Shifting Mix At Nexeo Solutions Drives ~70% Upside

Shifting Mix At Nexeo Solutions Drives
~70% Upside
|Must Read Jul. 21, 2016 1:57 PM ET1 comment
by: Lester Goh
Summary
• Trades at a 20-30% discount to peers despite superior EBITDA growth
trajectory, which instead warrants a premium.
• The market appears unaware of the shifting mix to specialty products.
• Fair value of ~$14.40, or ~70% upside from current levels.
• Downside well protected by increased supplier outsourcing during economic
downturns as well as a large discount to comps.
Shifting Mix At Nexeo Solutions Drives ~70% Upside - Nexeo Solutions, Inc. (NASD… Page 1 of 15
http://seekingalpha.com/article/3990292-shifting-mix-nexeo-solutions-drives-70-percent-up… 1/8/2016

Nexeo Solutions (NASDAQ:NXEO) ("Nexeo", "NXEO" or "the Company") goes for
~8x EV/'16E EBITDA on the market. Relevant comps in the chemicals/plastics
distribution space which Nexeo appears undervalued against are Brenntag
(OTCPK:BNTGF) (OTCPK:BNTGY) and Univar (NYSE:UNVR) that trade
approximately 20-30% higher - both are priced at 9.5-10x EV/'16E EBITDA.
Source: Company filings and presentations
Why is this so?
The issue can't be debt. Although Nexeo is levered at ~4x net debt/'16E EBITDA,
relatively speaking, this is not concerning as peers Brenntag and Univar possess
~2x net debt/'16E EBITDA and ~5x net debt/'16E EBITDA, respectively. In
particular, UNVR does not appear to be punished by the market as a result of its
high debt load.
On an absolute basis, such levels of leverage appear high at first sight, but are
actually not overly aggressive. This may seem counter-intuitive as NXEO is a
chemicals and plastics distributor; large chemical companies are struggling to grow
sales and earnings, a situation which might imply to the casual observer sales at
NXEO should decline on a forward-looking basis.
Commodity price declines and a strong dollar continued to pressure Dow in 1Q '16.
The pending Dow (NYSE:DOW)-DuPont (NYSE:DD) merger can be seen as an
implicit admission that earnings growth through higher sales are unlikely. Instead,
cost cuts and synergies will be the main drivers going forward. These troubles are
not solely limited to Dow, but are also experienced by firms such as Monsanto
(NYSE:MON).

But such an assessment neglects to consider the nuances of the industry. Most
suppliers to distributors such as NXEO are highly concentrated - top 10 suppliers
fulfill ~50% of total product procured at the firm. In contrast, the distributors'
customer base is highly fragmented - the Company's facilities serve >20,000
customers, with none accounting for a material portion of sales. This introduces an
interesting dynamic.
In times of economic softness, end-users reduce purchases, making extensive
distribution infrastructure at firms like Dow hugely unappealing - high fixed costs on
declining sales is not a fun combination. Hence, companies like Dow are
increasingly turning to outsourcing product distribution to middlemen such as NXEO
in order to defend their margins in such environments as the Company can drive
higher utilization out of its infrastructure by spreading its footprint across thousands
of customers. This is exceptionally important in the current environment in order for
suppliers to lower capital spending as distribution is typically a non-core operation
for them; after all, Nexeo only exists today because Ashland (NYSE:ASH) sold its
distribution business to TPG in the earlier part of the decade.
This dynamic is precisely why I am confident top-line troubles at major
chemicals/plastics giants are actually a net positive for NXEO. It encourages
suppliers to outsource more work to distributors when times are hard. Notably, there
does not appear to be a symmetrical reaction on the opposite side - when times are
good, suppliers still outsource to distributors, likely because they have come to
realize access to distributors - especially large ones like Nexeo - gives them more
revenue opportunities.

Source: Investor Presentation
It also explains why gross margins at Nexeo have been robust in recent years
despite significant commodity price declines and other headwinds experienced by
its suppliers and customers (as an example, ag has been very tough in recent years
due to low crop prices). The situation at UNVR further corroborates my assertion.
The firm is guiding for modestly lower EBITDA despite significant oil & gas
exposure; an uninformed observer would expect a larger decline.
It also doubles as downside protection during a recession along with the fact that
NXEO trades at a meaningful discount to peers. Note the Company has no raw
material exposure as a distributor due to pass-through pricing and thus has less
earnings volatility compared to suppliers.
So if it's not leverage, what could explain the discount to peers?

