The chemicals industry is a tough one in the best of times, with many companies like Dow (NYSE:DOW) largely dependent on global economic cycles and others like DuPont (NYSE:DD) having to spend billions on mergers and acquisitions or research and development to stay out of cutthroat commodity competition. While Aceto (Nasdaq:ACET) addresses what looks like long-term growth markets (particularly healthcare), investors need to be wary of a relatively poor history of cash flow generation as well as strong competition from China and India.

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Slow Top-Line Growth, but Better Mix
Aceto's fiscal third quarter was a picture in trade-offs. Overall top-line sales growth was not very spectacular at all (up just 3%), but the mix was decidedly more favorable and the profit growth was quite solid.

Within that 3% overall sales growth, the health sciences business rose more than 10% and the specialty chemicals business saw nearly a 9% growth. The agricultural business continues to decline, though, and sales here fell 45% as the company has moved on from the glyphosate business.

Gross margin ticked up nearly two full points, and although the company lost a little of that leverage through its operating expenses, operating income still rose more than 20% and the company handily surpassed the lone earnings per share estimate out there.

Will a Move to Generics Stave off Emerging Market Competition?
Aceto's business has long been based in large part to serving the biopharma and over-the-counter (OTC) markets with active pharmaceutical ingredients (API) and nutriceutical products - basically the raw materials for many drugs and OTC vitamins. Unfortunately, this is an industry with some extreme long-term challenges as large Chinese and Indian companies have built an enormous capacity in many basic compounds like vitamin C, acetaminophen and so on.

While Aceto has long played on growth in prescription drugs and generics by supplying those ingredients, the company is taking a more direct role now. The acquisition of Rising Pharmaceuticals gives the company a stronger platform to launch its own generics, and the company has multiple ANDAs at the FDA. Although the company is a long way from being any sort of threat to Teva (Nasdaq:TEVA) or Mylan (Nasdaq:MYL), this is an opportunity to lever existing infrastructure and the know-how to produce higher margin products.

Still an all-Around Hard Business
Aceto still has to prove that it can generate strong returns from the business it has. Management has been relatively diligent about facing reality and moving away from businesses with poor long-term prospects (glyphosates in agricultural, pet vaccines in health science), but the company has lagged the likes of Ferro (NYSE:FOE) and Innospec (Nasdaq:IOSP) in terms of returns and free cash flow production.

Not surprisingly, the stock has basically been chopping between $5 and $12 for the last 10 years and has not really generated a true positive economic return in that time. The deeper dive into generics could change that in time, but distribution is a critical factor in generics and Aceto may well have to spend a lot more capital to establish a viable competitive generics business.

The Bottom Line
Aceto only works as a stock if an investor is willing to make some bold projections for revenue growth and free cash flow improvement over the next decade. With little evidence so far of that being in the cards, this really is an exercise in faith and hope. I won't quarrel with anybody who believes that Aceto will be a very different company in five or 10 years' time, and therefore deserving of a robust valuation, but I'm not willing to take that leap of faith today.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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