I recently fully exited my long position in Platform Specialty Products (NYSE:PAH) (“Platform” or “the Company”). This post details how I got interested in the company, my original thesis and variant view, as well as where I (think) my variant view has probably been falsified.
My PAH articles on Seeking Alpha covered a significant (though not comprehensive) portion of my research. I will not rehash them entirely, but stick to the main points, as well as include the rest of my research.
As some of you may know, PAH was conceived by Martin Franklin of Jarden fame. The idea was that Franklin could potentially replicate his Jarden’s success in specialty chemicals by consolidating the industry. This was also Pershing Square’s stated thesis.
I largely disagreed with this thesis because I believed (and still believe) it was overwhelmingly reliant on the continued health of the capital markets; if I had agreed with this thesis, I would have went long in the $20s. Ackman also recently mentioned he made a mistake in believing the “roll-up” thesis was anything but ephemeral. Instead, I researched the company and waited for a lower price. Shares soon fell to the $10 range.
I was of the opinion that shares fell for the following reasons:
- the company was over-levered, largely due to two guidance cuts increasing net debt/adjusted EBITDA levels,
- that the ‘outsider’ roll-up thesis had been busted, hence resulting in indiscriminate selling by event-driven hedge funds and other ‘outsider’-focused investors,
- weakness in end-markets, particularly ag, driven by high channel inventories and low commodity prices,
- that its Series B preferred – which had characteristics which made the name ‘death spiral preferred’ more apt – would result in a negatively reflexive outcome (under the share purchase agreement, the Arysta seller had capped their downside at ~$27/share as PAH agreed to pony up a variable amount of cash to a maximum of $600m to make the seller whole as shares fell below that level),
- concern over significant non-GAAP adjustments, spring-loading, and other accounting issues
As a result, I thought the above reasons had created a compelling opportunity. The main points of my long thesis were as follows:
- While leverage was very high at first sight (exceeding 7x net debt/adj EBITDA, slightly higher if we include unfunded pensions/capitalized operating leases), the amount of leverage was not inappropriate considering the stability of the underlying businesses. More importantly, there was significant headroom (~40% based on the net first lien debt/LTM adj EBITDA maintenance covenant) provided by the company’s lenders, and the company did not require incremental debt financing, which would have likely triggered the incurrence covenant.
- The guidance cuts were not due to deterioration in the underlying businesses, but instead due to 1) strength of the USD vs the BRL, and 2) a discretionary change in distribution strategy for the North American agrochemical business unit. Thus, there was little reason to expect further adj EBITDA deterioration.
- Consensus estimates (which mainly tracked management guidance) were far too low as the sell-side appeared unaware of incremental profitability stemming from the anniversary-ing of the distribution strategy change, potentially significant tax savings to be realized through restructuring of legal entities, and a normalization of corporate costs. If realized, these factors would significantly boost free cash flow and allow the company to deleverage at a rapid pace, potentially resulting in over 100% upside.
- Non-GAAP adjustments were reasonable, restructuring expenses were not ordinary expenses being placed in the one-off bucket, and there was limited, if any, spring-loading. Further, acquisition accounting and depreciation & amortization policies were also not out of line. There were also no one-time gains included in adj EBITDA.
Note my original thesis was largely researched over the 2016 to early 2017 period, and hence the stale numbers. In the section where I falsify my original thesis, the numbers are updated.
Leverage Levels Appropriate Considering Business Quality
Management commentary in 2Q’15 warned the continued rapid devaluation of the Brazilian Real might cause the firm to cut full-year guidance. The continued depreciation of the Real resulted in two guidance cuts; one in August (from $670m to $635m @ the midpoint, or ~5%), and another in October ($635m to $560m @ the midpoint, or ~12%). Aforementioned numbers are pre-Alent/OMG acquisitions.
Pro forma for all acquisitions, this led to net debt/adj EBITDA skyrocketing to ~7.3x incl. the Series B preferred. This also highlighted the mismatch between the Company’s sales exposure (~80% of sales are outside US) and its USD-denominated debt (which was ~70% of total debt at year-end 2015). Additionally, this decline in EBITDA also brought PAH dangerously close to breaching its incurrence covenants (~10% headroom to <4.5x gross first lien and 15%-20% headroom to <6.75x-7.00x total net leverage).
