Overview

Ferro is a specialty chemicals company that is trading 25% below book value, as the market extrapolates recent weakness in its solar paste business far into the future.  Five years of aggressively cutting fixed costs, re-positioning the product portfolio and deleveraging the balance sheet during a period of rising input costs and weak end demand left the Company positioned to earn its cost of capital.  Instead, excess PV module inventory hugely curtailed demand for Ferro’s high margin conductive paste. 

The subsequent earnings decline was brutal and caught the Street and management off guard.  After lowering guidance multiple times during 2011, management finally threw in the towel and settled on 2012 EPS of $0.40 to $0.65 (from $0.71 in 2011).  Since 4Q11/early 2012, leading indicators and recent comments suggest that most of the Company’s end markets, including solar, look stronger and yet management recently guided towards the lower end of the $0.40-$0.65 guidance range it provided in February, which is likely too low.  Longer-term, as management shifts the product portfolio from lower-growth, lower ROA businesses to higher value-added ones, I would expect the stock to trade above book value and the Company to earn over $1.00 / share in a few years.

A Short History

In 2001, Ferro acquired various business units of DMC^2 for $540mn in its largest acquisition to date,    transforming itself from a mostly boring plastics and coatings company to one with expanded capabilities in higher growth electronic materials and glass, and a deeper presence in Europe and Asia.  The acquisition largely molded the Company’s current business composition.  Over the next several years, FOE rid itself of various subscale coatings businesses and things were humming along, when in 2004 the Company discovered accounting discrepancies in its Polymer Additives segment that led to restatements and a year of accounting audit investigation headaches.  In the midst of this scandal, a 19-year Dow Chemical veteran, James Kirsch, was hired into the COO and assumed the CEO title upon the unexpected death of Hector Ortino, Ferro’s former chairman and CEO, a year later. 

He wasted little time and began a broad restructuring program in 2006 that finally concluded in 2010 and required $145mn in restructuring accruals, mostly spent shuttering capacity in Europe across primarily the EM, PC and CGM segments.  That time was spent on operational improvements – trimming overhead, closing redundant manufacturing facilities across Europe, reducing headcount from 6,839 to 5,120 and optimizing footprint – and fixing the balance sheet, doubling the share count in November 2009 to cut leverage in half from a peak of 6.0x EBITDA in 3Q09 to 3.0x the following quarter and less than 1.5x today. 

Certain challenges have made it difficult to see the benefits of management’s restructuring initiatives in segment operating margins.  While the Company has generally recaptured higher raw materials cost on a dollar for dollar basis, dual headwinds of higher commodity prices since 2005 and weak demand in housing and construction beginning in 2H06 still resulted in weaker operating margins in most of FOE’s business segments, and an inability to earn its cost of capital overall.  High pension expenses have likewise hurt corporate-level costs in recent years.  Still, I estimate that management has removed at least $40mn in segment SG&A (total pre-corporate operating income was $173mn in 2011) since 2008 on top of improvements in manufacturing efficiencies. 

Now that fat has been cut, the portfolio pruned, and the balance sheet strengthened, Ferro’s next five years will be devoted to devoting growth investments in its high-margin businesses and allowing its right-sized cost structure to drive operating leverage. 

Business Segments

Ferro’s products are omnipresent – they conduct electricity through solar cells, pigment glass bottles, reinforce plastic in PVC pipes, reflect sun off of tile roofs, etc.

Here’s a not-so-brief overview of Ferro’s 5 business segments:

