A. Schulman (NASDAQ:SHLM) started the year on a bad note as the company reported soft first quarter earnings results. As a matter of fact, organic sales are declining, on top of which comes the effect of a strong dollar. All of this has weighted heavily on the shares, which have lost nearly half their value since the high of last year.
Worsening conditions, a continued occurrence of one-time costs, worries about the debt load, and a moderate track record at best, all act as key reasons why investors are rightfully worried.
A Business, Driven By Deal making
Schulman has tried to make a transformation in recent years. Through deal making, the company has steadily become a specialty materials solutions provider. By focusing on higher-value added products, Schulman has tried to structurally improve margins and fence off stiff price competition. I cannot really say that the company has been very successful in this objective.
The company has arranged its output in six product families. Masterbatch solutions and engineered plastics combined make up roughly two-thirds of sales, being used for food packaging and durable goods among others. The other four smaller segments combined make up the remainder third of sales. These smaller segments produce performance colors, engineered composites, specialty powders and distribution services.
While the packaging business is not very cyclical, being the company's largest end market, some other end markets certainly are. Schulman's exposure to more cyclical end markets such as the mobility sector, building & construction, and electronics, certainly poses a modest.
Something Does Not Add Up
Schulman has grown sales from $1.6 billion in 2006, and those revenues have grown towards $2.4 billion on a trailing basis. While this 50% growth looks decent, the reality is that Schulman has made many acquisitions over the past decade.
Page 12 of the most recent investor presentation lists the exhaustive number of deals, which the company made over this time period. The largest deal is of course the purchase of Citadel at the start of 2015.
In total, Schulman lists 19 deals since 2007, although many are reasonably small. These acquisition targets combined generated $1.6 billion in revenues at the time of the acquisition. The trouble is that actual revenues have only increased by some $800 million since 2006.
While the company claims to have made a transformational strategic path, I am not convinced. Gross margins have only increased from 13% of sales in 2006 to 15% at the moment. These modest margin gains have not even been fully translated towards the bottom line as the reported operating margins have hardly seen any progress.
This acquisition spree had some other consequences. While the outstanding share base has been flattish, total debt has risen above the $1 billion mark. The main chunk of this relates to last year's $800 million purchase of Citadel Plastic Holdings. This deal took place when the market was still in good shape, forcing Schulman to pay a relatively steep 10-11 times EBITDA multiple.
Soft Start To 2016
In the second week of 2016, Schulman already released its first quarter results for the fiscal year of 2016. First quarter sales were up 5.6% to $649.2 million. This picture is flawed as the acquisition of Citadel added $111 million in revenues, while the strong dollar had a $62 million negative impact. If not for these two items, sales fell by 2.4% compared to last year.
The good news was that adjusted gross margins were up 260 basis points to 16.8% as a result of the strategy and acquisition of Citadel. Unfortunately, the negative sales leverage and higher cost structure at Citadel prevented these margin gains from fully materializing to the bottom line. Adjusted operating margins were up just 120 basis points, as GAAP margins improved by 60 basis points to 4.0% of sales.
With quarterly interest expenses skyrocketing to $13.6 million following the purchase of Citadel, net earnings were down by roughly 60% to just $5.2 million. These earnings of $0.18 per share are very low and have the opportunity to cast doubt about the viability of the debt load. After excluding deal-related expenses and other "one-time" costs, earnings did come in at $0.45 per share.
Appealing Non-GAAP Valuation, Watch The Leverage
The company holds roughly $96 million in cash at the moment, with debt holdings standing at $1.03 billion. This net debt load of roughly $935 million excludes pension liabilities of little over $100 million as well. With first quarter adjusted EBITDA coming in at just $58 million, Schulman operates with an annualized leverage ratio of roughly 4 times adjusted EBITDA, a high ratio given the current turmoil.
The company's 29.5 million outstanding shares trade at $25, translating into a market valuation of roughly $740 million, for an enterprise valuation of $1.7 billion. This absolute valuation is depressed as a result of the economic conditions and worries about the debt overhang.
To create real appeal, Schulman has to manage to survive this turmoil without incurring dilution, as the Citadel purchase has been too expensive in hindsight. Despite the disappointing first quarter adjusted earnings of $0.45 per share, the company sticks to the full year guidance of $2.80-$2.85 per share on the back of further cost savings and an increase in synergies. If the company manages to achieve this, shares trade at just 9 times adjusted earnings. The trouble is that investors have been disappointed in the past, as I see downside risks towards this full year guidance.
Adding It All Up
A. Schulman has long been a decent, boring and low margin business. The company decided to become more appealing to investors by embarking on a transformational strategy. This included the acceleration of organic growth, a string of acquisitions and move towards higher margin businesses.
In the period 2005-2012, shares have pretty much traded in the $15-$25 trading range. Investors applauded the transformation strategy and complementary deal making, as shares hit a high of $50 at the start of 2015.
The deal to acquire Citadel and the slower economic conditions have weighted heavily on the shares ever since. Shares have fallen from $50 towards the high 20s, marking a 40% retreat in the share price. Not only are the economic conditions to blame, the high price paid for Citadel and debt overhang concerns are all reasons for the disappointing price action.
The reality is that shares now trade at similar levels as they did in 2012. The trouble is that the business is still carrying quite some leverage, which could be a real concern if the slowdown will continue or potentially accelerate going forward. The simple reality learns that the company has never structurally posted operating margins, which are very appealing.
If I would assume that 6% operating margins are attainable on a $2.5 billion revenue base, operating profits can be seen at $150 million. After subtracting $50 million in interest costs and statutory tax rates, earnings are seen at $65-$70 million, or at around $2.30 per share. The company itself anticipates somewhat higher profits, on the back of to be realized synergy estimates.
Past experience learns that these margins and earnings have never really been realized, at least not on a GAAP basis. While the 9 times earnings multiple seems attractive, in combination with a 3% dividend yield, actual earnings have structurally disappointed investors. Given these reasons and the leverage being taken on, I see no compelling upside given the elevated and increasing risks involved.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.