Guidance Cuts Not Driven By Deterioration In Underlying Businesses
Of the ~17% adj EBITDA guidance cut, ~5% (or $40m) was due to a change in the pre-season distribution strategy for NA ag which should return at enhanced margins as the cycle turns, while the remaining stemmed from Real depreciation. I was of the opinion that FX risks, particularly the Real, had been significantly overstated by the market as a result of a misunderstanding of how the working capital cycle works in ag.
Seasonally, the growing/harvesting seasons in Brazil dictates that working capital would accumulate for much of H1 ’15 (the first five months or so) and begin to release in the later months of the year. This is the reason why DSO metrics in the ag space tend to be ~120-150 days. The depreciation in the Real was largely concentrated in H2 ’15 – the USDBRL exchange rate jumped from 3 to 4 during those few months.
Therefore, the flaw in the bear argument with regards to pricing is as follows – it was not that PAH could not increase prices in a major way to offset currency depreciation. Instead, it was the mechanics of the ag working capital cycle which prevented them from doing so.
As of 2Q-3Q’16, much of the Real-related reduction in EBITDA has been recovered as the Company’s implemented “catch-up” pricing initiatives for much of 1H’16. However, this improvement has been disguised due to increased integration-related corporate costs.
In my view, a repeat of the Real depreciation was highly unlikely given the confluence of events required, 1) 30%+ depreciation, 2) occurring largely in the second-half of the year, and 3) occurs over a period of 2-3 months making PAH unable to adjust pricing quick enough. Apart from the Real, the Company’s sales exposures are mainly in hard currencies, which are relatively less volatile than the Real and hence should present even less of a risk.
Mismatch In Sales Exposure & Currency Of Debt Denomination Correcting
In addition, the Company has also begun shifting its USD-denominated debt into EUR-denominated debt, reducing the risks associated with the mismatch between sales exposures and currency denomination of debt. On 7 December ’16, PAH repriced its debt, essentially shifted $425m in USD debt to EUR debt and also resulted in ~$15m in interest savings. The fact banks, in addition to the above, did not rewrite covenants to tighten up covenant leverage ratios also suggests significant lender support, which has persisted as the Company continues to reprice debt at lower interest rates.
Stable Underlying Businesses
The Company’s products are a small portion of its customers’ costs, but are essential to the performance/quality of their end-products. PAH’s businesses have the #1 or #2 market share position in each of their markets, suggesting dominant competitive positions. While anyone can open a chemical formulation plant, genuine replication would be costly. Entrants are guaranteed years of losses with low likelihood of ever achieving profitability.
In AgroSolutions (“Ag”), significant R&D budgets, technical & regulatory expertise, as well as a track record is required to convince large discovery-focused ag companies (Monsanto, Syngenta, etc) to license AIs. Long product registration approval processes, required maintenance of said registrations, sufficient scale to leverage retail distribution, end-user needs for support from technical personnel, the difficulty of convincing risk-averse farmers to switch products, and the need for continuous incremental innovation due to evolution, serve as further barriers to entry.
In Performance Solutions (“PFSN”), significant R&D budgets, long-term collaborative relationships with risk-averse OEMs, and end-user needs for on-site technical personnel make for a highly defendable business model.
~6% of farmer costs are spent on specialty chemicals, whereas $0.90 is spent per phone, and $30-$50 per car, illustrating the low costs of specialty chemicals relative to total costs of the end-product.
As an example, within PFSN, PAH provides specialty chemicals to subcontractors of auto OEMs to prevent car corrosion, something which is highly prized given corrosion can result in recalls; warranty costs are the death knell for the auto OEMs.
The Company’s products are developed in collaboration with OEMs; they often award specification to PAH, which mandates usage of said products by the OEM supply chain. Minimum usage of the Company’s products is required, as customer production lines shut down without said products.
Within Ag, PAH provides a variety of pesticides for usage throughout the entire crop life-cycle. It is also unique due to its ownership of a market-leading bio-solutions portfolio. Products are often combined and sold as a complete solution. Customer lock-in is unsurprising given high benefits/costs.
