Description

Intro

Hillenbrand (HI) primarily sells capital equipment for plastic processing and related aftermarket parts and services, as well as other industrial machinery. It also operates a funeral casket business. HI began life in 2008 when the Batesville casket business was spun out of Hill-Rom. As a new company they looked to diversify away from the funeral casket business and into industrial machinery. The first major acquisition was Coperion in fiscal 2013 for $545M. Coperion makes plastics compounding systems, feeding technology, bulk materials handling systems and services. After a few smaller acquisitions, they acquired Milacron in 2019 for $2B, or around 10x trailing EBITDA before synergies and 8x after synergies. Milacron primarily makes hot runner systems and injection and extrusion equipment. In 2020 and 2021 management sold off their smaller, non-core businesses.

Note that HI has a September fiscal year, so all references to years are fiscal years unless noted.

Business Overview

HI now operates in three segments: Advanced Process Solutions (APS), Molding Technology Solutions (MTS) and Batesville.

APS was 44% of LTM June sales and 39% of segment EBITDA. It is mainly comprised of compounding, extrusion, material handling and flow control products for a wide variety of manufacturing processes. Key brands are Coperion (compounders and extruders, feeders, components, material handling equipment, system solutions) and Rotex (screening and sizing equipment). Here is a segment snapshot:

They are mainly playing in the base resin production stage of the plastics production process, where polyethylene or polypropylene plants use large systems to produce up to 100 tons or more of plastic pellets per hour. These systems sell for something like $20M and can last up to 20 years (but frequently need upgrading along the way due to product changes). HI also sells equipment that is downstream from there where it takes the base resins and adds something to it, like color or UV protection or strength, which is what they call engineered plastics or compounding. In addition, they have material handling equipment that helps move the pellets along through the various steps.

MTS was 34% of LTM June sales and 33% of segment EBITDA. It is mainly comprised of hot runner systems and plastics processing technology. This segment was formed with the acquisition of Milacron in November 2019. Key brands are Mold Masters (hot runner systems, temperature controllers, hot halves, gating technologies), Milacron (injection molding, extrusion and auxiliary systems), and DME (mold bases and plates, die cast assemblies, ISO components). Here is a segment snapshot:

Milacron’s extrusion systems are smaller and less sophisticated than Coperion’s. This gives Milacron a bigger market as many applications don’t need the size and sophistication of the Coperion system. Hot runner systems are purpose designed for each product a customer manufactures on an injection molding machine. Hot runners have much higher margins due to the customer specs and quick turns (it’s close to a consumable product as every time a customer changes an existing product or introduces a new one, they need a new hot runner system and molds). As such, while Milacron has more sales in extrusion and injection molding products, the bulk of profits comes from hot runners given its much higher margins. 

Batesville was 22% of LTM June sales and 27% of segment EBITDA. It mainly sells funeral caskets. Here is a segment snapshot:

Management runs Batesville for cash given it is a declining oligopoly business. 

Business Quality

HI’s financial results point to a solid business. They produced close to 20% EBITDA margins in the LTM period and sport infinite ROTC given a lack of tangible capital in the business. On an ROIC/ROE basis the results are also compelling in the 20-27% range. The Batesville business likely contributes disproportionately to these metrics, but even without it the results are good. EBITDA margins are around 19% in APS with returns on segment assets (excl. goodwill) of around 18%. In MTS, EBITDA margins were 21% in the LTM period with returns on segment assets (excl. goodwill and estimated intangibles) of 27%.

These results stem from several positive characteristics:

• There is a high degree of engineering. Many of the systems are unique and engineered to order.

• Equipment downtime is expensive for customers. As such, HI’s products are mission-critical and need high reliability and productivity. For instance, a customer might lose $1M per day on a downed large polyolefin extruder. Management has said that a large system might run every day all day for 5 years before it’s ever brought down for one minute of maintenance. This makes branding important too and HI has well-known, trusted brands.

• Though we have not found market share data, HI appears to be the scale provider in its product lines. Scale creates manufacturing and distribution efficiencies and a large installed base for aftermarket revenues. 

• HI tends to play in the key plastics conversion steps (base resin conveying extrusion, plastics compounding, plastics extrusion, and drying and molding). This allows them to work closely with the customer to understand how materials flow and where the different issues are in various parts of the value chain.

