Description

Overview:

Bodycote International Plc (ticker BOY LN on Bloomberg; price: 265.75p) is a British company that provides thermal processing and testing services to manufacturing companies in virtually every sector of the world economy from 300 facilities in 30 countries.  It is the leader in thermal processing and testing, and the scale benefits from its position are evident in its margins.  Trailing EBITDA and EBIT margins are 22.6% and 14.6% (well ahead of “engineering” comps).  Return on capital is 17% - defined as trailing EBIT / (net working capital + net fixed assets).  The company trades at 7.0x 2007E EBITDA and 6.4x 2008E EBITDA (over 2 multiple points below engineering comps).   The sectors in which Bodycote operates are very fragmented, with numerous “mom & pop” operators.  This permits the company to make accretive acquisitions at ½ to 2/3s the EBIT multiple at which BOY LN trades.  Bodycote spends about £60 million per year on acquisitions, and these contribute to growth on top of the organic growth the company enjoys.  Bodycote has also been making good progress in convincing manufacturing companies with captive thermal processing/testing units to outsource this function.  With this, Bodycote is able to enjoy organic growth in some of its more mature manufacturing markets.  The company also targets growth through new business in emerging markets. 

 

Business:

The company has two strategic business units: Thermal Processing and Testing.  The Thermal Processing business unit accounted for 74% of sales in 2006, and has two primary divisions, Heat Treatment and Hot Isostatic Pressing, as well as a small metallurgical coatings division.  The Testing business unit, accounting for 26% of sales (up from 18% in 2005), also has two divisions: Materials, Engineering & Technology Measurement, and Health Sciences/Environmental. 

 

There are many different kinds of heat treatment services Bodycote performs.  These services change the properties of the metals and other materials, and depending on the treatment can make them stronger, harder, softer (to enable metalworking), or straighter, or can join metals together.  Hot Isostatic Pressing is used to better bond different materials.  For example, a diamond tool can be made more wear resistant through HIP.

 

Just a few specific examples of the kinds of things Bodycote does: they treat many components that go into engines and transmissions of cars (gears, sprockets, etc), and they do hot isostatic pressing for BMW engine blocks and heads.  They treat many components that go into jet engines and power turbines and treat drills and other components for oil and gas rigs.  To do the heat treating they use specialized furnaces.  These are expensive so to the extent they can increase utilization rate they spread the cost out so that it’s lower per unit (like any fixed asset intensive business).  So they don’t run just one shift, and would like to run 24/7 if possible in order to utilize the equipment more. 

 

Of all the heat treatment that’s done in the world, about 20% is subcontracted to companies like BOY LN and 80% is done by engineering manufacturers by their own in-house departments.  Increasing the outsourcing of this function is a focus of Bodycote’s sales effort.  Even though UK manufacturing is in a decline as it shifts towards a service-based economy, Bodycote is able to get growth in the UK by convincing manufacturers to outsource this function. 

 

There are hundreds and hundreds of subcontract heat treatment companies, and a few big ones, of which BOY LN is by far largest.  The next biggest thermal processing player is a Japanese company whose thermal processing sales are a little more than 1/3 of those of Bodycote.   After the top 10 it's mom and pop outfits with £20mm in sales and less. 

 

Bodycote’s Testing unit has over 100 different labs in 19 countries, and provides independent, accredited testing for clients in materials testing, health sciences, engineering & technology, environmental and measurement. 

 

In the western hemisphere BOY is the leader in thermal processing, competing predominantly with local, privately-owned companies and manufacturers’ in-house departments.  In Hot Isostatic Pressing BOY has 60% of western hemisphere capacity since few manufacturers invest in this expensive technology. 