Ag focuses on specialty crops (~30% of their crop exposure, likely generating disproportionately high margins) such as fruits & vegetables, which offer farmers much higher gross margins as compared to row crops (corn, soybean, etc); wheat gross margins range between 10%-30% while bananas enjoy 70%-90%, depending on price assumptions. While the Company does have ~32% exposure to row crops, this exposure is located primarily in LatAm where strong growth tends to insulate cyclicality. The remaining exposure are to diversified crops, which are individually cyclical but collectively stable. Main competitor FMC is run by shareholder-oriented management, suggesting rational competition in Ag.
The above dynamics equates to strong predictability in cash flows and exceptionally high resilience to down-cycles in the segments’ respective end-markets.
Significant Headroom to Maintenance Covenants
Bears cite the Company’s high debt load (~7.3x net debt/adj EBITDA incl. the Series B preferred) as unsustainable and suggest PAH could violate its covenants, hence triggering a vicious cycle where lenders will likely force stricter covenants, mandate larger compulsory principal payments, or a large equity offering.
Despite the high leverage in absolute terms, the situation is not as dire as bears seem to believe. The Series B preferred amount is not included in the covenant EBITDA calculation and has since been settled through a small equity offering which caused ~12% net dilution (263 o/s – 22.1 + 5.5 + 48.7 over 263).
In addition, the Company’s covenants are split into two types – maintenance and incurrence covenants. Maintenance covenants subjects Platform to a quarterly test as to whether it has a net first lien leverage ratio of less than 6.25x. As of 3Q ’16, the Company has EBITDA ~40% headroom (or ~$384m in EBITDA) to maintenance covenants, adjusted for the Series B settlement.
Considering the resiliency of the business, tripping maintenance covenants seemed highly improbable. Note of the larger legacy assets acquired by PAH (Arysta, Alent, and MacDermid), the largest drop in adj EBITDA was ~25% peak to trough during the financial crisis, implying significant margin for error – especially considering the current down-cycle in ag.
Incurrence covenants are only tested when the borrower takes an affirmative action, such as when the borrower wishes to take out more debt. This difference is notable as it means that the Company can exceed the incurrence covenant limit without resulting in a violation if it did not take an affirmative action.
The issue now turned to whether the Company would need to take on more debt. The Series B has already been settled, so the most likely consumer of cash would be working capital – particularly in the ag business. Management mentioned that peak working capital would consume ~$200m. Considering the Company’s current cash balance of ~$264m (3Q’16 balance adj’d for Series B settlement of $460m), significant projected 4Q’16 WC release (mgmt. thinks >$100m, probably a highly conservative estimate as FY15 release was ~$250m [albeit FY15 release was likely too high]), in addition to a $500m unused revolving credit facility, year-end ’16 liquidity is substantial, cumulatively amounting to >$800m. As a result, it seemed highly unlikely PAH would need to incur more debt, and thus incurrence covenants are a red herring and maintenance covenants should be the prime focus here.
Consensus Estimates Were Far Too Low
Per the Company’s revised guidance in 3Q ’16, pre-WC FCF is $180m-$200m. I believed these numbers are highly depressed and do not take into account a) interest expense reductions due to debt repricings, b) elevated corporate costs, c) a strategy change in NA ag distribution, d) unrealized synergies, e) the current ag down-cycle, and f) inefficient tax structure.
In April 2017, the Company completed its third repricing, with aggregate interest savings of $48m from all three repricings, or ~$36m after-tax.
Corporate costs have been elevated to the tune of ~$50m as PAH invested in infrastructure and disproportionately used third-parties to support a larger business. Management expects most of these costs to disappear over time, but not all; I estimated ~$35m goes away, or ~$26m after-tax.
The Company’s distribution strategy change which limited pre-season selling at lower margins reduced EBITDA by ~$40m; its return would portend incremental EBITDA in excess of $40m – I estimated $40m, or $30m after-tax.
As of 3Q’16, $73m in synergies remain unrealized, which would contribute ~$55m after-tax. Peak ag EBITDA excluding corporate costs was $446m in 2013 while the trough was $382m in 2015. Excluding the pre-season change, trough EBITDA would be $422m. Mid-cycle EBITDA would thus be $436m, or an incremental $12m in EBITDA, which is $9m after-tax.
