Description

LXFR                                                           

Combination of diverse set of businesses and cyclical headwinds obscure quality and growth prospects; trading at a ~50% valuation discount to peers based on a detailed SOTP analysis

Full writeup with exhibits available here (password is VICLXFR): https://securisync.intermedia.net/Web/s/F4R8YRIX_40X348UJKELDB

Overview

We recommend Luxfer Holdings PLC (“the Company”, “Luxfer”, or “LXFR”) as a long.

Luxfer is a global supplier of targeted advanced materials and high-pressure gas cylinders to customers in a broad range of end-markets.  Established in 1996 with the management buy-in of British Alcan’s downstream assets, the Company has been reshaped by a series of subsequent acquisitions.  LXFR currently operates 18 manufacturing plants in the United Kingdom, United States, Canada, France, Germany, Czech Republic and China.  The Company’s ADR shares were listed on the NYSE in October 2012.

Our Luxfer investment thesis is based on the following: (1) Cyclical headwinds in certain end markets and foreign exchange movements currently mask true earnings power; (2) Meaningful sustained sales growth expected from the Company’s SCBA business; (3) Valuation represents a 50% discount to peers and attributes zero value to near term growth drivers; (4) Ideal template for activist involvement due to unproductive R&D, recent capital allocation missteps, and the disparate nature of business segments, potentially resulting in a sale of some or all of the business.  

Business Overview

Elektron Segment Overview (50% of 2015E revenue; 72% of 2015E EBITDA)

Luxfer’s Elektron division is comprised of two businesses (see Exhibit 1 for segment detail).  Magnesium Elektron (31% of total LXFR 2015E sales; 56% of total LXFR 2015E EBITDA) manufactures magnesium alloys, extruded magnesium products, magnesium powders, magnesium plates, rolled sheets and photo-engraving plates for the aerospace, automotive, defense and printing industries.  MEL Chemicals (19% of total LXFR 2015E sales; 16% of total LXFR 2015E EBITDA) produces specialty zirconium compounds for use in automotive applications, electronics, structural ceramics, aerospace and chemical synthesis.  Elektron is well diversified across end-markets, with no end-market comprising more than 10% of total LXFR revenues.

The Elektron division maintains a strong competitive position due to its proprietary knowledge of magnesium and zirconium metallurgy, and technical expertise.  Our conversations with former Elektron executives indicated that the only way these executives could launch a competitor would be to hire at least twenty of their former Elektron colleagues.  In addition, many of the Company’s Elektron products, especially magnesium alloys and zirconium compounds, are patented.  As a result, Elektron likely is and will remain the sole supplier in end-markets that account for more than 90% of the division’s EBITDA and 60% of total LXFR EBITDA.  Detail by end-market:

1. Photo-engraving (~16% of total LXFR EBITDA): during its review of Luxfer’s acquisition of Revere, the FTC noted that the combined company is the sole supplier of magnesium plates for photo-engraving and that competitor entry was unlikely due to the highly technical nature of rolling magnesium plates for photo-engraving

2. Aerospace alloys (~12% of total LXFR EBITDA): Per management, Luxfer is the sole supplier of magnesium to customers producing magnesium parts for military helicopters

3. Countermeasures (~6% of total LXFR EBITDA): Luxfer is the sole supplier of magnesium powders to Chemring and Esterline, who are the two countermeasures suppliers to the US Department of Defense

4. MEL Chemicals (~22% of total LXFR EBITDA): Per management, most of the applications that MEL Chemicals supplies are highly niche in nature, rendering market share irrelevant

The Elektron division grows roughly with GDP and has the following geographic exposures:  North America (55%), UK (34%), Other Europe (11%).  Importantly, Elektron has almost no direct exposure to Russia or to oil & gas customers.

