Description

Overview

Nexeo solutions is chemical distributor (comp to Univar and Brenntag) that is basically public right now but most people are not aware of it. As a true value investor I seldom encounter an opportunity where I literally have no downside. The unique situation with WLRH provides me no downside for the next 2-3 months, a double under the blue sky scenario and approximately 50% upside in my base case scenario.  Did I mention that I get a free look for the next 2-3 months?

On March 21^st, Nexeo Solutions announced that they are merging with Wilbur Ross Holdings (WLRH - a publicly traded SPAC) and will start trading on the NASDAQ once the transaction is finalized, around June/July.

Before I get into the interesting aspects of the investment and the upside, I want to touch on what a SPAC is and why there is no downside until the deal closes.

The SPAC

Wilbur Ross Holdings (WLRH) is a SPAC (Special Purpose Acquisition Company). In June of 2014, Wilbur Ross raised $500m from investors with a purpose of using that capital to make an acquisition.  Why would investors write a blank check with a 2 year promise? 3 main reasons –

1.       When investors participated in the deal they received a free warrant (ticker WLRHW, currently trades at $0.36/warrant) – basically their yield on locking up the capital for 2 years.

2.       The opportunity to get a free look at a potential deal and get their money back if they were not interested.

3.       Invest alongside Wilbur Ross.

As a WLRH holder you need to vote to approve the deal. The vote date has not been set (although the preliminary proxy is out). If you choose to vote against the deal, even if you are the only investor that chooses to do so, you will get $10.01/share back in cash. Otherwise, once the deal closes, your WLRH shares will convert into Nexeo shares. At that point, the stock should trade like any other stock.

2 more technical comments:

1.       Mismatch of supply/demand creates a great entry point. There is no typical SPAC investor but many of the holders of WLRH do not intend to hold the shares post the close for reasons that have nothing to do with fundamentals. The company only started marketing this week and the brokers (DB/ML/CS) did not reach out broadly to all investors as they would in an IPO.  Thus, most of the potential holders of Nexeo do not know of this opportunity’s existence.

2.       Because there are large sellers right now the liquidity profile for the stock is pretty much irrelevant. The brokers on the deal (DB is the lead I believe) can easily locate liquidity.

Nexeo

Description

Nexeo Solutions is a chemical distribution company (formerly Ashland distribution). It has 2 segments: Chemicals and Plastics. Sales / EBITDA is split roughly 50-50% between the two segments.  83% of sales are in NA where Nexeo is the #1 distributor of plastics and #3 distributor of chemicals (behind BNR GY and UNVR).

The Chemical distribution business is an interesting business. It is highly fragmented and is slowly being consolidated by the top 3 players. Only 10% of global chemical production is sold through distribution, however, that number is slowly rising. Chemical distributors do not only offer logistics and supply chain management. They often provide technical assistance through the usage of their blending capabilities and their R&D labs. For example, if a small manufacturer uses some sort of chemical blend to improve a certain quality of its product – they can utilize the services of a distributor and potentially come up with a better chemical or blend that would reduce its costs or improve its product volumes through distribution have been growing at twice the CAGR as chemical volumes. Further, as a distributor Nexeo has almost no raw material exposure.

What is somewhat unique in chemical distribution is that the companies do not only compete on the customers’ business but also on exclusive agreements with suppliers. It is very common for a certain producer to use one distributor for a specific chemical in a certain geographic region.

Thesis / What I like about this name

1.       How it came together:

Nadim Qureshi, the managing director at WL Ross who did the deal, joined the firm during September of 2015.  Qureshi, is not your typical private equity executive. He is a chemical engineer who was part of the management team who turned around Solutia and sold it to Eastman. Qureshi, ran Solutia’s successful Nylon business, its photovoltaics and had several business development and corporate strategy roles. He also dealt with Ashland distribution regularly in some of his roles with Solutia. Per the proxy filed on 3/31/2016, On October 6^th, Nadim Qureshi contacted TPG unsolicited to do this deal. There was no process and the deal was struck immediately. We can already see signs of his actions – on 3/31/2016 Nexeo announced that the head of the chemicals division is leaving the company.

2.       Margin improvement opportunities:

In 2015 – both of Nexeo’s pure play comps had significantly higher margins. UNVR did 6.3% EBITDA margins and Brenntag did 7.6% while Nexeo had 4.5% (9/30 year end). There are several reasons why Nexeo’s margins are currently lower which I elaborate on below. Nexeo can achieve significantly higher margins - even higher than UNVR’s 6.3%. As part of its presentation to investors Nexeo disclosed FY (9/30 year end) 2016 and 2017 guidance. Nexeo is currently guiding to 4.8% and 5.0% margins respectively but these assumptions are conservative and management will confirm that.

Why are margins lower?

