I liked small specialty chemical company KMG Chemicals (NYSE:KMG) back in August of 2014, but little did I expect the company to shoot up 67% in less than a year. I believe the gains can be tied back to management doing what it said it was going to do - deploying capital to add a third business, delivering better margins through restructuring, and upgrading the overall business (by exiting the creosote operations).
I do have some concerns that this somewhat illiquid and under-followed stock has now overshot the mark. A mid-$20's fair value seems reasonable even when factoring in additional M&A, but if KMG can identify acquisition targets with margins and FCF potential along the lines of Val-Tex, perhaps that target too could prove conservative.
Strong Growth And Stronger Margins
KMG Chemicals is generating good financial results. Revenue fell 12% in the fiscal third quarter (reported about a week ago), but that was due to the company's sale of its creosote wood treatment business. Electronic chemical sales rose 8% as reported (up closer to 15% on a constant currency basis), while wood treatment sales were down 67% as reported.
Between selling the creosote business and restructuring costs out of the electronic chemicals business, KMG management has unlocked meaningful margin leverage. Gross margin rose seven points on a yoy basis, while adjusted EBITDA rose 20% and adjusted operating income rose 47%. At the segment level, electronic chemical margins improved more than four points (to 10%), while the sale of the creosote business more than tripled segment operating margin to 30%.
All things considered, I think the electronic chemicals business is doing well. Semiconductor sales rose 6% in the first quarter of 2015 (not a perfect calendar overlap, but close enough) and wafer shipments were up almost 12% in total area terms. As KMG Chemicals' chemicals are used in a range of cleaning and etching applications that are key to the semiconductor production process, overall industry volume is an important driver but I believe the company is showing that it can be more than just a passenger.
Shuffling The Deck
In the months since I last wrote on the company, KMG Chemicals management has also been quite active on the M&A front. Back in January the company announced the sale of its creosote wood treatment business to Koppers (NYSE:KOP) for $15 million. I was quite pleased to see this move. Creosote has been increasingly phased out in favor of other treatment chemicals or boron-creosote combinations that nevertheless reduce the amount of creosote needed and KMG wasn't really in a position to add a lot of value.
With the creosote business gone, the margins in the wood treatment business have shot up. KMG is the sole manufacturer of penta (pentachlorophenol) and while sources vary as to the percentage of utility poles treated with penta (I've seen a low of 45% and a high of about 65%), it's a lucrative business even if there isn't a lot of growth potential in the number of penta-treated poles sold in a given year (estimated to be around 2 million).
As one business left, KMG Chemicals brought a new one into the fold with the acquisition of Val-Tex in April. Val-Tex operates in the industrial valve lubricant and sealant market, where it sells not only the lubricants and sealants, but also application equipment and fittings. This is a small business (about $12 million in trailing revenue), but at 28% EBITDA margin it is a highly profitable business.
I will not pretend to be an expert on the topic of industrial valve lubricants. I know that companies like Dow Corning sell products for this market. I also know that specialty lubricants have been a pretty good business for the likes of DuPont (DD), ExxonMobil (NYSE:XOM), and BASF (OTCQX:BASFY). I also know that industrial valves has been an attractive space in the industrial sector for a few years now (or at least before the oil/gas meltdown) as they are a key component in process automation. KMG Chemicals estimates that the valve maintenance market is a $200M/year market, so that would suggest an opportunity to grow within this business, but not so much opportunity that larger chemical companies will want to target it.
Drive The Growth
Given the recent trends in wafer starts and the potential growth of Internet of Things devices, I think KMG can look underlying semiconductor/electronics market growth in the mid-single digits for the next few years. There may be opportunities on top of that to raise prices, gain share, and/or expand into adjacent products, but Honeywell (NYSE:HON) and BASF aren't exactly pushovers. Recent steps to reduce costs and more effectively leverage existing assets (like ending hydrofluoric acid production in California and making better use of the Pueblo, CO facility) should help support further margin growth over the next 12-18 months provided there is no sharp downturn in semiconductor production.
The wood treatment business "is what it is" - a low-growth business that can generate impressive margins and cash flow. The Val-Tex business is harder to peg at this point; if management uses this as a starting point for a larger specialty lubricants business, there is significant growth potential but it will require upfront spending.
As is, I'm looking for mid-single digit revenue growth and mid-to-high single-digit FCF margins from KMG over the next ten years. I'm also making an estimate as to the value that the company could add from additional M&A. Were the company to deploy another $40 million over the next year, I could see that adding another $3.50 or so to the fair value today. Obviously there are a lot of guesses and assumptions that go into that - the multiples that the company pays, the underlying profitability, the growth potential and so on - but I believe it is at least a reasonable placeholder. All told, I think the DCF value of KMG today is about $27.
EV/EBITDA and ROE/BV support similar conclusions. An 8x multiple to my fiscal 2016 EBITDA estimate ($42 million) gives me a $26 target, while regaining a double-digit ROE would argue that today's book value multiple is reasonable.
The Bottom Line
I was pleased to see KMG Chemicals redeploy capital into a profitable niche business that can serve as a foothold into a new fully-fledged business segment. I've also been surprised to see just how much margin leverage the company has been able to achieve by selling the creosote business and restructuring its cost base. All of that certainly supports a stronger share price.
Looking out from here, I expect management to look for more M&A opportunities, though the multiples still aren't what I'd call attractive on a general basis. I have underestimated this stock before and am wary of doing so again, but I think today's price pretty reasonably captures the near-term potential from this small specialty chemicals company.
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.