In January I wrote an article about CP Applied Technologies (GCP), a spin-off from W.R. Grace & Co (GRA). The shares underperformed in the first weeks of trading following the spin-off, but doubled from $15 in this period last year towards $30 in September of 2016.
Ever since shares have come down a bit, and have mostly traded in the mid-twenties, but that is about to change as the company received a binding offer from German-based Henkel for its Darex Packaging business. The Germans are willing to pay up to $1.05 billion for the business, unfortunately net proceeds to CP come in at just $800 million after taxes and transaction costs.
While the sales price is great, I am somewhat disappointed by these deal related costs, in what remains a net positive development, accompanied by a solid outlook for 2017. As such I am a buyer in the mid to high twenties, on the back of a strong remaining business, good positioning & outlook, reasonable valuation and very strong pro-forma balance sheet.
Who Is CP Applied?
GCP has long been part of W.R. Grace and operates three segments which combined generate nearly $1.4 billion in sales in 2016. Specialty construction chemicals is the largest segment and posted sales of $624 million last year. Adjusted for the issues in Venezuela and currency moves, sales were down by 60 basis points following a softer fourth quarter in which adjusted sales fell by 2.5%.
The specialty building materials segment reported a 6% increase in sales last year. Revenues of $422.7 million were up by 7.9% if adjusted for currencies, with growth slowing down to 5.1% in the final quarter.
The Darex Packaging Technologies segment posted a 5.2% decrease in sales towards $309.3 million, but sales were up 0.9% adjusted for Venezuela and currencies. Like the other segments, fourth quarter momentum was fading a bit, as comparable sales were down 70 basis points.
What About The Packaging Deal?
The $1.05 billion deal for the Darex segment looks rich with sales coming in at $309 million a year. Adjusted EBIT came in at $61 million, but that is before allocating a portion of roughly $34 million in corporate and pension costs for all of GCP. If I allocate 20% of these costs to the segment, (based on the sales portion, while the company is not willing to disclose the real number) adjusted EBIT comes in at $54 million. That suggests that Henkel is paying a more than fair multiple at nearly 20 times operating earnings.
The specialty construction chemicals segment posted adjusted EBIT of $70 million for the year, as the specialty building materials segment reported EBIT of $114 million. The remaining two businesses therefore generated adjusted EBIT of $184 million a year. After allocating 80% of the $34 million in corporate costs to GCP, adjusted EBIT is seen around $157 million going forwards.
The good news is that financing costs could come down dramatically following the deal with Henkel, especially as GCP carries along quite some expensive debt. Holding $163 million in cash and $21 million in pension assets, GCP operates with $929 million in debt and pension related liabilities. These liabilities of roughly $745 million on a net debt basis weigh heavily on the balance sheet, with annualized interest costs coming in around $75 million. The net proceeds of the deal would be sufficient to retire net debt entirely, and thereby allow GCP to avoid $75 million in interest costs, which is actually more than the EBIT contribution of Darex.
Following the deal, GCP operates with a flattish cash position, or perhaps with roughly $50 million in net cash. Note that the remaining core business continues to post adjusted EBITDA of $200 million per annum going forwards. This indicates plenty of firepower going forwards as the company was actually quite leveraged ahead of the deal.
The Pro-Forma Earnings Picture
Let´s assume that GCP could indeed retire all of its debt and thereby avoid financing costs altogether, even as management indicated that it prefers to reinvest some of the proceeds into the business. In the debt retirement scenario, adjusted EBIT of $157 million leaves a net profit of $110 million after applying a 30% tax rate. With 72 million shares outstanding, that means that adjusted earnings come in at roughly $1.50 per share.
The best thing is that the company no longer torsos along the net debt load. At $29 per share, the valuation at 19-20 times 2017s earnings looks reasonable. This comes on the back of the quality business, solid growth and debt free balance sheet in this scenario.
If the company is willing to leverage up towards 2 times EBITDA to expand the business, and/or engage in buybacks, there is roughly half a billion in firepower available. That said on the call the company reiterated that reinvestments in the business is the key priority, as investors should not pin their hopes on huge buybacks.
Final Thoughts, Nice Deal Reveals Appeal
Let´s assume that the company will operate with a net leverage ratio of 2 times following the deal. That leaves roughly half a billion dollars to be spent on acquisitions and or buybacks. Let´s for simplicity reasons assume that all these efforts are geared to buybacks, which is not that realistic in all likelihood given management´s comments.
At $29 per share, that allows for the retirement of 17 million shares, reducing the float to 55 million shares. With adjusted EBIT of $157 million, I see modest financing costs of $20 million in such a scenario, for after-tax earnings of $96 million in a 30% tax rate scenario. That would be equivalent to $1.75 per share in terms of earnings. After applying a reasonable multiple to this well-positioned business, I think a $30-$33 valuation should be within reach.
The fact that I am somewhat upbeat has everything to do with the big valuation which Henkel is paying for to Darex. After-tax profits of the unleveraged business come in just shy of $40 million, as the Germans paid a steep 28 times multiple in that respect. That is a huge premium of course and is to be applauded. Unfortunately there are roughly $250 million in taxes and transaction costs involved with the deal, as this ¨leakage¨ amounting to roughly $3 per share, being a very substantial amount.
Using the $1.75 pro-forma earnings number and taking into account the good market positioning of the remaining core business, I am willing to buy shares at a 15-16 times multiple, for a $26-$28 entry target. All in all the sale is great, yet it is disappointing to see quite some leakage in the deal, as I am eager to buy on dips in the coming weeks.
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.