Merging With A SPAC: Not Exactly Your Standard IPO
One potential reason for the opportunity could be due to the lack of coverage. This
should not be surprising. Most firms listed on the public markets got there through
an IPO while Nexeo took the unconventional route by merging with a SPAC that
was sponsored by famed investor Wilbur Ross.
Investment banks typically distribute company information during the months
leading up to the IPO for book-building purposes and to ensure a smooth transition
for its client onto the public markets.
Unlike IPOs, however, SPACs are not given the same degree of publicity due to
their lack of activity pre-deal; without an imminent acquisition, there is hardly
anything for the sell-side to write about.
As a result, significant mispricings can and do occur in the SPAC space, and this
absence of coverage on NXEO could be a reason why it trades at a discount to
peers, in my view.
Limited Market Awareness Regarding Shifting Mix

The Company is guiding to (1) ~1% and ~6% sales growth and (2) ~10% and ~9%
adj. EBITDA growth in '16 and '17, respectively, according to the April investor
presentation. In contrast, Brenntag's EBITDA is expected to grow at ~4.5% and ~6%
in '16 and '17, respectively, while Univar is guiding for a decline in '16 EBITDA.
From the above, it appears to me another potential reason for the mispricing is that
the market simply does not believe management's estimates. If the market thought
NXEO could hit said estimates, the stock would probably trade in line with peers, or
likely at a premium due to its stronger growth trajectory.

That said, the apparent market skepticism is not totally unfounded. After all, post-
merger, the Company has a limited public market history. Sure, Ross is a
phenomenal investor, but to the best of my knowledge, he has little documented
experience in the chemicals/plastics distribution space. Hence, it appears there is
some justification for treating Nexeo as a "show-me" story.
However, it is evident to me there is likely limited market awareness regarding
NXEO's shifting mix towards specialty products. Reason being, while the Company
states that it sells both commodity and specialty products, it does not disclose a
breakdown of the commodity/specialty mix, making it hard to decipher the shifting
mix. Thus, said shift is unlikely to be noticed by most market participants. It can only
be inferred through close examination of the Company's disclosures. This shifting
mix makes it highly likely the Company will be able to hit management's estimates.
Commodity Versus Specialty: Explaining The Nuances
Back when Ashland sold Nexeo to TPG in early 2011, the Company was earning
~3% EBITDA margins while peer Brenntag clocked ~7%. Both companies state that
they distribute commodity and specialty products, but do not provide breakdowns.
Judging from their EBITDA margins, however, it is clear that Brenntag's sales were
weighted more heavily towards specialty while Nexeo was more focused on
commodity.
The distribution of commodity products is not complicated. This is because end-user
demands are fairly homogenous and hence end-products are standardized. One
example is titanium dioxide (TiO2). The fact that there are many uses for TiO2 -
paper, plastics, rubber, cosmetics are just a few specific applications - highlight the
lack of customization required by end-customers. In turn, this implies the distribution
of commodity chemicals does not require any special knowledge whatsoever.
Customers buy in bulk; business is thus more transactional and oriented for the
short term, and purchase decisions are made almost solely based on price and on-
time delivery.
On the other hand, the distribution of specialty products is highly complex. Unlike
their commodity counterparts, specialty products are sold in much smaller quantities
and require application-specific know-how as end-user needs often differ greatly.

Essentially, it requires one to have extensive knowledge and frequent interaction
with its customers to ascertain their often unique problems, and to come up with
tailored solutions.
While it is true that suppliers like Dow can skip the middleman and go direct, this is
often uneconomic because the end-user base is highly fragmented (think: millions of
small-time farmers). Hence, although customers are cumulatively large, they are
individually small. Ergo, it makes much more economic sense for the supplier to go
through an independent distributor; the independent distributor can do it more
cheaply because its position as the aggregator of demand from thousands of end-
users enables utilization rates to remain higher as compared to captive distributors
(i.e. distributors that exist within suppliers).
A good example of the intricacies of serving the specialty market is illustrated by an
Alent case study. A metal-finishing firm's "home-brew" plating process was
hampering its ability to meet growing OEM demand (i.e. a fairly unique problem) and
also called for additional equipment replacement due to looming environmental
regulations. Through understanding the customer's situation, Enthone, a subsidiary
of Alent, installed and introduced more efficient processes which also compiled with
regulations as evidenced by third-party validation (i.e. tailored a solution to fit unique
customer requirements).
Generally, specialty products tend to command higher margins due to the highly
customized nature of the offering. While serving the specialty space requires
financial commitment, this commitment is largely one-off in nature; once you
implement the required costly infrastructure, no further investments are required
apart from maintenance expenditures. In order to customize solutions, testing out
different formulations of chemicals is required, but this comes at minimal cost. Due
to the above reasons, players who overweigh specialty sales (i.e. Brenntag and
Univar) tend to earn higher margins.
Serving the specialty space would only have been possible if one had the
infrastructure, personnel, and expertise in place to maintain an intimate relationship
with the end-user. Apparently, Nexeo did not possess such capabilities when it was
a subsidiary of Ashland.

