What’s going on with Platform Specialty Products?

It’s been a tough year for anything remotely related to commodities or agriculture and PAH is certainly no exception. Since the highs of $28 during 2015 summer the stock is down some 70% (40% YTD), below the IPO price of $10. The PAH story was positioned as one of growth-via-M&A with best-in-class capital allocation/board/management/core shareholders (very sexy), which has turned into delevering, integration and focusing on operations (less sexy). In a blink of an eye PAH acquired six businesses (one just closed this December) for total EV of around $9.3bn compared to the current $6.8bn ($1.7bn equity).

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.

Source: Company filings

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

Outsiders in chemicals, the story of Rockwood Holdings

This piece is not about an investment idea, rather a case study of capital allocation and a story of a few Outsiders. When I first came across Rockwood I thought that this could be summed up neatly in a few paragraphs. Technically speaking it is possible but wouldn’t do justice to the story. The content is rather on the long side, however if you don’t feel like reading the whole thing the below quote, from Rockwood CEO Mr Seifi Ghasemi in early 2014, will give you the essence of what I’m about to describe.

This post is for investors who are (i) interested in stories of shareholder friendly managements and capital allocation, (ii) doing their homework on Air Products and want to learn further about Mr Ghasemi or (iii) doing their homework on Albemarle (eventual acquirer of Rockwood in 2014).

Onto the quote from Mr Ghasemi.

“In the last nine years as a public company we have on a consistent basis said that the only strategic goal we have at Rockwood is to maximize shareholder value. This is the guiding principle, which drives everything we do. Our job is to make money for our shareholders. We believe that in the long-term what matters is the increase in the per share value of our stock and not overall size or growth. 

I want to emphasize this point since it is the core of our strategic thinking; the act to increase the per share value of our stock and are not enamored with building an empire and running a bigger company. So it is this fundamental principle of focusing on increasing the per share value of the stock that led us to this strategic decision to sell 60% – yes, 60% – of our company and focus on our two core businesses. We publicly announced the key elements of our strategy a year-ago in January of 2013 and set the target of executing it in two years. Today, a year later, we have delivered on all elements of that strategy well ahead of plan.”

Rockwood was a specialty chemicals company ran by a great management team and ultimately acquired by Albemarle, returning 18% p.a. since the IPO in 2005 until the announcement of the sale in July 2014. The CEO – Mr Ghasemi - has since went on to transform the Bill Ackman backed Air Products.

Rockwood's history goes all the way back to the 1880s when the founder, Bernard LaPorte (back then known as LaPorte Chemicals) came up with a process to manufacture hydrogen peroxide, which was used for bleaching wool and straw hats, key products of the British economy during the industrial revolution. To conveniently skip 100+ years, LaPorte has fallen on hard times and certain parts of its business were acquired by KKR in 2000 for c. $1.2bn. In 2001 KKR brought in Mr Ghasemi, who has a background in chemicals and industrials and previously worked for GKN and BOC (now part of Linde). Mr Ghasemi, along with CFO Mr Robert Zatta and SVP of Law and Administration Mr Thomas Riordan took this business and over time converted into the largest lithium player in the world, handily enriching shareholders in the process.

Flying under the radar

The reason you probably haven’t heard about the company (unless you follow the lithium business) is partly because it’s a B2B company and partly because promotion was the last thing on management’s mind. Companies like Rockwood can hide in plain sight while compounding away. Management was always very low key but very much aligned with shareholders. Their mantra was decentralised operations and they ran Rockwood out of a small office in Princeton, small staff (25 at IPO, 35 at last count) with everybody on one floor. You could think of Rockwood as a holding company with a bunch of assets and hard-nosed approach for lean operations and value creation.

Comments from Mr Zatta (who previously worked at food giant Campbell Soup) in a 2014 interview paint a clear picture.

“Rockwood, with its small management team, definitely provided that [working in a non-bureaucratic environment]. “We didn’t have any bureaucracy,” Zatta recalls. “We didn’t create levels and layers of management for the sake of having process. We were very much focused on getting things done.”

The business is run on a decentralized basis, with the managers of individual units given the autonomy to run things how they needed to be done. “If they had a big capital project, or if they needed approval to shut something down, they only had to talk to myself and Seifi. And now that he’s not here, basically just myself.”

