SIF Folio: Synthomer could be too cheap

FTSE 250 chemicals group Synthomer (LON:SYNT) describes itself as “one of the world’s foremost suppliers of aqueous polymers”. The firm’s polymers are used in the production of products including adhesives, carpet, paint and -- of course -- latex gloves used in healthcare.

Sales of such nitrile butadiene rubber (NBR) products have rocketed during the pandemic. Operating profit from Synthomer’s Performance Elastomers division rose by 800% to £209m during the first half of 2021, compared to the same period in 2020.

This surge in demand has somewhat distorted the company’s financial performance. But the City consensus view seems to be that much of this growth will be retained to form a new baseline for sales. 

If this view is correct, Synthomer shares look potentially cheap to me, on 10 times rolling forecast earnings. 

Synthomer published its interim results last week and the shares now qualify for my SIF stock-buying screen. This seems to support my view that this stock could offer the kind of affordable growth I’m looking for. This week I’m going to take a closer look at Synthomer to decide whether to add the shares to SIF and my personal holdings. (For a quick summary of how I run the rules-based SIF virtual portfolio, click here.)

Synthomer (LON:SYNT)

Before I look at the numbers, I think it’s worth understanding a little more about Synthomer. This business produces specialist polymers that are used by clients in a wide range of industries. You can see an overview of all the markets served by Synthomer here.

The business can trace its roots back to 1863 and was previously known as Yule Catto. This business had ties to rubber and oil plantations in Malaysia. This link remains today - plantation owner Kuala Lumpur Kepong Berhad has a 21% stake in Synthomer. The shares have tripled over the last 10 years, providing attractive returns for long-term holders:

In 2020, Synthomer decided to scale up with a £654m deal to acquire rival Omnova Solutions. The transaction was funded with a £204m rights issue and new debt, leaving the group with leverage of 2.5x EBITDA. Strong cash generation - and the Covid-19 profit surge - means that this leverage ratio is now down to 0.8x EBITDA.

The company hasn’t broken out the revenue and profit contribution made by Omnova since the acquisition completed in April 2020. This means we can’t get an idea of the split between acquired growth and organic growth. However, management have said that Omnova’s performance is currently ahead of the acquisition investment case.

Revenue growth has certainly improved since the Omnova acquisition, as I’ve highlighted below. The trailing 12-month (TTM) numbers also reflect the H1 2021 boost provided by Covid-19 demand. Interestingly, these numbers do seem to suggest that performance was stagnating somewhat before the acquisition:

One final point of interest is that Synthomer is about to get a new chief executive and a new chief financial officer. Both departures seem to be orderly and amicable, so I don’t see any concerns. But history suggests that if there are any hidden problems with Omnova or any other part of the business, we’ll find out about them when the new boss takes charge in November.

Growth outlook: Looking ahead, profits are expected to return to more normal levels in 2022, after the Covid-19 boost. However, Synthomer expects the underlying NBR market to keep growing by at least 10% each year over the longer term. Management cite the “hygiene megatrend” and growing emerging markets demand. 

To capitalise on this apparent structural growth opportunity, Synthomer is currently adding 200,000 tonnes of new NBR manufacturing capacity in Asia.

So far, I have a favourable impression of Synthomer. Stockopedia’s algorithms like Synthomer too, awarding the stock a near-perfect StockRank of 99:

Let’s take a closer look at the numbers.

Value: Peak profits?

Synthomer’s ValueRank of 82 suggests the shares could offer good value. They score well on most counts:

• Trailing P/E: 7.6

• Trailing P/FCF: 12

• Trailing dividend yield: 3.3%

• Earnings yield (EBIT/EV): 11.6%

Balance sheet: There are a couple of points I’d like to make about Synthomer’s balance sheet. These are highlighted by the TTM valuation metrics:

Synthomer stock trades on a price-to-book value ratio of 2.8 and its tangible book value is negative. Looking at the balance sheet, I can see several reasons for this:

• £163m pension deficit

• £355m net financial debt

• Goodwill and acquired intangible assets totalling £799m. Stripping out these and other intangibles leaves the group with a NTAV of -£17.3m

I’d prefer to see a little more asset backing here. But given the group’s modest gearing and solid cash flow and profitability, I’m not too concerned.

I think a more important question to ask is whether Synthomer looks cheap because the current level of profitability is unsustainable. It’s certainly true that management and City analysts expect profits to fall next year. That’s a risk. But as I’ll explain, I think the company’s quality and momentum metrics could justify the current valuation.

Quality: Back on track?

Synthomer’s QualityRank of 86 looks promising, but the company’s performance has been a little mixed since 2015. Margins and return on capital have varied from year to year. 

Without further research, I’m not sure of the reasons for this varying profitability. This might be worth investigating in more detail, to understand the dynamics behind the company’s mixed performance in recent years.

I’m not going to do that here - my rules-based approach involves a certain amount of tactical ignorance. But I am reassured to see that the trend appears to be improving. This is emphasised by Synthomer’s high Piotroski F-Score:

The F-Score looks at a number of metrics relating to profitability, cash flow and leverage. To pass each test, a company must show an improvement relative to the same period last year. I find the F-Score a very useful tool - you can see full details of a company’s results by clicking on the F-Score link. Here’s an example:

On balance, I’m comfortable with Synthomer’s quality metrics, given the positive outlook for the business.

Momentum: a top score

A MomentumRank of 94 suggests a strongly positive outlook. Broadly speaking, I think that’s a fair view of the situation here. As usual, let’s split Synthomer’s momentum into its constituent parts.

Price momentum: The shares have risen by 80% over the last 12 months:

Synthomer stock continues to display positive relative strength characteristics and show strong volumes:

Positive relative strength over 6m/1y is generally seen as a good leading indicator of medium-term performance, according to Stockopedia research.

Earnings estimates: We know that profits are expected to fall next year. Broker consensus currently suggests that earnings will be around 25% lower in 2022:

However, based on 2022 forecasts alone, Synthomer is still only trading on 11 times earnings, with a 3.3% yield. That doesn’t seem excessive to me for a profitable, specialist manufacturer.

My main concern is that I can see a lot of moving parts that could affect performance over the next 18 months. I don’t think the net effect of these changes will be easy to predict:

• Organic growth

• Omnova contribution

• Covid-19 contribution

My decision

I’m not sure how confident we can be in broker forecasts for Synthomer. My feeling is that there’s a higher-than-usual chance the business could outperform (or underperform) over the next 12 months.

Despite this, I can see a lot to like here. The core business appears to be reasonably profitable and cash generative. The group’s leverage is not excessive and cash generation is generally good. 

Omnova appears to be making a positive contribution, ahead of schedule. Meanwhile, bumper profits from Covid-19 sales are helping to repay debt from this deal more quickly than planned.

Synthomer stock passes all of my screening tests and looks affordably valued on a 12m forecast view.

For these reasons, I’m going to add Synthomer to the SIF Folio and my own holdings this week. As always, I’ll execute these trades after this article has been published.