Description

Summary of the investment opportunity:

Alent’s business is highly engineered, speciality chemicals, listed in the UK. The company manufactures materials used in (a) the production of printed circuit boards (“PCBs”) and semiconductor integrated circuit assemblies (“ICs”), and (b) electroplating chemicals for auto/industrial coatings.

Alent’s product markets exhibit attractive industry dynamics, very concentrated and stable market shares, high barriers to entry and good growth drivers. The company enjoys a degree of operating leverage and low utilisation production facility rates, meaning future capex requirements are relatively low and cash conversion is high. As such, returns on capital are high. In many ways, it can be seen as a high quality compounder business (perhaps not in the preeminent class of a Moody’s or Wells Fargo (few businesses are), but definitely a very stable, defendable business with low capital intensity and good returns on capital that is likely to provide investors with a strong and growing long-term runway of cash returns). As such, we think Alent should be seen as a compounder that is trading at a discount to intrinsic value and which has a number of catalysts on the horizon that should prompt a re-rerating of the shares towards fair value.

The current share price of c. 385p presents a compelling asymmetric risk-reward profile, offering:

1.     The potential to return c. 80%+ in c. four years (c. 20 to 25% annualised)

2.     Numerous catalysts that should appear in the next 12 to 24 months and prompt the market to revise its expectations upwards

3.     Three to four times the potential upside vs. downside, accompanied by a substantial margin of safety, supported by an inexpensive valuation, high quality business model and high barriers to entry in core markets

Alent’s dominant position in its product markets is protected by numerous demand- and supply-related barriers to entry, driving returns on tangible capital (“ROTC”) of c. 40%. As such, the company throws off a decent amount of free cash flow that is either returned to shareholders (as has been done historically) or invested organically or inorganically (of which there a number of interesting opportunities available).

Semiconductor ICs starts are running 10 to 15% below long-term trends (and have been for a number of quarters) but should rebound in 2015-16E, whilst data from automotive manufacturers suggest unit growth in 2014E should return to long-term trends of 3 to 5% p.a. Auto sales in Europe were up c. 8% in January 2015, for example, after a very tepid few quarters.

Good scope for margin expansion and cash flow growth. Low current production facility utilisation and a high degree of operating leverage - fixed costs are c. 50% of net sales value (“NSV”*) - means Alent has the potential to grow unlevered FCF at a c. 8 to 10% 2015-18E whilst NSV grows at mid-single digits, e.g. c. 5% p.a. (estimates that we believe are conservative and have the potential to be revised upwards). Furthermore, the company’s continued product mix shift towards substantially higher margin offerings should allow Alent to continue expanding operating margins from c. 17% in 2012A to 26% by 2018E (an c. 11% EBITA CAGR), continuing historic margin expansion trends.

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Alent’s inexpensive valuation provides a solid margin of safety and reduces the risk of permanent loss of capital. Alent trades at a c. 20% discount to other UK speciality chemical peers, even though it enjoys similar (if not better) economics. We have done substantial research into Alent over the past six months and believe Alent has the potential to return double an initial investment over the next c. four years, benefiting three-fold over this period:

1.     Earnings compounding at a c. 9 to 10% CAGR, off conservative top-line growth estimates (c. 5% p.a. growth)

2.     Re-rating to a valuation more appropriate to Alent’s growth and returns profile, c. 12x NTM EV/EBIT, 16.5x NTM P/E and 5.5% NTM unlevered FCF yield (each of which is at a c. 10 to 25% discount to peers’ valuations and the broader UK market)

3.     The company, on conservative estimates, should also return c. 15 to 20%+ of the market cap. in dividends from 2015-17E. This is our base case. But more excitingly, given Alent’s high returns on capital and low capital intensity, Alent has the capability to pay out c. 35p per share in dividends (ordinary and specials) per year at the target leverage ratio of 1.5x ND / EBITDA, which would equate to a c. 9.5% dividend yield at the current share price (c. 3x peers’ dividend yields), or c. 25 to 30% of the current market cap. just between 2015-17E. Whilst this is not our base case as a recurring ordinary dividend, it is very feasible: management (and a large activist shareholder, Cevian) have shown considerable focus on capital returns and running an efficient balance sheet, suggesting that a repeat of 2014A’s special dividend is very possible

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Today’s inexpensive valuation offers a highly asymmetric risk-reward profile: we think potentially three to four times the upside vs. the downside risk (even assuming an unlikely but aggressive ‘bear’ scenario). Even if (a) top-line product volumes collapsed by 5% in 2014E and stayed flat in 2015E, (b) operating margins contracted by 400bps, and (c) multiples fell one turn below today’s trough values, the c. 15 to 20% downside vs. today’s share price is only a roughly a quarter of the potential 80%+ upside in the base case over three to four years.