Electronic Materials (EM): Highest margin, highest growth, highest return segment of Ferro, where management is devoting growth capital.  Relative to Ferro’s other business segments, EM is tangible-asset light.  Management expects top-line growth of 1.5x-2.5x GDP and long-term EBITDA margins of ~30%, vs. ~33% in 2011.  Ferro basically manufactures three main products in this category: first, solar pastes, which I’ll talk about in more detail later; second, surface finishing materials – for example, ceria-based (rare-earth) slurries that are used in the semiconductor fabrication process to polish silicon surfaces, and other metal oxides to similarly polish hard disc drives, lenses and LCD screens; and third, metal powders and pastes that are used in the manufacture of plasma and touch screen displays.  The non-solar portion of Electronic Materials is dependent on consumer electronics demand.  Since 2006, I estimate EM’s average return on assets as ~12%-13%.  Goodwill is nearly half EM’s asset base, so return on tangible assets is significantly higher.  Even with problems in solar, I estimate EM’s ROA to have been ~16% in 2011.  Consumer electronics production clearly took a hit during the recession but seem to be recovering, particularly this year, based on semiconductor book-to-bill ratios and Industrial Production – Consumer Electronics data.

Color and glass performance (CGM): Grows 1x-1.5x GDP with long-term EBITDA margins in the 15%-20% range vs. ~11% in 2011.  FOE provides products with both functional and decorative features focused on the automotive, construction/architectural and consumer end markets.  We can think about their product set in two buckets: glass-based pastes/enamels and color/pigments.  Within glass-based enamels, some key product applications include glass-based enamel sold to automobile glass manufacturers, who fire it onto windshields to block UV lights that can damage the adhesive binding the windshield to the car; coating applied to office building windows to deflect sunlight (conserve energy) and provide a reflective look; and decorative uses like the glassy designs fired onto Corona bottles.  Within color and pigments, uses include reflective pigments applied to asphalt shingles to cool building roofs; decorative colors on fine china; colored glass bottles (like those containing Absolut-brand vodka); and pigments for paints and plastics.  Since 2006, I estimate CGM’s average return on assets as ~8%-9%.  Around 15%-20% of CGM’s assets are goodwill, so return on tangible assets is somewhat higher.  This business segment has heavy exposure to the auto industry.  Auto sales, which have improved meaningfully off the bottom, are still below 2000-2008 peak demand in most developed countries, while auto demand continues to grow in developing Asia.

FOE commands anywhere between 30% and 50% world-wide market share in most product markets within the EM and CGM business segments, which are dominated by a number of large, global players.

Performance coatings (PC): There is some product spillover with CGM.  FOE’s two primary products are porcelain enamel and tile coatings, with tile coatings constituting most of the segment’s revenue.  Porcelain enamel is used to coat steel appliances like hot water tanks, ovens, and washers/dryers.  It’s an oligopoly in which Ferro has a 50% market share with the next largest player owning 35%.  Pricing is generally rational though there seems to be some pressure in 1Q12.  This product segments has similar growth and margin characteristics as CGM.  Tile coatings (decorative colors/designs applied to ceramic tiles), on the other hand, is a much less attractive business – it’s fragmented (100+ companies, many of them small, family owned private companies), subject to intense price competition, low margin (~20% gross), and suffers from perennially high excess capacity.  Management expects this product segment to grow with GDP and command EBITDA margins of between 8%-15% vs. ~9% in 2011.  Since 2006, I estimate PC’s average return on assets as ~6%-7%.

However, there is a pocket of opportunity within tile coatings.  Pigmented ink uses vivid colors to make tile look like wood, or stone, or…..anything else, really.  The technology allows customers to broaden their target market to compete with natural materials and provides quicker changeovers (from hours to minutes).  The market went from nothing to $200mn very quickly.  Pigmented inks command selling prices 5x greater than normal tile coatings resulting in gross margins of 40%-45%.  FOE has a ~45% market share and is the largest player.  The economics are compelling – assuming even 40% of a $200mn market at 20% operating margins provides $16mn in pre-tax earnings to FOE.  With a market size of $100mn in 2011, this comes to ($200mn - $100mn) x 40% x 20% = $8mn in incremental pre-tax earnings.  Finally, FOE has shifted some tile production to Egypt, where gross margins are 3x higher than in Spain, where supply used to come from.  Management believes this reorientation will save the Company $6mn annually and that these savings will hit 2012 earnings.

Combined, these overlooked factors amount to ~$9mn-10mn in incremental after-tax earnings to the firm, or $0.10/share.  It’s unclear whether sell-side analysts have explicitly baked this into their numbers. 

