KMG Chemicals: The Story Is Playing Out

Summary

• KMG shares are outperforming the broader market by a wide margin, and I believe that the outperformance will continue through 2018.
• The company reported Q1 2018 results that blew away analyst estimates.
• KMG is a long-term buy at today's price.

On December 12, 2017, KMG Chemicals' (NYSE:KMG) stock finished the trading day up 14% after the company reported strong quarterly results to start its new fiscal year. This one-day jump contributed to the already impressive YTD stock performance for KMG shares (shares are up over 60%), as the stock is now outperforming the broader market by almost 50 percentage points.

As I described in early September 2017, KMG is an unknown specialty chemicals company that is "worth a look" (the stock is up 35% since that article was posted). In my opinion, KMG's Q1 2018 results show that the company's long-term story is still intact and that there is potentially a lot of room for shares to run.

The Story Is Playing Out

My investment thesis for KMG revolves around the fact that this small specialty chemicals company has several promising businesses that have great long-term prospects. For example, KMG's electronic chemicals business has experienced strong earnings growth and this operating unit should continue to benefit from a high demand for semiconductors.

(Source: August 2017 Investor Presentation)

Additionally, KMG has a strong position in several key markets and it has established long-term partnerships with plenty of major players in the space.

The company also recently acquired Flowchem, which is a key player in the drag-reducing agents ("DRAs") industry. Moreover, the Flowchem acquisition diversifies KMG's business by creating a brand new material revenue stream that should benefit from a recovery in [or stabilization of] the oil and gas industry.

(Source: August 2017 Investor Presentation)

KMG has great businesses under its umbrella and I believed that the market would soon reward this company (and its shareholders) for its future growth prospects. So far, my investment thesis for this company has been playing out and, in my opinion, KMG's Q1 2018 results show that I may not have been bullish enough.

Great Results From Top To Bottom

KMG reported Q1 2018 results that beat on both the top- and bottom-line. The company reported adjusted EPS of $0.83 on quarterly revenues of $110.7M, which compares favorably to the analyst estimates for earnings ($0.63) and revenues ($106.6M). For comparison purposes, the company reported adjusted EPS of $0.48 on revenues of $76.4M in the same quarter of the prior year.

(Source: Q1 2018 Earnings Press Release)

The significant top- and bottom-line growths were largely fueled by the Flowchem acquisition as management has worked diligently to fully integrate the newly acquired assets. The Flowchem and Sealweld (another recent acquisition) assets are a part of KMG's Performance Materials division, so it should come as no surprise that this operating unit had substantial YoY growth in net sales and operating income.

The division's operating margin decline is not great but this was a direct result of the recent acquisitions, as the company had an uptick in depreciation and amortization. Not only has KMG benefited from integrating the Flowchem operations, but the company is also seeing positive signs for the possibility of cross-selling in the future. This was a topic that management highlighted during the Q1 2018 conference call:

..the pipeline operators are beginning to look at us as a total solution provider, so they are having discussions with us. Our DRA customers are saying, I'd like to talk to your lubricants guys and the contact points we have there and vice versa; so I can't point to any specific sales that have been through that but the awareness is going on, the introductions are happening and the connectivity is occurring. So, I mean that's going to happen overtime and our whole desire and strategy there was to be seen as this holistic supplier and solution provider and have the dialogue begin to take place so that as they consider either alternative DRA suppliers or alternative lubricant suppliers that they see us from that standpoint and we'll begin to see some crossover sales there.

So it's good interaction between the teams, they've been exchanging information about where we have various sales context, where there might be some opportunities, not only domestically but internationally as we think about the Middle East and other regions that each one of the businesses might have had higher concentration. So we're seeing some good dialogue internally and that's relating to some good dialogue with our customers. So we're pleased with the progress there and excited about the future opportunities."

This bodes well for KMG's growth prospects and, in my opinion, the cross-selling potential has the opportunity to be a major long-term catalyst for the stock.

The Flowchem acquisition had a significant impact on KMG's Q1 2018 results, but the company also reported strong organic growth from its Electronic Chemicals division. For the quarter, volume growth drove substantial top-line growth for this operating division and its operating margin expanded by over 300 bps.

This company reported impressive Q1 2018 results, but more importantly, shareholders should be encouraged by the fact that management is extremely bullish on the company's near-term prospects:

KMG accomplished a great deal, both operationally and financially in the first quarter and I'm proud of the progress we continue to make as an organization...... as we discussed in our fourth quarter call in October, KMG is experiencing solid fundamentals and favorable trends in each of our businesses that are helping to drive continued growth in sales and EBITDA, as well as margin improvement.

In summary, I'm pleased with our performance and continued progress in the first quarter with favorable tailwinds in each of our businesses, our physical 2018 year is off to a solid start and I'm excited about our opportunities for further growth this year and beyond.

- Christopher Fraser, President & CEO, Q1 2018 conference call

An Improving Balance Sheet

My biggest concern for KMG, as described in this article, was the debt load that the company would have to take on for the Flowchem acquisition. However, the management team was able to greatly improve the company's financial leverage during the most recent quarter. To do this, management issued shares in a secondary offering and used the proceeds to pay down debt.

(Source: Q1 2018 10-Q)

As a result, the company's long-term debt balance is down ~33% from what was reported at Q4 2017 (from $523.1M to $352.8M).

As such, KMG now has a more-manageable net debt balance and, in my opinion, the company's strong balance sheet will provide some flexibility for its management team as we head into 2018.

Valuation

KMG shares are up big so far in 2017, but the stock is still trading at an attractive valuation based on forward earnings estimates.

(Source: Fidelity)

Plus, it is important to note that the recent acquisitions, especially Flowchem, have created a lot of noise in the numbers so it is hard to get a good feel for KMG's current valuation. With this in mind, I believe that analyst estimates ($3.14 for 2018 per Yahoo! Finance) do not factor in all of the positive benefits of the recent news - i.e. debt reduction, tax reform, acquisitions - so, in my opinion, the current estimates will eventually turn out to be too low.

Bottom Line

KMG reported impressive operating and financial results for its first quarter of fiscal 2018 and I believe that the company is only getting started. Management has made several promising acquisitions over the last few years, and KMG now has multiple levers to pull to create shareholder value. Therefore, I believe that the outperformance for KMG shares should continue through 2018 and beyond.

Moreover, I believe that there are several catalysts - debt rating upgrade, tax reform, potential for infrastructure spending bill - that will play out in 2018; so investors with a time horizon longer than two-to-three years should treat any pullbacks as buying opportunities.

Author's Note: I hold a small KMG position in the R.I.P. portfolio, and I plan to build the position in 2018.

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.