What’s the best entry point for the shares? It’s worth flagging that, as a relatively small company (with a very stable shareholder base, menaing liquidity is relatively low at c. $3m a day (incl. off exchange trades)), the shares can move a fair bit week-to-week or month-to-month. The shares have fluctuated between 350 and 400p in recent weeks / months. Therefore, if you think the story sounds compelling but are not 100% sure about the right entry point, you might be minded to wait and see if you can time it better; you may be able to pick shares up at 370 to 380p….

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Alent is mispriced for three main reasons:

1. The market is focused on historical temporary, market-wide growth issues. Yet mid-term annual growth potential in its consumer electronics (e.g. smart phones and tablets), semiconductor IC and automotive markets remains in the high single-digit to low double-digits. As management acknowledged, Alent’s position in each of its key markets has, if anything, strengthened throughout 2015 YTD.

That said, Alent has failed to deliver really exciting top-line growth since it spun out of its previous parent company (Cookson Group), which has meant that Alent has not benefited from peers’ premium valuation multiples. A dose of strong growth in 2015E could easily lead to Alent’s multiple expanding significantly (peers with similar economics but with revenue growth in the 5 to 7% range trade at c. 16 to 19x 2016E earnings, vs. Alent on c. 14x).

Alent has a new CEO who is focused on growth, which should help unlock the value in Alent’s strong business model. The new CEO (who joined in Q1 2015A) is resolutely focused on growing Alent’s top line – this is the core mandate that he has been set by the board (and by Cevian, the large activist shareholder, who are on the board). We have meet the CEO (ex-Rolls Royce) and believe that his understanding of the key levers for creating value is solid and in-line with our analysis; we believe he should help drive meaningful shareholder value creation. Lastly, his incentives are well aligned with shareholders (based on a combination of TSR outperformance vs. peers, ROIC and FCF growth), providing us with additional confidence in his stewardship.

2. Having only spun out in 2012, Alent is still suffering from its association with Cookson Group, its previous parent company. Many UK investors unfairly transfer onto Alent some of their negativity towards its old parent, Cookson – its rights issue in 2009, its poor M&A record within the Ceramics division (i.e. the non-Alent division) and even its contentious remuneration policy – none of which is applicable to Alent or its management but none-the-less remain in the minds of investors. We believe this unfair association will disappear with time

3. Lastly, Alent’s small size (£1.2bn EV) and limited sell-side coverage contributes to a general misunderstanding on the buy-side of Alent’s strong competitive position and c. 10% p.a. EBIT growth potential. Only six sell-side analysts cover the company and only four actually publish proper reports. Of the analysts at major banks that cover Alent (UBS, GS, Barclays, Credit Suisse), it’s clear that Alent is a low priority for many of them, given its small size in their coverage universe. Thin sell-side coverage means that many buy-side investors incorrectly correlate limited sell-side information with increased investment risk.

A number of catalysts are likely to emerge in 2015-16E that should prompt the market to revise expectations upwards. Led by (a) potentially product volume growth in 2015E, as per industry participants’ forecasts, other likely catalysts include (b) Alent being granted more “process of record” qualifications for its copper damascene business at the 14nm level (a quasi-recurring stream of high margin revenue), (c) the company delivering on (or even exceeding) conservative 2015E guidance, (d) a more efficiently run balance sheet, driven by activist shareholder demands, which will lead to either (i) an increased payout ratio (making the shares more attractive to income-focused investors), or (ii) potential small-scale, bolt-on M&A (which is likely to be highly accretive), boosting top-line growth, or (e) the scope for Alent to be a potential take-out target for a larger, diversified chemical peer.

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Business overview:

Mission-critical, highly tailored and hard-to-substitute products. Alent’s products are essential to the manufacture of semiconductors and printed circuit boards for a wide range of electronic devices, including smartphones, tablet computers and auto electronics. The company also has a leading position in the global protective and decorative chemical coatings market, which includes high value-add automotive products, such as decorative chrome and headlight reflectors.

Alent focuses on partnering with original equipment manufacturers (“OEMs”) that then mandate the use of Alent’s products to their supply chain partners. Over the past 20+ years, Alent’s strategy has focused on rigorously quantifying the value added for customers by using Alent’s products, even though Alent’s are usually more expensive than competitors’. OEMs assign Alent “qualified process” status - often exclusively - which means the contract equipment manufacturers (“CEMs”) that make the OEMs’ products (e.g. the iPhone 6) must use Alent’s products (often exclusively), leading to, c. 50 to 60% of Surface Mount Assembly product volumes being OEM specified (i.e. can be considered quasi-recurring revenues).