 

 

Financial Info:

As noted above, the portion of total revenues from Testing increased to 26% in 2006 from 18% in 2005.  This is in line with company’s strategic plan (adopted after a thorough review in early 2005) to increase the contribution from the Testing business as the company believes it will give an improved ROCE and is less cyclical than Thermal Processing.  The company aims to increase Testing to half of group revenues.  The company’s strategy also calls for expanding into developing manufacturing geographies and to intensify outsourcing initiatives.  The company measures its performance against strategic goals using progress towards financial KPIs (5 year targets) such as ROCE in the mid-teens % (reached 10.8% in 2006) , return on sales in the high teens % (reached 14.3% in 2006), organic sales growth in the mid/high single digits % (was 5.5% in 2006), and personnel costs as a % of sales of 40% in Thermal Processing (was 40.7% in 2006) and 50% in Testing (was 51.8% in 2006).  The company also has non-financial KPIs such as Utilization in Heat Treatment of >80% (was 72% in 2006), ISO 14001/17025 compliance in all 300 facilities (184 facilities met this in 2006) and accident frequency of zero (versus 2.2 per 100 man-years worked in 2006). 

 

In the ROCE measure, the Hot Isostatic Pressing division (as noted above, one division of the Thermal Processing business unit) and Testing business unit are above target, but the Heat Treatment division (the other main division of the Thermal Processing business unit) is not performing as well and is the company’s focus for improvement.  The company is focusing on improving Heat Treatment’s capacity utilization (key to hitting ROCE target), and 2006 saw a small improvement over 2005.

 

2006 saw sales up 18.6% to £558.6mm.  5.5% of the sales increase was from organic growth and 13.1% was from acquisitions.  Increasing demand came from markets such as aerospace, power generation, oil & gas, and health sciences.  The Thermal Processing business unit had 2006 sales of £413.9mm, up 7.6% over 2005 (of which 5.2% was organic growth), comprised of £375mm from the Heat Treatment division and £38.9mm from Hot Isostatic Pressing (“HIP”).  HIP had operating margins of nearly 33% compared to 13.4% in Heat Treatment in 2006.  The Testing business unit had £144.7mm of revenue in 2006, up 67.3% over 2005 (6.6% of which was organic) with an operating margin of 14.7%.  In the Testing business unit, Materials, Engineering & Technology Measurement had sales of £99.6mm (14.3% operating margins) while Health Sciences/Environmental had sales of £45.2mm (15.6% margins).  After £4.7mm of central overhead costs group operating profit was £79.7mm for a 14.3% overall margin.  2006 saw strong demand in most sectors with the exception of automotive in North America and France. 

 

The company’s strong performance continued in H1 2007 with sales up 13.7% (6.3% of which was organic growth).  Operating profit improved 18.7% to £48.2mm and operating margin increased to 15.2% from 14.5%.  Testing comprised 27% of H1 07 sales, up from 24% in H1 06.  

 

Geographically, 64% of revenues come from EMEA markets, 34% from the Americas, and 2% from Asia Pacific.  BOY LN gets 10% of its sales from its top 10 customers with the balance made up of thousands of other customers.  The company has no significant supplier dependency.  Most of the markets BOY operates in are fragmented. 

 

Cyclicality:

I believe there’s a perception that Bodycote’s business is more cyclical than it actually is.  I looked at the decline in EBITDA from the fiscal year before 2001 to the FY after 2001 for Bodycote versus the peer group of UK engineering companies, along with AALB NA, CW US, and SUN SW.  These are the same companies I talk about in the valuation section below.  The result is that Bodycote’s EBITDA declined 21% while the entire peer group suffered an average decline of 31% (46% if I look just at the UK engineering comps.  So Bodycote showed less cyclicality than the peers.  I’ve spoken with Bodycote about this and they say they have made moves to reduce cyclicality further since the 2001 downturn by doing things like growing the Testing side (which is less cyclical) and shifting locations to areas where it is easier to adjust employment levels in response to market conditions than it was in 2001 (labor is one of Bodycote’s biggest costs).  So the focus is to be more geographically, sector, and market diverse than they were in 2001, and to be able to adjust costs (employment levels) more quickly in reaction to changing market conditions.

