Versum recently spun-off from Air Products (leading industrial gas company with $30bn mkt cap) as Air Product’s wanted to streamline operations and focus on its core products. I would like to present Versum (“VSM”) as a short idea.
Versum, a leading provider of specialty chemical materials and gases for the semiconductor manufacturing industry, has about $1bn of sales with ~$345mm of EBITDA (~35% LTM EBITDA margin). The Management’s main selling point to investors is that the Company has high margins and is less capital intensive. Most sell side research analysts are repeating what is being feed to them and have a Buy rating mentioning “best-in class margins”, “leading technology”, etc., which has resulted in the current stock being valued off of some inflated operating numbers. We believe that the margins will normalize to its peer operating margins. Additionally, maintenance capital and R&D expenditure will have to increase in the future to promote organic growth and be relevant in the industry. The stock price is currently trading around $24 (10.2x LTM EBITDA), and we believe that there is potential for the stock to trade down 30%+ for the below key reasons:
1)Operating margins are currently elevated (~35% EBITDA margins) for a number of reasons which we will discuss later and should drop to around 22-27% (Margins for its two closest peers has been ~22% for the last 3 years)
2)Management has not reinvested enough on its infrastructure in the past couple of years to maintain operations. Maintenance capex (2.5% of sales and 48% of D&A) for the past few years has been way too low for a manufacturing Company. Net PPE (critical to daily operations) value currently stands at 1/3rd of total initial value since the Company has not been spending enough to replenish. The Company is pitching the past low capex spend as a positive selling point. We strongly believe that to maintain operations and grow organically, we should expect a big one-time capex spend of $250mm+ in coming 1-2 years. Additionally, ongoing annual maintenance capex spend should increase to $30-40mm from the current $25mm
3)Management is determined on acquisitions to drive growth and consolidate the industry. While smart strategic acquisitions are a good thing, acquisitions done in haste and with the motivation of growing the Company for Management’s greed (Compensation directly related to earnings) often end up being a disaster. Additionally, Management team is not very experienced with integrating acquired companies
4)DSS Segment, which generates about 25% of sales, is exposed to infrastructure expansion cycle of the semiconductor industry, implying earnings can be volatile for this segment
Diving deeper into the core issues:
1.Operating margins are currently extraordinarily high and we should expect the margins to come under pressure in the coming quarters. Total EBITDA margins have increased from 17% in 2013 to around 35% in 2016. Margins in the Materials Segment (75% of total sales) have increased from 22% to over 40% in the same period.
Versume (Materials Segment)
*9 Months in 2016 for VSM and CCMP, 6months for ENTG
While substantial portion of the margins improvements in 2013 and 2014 were fundamentally driven due to number of self-help initiatives (improvements in mix, price, exiting unprofitable businesses and transfer of production facilities from US to Asia (close to the end customer)), the margin improvements in 2015 and 2016 where predominantly due to favorable demand dynamics in the memory market (positively impacted prices of NF3, WF6 and a few other products). The Company was fortunate enough to enter into long-term contracts that helped improve margins as demand increased, but the Management has stated (Feb 24, 2016 call) that VSM is bringing in new capacity (along with competitors), and that the market prices would adjust over-time - which should imply lower margins.
Secondly, VSM’s closest peers (CCMP and ENTG) on the other hand have EBITDA margins consistently in the 22% area. Both CCMP and ENTG operate in the same industry as VSM and have the same end customers. CCMP generates 90% of its revenues from CMP slurry (#1 provider with 45% market share), which is an advanced polishing material that is meant to have higher margins. VSM’s sales from similar advanced materials is less than 35% of its total revenues and does not even hold #1 market share in any of the big items.
Additionally, VSM generates 40% of its total sales from Process Materials, where it competes primarily on price with other companies, and so the margins for this segment should be much lower than the Advanced Material segment. For the above reasons, we do not believe that VSM’s current margins are sustainable and would expect the margins to drop to around 25-27% area (still 300-500bps above its peers).