• The aftermarket parts and services businesses are high margin and recurring. Parts and services are 33% of APS revenue and 29% of MTS revenue.

• The business is not super capital intensive. Capex is relatively low at around 3% of sales.

Management has built a culture around what they call the Hillenbrand Operating Model (HOM), which is the foundation of their business improvement initiatives. The outgoing CEO Joe Raver put HOM in place after studying Roper, Danaher, IDEX and Nordson, with a particular emphasis on Danaher. He also hired several operating executives from these and similar industrial companies to help build the muscle at HI. At a high level, HOM is based on three pillars: understanding the business, focusing on the critical few (meaning, knowing the main 2 or 3 drivers of profitability), and growing to get bigger and better. The system seems rigorous and thoughtful. HOM underpins much of the margin improvement the business has exhibited over the past few years (they claim to have grown EBITDA margins by 600 bps at Coperion, for example). They also use it for M&A as a means of integrating and dramatically improving margins of acquired companies.

Long-Term Outlook

Several mega trends support growing global demand for plastics. From the 10K: “We expect demand for plastics to continue to grow over the long run driven largely by rising living standards globally. In addition, we expect that the benefits of lightweight, durable plastics will support continued growth in applications like automotive, where demand for more fuel efficient and electric vehicles continues to increase, in consumer goods and construction where plastics improve longevity and require less maintenance, and in medical products with an increased focus on safety and improved drug and therapy delivery. We plan to leverage our strong positions across the plastics value chain to cross-sell product lines, expand our combined product offering in key end markets and, over the long run, leverage our combined technical know-how to win in emerging segments, such as recycling and biodegradable plastics. We also see opportunities for growth in other applications, like pharmaceuticals and processed foods.” 

Management expects 3-5% top-line growth for the core plastics businesses. This type of growth would be consistent with their claimed organic growth rates in APS prior to Covid. For APS, food and pharma applications are growing a bit faster than plastics and chemicals. A lot of the growth comes from Asia, particularly for large plastic systems. For MTS, the rates are a bit higher than APS, as the following somewhat dated slide shows:

Management targets investments in organic and inorganic growth to its biggest platforms, playing a trend towards larger scale systems and more technically demanding applications (both areas where they claim to excel). Specific target markets include plastics recycling, food and pharma (where customers are continuing to shift from batch to continuous manufacturing), and bioplastics/alternative plastic materials. They also see an opportunity to grow the aftermarket business, especially with MTS. 

In addition to top-line growth, management thinks they can continue to expand margins using HOM, including transforming and scaling shared functional business processes and leveraging spend through their global supply management team. For the Milacron deal, they expect to deliver $75M of synergies over 3 years. They already achieved $27M in year one and are on pace to do another $25M this year. Applying HOM to Milacron the way they did with Coperion (where they expanded EBITDA margins by 600 bps) suggests there could be upside from those targets.

On the flip side, some Covid-related cost savings from areas like T&E and marketing will come back into the P&L to the tune of around $10M in 2H 2021, and management expects to invest an additional $10M in 2H 2021 into its growth platforms.

Leadership

Kim Ryan will take over as CEO at the end of 2021, succeeding Raver who ran the business since 2013. She is 54 years old and has been with HI and predecessor companies since 2001, including running Coperion and Batesville. She is credited with employing HOM to drive dramatic margin growth at Coperion while growing revenues by 30% from 2015 to 2020. She seems focused on the right things financially (like FCF and ROI) and strategically (focusing on the larger growth platforms by selling off non-core businesses and buying core ones like Milacron), though I’m not thrilled that she could be distracted by her role as Chairman of another public company (Kimball).

HI uses an interesting an unusual incentive structure for long-term comp. It has a bit of an EVA feel to it. Stock awards are made for creation of shareholder value (SV) and relative TSR. SV is measured by cumulative cash returns and final period net operating profit after tax compared to an established hurdle rate over a three-year period and a corresponding service requirement. The hurdle rate is based off WACC and the targeted capital structure.

One negative is that while leadership seems good and the long-term comp plan is thoughtful, insiders do not own a ton of stock. Daniel Hillenbrand, a director and family namesake, is the largest insider with a $12M stake.

