The market punished PAH given the high leverage, recent management changes, guidance misses, exposure to the cyclical challenges of ag and other commodity markets and some issues in governance (dilutive securities etc). In the below I’ll go through briefly the history of PAH and the businesses it acquired (there are plenty of write-ups on this already), address the leverage and see what is on offer at current valuation. The base/bull cases are often cited but I’m more interested in how a downside scenario might look like, how much the equity would be worth, would I get diluted and so on given where we are in the cycle.
My personal view is that agriculture is very interesting as an investment idea (naturally a question of asset and valuation) given the underlying trends of increasing food consumption but declining quality of arable land, which in turn requires “technology” to improve quality and quantity of production. On the speciality chemicals side it is too broad to define. Suggest you talk to any chemicals company’s management and ask them to define “specialty”. You’ll end up with multiples of explanations but most will give the very helpful answer of “anything that’s not commodity”. My point is that given the diversity of products and end markets it is not a sector that one “consolidates” (which investors/analysts often cite regarding PAH) but it certainly doesn’t mean that a company cannot go after certain verticals and acquire market leading companies in them. What makes PAH’s chemicals businesses valuable is that the products they sell represent a small portion of their customers’ costs but hugely important to production.
PAH actually reminds me of the Rockwood story a bit: (a) started out life as a levered company, essentially a public LBO, (b) focused on “speciality chemicals” businesses with #1/#2 positions in their respective markets and built them out by bolt-on acquisitions, (c) highly talented senior leadership whom (d) delevered, dismantled, returned hundreds of millions of dollars to shareholders and eventually sold the company (this chapter is TBC at PAH).
What is PAH?
PAH is the brainchild of Martin Franklin (the genius behind Jarden) and Nicolas Berggruen (the “homeless” billionaire), who founded and floated the company in London during late 2013 and raised nearly $900m in the process.
The idea was to create a business model that is “Asset Lite, High Touch”, i.e. low capex but requiring highly specialised knowledge, R&D and personnel. The goal was that Platform would acquire businesses with EV of $750m-2.5bn, seeking a 10% cash on cash return (levered cash flow/equity) and build them up with the proposition that companies with shareholder-focused capital allocation and value creation processes normally trade at some premium (it’s a fancy way to describe a high quality roll-up). You might disagree but personally I don’t think there is anything wrong with roll-ups provided they are conducted in an ethical and financially prudent manner and there are plenty of examples around of such successful examples (Colfax, Danaher, Liberty etc).
The capital to acquire these businesses came in forms of equity and debt issuance. The below tables provide a summary of all the sources (debt and equity) as well as the uses (acquisitions). In summation, the company raised a total of $4bn via equity (either primary, issued as part of an acquisition and preferreds) and $5.3bn via term loans, bonds or assumed debt. The average share price of the equity raise is approximately $15 (vs the current $7.6) so if you assume that management knew what they were doing at the time of the acquisitions you are buying into PAH at a substantial discount.
Source: Company filings
PAH paid 12x EV/TTM EBITDA on average (10x with synergy projections) for the six businesses, which are OK multiples, however note that for the ag businesses these would have been on 2013/2014 earnings, which will likely be higher than the next 1-2 years. Specialty chemicals businesses tend to carry higher multiples than commodity (through the cycle forward 9-12x on average vs 6-8x commodities) given margins, relatively less cyclicality and stickiness of the products.
The below two slides from a recent investor presentation illustrate the assets PAH has acquired since 2013 and the composition of the portfolio. Up until the recent acquisitions of OMG and Alent late last year the portfolio was very much ag heavy, while now it’s more balanced with 55% of sales coming from the ag business. The two core segments are (i) Performance Solutions (e.g. chemical products used in electronics, packaging, drilling fluids etc) and (ii) Agricultural Solution (e.g. crop protection, animal health related products etc). The first group includes Macdermid, OM Group and the recently closed Alent, while the second contains CAS, Agriphar and Arysta.
Source: Company filings
Capital Structure
Including the Alent acquisition that closed last December, the company will have approx. $5.3bn gross debt after tapping its USD and EUR notes recently and net debt of $5bn. The company will also be issuing an additional 18m shares to Alent, taking the share count to around 230m.
