Description

Brenntag has been written numerous times on VIC, the last time in 2023 by mike126. The reasons behind the underperformance of the stock to date are now in the rear mirror and the setup is now very favourable going into 2025. We see an opportunity to earn a high teens / low 20s IRR over the medium term in a base case scenario with little to no downside in a bearish scenario.

I won’t spend much time on the business as it’s been discussed at length in previous posts. Very briefly, Chemical Distribution is a desirable business for the following reasons:

• Secular tailwinds should sustain GDP+ growth in the future. While chemical manufacturing is expected to grow in line with GDP, increasingly more volumes are sourced via distributors. Historically, distributors have grown 1-2% more than the overall chemical market
• Barriers to entry are very large. Distributors need to have a large network of fixed assets as well as distribution channels to operate efficiently. There are significant economies of scale. A single truck would be used more efficiently if 2 deliveries were to occur in one trip. There is no way around scale to achieve such efficiencies
• While in the classic commodity business there is little know-how required, the Specialty business requires a high degree of technical knowledge
• The chemical distribution industry is highly regulated and needs to comply with health and safety standards, creating further barriers to entry
• The industry is still very fragmented, favouring consolidators such as Brenntag and Univar picking up smaller competitors and extracting cost synergies integrating them in their operations. Brenntag spent over €3.5bn in revenues since 2010 via over 100 acquisitions
• The business is highly cash generative. Over the last decade, FCF conversion over EBITDA averaged 75%
• The business is highly resilient. In recessionary times, distributors sell down inventory so free cash flow generation is actually counter-cyclical
• Risks of disintermediation are very small as distributors have a full line of products and connect between thousands of customers and suppliers

Brenntag is the global leader with the largest product portfolio, at least in the non-specialty side of the business:

The basic growth algorithm for Brenntag should therefore be the following:

• 2-3% growth in the chemical markets, plus
• C. 1% extra growth in distribution as customers tend to outsource
• 2% margin growth via efficiencies
• 3-5% growth from M&A and other specific growth initiatives

All in all, Brenntag long term EBITA growth should trend towards c. 10% per annum:

Because of the above characteristics, chemical distributors have historically traded at significant premium to chemical producers and have often been the targets of Private Equity investments. Until 2022, Brenntag traded on average well above 10x EV EBITDA. On our estimates, Brenntag is currently trading on less than 7x EBITDA 2025. In our base case which assumes a mild margin recovery, well below company targets, and a very modest re-rating to 8x EBITDA, we see a fair share price of c. €90 in 2-3 years for an IRR well in the 20s.

Reasons for share price dislocation

Over the last couple of years, a series of missteps, communication blunders and bad management caused 1) the company to miss its targets / guidance and, 2) its valuation multiples to compress further to all-time low levels. Adding to this a negative chemical cycle characterized by falling prices and subdued volumes explains why a seemingly good business finds its share price where it was 10 years ago. We shall look at the main reasons for underperformance.

Organic underperformance

In June 2023, PrimeStone Capital released via a newly created website www.revivebrenntag.com a 65-slides presentation arguing their case against current management. One of the most interesting slides is the one below, showing how cost management at Brenntag has been significantly poor over the last decade if compared to IMCD. The issue is not the absolute gap in OPEX as % of gross profit between Brenntag and IMCD – there are some structural reasons favouring specialty distributors over commodity distributors. The problem is the widening gap over the years:

Brenntag significantly underperformed Specialty players like Azelis and IMCD over the last few years. Their gap in terms of OPEX as % of Gross Profit was c. 3% in 2012. It widened to over 9% by 2022. While IMCD is a pure specialty chemical distributor and as such benefits from significantly better economics, the year-on-year changes are indicative of the way the two businesses have been managed. These trends have actually accelerated in the last 2 years. While we are in a chemical downturn and all players exhibited negative gross profit organic growth (distributors tend to see expanding margins in an inflationary environment and contracting margins as prices fall), the cost management on the part of Brenntag has been abysmal.

