Description

Luxfer is in the early innings of a multi-year recovery after a bevy of cyclical and structural issues have eroded its earnings power and cuts its stock in half. The stock was around $20 in early 2022 when the company laid out a path to $2.00 in 2025 EPS. Shortly after, four primary issues – mostly unrelated (but not all) – caused severe earnings degradation. We believe each of these issues is at an inflection point and will either be resolved or improve in the near term. The stock is not pricing in much of this as 2024 earnings estimates sit only marginally above the 2022 nadir.

Looking out to 2025, we see a tangible path to $1.50 (vs. one sell-side estimate at $1.00), which would put the stock at $21 based on a 14x historical P/E multiple. Furthermore, the company has retained a strategic advisor and could sell one or both of its divisions, which would yield further upside.

Situation Overview

LXFR has a storied history as an obscure industrials company with an inconsistent earnings profile and complexity disproportionate to its size. The company IPO’d in the US in late 2012 at $11 and its market cap, which peaked in 2018 around $750mm, has mostly meandered sub-$500mm and was near its low of $200mm earlier this year. At the behest of activist investors in mid-2017, LXFR brought in an operationally minded CEO, Alok Maskara, who implemented aggressive cost reduction and productivity enhancement programs. By the time Alok handed the CEO reins (he is now CEO of $16bn LII) to #2 exec Andy Butcher in 2022, the company’s turnaround translated into $2.00 of FY25 projected earnings power (vs. $0.87 in 2017) and analysts had an average target price of $27 on the stock.

Optimism quickly faded when a handful of unrelated issues emerged, including 1) significant disruption to the global supply of magnesium, 2) competition from Asian manufacturers in the Graphic Arts business (which swung from $5mm of profit to an equal loss), 3) a muddied outlook for Gas Cylinders as the key driver to growth, alternative fuels, was stagnating, and 4) a legal dispute with the company’s insurance carrier that was costing over $5mm annually. At $12/share, the stock has bounced off the bottom, but sits well below the low $20s price garnered in late 2021 when forward EPS estimates were $1.50, our current estimate for 2025.  Additionally, at 11.3x 2025 consensus EPS estimate (only Sidoti), the market is doubtful of the company’s earnings power and wrongfully assuming these challenges will continue indefinitely.

We believe the stock is worth $21 and should migrate there with 1) positive news flow on improvement in the issues we list below, 2) positive earnings revisions as we estimate 2025 EPS of $1.50 vs. consensus of $1.00, and 3) free optionality that one or both segments are sold.

There are four primary drivers:

• Magnesium (Mg) Supply Disruption in Elektron Easing and Offers $0.35 of EPS Opportunity. Approximately 30-35% of Luxfer’s sales are dependent on Mg supply. In September 2021 the primary domestic producer, US Magnesium, declared force majeure, halting production of Magnesium. Due to the supply shock, Mg costs soared 200-400%. While some of Luxfer’s Mg based end products are inelastic (i.e. defense flares) others are elastic (general industrial end markets), driving demand down. Elektron margins were consistently above 20%, yet finished last year at 10%. The biggest fallout from this supply disruption has been Graphic Arts (a business line within the Elektron segment), which could not pass on price increases due to European competition that had Mg supply advantages. While the issues with domestic supply still persist, over the last few quarters management has successfully contracted alternative sources and signaled costs are starting to improve. We estimate the overall impact at around $60mm of revenues and $0.35to EPS. The financial impact is somewhat hard to gauge given the cost-plus nature of some contracts, which have inflated revenues, with the cyclicality of others. Net-net, Elektron was consistently a 20%+ EBITDA margin business and generated 9.6% margins in 2023. Q1 2024 produced 17% margins and we believe the business should trend to 20% by 2025.
• Growth from Alternative Fuels Should Eventually Buoy Gas Cylinders (Starting with this Summer’s Cummins X15N Engine) Adding $0.20 to EPS. Historically, the Gas Cylinders segment produced great cash flow, but minimal growth. That was expected to change as the company was anticipating a growth renaissance starting in 2023, driven by the market for alternative fuels. To investors’ chagrin, wider adoption of hydrogen fuel systems, which are in large part driven by government infrastructure investments, has been pushed out. The market is giving LXFR no credit for this end market, which we believe could add $0.20 to EPS over the next two years. Timing is always uncertain, but investors have a hard catalyst with the June rollout of the 15-liter Cummins X15N natural gas engine to the heavy-duty trucking market in North America. As a supplier of the gas storage tank to Cummins, LXFR should begin to show growth in this important end market. Management also recently completed an expansion project in Nottingham, England to capture market share in the bulk gas end market. Incremental capacity of that facility is now $30mm. Additionally, we believe the opportunity in the US is quite large in the alternative fuel storage market and offers nearly $80 million of incremental revenue over the next 3-4 years.
• Sale of Graphic Arts Unit and Strategic Review Process. As part of its comprehensive strategic review, the company announced in February that it has begun a process to divest Graphic Arts. This is a significant development, and if consummated in 2024 as planned, the sale would rid LXFR of this low margin, highly commoditized business and $0.15 drag on EPS. More importantly, in October 2023, management stated it is open to divesting Gas Cylinders, Elektron, or both. The announcement marks an important shift in attitude by the current management team, where prior thinking was reluctant to shed even one segment. We believe a sale of one or both segments could yield an additional $5 of value to our $21 target price.
• Insurance Dispute Resolution Adds $0.15 to EPS and $10mm Windfall (4% of Market Cap). For several years LXFR has faced elevated legal costs from lawsuits pertaining to a 2018 accident at a third-party waste disposal facility. The company’s insurance provider had been disputing coverage of these legal costs, but in December finally determined any potential liability from these lawsuits, along with reasonable defense costs, would be in fact be covered. This effectively eliminates $5mm of annual expenses that have been weighing on LXFR, and even more, the company stands to recoup historical costs which we estimate could be $10 million (4% of market cap). The company already recouped $1.3 million in Q1. Our base case assumes they will recoup another $5 million over the next year.

Risks:

• Magnesium supply deteriorates again: Given global magnesium supply largely comes from China, and the primary US supplier is still offline, the market remains fragile. While prices have begun normalizing and LXFR has improved its sourcing, additional dislocations in the market would likely hamper the company’s profitability.
• Competition in alternatives fuels: There are several established players in the market for alternative fuel systems, particularly for transportation applications. While we believe this growing market can support multiple suppliers and platforms, it is still early innings and will be some time before clear winners emerge.

Catalyst

1. positive news flow on improvement in the issues we list below

2. positive earnings revisions as we estimate 2025 EPS of $1.50 vs. consensus of $1.00

3) free optionality that one or both segments are sold