BNTGF - Brenntag: Need To See Evidence Of Margin Stabilizing

2023-03-20 18:40:25 ET

Summary

• The Brenntag SE Q4 2022 results show weaker underlying trends such as customer destocking and reduced business activity.
• Margins will impact Brenntag's path to earnings growth and valuation rerating, and management must manage the opex line (SG&A) to see stabilization of margins in 2023.
• Project Brenntag seems to be successful, and site network optimization has resulted in a significantly reduced number of employees needed to maintain performance levels.

Overview

Brenntag SE ( BNTGF ) sells and distributes industrial and specialty chemicals. The firm also works on developing and manufacturing selected chemical compounds. After looking at the Q4 2022 numbers , I think investors should temper their optimism about the company's earnings potential in the near future.

Even though the recognition of some unexpected costs likely had an impact on the reported weaker profits for the fourth quarter, the important thing to note is that there are weaker underlying trends, such as customer destocking and reduced business activity. In my opinion, however, the slowing of growth and the narrowing of margins in 2023 are already factored into market expectations. This is evidenced by the stock's current price-to-earnings ratio of 11x forward P/E, which is lower than the stock's historical P/E of 16x. Despite the fact that there will be difficulties in 2023 with respect to normalizing profits amidst a weakening macro environment, I believe BNTGF enjoys a mix advantage in that is has exposure to Essentials and Specialties, which offers resilience for growth in the short term. To take advantage of this mix effect, however, I agree that management must refocus its efforts on more resilient end markets.

As for the company's valuation, I think an upward re-rating is feasible. First, BNTGF needs to demonstrate that FY23 is on track to normalize (especially margins should stabilize), and it should execute as guided with no revision to earnings. If this is carried out effectively, the market's forward-looking valuation should gradually approach the historical valuation. A re-rating higher and a narrowing of the valuation gap versus IMCD (22x forward P/E) are both possible after this, but only if BNTGF demonstrates sustained growth and profitability consistent with the profile of its peers. However, I am not betting on this given the sheer lack of visibility and everyone's focus, I believe, is on FY23 margin management.

Overall, I would recommend to stay neutral for the first half of 2023 and re-evaluate the situation post Q2 2023 earnings before investing.

Q4 2022 results

In the fourth quarter , there was a 7% year-over-year increase in gross profit and a 3% year-over-year decrease in adjusted EBITDA, with both figures adjusted for FX. The Essentials division saw an 18% organic growth in adjusted EBITDA, while the Specialties division experienced a 13% organic decline. The organic adjusted EBITDA decline of 13% year-over-year in the Specialties division for 4Q22 was due to an adjustment of intra-segment service costs, with all of these higher service costs recorded in the fourth quarter. This adjustment has also impacted the 18% organic adjusted EBITDA growth in the Essentials division.

Margins

I believe the key element that investors will focus on margins – which impacts path to earnings growth and rerating. Specifically, the focus is on how BNTGF management its opex line (SG&A). This is important as FY23 is going to be a tough year for growth given the weak macro backdrop. If opex is not managed properly, it would cause margins to decline, which will further shake investors' confidence for FY23 performance.

To give some context, 2H21 and 1H22 were banner years for BNTGF's bottom line thanks to the inflationary effects of and supply chain volatility for chemicals. Given that price was a major factor in generating growth, losing this "pricing" advantage would have a significant negative impact on profits due to the extremely high incremental margin they represent. This "inflationary" trend has slowed considerably since the 2H22, with volumes also affected by the destocking effects of customers in the 4Q22. One would expect margins to flourish from this cyclical movement, but not as much as expect as SG&A growth also accelerated.

I believe Brenntag SE must manage the SG&A line in order to see stabilization of margins in 2023, given the expected slowdown in top line and gross profit. Examining the SG&A line item more closely, I believe that the growth in opex over the past two years has been primarily attributable to an increase in employee cost; this is something I anticipate will return to a more typical level in 2023, (more below) when slower growth is anticipated and Project Brenntag has proven successful.

Brenntag needs to reduce personnel cost

As was mentioned above, SG&A growth over the past two years has been largely attributable to rising employee cost, and this trend must be slowed down in FY23 if margins are to be preserved, in my opinion. To put things into perspective, as of 2022, a little over half of BNTGF SG&A base (which is defined as gross profit minus EBITDA) was employee cost. As such, a cut or moderation in this would significantly aid in managing margins for FY23. I believe there is definitely room to cut given the success of Project Brenntag, BNTGF's reorganization plan, aimed to sharpen the company's focus, simplify its operations. Site Network optimization was central to the strategy, with the company setting out to maximize the efficiency of its network by simplifying it. This included consolidating some locations into larger "mega sites," so as to lessen geographical duplication. The result is a significantly reduced number of employees needed to maintain performance levels at a significantly increased number of sites. Given the successful execution of this plan, I have faith that BNTGF's cost base will be stronger come 2023.

Conclusion

In my opinion, Brenntag SE's margins will be crucial for earnings growth and potential re-rating. With FY23 expected to be a tough year for growth amidst a weak macro backdrop, Brenntag SE must manage its opex line, particularly its employee costs, to preserve margins.

The successful execution of Project Brenntag gives hope for a stronger cost base in 2023. While an upward re-rating is feasible if Brenntag SE demonstrates sustained growth and profitability, I recommend staying neutral in the first half of 2023 and re-evaluating post 2Q23 earnings before investing.

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