Synthomer Warns On Profits As European Economies Falter: Shares Fall

Shares in chemical specialist Synthomer (LON:SYNT) dropped in early trade today as a third quarter update revealed that profits were estimated to fall 10% on last years, thanks to depressed European industrial activity. The share price almost exactly reflected this after the latest Synthomer profit warning:

The share price movement is quite interesting. In the bigger picture this fell to around the same levels in August, before recovering all the gains. These have been lost again today. The share price has almost halved in the space of just over a year. Longer-term holders should still be happy with the performance.

Synthomer are an interesting company, and popular with private investors. They are a leading manufacturer of aqueous polymers which in turn have a wide range of applications in a wide variety of different industries. Spit across a range of different products and also countries, this is a well diversified company which has followed the fortunes of the wider economy very well. It suffered during 2008-2009, but since then has bounced back and has been pretty resilient.

There have not been many chemical companies that have warned in previous times. Perhaps Plant Health Care is one but they are much smaller and concentrated.

What did the Synthomer profit warning say?

The bad news was delivered in the third quarter update which was published today. Anyone following the bigger macro picture will not be surprised at the opening shot:

The growing weakness in the global economy has created a more challenging backdrop for the Chemical industry. Depressed European industrial activity combined with increased political and economic uncertainties have resulted in an overall slower trading environment throughout Q3.

We have a divisional overview, and the Performance Elastomers division appears to be taking the brunt of the hit. Perhaps they are setting us up for another profit warning some time in the future, as it does seem that the problems faced will not be going away any time soon:

Whilst Synthomer continues to benefit from its strong product portfolio, end market diversification and geographic presence, the slower trading environment is expected to continue through the remainder of the year and into 2020, particularly in Europe.

For now, it is helpful that this profit warning is quantified:

If the current weakness in macroeconomic conditions persist through Q4, excluding any impact from the potential acquisition of OMNOVA, the Board expects underlying profit before tax for FY 2019 to be approximately 10% below 2018 and accordingly current consensus expectations*.

Underlying profit before tax was £135.1m, so this is a fair hit and almost symmetrical to the share price decline.

Synthomer: Growing Pains?

The Synthomer report claims ‘Delivering Growth in Speciality Chemicals’, and to be fair, this is exactly what they have done. In the last couple of years their growth has taken a spectacular upward trajectory.

As we can see, turnover is set to double in the space of a few years since 2016. The catalyst for this is not organic, but rather growth by acquisition. The company this year announced the takeover of Omnova. This takeover is not cheap: the headline price is £654m. It promises to create a global chemicals company amidst a natural strategic fit.

Payment for the new business is coming by the way of a large rights issue (some £204m), and the rest coming by means of a new debt facility. When we consider the market cap of Synthomer today is £1.17bn we can see that this is a very large acquisition. The target is approximately half its size. This also makes judging the company a little tougher than usual, as not all acquisitions end up going smoothly.

It should be said that despite the fast level of growth, Synthomer has been performing well, and boasts a very strong level of cash conversion:

Some of this has gone back to shareholders in the form of dividends, which has followed a progressive policy. Last year’s dividends totalled 12.2p which at today’s price is a good yield. However, despite this strong performance, the company debt pile has gone the other way, from a net debt position of £80m in 2015 to one of £250m today (and greater once the acquisition is complete). Capital expenditures have rocketed (last year it comprised of 77% of operating cash flow), and there have been other acquisitions on the way.

Is there a stretched balance sheet?

We could say perhaps. Intangible assets make up a fair chunk of all assets, and the net tangible position is £52m. Current ratio (current assets to liabilities) is 1.22. Cash decreased over the years, asset increases are down to bigger inventory and accounts receivable balances. Nothing particularly suspect with this, for an expanding business.

Borrowings will be an interesting topic. With something like £450m to find to make the Omnova acquisition, it appears that longer-term borrowings will be at least £700m. This was in line with the £750-1500m figures mentioned by the board with respect to their refinancing. This still leaves plenty of headroom.

From the finance charge in the last statement (£4.9m) it does appear that these borrowings are on fairly low interest rate terms. If the new facility is on similar terms this should not be onerous.

One more pertinent aspect is that the company has a reasonable sized pension deficit of over £100m. Additional contributions cost Synthomer £13.8m last year, a far more significant sum.

Is the Synthomer profit warning a buying opportunity?

It cannot be denied that Synthomer have been a solidly performing company. They have grown successfully over the years at little detriment to their margins.

However, at present we appear to have a situation where macro headwinds are blowing strongly. This at a time where the company have decided to increase their debt via acquisition. This could be said to be at some risk, as the size of the acquisition is fairly large. A change in business environment mean that the synergies may not necessarily materialise. A further Synthomer profit warning in the future is a risk.

The company also have had their share of boardroom wars with the current chairman Neil Johnson under fire for his duties at other companies. Johnson has recently taken up a similar role at Qinetic and there are concerns at the effect on what this might have for the stewardship of Synthomer. I think this does have some merit, although typically non-executives have several business roles.

Assuming underlying profits come in at £120m, the enterprise value means that this is fairly cheap. However, given the current headwinds and increased leverage I do think this may become even cheaper at another time. From what I have read I do like the business, but I feel the price is not bargain territory yet. 4/5.

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