Knowing when to exit a successful position is one of the hardest things in investing; good companies have a way of surprising you, and the market is often willing to reward excellence with higher multiples than the fundamentals might otherwise support. So while I thought KMG Chemicals (NYSE:KMG) was fairly valued a couple of years ago when I last wrote about this small specialty chemical company, I can't say I'm all that surprised that the shares are up another 25% or so since then (doubling the S&P 500 and doing pretty well against a grab-bag of other specialty chemical names).
Unfortunately, I find myself in a familiar position with the shares. I don't doubt that management can and will find more value-adding M&A opportunities, but the shares already seem to factor in positive developments from here. While I think a credible argument can be made for a fair value near $40, that really doesn't leave much upside for a company that I think will find organic revenue growth somewhat challenging to achieve.
Diversified, But Not Really Balanced
KMG has achieved a long-term goal that management had discussed for years - the company now operates three viable independent business lines. The company is really not all that diverse, however, as the electronic chemicals business contributed close to 90% of revenue in 2016 and will likely still contribute close to 85% of revenue this fiscal year and for the near future.
The electronic chemicals business has been built through M&A, with four deals between 2007 and 2016 establishing the business. While KMG has a high teens share of its overall target segments within the electronics chemicals market, that is a little misleading given the company's small presence in Asia - the prime manufacturing region for semiconductors. On a more "like for like" basis, KMG's actual share appears to be in excess of 50% of the U.S. market and over 20% of the European market.
The challenge there is that chip manufacturing in the U.S. and Europe really isn't much a growth opportunity. Fab operators like Taiwan Semiconductor (NYSE:TSM) and Samsung (OTC:SSNLF) have achieved impressive economies of scale, and many semiconductor companies in the U.S. and Europe chosen to go with a "fabless" model, outsourcing the manufacturing to fabs that are most often in Asia.
A recent small deal should help KMG address this at least in part. The company spent about $3 million to acquire Singapore-based Nagase in 2016. This acquisition won't move the needle much in terms of direct revenue and earnings contributions, but it gives the company a stronger presence in Asia from which to grow. To that end, management intends to spend around $10 million in growth capex on Nagase to build on that opportunity and hopefully gain more business with Asian fabs.
With the electronic chemical business contributing close to 90% of revenue, the remaining businesses clearly don't contribute much to the top line. They do have attractive margins, though, and they contribute more than 30% of segment profits.
KMG Val-Tex is the company's specialty lubricant and sealant business, which mostly addresses the global valve maintenance market. That market has seen some challenges given the decline in oil prices (a lot of the valve market is made up of oil/gas, refining, petrochemical, and transport/storage companies), but KMG recently announced the acquisition of one of its major competitors - Sealweld. KMG paid a little more than $17 million for Sealweld, and bought a business with attractive margins. Sealweld's EBITDA margin of over 21% compares favorably to the 11% to 14% overall EBITDA margin for KMG in the last couple of years, though Val-Tex had an even higher margin at the time of its acquisition (approximately 28%). Sealweld should roughly double the company's valve lubricant/sealant/service business, and should offer growth from here as companies start spending on more than just bare-bones maintenance.
KMG also still operates its penta wood treatment business (KMG-Bernuth), the only penta manufacturer in North America. Low oil prices have boosted the profitability of this business, though sales growth has been lackluster and it is unlikely that this will ever be more than a "cash cow" type of business. There's nothing inherently wrong with that, particularly as management has shown it can redeploy cash into M&A.
What Can Drive Better Results?
I'm cautiously optimistic that management can leverage Nagase to increase its presence with Asian fabs and drive above-market revenue growth. At this point, though, I'm leaning more "cautious" than optimistic. While these chemicals are mission-critical and not a large component of the cost of production, the fabs KMG will be targeting will already have suppliers in place so it could be a longer process of convincing customers to switch over.
Said differently, if you're already getting the sulfuric acid and ammonium hydroxide you need (at acceptable quality levels), why would you switch without a compelling driver like price concessions? On the other hand, the company does have advanced purification technologies/capabilities, and the more stringent demands of next-gen processes could (and should) drive more business to KMG over time. All of that said, I think it's important to remember that wafer starts are not likely to grow beyond the low-to-mid single digits, even with increased production for autos, IoT, and other applications.
I do believe that there is more to gain from the specialty lubricants business. Plant and system operators should be increasing their maintenance spending (you can only cut back for just so long before you'll get failures and breakdowns) on more stable oil prices, and Sealweld should offer meaningful synergy potential. I would also note that there is a large number of specialty lubricant companies/markets out there with respectable barriers to entry that could appeal to KMG as future M&A targets - these companies are generally too small to make much of a difference for larger chemicals companies, but they would be impactful (and digestible) for KMG.
KMG is pretty well run already, but I think it has room to "grow into" its SG&A base and drive better margins in the coming years as the electronic chemical and lubricant businesses grow. Moreover, I think there would be meaningful synergy opportunities for future tuck-in deals, but I don't explicitly model M&A.
As is, I look for KMG to generate 3-4% organic revenue growth with high-single-digit FCF margins and the potential for low-double-digit margins down the line. Discounted back, that supports a fair value in the mid-$30s. I would note, though, that lowering the tax rate to the high 20%'s would push the fair value above $37. I would also note that if the company deployed another $70 million to $80 million into M&A in the lubricants space at margins and valuations in line with Val-Tex and Sealweld, it would potentially create another $4 to $6 per share in value.
The Bottom Line
Given where the price is on KMG's shares, I believe the market is already assuming that revenue growth improves in the electronic chemical and lubricant business, that corporate tax rates do go lower, and that the company continues to recycle capital into M&A. Those are all reasonable assumptions in my view, but they make it harder to find/make the case for outperformance from here. I'd certainly keep KMG on a watchlist in the hope of taking advantage of a pullback, but I think it takes a pretty bullish collection of assumptions to find a lot of value beyond today's price.
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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.