Rockwood’s leaders were crammed into close quarters. “We had our treasurer sitting in the kitchen. That was his office,” Zatta says. “Our controller sat at a secretary’s desk outside my office. When the CEO came in, the only room he could work out of was a conference room.” Zatta said the nimble management structure was a breath of fresh air compared to his big corporate background. “It was exhilarating,” he says.”

A slide from a 2014 investor meeting gives you an overview of their MO. Having read their filings, conference transcripts and presentations I’ve stopped counting the occurrence of “shareholder value creation” at about 347. At least I got the point.

Source: company filings

Act I: The beginnings - IPO (2005)

Rockwood started life as a portfolio company of KKR, when the PE fund acquired the pigments, additives, metal processing and other businesses, which constituted over 50% of LaPorte’s (UK chemicals co) sales, for $1.2bn (around 1.2x TTM sales and 8x EBITDA). Apparently, LaPorte’s share price drastically underperformed the FTSE at the time as the business had a bit of a rough patch due to a strong pound, rising oil and other input costs, hence they hoped that selling assets and focusing on their core operations (fine and performance chemicals etc) would help performance. LaPorte was also a bit of a hodgepodge of loosely related assets so selling things off seemed like the right thing to do. In general, the growth profile of chemicals and industrials businesses is modest, but PE firms like these assets given the stability i.e. they can be levered to the hills. In this deal KKR put about $0.3bn equity with the rest financed by debt.

As a side note, what makes a chemicals company a “specialty” business is that the products they sell make up a small percentage of customers’ operations but are critical to performance. These are in general lower volume, higher margin products as compared to their commodity cousins. Rockwood has built a portfolio of inorganic chemicals assets (i.e. no relation to carbon related minerals such as oil) in a diversified way.

Rockwood has grown via acquisitions of which the largest was the 2004 acquisition of Dynamit Nobel. The Dynamit acquisition included the businesses of Sachtleben (TiO2), Chemetall (lithium and surface treatment) and CeramTec (ceramics, hip implants etc) amongst others. Total consideration was $2.3bn (inc. assumed debt) and the seller was MG Technologies (now GEA Group) as the German conglomerate was separating its engineering and chemicals businesses. At the time Dynamit had sales of $1.6bn (compared to Rockwood’s $0.8bn) and EBITDA of c. $300m (paying just above 8x TTM).

With this acquisition Rockwood expanded into new platforms. While the actual operational overlap was limited, these businesses had one thing in common with the existing operations: speciality chemicals and the products represented a small portion of customers’ production costs.

From Mr Ghasemi at the time (the last point is key). “The four businesses we are buying are profitable stand-alone companies,” says Mr. Ghasemi. “There is no particular product overlap, but there is overlap in customers in the consumer products, construction, electronics and coatings markets. These are specialty chemical businesses where the definition is that the products they make are a small percentage of customers’ costs and essential to the way they make their products.”

The key here, as you’ll see below, was to get to the lithium business. Rockwood’s management was developing a thesis that an inflection point in the demand for electric vehicles in 10-15 years would cause a surge in lithium demand and a scramble for supply. But to get that business they had to buy the whole thing from Dynamit, with a few problem children.

Following this acquisition, as well as other smaller bolt-ons such as Groupe Novasep (subsequently sold in 2006 in an MBO) and the pigments business of Johnson Mathey, Rockwood would report $3bn in revenues and $570m in adj. EBITDA in 2005 (year end). The other side of this breakneck growth was the increase in leverage, on a gross basis Q1 2005 was close to $3.5bn with interest expense over $200m annually.

KKR decided that it was time to take Rockwood public and did so in August 2005 by selling 23.5m (inc. 3m greenshoe) shares at $20 apiece, raising $440m after discounts, which almost entirely went to pay down debt. Rockwood starting trading on the NYSE under the ticker symbol ROC (Jay Z must have been a buyer).

Prior to the IPO, the business was 75% owned by KKR, 22% DLJ (remember them?) while mgmt owned c. 1% of the business. Post IPO KKR’s stake was down close to 50% and has exited the business via a multiple of sell downs during November 2007, June 2008, December 2010, May 2011 and finally in October 2012.

The below slide gives you an overview as to the development Rockwood has gone from formation to post-IPO.

