Description

Fenner is a falling knife worth trying to catch, based on business quality and a valuation that has begun to provide an adequate margin of safety.  The stock price dropped 62% in twelve months, exactly matching the 62% of company sales generated by Oil and Gas producers, Coal and Iron Ore miners.  That discounted valuation looks hasty.  Pay 8.8x EV/normalized EBIT for a resilient industrial business that has generated 16% post-tax returns on capital for the past 25 years.  Fenner's long history of side-stepping various macroeconomic challenges, delivering operating profits in 49 out of the last 50 years, should be especially prized in the current challenging environment.  This track record is the fruit of genuine competitive advantages, which if sustained, should provide investors with asymmetrical outcomes.  

Company description

Example products:

·      heavy-duty conveyor belt used by a coal miners for US electricity generation.  Replacement cycle: 3-4 years depending on environmental conditions and volumes transported. 

·      PVC V-belt used for power transmission of air conditioning units. Replacement: 3 years.

·      Blood transfusion bag, replaced each use.

Fenner PLC is a United Kingdom-based manufacturer and distributor of reinforced polymer products providing local engineered solutions for performance-critical applications. The Company operates in two segments: Engineered Conveyor Solutions and Advanced Engineered Products. Engineered Conveyor Solutions is engaged in the manufacture of rubber ply, solid woven and steel cord conveyor belting for mining, power generation and industrial applications. It also offers service operations which design, install, monitor, maintain and operate conveyor systems for mining and industrial customers. The Advanced Engineered Products segment manufactures precision polymer products, including precision drives, power transmission and motion transfer components, silicone and complex hoses, lay-flat hoses, seals and sealing solutions, technical textiles, silicone-based products, rollers and fluropolymer components. (source: Reuters)

The company has two segments: Engineered Conveyor Solutions (ECS) and Advanced Engineered Products (AEP).  One third of revenues come from end markets currently in tact: mainly industrial and medical.  The other two thirds of end markets served are clearly severely challenged: Oil & Gas (11%), Coal (32%) and Iron Ore and Other Mining (19%). 

For a group of businesses that at first glance does not share much in common, other than that the products are all constructed from polymers, I will attempt to explain how it all fits together by focusing on Engineered Conveyor Solutions (ECS), which makes up almost half of operating profits, for two reasons.  Firstly, it could be the source of significant valuation inefficiency if current weakness in coal and iron ore markets underestimates the resilience of a business that should survive so long as volumes (not value) of mined material do not collapse in the geographies served.  Secondly, current management and board members who have made capital allocation decisions over the past 20 years, including significant growth capex and acquisitions over the past decade, have been shaped by their experience in this original core business.  Having lived through several vicious commodity cycles, they have learned how to identify and reinvest in sustainable competitive advantages.   The lessons learnt from what makes ECS a good business have informed their process in building Advanced Engineered Products (AEP), in an attempt to diversify end markets served.  

Valuation on normalized earnings

One of the benefits of studying a company with such a long history is that allows the measurement of past performance during different, but just as treacherous, macroeconomic conditions as those faced today.  In 2003 the only annual operating loss over the past 50 years was less than £2 million or 0.6% of sales, and even that blemish would not appear but for two exceptional charges in that year (integration costs after a large belting acquisition, and an unrelated impairment charge).  This impressive track record is the product of robust competitive advantages, which I conclude should allow the business to continue to earn, over the next ten years, similar above average returns on capital to those it has over enjoyed over recent decades.  Therefore 10 year historical average pre-tax earnings of £63 million should prove a conservative estimate of future normalized earnings since this measure does not adequately adjust future returns for the last decade’s major investments that total 75% of current EV: net acquisitions of £290 million and £110 million of growth capex (i.e. in excess of depreciation, which for this business overestimates economic depreciation, since assets are longer lived than their accounting schedules).  Are operating losses possible in the current challenging environment?  Of course.  Consensus profit of £55 million for FY2015; however I am less confident about operating results over the next year or two than over the next 10 years.  Though volatile commodities can affect short term performance, for this company, competitive advantages should determine its long term earnings power.

Significant uncertainty for short term earnings, combined with availability bias from relentless negative headlines, creates an opportunity to pay a below market valuation of 8.8x EV/normalized EBIT (9.1x including pension) for an above average quality businesses. 

What makes this a good business?  Qualititative evidence from Engineered Conveyor Solutions (ECS).

Fenner has supplied industrial belts for 150 years.  Over that period, in order to survive huge technological change, it has been forced to develop a culture of innovating engineered solutions to customers’ changing needs.  Founded in 1861, it originally supplied leather belts for power transmission.  In 1952 the company launched a fire resistant conveyor belt for use in underground mines. 

