4/20/2018 Value Investors Club / KRATON PERFORMANCE POLYMERS (KRA)

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KRATON PERFORMANCE POLYMERS KRA W

September 29, 2015 - 5:17pm EST by of21 (/member/of21/46935)
2015 2016
Price: 17.12 EPS $1.88 $3.50
Shares Out. (in M): 31 P/E 9.1 4.9
Market Cap (in $M): 533 P/FCF 7.2 4.4
Net Debt (in $M): 305 EBIT 95 260
TEV ($): 838 TEV/EBIT 8.8 9.2

Description
I’m sure you all are looking for more levered, beaten-up small-cap chemicals companies. However, we believe Kraton presents a
unique opportunity to purchase a niche chemical company embarking on a strategic cost reset and transformational acquisition at
~2.5x Pro Forma “cash” EPS. Peer multiples would translate to >4x upside over the next three years. Although the company will be
significantly levered upon closing its recently announced acquisition, we find the risk / reward attractive given the potential upside.

 
        Price / EV / 
    EBITDA "Cash" EPS (1) Cash EPS EBITDA
Standalone:          
Current Run-Rate (2)                    171 $2.39 7.2x 4.9x
2018 Target                    250 $4.16 4.1x 3.4x
           
PF For Deal:          
Current Run-Rate (2)                    380 $3.90 4.4x 6.0x
2018 Target                    500 $6.50 2.6x 4.6x
2018 Target W/ Debt Paydown                  500 $7.20 2.4x 3.7x
           
(1) Adjusts FIFO to ECRC and includes maintenance capex    
(2) Kraton standalone LTM EBITDA of $145.5 million adjusted for normalized turnaround expenses and run-rate cost savings
 

Even excluding the benefits of the cost savings and the deal, the company still trades at a double-digit unlevered free cash flow yield.
Additionally, we have not given the company the benefit of repurchases in any of these cases. Management anticipates generating
$450 million of free cash flow over the next three years against a market cap of $500 million.

Kraton, which has been written up a couple times on VIC, manufactures styrenic block compounds (SBC’s), a synthetic elastomer
and rubber alternative used in a variety of stable end markets like baby diapers and surgical gloves. Kraton has historically traded at
a substantial discount to specialty chemical peers for what we think are four main reasons:

· While Kraton contractually passes through almost all commodity costs, it reports GAAP earnings on a FIFO basis, leading
headline earnings to appear much more volatile than its stable underlying cash flows.
· As Kraton has dominant share in its niche business, the company has no real publically traded comps and tends to be
underfollowed and misunderstood.
· Although the majority of volumes are sold to commoditized end-markets (e.g., paving and roofing), these products represent
a significantly smaller portion of gross profit. Management recently disclosed for the first time that ~2/3rd of contribution
product come from their differentiated products.
· Kraton has been steadily taking out costs, upgrading its product portfolio, and addressing scale issues to transition the
business to specialty peer margins.

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Kraton has been working to address several of these issues over the past few years. The company appeared to have a
transformational deal in mid-2014 with a Taiwanese competitor, but the merger plan fell apart when one of that competitor’s plants
exploded in a freak accident. The 2014 write-up by kwee12 covers this deal. The company’s merger proxy for that transaction
detailed a long strategic process by management and the board focused on addressing the company’s cost structure through a
variety of internal and external alternatives.

At the company’s mid-June investor day, management outlined a series of cost initiatives that would increase EBITDA from roughly
$150 million in 2014 to $250 million by 2018. All of the cost initiatives are tied to specifically identified projects, with most already
underway. There are four main components to the cost plan: (1) leveraging lower cost facilities in Europe (less expensive feedstock)
and Asia (new plant coming online in 2016), (2) targeted cost reduction projects at existing plants (e.g., converting Belpre, OH plant
from coal to natural gas), (3) SKU reduction and new fulfillment practices, and (4) reducing overhead costs. Management has said
that their compensation packages will be heavily tied towards meeting those targets. Based on management’s plan, we see fully-
taxed “cash” EPS going from around $2 today to $4 by 2018 on a standalone basis. We also see the company generating $300
million of cumulative free cash flow (even net of restructuring costs) in the next three years against a market cap of ~$500 million.

