raiseonce (70772) Generated on 9:06AM 12/11/2016 EST

VERSUM MATERIALS INC -SPN VSM S

October 20, 2016
by vfm343
2016 2017
Price: 24.00 EPS 1.70 0
Shares Out. (in M): 108 P/E 14.2 0
Market Cap (in M): 2,600 P/FCF 0 0
Net Debt (in M): 975 EBIT 295 0
TEV: 3,506 TEV/EBIT 11.9 0
Borrow Cost: Available 0-15% cost

Description

Versum recently spun-off from Air Products (leading industrial gas company with
$30bn mkt cap) as Air Product’s wanted to streamline operations and focus on its core
products. I would like to present Versum (“VSM”) as a short idea.

Versum, a leading provider of specialty chemical materials and gases for the
semiconductor manufacturing industry, has about $1bn of sales with ~$345mm of
EBITDA (~35% LTM EBITDA margin). The Management’s main selling point to
investors is that the Company has high margins and is less capital intensive. Most sell
side research analysts are repeating what is being feed to them and have a Buy
rating mentioning “best-in class margins”, “leading technology”, etc., which has
resulted in the current stock being valued off of some inflated operating numbers. We
believe that the margins will normalize to its peer operating margins. Additionally,
maintenance capital and R&D expenditure will have to increase in the future to
promote organic growth and be relevant in the industry. The stock price is currently
trading around $24 (10.2x LTM EBITDA), and we believe that there is potential for the
stock to trade down 30%+ for the below key reasons:

1) Operating margins are currently elevated (~35% EBITDA margins) for a

number of reasons which we will discuss later and should drop to around 22-
27% (Margins for its two closest peers has been ~22% for the last 3 years)

2) Management has not reinvested enough on its infrastructure in the past couple
of years to maintain operations. Maintenance capex (2.5% of sales and 48% of
D&A) for the past few years has been way too low for a manufacturing
Company. Net PPE (critical to daily operations) value currently stands at 1/3rd of
total initial value since the Company has not been spending enough to
replenish. The Company is pitching the past low capex spend as a positive

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selling point. We strongly believe that to maintain operations and grow

organically, we should expect a big one-time capex spend of $250mm+ in
coming 1-2 years. Additionally, ongoing annual maintenance capex spend
should increase to $30-40mm from the current $25mm

3) Management is determined on acquisitions to drive growth and consolidate the

industry. While smart strategic acquisitions are a good thing, acquisitions done
in haste and with the motivation of growing the Company for Management’s
greed (Compensation directly related to earnings) often end up being a
disaster. Additionally, Management team is not very experienced with
integrating acquired companies

4) DSS Segment, which generates about 25% of sales, is exposed to

infrastructure expansion cycle of the semiconductor industry, implying earnings
can be volatile for this segment

Diving deeper into the core issues:

1. Operating margins are currently extraordinarily high and we should

expect the margins to come under pressure in the coming quarters.
Total EBITDA margins have increased from 17% in 2013 to around 35% in 2016.
Margins in the Materials Segment (75% of total sales) have increased from 22%
to over 40% in the same period.

EBITDA Margins

2013 2014 2015

2016*
Versume (Total) 17.0% 23.7% 31.7% 34.5%
Versume (Materials
22.3% 28.0% 35.4% 40.4%
Segment)

CCMP 22.5% 22.0% 22.5% 22.5%

ENTG 19.1% 21.6% 21.5% 22.1%
*9 Months in 2016 for VSM and CCMP, 6months for ENTG
While substantial portion of the margins improvements in 2013 and 2014 were
fundamentally driven due to number of self-help initiatives (improvements in
mix, price, exiting unprofitable businesses and transfer of production facilities
from US to Asia (close to the end customer)), the margin improvements in 2015
and 2016 where predominantly due to favorable demand dynamics in the

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memory market (positively impacted prices of NF3, WF6 and a few other
products). The Company was fortunate enough to enter into long-term
contracts that helped improve margins as demand increased, but the
Management has stated (Feb 24, 2016 call) that VSM is bringing in new
capacity (along with competitors), and that the market prices would adjust
over-time - which should imply lower margins.

Secondly, VSM’s closest peers (CCMP and ENTG) on the other hand have
EBITDA margins consistently in the 22% area. Both CCMP and ENTG operate in
the same industry as VSM and have the same end customers. CCMP generates
90% of its revenues from CMP slurry (#1 provider with 45% market share),
which is an advanced polishing material that is meant to have higher margins.
VSM’s sales from similar advanced materials is less than 35% of its total
revenues and does not even hold #1 market share in any of the big items.

Additionally, VSM generates 40% of its total sales from Process Materials, where
it competes primarily on price with other companies, and so the margins for this
segment should be much lower than the Advanced Material segment. For the
above reasons, we do not believe that VSM’s current margins are sustainable
and would expect the margins to drop to around 25-27% area (still 300-500bps
above its peers).