 

Another point worth noting is that although Bodycote is exposed to the auto sector, Bodycote’s profitability with the auto sector is affected only by volume drops (not auto price declines), which don’t change all that much.  A 5% drop in auto volumes is large, yet considering how diversified their customer base is, this shouldn’t impact BOY LN greatly.  And the other sectors that are most important for BOY LN, aerospace, power generation, and oil & gas, don’t appear headed for a downturn anytime soon.  

 

Major sector exposure is as follows: automotive and aerospace each account for around 20% of revenues, and oil & gas and power generation each account for high single digits % of revenues.  Next come engine and transmission components for other transport uses (construction equipment for Caterpillar & Komatsu, locomotive, marine engines, etc).  So in the widest sense, the vast majority of work is in transport systems of one type or another.

 

The final point about cyclicality is that back in 2001 Bodycote had no business in emerging markets.  Now they’re in Asia, LatAm, and Eastern Europe (not in a big way, but growing it, with about £9mm in revenues currently).  So the growing manufacturing economies will become more important and add to the geographic diversification.

 

History of bid from Sulzer:

Bodycote became an unsolicited acquisition target of Swiss company Sulzer AG earlier this year (ultimately unsuccessful).  The background of the Sulzer bid is as follows.  In January 2007, the share price of BOY LN rose from around 230p to the 260p-280p range on speculation and press reports that Apax Partners was considering a bid.  At the time the rumor was that Apax were going to make a 300p bid.  Nothing came of the Apax rumor, but in early March Sulzer announced it had sought to enter into discussions with the board of BOY LN regarding a recommended cash offer.  The approach was fully financed and was conditioned only on limited due diligence and a board recommendation.

 

Sulzer said that over the prior month it initially proposed 305p, then 315p, and then 325p.  Sulzer also spoke to large institutional holders of BOY LN about a possible bid.  The sense I got from Sulzer’s bankers at the time was that discussions with BOY LN’s institutional shareholders was generally positive but not unanimous in supporting a bid at 325p.  SUN SW said Bodycote’s board rejected the approaches and did not wish to enter a dialogue regarding the proposals, and that Sulzer was considering its options with regard to a possible offer. 

 

At the time there was speculation that Sulzer went after BOY LN as a defensive move to protect itself from a Russian oligarch who was rumoured to be interest in Sulzer.  Sulzer discounted this and said it was interested in BOY LN for strategic reasons.  (The oligarch, who now controls about 1/3 of Sulzer, is said to have been supportive of the move for Bodycote).  Sulzer’s biggest business line is pumps, followed by Sulzer Chemtech (market leader in separation column and static mixing technology – used in industrial processes), then Sulzer Metco (thermal spray and thin film coating), and Sulzer Turbo (service and repair of thermal machinery).  In speaking to Sulzer’s bankers at the time they said Sulzer and Bodycote have complementary technology and they’re also geographically complementary.  End markets are also very similar (oil & gas, power generation, aerospace, automotive, etc).  So it wasn’t a cost savings story, but more of a complementarity/diversifying move. 

 

Between mid-April and the expiration of a “put up or shut up” order from the Takeover Panel on April 27^th, SUN SW increased its proposal to 332p and finally 344.5p (340p + 4.5p final dividend), both of which BOY LN rejected as too low.  BOY LN said it had the support of its major institutional shareholders in rejecting the approaches as too low.  After the put up or shut up deadline passed with no offer, I spoke to a banker for Bodycote who said BOY LN gave an indication to SUN SW of what it would need to propose to get due diligence access (but not a recommendation). This level was 345p ex- the final dividend or 349.5 including the final dividend.  So the two were a few pence apart from due diligence and an extension of the put up or shut up deadline.  The six month moratorium on Sulzer making another bid just expired in late October. 