Subtracting ~$340m in annualized D&A and ~$312m in interest expense (adjusted for loan repricings) from mid-point ’16 EBITDA guidance of $758m, I estimated the Company should pay ~$26.5m in cash taxes instead of the $100m-$125m it is guiding to. This would imply incremental ~$86m of cash flow at the mid-point.
According to IR, normalized tax rate would be in the 20s; I used 25% for the above calculations. The Company’s track record in outperforming synergy guidance suggests high likelihood of realization. IR also mentioned they will beat synergy guidance. Management mentioned legal entity rationalization, which would resolve the inefficient tax structure, would take place over 2-4 years.
In total, the above items should raise levered FCF to $424m-$440m on a normalized basis or an incremental $242m, implying shares were purchased at ~8x normalized earning power on my average cost (~$11.50), and that there was a wide gap between the consensus and my view of cash generation capacity. This significant boost in free cash flow would allow for quicker deleveraging.
Non-GAAP/Acquisition Accounting Adjustments Are Reasonable
The largest add-back to adjusted EBITDA is amortization expense. Thus, PAH could overstate adj EBITDA if it allocates an outsized amount to acquired intangibles. The Company has consistently allocated ~50% of the purchase price to identifiable intangible assets for its ag acquisitions (Arysta, Agriphar, CAS). FMC allocated ~55% of the purchase price to intangibles for its acquisition of Cheminova. The Company has consistently allocated 30%-40% of its purchase price to intangibles for its PFSN acquisitions (Alent and OM Group). In acquiring Rohm and Haas, Dow (PFSN comp) assigned ~34% of its purchase price to intangibles.
The MacDermid acquisition appears to be an outlier, with ~68% of the purchase price being allocated to intangibles. This could be due to the specifics of the acquisition. As the Company’s acquired intangibles allocation generally does not appear out of line relative to acquisitions in similar industries by peers, it does not seem PAH is overstating amortization expense.
Further, it is important to determine whether it made economic sense to disregard these amortization charges.
I believed it did. Platform has ~$2.3b in intangible assets – ~$800m in customer lists, ~$1.5b in developed technology, and a de minimis amount (~$18m) for trade-names and non-compete agreements. The majority (~$1.6b) of these intangible assets came from the Arysta acquisition and thus that will be our focus.
Prior to being acquired by Platform, Arysta filed an F-1 in preparation for its IPO. Note 15 to its financial statements shows that the company had ~$600m in identifiable (ex-goodwill) intangible assets (~$500m in product registration rights and ~$100m in software). When Arysta was acquired by Platform, its identifiable intangible assets were written up to ~$1.6b (pg 12 of 10-Q) and were required to be amortized over 12-20 years as set forth by purchase accounting rules.
Assets, whether tangible or intangible eventually wear out without continual reinvestment. Customer lists, trade-names and non-compete agreements are not the focus here – they are a product of normal business operations. Instead, product registration rights (renamed to “developed technology” by Platform post-acquisition) is the line item that investors should focus on.
Before products can be introduced into the ag markets, they must be registered with the relevant regulatory authorities. Product registration rights also include costs to combine/improve existing AIs. Clearly, amortization of developed technology is an ongoing business cost.
PAH has continued to maintain and occasionally increase its investment in product registrations, which it includes in its CapEx guidance. Furthermore, the Company has slightly increased its R&D spending over the years.
Amortization policies have changed as the Company embarked on its acquisitions, but has remained mostly unchanged since 2014; developed technology amortization has changed from 7-10 years to 5-14 years from 2013 to 2014 and remained the same thereafter, but this change actually resulted in a more conservative policy – weighted average useful life for developed technology was ~10 years in 2013 but increased to 12 years in 2014 following the change; the 2016 figure is 11.6 years.
PAH’s amortization policies is also conservative relative to peers – Dow has a weighted average useful amortization life of 15 years for intangibles, FMC is roughly 18 years, while PAH’s is at 14 years. Hence, it does not appear the Company is adjusting depreciation and amortization policies to shift said expenses to future periods.
As a result, I concluded the amortization add-back for PAH was reasonable.
