KMG Chemicals Is Still Worth A Look

Summary

• KMG shares have pulled back from the recent highs but the stock is still outperforming the S&P 500 so far in 2017.
• The company operates in several industries that are projected to experience strong growth in the years ahead, and the recent acquisition (Flowchem) is also expected to be accretive to earnings.
• KMG is a long-term buy at today's price.

KMG Chemicals' (NYSE:KMG) stock price has pulled back from the recent highs of ~$60 per shares but the stock is still outperforming the broader market by 15 percentage points.

(Source: Nasdaq)

In late May 2017, I published an article that described KMG Chemicals as a company that was worth a look under $50 per share. Since that article was posted, KMG closed on its Flowchem acquisition and reported Q3 2017 financial results that beat the top- and bottom-line analyst estimates.

Today, I believe that investors with a long-term perspective should consider adding KMG shares on any broader market pullbacks because, in my opinion, there is a lot to like about this company as we head towards 2018.

(Source)

What Have You Done For Me Lately?

On June 9, 2017, KMG reported Q3 2017 adjusted EPS of $0.53 (vs estimate of $0.47) on revenues of $81.6MM (vs estimate of $79.8MM). For the nine months ended April 30, 2017, the company reported revenue and net income growth of ~7% and ~23%, respectively. (Source: Q3 2017 10-Q)

KMG has benefited from its cost cutting initiatives and the integration of past acquisitions, so the company has been able to report strong earnings growth over the past few quarters. For Q3 2017, KMG reported adjusted EBITDA of $13.9MM, which was an ~24% increase from the same period in the prior year.

Q3 2017 marked the company's 13th consecutive quarter of double-digit YoY increases in adjusted EBITDA.

(Source: August 2017 Investor Presentation)

Looking forward, management is still confident that they are able to continue the impressive streak of executing on the company's overall growth strategy and they now expect for KMG's full-year EBITDA to hit the upper end of their guidance (ex Flowchem contribution).

Looking Out, The Trends Look Positive

The Flowchem acquisition will create a great deal of shareholder value, of course, in my opinion, but I believe that the electronic chemicals business will likely be the company's key growth driver over the next decade or two. During the Q3 2017 conference call, management described 3 positive trends that will impact the electronic chemicals business in the years ahead:

First, following a period of consolidation and rationalization of production capacity, multinational semiconductor manufacturers are ramping up capital spending on advanced technology and tools that will enable the next generation of semiconductor devices.

While semiconductor capital equipment spending doesn’t immediately impact our electronic chemicals business, it is a leading indicator for future growth given our focus on supplying the high purity and highest quality products for our customers’ most advanced manufacturing processes.

Second, semiconductor unit production has increased to meet rising demand for a numerous new applications in automotive, internet of things, artificial intelligence, cloud computing, and more. KMG is strongly aligned with many global semiconductor manufacturers who increasingly focus their product development efforts on these faster growing end markets, which should provide a favorable tailwind for semiconductor unit production in the years ahead.

Third, as semiconductor devices continue to become more highly integrated and complex, chemical purity and quality requirements are increasingly -- increasing to enable production of these more advanced devices. Manufactured process complexity is also increasing at new technology nodes, resulting in greater process chemical usage during the wafer production process.

KMG has a strong position in several key markets but, more importantly, the company has strong partnerships with several major global semiconductor manufacturers.

(Source: August 2017 Investor Presentation)

To highlight just one growth market, Gartner Inc. projects for connected devices that supports the Internet of Things (or IoT) to reach 20.8B devices by 2020 (up from ~6.4B in 2016). In addition, a recent ServiceMax survey shows that 96% of senior business leaders plan to use IoT in some capacity in the next three years.

The future for the IoT industry is now and I believe that this will bode well for KMG's electronic chemicals business, as semiconductors will play a major role in supporting the growing demand for connectivity.

Valuation

KMG shares are reasonably valued when compared to its peer group.

KMG PE Ratio (TTM) data by YCharts

The almost 30 P/E ratio (based on trailing earnings) appears high but let's not forget that the broader market is trading at a "lofty" valuation too. Plus, the earnings impact of the IoT growth are not likely going to come into play in 2017 (or even early 2018) but the Flowchem acquisition is expected to be accretive to earnings in the first full year. As such, I believe that KMG looks more and more attractive the further that you look out.

Bottom Line

KMG's management team has a proven track record of integrating acquisitions but Flowchem is larger than any all of the company's recently acquired assets. Therefore, investors should closely monitor management's commentary related to the newly acquired assets and the company's financial leverage ratios - KMG took on a substantial amount of debt to finance the acquisition - as we head into 2018.

On the other hand, KMG's long-term earnings growth prospects appear to be intact and there is a lot to like about this small cap company in today's market. Furthermore, KMG will greatly benefit from President Trump's proposed policies (infrastructure spending and tax reform) if the administration is able to get back to their agenda at some point in 2017 or 2018. It is also important to note that the company's President and CEO, Chris Fraser, recently purchased 4,000 shares of KMG for ~$190,000 ($46.99/share). A better entry point will likely present itself later in 2017, but I believe that long-term investors can start to layer into a KMG position at the current price levels.

Full Disclosure: I hold a KMG position in my R.I.P. Portfolio, and I have no plans to reduce my stake in the near future.

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Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

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.