Gas Cylinder Segment Overview (50% of 2015E revenue; 28% of 2015E EBITDA)

Luxfer’s Gas Cylinders division supplies advanced high-pressure aluminum and composite aluminum/carbon fiber gas containment cylinders for use in healthcare, breathing apparatuses, electronics, fire-fighting, and transportation.  Just like the Elektron division, Gas Cylinders is well diversified across geographies, products and end-markets.

LXFR is differentiated from other cylinder manufacturers by its ability to manufacture very high pressure aluminum and composite cylinders.  As a result of this capability, the Company has been granted difficult-to-obtain regulatory approvals in its key European medical and North American self-contained breathing apparatus ("SCBA") end-markets (which together comprise 46% of division 2015E revenue and 72% of division 2015E EBITDA). LXFR now dominates both of these markets, garnering close to 90% share in each, per our discussions with management and former executives.  

With the exception of the cyclical headwinds and tailwinds noted below, we expect the Gas Cylinders business to grow in line with GDP. The division has the following geographic exposures:  North America (53%), UK (24%), Other Europe (21%), APAC (2%).  

Investment Thesis

1.   Currency translation and cyclical headwinds in certain businesses currently mask the strong growth and earnings power of the remaining segments

Currency translation: 30% of LXFR’s sales are made in euros resulting in a significant currency translation headwind as the euro has depreciated 20% in the past year. During Q1 2015, currency translation accounted for $9mm of the year-over-year sales decline compared to a total revenue decline of $6mm (or a $3mm revenue increase in constant currency).

Rare earth: In addition to currency, the Company is facing a revenue headwind from rare earth surcharges imposed by the Company when the price of rare earth materials spiked in 2012. During Q1 2015 the rare earthe surcharge was $0mm compared to $0.9mm in Q1 2014. Rare earth surcharges were 100% pass through, and the Company did not earn any profit on them.

Alternative fuels: LXFR is also facing headwinds in its alternative fuels (“AF”) business. The AF business sells CNG containers to Class 7 and 8 fleet operators who are looking to convert their fleets to CNG from diesel. The Company also sells cylinders to virtual pipeline operators who deliver natural gas to customers who are located far away from pipelines. AF revenue was down 70% year-over-year in Q1 2015. Perversely, this is a blessing in disguise as the Company has initiated a comprehensive restructuring plan that should return the AF business to profitability compared to a significant operating loss in 2014 as the Company invested ahead of previously anticipated growth. AF revenue was down 67% or $7mm in Q1 2015 over Q1 2014.

Putting it all together, currency translation, rare earth surcharges, and AF contributed $17mm to the Q1 2015 revenue decline compared to an overall decline of $6mm, implying $11mm or 9% yoy growth for the remaining businesses. Stripping out the impact of the Company’s July 2014 Magtech acquisition, overall organic growth was $4mm or 3% yoy, in-line with our expectations for GDP+ growth.

2.   Meaningful, sustained growth expected from the Company’s SCBA business (15% of 2015E revenue and EBITDA) over the next few years  

Self-contained breathing apparatuses are worn by firefighters and other rescue workers while on the job.  Our conversations with industry experts indicate revenue contribution from SCBAs will increase meaningfully.  SCBA spending in North America surged between 2002-2004 following 9/11 with sales 25-50% higher than the years immediately preceding 9/11, per our discussions with SCBA OEMs.  As the average life of an SCBA is between 10-12 years, much of the SCBA gear from that period now needs to be replaced.

In addition to the positive impact from the upcoming replacement cycle, LXFR should benefit from recent product introductions by one of its largest SCBA customers, MSA Safety.  MSA is one of the leading SCBA OEMs with one-third of North American market share.  MSA’s next generation SCBA model, “MSA G1”, is a significant upgrade from the previous one, as it features reduced weight and centralized electronics.  The MSA G1 was stuck in a regulatory queue for most of 2014, but was recently approved for sale during Q4 2014.  Since LXFR is the exclusive supplier of cylinders (which contain breathable oxygen) for MSA Safety’s SCBA, the Company will benefit as firefighting departments place orders in 2015.  During its Q1 2015, sales of MSA’s North American SCBA sales were up 62% year-over-year.

