CCF - Why To Consider Chase Corp For A Challenging Economic Environment

2023-03-12 05:25:56 ET

Summary

• Chase Corporation is a specialty chemicals company that has a highly diversified customer base.
• Chase works like a well-oiled machine, consistently churning profits and free cash flows, year in and year out.
• While the company faces challenges from rising interest rates and a slowing economy, it is well positioned to face this tough situation.

An economic downturn is a fierce adversary, capable of causing significant harm even to the largest and most established companies. Chase Corporation ( CCF ), a Westwood, MA-based specialty chemicals company with decades of experience, might feel the heat of this downturn. Rising interest rates and a slowing economy pose a threat to this small-cap operator, potentially impacting its growth prospects.

However, fear not, for Chase Corporation is a well-run business that can weather such storms. It's precisely the sort of company that savvy investors should consider backing during difficult periods, particularly when its shares fall and become available at a discount. After all, it's likely that Chase Corporation will emerge from the downturn even stronger.

In this article, I will delve into Chase Corporation's future prospects, exploring why it's the kind of investment that investors should keep on their radar.

Strength in Diversity

Francis Chase and his two sons founded Chase Corporation in 1946. Originally operating under the name of Chase & Sons, the company initially made rubber pants for babies that could be worn over cloth diapers. By the 1950s, the company had leveraged on its strengths of dealing with rubberized coatings to make bedding, binding, and insulating tapes for the wire and cable industry. From there, the company went from strength to strength, building its tapes, coatings, and other protective materials businesses.

Chase Corporation is now a dominant force in its niche, boasting manufacturing plants in the United States, Europe, and Asia, and conducting operations in five countries. The company is divided into three segments: Industrial Tapes, responsible for 44% of annual revenues (for FY ended August 31, 2022); Adhesives, Sealants & Additives, which accounts for 42% of revenues; and Corrosion Protection & Waterproofing, which drives 14% of total revenues. North America remains its primary market, accounting for 79% of its annual revenues, while 11% come from the Middle East/Asia (including China), and 9% from other regions.

I think one of the most compelling aspects of Chase Corporation is its highly diversified customer base. Unlike some of the other companies that depend on just a few customers for the majority of their earnings, Chase Corporation boasts no single customer that accounts for more than 10% of its sales. Furthermore, the company is diversified in terms of the end markets it serves. From aerospace and automotive to electronics, medical, oil & gas, consumer packaging, and beyond, Chase Corporation's products reach a wide range of industries.

In my view, this diversity of both customer base and end-markets served translates into a low risk for investors, as the company faces minimal exposure to large clients or industries and their associated risks. Even if a major customer goes bankrupt or an industry comes under severe pressure, Chase Corporation's business is unlikely to be significantly impacted.

A well-oiled machine

I think Chase Corporation has established itself as a well-oiled machine, generating consistent profits and free cash flows year after year. The company's growth has been driven by a series of strategic acquisitions, all while maintaining a healthy balance sheet. Though the company's debt levels have increased due to its largest acquisition to date, NuCera Solutions, with a reasonable debt-to-equity ratio of 46%, Chase Corporation appears to be in good financial health. Additionally, the company's free cash flows can be used to pay off its debts, meaning that its current debt levels are not a significant concern.

A brief snapshot of the company’s financial performance is given in the table below.

Amount in US, except per share items. Image: Author. Data: Seeking Alpha

The company's long-term debt of $165 million at the end of the previous quarter relates to fund borrowed from the $200 million revolving credit facility to purchase NuCera Solutions. The deal, which was valued at $250 million, closed in September. Despite this increase in debt, I believe Chase Corporation's financial position remains strong, with manageable debt levels that do not cause alarm.

Chase Corporation's most recent quarterly results were impressive, highlighted by a strong uptick in revenues and adjusted earnings. Though GAAP earnings and margins experienced a decline, this was primarily due to one-off items related to the NuCera acquisition.

For the first quarter of FY23, Chase Corp. reported a 37.2% y-o-y increase in revenues to $102.89 million and a 42% increase in adjusted EBITDA to $25.2 million. While the GAAP net income fell by 30.9% to $6.72 million, or $0.71 per share, and gross margins weakened to 34.9% versus 37.0% in the previous year, this weakness can be attributed to an amortization expense and inventory step-up adjustment linked to the recent acquisition. However, when excluding this effect, margins would have been slightly better than last year's, at 37.1%. Despite the decline in net income and margins, it's not a worrying sign since it was mainly driven by one-time items.

Chase Corporation's most recent quarterly results were impressive, showcasing the company's ability to achieve solid growth despite external challenges. However, there are still some areas of concern to keep in mind. While the company remains strong in certain markets, it has experienced weakness in others. Additionally, the Federal Reserve's decision to increase interest rates could have a negative impact on the company's growth prospects moving forward.

Looking Ahead: Addressing Key Risks

The past year has brought about significant changes in the global landscape, and unfortunately, the future doesn't appear as bright as it once did. Geopolitical tensions have escalated following Russia's invasion of Ukraine, commodity prices have skyrocketed, and many countries, including the United States, are grappling with inflation. Stock markets have experienced a downturn, and central banks are tightening monetary policies, all while economic growth is decelerating.