2. Company will not be able to sustain its historical low capital

expenditure: Company is grossly underestimating the capital expenditure it
will need to maintain operations in the future. Company keeps stating that one
of its strongest point that the business is “Low Capital Intensive”. The average
capex for the Company over the last 3 years has been around $25mm (2.5% of
sales; ~48% of D&A). In our opinion, $25mm of maintenance capex is
extremely low simply considering the state of its current PP&E. Machinery and
Equipment which makes 80% of its total PPE and the main item required to run
its daily operations has depreciated over 80% of its initial value. Company
would require about $250mm+ to simply bring the useful life back to these
assets back to 50% of the original value. Additionally, capex of $25mm per year
is only 50% of D&A and so the ongoing capex would definitely need be more to
stay relevant and maintain the quality of its operations.
VSM CCMP ENTG
Capex as % of Sales (3 Year Average) 2.5% 3.2% 7.0%
Capex as % of D&A (3 Year Average) 48.2% 69.1% 84.8%

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3. Management is determined on being acquisitive; acquisitions may come at a very high

cost to equity investors: Management has clearly stated its intention to be acquisitive with
the intention of consolidating the industry. Management, in one of the initial roadshow
calls, had also mentioned that they would be comfortable levering up to 5x. While strategic
acquisitions are certainly not a bad thing, the concern would be that the Company overpays
for the acquisition and ends up in a leverage position that would be hard to get out of,
especially considering that margins would drop and revenues might not grow as fast as
expected if the Company is caught up in the semiconductor industry down cycle.

From an acquisition standpoint, CCMP (Cabot Macroelectronics Corp.) is the most obvious
target out there, which will be good strategic fit. On the other hand, CCMP’s Board and
investors (Hudson Executive Capital) are also strongly motivated to sell the Company. For
more on this, I would highly recommend that you read “mement_mori" CCMP write-up on
VIC from July 2016. Mement_mori made a good call on CCMP and the stock is already up
~25% since the write-up.

CCMP is currently a $1.2bn EV company; a 25% premium would imply an acquisition price
of $1.5bn. Assuming proforma EBITDA of $490mm ($325mm EBITDA for VSM, $115mm
for CCMP and $50mm of synergies), VSM’s total proforma leverage would be 5.1x, fitting
perfectly in VSM’s wheelhouse. The happy dream could them soon turn into a nightmare if
VSM’s EBITDA margins where to drop and synergies don’t fully realize (27% EBITDA
margins and $25mm synergies would bump the leverage from 5.1x to 6.1x).

While the levered acquisition scenario might seems hypothetical at first, there is a very
good chance that the Company would pursue this in the near future for two main reasons:

i) The management team comes from Air Product, where acquisitions has been an
important growth strategy. VSM’s CEO, Guillermo Novo, while has spent 3 years at
Air Products and is familiar with Air Product’s playbook has limited experience with
integrating assets

ii) Management’s bonuses would be tied closely to earnings and acquisitions is the

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only way to hit the numbers. While, VSM’s annual compensation plan has not yet
been set, the Company has mentioned that it will closely replicate Air Product’s
compensation program. Air Product’s compensation program for its CEO includes
base + annual compensation in cash (equal to 1.3x base x up to 200% of base (if
EPS grows by ~20%)) + Long-term incentives in the form of shares depending on
relative share price performance versus peers.

4. The company is exposed to the cyclical semiconductor industry more so than the
Management wants to admit. While in general, the semiconductor industry today is much
less cyclical than in the last 2 decades, it is still cyclical, especially when it comes to new
investments for capacity expansion. VSM’s DSS (Direct Systems and Services) Segment,
which generates about 25% of total sales, is directly exposed to infrastructure expansion in
the semiconductor industry. The segment was fortunate been enough to take advantage of
the expansion in the semiconductor space during 2013 and 2014, but since 2015 has been
experiencing some downturn. Sales peaked in 2014 at $300mm (due to some big projects)
but since then have dropped 12% in 2015 and 21% in 2016 on yoy basis.

For Company and industry overview, please refer below links:

http://www.airproducts.com/~/media/Files/PDF/microsites/versum-materials/versum-
materials-form-10-IR-slides.pdf?la=en

https://www.sec.gov/Archives/edgar/data/1660690/000119312516706646/d49062dex991.htm

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

Catalyst
quarterly numbers with lower ebitda margins

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Messages
Subject LT Supply Contracts and Prices
Entry 10/21/2016 12:36 PM
Member Mencken
Interesting idea, thanks for posting.

(1) Do you know how much of their Process Materials revenues are tied to these long-term supply contracts? Also, how
much are the contracted prices above current market prices? Any idea how we can track these prices real-time -- I
assume these are commodity markets so should be able to get a roughly live snapshot?

(2) How did you come up with the capex amount needed to refresh the company's PP&E? I understand the business has
changed quite a bit over the years from restructuring -- is historical cost PP&E the right way to think about go-forward
capex?

(3) It seems like the thesis hinges on Entegris and Cabot being the appropriate comps -- are there other public
companies with comparable (or higher?) margins, and is the business mixes for Entegris and Cabot the same as for
Versum?

Subject Valuation
Entry 10/26/2016 11:58 AM
Member Siren81
Even at a 27% EBITDA margin and $35mm maint capex I still get the stock trading at 19x-20x "normalized" cash flow. Is
expensive enough to short? Should earnings be even lower in the future from the semi cycle, compeittion, etc?

Subject Re: Valuation

Entry 10/26/2016 12:58 PM
Member SwissBear
i'm getting to about $1.40 in fcf/share for fiscal 2017 at 27% EBITDA margin, using $30mm of total capex. Co put out a
slide with $15mm in maintenance capex + $15mm discretionary for LTM 6/30. $1.40/share adds back $50mm of one-
time separation costs and ERP implentation in CY 2017 that was mentioned at a group presentation I attended. what
am i missing?

Subject Margins
Entry 11/01/2016 03:19 PM
Member jwilliam903
Is there any catalyst you see on margins normalizing? It looks like they're earning a healthy margin on the fluorine
business, which they have the best market reputation in but, given the long-term nature of product design and position
with customers, are we just waiting 2-4 years for margins to come in?

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