The tragic seed of this innovation was a fire 60 miles from its headquarters in the North East of England, which started in an underground coal mine at 3:45 am on 26^th September 1950.  As the subsequent public enquiry concluded, the frictional heating of a worn conveyor belt led directly to the deaths from carbon monoxide poisoning of 80 workers - one in three of those working underground at the time.  In an insight that remains valid for the business today, the pivotal role of the onsite belt-maintenance man was emphasized in the reconstruction of that sad night’s events.  At 8:30 pm on the evening before the fire, the belt-maintenance man was deep underground, as usual, when he spotted a groove in the belt, a common event due to sharp loads.  Since the groove had not extended to a tear in the belt at any point, and presumably conscious of the cost of idling the whole mine’s activity if the conveyor was stopped, he did not replace the belt and allowed operations to continue.  The night shift took over, and at 3:10 am the groove in the belt tore through, causing frictional heating of the rubber strips as the belt was pulled through the winding mechanism.  Although mine workers further along the belt noticed the tear, and stopped the whole conveyor within 10 minutes of it occurring, by that time the heat at the point of friction had transformed into smoke, and with incoming flammable belt strips serving as fuel, fire spread quickly through the mine.  Within just a few hours, men above ground were dumping sand into shafts to seal the mine shut, in an effort to stop the further spread of such an intense blaze, certain that all those remaining underground must already be dead.

Though technologies have changed since 1950, many things about the industrial belt business remain the same.  The first barrier to entry is having an externally verified product, such as the Fenaplast fire resistant belt, the fruit of polymer research conducted in 1950-52 at the encouragement of the National Coal Board, that meets stringent local safety regulations in all its markets, and remains a world standard in underground coal mining. Then, as now, the value proposition for conveyor belts is not just the quality of custom manufacture, but also the crucial ongoing services such as monitoring and maintenance, that remain constant as long as operations continue, irrespective of spot prices for the particular commodity that is being transported by the belt.  This service element runs through company history, from the statement in the 1973 Annual Report, “When people ask us about Fenner we tell them we’re a service industry,” to its belt operations in 2015 Australia, where service revenues account for 50% of sales.  A decent industrial belt business solves customers’ most challenging problems, is performance-critical to the customer’s business, has a small price relative to the customers’ total costs, and gets sold by a long-trusted, externally certified supplier.  These qualities combine to make Fenner’s ECS segment a good business, despite inevitable cyclical peaks and troughs in activity, earnings and valuation.

The heavyweight conveyor belt industry

The industry exhibits local economies of scale in distribution, testing and maintenance.  Industrial conveyor belts are very heavy (in excess of 50 tonnes) and long (finished installations use 5-20 miles of belt) meaning that local manufacture is most economical for repeat buyers (replacement frequency depends on nature of the load and harshness of environment).  Apart from manufacture, several steps of the finished product must be completed locally.  Having obtained external validation such as fire resistance, the qualification process for a new supplier can take more than a year, with testing required onsite to demonstrate suitability to local conditions.  Fitting can require splicing and x-raying after installation to ensure quality.  Finally, the maintenance of these crucial elements of production is hyper-local, provided by Fenner technicians who are present on the customer’s site 24/7, as they monitor the belt, and preempt or quickly address any defect. 

Anyone who doubts that this is indeed a local business needs to just look a map of ECS sites.  Note that for this large global manufacturer, the only two countries where it has multiple manufacturing plants are those same markets where it has a dominant position: the US and Australia.

Please see maps below:

http://www.fenner.com/en/what_we_do/geographic_locations#north-america 

Manufacturing units are concentrated in the lower cost Illinois Basin and Northern Appalachians, rather than the Powder River Basin and Central Appalachians.  (For additional context on US Coal Regions, please see excellent VIC write-ups by thistle933 and gandalf on AHGP and ARLP). 

