KMG Chemical: An Unknown Specialty Chemical Company, But Not For Long

Summary

• This small specialty chemical company is worth a look.
• The latest acquisition is a game changer for KMG, if approved.
• KMG Chemical is a great long-term buy, but I would wait for a pullback before starting a position.

KMG Chemical (NYSE:KMG) is a Texas based company that manufactures, formulates, and distributes specialty chemicals products across the globe. The company's growth strategy has been to acquire mature businesses in markets that still have promising business prospects but that are largely ignored by larger chemical companies. It is important to note that KMG's management team has a proven track record of acquiring and effectively integrating small specialty chemical companies since 1985 (see here for more detail on the company's history of acquisitions).

KMG has flown under the radar for many years, mainly due to the company's small market cap (~$670MM as of May 14, 2017), but, in my opinion, this company will soon catch the attention of many analysts in the financial community, so now may be the best time to start a position. I purchased my first KMG shares for the R.I.P. portfolio in late 2016 when the company's stock was trading below $40, but I failed to build a sizable position before the stock price shot up by over 70% in short order.

(Source: Nasdaq)

KMG's stock has greatly outperformed the broader market over the last year, but I believe that the company's shares are still worthy of your investment dollars, even at $50/share.

A Proven Track Record

This company has made several transformative transactions over the last five years that have greatly improved its business prospects, and the proof has shown up in the numbers.

(Source: 2016 10-K)

KMG disposed of several non-core assets - the most notable example being the Creosote Distribution Business in 2015 - and the management team has spent a lot of time and effort (and resources) in 2016 on restructuring and realigning its operations. So, the YoY decline in the net sales figure does not tell the whole story. On the other hand, KMG's impressive growth in income per share (52% YoY) and net cash flow from operating activities (133% YoY) shows that management's strategic decisions are already starting to bear fruit.

Furthermore, KMG recently reported Q2 2017 financial results (period ended January 31, 2017) that beat the adjusted EPS analyst estimates by $0.15, or ~35%, by reporting earnings of $0.57/share. For comparison purposes, the company reported adjusted EPS of only $0.40 in the same period of the prior year.

The reported YoY increase in adjusted EPS is great, but, in my opinion, the market has rewarded this company with a rising stock price largely due to an improvement in sentiment related to KMG's near- and long-term business prospect. To this point, KMG has shown the ability to improve its margins and cash flow performance over the last three years, and it appears that the impressive results should continue in the quarters/years ahead.

KMG EBITDA (TTM) data by YCharts

Management has been laser-focused at improving KMG's EBITDA and cash flow generation, especially when making strategic acquisitions and/or disposing of assets, and these two areas were bright spots in fiscal 2016 and through the first half of 2017. During the conference call, management mentioned that Q2 2017 was the 12th consecutive quarter that KMG reported double-digit YoY growth in adjusted EBITDA.

Based on the company's focus on cutting costs, it should come as no surprise that KMG entered into an agreement to acquire Flowchem LLC because this proposed acquisition is expected to be accretive to both EBITDA and improve free cash flow generation.

The Flowchem LLC Acquisition, Worth The Risk?

KMG agreed to acquire Flowchem for $495MM, including working capital of ~$17MM, and the purchase price equates to ~11x Flowchem's EBITDA. KMG is expected to take on debt to finance the purchase, which will have a big impact on the company's risk profile. For example, KMG had ~$40MM in long-term debt as of Q2 2017, so thinking about the company taking on several hundred million dollars of debt greatly changes the way that I view KMG's balance sheet.

(Source: Q2 2017 10-Q)

KMG has strong cash flow metrics - and so does Flowchem (discussed below) - and the company has improved its margins, so the combined entity should be in a position to service the debt. The deal, however, definitely adds risk, but the acquisition also has the potential to create a great deal of value for the company and its shareholders. Below are some of the highlights from management's presentation of the deal:

• Flowchem has been a global leader in the drag-reducing agents ("DRAs") industry
• The DRA market has had a CAGR of ~10% over the past six years, and research shows that the market is expected to grow by 5-10% over the next 10 years.
• Flowchem adds another product to KMG's portfolio, which helps diversify the business.
• Management expects for the acquisition to be accretive to adjusted EPS in the first year by $0.75-0.90.

(Full Disclosure: Please review management's presentation to learn more about KMG's acquisition of Flowchem).

Most importantly, the Flowchem acquisition is expected to be accretive to EBITDA and positively impact free cash flow generation.

(Source: KMG Presentation)

The deal comes with risk, but the acquisition has the potential to be a game-changer for KMG. Furthermore, KMG could potentially sell equity to pay down the debt (this very likely to happen, in my opinion), which may be a good option at the moment due to the fact that KMG shares are trading at a rich valuation.

Valuation

There is no denying that KMG is currently trading at a rich valuation, as the company's current P/E ratio [ttm] is ~30.

KMG PE Ratio (TTM) data by YCharts

I would, however, contend that KMG has great long-term business prospects in place, and management has consistently shown improvements in the company's cost structure and ability to generate cash, so I believe that the company will quickly grow into the current valuation. Plus, KMG's forward P/E ratio is more reasonable (~21), and the Flowchem acquisition, if completed, will be accretive to earnings and make the current P/E ratio more in line with the company's historical valuation levels.

Risk

The biggest risk to my investment thesis is actually the Flowchem acquisition due to the amount of debt that KMG will have to take out. The ~$500MM purchase price is close to the current market cap of KMG, so management definitely has to get it right with this acquisition. I do believe that the combined entity will be able to service the debt in the near term, but that does not mean that investors should expect everyone in the financial community to like this acquisition. On one hand, the Flowchem acquisition will greatly improve KMG's EBITDA and cash flow prospects, but, on the other hand, management will have to effectively integrate the business while also trying to manage current operations. As such, this deal should not be viewed as a sure fire win for KMG or its shareholders.

Bottom Line

I try not to pay up for smaller companies that I am interested in, but KMG's management team keeps making all of the right moves, so I fully believe that the company has the potential to grow into its current valuation. There is a lot to like about KMG at the current levels, but the most important metrics for investors to follow throughout 2017 are EBITDA and operating cash flows. Management has improved margins and reported strong cash flow generation over the last few quarters, so investors should expect more of the same over the second half of 2017.

The Flowchem acquisition should be viewed as both a catalyst and a risk point, but the additional risk is outweighed by the potential near-term reward, in my opinion. I recommend for long-term investors to wait for the broader market to pullback, and I would add KMG shares around the $50 level. I have a 12-18 month price target of $65, which assumes that the Flowchem acquisition is completed.

Full Disclosure: A preview article on KMG Chemical was published last week to the Going Long With W.G. marketplace service.

Disclosure: I am/we are long KMG. 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.