Changing depreciation and amortization policies related to useful life can also lead to overstated income. The Company has not changed its depreciation policies since inception. Its depreciation policies are also relatively conservative as compared to peers – FMC depreciates land improvements at 20 years, buildings at 20-40, and machinery at 3-18, Dow does not disclose, while PAH depreciates buildings and improvements at 5-20, and machinery, equipment and fixtures at 3-15.
In addition, the Company could overstate income by inappropriately writing down assets and writing up liabilities of the acquired companies which would lead to excess income in future periods as the asset is monetized and the liability write-up is reversed. A high-level check would be to look at whether there were large goodwill changes in the year subsequent to the acquisition.
Initial purchase price allocation shows $993m of goodwill for the MacDermid acquisition, with the eventual number being $990m, initial goodwill of ~$179m for Agriphar, eventually ~$169m, initial goodwill of $281m for CAS, eventually ~$269m, initial goodwill of ~$1,697m (restated to ~$1,770m) for Arysta, eventually ~$1,798m, initial goodwill of ~$1,142m for Alent, eventually ~$1,155m, initial goodwill of ~$116m for OM Group, eventually ~$121m, initial goodwill of ~$67m for OM Malaysia, eventually $79m.
Another check would be to look at whether the Company steps up inventory to fair-value following its acquisitions. In all of its acquisitions, PAH has stepped up its inventory and thus incurred manufacturer’s profit in inventory purchase accounting costs, decreasing income. In contrast, if the Company had wrote down its inventory following the acquisition, it would inflate reported gross profits.
(Although inventory step-up is an add-back to arrive at adjusted EBITDA and hence a larger number would inflate adjusted EBITDA, the magnitude of the adjustment has declined sharply (from $77m in FY15 to $12m in FY16) as PAH turns over its inventory, as one would expect.)
Couple the fact initial and eventual goodwill has not systematically increased by large amounts and the Company has historically stepped up its inventory, it does not seem PAH is overstating income.
Restructuring/Acquisition/Integration Expenses Are Not Ordinary Expenses Being Placed In “One-Off” Bucket
Cumulatively, the Company indicated the potential for $150m in cost synergies in aggregate over all its acquisitions, excluding MacDermid (MacDermid was the first acquisition and with no pre-existing business, there was no synergies to speak of).
In order to determine whether this synergy target was not used as a rationale to put ordinary expenses in the one-off restructuring business, I looked at it from multiple angles.
First, $150m in cost synergies (proxy for restructuring expenses, given management mentioned 1:1 ratio of synergy to expense) were estimated over $2.9b in sales ($3.6b – ~$700m estimate of MacDermid sales), representing ~5% of sales. This seemed reasonable given most specialty chemical M&A had similar or even more aggressive synergy estimates as a proportion of sales.
FMC Corporation, which acquired Cheminova in early 2015, is probably the closest comp and hence the best example. FMC estimated US$120m synergy potential over 3 years, on 2014 Cheminova sales of DKK$6.8b (or ~US$1.1b), representing 11% of sales. As a result, PAH synergy estimates appeared very reasonable.
Secondly, the Company’s restructuring cash charges largely matched provisions over time, evident by limited restructuring liability ($1.6m, $1.1m, and zero in FY14, FY15, and FY16 respectively) being held on the balance sheet.
Thirdly, PAH’s adjusted EBITDA margins were in-line with peers such as FMC in the low-20% range. If restructuring expenses were instead ordinary expenses and not one-offs, PAH adjusted EBITDA margins (which, among other things, add-backs restructuring expenses), would have been materially higher than its peers.
For the above three reasons, I concluded that it is highly unlikely restructuring expenses were ordinary expenses in disguise being placed in the “one-off” bucket in order to inflate adjusted EBITDA. Acquisition and integration costs have also declined sharply from $93m in FY15 to $33m in FY16, suggesting a similar conclusion.
A common method of acquisitive companies to flatter their financial results is to engage in spring-loading. Basically, spring-loading involves holding back revenues prior the closing of the acquisition in order to inflate revenues following the close as these inflated revenues would show up in reported numbers and thus provide the illusion of strong financial results.