-          Ashland underinvested in the business and ran it as a cash cow. When TPG took control of the asset in 2012 they were shocked at how much work and investment the business required. TPG invested heavily in infrastructure, IT, logistics and a technical lab. These investments resulted in higher capex (30-50m / year vs. maintenance of ~20m) and higher operating costs. FY 2015 was the first year where the growing / investing phase was fading out and resulted in a significant EBITDA margin expansion from 3.4% in 2014 to 4.5% in 2015.

-          Because of the significant investment the company currently has excess capacity. In fact, the company believes it can double the volumes running through its facilities without additional investment. The underutilization of assets is hurting margins.

-          50% of sales and slightly less than 50% of EBITDA is plastics. Plastics are inherently lower margin but super high ROIC (mid 20s) business. Nexeo is the #1 distributor of plastics in the US. Currently, plastics have similar EBITDA margins as the chemicals business but the margin improvement potential is lower.

-          When TPG purchased the business, 95% of the chemical volumes were commodity chemicals vs. 5% specialty. Commodity chemicals are inherently lower margin. Currently, 20% of volumes are specialty – which is an improvement but the goal of the company is to significantly increase their specialty mix.

How will margins expand?

-          The company announced a 20m cost cutting plan and is guiding that cost optimization plans will increase margins by 50bps. That is the entire margin improvement the company is guiding to by 2017. Based on conversations with former employees, customers, competitors and the WL Ross team – it seems these figures are very conservative and there are several more things that can be done to improve margins.

-          Adding additional specialty chemicals to the portfolio. Nexeo offers an interesting proposition to the suppliers. For some specialty chemicals the producers do not use distribution, do not work with one exclusive partner or choose to work with Nexeo’s competitors. What Nexeo brings to the table that is somewhat unique from its competitors is significant IT capabilities that allow them to completely manage the supply chain for the producer. Further, Nexeo’s IT capabilities allow the company to share their entire database of clients, sales, market intelligence related to a producer’s specific product with the producer. This unique capability is very attractive to producers as they do not feel they are losing contact with their end market demand. In the last several months Nexeo won significant contracts with DSV and Dow Chemical.

-          M&A – Nexeo can utilize their spare capacity in the system to add additional volumes through M&A. Their prior 2 acquisitions were done at sub 6x EV/EBITDA post synergies.

-          ~83% of sales are in NA. This figure is lower for UNVR (60%) and Brenntag (35%). North America has the highest margin profile for both UNVR and BNR GY. UNVR’s core distribution EBITDA margins (excluding their O&G upstream business) is between 8-9% and Brenntag’s is slightly over 10%. The fact Nexeo is focused on North America highlights even further the margin improvement potential. Even when considering that the plastics division structurally cannot do more than 5-6% EBITDA margin – if they can improve their core chemical margins to 8-10% there is significant upside to current management estimates.

3.       Earnings growth potential / ROIC / FCF:

-          Based on management estimates – which are conservative (as management admits) – the company is expected to grow EBITDA by 20% between 2015 and 2017 (important to highlight that they have a September year end – which means that ½ of their fiscal 2016 is already over and in the bag). For comparison, UNVR is expected to grow EBITDA by 4% in this period (mainly due to high O&G exposure – Nexeo’s exposure is minimal) and BNR GY is expected to grow by ~14%..

-          Nexeo’s ROIC is ~18% vs. UNVR low teens and BNR at ~20%

-          Nexeo’s FCF profile is even more attractive – based on management’s EBITDA and capex guidance – I assume the company will generate 85m of FCF in 2016 which implies north of 9% FCF yield. UNVR is at 8% (and has a turn higher of leverage) and BNR GY is at 5%

4.       Valuation:

-          At $10 per WLRH shares – Nexeo is trading at 8.4x EV/2016 EBITDA. UNVR with its O&G exposure, lower growth potential and pension deficit is trading close to 10x EBITDA and BNR GY is north of 11x

-          It is almost impossible to find another distributor trading at such a low multiple. When I look at distributors I tend to look for ROIC, earnings growth potential (both short and long term), FCF and quality of management. Nexeo ticks all these boxes. With decent execution I expect this business to trade closer to 10x EBITDA in a quarter or two.

-          So what do I think it’s worth?

o   I think that Nexeo can generate 240m of EBITDA by 2017 mainly due to upside of ~20m of costs and rationalization potential (vs. guidance of 213m). At 10x EBITDA – the stock should be worth ~$15

§  I’m assuming a total share count of ~110m shares (to account for the warrants and ½ the founder shares that would be in the money at $12.50. I am not accounting for the 6.25m shares that convert to common at $15)

·         DB/ML/CS are on this deal. Initiations should come 10 days post the close of the deal. But all brokers have analysts that are smart on the company and can talk about it.

·         Company presentation: http://www.sec.gov/Archives/edgar/data/1540047/000110465916111102/a16-8196_1ex99d1.htm

Catalyst

- Company will be marketing for most of the upcoming month (both for debt and equity investors)

- Selling pressure from legacy SPAC holders abates

- Sellside initiations (June)

- Mainly, potential holders learning about the opportunity