Alent’s strategy is to dominate secular growth markets that have high barriers to entry and where Alent has durable competitive advantage. The company’s revenue is roughly evenly split between Asia, Europe and The Americas. Over the long term, Alent exposed to attractive end markets with high single-digit to low double-digit secular growth in electronics (e.g. PCBs, semiconductor ICs) and targets pockets of even higher growth from smartphones, tablets and telecommunications infrastructure. A good example of a higher growth segment is automotive electronics, which is growing at c. 10% p.a. (i.e. double underlying automotive unit volumes) and which accounts for c. 20% of Alent’s revenues.

Lastly, Alent invests substantially in R&D and focuses on the highest margin and least-likely to be commoditised products within its markets, which has driven substantial margin expansion. Structural mix effects include the move from basic to advanced “surface mount” soldering techniques (>3x margin) and increasingly small semiconductor IC chips (14nm level, with Alent the sole qualified supplier globally). This mix effect should drive c. 1 to 2% NSV growth per year above the market and sizeable margin expansion potential. 

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Economics of Alent's business model:

High historical ROTC of c. 40% is likely to continue in the mid-term.  This is a function of Alent’s low capital intensity, substantial barriers to entry, dominant position in attractive secular growth markets and the continued shift towards higher margin products.

Margin expansion should continue over the mid-term. From 2010-14A, NSV grew in absolute terms by c. 5% whilst EBIT grew by c. 21%. Weak end-market growth over the past 18 months means group EBITDA has been flat, leading to Alent’s depressed valuation. Though far from ideal, we believe this is not indicative of Alent’s potential profitability and earnings growth. Rigorous primary research and competitive analysis has shown that flat EBITDA from 2011A-13E is due to temporary, cyclically soft end-market growth and is not a result of a weakening of Alent’s competitive position or top-line growth potential. Indeed, Alent has taken share over this period (c. 50 bps per annum).

Alent’s historical and future margin expansion potential is broad based, with three main drivers. (1) Operating leverage from a large fixed cost base, low current utilisation rates, substantial historical capital investment, all combined with attractive top-line growth opportunities; (2) constant product innovation and mix shift towards higher-margin products; and (3) continued focus on efficiency improvements across all cost components (e.g. manufacturing, SG&A and R&D). Management’s focus on all three distinct profit drivers means Alent is well-positioned to expand margins in a variety of possible future macroeconomic scenarios, helping to ensure that Alent is not a one-trick pony

Margin driver no. 1: sizeable operating leverage and c. 50% current capacity utilisation. Whilst 2009A can be considered a trough year for PCB, semiconductor and automotive production volumes, and therefore a degree of the 2009-13A EBITDA growth is cyclical, analysis of Alent’s costs illustrates the business’ high degree of operating leverage.

The company is well positioned to benefit when top-line growth returns to more normalised levels, which is likely to happen in 2014E. Fixed costs equal to c. 55% of 2012A NSV and considerable investment to date in state of the art production facilities means that Alent is operating at c. 50% capacity. Discussions with the company have confirmed stable near-term capex requirements and that current capacity is sufficient to meet high-teens volume growth over the next five years (even bearing in mind that Alent targets a minimum of 30% spare capacity so as to ensure adequate just-in-time supply to customers).

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Margin driver no. 2: Constant product mix shift towards the higher margin and least-likely to be commoditised products. This mix effect should drive c. 1 to 2% revenue growth per year above the market and sizeable margin expansion potential. 

The Assembly Materials division’s strong EBITDA margin growth (17% to 30% between 2009-12A) should continue over the mid-term. Solder-related products (used in the production of PCBs) represent c. 35 to 40% of group NSV. The on-going shift from semi-commoditised “bar solder” to highly technical and customer-specific “surface mount” solder products (at c. 3x margin) will be a major contributor to Assembly Materials’ margin expanding by c. 50 to 80bps p.a. (in line with management’s guidance).

The Surface Chemistries division’s EBITDA margin expansion (12 to 20% from 2009-12A) should also continue. Alent’s is the leader (c. 80% global share) in the production of highly technical copper damascene products - a major technological advancement that has replaced traditional aluminium semiconductor IC interconnects (the microscopic “wires” within a semiconductor IC). The Electronics sub-segment of the Surface Chemistries division (i.e. copper damascene-related products) represents c. 23% of NSV, is highly profitable (c. 25 to 35% EBITDA margins) and is fast-growing (8%+ CAGR). Given the business’ operating leverage and the potential growth in these high margin categories, Surface Chemistries’ margin could feasibly expand from c. 20% in 2012A to c. 24% by 2018E.

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Margin driver no. 3: Historical margin expansion is also a result of management firmly focusing on minimising costs on an on-going basis. For example, the majority of Alent’s R&D investment (c. 5% of cash costs excl. raw materials) is in state-of-the-art facilities in Bangalore, India (ranked one of the top five technology hubs, globally). Far from being a short-sighted cost saving attempt by off-shoring a critical source of Alent’s competitive advantage, Alent’s R&D strategy is the result of a multi-decade strategy whereby most of Alent’s c. 170 researchers and scientists are established in a low-cost geography near to major customers’ R&D efforts, saving c. 25% to 40% p.a. in R&D-related costs (c. 1.5 to 2.0% of NSV) vs. being located in Europe or the US.

