August 31, 2017 - 12:21pm EST by
2017 2018
Price: 138.60 EPS 0 0
Shares Out. (in M): 18 P/E 0 0
Market Cap (in $M): 1,814 P/FCF 0 0
Net Debt (in $M): -12 EBIT 0 0
TEV ($): 1,802 TEV/EBIT 0 0
Borrow Cost: General Collateral

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Quaker Chemical
Short Thesis

Quaker Chemical (Ticker: KWR) is a major supplier of chemical specialty products (oils, greases, and lubes) to the global automotive and steel industries.  The Company has benefited significantly from the seven year upward gains in global automotive and steel production, coupled significant gross margin expansion from key input price declines (primarily crude & mineral oils) that we believe has allowed the business to over-earn over the past two years.  The stock is up about 4x since 2010, versus +2x for the S&P.

Despite potential headwinds from end market slowdowns and price compression, KWR trades outside of its typical valuation multiple band (albeit less so when fully accounting for the in-process acquisition of a sizeable competitor).  We believe the potential from a Trump infrastructure plan has buoyed the outlook for the company, which saw its forward EV/EBITDA multiple increase from ~10-11x EBITDA to +16x post-election through March 2017.  We believe the underlying end market fundamentals and business cash flow characteristics suggest a base case stock price decline of 25-30%.

Furthermore, historically KWR has been underlevered with minimal net debt or even net cash on the balance sheet.  Pro forma for an in-process sizable transaction announced April’17, the business will be ~3.7x levered (~3x levered with fully baked synergies).  This may put unexpected strains on a management team that is relatively inexperienced managing such a high debt burden on top of a major integration with stated synergies representing 40% of the acquired company’s EBITDA.  In addition, should the steel or auto markets truly turn over (think peak SAAR or the subprime auto issues finally coming to a head), or should valuation multiples contract due to a reversal in investor sentiment, this will accentuate the negative share price impact and KWR could quickly become a levered equity with a share base that is long only and not typically prone to loving leverage on cyclical businesses.  

Business Summary

KWR develops, produces, and markets a broad range of formulated chemical specialty products and offers chemical management services for various heavy industrial and manufacturing applications in a global portfolio (North America 45% of sales, EMEA 27%, Asia/Pacific 24%, and South America 4% of sales).  Because the business is global, shifts in regional production are less important (excluding FX impacts) than changes in total global production and demand.  

The Company is the market leader in a variety of industrial niches serving the steel and metalworking markets such as: 1) rolling lubricants (rolling oil) used by steel and aluminum makers; 2) machining/grinding compounds for the metalworking market; 3) corrosion prevention chemicals, and; 4) hydraulic fluids for the steel market.  According to analysts, KWR has a 60% market share in cold rolled steel segment.

The principal products and services in Quaker’s global portfolio include:

  1. rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel and by manufacturers of aluminum in the hot rolling of aluminum);

  2. corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment);

  3. metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing);

  4. machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process, achieve closer tolerance, and improve tool life);

  5. hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment.

Key Performance data

KWR has demonstrated positive performance since 2010, with EBITDA up ~60% and volumes / sales up ~40%.  With that said, KWR’s market cap and EV have increased about 4.0x / 3.4x, respectively, over the same time frame due to significant multiple expansion.  We point to a few ways KWR has grown outside of organic growth rates across the auto / steel sectors:

  1. KWR has pursued a variety of tuck-in transactions ranging from a few million to +$50mm (for a total of nearly $200mm).  Assuming a 6x-8x purchase multiple for these deals, that would add an incremental $25 – +$30mm of EBITDA and would explain a significant % of the incremental EBITDA.  We show the purchase history below (excludes recently announced Houghton transaction), and further we note part of KWR’s strategy is to leverage its distribution channels post-acquisition in a 1+1=3 framework.

  1. KWR has benefited greatly from lower input costs over the past 24-36 months, primarily mineral oils (crude-based), vegetable oils, and animal fats.  The chart below illustrates the benefit in margin that KWR experienced starting in Q3/Q4’14.  Gross margin creeped up to +38%, and this has recently started to fall.  KWR previously stated that their long term gross margin target was 35%, however the CEO noted 37% on the last earnings call.  For reference, a reversion to a 35% gross margin would have reduced 2016a EBITDA by 15-20% based on constant sales.  It’s important to note, however, that in a deflationary input cost environment with pushback from customers around pricing, the impact would be much more pronounced as top line would actually fall.  Part of the margin benefit is from crude oil prices contracting, although other inputs are less correlated.

Stock Price & Valuation

Post-election, KWR’s stock price rallied from about $108.00 to nearly $140.00 per share, and then moved to +$150.00 per share following the announcement of a cash/share acquisition of Gulf Houghton Lubricants, Ltd (“Houghton”).  

We show KWR’s historical EV/EBITDA below, which averaged at 10.4x before moving to +16x post-election (note: this excludes multiples after the Houghton deal was announced in early April).  

Houghton Combination

Our hat goes off to KWR’s management, as they capitalized on KWR’s the skyrocketing stock price to get a pretty sizeable deal completed with a comparably sized business and plan to use ~40% stock as currency.  For reference, KWR’s stock is up 60% since June 2016 (50% through March ’17, to eliminate the impact of the Houghton deal)!  

Below are some relevant slides from KWR’s recent investor deck regarding the combination.  Among other items, KWR expects to realize $45mm of synergies.