Below are a few charts showing the performance of the shares as well as the bonds. The stock is down 70% from all-time highs and the bonds (USD and EUR notes) are trading 80-85c on the dollar, while the recently issued senior notes on 95c. The current yield to maturities are in the 10-12% range (mid YTM) vs coupons of 6%, 6.5% and 10.375% (USD notes, EUR notes and senior notes, respectively) with the market implying some level of tension regarding PAH’s credit.
It’s worth addressing the question of solvency here. The net leverage is around $5bn (PF for Alent), which is around 6.4x EBITDA if you factor in the incremental EBITDA and partial synergies (i.e. 2016e), well above the 4.5x through the cycle plans. The company has $5.3bn gross debt with the maturity is illustrated below. The good news is that PAH has no debt coming due until 2020 and no meaningful amortisation thus there is no exposure to refinancing risk. Most of the debt (actually $1.9bn) is not due for another 5 years thus the company has plenty of time to get its financial house in order. It’s very hard to go bankrupt when there is no debt maturing for a few years, however with such high leverage interest coverage is paramount.
Source: Company filings
I’m estimating that with the current leverage the company is paying a blended 6.1% interest or approximately $320m p.a. Looking at the cash flow, additional cash needs include a combined $120m capex and working capital per annum and of course taxes thus the lowest EBITDA the company must generate is around $500m p.a. Their 2015e guidance is $550m and if we factor in the remaining M&A that is expected to add another $200m to EBITDA for 2016e (in addition to some synergies) i.e. a total of around $770m. The bear case EBITDA is probably somewhere in the $600-700m range, say $650m for next year (call it the polar bear scenario: assuming delays in integration, further pricing risk, FX etc). If EBITDA is at this level net leverage is actually around 7.7x. While the company can make plenty of adjustments to EBITDA for their covenant calculation this would probably be stretching it.
While leverage is high it is manageable at the current state. However, if the ag downcycle extends longer than expected an equity issuance could be on the cards. My speculation is that management will be watching closely how 2016 goes and if things don’t start improving they could pull the trigger as and when the share price improves. How much? Assuming three cases: $650-770-850m illustrative EBITDA the net leverage is 7.3x, 6.2x and 5.6x implying excess debt of $1.8bn, $1.3bn and $1bn in 2016e, respectively (including some net debt reduction during the year). Now I don’t think PAH would issue the entire amount as dilution would be significant rather show creditors some path to a sustainable 4.5x net leverage. Just to give an order of magnitude, a $500-600m raise, coupled with a c. $150-200m p.a. net debt reduction from cash flow would enable them to get to their target leverage target by 2017/2018e, if necessary. A potential equity raise (specifically for delevering) will be a function of the share price and the jumpiness of creditors.
Lastly on the debt, it’s worth addressing the rising interest rate environment. The company’s debt is split into bonds ($3.3bn/60% of total) and term loans ($2bn/40%). The bonds are at a fixed interest rate, while the term loans are floating with the Libor. Assuming an illustrative 0.5% raise in rates (above the interest rate floor) it would increase the annual interest expense by $10m, which is not drastic.
Other funky items in the capital structure include the founder preferred shares and preferred shares issued to Permira at the time of the Arysta acquisition.
The founder preferred shares work as follows. At the time of the IPO the founders (Franklin and Berggruen) subscribed to a Series A Preferred shares (2m shares, fully convertible to common by December 2020 at the latest), which enables them a carry based on the share price development. The mechanics are illustrated below but in broad terms the founders will receive 20% of the value the share price exceeds the high watermark (currently $22.85) at a given year end times the IPO share count of 90.5m dividend by the year end closing price. In 2014 the founders received 10m shares worth $230m at the time. As the share price closed around $13 in 2015 there was no incentive payment. The below table illustrates some scenarios as to what would happen if and when the share price recovers. The good news is that the share price has to go up almost 3x for the company to issue shares. The bad news is the dilution. I’d say the “let’s worry about it when we get there” line.