Polymer additives (PA): Additives that enhance polymer properties for end markets including PVC, adhesives, sealants, inks and lubricants.  Within additives, FOE got its start manufacturing additives for PVC (plasticizers that make PVC flexible), extending its chemistry into different markets as PVC became more competitive and commoditized.  While this business segment is mostly exposed to the North American construction market, there are some consumer applications including hand lotions and vitamin pills (binders that stick the pill ingredients together).  Still, 60%-70% of this business segment is still PVC.  Since 2006, I estimate PA’s average return on assets as ~5%-6%.

Specialty plastics (SP): Ferro operates in niche market segments within the broader plastics industry that includes reinforced plastic found in cars and household appliances; advanced rubber material found in end cable jacketing, power tool grips, and cell phone touch pads; and gel coats applied to wind turbine blades and motor boats to reduce friction.  Plastics is a very competitive market and like polymer additives and performance coatings, is characterized by high fixed costs, high volume and low margins.  Since 2006, I estimate SP’s average return on assets as ~10%-11% (the segment has historically carried very little goodwill and was written off entirely in 2008).  As a caveat, this level of returns stems from high asset utilization vs. margins; high asset utilization in turn, has been driven by a depreciating asset base (depreciation has consistently run 2x+ higher than capex since 2005).  

Management made deep SG&A cuts in Polymers and Plastics in 2009/2010, savings that were partially reinvested in EM, CGM and coatings.  Longer-term, the Company is expecting polymer and plastics to grow with GDP and earn 8%-15% EBITDA margins, vs. 7%-8% in 2011.  Both business segments are highly linked to North American construction and housing, which appear to be recovering from cyclical lows based on housing starts, building permits and lumber prices.

Pharmaceuticals: Specialized APIs used in cancer and asthma drugs.  The segment has highly volatile margins, revenue and profits, and is not significant to FOE’s overall results.

Ferro’s strategy is to invest growth capital in technically demanding, high margin businesses like EM and CGM where the Company has medium to large scale and is generating returns in excess of capital costs, while harvesting the more commoditized product segments (coatings ex. enamel, additives and plastics) for cash.

Problems with Solar

Even 30% greater PV installs in 2011 vs. 2010 was not enough to work off the excess solar cell supply (which tripled over the last three years), limiting cell production and demand for Ferro’s most profitable product, conductive solar paste.  EPS declined by $0.37 from $1.08 in 2010 to $0.71 in 2011; solar paste accounted for $0.51 of that fall.  To make matters worse, for most of 2011, management maintained that solar paste demand would improve in the 2^nd half; it didn’t, it got worse and guidance was lowered several times, resulting in a 70% decline in the stock price.

What is solar conductive paste?  Basically, the sun shoots photons at a PV module made up of silicon-based solar cells, which each have front and back sides that produce an electric field.  These photons excite and dislodge electrons, which leave the solar cell as a current and create electricity.  Solar paste is smeared on the front and back sides of a solar cell during the manufacturing process to improve conversion efficiency (the proportion of photons that is converted to electricity).  If you Google a picture of a solar cell, the solar paste is visible in the form of the really skinny lines on the front side of a solar cell.

The backside of the cell also has metal paste in the form of thicker busbars which carries the electricity from inside to outside the cell (these busbars also often show up on the front side).   Paste generally constitutes roughly 12% of a PV module’s cost (6% if you include module installation costs), but is a necessary manufacturing component.  While this metallization paste can be made with aluminum or copper, silver is the most conductive element, but is also the most expensive and technically challenging paste to manufacture.  FOE specializes in silver paste. 

DuPont and Ferro were the two market leaders in silver paste until about two years ago when Heraeus introduced its own version.   While FOE believes that all three players have roughly equal market share at any given time, increasingly short product cycles (4-6 months) translates into frequent share shifts.  Every 9-12 months, a solar cell manufacturer will evaluate a new paste for a line based on which paste exhibits best adhesion characteristics, thinnest lines, or least shadowing from busbars (basically, which paste results in the best conversion efficiency).  Outside of DuPont, Heraeus and Ferro, Ru Shing (Taiwan) and GIGA (China) specialize in aluminum pastes, which are less technically demanding and as a result have seen more pricing pressure.