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If we look at the table below, we can see what happened in 2022-24 on the margin side. Both IMCD and Brenntag faced very similar industry pressures characterised by stagnant gross profit growth as chemical prices were in a deflationary environment. However, while OPEX as percentage of gross profit increased by c. 370bps over 2022-24 for IMCD, the increase for Brenntag was as high as 570bps, 200bps more than IMCD:

If we were to extend further the useful PrimeStone chart above, we can see how Brenntag cost management continues to get worse compared to IMCD:

This is a business where there is natural inflation in the cost base and a continuous and constant review of the cost base is necessary to maintain healthy margins. As we shall see, Brenntag management has been distracted elsewhere and failed to execute on efficiency measures when competitors such as IMCD succeeded. We can also safely assume that after a decade of cost mismanagement, there are serious low hanging fruits on the cost base to go after.

Failed Activism

PrimeStone Capital, a European based activist group founded by former partners of Carlyle, got involved in Brenntag at the end of 2022 with a letter to the Supervisory Board effectively asking for 3 things:

1. Terminate any discussion to take over Univar

2. Buyback shares and re-lever the balance sheet

3. Separate the Specialty division

The genesis of their involvement was a series of reports in November 2022 stating that Brenntag was about to bid for its largest competitor Univar. Univar was ultimately taken private by Apollo shortly thereafter. Brenntag shares sold off on the back of those reports because the market saw through the value-destroying nature of these large deals. While smaller transactions are part and parcel of the industry, and they tend to be very accretive, large chemical distribution deals don’t seem to work out as well. Univar acquisition of Nexeo in 2019 proved that large chemical distribution combinations actually come with significant revenue dyssynergies. Customers try to de-risk supply by avoiding sole source distributors. If a large customer was using Univar and Nexeo, they’d often decide to significantly curb one of the two contracts and seek new distributors. Furthermore, the operational and IT integration involved is often more complex than originally forecasted. It took Univar a lot longer and a lot more money to successfully integrate Nexeo and extract the targeted cost synergies. In the end, Brenntag did not bid for Univar but the mere fact that it was openly considering it, tarnished its Board reputation and damaged its credibility.

The second point – share buyback – was less controversial. Brenntag targets a 2x Net Debt to EBITDA over the cycle and in 2022-23, the company was comfortably below stated target. Brenntag eventually initiated its first ever share buyback in 2023, buying back c. €500m in 2023 and another €250m in 2024.

The third point in PrimeStone letters turned out to be the most contentious. PrimeStone highlighted in their presentations how Specialty distributors that focused their business on higher value-added services fared much better than commodity distributors. Many customers expressed real interest in moving some of their business away from the likes of IMCD and Azelis if only Brenntag could offer a comparable level of service. Furthermore, specialty chemical distributors trade on much higher multiples. IMCD today trades on c. 15x 2025E EV/EBITDA which is more than double the multiple of Brenntag. We shall discuss more on this below. Eventually, PrimeStone lost its activist battle. As VIC investors should know by now, Germany is not a friendly country to activist hedge funds. PrimeStone pushed for 2 new Independent Board Members backed by Glass Lewis, but they ultimately lost the vote to a very antagonistic Board led by CEO Christian Kohlpainter. Eventually PrimeStone had to declare defeat and sold out of the position. Interestingly, Artisan Partners recently got involved in Brenntag and is currently holding a 10% position. While Artisan refuses to call themselves an activist shareholder, they do often take an active approach. For example, in the case of Danone, they’ve lobbied for strategic changes. We would not be surprised to see some pressures on the Board coming from them in the near future.

Two divisions split

Brenntag operates 2 divisions: Brenntag Specialties and Brenntag Essentials. The Specialties Division is characterized by tailored services for customers, where mixing, blending and formulating chemical compounds enable Brenntag to earn superior margins compared to its Essentials division, which is effectively a commodity distributor.

There’s been a trend in the industry towards bifurcation of supplier and customer needs. The needs for specialty products are very different from the needs for commodity products. Players such as IMCD and Azelis were early to recognise this trend and focused their entire operations on specialty chemicals. Brenntag is admittedly late to the party, but it has realized the importance of giving operational independence to the Specialty division. In industrial products, customers need broad access to many commodity products at the lowest possible cost in the most reliable manner. In specialties, there is a much deeper relationship between the distributor and the customer. Technical and innovation support are crucial. Formulating capabilities become an important competitive advantage. Pricing is less transparent and relationships are more stable, leading to higher margins and more resilient business.