If there was any spring-loading going on at PAH, I figured it would most likely occur in relation to the Arysta and Alent acquisitions, simply because these were the two largest acquisitions (acquired for $3.5b and $1.75b respectively) and hence could have provided the most spring-loading ‘ammunition’, so to speak.
The Arysta acquisition was completed on 13 Feb 2015, 44 days into a 90-day quarter. This was the only acquisition during said quarter. The 1Q15 10-Q disclosed that Arysta contributed $178m in revenue through the 13 Feb 2015 to 31 Mar 2015 period. It also disclosed pro forma revenues of $622m, as if the Arysta business was owned throughout the entire quarter.
Reported 1Q15 revenues were $535m, implying Arysta sales throughout 1 Jan 2015 to 13 Feb 2015 were $87m (622 – 535). This figure represents ~33% of total Arysta revenues generated during the quarter (87/[87+178]). As it was 44 days into a 90-day quarter, we would expect ~49% of sales of be generated throughout the 1 Jan 2015 to 13 Feb 2015 period. On this basis, it appears the company spring-loaded the Arysta acquisition.
However, I ultimately decided they did not engage in any spring-loading for Arysta because agrochemicals is a seasonal business as it follows the planting season for farmers. Based on Arysta’s geographical exposures, one would expect sales to be lowest in the beginning of the year, ramping up throughout. Hence, Arysta would have very low sales in January, which would generally accelerate through the 4th quarter.
For this reason, I decided generating ~33% of total quarter sales 44 days into a 90-day quarter was reasonable. I would come to a different conclusion if Arysta did not have the seasonal dynamics it has. Moreover, I figured if the company really wanted to spring-load the Arysta acquisition, the differential would be much larger than ~16% (49-33).
The Alent acquisition was completed on 1 Dec 2015, 31 days prior to the end of the fiscal year. This was one of two acquisitions completed during 4Q15, the other being the $237m acquisition of certain OM Group businesses.
The 2015 10-K disclosed that Alent generated $71m in revenues over the 1 Dec 2015 to 31 Dec 2015 period. The full-year 2015 presentation slides disclosed that Alent generated pro forma (as if Platform owned the business throughout the FY) revenues of $919m. In other words, Alent’s December sales represented ~8% of full-year sales (71/919), which is what one would expect if there was no spring-loading going on and limited seasonality; 31 days in December represents ~8% of the days of a full calendar year (31/365).
In addition, the lack of spring-loading of the Alent acquisition also increased my confidence that there was unlikely to be any substantial spring-loading occurring with the Arysta acquisition.
To further support my view that there was no spring-loading going on, I looked for an absence of sales falling off the cliff following the year of acquisitions for respective segments, where there were no acquisitions for said segments in that following year. I also checked for an absence of days sales outstanding and days in inventory drastically changing, the opposite of which would suggest shenanigans to prop up financials.
There were no ag acquisitions in 2016. 2016 ag net sales fell by 1% y/y, and on a constant currency basis it rose 1%. While segment DSO increased, it was a slight increase. DII fell by a slight amount.
There were no PFSN acquisitions in 2017. 9M17 PFSN net sales grew 6% y/y, 7% in constant-currency. While both segment DSO and DII increased, the increase was slight.
PAH has excluded one-time gains from multiple sources that would have inflated adjusted EBITDA if it were not excluded. These one-time gains include 1) legal settlements, 2) settlement of Series B preferred, 3) amendment of Series B preferred, among others.
The remaining add-backs – FX losses on foreign-denominated debt, losses on FX forwards utilized to hedge the purchase price of Alent, fair value changes on preferred stock redemption liability, fair value changes on the earn-out, debt refinancing costs – are clearly warranted as they are of the non-operating nature.
Falsifying The Original Thesis
In my view, the points relating to business quality and most of the accounting factors has probably been proved to be correct. However, I believe my view that consensus estimates were far too low most likely had been incorrect and the assertion PAH was not over-levered could potentially be misguided. In addition, there is an accounting development, separate from the items I identified above, that is a major cause for concern.
The two big reasons I believed the consensus was not pricing in were the savings from an improved tax structure and the anniversary of the pre-season distribution strategy change for the North American ag unit. Collectively, I estimated these would add just shy of $130m in incremental free cash flow, which is roughly half of the guided 2017 free cash flow generation, disregarding changes in working capital.
