Description

Thesis Summary: Cookson (CKSN) presents an opportunity to buy a high quality industrial business with dominant global market share in niche products, significant pricing power, recurring revenue, and operating within high barriers to entry at a 45% discount to its intrinsic value. At the current valuation CKSN trades at 7% 2010 FCF yield and 13% 2011 FCF yield implying over 30% discount to its peer group. This discounted valuation that does not give the company any credit for its restructuring program and reflects CKSN's poorly understood exposure to macro headwinds and its ability to unlock value through asset sales.  Strong operational performance will alleviate at least some of the macro concerns in the near future and will facilitate dividend reinstatement, helping the equity's appeal to a broader shareholder base. In the medium term, spin-off CKSN's highly cyclical electronics business will trigger multiple re-ratings and unlock additional value for the shareholders.

Business Description:

CKSN has two main business segments: Ceramics (59% of sales, 60% of adjusted EBIT) and Electronics (27% of sales, 33% of adjusted EBIT). The rest is made up by its small Precious Metals business.

Ceramics

Ceramics consists of four key product categories, each of which is a form of consumable product used in predominantly in steel and foundry industries as well as other industrial sectors. The products include steel flow control, lining materials, metal feeding systems, solar crucibles and others.

Electronics

Electronics consists of two sub-divisions, Assembly Materials and Chemistry, each of which sells consumable products, such as solder based products, chemicals used in printed circuit board manufacture, etc. into consumer and industrial electronics markets. Volumes are linked to end market activity levels.

Why the Opportunity Exists:

Fear of a slowing Chinese economy. Perception: "Cookson's sales are levered to global steel production volumes. With China producing ~50% of world's steel, any slow-down in economic and/or construction activity in China would have adverse effect on CKSN's sales". Reality:  (1) CKSN's derives 5% of revenue from Chinese sales of steel-related products.  Even if CKSN's operation in China came to complete halt, the impact on EPS wouldn't exceed 6-8%. (2) CKSN's products are used in flat steel manufacturing processes. Unlike long steel, which is used in construction, flat steel is used in appliances and auto manufacturing. As a result, CKSN's sales in China are not only uncorrelated with construction activity, but are actually positioned to benefit from Chinese economic rebalancing towards consumption.  Future steel industry consolidation (and re-tooling) position CKSN to grow revenues at rates exceeding those of overall steel consumption.

Double-dip recession fears. Perception: "CKSN suffered 48% trading profit declines in 2009 over 2008. Should the global economy double dip, the profitability will drop at a similar magnitude again". Reality:  Steel production is a lot less cyclical than the recent recession made it appear.  The 61% drop in the US steel production at the end of 2008 was the largest drop in over 30 years, and was largely driven by inventory reductions (destocking).  Restocking from the rock-bottom levels has not yet occurred, and global steel inventories remain at 40 year lows.  Consequently, a slump of a similar magnitude is unlikely to occur.

CKSN Management suffers a poor reputation Perception:  "CKSN's management team has a propensity to destroy value by implementing poorly timed acquisitions and failing to prudently manage the balance sheet considering the cyclical nature of the business".  Reality: CKSN's structural repositioning coincided with the recession. The management did, in fact, buy Foseco at a peak valuation in 2008. The transaction was funded with debt and the subsequent slump in profitability forced CKSN to do an equity rights issue and cut the dividend in order to repair its balance sheet and maintain liquidity. However, the acquisition of Forseco repositions the company for less cyclicality and higher future margins. The original plan, disposal of the electronics business, was derailed by the global recession, and management had to resort to damage control while waiting for their opportunity to realign the business.

Investment Positives:

