fotokostic
Flexible Solutions (NYSE:FSI) is a manufacturer of TPAs, chemicals used in the O&G and agricultural industries. The company has a mature business currently in expansion helped by the bull market in commodities.
In April I wrote an article on FSI with a hold recommendation given that the company operates in a relatively mature industry, and that it was trading at high multiples.
Since then the stock price has fallen almost 40% and I decided to review the company to see if it had become an opportunity. However, in the meantime, FSI announced the acquisition of Lygos, a development stage company that is creating several bio based chemicals.
The terms of the acquisition are so diluting to FSI shareholders, and the combined business so different from what made FSI desirable, that I do not recommend FSI’s stock.
Note: Unless otherwise stated, all information has been obtained from FSI’s filings with the SEC.
FSI core business before the acquisition
For a complete revision of FSI’s core businesses and pre-acquisition perspectives, I recommend you read my previous article from April (linked above.) Below is a simplified summary.
FSI manufactures TPAs, or polyaspartic acids. These chemicals are used as enhancers in several processes in O&G and agriculture, and also as components of detergents.
From an industrial perspective, FSI operates in a relatively mature industry that is not particularly cyclical. For much of the last decade, FSI was able to increase revenues, and by keeping costs at bay, increase its operating margins.
FSI’s customers are mainly in commoditized industries, where their investment decisions are influenced by cyclical changes in profitability. This showed up in a significant increase in revenues since the start of a bull market in commodities in 2020.
At the competition level, FSI competes in a competitive industry, with low average margins, offering an undifferentiated product. Most of FSI’s competitors are located in China.
The main component of TPAs is aspartic acid, which is also manufactured mostly in China, and is produced using fossil fuels as the main input.
FSI has very little debt, less than $5 million in average for the past decade, and has a relatively good conversion of operating profits to FCF. The company does not need significant R&D or PP&E investments.
This all means that FSI is a stable, mature business, with low cyclicality and low leverage. It seemed the kind of business that can be followed for opportunistic dips.
Back in April, the stock was trading at a PE of 13 compared to record 2021 earnings. Considering the company’s recent increase in earnings might have been based on the commodities boom, with uncertain perspectives, I considered the stock expensive.
FSI after acquiring Lygos, something completely different
Then in April, FSI announced a merger agreement with Lygos. This agreement completely changes the previous thesis on the after-merger company.
Lygos is a company in the developmental stage, with no revenues and R&D expenses on the order of $10 million yearly. The company is developing several bio based chemicals to replace fuel based chemicals.
One of those chemicals is bio based aspartic acid, which could eventually replace fuel based aspartic acid, opening a market for environmentally more friendly TPAs.
The logic behind the merger is that FSI and Lygos combined will vertically integrate bio based aspartic acid into FSI’s already developed manufacture and commercialization chain for TPAs.
So far so good. I even commended FSI’s previous investment of $500 thousand in Lygos as a way to tap into the future of the industry.
The problem is that the merger agreement puts most of the combined entity value in the hands of Lygos shareholders. For current or pre merger FSI shareholders, the proposition is to be significantly diluted in exchange for participating in Lygos business.
The merger is structured to be completely share based. According to the merger proposal form S-4 filed with the SEC, after the merger, Lygos current shareholders will have 66.7% of FSI’s shares. The current board of FSI will be replaced by a new board and Lygos’ CEO, CFO and CTO will replace FSI’s current management. That means that the transaction is akin to Lygos actually acquiring FSI, and not the other way around.
For the FSI shareholder the investment proposition changes dramatically. Before the merger, a share in FSI represents a 100% stake in a mature, stable business with meager growth perspectives. After the merger, that same share represents only 33% of the stable business, and the rest in a developmental stage company, which is by its very nature much more speculative than a mature company.
We can understand FSI’s business from the outside because it has recurrent customers and a history of profitable operations. It is much more difficult to gauge the perspectives of Lygos’ business because it has no customers, and the markets for its products are not even developed yet.
According to the Lygos MD&A section of form S-4, Lygos currently has no sales and does not manufacture any of its developments at commercial scale. That means that the current FSI shareholder, on a pro forma basis, will move from earning 0.28 per share in 2021 to 0.02 per share for 2022 by absorbing Lygos’ R&D expenses (unaudited pro forma combined consolidated financial information from the S-4 form).
To add to the already much more speculative proposition, FSI will take $160 million in convertible notes, significantly leveraging up, from a previous unlevered balance sheet. The convertible notes will be priced 12 months after the transaction, but at a minimum price of $250 million, meaning even more future dilution for FSI’s shareholders. According to the S-4 form, the debt will be used to double FSI’s current production capabilities and to continue financing Lygos’ research.
Conclusions
FSI was attractive as a mature business with stable outlooks. When I wrote the previous article in April, the stock was not a buy based on its PE of 13.
Today, the situation is radically different. An investment in FSI is a small stake in a mature business and a big stake on a totally undeveloped business. On an after merger pro forma basis, FSI is currently trading at a PE of 100 or more. It moved from a relatively expensive value business to a speculative growth proposition.
I am not an expert in valuing growth, but I know that for a PE of 100 to prove profitable, the business has to do very well. This is highly uncertain given that Lygos has not even started selling its products, and has no customer base. Adding to speculation, the company will be heavily leveraged.
Under those circumstances, I do not recommend FSI. I recommend readers to keep following it, because after the merger its price might fall and it may become better priced, at a much smaller PE, based on its mature business, with a small stake in a speculative research business.
Be the first to comment