According to the World Bank's estimates , the global economy is projected to grow by a mere 1.7% in 2023, with the United States expected to see a GDP expansion of only 0.5% during the year. This represents a sharp deceleration from the 2.9% of global growth and 1.9% in the US witnessed in the previous year.

As the global economy slows down and central banks increase interest rates, a number of industries - including automotive and technology companies - might struggle. Unfortunately, this could also impact some of Chase Corporation's end markets, such as automotive, technology, aerospace, packaging, and industrial sectors. The company got a taste of it in the previous quarter. Despite holding up well thus far, Chase Corporation experienced weakness in demand for its Corrosion, Protection, and Waterproofing segment.

Furthermore, the company has admitted to feeling “inflationary, logistical, and labor pressures”, which has forced them to raise prices at times. While this has contributed to an increase in revenues, if the business environment remains challenging and more of Chase Corporation's end markets begin to experience weakness, the two major segments that are responsible for over 85% of its annual revenues may be negatively impacted.

Then there is the high interest rate environment. It's important to remember that in just six short months last year, the Federal Reserve raised interest rates from near-zero to 4%, with the latest 25 basis points hike in February pushing the policy rate to a range of 4.5% to 4.75%. I believe more hikes are likely to come, as consumer spending, job growth, and inflation remain high. The Federal Reserve had already projected an increase in the federal funds rate to 5% - 5.25% back in December. Given the current economic environment, it remains to be seen whether these projected hikes will be in line with or even greater than the initial forecast.

The recent increase in interest rates poses a significant challenge for Chase Corporation. As a company that has historically relied on acquisitions to drive growth, these purchases are often backed by a significant amount of debt. However, after completing these acquisitions, the company's earnings typically rise, allowing it to generate strong levels of free cash flows that can be used to pay down its debt. While this strategy has worked well in the past, the current economic climate presents new challenges. Rising interest rates mean that it may take longer and could become more expensive for the company to pay off its debt, which could impact its ability to continue generating solid returns for investors.

Chase Corporation's most recent and largest acquisition yet presents a new challenge in the face of rising interest rates. The company's purchase of NuCera Solutions for $250 million last year involved a significant amount of debt - $180 million, to be exact. That’s helped power earnings growth and the company has already started using the excess cash that it is now generating to reduce debt. In fact, the company earmarked $15 million for debt repayment in the first quarter and I expect it to continue paying down its debt in the coming months.

However, even the company's current debt may become more expensive in this environment, given that its revolving credit facility charges LIBOR (London Interbank Offered Rate) plus a spread of 1% to 1.75%, depending on the company's leverage metrics. As LIBOR rises, the company's interest expenses are likely to climb, further impacting its financial performance.

Moving forward, it's possible that major acquisitions - which in the past may have been powered by debt - may become less likely in the face of this high-interest rate environment. As such, it's clear that the rising interest rates have dampened the company's growth prospects, creating a more challenging economic landscape for Chase Corporation to navigate.

While the current economic climate poses challenges for nearly all companies, Chase Corporation is well-positioned to weather the storm and emerge unscathed. With a long history of successful operations, the company has demonstrated its ability to navigate economic challenges time and again. As mentioned earlier, like a well-oiled machine, the company is built to continue churning out strong financial results quarter after quarter, even if the business environment becomes more difficult.

It's worth recalling here that Chase Corporation's highly diversified operations, both in terms of its customer base and end markets, will prove to be a major advantage during this economic slowdown. This diversification will likely shield the company from the risks associated with individual companies or single industries, while also positioning it to capitalize on strength in some sectors - such as the oil and gas industry.

I believe Chase Corporation’s geographical diversification might also come to its aid during the difficult period. Its global operations across the US, Europe, and Asia could aid the company during the economic downturn. Although the company experienced weakness in Asia, particularly in China, due to COVID-19 lockdowns and travel restrictions, the reopening of the country presents an opportunity for the company to bounce back.

While high interest rates are certainly a challenge, I like Chase Corporation's proactive approach to improving its cost structure. From relocating its head office to implementing work-from-home initiatives, the company has taken steps to cut down costs. This might also minimize the impact of rising interest rates on its margins. And if push comes to shove, I expect Chase Corp to explore additional cost-cutting measures to keep its financials on track.

Looking to the future, I anticipate that Chase Corp.'s reliance on debt to fuel its growth may become less sustainable in the long run, especially if interest rates continue to rise. In response, I believe that the company will shift its M&A strategy to focus more on using cash to acquire other companies, leveraging its impressive track record of generating free cash flows and building up its cash reserves over time. The beauty of this approach is that it allows Chase Corp. to continue making accretive acquisitions without taking on excessive amounts of debt.

Takeaway

In short, despite the headwinds faced by Chase Corporation, its history of consistent profitability and diverse customer and market bases should give confidence to investors. The availability of cheap debt would have made things easier, but in my view, Chase Corporation can still find plenty of ways for growth even with higher interest rates.

Chase Corporation has shown impressive growth in the last six months, with its shares increasing by almost 10% while the S&P-500 declined by 5%. Although it may not be considered a bargain at the moment, trading at almost 22x ttm earnings, it remains a strong company that investors should keep a close eye on and consider purchasing on weakness.

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