• High barriers to entry: Evidenced by the absence of new entrants and stable market share, barriers to entry in the industry are high due to high capital intensity, brand recognition, and CKSN's dominant market position.
• Pricing power: In Steel Flow Control and Linings, CKSN manufactures consumable parts used in steel production and in regular maintenance procedures. These products are sold to large international customers on the ground level, i.e. to the individual mills, as opposed corporate level. CKSN's products account for less than 1% of mill customers' costs and the strong Vesuvius brand name promotes repeat business. CKSN has demonstrated the ability to pass through input costs and routinely raise prices.
• Recurring revenue model: Essentially all ceramics products are consumables that need to be replaced daily, generating recurring revenue for the company as long as customers are producing.
• Dominant market share: CKSN enjoys 55% market share in global Steel Flow Control products, 50% market share in Foundry, 60% global market share in Solar Crubicles, and is also a local market leader in APAC and the US in Linings. In Electronics, CKSN's market share is between 20-30% globally.
• Structurally higher margins in the next cycle: Since joining Cookson in 2004, CEO Nick Salmon has been implementing the strategic business repositioning plan aiming at higher margins and reduced cyclicality. Under his leadership CKSN disposed of over 14 underperforming business lines (mostly in Electronics) and acquired Forseco in 2008. As a result, mid-cycle margins in the current cycle should be 200-300bps higher compared to the previous cycle.
• Spilt-up can unlock value: The Ceramics business on a stand-alone basis deserves a premium to its peers due to its lower cyclicality and dominant niche market share. The sale of the Electronics division would unlock value for the shareholders and substantially improve the company's capital position.
• Late cyclical products are not priced in: The market is not giving CKSN any credit for the rebound in its Foundry end market (luxury cars and trucks). Meanwhile, according to the German business daily Handelsblatt, BMW and Daimler plants in Leipzig, Dingolfing and Woerth that manufacture luxury cars and heavy trucks, were running at full capacity in June and are in the process of setting up night shifts. Germany alone accounts for 25% of CKSN's foundry sales, so announced improvement in manufacturing activity there should result in higher than currently anticipated foundry sales and profits.
• Dividend will be reinstated: The management clearly stated its desire to reinstate the dividend once it becomes comfortable with the business climate. As the last of the late cyclical product revenues normalize, CKSN is positioned to generate at least 28p per share in FCF in 2009 and 56p in 2011 (as the effect of working capital wears off). Considering moderate financial leverage (33% Debt to Capital) and the absence of near term debt maturities, this should give the management team plenty of headroom to reinstate the dividend, which would attract UK-based income investors.

Investment Risks:

• China headline risk: while I believe a Chinese slowdown would have far less impact on the company than the market assumes, it definitely constitutes the "headline" risk at the moment
• UK/Europe risk: well-publicised sovereign debt issues lingering in Europe contributed to the recent sell-off and also constitute significant risk going forward.
• Leverage: CKSN's has 3.2x of debt (on TTM Ebitda), which is the highest in its peer group (average 2.0x among UK engineers), which could result into higher volatility near-term relative to the peer-group. However, CKSN's debt/capital ratio is in line with its peers at 30%, appropriate for the industry, and leverage metric should show improvement moving forward.
• Decline in global steel volumes: CKSN is a just in time supplier of consumable products to still mills around the world. Any decline in global flat steel volumes would negatively impact CKSN's Ceramics revenues.

Valuation:

I view the sale of Electronics as imminent, and therefore value CKSN on the sum of the parts ("SOTP") basis.

Ceramics have the following normalized mid-cycle EBIT margins: Steel Flow Control 17%, Foundry 12%, Linings 10%, Solar 15%, resulting in a blended normalized margin of 10.1%. On projected 2011 sales of £1,441m, normalized NOPAT is £145m. Considering the business characteristics, a premium multiple of 10-11x NOPAT is warranted, resulting in EV of £1.45bn for the Ceramics division.

The electronics business is highly cyclical, and because products become obsolete every 5 years, it requires constant investment. The normalized EBITDA margin for this business is close to 12%, and management believes that it can be sold to a strategic or a PE buyer at 9x EBITDA. Assuming 9x EBITDA exit multiple, on the 2011 sales of £651m, the business is worth £703m.

I do not assign any EV to the Precious Metals, but assume management will eventually move to liquidate it.  This segment will remain a low priority as long it doesn't burn cash (currently generates ~£10m in FCF per year).

The SOTP EV of Electronics and Ceramics is £2.078bn, translating into equity value of £1.79bn, or 646p per share, implying 45% upside from the current share price.

Recent Transactions:

On July 19^th, 2010, Tomkins Plc ("TOMK"), a UK engineering firm comparable to CKSN, announced that it received a $4.37Bn (£2.87Bn) takeover approach from a private equity consortium lead by Onix, a Canadian PE firm. This is a first large PE transaction in the UK engineering space since the beginning of the economic downturn in 2008. The offer values TOMK at ~£3.00 per share, a 14x 2011 P/E, compared to 7x 2011 P/E for CKSN.

Relative Valuation:

Model Summary

Catalyst