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A chemicals stock that looks to have bottomed

Synthomer’s sale of its laminates arm is the first step in the FTSE 250 group’s potential turnaround
February 2, 2023

History only offers us one version of events, so it’s difficult to know whether, if given the opportunity to do so again, management at Synthomer (SYNT) would still agree to pay $1bn (£760mn) for US chemicals company Eastman’s (US:EMN) adhesive resins arm. And, if they would, whether they’d have looked to have financed it more conservatively.

Tip style
Value
Risk rating
High
Timescale
Medium Term
Bull points
  • Shares at historic discount
  • Asset sale strengthens balance sheet
  • Focus on higher margins
  • Strategic buyer in the wings
Bear points
  • Weak earnings
  • Covenant breach

When the British firm agreed to acquire the division in October 2021, it was still digesting the $824mn purchase of competitor Omnova, completed around 18 months earlier, which it funded through a five-year, €520mn (then £437mn) bond issue.

The FTSE 250 company had reasons for feeling flush, though – 2021 had been a year of “extraordinary outperformance”, chief executive Michael Willome later said; the Covid-19 pandemic had led to a surge in demand for one of its key products, Nitrile, a synthetic rubber used in surgical gloves. 

As a result, operating profit before exceptional items soared from £190mn to over £450mn, although one-offs – including a £57mn provision relating to a European Commission investigation into a chemical-buying cartel – were over £140mn.

Still, when the Eastman deal was done (at 10.3 times adjusted cash profits) there was a great deal of confidence it would soon pay dividends. Management spoke of a “global leading position in adhesives” while identifying around $23mn of annual synergies through the combination. This meant it was effectively only paying 8.3 times earnings, the company argued. 

Synthomer raised $275mn in fresh equity from shareholders and borrowed an extra $300mn to fund the splash, utilising its cash resources of $425mn for the remainder. Yet in the six months from the deal’s unveiling to its completion last April, the economic backdrop quickly chilled. 

Initially, the company estimated the deal would lead net debt to hit 1.6 times cash profits. But as interest rates rose and end markets softened, the leverage ratio edged up to 2.3 times in June; by October, the company told investors it was immediately halting dividend payments as it sought a relaxation of banking covenants. Lenders eventually agreed to temporarily lift the limit from 3.25 to 4.75 times cash profit as of June 2023, declining to four times by year-end.

 

 

Risky business

Investors, understandably, were not happy. Shares in Synthomer, which was known as Yule Catto until a 2012 rebrand, are now off 69 per cent since the Eastman deal was announced, meaning its current market capitalisation is less than the sum it paid for its target. 

Debt is clearly the main concern. Total borrowings including lease liabilities stood at £1.26bn on 30 June – up from £640mn a year earlier. Almost all of this was in euros or dollars, both of which gained against the pound in the half-year, leading to an “adverse £44.3mn foreign exchange movement”.

At the same time, earnings have stumbled. First-half operating profits more than halved to £132mn, as the boom in synthetic rubber glove demand turned to a bust. This continued into the third quarter, when the company issued a profit warning and said that a global “destocking” could last throughout 2023.

But the sell-off looks to have been overdone. Synthomer’s current valuation is only around a quarter of its trailing sales of £2.85bn in the year to June, and a 36 per discount to book value. More importantly, it’s not as though the Eastman business has underperformed. In fact, the company recently increased synergy expectations from the deal to $25mn-$30mn – around $12mn of which is expected to be delivered by the end of 2022. 

Willome, who joined the company days after the Eastman deal was announced, recently set out plans for a reorganisation of the group. Its structure is being simplified from five divisions into three and focused on end markets rather than product groups. As part of this, both the number of sites and business units are set to be cut.

Synthomer currently manufactures from 43 sites which, for a company of its size, “is a lot, probably too much”, Willome told investors. The group now plans to streamline this to fewer than 30 over time, through divestments and consolidations.

Its 23 separate business units were also assessed as to where they fit into future plans. The company categorised each of these as either a “base” or “speciality” chemicals business, the latter concentrated on areas where Synthomer believes it can add value, and command greater pricing power. Its base businesses, by contrast, are more cyclical, and prices are driven largely by supply and demand.