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All raw materials pricing risk is borne by customers, de-risking a large and volatile cost item. Though c. 50% of Alent’s cash costs are related to metals, Alent passes through these costs entirely to clients. As such, net sales value (“NSV”, equal to revenue minus passed-through raw material costs) is the most useful top-line metric to focus on, rather than revenue. All margins referred to in this write-up (and in the company’s materials) are on a net basis and refer only to revenues, costs and income that Alent will bear (e.g. excluding customer-covered raw material costs), to ensure an apples-to-apples comparison.

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Sizeable amounts of cash is returnable to shareholders. Alent’s forecast FCF 2014-18E CAGR of c. 10% means that if the company was to retain a conservative gearing of 1.5x ND/EBITDA, it could return c. 25 to 30% of the current market cap. to shareholders over the next few years without impacting the underlying operations. We are confident that Cevian Capital, Alent’s largest shareholder and quasi-activist fund (who are on the Alent board) will make sure that shareholder returns are prioritised and that the management team remain focused on running an efficient balance sheet

Declining capex could boost Eq. FCF and cash returns to shareholders from 2016E onwards. Management guided for capex for 2015E to equal c. 3.5% of NSV, as production facilities are completed in Shanghai and in Chennai. Management have guided for capex to decline to 1.1x of 2012A depreciation by 2016E and remaining at that level for the longer-term (c. 3% of NSV), driving a further boost to mid-term FCF generation.

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Competitive advantage and barriers-to-entry protecting Alent's earning power:

Numerous barriers to entry should protect Alent’s dominant market position over the mid-term and drive high returns on capital. Alent benefits from four main forms of barriers to entry:

1. Consumer: e.g. captive customers / pricing power

2. Producer: e.g. proprietary production capabilities

3. Scale economies: e.g. lower long-run average costs

4. External: e.g. govt. regulation, patents, tariffs, etc.

Pricing power comes from customers being primarily focused on quality, not price. The majority of Alent’s products fulfil ‘mission critical’ functions for customers. Alent’s strategy is to rigorously quantify the economic benefits of its products to customers, using evidence to prove why apparently “cheaper” alternatives are actually uneconomical. Furthermore, Alent’s products represent a very small proportion of customers’ costs (typically less than 3%). This reinforces customers’ focus on quality, not price, and provides an opportunity for Alent to generate sizeable economic profits.

Collaborative, multi-decade long customer relationships are hard for competitors to replicate. The average relationship length for the ten largest customers of both the Assembly Materials and Surface Chemistries divisions is over 20 years, whilst the average relationship period for other customers – including virtually all leading electronics manufacturers, OEMs and CEMs – is 15 years.

Alent’s “qualified supplier” status from OEMs and fabless semiconductor IC companies means that many CEMs and foundries are required to use Alent’s products, often exclusively. This includes the majority of smartphone and tablet OEMs as well as the largest manufacturers of PCBs and semiconductor ICs, including Foxconn, STMicro and TSMC. Key OEM partnerships include Intel, Apple, LG and Samsung.

The qualification process is complicated, often six to 18 months long and unique to each customer. As such, once a supplier (e.g. Alent) is qualified it is unlikely that customers will switch suppliers, limiting Alent’s risk of substitution.

Alent’s R&D facilities contain equipment supplied by customers specifically to replicate their production processes, further increasing customers’ switching costs. This also provides Alent with unique visibility into (a) customers’ near-term product requirements, and (b) how product demand is likely to develop over the longer-term, allowing Alent to position itself to best service future market demand.

Significant patent portfolio. Protecting Alent’s investments in R&D and customer partnerships is a strong portfolio of over 500 patents (and another 360 patents pending).

Alternatives to Alent’s products are often limited, particular on a month-to-month or quarter-to-quarter basis. Increasing customers’ high switching costs are limited substitute products or alternative suppliers in many of Alent’s markets. For example, Alent supplies 80% of the world’s copper damascene, an essential and un-substitutable component for semiconductor IC production (the microscopic “wires” within high-tech computer chips).

Alent’s global just-in-time footprint is uniquely able to meet customers’ short lead times. Trends to shorten inventory cycles throughout the PCB, semiconductor IC and automotive supply chains means that customers pay a premium for products supplied at four to eight weeks’ notice. Alent’s leading market share and ability to deliver products on a just-in-time basis from 23 facilities strategically located around the world near major PCB, semiconductor and automotive production hubs is unique amongst peers, further strengthening Alent’s pricing power.

Alent’s customer base is very diversified, limiting customers’ bargaining power. The top 15 customers represent only 15% of revenue (the top five Assembly Materials and Surface Chemistries customers represent <12% and <4% of divisional revenue, respectively). 