Subsequent to the buyout by TPG, the Company made the required technological
investments through the implementation of an ERP system and also spent
significant amounts on personnel to enhance its commercial capabilities. Nexeo also
embarked on inorganic initiatives such as the CSD and Archway acquisitions in
order to expand its capability in lab testing, formulation, and custom blending, hence
obtaining the expertise required to serve the specialty market.
As a result, the Company has morphed into a distributor capable of serving clients in
the specialty space. Indeed, this must have been the case considering NXEO only
won large deals with BASF (OTCQX:BASFY), Solvay (OTCPK:SVYZY), and Royal
DSM (OTCQX:RDSMY) after it had achieved the aforementioned requirements.
While management does not quantify the details of these deals in their respective
press releases, it is likely that said deals make management's guidance highly
achievable, in my view.
This is because all three deals were made with large firms with many billions in
revenue. Two of those deals (BASF and Solvay) were exclusive contracts,
suggesting the suppliers were heavily committed to making the partnership work.
Furthermore, the Company specifically acknowledges BASF as one of its largest
suppliers. Additionally, it appears to me the aforementioned deals would not have
warranted their individual press releases if they were not material to the Company.
Moreover, there is likely upside to management's guidance - specifically '16/'17 adj.
EBITDA estimates. As discussed, management is guiding ~10% and ~9% adj.
EBITDA growth for '16 and '17, respectively. This compares to ~13% CAGR adj.
EBITDA growth from 2012 to 2015. While this historical double-digit annual growth
was likely boosted by a low-hanging fruit as TPG removed costs post-buyout, I still
have a hard time reconciling why the growth trajectory of adj. EBITDA would slow
down.

This is especially so when one considers that management is guiding ~$15-24m in
cost savings going forward, which accounts for ~42-67% of incremental adj. EBITDA
'17 number as compared to the '15 figure. Furthermore, we have already
established that revenue growth going forward is likely to be higher-margin due to
the mix shift towards specialty. These incremental high-margin revenues are also
turbo-charged by significant operating leverage - after restructuring operations,
management cites that the Company has the "ability to increase volumes 50-100%
with [its] current asset base".
The collective impact of these variables makes it highly probable that management
is low-balling guidance, in my view. '17 numbers are particularly intriguing, as while
management is forecasting an acceleration in sales growth (from ~1% to ~6%), it is
curiously projecting a deceleration in EBITDA growth (from ~10% to ~9%) in a
business which clearly possesses material operating leverage.

It is not difficult to deduce why management is likely low-balling guidance. Given the
Company's limited public market history post-deal, management likely wants to set a
conservative tone so as to not run the risk of over-promising and under-delivering.
This point is further supported by the fact the SPAC founders subordinated the
entirety of their promote; i.e. they restructured the 12.5m founder shares as an earn-
out, with 50% realizable when shares trade to $12.50 (~45% upside) and the
remainder realizable when shares go for $15 (~75% upside). In my view, this not
only hints at the probability of guidance being conservative (if guidance is easily
exceeded, the stock would likely pop higher, and vice versa), but also aligns
founders with minority shareholders.
Why Did TPG Sell?
With such promising prospects, the debate inevitably turns to why would TPG sell at
a discount? As a point of reference, management cited that NXEO was valued at
8.4x EV/'16 adj. EBITDA while peers Univar, Brenntag, and IMCD (OTC:IMDZF)
were priced at 9.8x, 11.2x, and 14.4x, respectively, at the time of the investor
presentation, which serves to highlight the extent of the discount.
In my view, merging with Ross's SPAC represented an opportunity to bring Nexeo
onto the public markets faster than a traditional IPO process would. The Company's
investor presentation highlighted the potential for Nexeo to roll up smaller peers due
to the highly fragmented nature of the distribution space.