There are some tepid signs that solar is on the mend.  While I have not done a detailed analysis of shipments versus demand, comparing net capacity expansion (aggressive at a few Chinese manufacturers but modest as a whole) vs. 0%-10% expected module demand (sharply lower demand from Europe offset by growth in the US, Japan and China) suggests that excess inventory may at the very least not be growing.  Suntech has started to see signs of price stabilization as polysilicon prices have firmed.  DuPont claims that inventories are half of what they were in 3Q and 4Q and their paste volumes are increasing.  Even Ferro believes that “things are trending to a better place.”

Valuation

The market is valuing FOE at a 25% discount to book value, suggesting that the Company will forever under-earn its cost of capital.  If management successfully executes on its mission of shifting the portfolio towards the higher return businesses with better entry barriers like electronics, glass and pigments over the next few years, I would expect margins to expand and asset utilization to contract (FOE’s higher value-added businesses have lower asset turns), to level out to an ROIC of around 12% in 2015.  Heroic assumptions are not required to get there.  I am assuming that solar paste earnings never regain their 2010 highs, and that EBITDA margins are several percentage points lower than management’s 18% goal.

ROIC = NOPAT % x (Sales/Assets) x (Assets/IC) = 8.5% x 1 x 1.4 = ~12%

I estimate FOE’s WACC to be around 11%.  Assuming a 2% growth rate to recoup inflation gets me to a Value/Invested Capital of 12% x ((1-2%/12%)/(11% - 2%)) = 1.25x

Backing out debt and discounting the implied equity value back to today, gets me to a stock price of $8.50.

Since 4Q11/early 2012, leading indicators suggest most of the Company’s end markets look stronger; yet management recently guided towards the lower end of the $0.40-$0.65 guidance range it initially provided in February.  To get to the lower end would require the following onerous assumptions: significant solar losses in 2012 vs. positive solar earnings 2011 (rather than a “modest” contribution as management is expecting), no top-line growth in coatings or CGM, slight top-line contraction in specialty plastics and polymers, and only partial realization of gains from consolidating Austrian with German plants, moving tile coatings plants to Egypt and pigmented inks.  I think a more realistic earnings print for 2012 is somewhere between $0.60 and $0.70.

Here are some comparable P/E ratios:

If Ferro were to beat expectations by delivering $0.60/share this year, I don’t find it unrealistic to assume a stock price of 13 x $0.60 = $7.80.

Finally, I expect normalized FCFE/share to be at least $1.00 (and earnings somewhat higher) a few years out.  A 10x multiple, gets me to $10.00.

I think a reasonable downside scenario for the stock is TBV/share, which stands at $3.35/share (using the average of book and tax PP&E for conservatism).

Risks

FOE was caught flat-footed as capacity moved away from Europe and Japan and towards China.  As a result of this geographic shift, as well as a shift away from Tier 2 and 3 solar manufacturers towards Tier 1, during Q4 management indicated it lost market share in the conductive paste market.  The Company is responding aggressively to these developments, courting Tier 1 manufacturers most likely to survive after much needed industry consolidation, expanding Chinese capacity, and introducing new products.  While management signaled some positive developments on this front during the most recent Q1 call, there is still tremendous uncertainty around whether FOE’s attempts will prove successful.  The Chinese market is already competitive as it is, especially in the aluminum backside market where FOE competes with embedded paste companies Ru-Shing and Giga.

In addition to price pressure from competition, as polysilicon prices have plummeted over the last few years, it seems reasonable to expect solar manufacturers to push back on silver paste prices or substitute for cheaper alternatives like aluminum and copper, where FOE has a lower presence.  Finally, solar manufacturers are becoming more efficient every quarter, economizing on size and material while improving efficiency.  Consequently, management expects the conductive paste market to grow slower than end solar module demand.