Source: company filings

Act II: The middle part – 2006 to 2012

As Mr Ghasemi elaborated during a 2011 investor meeting:

“We had two five-year plans that we have executed. The first five-year plan was to change the company culture, service the debt and live within the covenants, grow by acquisitions to more than $3 billion and take the company public. That was our main goal for the first five years. We accomplished that. 

Second five years, we wanted to optimize our portfolio, therefore we sold a lot of businesses. We executed bolt-on acquisitions to strengthen our core businesses. We improved our EBITDA margin to 20%. And we paid down debt. Our goal was three times, which we have – we are very ahead of that. So that was our second target. 

But I'm sure you are very interested in terms of what we are going to do for you in the future. I have some more details on that. But moving forward in the next five years, what are we going to do? First of all, why are we going to do what we are going to do? We want to create value for our shareholders. We measure ourselves strictly by the price of our shares. That is what – we exist to create value for our shareholders […]”

Rockwood closed the 2005 financials with $3.1bn in sales and $570m in adj. EBITDA. By 2012 the surviving businesses in the pursuit of higher returns on capital reported sales of $3.5bn and adj. EBITDA of $780m. While this might not seem like a lot of increase consider the divestments in the process. The core businesses such as lithium and surface treatment (previously part of specialty chemicals) or advanced chemicals have all performed well.

Source: company filings. Pie charts represent breakdown of revenues

During the 2005-12 period EBITDA margins increased from 18% to 22% given changes in the portfolio and operational efficiencies. More importantly net leverage decreased from about $2.7bn (almost 5x net leverage) to $1.5bn (about 2x), which is pretty substantial. In June 2012 management even instituted a dividend policy of paying out $35c per share per quarter ($27m per quarter). In the same period ROIC averaged 12%, FCF margin approx. 5% (positive every year, even in 2008/09) and FCF yield around 8%. This is pretty good in the chemicals space.

I’d mention a few key developments here and deal with a few housekeeping items. To start with the divestments, management sold a few businesses that you see in the 2005 breakdown but not in the 2012 financials, such as Group Novasep in an MBO (it produced pharma ingredients, for EUR425m or $540m EV at approx. 8x EBITDA), specialty compounds business to Mexichem ($300m EV at 1.3x sales and c. 9x EBITDA) or the electronics business to OM Group ($315m EV at c. 8x EBITDA). In addition, they bundled their TiO2 business (Sachtleben) with Kemira, Finnish chemicals co to form a JV where Rockwood owned 61%.

Management also made a run for Talison, a Canadian listed company with the world’s largest ore based lithium mine in Australia. Ultimately they lost out to a Chinese co named Tianqi, but as life works in mysterious ways Rockwood got another shot at it.

Management has been very disciplined in capital allocation. On a 2008 conference call, just before the crisis they noted the following: “Our priority we have said that our priorities number one is organic growth, number two is bolt-on acquisitions. We still have a lot of opportunities. We think actually that with the economic downturn, asset prices have gone down. We are not facing as much competition from private equity as before. As a result we think it's an opportunity to put our cash in use and to do some additional bolt-on acquisitions, which would be helpful.“

They had clear guidelines for acquisitions: the target had to be or have (i) global market position, (ii) adj. EBITDA margin of 25%+, (iii) global industry technology leader and (iv) limited exposure to oil-based raw materials (Rockwood’s bread and butter is in inorganic chemicals).

A word on the 2008/09 crisis. This had a pretty significant impact on Rockwood – sales and EBITDA declined 20% vs 2008. This was coupled with a pretty strong exposure to Europe as well as FX fluctuations. The business was helped by the diversified portfolio and a very proactive management – they’ve started cost cutting already in 2007 to reach $150m by 2009. As leverage was still high, they’ve renegotiated covenants and ultimately came out OK from the crisis. They also had to let people go (about 900 or 9% of the workforce) but mgmt. also froze their base pay, which didn’t increase $1 until 2013 (even then Mr Ghasemi’s stayed flat). Despite the solid results the share price dropped from above $40 at the peak in June 2008 to as low as $4 in early 2009.

A few housekeeping items before we move on.

You’ve noticed that in places I used adj. EBITDA as a metric. This was management favoured reporting method (and what they used internally too). This is basically reported EBITDA adjusted for one-off items. Now EBITDA is one thing, but when I see adjusted EBITDA all sorts of red flags are raised. To their credit they’ve at least been consistent and covenants were also tied to adj. EBITDA metrics. More importantly the company has been FCF positive all through the years (even in 2008/2009), while mgmt. comp was also tied to cash generation.

