Synthomer: An Attractive Bull Case Following Omnova Acquisition

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About: OMNOVA Solutions Inc. (OMN), SYHMY
by: Vince Martin
Summary

UK-based Synthomer waited for a material M&A opportunity and seemed to get a good deal in acquiring US specialty chemical company OMNOVA Solutions.

Valuation looks reasonable, and SYHMY shares are likely to rise if the acquisition indeed is a smart move.

Risks are myriad: M&A is always risky, cyclical fears are hanging over the space, and OMNOVA has been an inconsistent performer for nearly two decades.

But Synthomer shares look like they're worth taking on that risk.

Synthomer's (OTC:SYHMY) (OTC:SYYYF) acquisition of OMNOVA Solutions (OMN) is interesting for two reasons. First, the acquisition itself seems attractive. OMNOVA has an attractive specialty chemicals business, growth in which had been overshadowed by weakness in declining markets like paper and carpet. And, from both a product and geographic standpoint, the acquisition seems like a good fit.

Synthomer is paying a seemingly hefty premium - the offer price is 58% higher than Tuesday's close - but OMN shares have tumbled of late. Including an estimated $29.6 million in synergies, Synthomer is paying not much more than the multiples the market assigned OMN in recent weeks - at a valuation where I was getting increasingly intrigued. (Indeed, OMN was high on my watchlist; another week and I well might have lucked my way into a nice payday.) This looks to be a smart, and material, acquisition by Synthomer, and indeed the company's London-listed stock (SYNT.L) has risen 2% after initially declining on the news of the deal.

The second reason the deal is interesting is that investors have been waiting for it for quite a while. Synthomer CEO Calum McLean helped build Ineos into the UK's largest private company largely through M&A. Yet, so far, activity at Synthomer largely has been relegated to smaller tuck-in deals. The OMNOVA deal isn't quite a 'bet the house' type of acquisition, but it is material enough to boost Synthomer shares if it works out.

With Synthomer still receiving a reasonable valuation, there's enough here to at least take a long look. To be sure, the risks are real: cyclical concerns have put a lid on larger chemical plays like Dow (DOW) and LyondellBasell (LYB), and M&A always looks attractive on paper. OMNOVA has scuffled of late, and nearly 60% of revenue still will come from Europe (probably not a good thing in light of macro performance on the Continent). Still, for investors willing to take on those risks, Synthomer stock is an intriguing play.

The Legacy Synthomer Business

Synthomer, formerly known as Yule Catto, is a leading UK specialty (or speciality, as the Brits phrase it) chemical play. The company re-organized into three segments ahead of 2019: Performance Elastomers, Industrial Specialities, and Functional Solutions.

The Performance Elastomers is the key business, generating 44% of revenue and 55%+ of segment-level operating income in 2018. The segment contains the company's Nitrile butadiene rubber latex (NBR) and Styrene butadiene rubber latex (SBR) products. Key end markets are carpet, paper, and healthcare.

It's the NBR opportunity in healthcare that is the most attractive. Nitrile gloves are quickly taking market share, as LD Investments detailed in an interesting article on this site in January. The key reason: nitrile gloves avoid latex allergy issues, which are reasonably pervasive and occasionally quite dangerous.

The largest glove producers all are based in Malaysia, where Synthomer expanded its capacity in a project that wrapped up at the end of 2018. The overall market is growing 10%+, according to Synthomer's 2018 annual report, and Synthomer's #2 position in NBR should allow it to continue to capitalize on that growth going forward. It's worth noting, too, that in a chemical sector dogged by cyclical concerns at the moment, medical glove demand should be relatively immune (pardon the pun) to macro fluctuations.

Functional Solutions is nearly as large on a revenue basis (42% of sales versus 44% for Performance Elastomers), yet not quite as profitable, generating a touch over one-third of profit. This business includes Synthomer's aqueous polymer business, a top five global producer targeting construction, coatings, adhesives, and oilfield applications.