p. 15, 2012 Annual Report http://www.fenner.com/resources/466/annual-report-2012.pdf or

http://www.fenner.com/en/what_we_do/geographic_locations#australia

Australia shows a particularly dense clustering of Fenner manufacturing and service sites, the manifestation of a strategy that in a relentlessly cyclical industry like iron ore, the company must sell to miners destined to survive, i.e. low cost, large Australian producers.  The company now dominates the Australian conveyor belting market, partly due to a string of acquisitions, but especially through large capital expenditures.  Significant organic reinvestments such as the $70 million 2009 opening of the Kwinana facility in Western Australia, which houses the world’s largest steel cord press and was the largest manufacturing investment in conveyor belting ever made in Australia, simultaneously cement their local dominance and, as game theory would suggest, dissuades competitor suppliers from setting up.  The large capital investment required for a steel cord plant is hard enough to justify when in all probability it will only serve one small region, with a handful of customers, and probably one or two highly cyclical commodity end markets.  For these reasons, the second competitor plant typically just does not get built, and the threat of potential new entrants remains low.  Meanwhile the threat of substitute products, such as cheaper textile or narrow belts is also low, since only steel cord heavyweight belts stretch under load by less than 0.1% of their length, whereas cheaper textile belts can stretch by 2.0%.  Fenner shares the whole Australian market with just one other smaller manufacturer, until recently owned by Carlyle private equity.

In the current environment of distressed commodity pricing, these local economies of scale might actually increase as sources of competitive advantage, as long as the mines are actually still producing (and recent evidence suggests that volumes are intact despite lower commodity prices).  As margin pressures have intensified over recent months and years, more miners have tried to extend the replacement cycle for belt and shifted inventory requirements to the supplier.  As the CEO recently noted, “now the mines are running to “Replace to fail”, they call us up when it fails, and they don’t want to wait 3 hours for our people to get there from 150 miles away.”  So even a duopoly like Australia could perhaps be better seen as a series of local monopolies, as the nearest supplier is the lowest total cost producer.  Occasionally these two suppliers do lose a contract, as happened on a relatively small $4 million installation last year, which went to Japanese competitor Bridgestone.  However Bridgestone did not supply at a cheaper price than Fenner’s, and the example seems to have been a signaling attempt by the client.  Rational buyers at the mercy of local monopoly suppliers will incur small additional costs from time to time, in order to remind those monopoly suppliers not to drift into price abuse.  Management acknowledged such responsibilities recently:

“We are the biggest in Australia, and it will be the long term winner in mining, so we accept price downs there as a reality of our strategy of staying the market leader there.  Miners continue to drive their costs down, and we have not walked away from business.  Our customers are strategic, relational, and our business is not Request For Quote type, but is longer term…”

What this all means is that although serving commodity markets, the company does not make a commodity-like product.  The three largest global competitors (Continental, Bridgestone and Fenner) might benefit from long-lived Rubber brand names (Goodyear owned by Continental; Dunlop by Fenner).  However, unlike branded car tires that can be sourced from the cheapest location worldwide, the buying decision for heavy industrial belts is typically a local one, which is the key sustainable competitive advantage for Fenner.  Other competitive advantages include the low threat of new entrants and substitutes, and weak bargaining power of suppliers of commodity raw materials.  Of two competitive weaknesses, one is insignificant.  The strong bargaining power of labor supply during commodity booms is mitigated since these co-incide with peak client demand, allowing higher costs to be passed on and margins maintained.  The biggest competitive weakness by far is that, perhaps counter-intuitively, the bargaining power of buyers is strong during commodity crashes.  If costs are not radically cut during commodity price weakness, mines close, rendering Fenner’s investments redundant.  Rational managers therefore decrease prices to marginal cost, which undoubtedly depresses returns on capital at cyclical troughs.  Nevertheless, there are reasons to find competitive solace even during dark days like these.  As customers push inventory management back to suppliers like Fenner, “running to fail”, they in fact increase their dependence on a local, just-in-time supplier, who can accurately monitor belt condition.  Just as many of Fenner’s AEP businesses increased their market share in 2009 when inventory was removed from every link of supply chains, if (or when) end markets actually improve, instead of just windfall pent-up demand, Fenner could emerge competitively stronger.

Evidence of business quality

Above average returns on capital over various cycles give plausible evidence of the existence of sustainable competitive advantages:

Since 1972, post tax returns on capital have averaged 11.3%.

Supporting my claim that current management has migrated the business towards higher return activities, 10 year trailing post-tax return on capital has consistently improved during their tenure:

1985-1994       10.2%

1995-2004       15.6%

2005-2014       18.6%

Post-tax Return on Capital is calculated as:

(Net cash from operating activities excluding movement in working capital less depreciation and computer software amortization) / (net working capital plus PP&E)

Capital allocation and Management

Of the group responsible for these numbers, the first to join Fenner, in 1990, was current Chairman Mark Abrahams.  After earning a First Class Maths degree from Cambridge he spent his early career as an accountant and management consultant before picking the business in which he would invest the rest of his career.  Initially CFO, he became CEO in 1994, and chairman in 2011.  I won’t pretend that he walks on water.  Early investment efforts (notably a polymer moulding factory in Wales) produced negative returns.  He once made an early option exercise decision p.a. that was probably theoretically and mathematically wrong.  Over the course of his career he could probably have made a lot more money for himself if he had operated in financial markets, rather than choosing to run a small but global industrial business from the bleak surroundings of Hull, in the unglamourous north-east of England.  Nevertheless the capital allocation decisions made by him and the recently retired CFO, and continued by the current CEO, demonstrate a deep appreciation for what makes a good business, as well as what threatens one.