If you look back historically, the company for a long time traded at a discount to peers mostly due to the complexity of the portfolio (7 segments and 17 business units at IPO). The thing about specialty chemicals is that analysts are looking for a comp and if they cannot find it they’ll assign a discount, which of course creates opportunities for investors. Rockwood’s operations were also mostly based in Germany and other parts of Europe and issues such as FX (cost side) or macro risks (demand) hurt the company vs their peers oftentimes.

The good news was that management was always focused on shareholders and never engaged in empire building. They were always more concerned about the long term, never giving quarterly EPS guidance or forecasts but always laid out a framework of how they thought the business could compound, margins, how they controlled costs and capex, leverage and so on. Reading their transcripts of conference calls going back 7-10 years was very refreshing and full of common sense.

Rockwood positioned itself to be number 1 or 2 by market share in their respective businesses. About 70-80% of their sales came from businesses in such positions and management focused on getting out of the non-core ones. While changes were happening all along in the pursuit of a more rationalised portfolio, prompted by the undervaluation management decided to take drastic actions just as 2012 was coming to an end.

Act III: Management goes activist (2013 to 2014)

On a cold day as the world was getting over a NYE hangover management laid out something radical on a January 2013 investor day: shrinking the business by selling over 60% of revenue generating units and focusing solely on lithium and surface treatments. They certainly didn’t believe in sacred cows. The thinking was that the surface treatment business would be the cash cow: 25% EBITDA margins, low capex requirements (3% of sales on average vs 15% for lithium) and relatively good stability, fuelling the growth that was to come from lithium.

Management made a bold bet and starting selling assets off aggressively. In June 2013 they agreed to sell the advanced ceramics business (CeramTec) to Cinven (European PE fund) for $2bn (3.5x TTM sales and 11x TTM EBITDA). It was a high quality business with margins in the mid 30%s and given its presence in healthcare ceramics (think hip implants etc) a good exposure to the theme of ageing population.

Since they bought it as a package deal when acquiring Dynamit the like for like return comparison is not straightforward but assuming the $2.3bn price paid (inc. assumed debt) for then $1.6bn of sales (1.4x TTM sales), which then allocated equally to the segments (CeramTec was 18% then) would result in a 5x gross return (the multiple allocation is pretty subjective). If you assume constant multiples i.e. 3.5x TTM sales it’s a 2x gross return. The important point is that the return above is on an asset basis, in reality Rockwood used about $425m equity to buy the entire Dynamit business (as noted above CeramTec was less than 20% of the valuation) compared to selling just the CeramTec business for $2bn (gross proceeds – about 10% went to taxes, other fees etc - and a large portion went to pay down debt). It’s a pretty good achievement on an asset basis, amazing on equity. Why did they sell such a high quality business? On a conference call after the close Mr Ghasemi admitted that the exposure to a potentially huge medical liability didn’t let him sleep well at nights.

Next on the line was the Clay-based Additives business in July of the same year for $625m to Altana, a German specialty chemicals business for 3.3x TTM sales. This business was part of the performance additives segment. As a fun fact Altana (a company owned by one of the children of BMW founder Herbert Quandt) was considering buying Rockwood or parts of it in 2008, but talks didn’t materialise in the end.

Then to conclude the divestiture spree Rockwood neared the year-end by selling its TiO2 and the remainder of the performance additives business for $1,275bn (inc. pension) to Huntsman. The business generated $1.5bn TTM sales and $105m TTM EBITDA at the time of the announcement. Huntsman’s acquisition price was $1bn (exc. pension) so a multiple of about 0.7x TTM sales and 10x TTM EBITDA, however 2014 adj. EBITDA was expected to be over $200m (improvement of about $100m yoy, on volume, price recovery, raw material reduction etc) so the multiple is in effect was about 5.5x EBITDA at announcement (before synergies). The multiple seems low, but it’s roughly in line with peers. Some saw multiples fetching 6-7x given the speciality element in Rockwood’s business but that ultimately didn’t materialise. The deal happened amid a volatile period for the TiO2 industry with an industry restructuring so probably mgmt. preferred not spending any more resources on this business, which resulted in a decent sale in the end. This business was always a problem child for Rockwood, but as noted above the only way to get to the lithium business. The business was probably worth more in the hands of Huntsman. After a bit of back and forth on regulatory matters the deal finally closed in October 2014.