In addition to this cost reset, Kraton recently announced a transformative debt-funded acquisition to purchase Arizona Chemicals,
roughly doubling the size of the company without issuing any equity. Arizona Chemicals is a market-leading producer of pine-based
chemicals, focused on adhesives, paving and roofing, high performance tires, and chemical intermediates markets. Arizona
Chemicals is very complementary to Kraton’s existing business with 50% of Arizona’s sales into common end markets. The company
has guided to $1.40 of GAAP EPS accretion in the first full year (against KRA street 2015E EPS of $1.88). We see higher ultimate
accretion as synergies fully come on and the company rapidly delevers in the first three years.

Layering in management’s standalone cost reset plan, we see the company reaching $6 of PF “cash” EPS in the next three years
(assuming Arizona LTM EBITDA of $184 million and announced $65 million of synergies). Additionally, management expects the
combined business to generate $450 million of cumulative FCF over the next three years. Assuming this cash goes to debt paydown,
our PF “cash” EPS increases from $6 to $7 based on lower interest expense. The company will have ample room to resume
accretive repurchases once it reaches its target leverage level by end 2017, driving potential upside to “cash” EPS. While we expect
the company to use this cash to delever to a more comfortable level, we note that $450 million could roughly repurchase the entire
market cap at the current price or pay out a special dividend comparable to the stock price.

In addition to the accretion, we believe the absolute valuation for the Arizona acquisition is attractive at 7.4x LTM EBITDA and 5.5x
EBITDA post-synergies, translating to a 10% unlevered FCF yield. The closest competitor is WestRock’s specialty chemicals
business (the former MeadWestvaco assets), which most street sum-of-the-parts value at 10x+ EBITDA. Their pine chemicals
business is combined with a higher quality activated carbon business, so the multiple comparison is not perfect but the best available
comp.

While we view the rationale behind the deal as sound, the stock traded down following its announcement. As best as we can tell,
there are two apparent reasons. First, the company will be significantly levered following the deal with closing leverage of 4.6x
dropping to 3.0x by end 2017. Although we are generally not fans of levering up to do large M&A at this point in the cycle, we take
comfort in the strategic nature of deal, significant cost synergies, and a near-term FCF profile driving rapid debt paydown.
Additionally, management has prior experience at comparable leverage levels under private equity ownership before the company’s
IPO – the company has been owned by PE twice before. The acquisition financing is fully committed, consisting of $1.35 billion of
covenant-lite term loans and the remainder from senior unsecured notes. We also believe there is significant hidden value in the
Cariflex business (primarily used in surgical gloves and condoms; grew volumes by 24% in 2014). If liquidity becomes tight, we
believe Cariflex could be divested at a sufficiently high multiple to reduce aggregate leverage by 1x. There is certainly a lot to
manage between the acquisition integration and the standalone cost reset, but we believe the potential upside more than justifies
higher risk level posed by the elevated leverage level.

The second concern we have heard is over Arizona’s margins. Kraton’s specialty product-set passes through commodity prices with
stable underlying margins. Arizona’s products, however, compete against gum-based rosins (derived from manually tapping pine
trees) and other hydrocarbons tied to the price of crude oil. We believe there is the fear that Arizona’s EBITDA will fall due to a
lagged effect from oil prices. Based on follow-up conversations with management, we believe the impact from the move in crude oil

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prices to the mid-$40s is largely captured in the current EBITDA run-rate of $180 million. To be clear, should oil prices fall further,
there could be an incremental negative impact on Arizona’s EBITDA though still manageable within the context of the company’s
leverage and business plan.

As management executes on a highly achievable cost cutting plan and integrates Arizona, we think the Street will recognize the
substantial upside that Kraton offers. With a board that has recently demonstrated a willingness to explore strategic alternatives, we
think Kraton could also become a target for a strategic or financial buyer at some point along the way should the valuation not
improve.

Risks:

Operational Integration Risk: Management will have a full plate to execute the cost reset program and integrate Arizona. While
management seems confident they have enough operational bandwidth, there is not a large margin of error.

China: Although only a small portion of sales are directly tied to China, Kraton competes against Chinese chemical conglomerates,
such as Sinopec, in their more commodity products. Should China experience a hard landing, Sinopec and other could seek to take
share in US and European USBC markets at the cost of Kraton’s commodity business.

Developed Markets Macro: Kraton’s end-market growth is tied to US and European GDP growth. While exposure to CPG and other
more stable industries should insulate them to some extent, they are still a niche chemical company in a generally cyclical industry.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst
Deal Closing
Debt Paydown
Executing cost savings and synergies
Additional analyst coverage
Potential takeout down the road 

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Messages
Subject Re: thnx
Entry 09/30/2015 10:47 AM
Member aviclara181
First, we agree that KRA represents a multi-bagger at these levels.  We’ve followed KRA for many years and believe management is
thoughtful about creating shareholder value.  On why KRA’s share price reacted negatively to the Arizona announcement, we believe that
many shareholders owned KRA on a cost-cutting, cash generation, share repurchase thesis.  The Arizona deal creates thesis creep,
which we believe resulted in some shareholders selling.