In 1997-8, Abraham’s first major capital allocation decision - beyond strengthening the balance sheet shortly after he joined - exchanged a power transmission business without any competitive advantage for the #2 player in US industrial belts, which served as a springboard for achieving regional economies of scale in the US, and product capability in higher margin, niche belt applications.  Ever since, the development of ECS has been a story of migrating from low margin, competitive business towards niches in product and location where competition is scarce.  The simultaneous development of the other segment, AEP, was a deliberate attempt to maintain profitability throughout the economic cycle.  For people like me (and possibly you) who shuffle paper for a living, when management expand their consumable, reinforced polymer products into medical and other industrial end markets, it is tempting to quickly deride the strategy as diworsification.  However for people who build things for a living, especially for someone like Abraham responsible for the business shortly after the 1984-85 UK Miners Strike which saw a complete collapse in a key business driver (volumes of coal mined) due to extraneous factors, a sensible strategy for ensuring corporate survival is called something else: belts and braces.

Advanced Engineered Products (AEP)

Current CEO Michael Hobson, whose tenure at the company matches Abraham, explains the type of businesses that they have tried to build in AEP:

·      Solves customers’ most challenging problems

·      Is performance-critical to the customer’s business

·      Has a tiny unit price relative to the customers’ total costs

·      Preferably requires external certification

AEP’s reinforced polymer products are diverse in application: PowerTwist Plus V-belts that save installation labor costs due to their 3 year replacement cycle (innovation inspired by customers of earlier versions of its V-belts, manufactured in the US since 1937); lay-flat hoses which get replaced every 3-4 years; fracking seals that require replacement every 50 hours; blood transfusion bags and other single use medical consumables.  Each example meets the above criteria.  One brief video illustration of a typical niche product:

https://www.youtube.com/watch?v=kobBWlc3ZmE

When successful, such products benefit from high switching costs as customers incur a lot of technical risk in attempting to switch suppliers.  Such advantages have been learned from many years selling industrial belts, migrating out of low margin and competitive types of belt, and concentrating on the types of product capable of generating above average returns on capital over the cycle. 

CEO Hobson thinks that investors don’t fully appreciate the AEP businesses that he expects to grow quicker than ECS.  A comprehensive investor presentation on AEP is linked below. 

Risks

Oil (mainly US), Coal (US power generation and Australia), Iron Ore (Australia) volumes dramatically decline or stop.

Financial leverage. Management argues that some debt is sensible: “Share capital is an expensive and valuable resource which should be put to work with sensible levels of complementary leverage. The fixed-term nature of our senior debt directs us to maintain a net debt to underlying EBITDA ratio of at least 1x in order to ensure efficient utilisation of the facilities available to us.”  Personally I would prefer none, since it limits the company’s options when, like now, it must trudge through thick brown mud.   Still, management does not fall into the common pitfall of increasing leverage during cyclical peaks.  Most net debt currently funds freehold land and buildings.  They have a history of compliance with the covenant of 3.5x net debt/adjusted EBITDA throughout various cycles, and the previous CFO Perry always claimed that if they took this above 1.5x “I think we would have some explaining to do to ourselves, as to why we were actually doing that.” 

Management alignment.  The founding family maintained some formal oversight for the first 98 years, including for a long period after the company went public in 1937, but shareholders are now dependent on the conservatism of long-standing professional management, with direct alignment only provided by their DB pensions and personal shareholdings which, though not huge, are significant relative to compensation.  Chairman Abrahams owns $2.2 million of stock, CEO Hobson $1 million.

Further reading

AEP investor presentation

http://www.fenner.com/en/investors_media/reporting_centre/presentations 4 decks

http://pres.event1.co.uk/fennercmd/  audio

Summary fundamentals 1-page

http://hsprod.investis.com/servlet/HsPublic?context=ir.access&ir_client_id=276&ir_option=PDF_TEARSHEET

Brandes research on falling knives

http://www.brandes.com/docs/default-source/brandes-institute/falling-knives-around-the-world-paper

Catalyst