Source: Company filings, estimates. Assume 20% p.a. share price increase for illustration
The other peculiar item is a $600m series of preferred shares held by Permira whom sold Arysta to PAH. In effect they are entitled to convert this class into common at a price of $27 in exchange for receiving 22m shares. If the share price is above this figure the shares will simply convert and investors will get diluted, however if not then PAH will owe the delta between the conversion price and the actual share price, in cash as a make whole. The bad news (besides the dilution) is that this will have to take place by April 2017. Originally, the due date was October 2016, however this has been extended by a few more months at a cost of $4m per month paid to Permira from October 2016 as compensation for them holding onto an illiquid security. At the moment, this is a huge off-balance sheet liability for PAH of around $430m (25% of market cap) and increasing as the share price drops.
Management Changes
Key to the PAH thesis is the quality of the management given the strategy of acquiring, integrating and running these businesses. Last year has been a bit challenging on the management front. First, the head of the ag business Wayne Hewett resigned in August 2015 followed by the CEO Daniel Leever in October 2015, which is perhaps not the two people you want leaving during a downturn. However, Platform was able to hire two people with very strong credentials. In December 2015 Rakesh Sachdev joined PAH as the CEO. He previously headed up Sigma-Aldrich, US based chemicals company, 2010 through the sale to Merck in November last year. Sigma was a highly acquisitive company so his background in M&A and operations should be suitable to PAH. Then in early January this year Diego Lopez Casanello joined PAH to head up the ag business. He was previously in BASF’s ag business thus also with a suitable background.
Valuation
Following two guidance cuts last year (August and October 2015) management expects the company to generate $550-570m EBITDA in 2015 vs initial expectations of $660-680m (delta of $110m at midpoint). As noted above, there is still c. $200m of EBITDA (based on historical numbers) that will be added by 2016 from M&A on top of $30m synergies (25% haircut to guidance). If we factor in the additional synergies the run-rate EBITDA in the downcycle could be around $800m p.a. (call it 2017-18e). On this figure the company could be generating $350-400m operating cash flow (after tax and interest) and $250-280m in free cash flow, before any reduction of debt and interest (FCF is obviously theoretical in a highly levered company). Under this base case the company could generate cumulative free cash flow of around $1.3bn over the next five years. They must reduce net leverage (importantly the $500m, 10.375% senior notes that are ridiculously expensive) and integrate these businesses before doing more acquisitions, which seems to be management’s plan as well.
Source: Company filings and estimates. Illustrative P&L, cash flow and balance sheet. Base case assumes 75% of FCF used for delevering. Note interest payment is calculated based on prior year gross debt balance
The below illustrates how the market might value PAH once the downcycle subsides a bit. If the company can execute the integration the EBITDA generation could be around $800m as noted above and around $400m in operating cash flow (after tax and interest). Specialty chemicals business trade in the high single digit to low teens forward multiples, while the market is currently pricing PAH on the lower end of this spectrum. If conditions normalise and sentiment improves a valuation on the higher end of this range would imply a mid-teens share price (discounted to today). While this is certainly not impossible it’ll take time and work to get there.
Source: Estimates. Assume forward EBITDA, net debt at respective year end and full dilution
Risks
- Leverage: It is on the very high end of the through the cycle target and while manageable at current run-rate any deterioration in fundamentals would impact cash flow and interest coverage negatively thus an equity raise/dilution cannot be ruled out. Additionally, assuming no recovery in the share price PAH could be exposed a significant cash settlement of the Series B Preferreds. Any downward revision to the current B2 credit rating (Moody’s) would make refinancing more expensive
- Dilution: Equity issuance is part of the thesis and so far the company has issued shares well above the current market price. Both series of preferreds pose risk for further dilution as well as a potential issuance to improve the leverage
- Management: High calibre operators and capital allocators are key to the success of PAH and while changes in the downcycle can cause turmoil in personnel it is never positive to see senior management leave. The company has addressed the management issue recently with two high profile hires thus there seems to be stability for now
- Operational: Integrating six companies is no small feat and is absolutely key to the realisation of the business plan. Any delays to the process would impact cash flows negatively
- Exposure to the ag downcycle: 2016 is going to be another tough year for anything ag related not least due to increasing production supply (e.g. Argentina) which is not positive for crop prices, farmer margins and production input purchases. Main crop prices are expected to be range-bound from here, however from the second half of 2016 onwards a change in the weather pattern (currently we are experiencing one of the strongest El Ninos in history) could impact crop production therefore prices
- Currency: Related to the above, any further weakness for instance in Brazil and the BRL is negative for PAH’s cash flow
