., paving and roofing), these products represent a significantly smaller portion of gross profit. Management recently disclosed for the first time that ~2/3^rd of contribution product come from their differentiated products.  

·        Kraton has been steadily taking out costs, upgrading its product portfolio, and addressing scale issues to transition the business to specialty peer margins.

Kraton has been working to address several of these issues over the past few years. The company appeared to have a transformational deal in mid-2014 with a Taiwanese competitor, but the merger plan fell apart when one of that competitor’s plants exploded in a freak accident.  The 2014 write-up by kwee12 covers this deal. The company’s merger proxy for that transaction detailed a long strategic process by management and the board focused on addressing the company’s cost structure through a variety of internal and external alternatives. 

At the company’s mid-June investor day, management outlined a series of cost initiatives that would increase EBITDA from roughly $150 million in 2014 to $250 million by 2018.  All of the cost initiatives are tied to specifically identified projects, with most already underway. There are four main components to the cost plan: (1) leveraging lower cost facilities in Europe (less expensive feedstock) and Asia (new plant coming online in 2016), (2) targeted cost reduction projects at existing plants (e.g., converting Belpre, OH plant from coal to natural gas), (3) SKU reduction and new fulfillment practices, and (4) reducing overhead costs. Management has said that their compensation packages will be heavily tied towards meeting those targets. Based on management’s plan, we see fully-taxed “cash” EPS going from around $2 today to $4 by 2018 on a standalone basis.  We also see the company generating $300 million of cumulative free cash flow (even net of restructuring costs) in the next three years against a market cap of ~$500 million.

In addition to this cost reset, Kraton recently announced a transformative debt-funded acquisition to purchase Arizona Chemicals, roughly doubling the size of the company without issuing any equity. Arizona Chemicals is a market-leading producer of pine-based chemicals, focused on adhesives, paving and roofing, high performance tires, and chemical intermediates markets. Arizona Chemicals is very complementary to Kraton’s existing business with 50% of Arizona’s sales into common end markets. The company has guided to $1.40 of GAAP EPS accretion in the first full year (against KRA street 2015E EPS of $1.88). We see higher ultimate accretion as synergies fully come on and the company rapidly delevers in the first three years.

Layering in management’s standalone cost reset plan, we see the company reaching $6 of PF “cash” EPS in the next three years (assuming Arizona LTM EBITDA of $184 million and announced $65 million of synergies). Additionally, management expects the combined business to generate $450 million of cumulative FCF over the next three years. Assuming this cash goes to debt paydown, our PF “cash” EPS increases from $6 to $7 based on lower interest expense. The company will have ample room to resume accretive repurchases once it reaches its target leverage level by end 2017, driving potential upside to “cash” EPS. While we expect the company to use this cash to delever to a more comfortable level, we note that $450 million could roughly repurchase the entire market cap at the current price or pay out a special dividend comparable to the stock price.

In addition to the accretion, we believe the absolute valuation for the Arizona acquisition is attractive at 7.4x LTM EBITDA and 5.5x EBITDA post-synergies, translating to a 10% unlevered FCF yield. The closest competitor is WestRock’s specialty chemicals business (the former MeadWestvaco assets), which most street sum-of-the-parts value at 10x+ EBITDA. Their pine chemicals business is combined with a higher quality activated carbon business, so the multiple comparison is not perfect but the best available comp.

While we view the rationale behind the deal as sound, the stock traded down following its announcement. As best as we can tell, there are two apparent reasons. First, the company will be significantly levered following the deal with closing leverage of 4.6x dropping to 3.0x by end 2017. Although we are generally not fans of levering up to do large M&A at this point in the cycle, we take comfort in the strategic nature of deal, significant cost synergies, and a near-term FCF profile driving rapid debt paydown. Additionally, management has prior experience at comparable leverage levels under private equity ownership before the company’s IPO – the company has been owned by PE twice before. The acquisition financing is fully committed, consisting of $1.35 billion of covenant-lite term loans and the remainder from senior unsecured notes. We also believe there is significant hidden value in the Cariflex business (primarily used in surgical gloves and condoms; grew volumes by 24% in 2014). If liquidity becomes tight, we believe Cariflex could be divested at a sufficiently high multiple to reduce aggregate leverage by 1x. There is certainly a lot to manage between the acquisition integration and the standalone cost reset, but we believe the potential upside more than justifies higher risk level posed by the elevated leverage level.

The second concern we have heard is over Arizona’s margins. Kraton’s specialty product-set passes through commodity prices with stable underlying margins. Arizona’s products, however, compete against gum-based rosins (derived from manually tapping pine trees) and other hydrocarbons tied to the price of crude oil. We believe there is the fear that Arizona’s EBITDA will fall due to a lagged effect from oil prices. Based on follow-up conversations with management, we believe the impact from the move in crude oil prices to the mid-$40s is largely captured in the current EBITDA run-rate of $180 million. To be clear, should oil prices fall further, there could be an incremental negative impact on Arizona’s EBITDA though still manageable within the context of the company’s leverage and business plan.  

As management executes on a highly achievable cost cutting plan and integrates Arizona, we think the Street will recognize the substantial upside that Kraton offers.  With a board that has recently demonstrated a willingness to explore strategic alternatives, we think Kraton could also become a target for a strategic or financial buyer at some point along the way should the valuation not improve.

Risks:

Operational Integration Risk: Management will have a full plate to execute the cost reset program and integrate Arizona. While management seems confident they have enough operational bandwidth, there is not a large margin of error.

China: Although only a small portion of sales are directly tied to China, Kraton competes against Chinese chemical conglomerates, such as Sinopec, in their more commodity products. Should China experience a hard landing, Sinopec and other could seek to take share in US and European USBC markets at the cost of Kraton’s commodity business.

Developed Markets Macro: Kraton’s end-market growth is tied to US and European GDP growth. While exposure to CPG and other more stable industries should insulate them to some extent, they are still a niche chemical company in a generally cyclical industry. 

Catalyst

• Deal Closing
• Debt Paydown
• Executing cost savings and synergies
• Additional analyst coverage
• Potential takeout down the road