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Alent’s high and stable market share is evidence of the company’s durable competitive advantage. Alent’s markets have exhibited relatively stable share trends, with the top 5 to 8 competitors controlling c. 65 to 80% of Alent’s main markets (PCB assembly materials, semiconductor IC materials and automotive protective coatings). Furthermore, the top one or two operators (e.g. Alent) have enjoyed share gains of c. 50 to 100bps p.a. and have seen few successful new market entrants over the last decade, reinforcing the argument that Alent benefits from sizeable barriers-to-entry around its core businesses

In the Surface Chemistries business, Alent is the no. 2 operator by revenue (c. 20% market share), with the top seven companies possessing c. 65% of the market. With the majority of competitors privately owned or subsidiaries of larger corporations (eg. Atotech is part of Total), the competitor set is a bit more fragmented than the Assembly Materials division. Lower margins than Assembly Materials reflects the broader competitor set, which is likely to restrict Alent’s ability to grow margins.

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Alent controls an estimated c. 40% of the world’s solder market (i.e. soldered PCB interconnects) by revenue. The lower margin, commoditised Wave Solder sub-segment volumes has declined c. 40% over the past five years with this revenue replaced by even greater growth in higher margin (>3x) Surface Mount Assembly volumes. Wave solder (12% margin; 13% of group NSV) is relatively commoditised but still capable of delivering economic profits. The global wave solder market is too small (<£500m, with Alent the dominant producer) for Chinese tin manufacturers (solder is 95 to 99% tin) to justify entering the market; incumbents have invested all or most of their required capex and are now capable of operating at cost curves below the break-even profitability of new entrants, warding off entry.

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Alent’s Assembly Materials division’s product mix should continue to shift to higher margin products. The Surface Mount Assembly sub-segment (38% margin; 24% of group NSV) is protected by high barriers to entry - including patents, complicated R&D and production technologies and exclusive customer “qualification” requirements - which drive margins c. 3x those of commoditised Wave Solder products.

Pricing rivalry is unlikely to be a margin spoiler. Interviews with competitors and industry analysts show that Alent’s competitors in the semiconductor IC and PCB markets are very rationale in the way they use pricing as a competitive tool, which should support Alent’s mid-term profit margins.

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In summary, Alent’s supplier-customer dynamic is well-suited to the generation of mid- to long-term economic profits. The risk to Alent of new competitors entering the market is low; no matter how great the service or price offered by the new entrant over the long-run, the ‘mission critical’ nature of many of Alent’s products means any possible benefits of switching away from Alent are substantially outweighed by customers’ risk aversion and the considerable uncertainty associated with changing suppliers.

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Secular growth trends impacting Alent:

Alent is well-positioned to growth group NSV at c. 5%+ p.a. between 2015-19E (which is a lower CAGR than the 2008-12A period). The company is exposed to numerous structural tailwinds that are (considerably) stronger than global GDP growth rates. With most of Alent’s product markets growing at between 5 and 15% in the mid-term, our forecast c. 5% NSV CAGR may prove conservative, especially given Alent’s historically high pricing power and steady share gains. We think its right to be conservative on growth (especially given the muted performance in 2013-14A), but really see tremendous potential for the business to “kick into gear” in 2015-16E; if this happens, the drop-down impact on EBIT and EPS will be impressive, and should drive margin expansion.

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Alent targets 1/3^rd of revenue to come from products developed within the preceding three years. Management recognises that Alent’s competitive advantage is, in large part, derived from its technologically advanced products and that R&D allows the company to keep ahead of the short product cycles of the semiconductor and electronics sectors. R&D spend in 2013-14A was c. 4.0% of NSV p.a., above the speciality chemicals sector average of 3.5%, and investment is only directly at high-growth, high-margin projects (e.g. more commoditised products, such as bar solder, are managed as “cash cows”). 

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NSV growth driver no. 1: c. 6% growth p.a. of electronic and speciality chemicals and printed circuit boards volumes drives c. 50% of group NSV. Analysts forecast the broader electronic and speciality chemicals market to grow c. 6 to 9% p.a. to 2020E. This is the main driver of the Wave Solder and Surface Mount Assembly sub-segments (c. 13% and 24% of group NSV, respectively) of the Assembly Materials division. It’s also a major driver for the Electronics sub-segment of the Surface Chemistries division (24% of group NSV).

c. 6 to 7% p.a. growth forecasts for the Assembly Materials division are, if anything, conservative. Alent focuses on “pockets of growth”, such as smartphones and tablets (with c. 20 to 30% mid-term CAGRs, as per forecasts from Gartner, Prismark Partners and other industry analysts). Whilst the company does not disclose its revenue mix to this level of granularity, management confirmed Alent has a “particular focus and strength” in smartphones and tablets, suggesting top-line growth could easily outpace the 6% p.a. forecast. For conservatism’s sake, we have modelled 5% top-line growth in these segments. This is more a function of (a) our conservatism re. forecasting, and (b) the fact that Alent’s top-line growth has been a bit more muted than hoped for over the past two years and therefore warrants a degree of “show me” scepticism; we see real scope for increasing our forecasts if the company begins to deliver.

