Kannan D
The following segment was excerpted from this fund letter.
Business Summaries:
Headquarters: Essen, Germany
Founded: 1874 as an egg wholesale business in Berlin and entered the chemical distribution business in 1912
In his book Antifragile: Things That Gain From Disorder, Nassim Taleb describes the robustness of things through time with reference to the Lindy Effect also known as Lindy’s Law. In short, the longer something has been around, the longer we can expect it to last into the future. This interesting phenomenon bears keeping in mind in the arena of business analysis and investment – if priority number one is to not lose money, Lindy’s Law would suggest that if a business has been around for a long time, it is likely (ceteris paribus) that it will continue into the future.
On this (rather circuitous) note, we would like to give you a brief overview of one of our portfolio companies, Brenntag. This company will celebrate its 150th birthday next year. That is a lot of candles.
Brenntag is the world’s largest third-party chemical distributor. During the course of business, the company bulk-buys chemicals from large manufacturers and sells them to its almost 200,000 customers.
Often these customers are small and medium-sized enterprises and rely on chemical distributors like Brenntag to find them the right products (sometimes even blended and mixed by Brenntag), package them into the appropriate size, and deliver them in an efficient manner.
There are two key drivers of operating earnings for this business. The first is the gross profit Brenntag is able to earn per tonne of chemicals supplied. This is driven partly by the market value of the chemicals themselves, but also by the value Brenntag provides to suppliers and customers alike. Below the gross profit line are operating expenses, which net off to leave operating profit.
It is Brenntag’s position as a scaled intermediary which, we believe, give it an advantaged position as a business with a strong value proposition for both customer and supplier.
While a large chunk of chemical manufacturers’ product is sold directly to very large customers, the large producers are simply not geared up to sell directly to the long tail of smaller customers. With an average order value of EUR 3,000, distributors like Brenntag give them an effective channel to this market, without the headache of supply chain and cash management for hundreds of thousands of small clients.
Likewise, Brenntag’s customers benefit from the company’s ability to procure chemicals from large producers and blend and package them in the correct quantities. Customers also benefit from Brenntag’s significant expertise in chemical formulations.
This business exhibits a strong degree of customer stickiness. Often, the chemicals Brenntag supplies to its customers are critical to their production processes (often with a ‘design-in’ element), giving Brenntag – and others like it – a loyal customer base. Separately, there are also considerable cost benefits to a distributor of having a dense group of customers in each area it serves. For these two reasons, this industry lends itself to a fragmented structure of small ‘local leaders’ – small distributors which dominate in a particular location. Brenntag, for example has just a 5% share globally despite being the number one player. This all translates into a profitable business model, and Brenntag is able to comfortably earn over its cost of capital, with returns exhibiting a strong degree of stability, too.
Given the highly fragmented nature of the industry, as well as the entrenched nature of chemical distributors, Brenntag makes use of acquisitions to fuel inorganic growth. In fact, it has spent almost half of its free cash flow over the last decade on acquisitions. That the business is dominated by small players is not to say that there are no benefits to scale – operating profit is in part dictated by the level of fixed costs, and larger businesses like Brenntag benefit from a greater degree of fixed cost absorption.
Likewise, an increasingly strict regulatory environment should advantage Brenntag over smaller peers.
Combining Brenntag’s inorganic growth with the structural growth of the ‘third party’ chemical distribution industry as manufacturers increasingly exit the distribution segment, we believe this business should exhibit moderate, above-GDP growth in the medium to long term.
Of course, not all acquisitions are made equally – and we note with interest Brenntag’s now-aborted desire to acquire Univar, the next-largest (and publicly traded) peer. Big M&A is always tricky to execute, and this deal would likely have resulted in some significant revenue dis-synergies, and with a tried-and-tested model of acquiring small distributors, perhaps Brenntag would better serve its shareholders by sticking to its knitting.
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