Quaker – Confusing Math, Is It a Short Or A Buy, We Think The Latter!

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 20th 2018

Quaker – Confusing Math, Is It a Short Or A Buy, We Think The Latter!

  • KWR is a smaller and riskier version of PX today; unlike PX, we see some of the benefits of KWR’s pending acquisition (Houghton) already priced in, but not all.
    • If the deal goes ahead, the stock still has significant upside – 30% or more.
    • If the deal does not, the stock has quite a bit of downside – at least 20%.
    • The significant rise in the stock month to date (Exhibit 1), suggests that there is heightened expectation that the deal will close according to the most recent guidance – by year-end.
  • Apart from the complications associated with modeling the deal, the company is in an interesting segment of the economy and very levered to improved economic growth as well as improved US manufacturing, although less than 50% of sales are in the US.
    • Houghton adds scale in some business segments and exposure to adjacent segments.
    • KWR would be a net beneficiary of tariff changes longer term if they encouraged more manufacturing in the US – simply raising steel and aluminum pricing in the US is unlikely to do that as reflected in the steel and aluminum stocks year to date.
  • Valuation is complicated because the Houghton deal should result in a step change in capital and a step change in earnings and if the step change in earnings is proportional to the step up in capital then the stock is still cheap today.
    • For KWR to get its return on capital back to trend it will need to deliver more than the promised synergies but will be in no different position than SWK was post its Black and Decker acquisition or how FUL is today – both good stories.
    • A return to trend return on capital would give KWR earnings that support a share price above $270, but we think it would probably take 18 months post the deal close to get there. This is without organic growth because of the better manufacturing environment.
  • If the deal fails – is blocked by the regulators or KWR is out-bid (it is unclear why the deals is taking so long) – the stock has downside as KWR will likely miss 2019 estimates without deal synergies.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details – Making Sense of Valuation

Acquisition modeling is always complex and is clearly causing controversy at Quaker, as the run up in the share price, while welcome given our recommendation, has now pushed the stock well above the top end of the target price range and well above what current estimates should justify. If you take a snap-shot of our valuation model today you get what appears to be a very expensive stock (Exhibit 2), but you get a skepticism index of zero – Exhibit 3 – and forward earnings suggest a premium to returns on capital that mirror the premium to value – Exhibit 4.

The stock is not well covered, and the sell-side clearly does not like the deal as much as the buy-side. Every covering analyst has a hold recommendation on the stock (unlike us) and the share prices is now $20 above the highest published target price.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exbibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Forward earnings have some benefit of the Houghton deal baked in, but the balance sheet does not reflect the change in capital and consequently you get the disconnect in the first three charts and the high stock price relative to targets.

In Exhibits 5 and 6, we re-do the return on capital chart and the valuation chart but add the capital jump associated with the Houghton deal such that forward capital now begins to reflect forward earnings – but this also shows a disconnect.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

At trend ROC, current earnings – accounting for the capital jump with Houghton – would be closer to $14 per share than the current 2020 estimate of just under $9.00 per share – in Exhibit 7, this is net income of $180 million versus the consensus $156 million for 2020. Normal value on that basis is around $270 per share on the pre-deal share count and begins to explain why the stock has overshot what would be justified by current estimates and suggested in current target prices.

Exhibit 7

Source: Capital IQ and SSR Analysis

For this higher valuation to be reasonable:

  1. The Houghton deal has to close – note that it was announced in April of 2017.
  2. KWR has to get more synergies than suggested and drive returns on capital back to trend – showing that the Goodwill and other intangibles that will come with the deal are worth it.

We continue to like the KWR story here, but if the Houghton deal does not go through the stock has a minimum of 20% downside in our view. Right now, the stock appears to be pricing in a 40% chance that the deal is both done and executed well.

Addendum – What is KWR and Why The Fundamental Interest.

KWR is a mid-cap specialty chemical company focused on the supply of chemicals into the metals industry, roughly 50/50 split between the primary metals industry and the metalworking industry – Exhibit 8. Revenues for the 12 months through June 2018 were $860 million, and EBITDA was $120 million. Quaker is buying Houghton International, which has a mix more biased to metalworking – Exhibit 9 and there are overlapping segments and complimentary segments Exhibit 10. In 2016 Houghton had very similar revenue and EBITDA to KWR – KWR is paying $1.70 billion for Houghton in cash, shares and assumed debt – assuming a share price of $195.

Metals and metalworking are economic growth driven industries and KWR has shown much stronger revenue and EBITDA growth as the global economy has improved. Both companies are geographically diverse, but with a North American and European bias.

Exhibit 8