2.Company will not be able to sustain its historical low capital expenditure: Company is grossly underestimating the capital expenditure it will need to maintain operations in the future. Company keeps stating that one of its strongest point that the business is “Low Capital Intensive”. The average capex for the Company over the last 3 years has been around $25mm (2.5% of sales; ~48% of D&A). In our opinion, $25mm of maintenance capex is extremely low simply considering the state of its current PP&E. Machinery and Equipment which makes 80% of its total PPE and the main item required to run its daily operations has depreciated over 80% of its initial value. Company would require about $250mm+ to simply bring the useful life back to these assets back to 50% of the original value. Additionally, capex of $25mm per year is only 50% of D&A and so the ongoing capex would definitely need be more to stay relevant and maintain the quality of its operations.
Capex as % of Sales (3 Year Average)
Capex as % of D&A (3 Year Average)
3.Management is determined on being acquisitive; acquisitions may come at a very high cost to equity investors: Management has clearly stated its intention to be acquisitive with the intention of consolidating the industry. Management, in one of the initial roadshow calls, had also mentioned that they would be comfortable levering up to 5x.While strategic acquisitions are certainly not a bad thing, the concern would be that the Company overpays for the acquisition and ends up in a leverage position that would be hard to get out of, especially considering that margins would drop and revenues might not grow as fast as expected if the Company is caught up in the semiconductor industry down cycle.
From an acquisition standpoint, CCMP (Cabot Macroelectronics Corp.) is the most obvious target out there, which will be good strategic fit. On the other hand, CCMP’s Board and investors (Hudson Executive Capital) are also strongly motivated to sell the Company. For more on this, I would highly recommend that you read “mement_mori" CCMP write-up on VIC from July 2016. Mement_mori made a good call on CCMP and the stock is already up ~25% since the write-up.
CCMP is currently a $1.2bn EV company; a 25% premium would imply an acquisition price of $1.5bn. Assuming proforma EBITDA of $490mm ($325mm EBITDA for VSM, $115mm for CCMP and $50mm of synergies), VSM’s total proforma leverage would be 5.1x, fitting perfectly in VSM’s wheelhouse. The happy dream could them soon turn into a nightmare if VSM’s EBITDA margins where to drop and synergies don’t fully realize (27% EBITDA margins and $25mm synergies would bump the leverage from 5.1x to 6.1x).
While the levered acquisition scenario might seems hypothetical at first, there is a very good chance that the Company would pursue this in the near future for two main reasons:
i)The management team comes from Air Product, where acquisitions has been an important growth strategy. VSM’s CEO, Guillermo Novo, while has spent 3 years at Air Products and is familiar with Air Product’s playbook has limited experience with integrating assets
ii)Management’s bonuses would be tied closely to earnings and acquisitions is the only way to hit the numbers. While, VSM’s annual compensation plan has not yet been set, the Company has mentioned that it will closely replicate Air Product’s compensation program. Air Product’s compensation program for its CEO includes base + annual compensation in cash (equal to 1.3x base x up to 200% of base (if EPS grows by ~20%)) + Long-term incentives in the form of shares depending on relative share price performance versus peers.
4.The company is exposed to the cyclical semiconductor industry more so than the Management wants to admit. While in general, the semiconductor industry today is much less cyclical than in the last 2 decades, it is still cyclical, especially when it comes to new investments for capacity expansion. VSM’s DSS (Direct Systems and Services) Segment, which generates about 25% of total sales, is directly exposed to infrastructure expansion in the semiconductor industry. The segment was fortunate been enough to take advantage of the expansion in the semiconductor space during 2013 and 2014, but since 2015 has been experiencing some downturn. Sales peaked in 2014 at $300mm (due to some big projects) but since then have dropped 12% in 2015 and 21% in 2016 on yoy basis.
For Company and industry overview, please refer below links: