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Small Cap Idea: Diversey Holdings (DSEY)
Riding on Bain Capital's coattails
Update (March 8, 2023): Diversey to be acquired and taken private by Solenis, maker of specialty chemicals, for $8.40 per share. This is 41% premium over Diversey’s closing price, and 93% above the stock price of $4.35 when this report was published.
Given the small float (~$400mn) of this idea and recognizing that not all of our readers are able to invest in small-caps, we have decided to make this into a free/bonus report! Paid subscribers will receive an extra deep dive later this month on a large-cap idea.
Diversey Holdings is a provider of cleaning and hygiene products in the hospitality, healthcare, food and beverage, food service, retail, and facility management sectors. Their suite of solutions combines patented chemicals, dosing and dispensing equipment, cleaning machines, and services. Headquartered in the US, Diversey is a multinational serving more than 85,000 customers in over 80 countries with a network of 8,500 employees. It has a market capitalization of $1.4 bn, an EV of $3.3 bn and is 73% owned by Bain Capital. The company is currently trading at 10x depressed 2022A EBITDA or 7.0x normalized 2025E EBITDA.
While we buy our detergents and cleaning products from the supermarkets, commercial customers need institutional suppliers. Furthermore, these customers have very unique needs. Consider a brewery which has to clean its equipment after certain production cycles. The chemicals used to clean this equipment need to be safe - for the cleaning personnel, the life of the equipment, as well as the customers consuming products from this brewery. More importantly, while the equipment is being cleaned, it cannot produce due to which the time to complete the cleaning process is important. For example, at Brasil Kirin (one of the largest Brazilian breweries) Diversey implemented a one-step cleaning program without the need for an expensive and time-consuming disassembly process.
Moreover, with most businesses committing to increasing ESG commitments, lower water and energy consumption in this cleaning cycle is increasingly important. For example, this is a challenge at meat processors that have to regularly wash off thick layers of animal fats from their equipment and factory floors. Large amounts of hot water is used in the process. With the assistance of Diversey’s cleaning chemicals that are specially formulated to penetrate heavy animal grease, clients are able to reduce their hot water usage.
“Directly (Diversey) is helping us reach our sustainability goals”
- Manager, Goedegebuur (beef processor)
Chemical companies such as Diversey and Ecolab visit these facilities with their technicians, formulate the chemicals, decide on a cleaning and maintenance schedule and install dosing and dispensing equipment. The facility is then supplied regularly and service and maintenance personnel need to be on call in-case of emergencies as the cost of stoppage is too high.
“Let's say you're cleaning a very high-profile customer, Amazon, Microsoft..you don't want a glass cleaner, a multi-surface cleaner, or a disinfectant to harm one of your client's employees or damages some kind of substrate, so risk mitigation”
- Ex-VP Ecolab (Stream Transcript)
Diversey and Ecolab operate in this $32 bn global market where they have the following quality attributes:
Provides essential services to their customers without which they would not be able to run their businesses
The spend on their services is small relative to the total cost of running the business for the customer. This is an essential part of business for the customer if they are to maintain compliance with regulators. Due to this, this business is relatively recession resistant.
Razor and razor blade model where Diversey and Ecolab install dosing and dispensing equipment at the customer site locking in business, but most of the margin is made from consumable chemicals.
Scale is needed in the business in order to profitably serve the customer. Density and route-to-market are important variables. Although these are classified as chemical companies, the services aspect of the business is more important. Due to this, this industry lends itself to an oligopoly structure.
Smaller companies can have high market shares in certain geographies and both Diversey and Ecolab have been busy acquiring them and consolidating the industry.
Cleaning and sanitation services have a newfound importance after Covid-19. Many businesses are taking steps to further their standards in cleaning and hygiene which benefits Diversey and Ecolab.
The business is about more than just selling cleaning products. Some clients also expect Diversey to provide a total solution around the cleaning tasks.
To illustrate, hospitals are sophisticated users. Cleaning is done frequently (multiple times a day) and there is a need to accurately manage and track the cleaning real-time. Infection prevention protocols must be followed to a tee and information shared by different staff (administrators, cleaning staff, and nurses). Diversey has created a platform called SmartView which allows users such as hospitals to visualize and track all of the cleaning tasks in real-time.
A Diversey salesperson will pitch the customer on how its solutions will help them save money whether that’s through material savings (energy and water), improved staff efficiency, or reduced facility downtime.
Diversey breaks down its business in two segments - Institutional and Food & Beverage:
Diversey is a smaller competitor than Ecolab, with less scale in the US but competes head to head with Ecolab in Europe and Emerging Markets. In fact, Diversey has leading market shares in countries such as the UK, India and Indonesia (which were strong Unilever markets - Diversey used to be owned by Unilever).
73% of revenue is generated outside of North America (39% Europe and 34% EM)
Other than sales to distributors (22%), food services (14%) and healthcare (12%) are the biggest end markets. But overall, end market is highly diverse.
Risk of customer concentration is negligible - top 10 accounts for only 5% of total revenue.
Recently Diversey’s share price has declined precipitously to $4.35 per share (where we initiated a position) from highs of $14-19 per share in 2021. Diversey is facing some temporary headwinds due to high raw material costs and USD strength. Further, it has high debt levels. We believe these headwinds are temporary and Diversey should be able to overcome that in the next few years and de-lever its balance sheet. If this is the case, the stock can appreciate markedly within the next 2-3 years.
Industry Dynamics and Competition
Diversey’s main competitor is Ecolab. Ecolab has been a compounder and has done really well for shareholders. Due to its stable growth profile, high ROIC and shareholder friendly policies it regularly trades at 16-20x EV/EBITDA and 30x P/E. Ecolab has a large market share in the US which is the largest sanitation and hygiene market in the world due to which it benefits from economies of scale.
In its core segment of sanitation, competition in the industry is not just based on price but also on product and service:
“When a customer is evaluating a company like Diversey or a category that Diversey and Ecolab would compete in, yes. Is price important? Of course, it is. Diversey and Ecolab compete against each other but also the broader market with chemistry and competencies around the chemistry. How can you make the most concentrated chemical possible that's still safe and that still has a high efficacy? How can you put it into a dispensing or dosing platform that is equally safe, that cannot be tampered with, that cannot break, that cannot accidentally injure someone? You have a 256:1 or 512:1 dilution ratio on a cleaning chemical. If you get that in your eye, that doesn't feel very good. How can they assure the customer that those dispensaries are getting installed properly, on time, ready to go, literally on this exact date?”
- Diversey - Ex-President Global Strategic Accounts (Stream Transcript)
Importantly, the industry has high switching costs:
“Especially if you think about the customers having a large site, it is not easy to switch. Why? I just told you that if you have a large site such as Sodexo, you need them to let in that new supplier. The old dispensing system of the previous one needs to get dismounted from the wall. The new guys have to come in, mount a new dispensing system, and give training again. Before you're going to change a supplier and especially if you need these dosing systems, like in big food service locations, you're going to think twice. You really have to be that you're not happy about service-level agreements or whatever happens in the relationship with your supplier, but it's not something you're going to change each contract cycle. That is too cumbersome.”
- Diversey - Ex-President Global Strategic Accounts (Stream Transcript)
The contracts are typically 3 years in length with renewals based on prior performance. Unless there has been a problem with service, the customer does not switch. Over time, this customer becomes more and more profitable. Due to this, it has been increasingly difficult for Diversey to gain market share from Ecolab in the US.
However, given the growth in the industry and the market share controlled by independent operators, there is enough of a runway for both Ecolab and Diversey. It is important to understand that together, they hold only a small portion of the total market, as we’ll explain.
As we discussed above, competition in the core sanitation and cleaning segment is based on economies of scale, service levels, as well as switching costs. However, there is another division called water treatment that is big business at Ecolab. In 2011 and 2012 Ecolab made two transformative acquisitions: The first was Nalco Holdings, a water treatment business serving the mining, energy, and paper industries. The second was Champion Technologies, a specialty chemicals company that produces water treatment for oil drillers and products that prevent oilfield equipment corrosion.
While these assets increased Ecolab’s scale and diversified its revenue stream, they had the effect of introducing some cyclicality. The key difference between Ecolab and Diversey is that Diversey has a very small part of its revenues that come from water treatment. Although Ecolab is a $13-14 bn sales company, about half of these sales come from ‘water solutions’ and not pure-play sanitation and hygiene. Therefore, on an apples to apples basis, Ecolab is ~2.5x bigger than Diversey. In total, the top two players have combined sales of $8-9 bn in a $32 bn market.
Diversey has partnered with Solenis to offer water treatment products and cross sell these to its food and beverage customers. While it is currently a small portion of revenues (about 20% of F&B revenues), management is confident that it can penetrate more customers with this service.
Diversey has a long history and has been in business since 1923. In 1978 it was bought by Molson which owned it for a long time until partly divesting it in 1996 to Unilever and then fully divesting it in 2003. In 2002, Diversey was sold to a subsidiary of SC Johnson. In 2009, Clayton, Dubilier & Rice acquired 46% of JohnsonDiversey from the SC Johnson family. In June 2011, Sealed Air purchased 100% of Diversey Holdings for $4.3 billion (9.7x LTM EBITDA). It was a sizable acquisition for Sealed Air:
In 2016, Sealed Air decided to pursue a tax-free spin-off of Diversey in order to simplify its core business and reduce debt (it had lost a contract to sell SC Johnson products affecting revenues and op income).
However, in March 2017, Bain Capital bought Diversey for $3.2 billion from Sealed Air with the intention of running Diversey as a standalone company. In March 2021, the company came to the market with an IPO at $14 per share with Bain Capital owning 75% of the shares outstanding. Later that year, they did a secondary stock offering diluting Bain to 73% of the company. Furthermore, since Bain acquired Diversey in 2017, it has gone through 4 CEO’s. However, the current CEO, Phil Weiland, has been serving in his position since July 2020.
It is interesting that some problems never get solved! Molson had to get rid of Diversey to Unilever as its US operations were not profitable and because Molson was in a de-conglomerate mode. Under Unilever, Diversey thrived in Europe and Emerging Markets where Unilever itself had strong market shares. With so many owners over so many years, Diversey lost a bit of its soul and got stripped of their asset base. With increasing leverage, owners could not spend on the long term growth initiatives. However, in all this time, Diversey retained its brand and reputation. Clients and regulators trust Diversey.
“So in New York, for example, they (Ecolab) have three times the amount of salespeople that Diversey does, just in the state of New York. Whereas, Diversey in the UK has probably three times the amount of salespeople that Ecolab has.”
- Stream Transcript
Under Bain, some long needed changes were made. As an example, Bain spent capital on sales training and IT infrastructure including installing a CRM system. Most importantly, Diversey, under Bain, has been building a production facility and distribution warehouse in Kentucky in order to own more of its production and consolidate its disparate supply chain network. Management expects to add 100 bps to EBITDA with this facility completing construction in Q1 2023. Given that it's a scale business, there is a chicken and an egg problem with Diversey in the US - without scale it cannot get margins and without a willingness to invest in the business it cannot get scale. Some of this is being corrected with Bain - Diversey won a big contract with Aramark and the recent consolidation of production and supply chain both ensure better US margins.
“Scale's pretty simple. U.S. is full of big companies with lots of assets in lots of states. Moving around chemicals is expensive, and moving around people is expensive. If you've only got 10 people in all of the West Coast and the competitor has got thousands, those numbers I just picked out of the air, then that would suggest the competitor's got much more credibility with the customer... It was just as brutally simple as that. It was nothing more complicated than the cost to serve and when you take into account people and chemicals.”
- Stream Transcript
The current CEO stated Diversey’s objective at the IPO as follows:
“We look forward to building on the estimated long-term market growth of around 3%, with market share gains. We target to grow another 2% per annum through accretive M&A. And we target to expand adjusted EBITDA margin to 20% at the average rate of 50 to 100 basis points per annum through our improved sourcing, strategic pricing, supply chain improvements and operational excellence through SG&A cost initiatives. This should generate strong free cash flow that we can use to de-lever over time with a medium-term net debt goal of 3x adjusted EBITDA”
Diversey was making really good progress on margins in 2020 and 2021 with adjusted EBITDA margins at 15.7% in 2021. However, 2022 has proven to be much more treacherous. As a chemical company, Diversey’s cleaning chemicals are derived from crude and crude derivatives. With crude prices rising and unavailability of some chemicals due to supply chain, Diversey had to reformulate some products but still make sure they were available for their customers so as not to halt their operations. This had both gross margin and operating expense consequences. Furthermore, Diversey is more of an international business with 73% of its revenues coming from countries other than the US. This year, the USD has been on a tear (DXY up 21%!) due to which Diversey’s reported numbers in USD look awful. Its adjusted EBITDA margins declined to 11.6% this year.
In recent quarters, Diversey is passing on rising raw material costs to its customers and has taken pricing as well as surcharges to protect its gross margins. Importantly, we see that crude prices have stabilized, supply chains are better and the USD has topped. All the headwinds in 2022 are turning into tailwinds going into 2023. We believe that Diversey’s numbers will surprise to the upside in 2023-2025.
At this stock price, we don’t have to believe that Diversey’s margins will go to 20% or that they will gain scale in the US. If the margins return to their previous 2021 high at 16% (we will have the Kentucky facility come online in Q1 2023) then there is substantial upside potential in the shares.
More on Margins
On a more secular basis,
Ecolab makes a margin of 20-21% on a consolidated basis while still investing in its business. In the US, Ecolab has had a bit of a free reign as Diversey was distracted by different owners and different CEO’s. This pricing umbrella provides Diversey an opportunity to better its position.
One of the important things to understand about this business is that margins get better over time. As an example, when Diversey wins a contract it has to install the dosing and dispensing equipment, the costs of which can only be recouped over time. Due to this, the business will show a little bit of a margin contraction if it is growing too fast.
Diversey is now also selling water treatment to its customers. This is a ‘add on’ service that should help not only revenue growth but also margins in the long term.
Since the IPO, Diversey has made 5 acquisitions. They acquired Sanechem in Poland; Avmor in Canada; Tasman in Australia; Birko in the U.S. and Shorrock Trichem in the U.K. These acquisitions enhance their scale and competitive position in the global Food & Beverage business which is a strategic priority and a higher margin business (versus the Institutional business). Each of these acquisitions either gives Diversey customers, distribution channels or integration of the back end. Diversey has paused M&A until its debt/EBITDA comes in-line, but, after that, we can expect value accretion with this tuck-in M&A strategy.
On a more cyclical basis,
Revenues actually declined in 2020 even as health and hygiene were given increasing importance due to Covid, as a lot of client premises such as hotels were closed. Management estimates a decline of $400 mn (Ecolab reported something similar).
After Covid, Diversey managed freight issues where they had to airfreight some products and maintain higher inventory levels. They also went through a difficult and fast-changing raw material landscape where their R&D teams had to reformulate products. All of this was done to limit the impact on customers.
In Europe, where traditionally inflation is much lower it took the clients some time to accept the need to take continuous price increases but these price increases as well as surcharges are now being accepted. Diversey is taking double digit price increases (10-12% total in 2022) as seen by constant current growth in the last two quarters.
The important point to emphasize is that prices are sticky on the upside. If/when raw material prices ease, Diversey does not have to pass this on to the customer retaining the incremental margin.
As mentioned above, USD, as represented by the DXY index, was up 21% from the beginning of the year to September 2022. This essentially means that like-for-like 73% of Diversey’s reported revenue and EBITDA were down 21% just based on the currency. The fact that, on an absolute basis, revenues have held up because of the price and volume increases as mentioned above is remarkable.
We believe all these issues are temporary. As and when these issues are resolved or are lapped up by YoY comparables, we believe that Diversey will be seen as a stable consumer company.
Debt is a real issue at Diversey. The business has debt in USD and Euro and last quarter its debt/adj EBITDA was over 5x. Diversey has cash of $250 mn resulting in a net debt number of $1.72 bn. If we look at actual EBITDA with all ‘one-time’ items included then the situation is even worse! Management can report adjusted numbers all they want but if they have debt on the balance sheet that needs to be serviced then one needs to produce the cash flow to service it! We believe that the situation is stretched but under control.
Bain fixed the debt in Sept 2021 due to which servicing the debt has not gotten any more expensive this year even though rates have gone up. Currently more than 2/3rd of their debt is at fixed rates and termed out - term loan to 2026 and senior notes to 2029. In fact, in 2022, Diversey was able to monetize USD floating to EURO fixed swaps and credit a gain of $186 mn. We are not fans of financial engineering but believe cash interest costs of ~$100 mn should be manageable for Diversey. In order to manage debt level management has paused any incremental M&A. Further, we believe that there will be a working capital release that will help cash flow in 2023.
At a forecasted EBITDA level of $450 mn, net debt/EBITDA comes down to 3.8x and down from there as Diversey uses cash to pay down debt.
Numbers and Valuation
Given the ‘turnaround’ nature of the investment, there are a lot of ‘one-time’ costs that have been muddying the income statement. For example, Diversey is taking ~$80 mn in restructuring costs to consolidate its supply chain and is slowly charging it to the income statement. After last quarter, only $27 mn is left which will be taken in Q4 2022. From next year on, the financials should be fairly clean.
Regardless, the thesis rests on the assumption that this 11.6% margin is temporary and Diversey can go back to the 15-16% level it achieved in 2020-2021. As mentioned above, we believe that this will be increasingly possible with the Kentucky facility (which should help 100 bps) as well as an easing in crude and DXY. With some growth in the business, the actual EBITDA number is closer to $450 mn in 2024-2025 compared to $320 mn in 2022. With capex of about 3% of sales ($80-100 mn), cash taxes of $50 mn and interest costs at $100 mn, we are looking at free cash flow of about $200 mn per year.
Ecolab trades at 16-20x EBITDA. It is a much better business than Diversey so perhaps Diversey deserves to trade at a discount. We believe a 12x EBITDA multiple is justified given the stability and financial profile of the business. At 12x multiple and a $450 mn EBITDA we get an EV of $5.4 bn. Assuming that Diversey uses $150 mn of the $200 mn per year in FCF to pay off debt, it should have about $1.4 bn in net debt in 2-3 years. Subtracting this net debt number from the enterprise value gives us an equity value of $4.0 bn.
At 330 mn shares outstanding, the resulting stock price should be closer to $12 per share compared to the current stock price of $4.35 per share. At a more conservative 10x EBITDA we get to a per share value of $9.4 per share which is also more than double the current market price.
Clients can go to base chemicals and choose not to use specialty chemicals
Ecolab can initiate a price war in response to Diversey’s increasing attempts to gain market share in the US. It is important to note that even Ecolab has been struggling this year and has not met financial targets. Ecolab too has been taking pricing and is expected to do better going forward.
Diversey has a lot of intangible assets on its balance sheet which came from Bain’s purchase of the company. Customer relationships and brand value is the majority of the $2.3 bn in intangible assets recorded on the balance sheet. It amortizes these assets and a non-cash expense runs through the income statement. It has very low PP&E but 8,500 people. Its balance sheet makeup is essentially that of a ‘distribution’ business - which at its core - is what it is. Although Diversey is confident in these intangible assets, any write downs here can be unpleasant.
Bain owns 73% of the company and has effective control. So far, Bain has been taking actions to increase the LT value of this investment which is positive for minority owners. An investment in Diversey is essentially a ‘side-car’ investment with Bain. The risk is a take under by Bain.
With a low float, stock prices can move drastically to the downside (as they have) and to the upside.
Bain also engages in a fair bit of financial engineering. The swaps on debt as well as securitizing some of the receivables, while not out of the ordinary, create some complexity to the business and financials.
Debt is a double edged sword.
It can enhance returns but if the business environment turns south or there is a Diversey specific issue, then it can be debilitating for the business.
While Diversey is fairly recession proof, it is not completely recession proof. During hard times, customers look at all aspects of their P&L and will likely ask Diversey for concessions which can affect pricing and therefore, margins. Given high debt levels, Diversey is especially vulnerable to negative operating leverage.
Our belief is that while these risks are real, none of them takes away from the core thesis. However, due to these risks, an investment in Diversey has to be sized smaller.
Diversey participates in a consolidated global industry structure in which Ecolab and Diversey are the two market share leaders focused on cleaning chemicals. This market for cleaning chemicals should increase at a 2% to 4% longer-term organic rate in addition to which Diversey is growing with price increases, water treatment as well as acquisitions. We believe the margin issues experienced by Diversey are temporary and that, over time, as these issues abate the market will see a fairly stable services company that can grow, like Ecolab, at a stable pace for a long period of time.
More than 73% of Diversey’s revenue comes from countries outside the United States, making it effectively an international business. A lot of strategists are suggesting ‘Emerging Markets’ exposure in 2023. We believe Diversey provides a good way for quality-biased investor to obtain some EM exposure in their portfolios.
In order to make a substantial return on investment, one does not need to believe in management’s 20% EBITDA goal, but a 15-16% EBITDA margin will suffice. No investment comes without risks and Diversey’s risks force us to take a smaller position even as the upside potential is enormous.
Disclosure: The author and his clients have a position in Diversey Holdings.
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