Lest you think we are done, Rockwood announced that after a failed attempt about a year ago it agreed to acquire a 49% stake in a JV with Tianqi (the parent company of Talison, which owns the Greenbushes lithium mine in Australia) for a total consideration of $516m ultimately (c. $1bn valuation). The saying of "if you cannot beat them join them" comes to mind. Mgmt. guided c. $50m proportional EBITDA from this JV (c. $100m on 100% basis) so would imply a multiple of around 10x, which is along the lines of peers. On a TTM basis with $60m EBITDA (100% basis) the implied multiple was 16.5x. In their 2012 run for Talison, Rockwood offered a valuation over $720m for $30m EBITDA, just as earnings were ramping up.

Talison operates the largest lithium producer anywhere in the world with about 100ktpa lithium carbonate capacity (global production capacity is about 250ktpa). The idea was that the eventual growth from batteries, cars etc would in the next 3-5 years more than compensate for the introduction of this monstrosity of capacity. The Australian mine doesn’t actually supply lithium carbonate but hard rock lithium, which other players (such as Tianqi, a Chinese hard rock converter and the largest in the world) process further. The mine is not the lowest cost but very close to China, while Tianqi is their single largest customer. In commodities you either make money with a cost or location advantage, if you’ve both - think nitrogen fertiliser producers in the US Cornbelt - you have found yourself a gold mine. Ultimately this move strengthened Rockwood’s presence in lithium globally. Additionally, Rockwood entered into an option agreement with Tianqi through 2016 which stipulated that Tianqi can take a 20-30% stake in Rockwood Lithium (which controls the EU and Asian arm of Rockwood’s Li business) at 14x TTM EBITDA less net debt if they wished so.

With the sale of approximately 2/3 of Rockwood’s business and over $3.5bn of gross proceeds received or on their way (vs 2013 ending market cap of over $5bn) you could say that 2013 has been a rather busy year, but all of these moves resulted in a clearer equity story and a better positioning for a large M&A. You could think that the story ends here but it didn’t take long for Rockwood management to shake things up and cap this remarkable story off.

Capital returns

Before we come to the end it’s worth making a quick detour to address capital returns.

Given the leverage and focus on growth, dividends and buybacks haven’t been too high on the agenda until 2012. The first dividend payment came in June 2012 when the company announced a $0.35c per share quarterly dividend ($27m per quarter), which was then subsequently raised to $0.40c per share in February 2013 and then to $0.45c per share (c. $35m per quarter) in August 2013. The dividend payout ratio was in the low to mid 30%s with a view to maintain a 2.8-3.2% yield (higher than industry average). In addition, Rockwood announced a $400m buyback in January 2013 just as it was embarking on its strategic simplification. This was completed in whole during Q3’13 and in November management announced an additional $500m, two-year buyback (this ultimately wasn’t completed). All in, shareholders received about $600m in buybacks and $300m in dividends from June 2012 through the third quarter of 2014. Furthermore, Rockwood paid down debt aggressively - from gross $3.5bn leverage in 2005 it was in net cash (pro forma for the last of asset sales) by late 2014. At the beginning Rockwood was essentially a public LBO.

A word about compensation and management shareholding. Compensation included a mix of base and performance based remuneration, however for the three key executives base compensation hasn’t gone anywhere between 2008-2013, while their performance based compensation was entirely tied to both short and long term financial - mostly cash flow - and relative/absolute share price performance goals. In a 2011 conference Mr Ghasemi commented that almost all of his net worth was tied up in Rockwood shares (both directly acquired and via options). At peak management beneficially owned close to 3% of the company, by early 2014 this was around 2% worth over $100m.

Act IV: Sale of Rockwood (2014)

Just as management was completing their strategic plan, they were on the hunt for their next move. In August 2013 Mr Ghasemi approached the CEO of Albemarle (US chemicals co) to acquire ALB, which didn’t go anywhere and Rockwood went on to focus on the acquisition of Talison. In February 2014 Mr Ghasemi approached again the CEO of ALB, now with a merger of equals plan but again this did not materialise. Following on from the two rejections Rockwood approached other PE and strategic investors. Some were interested in pursuing a transaction but not at the right price, while some PE shops only wanted the cash cow surface treatment business. In an interesting turn of events ALB approached Rockwood about an acquisition in early 2014. Mr Ghasemi indicated that shareholders would need a premium and a significant cash portion to even consider a deal.