As per chart below, the superior nature of specialty chemical distribution attracted numerous private equity groups. The 4 specialty distributors behind IMCD in size are all privately held. We wouldn’t be surprised to see IMCD itself being taken over by private equity at some point.

PrimeStone highlighted how Brenntag has been on an endless journey to separate the specialty business from the commodity one with no clear end in sight. During 2013-17, when things were actually going well for Brenntag, the management view was to keep a united organization under the One Brenntag umbrella. In 2018, the company started messaging that a separation will be in the best interest of shareholders. Concurrently with PrimeStone pressure, the Board also expressed its desire to split the company in two. In July 2023, Brenntag announced a “new governance model for its two divisions according to its Strategy to Win”, which should have been another step towards full separation.

Ultimately, in December 2023, Brenntag held a Capital Market Day where the company effectively confirmed its intention to legally and operationally separate the two segments by 2025, with a view to become a new leader in the two segments by 2026.

The saga did not end there though. In Q3-2024 the company announced that a full separation would not be in the interest of shareholders because of the prohibitive costs and dyssynergies involved. The company said that a full legal separation would not happen before 2027, but operationally, the disentanglement process would continue. The two entities will continue to be legally joined and share some G&A costs:

While disappointing and very frustrating for many investors that were playing the imminent split, there is at least a long term plan in motion to separate the business. Those event-driven funds that bought shares in 2023 playing for the spinoff are now out of the picture and management has the opportunity to refocus its attention on running the business efficiently and bridging the gap in specialties to best in class operators like IMCD.

Setup for 2025

We believe the setup for 2025 is very interesting, providing investors with a particularly asymmetric return profile.

First and foremost, the CEO is finally leaving the company. Cushy German Boards rarely take aggressive actions against one of their own. Dr. Christian Kohlpainter “decision” to not extend his contract is in all likelihood a forced exit in German style. His job, as acknowledged in the press release, was nowhere near done and his track record to date has been very poor. Artisan Partners’ involvement is timely as they may positively affect the selection of the right CEO to guide Brenntag in the future. The Board has the opportunity to hire a true operator that should focus entirely on efficient operations.

In terms of other distractions such as M&A, legal separation of business segments and fighting activist shareholders, 2025 should be a relatively quiet year where all efforts will be dedicated to reign in on costs and execute its efficiency programs. As management acknowledges, this program requires the full attention and dedication of management. The heavy lifting was already done in 2023 and 2024, but the full €300m benefit of the program is starting to emerge only in 2025-26:

Cyclically, we also expect 2025 and 2026 to be good recovery years for the industry after the disastrous 2023 and 2024 where falling chemical prices affected all players. We’ve seen the first signs of a cyclical recovery in other chemical producers. We expect trailing 12m EBITA to trough in Q4-24 and growth to ensue in 2025, helped by an overall cyclical recovery plus the benefits of the cost take-out program.

Finally, in terms of market expectations and enthusiasm about the stock, Brenntag is probably one of the most hated stocks today on the DAX with very little hedge fund interest right now. Most analysts have a BUY recommendation with a target price in the €70s but no one cares. Jefferies is one of the most bearish analysts out there with a HOLD recommendation and a target price of €67, nearly 20% higher than current levels. In other words, everyone knows the stock is cheap, but the marginal buyer is waiting for some positive news to justify doing the work on the business to get involved. An inflection in margins and a return to organic growth may be enough to reignite interest in the stock.

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Scenarios

In our base case scenario, we are assuming LSD top line growth in 2024-27 and EBITA conversion rate to go from 27.5% in 2024 to 32-33% in 2027, primarily thanks to a cyclical recovery combined with cost take-out programmes. Note that Brenntag targets a 35-37% conversion ratio by 2027, so we are significantly below management goals.

In such a scenario, we assume a very modest re-rating to 8x EBITDA by 2027. In this event, we see a stock price around €90 in 2027 for 50%+ return and an IRR in the 20s.

In a more bearish scenario where the company fails to implement its cost take-out program and margins don’t inflect, we see very little downside, as the stock is currently trading on little over 7x EBITDA on depressed margins. The company generates enough cash to pay a dividend close to 4%, buy back shares and continue its M&A strategy of going after small tuck-in acquisitions. It’s hard to see further downside from here even if management were to completely miss its targets.