Risks and Concerns

HI operates in cyclical markets and is primarily selling capital equipment rather than consumables, making it more vulnerable to end market swings in demand. The current outlook is strong, but this will change at some point when the business cycle reverses. There are some mitigating exposures, like aftermarket parts and services, and the hot runner systems and molds business (which is closer to a consumables business). The big Coperion systems are also longer cycle as they are ordered typically well in advance (like 18 months) and rarely cancelled.

Clearly there is a bet that secular growth for plastics will continue. If that were to change, the need for new capital equipment would be disproportionately reduced. Environmental concerns, particularly for single-use plastics, could play a role, as could higher resin prices (which are heavily impacted by oil and gas prices). 

Rising inflation and supply chain disruption could pose problems (as could tariffs). They generally expect to recover inflationary costs through pricing, though there is a lag. Batesville, which primarily buys steel but also some wood, has the hardest time passing on inflationary costs. In Q3 2021 management talked to $17M of inflation in the quarter overall, of which they were able to offset 60% through pricing actions (80% in the industrial segments and 30% in Batesville). They expect a $25M hit in Q4 2021, offsetting about half through pricing. 

Batesville is declining and that trend is likely to continue as mourners favor cremation over casket burials, and the market within burials shifts into less expensive caskets. These trends are offset in part by increasing deaths and the fact that the declining market should impact smaller players first, allowing Batesville to pick up some market share. Overall Batesville has experienced a roughly 2.5% annual revenue decline. The business has a high fixed cost structure, making it hard to maintain margins as revenue declines (though management has done an admirable job so far). Covid provided a temporary windfall (speaking to the economics, not the horrible human impact) as deaths increased, but the rate of shift into cremation also looks to have increased. This slide is from 2017 but gives a good sense:

There may be a baseline for cremation demand where the business could level out, at which point it would be a nice, stable cash cow. That could be in the 75-80% range based on what management has seen in the state-level data and where Canada sits, vs. around 55% in 2020 in the U.S. Management is aware of the issues and is prudently looking to take cost out and modestly grow share without investing into the business. 

The balance sheet is in good shape with net debt to LTM EBITDA footing to 1.5x.

Valuation

HI is a bit of an orphan stock. There are not great comps, and the business has little in the way of sell-side coverage, with only 4 boutique shops covering the name. The story is relatively complicated with the funeral casket business layered on top of the industrial businesses. The $3.7B market cap is on the small side for many investors.

The multiples at today’s price of around $49 per share look attractive at 8.3x LTM EBITDA and 13.1x earnings. Furthermore, these earnings are a little depressed as sales took a small hit from Covid. However, we don’t think a consolidated multiple is the best way to look at HI, given Batesville deserves to trade at a much lower multiple. Instead, we assume Batesville is worth around $200M and subtract this value from the TEV. This assumption is conservatively based on revenue declining 2.5% a year from 2019 levels (that is, we’ve normalized 2020 and 2021 to remove the Covid impact) while cash costs remain steady at 2019 levels. This leads to positive EBITDA through 2028, at which point we assume they shut it down. If we PV those cash flows at 10%, we get a total value of about $200M for Batesville. After accounting for the Batesville value, we then attempt to normalize the APS and MTS results for Covid. We do this by applying the LTM EBITDA margins for each of APS and MTS to more normalized revenue levels for each (we use 2019 for APS and 2018 for MTS, with both adjusted for businesses since sold off). We add in another $20M of synergies for Milacron net of incremental expected spending and ding the business for all $55M of corporate costs incurred in the LTM. This last assumption is arguably conservative as management might be able to reduce corporate costs without Batesville. That pro forma works out to $428M of consolidated EBITDA excluding Batesville. The multiples on that basis are 10.1x EBITDA and 16.4x earnings. We think that is a more appropriate way to view the valuation. Note that HI also pays a 1.7% dividend yield. 

These pro forma multiples seem too low in today’s market for a high-quality business with longer-term GDP+ type growth prospects and the potential for margin gains under a proven operating executive who is taking the CEO reins for the first time. Perhaps Ryan would also consider selling Batesville rather than running it for cash. That would likely result in a net positive to our valuation and would free up the company to trade as a pure-play plastics equipment business with decent growth prospects and strong margins and returns, perhaps justifying a re-rating.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information. 

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through a partnership that it advises, may hold an investment in the issuer's securities.

Catalyst

- New CEO makes strategic moves