Alent is largely indifferent to end-market competition and declining ASPs in customers’ markets. 50%+ of smartphones and 70 to 80%+ of tablets contain Alent products. Alent is, therefore, largely indifferent to competition between individual OEMs, limiting the risk of Alent “hitching its wagon to the wrong train”. Furthermore, Alent’s revenue growth is driven by customers’ product volumes and is largely immune to the “price down” effects of its customers’ end-products (e.g. smartphones and tablets).

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Growth driver no. 2: c. 5% p.a. semiconductor IC materials growth drives c. 20% of group NSV. This is the main driver of the high-margin Electronics sub-segment (particularly copper damascene and semiconductor-related products) of the Surface Chemistries division (c. 23% of group NSV) and the high-margin Microelectronics sub-segment of the Assembly Materials division (c. 3% of group NSV).

Over the last 30 years, semiconductor IC unit growth has averaged c. 8 to 10% p.a.; the tepid end-market growth over the past 24 months is unlikely to be representative of future top-line growth potential. Semiconductor shipments are currently running c. 10 to 15% below historical trends, which is a probably a short-term ‘kink’ that should correct with time; chipmakers and industries analysts are optimistic on growth rebounding in 2015-16E back to c. 8 to 10% p.a. historical growth rates.

Putting the currently depressed semiconductor IC market growth in context, there have only been two instances in the past 15 years where semiconductor shipments have been 10%+ below trend for multiple quarters. After each of these downturns unit sales rebounded by 20%+, which bodes well for Alent in 2015E.

Furthermore, channel checks are suggesting that related companies are reporting low levels of inventory at most stages of the semiconductor supply chain and that Alent’s customers are operating on increasingly short lead times (typically four to eight weeks). This means that the time between consumer demand picking up and Alent’s order book increasing might be be measured in months, not quarters.

A combination of an uptick in market growth in 2015E and Alent’s (a) significant available production capacity (c. 50 to 55% utilisation rates), (b) high degree of operating leverage and (c) large number of exclusive “qualified supplier” relationships, suggests there is significant potential for operating income to grow dramatically over the next 12 to 18 months.

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Growth driver no. 3: c. 4 to 7% p.a. automotive unit growth is the driver for c. 25% of NSV. This is the main driver of the Performance Coatings sub-segment of the Surface Chemistries division, which provides protective and decorative coatings for automobile and industrial companies. Automotive unit growth in the US and Asia of c. 2 to 3% in 2014A was offset by marginally negative volume trends in Europe, but industry analysts forecast 4 to 5% mid-term growth from 2015E, supported by stronger industrial production and GDP growth forecasts for 2015E vs. 2014A. Indeed, European auto sales in the first months of 2015A were running at mid-single digits.

Importantly, a sizeable and increasing portion of Alent’s automotive-related NSV (estimated to be c. 30 to 40%) is from electronic systems within cars, which is growing at c. 6 to 9% p.a. Electronics content as a percentage of the total vehicle cost (currently averaging $2k per vehicle) is expected to rise significantly (c. 2 to 4% above automotive unit growth) as market penetration of hybrid and electric vehicles increase (forecast c. 75% CAGR to 2020E, according to Goldman Sachs and a range of other sell-side research firms).

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Management quality and incentives:

Numerous interviews with competitors, customers and industry observers have made it clear that the Alent management team is very well regarded. Management’s communications are direct and honest, with a welcome focus on shareholder value and returns on capital. The old CEO (Steve Corbett) was admired in industry circles but he left in late 2014A, ostensibly as a result of the Board of Directors wanting Alent to focus more on growth. Given’ Alent’s business model (low capital intensity, underutilised producton facilities, high degree of fixed cost operating leverage, etc.) we believe the focus on growth is exactly the right strategy to maximise shareholder value at Alent.

Major shareholders (top ten own c.70% of the equity, excluding any held on swap) are high quality funds with a long-term, value-focused attitude to investing. Though Cevian Capital (the largest shareholder with 22% of the equity) is often labelled an “activist” fund, it holds a concentrated, low-turnover portfolio and averages three to five years per position. It also has a track record of constructively supporting management. Cevian has publicly committed to remain a mid-term shareholder and Lars Förberg, its co-founder, sits on Alent’s board of directors. Förberg’s presence in the boardroom is very positive for the near-term investment thesis; the alignment of his and shareholders’ interests should de-risk a lot of operational and strategic uncertainty (e.g. capital allocation and market communications, etc.).