There were two things, should I observe them, would tell me I was wrong with respect to the above two factors:
- Lack of detail on the tax restructuring, especially in management’s public presentations, or its slow implementation
- the absence of the anticipated return of $40m of lost EBITDA due to the change in distribution strategy by year-end 2017, or its delay.
While the observation of these points would not necessarily falsify my views, it could suggest a much longer time horizon to realization, thus reducing their value on a net present value basis.
To understand why I believe the two aforementioned points has been falsified, some background is required.
The Company has mentioned multiple times during 2016 and 2017 that it has meaningful opportunity to reduce its cash tax rate over the medium term. While there has been progress in this area, the improvement is very slight; similar cash taxes despite marginally higher profitability.
The previous CFO, Sanjiv Khattri, briefly described the opportunity in the 4Q16 call – that there was significant local profitability in Brazil, China, and Mexico, which could be reduced through tax restructuring. He left PAH shortly after – which wasn’t a good sign. His post was taken up by a former Jarden executive, which made me accept the rumored explanation; because Franklin pushes his team very hard, Khattri could not cope with the stress it entailed.
Regarding the distribution strategy change, management explicitly mentioned on the preliminary 3Q15 call they expected these revenues and EBITDA to return fully by the end of 2017. Since this call, there has been little mention of the topic.
Concurrent with the abandoning of the sale of its ag unit in late August this year, the Company announced it was planning to split the firm into two by 2018, eventually settling on a mid-2018 time-frame. The plan was quite clear – the Company intends to raise equity by IPO’ing a portion of Arysta and using the proceeds to de-lever.
Because incentives drive human behavior, I expected the Company to pull out all the stops by year-end 2017 in order to improve market sentiment and increase its share price in an attempt to sell shares of Arysta at as high of a price as possible, thus limiting equity dilution. This is paramount, especially considering the bad optics following the failed sale of the ag unit to a strategic player or private equity.
However, PAH merely reaffirmed full-year 2017 guidance in 3Q17. I expected the Company to raise full-year guidance in anticipation that the ag unit would recover the lost revenues and EBITDA it had incurred in 2015, as expected at that time. I also expected more concrete details on the tax restructuring such as timeline and magnitude of savings.
Management clearly attempted to improve market sentiment, stating that the ag unit expected ~$1.3b in peak potential sales from its pipeline through 2025 as well as $100m in incremental cost savings over 5 years.
The fact management did not raise full-year 2017 guidance expecting lost ag revenues and EBITDA in 2015 would return suggests 1) they lost these sales to the competition, or 2) the sales and EBITDA returned, but was largely offset by organic declines in the business, or 3) they expect them to return on an extended timeline.
The fact management did not provide more concrete details on the tax restructuring suggests 1) the tax savings could not be realized, or 2) the tax savings could be realized, but it would occur over a longer timeline.
Regardless, this suggested to me I was most likely wrong regarding the assertion that consensus estimates were far too low. As a result, the potential for rapid deleveraging through these FCF boosters was gone, leaving the Company to de-lever primarily through EBITDA growth and not through debt pay-down due to the significant working capital requirements in ag as the business grows.
In addition, I initially expected management to run the business as-is instead of IPO’ing a portion of ag, given their (and my) belief that the Company was not over-levered. The fact management is choosing to go down the IPO route potentially falsifies that belief. Alternatively, it suggested to me management was listening to the Street (which generally bemoaned PAH’s leverage levels) too much.
Furthermore, management mentioned they expected to not be taxed on the proceeds of the Arysta IPO. Taxes are levied if you sell an asset at a higher price than your cost basis, and the fact management did not expect any tax on the IPO potentially implied they did not have high expectations. It also implies bad capital allocation or that they overpaid for Arysta (which still implies bad capital allocation).
The accounting development which concerned me was the usage of accounts receivable factoring both with and without recourse, along with financial guarantees.