Stepping back, we believe Arizona is a good deal.  It’s highly accretive and being purchased at an attractive price.  One of the key risks on
KRA was butadiene (their main input cost) volatility and this helps mitigate that business risk.

As for Arizona trends, on the transaction call, the company addressed this.  “Relative to the financial performance, as Kevin said, the markets
that Arizona participates in are growing at GDP plus. The company's done a very, very good job in rationalizing its cost structure. We feel
confident with the underlining supply-demand dynamics coupled with what the company has done. This is definitely a business that we expect to
grow EBITDA.
You may be looking at 2012. That was actually a tail end of a unique competitive environment where there was a shortage of competing products,
which led to some higher prices for Arizona's products. The competing substitute products are hydrocarbon, gum rosins and vegetable oils. In
subsequent periods, we believe it's more representative of normal supply/demand, that is 2013, 2014 and the TTM 2015.” 
 
We have subsequently spoken to some sellside analysts who are familiar with the Arizona business (e.g. guys who cover EMN because
EMN makes the competing oil derived products).  The Arizona products are substitutable with oil based products.  When oil prices
declined in the latter part of 2014, the oil based products became more competitive and resulted in lost market share.  EMN made a
comment on their earnings call, “Next is Adhesives & Plasticizers on slide six. Sales revenue declined 11%, primarily due to lower prices,
reflecting lower raw material costs and an unfavorable shift in foreign exchange rates. We continue to see a favorable shift in product mix due to
strong volume growth of differentiated hydrogenated hydrocarbon resins in the hygiene and packaging markets and non-phthalate plasticizer
substitution in North America.”

Now oil prices are already at the lows, we believe this share shift has already taken place.  EBITDA in 1H15 is run-rating ~$180 and that
takes into account lower oil.  To the extent oil prices recover, that should provide an EBITDA tailwind.  It appears as though KRA is
purchasing Arizona at a trough.
 
 

One last thing for those of you who are new to KRA.  It’s important when looking at the business not to focus on revenues because of
how their business model works.  They run their business trying to maximize pro t per unit sold without taking on raw material input cost
risk (butadiene).  Their input costs are generally passed-through to their customers when it goes up and down.  Therefore, you may see
the revenues decline meaningfully, but that may be a result of passing on the lower butadiene costs, so you won’t see that hurt their
EBITDA.  The way to really evaluate / model the business is to look at their gross pro t per ton sold.  

Subject Re: of21, spike, aviclara?

Entry 12/31/2015 02:28 PM
Member aviclara181

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So we actually did more work and our initial take on what was happening with Arizona volumes was inaccurate.  Arizona products are
almost always cheaper than oil based products, so generally customers do not switch to oil, there's just pricing pressure on Arizona
products.

Volume impacts at Arizona over the last few years were driven by a 1) a switch to a distributor that did not work out, and Arizona will take
that back in-house and 2) improved e ciency that reduced by-products that contribute little to ebitda, but result in less volumes old

That being said, KRA did post slides tied to the nancing deal in December.  Those slides contained 3Q15 numbers for Arizona that
showed EBITDA up yoy, despite oil taking another leg down.  They had some charts showing Arizona EBITDA mapped against oil prices
and there wasn't as meaningful a sensitivity as the market is assuming.

We spoke to the Company regarding the debt- nancing and our understanding is

1) They have committed nancing.  The banks have to fund, but don't want to hold the debt on their books at 12/31 because it impacts
their capital ratios.  So they are waiting til Jan to execute the deal

2) Company rea rmed that the Arizona EBITDA is not as sensitive to oil prices 

Here's the link to the CIM

http://www.sec.gov/Archives/edgar/data/1321646/000119312515391284/d161148dex991.htm
(http://www.sec.gov/Archives/edgar/data/1321646/000119312515391284/d161148dex991.htm)

See page 14.  Shows the Arizona gross pro t / ton fairly stable in 2015 despite oil being down materially in 2015 vs. 2014.

Also see page 17, KRA is effectively providing projections.  $450 of FCF over the next 3 years.  That's the entire market cap of the
Company.

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