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Management’s and shareholders’ incentives are well aligned, with remuneration linked to superior performance over the mid-term. Positively for shareholders, c. 50% of the CEO’s total possible compensation is share-based. The share-based LTIP (worth up to 220% of his base salary) is measured against mid-term TSR performance vs. the FTSE-250 index and EPS growth of RPI + 10% p.a., vesting over three years (with claw backs). Cash-based compensation makes up the other 50% of the CEO’s remuneration and, in addition to his base salary, is determined by meeting EPS, FCF, ROIC and working capital targets (worth up to 125% of his salary).

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Catalysts that could prompt Alent’s share price to move towards fair value:

The sell-side think Alent is undervalued. Every single sell-side analyst has a target price above the current share price. Normally, this is a “red flag” for us (a contrarian indicator at times). But in Alent’s case, we believe it’s simply the result of the company being under-followed on the buy-side and the limited number of sell-side analysts who cover the name understanding its high quality business model. When we speak with these analysts, it’s clear that most of them think this is a gem of a company but is a bit too small and under the radar for most investors.

Catalyst no. 1: The catalyst most likely to cause the market to revise its expectations upwards is an increase in unit volume growth in the company’s end markets (e.g. PCB volumes, semiconductor IC “wafer starts” and automotive production levels). The majority of semiconductor and automotive analysts forecast a strong pick up in 2014E, which should feed into Alent’s numbers relatively quickly due to its just-in-time supply agreements.

Catalyst no. 2: Alent being granted additional 14nm semiconductor “process of record” qualifications. Though Intel is the only chip designer to have begun production of 14nm technology (with Alent the sole supplier of copper damascene technology at this scale), IBM and ARM (and others) are investing billions in similar technologies.

Alent has confirmed it’s in the “qualification” process with other large chipmakers. Based on the time needed for a typical qualification process, an announcement may be made in Q4 2013E or Q1 2014E. Any confirmation that Alent has agreed a “process of record” with another chipmaker should be positive for Alent’s shares as it amounts to a multi-year quasi-guarantee of high-margin copper damascene revenue.

Catalyst no. 3: 2015E results coming in above expectations. This should help address the market’s caution regarding Alent’s ability to deliver on guidance. This is a bit of a weak catalyst, but it’s worth flagging only because we believe the new CEO is looking to be conservative with the market so as to beat consensus in his first year as CEO. From our detailed analysis of Alent’s markets, competitive dynamic and business quality, we genuinely believe that the company has scope to beat expectations in 2015E.

Catalyst no. 4: significant shareholder returns. Alent paid a special dividend in 2014A and has stated it will continue to do so if it sees no alternative options re. organic or inorganic growth. Management currently target a 35% pay-out ratio (of EPS) for the ordinary dividend. We believe this is too conservative given the company’s high ROTC (c. 40%) and limited capital reinvestment needs. There is huge scope to pay out cash. We estimate a more appropriate payout ratio is probably double the current yield. Management agree, but want to retain the flexibility to pay it via a special dividend rather than an ordinary dividend. This means that simple screening of the company’s dividend yield underplays the major scope for capital returns. Alent has the capability to pay out c. 35p per share in dividends (ordinary and specials) per year at the target leverage ratio of 1.5x ND / EBITDA, which would equate to a c. 9.5% dividend yield at the current share price (c. 3x peers’ dividend yields), or c. 25 to 30% of the current market cap. just between 2015-17E. As mentioned, management (and a large activist shareholder, Cevian) have shown considerable focus on capital returns and running an efficient balance sheet, suggesting that a regular repeat of 2014A’s special dividend is very possible.

Catalyst no. 5: bolt-on M&A. Alent has a very strong network of customers (OEM and CEM) and there is scope to selectively acquire adjacent technologies with less strong distribution capabilities / customer relationships, plug them into the Alent distribution platform, and generate a meaningful up-tick in revenues. Management are selectively exploring options and this could be an attractive, value-accretive means of driving top-line growth. We feel confident that, with Cevian on the board, shareholders’ interests are well represented.

Catalyst no. 6: Alent as a potential take out candidate. M&A is heating up in the chemicals sector and Alent’s lack of correlation to oil-prices makes it a potentially attractive diversification opportunity for larger peers. The extremely concentrated shareholder register increases Alent’s attractiveness as a take-out candidate for a would-be acquirer. Whilst we don’t bake this into our base case, we are fairly sure that Cevian (with 22% ownership) will be speaking with all its banking contacts to ensure that every chemicals sector investment banker is aware of Alent’s potential and encouraging them to push the idea to potential acquirers. Interestingly, a independent research firm that focuses on special situations and M&A candidates recently published on Alent as one of its top five most interesting ex-spin off M&A candidates. Who knows – maybe this is a firmer catalyst than we think.