 

After the deal broke, BOY LN shares initially traded at 295p, but steadily declined to a low of 235p in late September on a number of analyst downgrades on fellow UK engineering company Invensys Plc over concerns about the US part of its business (and risks from a US slowdown).  Since the summer BOY shares have recovered from those lows (along with the UK engineering sector) on Sulzer speculation as well as on a positive sentiment from an investor day the company held in late October, though they’ve retreated some lately.

 

Valuation

Bodycote has often traded at a discount to the UK engineering sector.  It still does.   

There’s no obvious reason for the discount at which BOY LN has traded to the other UK engineering companies.  There are no direct UK comps (since none of the other UK capital goods cos. do exactly what Bodycote does; they manufacture goods while BOY LN performs an industrial service) but there’s nothing about Bodycote’s business that should put it on a lower rating than others in the engineering space. 

 

I used the following comparable companies in looking at relative valuation: FKI LN, MGCR LN, ISYS LN, CKSN LN, CHTR LN, SMIN LN, AALB NA, CW US and SUN SW.  All are UK engineering/capital goods companies except for SUN SW (who I thought it made sense to include because of their former bid interest) and AALB NA and CW US, both of which have smallish business units similar to what BOY LN does.  Based on today’s prices, the comps universe [and BOY LN in brackets for comparison purposes] trade at the following EBITDA multiples: 2007E: 9.7x [7.0x], 2008E: 8.3x [6.4x]; 2009E: 7.6x [5.7x].  The mean EBITDA multiples of the comps for 2007E – 2009E data imply a value for BOY LN of around 365p.

 

The comps [and BOY LN] trade at the following EBIT multiples: 2007E: 12.0x [10.8x], 2008E: 10.1x [9.6x]; 2009E: 9.0x [8.5x].  The mean EBIT multiples of the comps for 2007E – 2009E data imply a value for BOY LN of around 288p.

 

The comps [and BOY LN] trade at the following P/E ratios: 2007E: 16.3x [13.4x], 2008E: 13.9x [12.1x]; 2009E: 12.6x [10.9x].  The mean P/E ratios of the comps for 2007E – 2009E data imply a value for BOY LN of around 313p.

  

BOY LN has a trailing EBITDA margin of 22.6% while the comps average EBITDA margins of 14.9%, for a 7.7% difference.  BOY LN has an EBIT margin of 14.6% while the comps average 10.8%.

 

Summary:

Bodycote is somewhat unusual in that it is in the UK “engineering” space, but is not a manufacturer.  It is tarred with the “cyclical” brush, even though its results in the last downturn showed lower cyclicality than engineering peers.  It has taken measures since the last downturn to reduce cyclicality further.  It trades at lower multiples than its engineering peers; multiples that look cheap for a company that’s the absolute leader in what it does with high margins and high return on capital.  Operating in fragmented sectors, it is able to play the role of consolidator, buying up small operators at the rate of £60mm per year at a fraction of the multiple at which it trades.  These acquisitions, on top of mid to high single digit organic growth, result in total revenue growth in the teens.  It also gets growth in mature manufacturing economies by selling the idea of outsourcing to manufacturing customers (moving the function to Bodycote, who can do it more efficiently).  Finally, growth will come from a greater emphasis on emerging economies.  The company is focused on increasing capacity utilization in heat treatment to drive up margins and ROCE, and is growing the Testing side of its business with a goal of this reaching 50% of group revenues. 

Catalyst

While there’s no imminent catalyst, Sulzer AG, who made an unsolicited approach in March/April 2007, is now free to make a new approach/offer after the six month moratorium on bidding for Bodycote recently expired (a technicality of the UK takeover rules). Aside from a bid, continued value-added acquisitions, greater emphasis on testing, a focus on outsourcing, increasing utilization rates, and business development in emerging markets should continue to drive earnings and reduce cyclicality. Eventually Mr. Market should discover this hidden gem.