 

New priorities

Base businesses currently provide around half of turnover, but Willome’s plan is to divert more capital spending (75 per cent between 2023 and 2026) to the speciality businesses, with a view to growing their revenue contribution to 70 per cent over time. In turn, this should help with efforts to hit a medium-term cash profit margin of over 15 per cent and a return on invested capital in the “mid-teens”.

Some 13 of its 23 arms fit into one of its speciality divisions, formed of construction, coatings and adhesives businesses. Only one base unit – health and protection – offers sufficient scale and growth prospects to be retained. The remaining nine units have been deemed non-core and earmarked for disposal. It is estimated that these could bring in around £635mn in cash.

It has moved quickly. Last month, shareholders voted unanimously to offload the first unit – its laminates, films and coated fabrics arm, which it is selling to German chemicals business Surteco (DE:SUR) for a net $245mn.

This division was acquired as part of the Omnova deal and is being sold for an enterprise value of eight times the business’s 2021 cash profit. This is an uplift of the “post-synergy acquisition multiple” of seven that Synthomer paid for Omnova, leading broker Peel Hunt to describe the price tag as reasonable, providing “encouragement in the context of the remaining assets to be sold”.

Perhaps more importantly, it takes some immediate pressure off the balance sheet. Berenberg analyst Sebastian Bray expected Synthomer’s net debt to hit four times cash profits at the end of 2022, but that the ratio will fall to 2.5 when the deal completes later this quarter.

There are a “handful” of other, smaller assets that Synthomer could sell reasonably quickly – including Lancashire-based subsidiary William Blythe (annual sales of around £25mn, and possibly worth around £80mn) – before the company has to engage in the trickier task of disentangling other units from the group, Bray added. Other measures to reduce gearing include holding down this year’s capital expenditure, currently forecast by Berenberg to hit £80mn in both 2022 and 2023, as well as working capital reductions and a plan – currently on track – to “deliver cash savings of between £150mn and £200mn by the end of 2023”.

 

 

Despite this reassurance, an investment in Synthomer clearly carries higher than average risks. If Willome wants to both balance the books and grow higher-value product lines, the prospect of a discounted rights issue cannot be ruled out entirely. In November, Reuters reported that Synthomer’s largest shareholder, Malaysian plantation owner Kuala Lumpur Kepong (MY:2445), wants to increase its stake either through primary or secondary shares. As well as backing the £200mn capital raising to fund the Eastman deal, Kuala Lumpur Kepong continued to build its stake in Synthomer as the price slumped last year, and currently owns 26.3 per cent of its shares, according to FactSet. Kuala Lumpur Kepong did not respond to a request for comment.

Whatever its intention, the Malaysian group is likely to be much happier with its strategic investment than it was a few months ago. The outlook for the chemicals industry is improving as gas prices retreat from historic highs, and demand in China (which buys around 45 per cent of global chemicals, according to Berenberg) is set to strengthen as the country reopens.

Synthomer shares trade on eight times forecast earnings – less than half of its peers' average and well below its own five-year average multiple of almost 11. With a clearer plan for growth and further scope for deleveraging, this represents decent value. A bit more market stability might be the only catalyst holding back a positive investor reaction.  

Company DetailsNameMkt CapPrice52-Wk Hi/Lo
Synthomer  (SYNT)£724mn155p383p / 83.0p
Size/DebtNAV per share*Net Cash / Debt(-)Net Debt / EbitdaOp Cash/ Ebitda
221p-£1.04bn3.8 x66%
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/Sales
81.2%29.8%0.7
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
10.9%27.4%17.4%9.7%
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
-21%49%31.5%-35.0%
Year End 31 DecSales (£bn)Profit before tax (£mn)EPS (p)DPS (p)
20191.4611725.29.4
20201.6416028.811.1
20212.3340374.928.1
f'cst 20222.5814625.01.6
f'cst 20232.4611118.61.2
chg (%)-5-24-26-25
Source: FactSet, adjusted PTP and EPS figures
NTM = Next Twelve Months
STM = Second Twelve Months (i.e. one year from now)
* includes intangibles of £831mn or 178p per share