Potential acquirers include Dow Chemical, which acquired Rohm and Hass for 12x LTM EBITDA - a lower-margin, lower-growth competitor to Alent’s Surface Chemistries business – could consider an acquisition, although the company had stated it is focused on reducing leverage. DuPont produces PCB assembly materials tangential to Alent’s solder products and has a strong balance sheet, making it another possible bidder. The third realistic potential acquirer is BASF: it lost out to Dow for Rohm and Hass in 2008 and has recently stated that it sees Alent’s electronic chemicals sector as an attractive, fast-growing market. The below clippings from the independent research firm that focuses on special situations and M&A candidates also highlights a few more potential acquirers.

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Alent’s current valuation and potential IRRs:

Alent’s inexpensive valuation provides a solid margin of safety and reduces the risk of permanent loss of capital. Alent trades at a c. 20% discount to other UK speciality chemical peers, even though it enjoys similar (if not better) economics. We have done substantial research into Alent over the past six months and believe Alent has the potential to return c. 80% over the next c. four years.

 Today’s inexpensive valuation offers a highly asymmetric risk-reward profile: we think potentially three to four times the upside vs. the downside risk (even assuming an unlikely but aggressive ‘bear’ scenario). Even if (a) top-line product volumes collapsed by 5% in 2014E and stayed flat in 2015E, (b) operating margins contracted by 400bps, and (c) multiples fell one turn below today’s trough values, the c. 15 to 20% downside vs. today’s share price is only a roughly a quarter of the potential 80%+ upside in the base case over three to four years.

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Risks, mitigating factors and downside analysis:

Risk no. 1: End-market growth remaining sluggish is likely to be the main drag in the near-term. Given Alent’s high fixed cost base, earnings growth is relative geared to volumes picking up. Alent’s operating leverage and specialised production facilities also create a risk of margin contraction if growth collapsed. 2014A disappointed and there is a risk of this underperformance vs. forecasts continuing in 2015E, even though sizeable volume declines are highly unlikely. We don’t see this as a risk in the sense that capital is likely to be permenantly impaired, but more a risk that an investment fails to generate the > 20% IRRs we typically look for in investments.

Risk no. 2: Customer dual sourcing risk. AZ Electronics, a peer that produces assembly materials for flat panel displays and semiconductor IC components, has suffered from some OEMs removing its “exclusive supplier” status. Though there are no indications that Alent’s customer agreements are moving in this direction – AZ’s markets are more competitive, more commoditised and its relationships with customers shorter and less collaborative than Alent’s – any signs of this happening to Alent will be negative for the share price.

De-risking a lot of the operational and strategic risks is the presence of Cevian Capital, the long-term “constructive activist” investor, on Alent’s board. In the short-term, the benefit of Cevian as an anchor investor is demonstrated by Cevian’s (a) record of investing for multi-year periods and targeting c. 100 to 150% absolute returns (c. 65 to 115% above the current share price).  That said, Cevian’s equity stake creates a risk in the mid-term, given its exit strategy is unclear. With Alent’s average daily trading volume of 440k shares (c. £1.5m) and Cevian’s 20% ownership (58m shares), selling the shares into the market or conducting an accelerated placement may be difficult to execute. This suggests that Cevian could see a sale to a strategic or a financial sponsor as a likely exit strategy.

Analysis of these risks via a ‘downside scenario’ suggests that the potential loss, even in a fairly aggressive ‘bear’ case, is c. 20% below today’s share price. This is only a quarter of the potential c. 80%+ upside in the base case. This is based on an unlikely bear scenario where (a) product volumes collapse by 5 to 6% in 2014E and stayed flat in 2015E, (b) operating margins contract by 450bps, and (c) multiples fall to one turn below today’s trough values.

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Summary

In summary, Alent offers a compelling investment opportunity with a highly attractive asymmetric risk-reward profile. The current valuation offers:

1. Potential to return c. 80%+ in three to four years, with the scope to continue compounding well into the future

2. Numerous catalysts that should emerge over the coming 12 to 24 months and prompt a re-rating

3. Strong margin of safety that limits the possibility of permanent loss of capital, supported by (a) inexpensive valuation and, (b) dominant positions in attractive growth markets protected by substantial barriers to entry

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Footnotes:

* Raw material costs are passed through entirely to customers. As such, net sales value (“NSV”, equal to revenue minus passed-through raw material costs) is the most useful metric for calculating margins and top-line growth, rather than revenue

Catalyst

Catalyst no. 1: Increase in unit volume growth in the company’s end markets (e.g. PCB volumes, semiconductor IC “wafer starts” and automotive production levels). 

Catalyst no. 2: Alent being granted additional 14nm semiconductor “process of record” qualifications. 

Catalyst no. 3: 2015E results coming in above expectations

Catalyst no. 4: significant shareholder returns. 

Catalyst no. 5: bolt-on M&A. 

Catalyst no. 6: Alent as a potential take out candidate.