Synthomer hasn't disclosed historical results under the new presentation, but it seems likely that end of 2018 weakness was driven in part by weakening demand in this segment. As reported, consolidated Europe and North America (74% of 2018 revenue) volumes fell 1.3% last year on an organic basis - with a roughly 5% decline in the second half offsetting 2.6% growth in 1H. Volumes declined y/y in Q1, according to a brief trading update in April, though unit margins did strengthen. (Lower input costs, which management said disrupted the business in the fourth quarter, no doubt helped.)

Industrial Specialities includes non-aqueous products for niche markets, some of which were picked up in bolt-on acquisitions in recent years. About half of revenue comes from the coatings and polymer additives end markets, per figures from the annual report; the segment also sells to the PVC, construction, and automotive industries. IS accounted for 14% of revenue in 2018, and a touch over 10% of earnings. It appears that here, too, sales declined in Q1 (the company cited "a slower start" but improved "end of quarter exit rates").

Overall, it's been a solid business in recent years - but growth has slowed. Underlying (i.e., adjusted) pre-tax profit increased just 3.9% last year. A 5% decline in Europe and North America was offset by 30% growth in Asia (again, due largely to nitrile strength). That performance is notably weaker than the 10% growth posted in 2017 and the 28% increase seen the year before.

Bolt-on acquisitions are a factor: the company spent £156 million for the PAC (performance adhesives & coatings) business of U.S.-based Hexion in early 2016, a deal that brought in about US$30 million in EBITDA (about £20 million at prevailing exchange rates), which drove roughly half of the company's EBITDA growth that year. Since then, Synthomer has stuck to smaller deals, picking up the Austrian business of BASF (OTCQX:BASFY) for €30 million (£26 million) in early 2018 and the speciality additives business of Perstorp for €78 million (£70 million) the year before.

It's been looking for a bigger deal, however - and finally made its move last week.

The OMNOVA Deal Looks Like A Good One

On paper, the OMNOVA acquisition makes an awful lot of sense - even by the standards of M&A, which usually looks good on paper. Synthomer had said for some time that it wanted to stay in the specialty space rather than moving into diversified chemicals, and OMNOVA fits that bill. OMNOVA's consolidated results don't look all that impressive, but it's had a roughly decade-long headwind from declines in its paper and carpet end markets, while its Specialty Solutions segment had posted solid revenue growth and improving margins until recently.

Qualitatively, the fit seems smart:

Synthomer acquires OMNOVA Source: Synthomer investor presentation [pdf]

The deal creates a nicely diversified revenue base in terms of end markets:

Synthomer acquires OMNOVA Source: Synthomer investor presentation

Geographically, there's a logic to the tie-up as well:

Synthomer acquires OMNOVA Source: Synthomer investor presentation

Valuation does look potentially stretched: Synthomer is paying 9.9x trailing twelve-month Adjusted EBITDA, pro forma for a small acquisition and the closure of a plant in Green Bay, Wisconsin. But synergies are material: an estimated US$29.6 million annually, which gets the EV/EBITDA multiple down to 7.3x. That's in line with OMN's historical range - and on an EBITDA base that has been depressed by recent results.

OMN as a standalone looked attractive at that type of multiple as shares plunged in recent months (the stock touched a three-year low just a few weeks ago), and Synthomer is buying the whole company at that price. A £204 million rights offering will keep leverage reasonable at ~2.5x EBITDA, which Synthomer expects to get down to 2.0x by 2021.

Again, most M&A deals look good on paper (or PowerPoint slides, as it were). But this deal seems better. It makes sense qualitatively. The valuation looks right. Synthomer CEO McLean has a long track record of successful M&A at Ineos - and truly waited for his pitch here. Indeed, McLean opened his prepared remarks on the post-announcement conference call by saying half-jokingly that it was "a pleasure" to make the announcement "after having sat in this room many times before and talked about acquisitions that we hadn't done and the reasons that we hadn't done them".

Investors have been waiting for years for Synthomer to make a material deal, and the company in its presentation called this a "step change transaction". It's not quite a 'bet the farm' acquisition: Synthomer has a market cap of £1.28 billion on its own, almost exactly double the OMNOVA enterprise value implied by the purchase. But unlike the Hexion, Perstorp, and BASF deals, it's a big move, one that builds out the portfolio and expands U.S. reach. It looks like the kind of deal investors wanted Synthomer to make.

