Description

Investment Thesis

We believe shares in HB Fuller (NYSE:FUL) represent a compelling long-term investment. The roadmap for the company is relatively straight-forward but is similar to some of our most successful investments of the past.  That roadmap includes a company with a solid, growing business that is nearing the end of a massive deleveraging program with potential synergistic industry consolidation opportunities on the horizon. As with many of the opportunities we have seen in the past, FUL does not screen particularly cheap on current numbers but is improving margins and producing enough free cash flow that valuation becomes compelling a year or two out.  On FY2023, we see the company trading at ~13x EPS, 8x EBITDA, and 12x FCF. We think this is cheap for a company that has a strong position selling mission-critical products that represent a small portion of overall end-product costs. 

In 2020, FUL announced that it was re-aligning its operating segments from 5 (mainly geographical) to 3 (based on end-markets).  The new segments include Hygiene, Health and Consumable Adhesives, Engineering Adhesives, and Construction Adhesives.  Along with the realignment, the company also announced a program to streamline operations and improve margins.  This program targets a 5% reduction in SG&A expense (~$35mm or 1.2% of revenue) and operational cost savings of between $20-30mm (0.7-1.2% of revenue).  The total savings of $55-65mm is targeted to be fully realized in 2022 and should result in a 2% margin improvement on a base of ~15%. 

Demand for the company’s products are strong and, after a dip in 2020, the most recent quarter’s revenue (Q221) were up 9.5% organically from pre-covid Q219. The issue that the company is facing, like many others, is cost inflation. Raw material cost inflation is up ~10% but the company has been aggressive, and successful, in announcing price increases to offset these pressures.  So far, the company has implemented $150mm in price adjustments with an additional $75mm adjustment in the third quarter.  3Q margins will likely dip a bit due to this lag but the company believes these price increases will offset the raw material increases in this fiscal year.  Competition has been rational and direct competitors have also announced prices increases.  Continued cost inflation is obviously a risk to the targeted margin improvement programs but we do not have to give them full credit for the investment thesis to work out.

One of the biggest drivers of value creation here is the free cash flow profile and deleveraging program.  In 2017, the company levered up to purchase Royal Adhesives (for ~$1.6bn).  Net debt at the end of 2017 was ~$2.26bn vs. ~$1.6bn today.  FUL is targeting $200mm in debt paydown this year with $60mm already occurring in the first half of the year.  The company has been targeting Debt/EBITDA of 3x and should get to that target by the end of this calendar year. 

We see the company producing another ~$250mm in FCF in FY2022 that can either be used for debt paydown or strategic acquisitions.  We are excited about the opportunity for industry consolidation as the top 5 players only control about 35% of the global market.  In fact, Ashland (ASH) has recently announced a strategic review of its adhesives business ($310mm rev in 2020 with $71mm of EBITDA – 22.9% margin) and this could be a great addition to FUL. 

Management, led by CEO Jim Owens, has proven to be solid operators while being patient for the right opportunities and getting aggressive with the balance sheet when they see a great opportunity like Royal Adhesives.  We feel comfortable that they will continue to paydown debt until they see the right kind of strategic opportunity. 

Company Overview:

HB Fuller is a leading producer of adhesives that are used in numerous global end-markets.  The company breaks down its business into three distinct operating units as follows:

-          Hygiene, Health and Consumable Adhesives

o   LTM revenue of $1.37bn and EBITDA of $196mm (14.3% margin)

o   This segment sells primarily into the packaging and hygiene (adhesives for diapers, feminine care, etc.) markets

o   FUL is targeting EBITDA margins in the mid teens for this segment

-          Engineering Adhesives

o   LTM revenue of $1.26bn and EBITDA of $200mm (15.8% margin)

o   This segment sells adhesives for assembly of durable products, performance wood (windows, doors, etc.), textiles (footwear, etc.), transportation, electronics, medical, clean energy, and aerospace.

o   FUL is targeting EBITDA margins to the high teens to 20% over the next year or two based on the above-mentioned operational improvement programs

-          Construction Adhesives

o   LTM revenue of $385mm and EBITDA of $49.7mm (12.9% margin)

o   This segment sells adhesives used in tile sealants, commercial roofing, and insulation applications.

o   FUL is targeting EBITDA margins in the high teens

Financials and Valuation

The company has guided FY21 revenue up 13-15% over FY2020 (which was down 4%) and for EBITDA of $455-475mm (~14.5% EBITDA margin due to pricing lags to make up for raw material inflation).  We think EBITDA margins can increase ~2% by FY2023 due to the operational and cost improvement programs that have been put in place.  In FY2023, we see revenue of ~$3.39bn, EBITDA of ~$558mm (16.5% margin), and EPS of ~$5.00.  In addition, FCF should approach $255mm in FY22 and $290mm in FY23. Our model assumes no acquisitions and continued debt paydown. 

Under these assumptions, we see FUL trading at 13x FY23 EPS, 8.2x FY23 EBITDA and at an 8% FCF yield. We think FUL deserves to trade, at least, at a 10x EBITDA multiple which is at the low end of current chemical comps.  This would bring us to a valuation of ~$84/share, which is also ~17x EPS (also reasonable, especially in this environment).  We see this 30% upside over the next year or so as our base case.  Real upside would come in the form of synergistic acquisitions that could start taking place in the next year or so.  There is plenty of opportunity in the global adhesives market and we feel comfortable with current management at the helm.  Otherwise, the company should continue to produce large amounts of free cash flow that will deliver excellent returns to equity holders. 

Major Risks

-          Continued raw material inflation is clearly a risk but management has been aggressive with price increases that have also been implemented by other players in the industry. 

The company being too aggressive on acquisitions in terms of pricing.  We feel comfortable that management is disciplined and will be patient 

Catalyst

- Continued debt paydown

- Potential for acquisitions in FY22