Eventually in July 2014 the two companies announced a $6.2bn acquisition of Rockwood by Albemarle. The acquisition rationale was analogous to when Rockwood bought Dynamit Nobel’s businesses - increasing the number of platforms but not necessarily in already existing categories.

The per share consideration at the time was $85.53, paid $50.65 in cash and 0.4803 ALB stock (roughly 60/40 split) and ROC shareholders would become 30% of the combined company. The price meant a 13% premium to prior closing price. While this technically speaking is not a lot, the multiple paid was already on the high end. ALB paid a 14x forward multiple (around 11x including synergies), which is still pretty fair considering that only half of the Rockwood business is in high multiple lithium. Furthermore, as you’ll see below Rockwood’s share price significantly outperformed the market in 2013/14 given the delivery on the strategic plan hence one could argue that the then valuation already implied a high multiple. It’s actually a peculiar turn of events where Rockwood went from being a suitor to getting taken out at a premium. Management played it well.

An interesting twist before the acquisition (though probably on the cards for a while) was the resignation of Mr Ghasemi and his subsequent appointment as CEO of Air Products (Bill Ackman backed industrial gases co) in June 2014. To handle the acquisition, Mr Zatta and Mr Riordan stayed on.

As Pershing was wading through the corporate slog that APD was, they appointed Mr Ghasemi to the board in September 2013 given his experience in the industry and after a 10 month long search process the board decided that Mr Ghasemi was indeed the best candidate and elected him as chairman and CEO effective of July 2014. The industrial gases sector is a lot more concentrated than the specialty chemicals (owning to a previous industry consolidation) hence his remit is to basically restructure the business internally and focus on capital allocation. When his appointment was announced APD share price jumped 8% on the day and reached all time highs. Here is a recent video from Delivering Alpha where Bill Ackman describes how the board came to appoint Mr Ghasemi (watch from the 6:20 mark).

In Conclusion

I know that this is highly theoretical but since the listing in August 2005 through the announcement of the acquisition in July 2014 meant a compounded total return of 18% p.a., performing in line with the wider specialty chemicals sector but outperforming the S&P’s 8% p.a. return. In line performance with the sector comes from a larger drawdown during the 2008/2009 crisis. If you look at the second chart, since the end of 2008 (not even counting from the lows of March 2009) Rockwood returned 46% p.a., ahead of peers and the S&P. Since the end of 2012 (just before the announcement of the strategic dismantling of the company) the stock returned 44% p.a., again ahead of peers and the S&P.

Source: Bloomberg

If you made it this far you probably wonder why I took the time to put all of this on paper. I think that the fundamental performance of Rockwood is remarkable, considering the time period and the sectors they operated in and shows a few key lessons.

Management matters - “Outsiders” are by definition rare. While there is certainly a hindsight bias here, once you find them just sit back and hope they have a long runway ahead of them. Running Rockwood from small HQs, tucked away in Princeton allowed management to make decisions without the burden of bureaucracy and analysis-paralysis.

Disciplined capital allocation is paramount - Having clear guidelines, conviction and financial discipline for growth and/or capital returns can make or break the company. Management essentially bet the farm on lithium but remained disciplined. For instance, instead of getting into bidding war over Talison, Rockwood walked away from a deal in 2012 only to come back in 2013 when the prospects were better.

No sacred cows - While somewhat related to the above, Mr Ghasemi and team were willing to let go approx. 2/3 of their business because that was the right thing to do, without fear as to how that would impact their compensation or social standing (most CEOs like to run bigger, not better companies). It’s not about growth, but value creating growth.

Leverage works both ways - Leverage was a big part of the story and prudent financial management ultimately led to great returns on capital. From $3.5bn gross to net cash in less than ten years, without capital raise is remarkable considering the cards they were dealt at the beginning.

I’d close with two slides Mr Ghasemi presented on his first ever investor call with APD in July 2014 and at a recent investor meeting just a few weeks ago this September. The message is clear.

Source: Air Products filings