|Shares Out. (in M):||13||P/E||0||30|
|Market Cap (in $M):||3,000||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||General Collateral|
Leveraging balance sheet to buy an organic decliner during the late stage of an industrial cycle + trading at peak multiple (30x + 2020E EPS) + technical selling pressure to come from large non-strategic shareholder + free optionality on this deal falling apart (which will make the valuation even more egregious)
KWR trades at a recurring-revenue-software-like valuation despite beng an industrials company with stagnant end markets and late cycle risk. Meanwhile, it is in the "middle" of closing a transformative deal that will load up the company with debt to acquire a deteriorating asset where no financial disclosure has been given for the past ~2.5 years. Most KWR shareholders are long-only's, index-closeters, or momentum chasers who are complacent about the financial trajectory of the asset being acquired -- they could very much face a day of reckoning when management gives the true picture of the acquired asset if and when this deal ever closes. There is also a chance that this deal falls apart given how much of a struggle it has been to get approval from FTC and EC, and that outcome will further demolish the stock given KWR wouldn't be able to reap the pro-forma cost synergy benefit associated with the deal.
Quaker Chemical is a global manufacturer and marketer of specialty chemical products for the automotive and steel industries. For more background information on 1) what this company does and 2) why it decided to acquire Houghton, please see HoneyBadger's write-up from almost 2 years ago here:
HoneyBadger also pitched it as a short back then, with the thesis focusing on 1) potential over-earning (on gross margin %) as KWR was benefiting from key input price declines in a low oil price environment and 2) expensive valuation paired with a leverage-inducing transaction while end markets were showing signs of slowing.
The stock has rallied ~60% since then, as KWR demonstrated its margin resiliency across a full commodity cycle (the over-earning short hypothesis is broken by now and management fully believes it can maintain current GM % level if not improving it slightly going forward given ability to raise price to offset any input cost headwind (lubricant is a small cost as % of metalmaking process so the customers don't push back on price much). Further, KWR showed it could grow at above end market growth rates over the past 2 years given its high-touch sales model allowing it to further gain market share. Multiple has only expanded even more to outrageous levels. I believe this backdrop actually sets KWR up as a timely short RIGHT NOW.
Elaborated Short Thesis Points
1) A decent amount of Quaker's recent operating strength came from Houghton. Yes, legacy Quaker/KWR has been growing at above its end market growth rates (KWR has been churning out ~MSD % organic revenue growth for the past 2 years compared to end market volume growing at LSD %, but I believe this very much came from taking share from Houghton, the company it is levering up to acquire. Essentially the company is "taking share from itself", but shareholders aren't exactly aware of this dynamics given Houghton's (target) financials haven't been updated for more than 2 years. From speaking to industry consultants and former executives at Houghton, I believe Houghton's own operating performance has been deteriorating over the past 2 years. Here is what I have gathered:
2) There could be revenue dis-synergy, leading to a slowdown in market share gain
3) There is a more than 10% chance that this deal ends up breaking -- in which case all that "EPS accretion" will be thrown out of the window
4) Once this deal closes, there will be significant technical selling pressure by the Hinduja family to come
5) KWR's EBITDA multiple on Bloomberg is flat-out wrong, making some think the valuation is reasonable. On the screen, KWR actually looks "reasonable" on Bloomberg/Capital IQ on EV/EBITDA metric because sellside analysts have already included Houghton EBITDA in their forward estimates, yet the capital structure is a pre-acquisition capital structure with net cash (compared to the net debt situation it would be in once the deal closes)
6) End market is even slower now compared to 2 years ago, making KWR a solid macro edge in a long/short portfolio
How does this all play out?
If this Houghton deal indeed closes, KWR would finally have to give updated financials for the first time in 2.5 years. If we are right about Houghton's deterioration, it would imply that sellside analysts' pro-forma models are wrong. By my estimate (accounting for modest Houghton share loss and a dilutive business divestiture), KWR would print pro-forma non-GAAP 2020E EPS of $7.4 (vs. analyst consensus of $8.3 as of today) implying the current valuation at 30x P/E multiple. I think people would balk at the lack of organic growth at Houghton and assign no more than 22x P/E on this combined business (I feel like I'm being generous). Specialty chemicals comps trade at ~16-17x fwd P/E and ~10x fwd EBITDA on average (Axalta, WR Grace, PPG, Ferro, Fuchs, Albemarle, Valvoline, HB Fuller, RPM International, GCP Applied Technologies, etc)
At 22x my 2020E EPS, this would be a $162 stock, close to 30% lower from here (and this would happen quickly to the extent the deal closes soon and we get to see the numbers). This $162 price target triangulates into ~12.5x EV/2020E EBITDA and ~17x P/2020E FCF, which are fair multiples within comps' range in my opinion.
In the downside case, I wouldn't be surprised by more multiple compression especially if the cycle starts to roll
If the deal falls apart...sweet.
I struggle to see how you lose material money shorting this stock given it trades at 27x 2020E consensus non-GAAP EPS and (adjusting for capital structure) it trades at 15x 2020E consensus adj EBITDA (PF to Houghton's closing).
Disclaimer: 1) shorting is hard. 2) this is not a bad industry
1. Houghton deal closes and people get to see its underwhelming financials under the hood
2. Houghton deal gets scratched