Valuation and Risks

After the acquisition, meanwhile, Synthomer hardly looks like it's pricing in much growth. The company expects OMNOVA to be accretive by the end of year one and "strongly" so from there. Yet the stock trades, pro forma for the rights offering, at barely 14x 2018 EPS - and closer to 13x accounting for the effective price created by that offering. (Shareholders get one right at 240p for every four shares.) Pro forma EV/EBITDA, including synergies, is about 7.8x - below where Synthomer has traded in recent years and not a bad multiple relative to the industry. (It very much matters which specialty chemical comparables an investor chooses.)

At the very least, Synthomer stock seems cheap enough if an investor trusts the wisdom of the acquisition - and, again, there are reasons to do so. Between the logic of the tie-up, the post-synergy valuation, and McLean's history and patience, this seems like the deal Synthomer wanted to get. McLean noted on the call that OMNOVA "had been on our radar for years". The combination of stronger performance on the specialty side and a plunging stock price created the opportunity to move.

And assuming the tie-up works, there's attractive upside here. Synergies, continued mid-single-digit EBITDA growth for the legacy business, and a return by OMNOVA to recent levels near US$100 million in EBITDA get Synthomer's consolidated EBITDA to ~£340 million by 2021. An 8.5x multiple - modestly up from Synthomer's ~8.2x pre-acquisition - gets the stock to 518p, up 39% from current levels. That price actually remains modestly below 2018 highs - and still suggests mid-teen earnings multiples and likely a P/FCF valuation that's a turn or two lower. The acquisition likely only needs to look good in retrospect - not spectacular - for Synthomer shares to move up nicely from current levels.

All that said, there are risks here. It's a big acquisition, which by definition creates risk. Even with the strength in nitrile, the cycle is a worry. The combined company still has substantial exposure to macro-sensitive areas like construction, and 58% of pro forma sales still come from Europe, where economic growth remains meager. Investors have sold off a number of stocks in the space, with issues like Chemours (CC), Olin (OLN) and Dow (DOW) (to name a few) selling off of late. Synthomer hasn't been spared, down about a third from late August highs. Butadiene rubber is at least one issue: demand appears weak at the moment, which could further pressure 2019 results in the legacy business.

There's the obvious question of why the OMNOVA board agreed to the deal: the $10.15 purchase price actually is a modest discount to the stock's 52-week high. Perhaps more concerningly, it's a reasonable discount to April 2018 highs around $11.50, which represented an all-time high for OMNOVA, which was spun from GenCorp (now Aerojet Rocketdyne (AJRD)) at $9 all the way back in 1999. (My math suggests annual appreciation post-spin of about 0.6% - with no dividends paid since 2001.)

Simply put, OMNOVA hasn't been a very good business over time. CEO Anne Noonan has done a nice job taking out costs and focusing on the specialty business. But margins have remained a concern, and OMNOVA has struggled in the first half of its fiscal 2019. Adjusted EBITDA declined 31% in the first two quarters. Some of that pressure came from a planned exit from still-profitable commodity paper markets, but even the Specialty business has seen profits fall 14% despite higher sales and volumes.

Assuming that performance continues, the multiple Synthomer is paying will move up quickly - and the post-acquisition profits will come down. And certainly, the market sees that as a risk: again, investors have been waiting for years for a deal to come through, and even with Synthomer stock down ~one-third from its highs, the reaction was muted, if modestly positive.

Still, OMNOVA's, 1H performance has been hit both by the paper exit and by volatility in key end markets. Both will pass. The valuation still looks reasonable enough based on TTM figures, and McLean probably deserves some benefit of the doubt. Meanwhile, there are few, if any, cyclicals or chemical stocks out there with limited risk at this point in the cycle. For investors willing to take on those risks plus that of a seemingly wise acquisition, Synthomer is a quite intriguing option.

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.