Being listed gives the Company several advantages, chief of which is an additional
currency (i.e. equity) that can be issued to support inorganic growth initiatives. As
discussed, NXEO also recently completed the roll-out of its ERP system and has
substantial operating leverage waiting to be utilized, which bodes well from an M&A
point of view.
In addition, TPG did not sell out entirely - the private equity firm still retains 35% of
the equity, with the potential to increase this to 38% with the aforementioned earn-
out. As a result, TPG still holds the potential to realize substantial upside if things go
well.
Valuation

Based on my suspicions that guidance is likely being low-balled, it may seem
appropriate to assume upside to management's '16 and '17 adj. EBITDA estimates;
to be conservative, however, I will opt not to. Management is forecasting ~$213m in
adj. EBITDA in '17. Slapping a 12x EV/adj. EBITDA multiple on this figure works out
to ~$2.56b in EV.
I believe a 12x multiple is warranted for several reasons: (1) the Company's growing
specialty mix allows for superior growth prospects (~10% annually through '17, likely
more) as compared to peers (mid-single digits at Brenntag, modest decline at
Univar), (2) net debt/adj. EBITDA would have come down materially by '17 (as I
estimate below, net debt/'17E adj. EBITDA should be ~3x by then), supporting a
higher multiple, (3) Brenntag's outsized European exposure vs. Nexeo (~40-50% of
sales vs. ~10% for Nexeo - the Company only discloses EMEA sales, which are
~12% of total sales) suggests Brenntag deserves a discount for Brexit uncertainty,
and (4) Univar's larger oil & gas exposure, as discussed, also deserves a discount
given the current depressed oil environment.
Note that IMCD is not a valid comp because of its sole focus on the specialty space
- Nexeo, Brenntag, and Univar are targeting a mix of commodity and specialty.
As discussed, management is forecasting ~$195m and ~$213m in adj. EBITDA for
'16 and '17, respectively. Averaging CapEx for the past four years implies
normalized CapEx of ~$37.5m. Cash interest expense is roughly $56m while taxes
should clock in at roughly ~$5m, judging from numbers in prior years. Net working
capital (excluding CC&E and short-term debt) trends since 2012 (~$434m in 2012,
~$548m in 2013, ~$546m in 2014, falling to ~$463m in 2015, and ~$454m in 2Q
'16) suggest normalized working capital is likely ~$544m, which implies a required
incremental ~$90m investment in 2016.
Per the above assumptions, FCF comes out to ~$7m in 2016 and ~$115m in 2017.
Thus, NXEO should generate ~$122m in free cash flow by year-end '17, which
would reduce net debt (currently ~$760m) by a similar amount. As a result, equity
value by year-end '17 is roughly ~$1.92b ($2.56b - ~$638m), implying a ~$16.80
stock on ~114.5m shares outstanding (note the share count is adjusted to account
for the earn-out at $12.50 and $15; 90.77m + 11.2m + 12.5m). Discounting this back
to the current year at an 8% rate gets me to just south of ~$14.40 per share, or
~70% upside from current levels.

Recommendation: Initiate a long position in Nexeo Solutions with a target
price of ~$14.40 per share and considerable downside protection.
Off the radar, armed with superior growth prospects as defined by EBITDA growth
(primarily due to shifting mix and incremental cost cuts) relative to peers, along with
significant downside protection due to (1) increased outsourcing by suppliers in
difficult economic environments to reduce fixed costs and (2) a material discount to
peers, shares of NXEO represent an opportunity with asymmetric risk/reward, in my
view.
While the natural catalysts to close the price/value disparity would be improving
EBITDA and delevering the balance sheet in future years, it's my opinion that shares
could re-rate as soon as the 3Q '16 earnings call. I think management would likely
utilize their first post-merger quarterly earnings call to quantify and highlight the
opportunities covered in this article, which could lead to a repricing of shares. Other
catalysts include sell-side initiations - Lazard, Deutsche, BoAML, and Credit Suisse
were the investment bankers running the deal - and the possibility of management
presenting at investment conferences.
The largest risk to my thesis would likely materialize in the form of a delay in shifting
mix; said delay would probably be caused by a stalling in new specialty business
wins. That said, this risk appears well mitigated by the fact that NXEO has already
signed up several large customers on an exclusive basis, which implies a proven
product. Large suppliers are capable of "fishing around" for the best distribution
deals and in all likelihood would not have committed to exclusivity without being
highly certain of long-term payback. Hence, the fact that they committed to an
exclusive distribution contract materially de-risks Nexeo's growth outlook.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship
with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The author's reports contain factual statements
and opinions. He derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are

accurate or complete. Opinions are those of the the author and are subject to
change without notice. His reports are for informational purposes only and do not
offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester")
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. Lester advises readers to
conduct their own due diligence before investing in any companies covered by him.
He does not know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.

Shifting Mix At Nexeo Solutions Drives ~70% Upside

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