Klöckner Pentaplast : Raw material price inflation probably further depressing earnings and leverage

LTM EBITDA erosion continued at end-September 2017: KP’s adjusted EBITDA declined in each quarter since March 2017 to € 249.4m currently (pro forma LTM March 2017: € 274.9m – including KP, Linpac and Farmamak). - We expect further raw material inflation pressure in the next two quarters given our indicative procurement basket assumptions and on average rising resin prices yoy. - It is not visible if KP is able to offset raw material headwinds by re-pricing its product portfolio. In each quarter of FY 17, KP incurred a negative EBITDA effect from raw material price inflation that could only be partially offset by sales price adjustments (30% through escalator clauses; 70% through manual renegotiations). - Extending the KP/Linpac cost synergy target beyond € 31m could provide additional merits, but these are still unidentified and would need to be financed as well. - We expect leverage to rise until end-September 2018 due to an estimated negative free cash flow after cash interest, continued raw material price pressure and an adverse FX effect (see below): Net leverage at end-September 2017 totalled 7.9x according to our calculation (subject to KP’s adjusted EBITDA, OLA adjustment and excluding synergies) and could go up to 8.5x until end-September 2018. - KP guides for “low to mid-single digits” revenue growth in 2018 and an adjusted EBITDA of € 260-280m, which includes c.€ 15m of unrealised synergies planned for 2018. Capex is projected to be € 105m including expansion projects in France, Canada and Switzerland. - > - Credit Opinion: S&P assigned a negative outlook and we believe that Moody’s will follow given negative raw material pricing trends and assumed deterioration in credit metrics (see View and Recommendation section for details). Our Buy recommendation was based on the strong likelihood that KP will be IPOed in 2018 and that margin pressure stops, while the coupon was guaranteed for the first two interest periods. The worst case would have been that equity market valuation levels deteriorate, putting IPO plans in jeopardy, raw materials continue to rise and as a result depress cash earnings, which in turn drives up leverage. This scenario has now become reality. Against this background, we are lowering our credit opinion from Stable to Negative. - Recommendation: We believe that the price of PIK toggle notes (at c.83% currently) will decline further after the next earnings releases and therefore change our recommendation from Buy to Reduce. If we deem that raw material prices have stabilised and KP is able to catch up on gross profit contribution, then we could move back to a Buy recommendation.