While proceeds from financial guarantees and factoring related to the sale of receivables with recourse is properly accounted as financing activities in the cash flow statement, and the sale of receivables without recourse is properly accounted as operating activities in the cash flow statement, they nonetheless bring forward future operating cash flows to the present period. Moreover, this also has the effect of depressing the DSO metric as the receivables amount is smaller than it would be if not for said arrangements.
The Company factored ~$105m and ~$167m of receivables without recourse and ~$71m and ~$38m with recourse in FY15 and FY16 respectively, totaling ~$176m and ~$205m in total factoring in the respective years. PAH had ~$1.02b and ~$1.05b in net accounts receivables and ~$3.58b in pro forma net sales representing consolidated DSOs (using management definition) of ~103 and ~106 of in the respective years, assuming a 360-day year.
Without factoring its receivables, PAH would have had ~$1.2b and ~$1.25b of net accounts receivables, representing DSOs of ~121 and ~126 in FY15 and FY16 respectively. If we assume ag had similar DSOs for FY14 and FY15 (i.e. 134 days) – as the ag acquisitions had not been consummated in 2014 – and that the ratio of PFSN and ag DSOs were similar for 2014 and 2015 (i.e. consolidated DSO accounts for ~48% of the sum of both segment DSOs), consolidated DSO would be ~100 days in FY14, a year where no factoring transactions had occurred.
This suggests consolidated DSOs, excluding the impact of factoring, had substantially increased from FY14 to FY15 and FY16, a clear red flag – one I should have caught much earlier but did not. It thus appears the Company factored receivables in order to conceal the large increases in DSOs.
Furthermore, the assumption that ag had similar DSOs for FY14 and FY15 is a conservative one because FY15 ag DSO includes the impact of factoring. I am also not cherry-picking FY15; FY16 consolidated DSO accounts for ~50% of the sum of both segment DSOs).
Management is targeting 3.5x net debt/adj EBITDA and 4.25x (mid-point) net debt/adj EBITDA leverage levels for ag and PFSN respectively, by year-end 2019. Assuming a 45/55 split between ag EBITDA and PFSN, this implies $369m and $451m in ag and PFSN adj EBITDA respectively at the mid-point of FY17 guidance.
Using the target leverage levels, the implied equity raise from the Arysta IPO is ~$1.8b (~$5b in net debt – [$369m * 3.5 + $451m * 4.25]). PAH aborted the sale of the ag unit to private equity and strategics because it failed to meet valuation expectations of more than $4.5b. If we conservatively use $4.5b as a base case valuation for Arysta, this suggests 40% of Arysta shares would be sold in the IPO.
As a result, shareholders of PAH would then own a company generating ~$672m in adj EBITDA ($369m * 0.6 + $451m), after accounting for the non-controlling interest of Arysta.
Assuming all IPO proceeds are allocated to principal debt payments, net debt would fall to ~$3.3b (3Q17 net debt is ~$5.1b) and gross debt would be ~$3.7b (3Q17 cash is ~$400m), costing ~$222m in interest expense (assuming a 6% weighted average interest rate, in-line with its current average; $330m in FY17E interest expense on $5.5b of gross debt).
Keeping cash taxes and net capex steady per FY17 guidance ($140m at mid-point and ~$100m respectively) – a conservative assumption for cash taxes given lower interest expense means higher profitability and thus higher cash taxes, PAH would generate $210m in levered free cash flow. After pension contributions, it would be ~$190m.
With ~300m in diluted shares outstanding and current trading prices of roughly $9.50/share, PAH does not have any upside, assuming a 15x multiple. It however has limited downside.
While it is true if we utilize management’s adj EBITDA growth targets through 2019, shares would see significant upside, these targets are not guaranteed to be hit, especially considering the current down-cycle in ag, and tepid end-markets for PFSN. A 15x multiple also suggests said targets are likely priced in. Moreover, the growth in DSOs excluding impact from factoring is a significant cause for concern and could potentially suggest a portion of adj EBITDA is unsustainable. Shares could be good value if management somehow manages to get a very good price for Arysta, which would limit equity dilution. It is however not a bet I am comfortable making.
As a result, I exited my long position in PAH and (luckily) broke even. Better to be lucky than good, I guess. Given the incoming IPO of Arysta, PAH could potentially develop into a special situations play, and I look forward to analyzing it once more following the offering.