We expect the G1 and the cyclical replacement cycle to drive 15-20% annual sales growth for LXFR’s SCBA business in 2015.

3.   Current valuation represents a ~50% discount to peers and attributes zero value to several near term growth drivers

We believe that Luxfer is significantly undervalued at its current share price.  LXFR should be valued as the sum of its respective businesses and more specifically, the sum of each of its distinct end-markets.  Exhibit 1 is a SOTP valuation for LXFR in which we assign an EBITDA multiple for each end-market based on the valuations of competitors and customers in that respective end-market (see Exhibit 2 for trading comps detail). The SOTP results in an implied valuation of $19 per share, 50% upside to the May 27, 2015 closing price of $12.54.

Given the substantial discount to peers, we believe that LXFR’s current valuation is more than justified by its base business and that no value is currently being attributed to several near term growth drivers that are not yet generating any revenue. We review each below:

1.   Magnesium airplane seats / interiors:

Luxfer’s magnesium alloys offer aircraft fleet operators significant fuel savings over aluminum. The FAA recently approved Luxfer’s alloys to be used in commercial airplane seats, and the Company is currently in prototype stage with three major commercial airplane seat operators. The Company expects sales of magnesium aircraft seats to the major OEs to begin in late 2015. We believe the seat opportunity represents $20mm in incremental revenue and $10mm in incremental EBITDA in 2016.

In addition to airplane seats, aircraft OEs are actively exploring the use of Luxfer’s alloys throughout the aircraft including in floor beams, galley equipment, doors, etc., which would result in a much larger opportunity.

2.   Bioabsorpable magnesium alloys

Luxfer has developed a magnesium alloy called Synermag to be used in bioabsorable stents. It has partnered with a European biotech company that is funding clinical trials in Europe. LXFR expects CE approval in 2016. The European stent market was approximately $500mm in 2014.

3.   Intelligent Oxygen System

LXFR has developed a patented pressure flow regulator that should help it capture more of the $1.4b medical oxygen cylinder market. The Company expects to receive CE certification and begin selling the product in late 2015.

4.   Ideal template for activist involvement potentially resulting in a sale of some or all of the business.

We believe that LXFR represents an ideal template for an activist shareholder due to its unproductive R&D spending, recent capital allocation missteps, and the disparate nature of its businesses.

1.   Unproductive R&D: Luxfer spends ~$10mm on R&D and an additional $5-10mm on product development included in G&A on its P&L. This represents approximately 25% of EBITDA, 50% more than similarly sized specialty materials and chemicals companies (FOE, OMN, FUL, Taminco, etc.). While we expect that the growth drivers above will materialize, most of the projects have been in development for several years, and we are skeptical of the IRR on the underlying R&D spending.    

2.   Capital allocation missteps: by the end of 2015, management will have spent approximately $30mm in M&A, capital expenditures, and operating losses on building out the Company’s alternative fuels business. Given the current state of the business (revenue down 70% in Q1 2015), we feel that this would provide an activist shareholder ample fodder to challenge management’s capital allocation policies.

3.   Complexity: Based on our conversations with management and former executives, there is no business reason for Elektron and Gas Cylinders to remain under the same corporate umbrella.  Due to its status as a conglomerate and exacerbated by its illiquid stock, LXFR trades at a significant discount to its SOTP valuation as shown in Exhibit 1.  We believe that a separation of Elektron and Gas Cylinders via spinoff would make LXFR’s complex businesses easier to analyze and yield a higher combined valuation.

In addition, we believe that LXFR is a potential private equity acquisition target due to its insulated market leading positions, stable growth prospects and profitability.  Given the recent spate of investor activism, we believe it is only a matter of time before either of these events occurs, particularly in light of the Company’s dismal LTM share price performance (down ~30%).  

Finally, we believe that increased shareholder activity may be imminent. Archer Capital Management, which owns nearly 10% of the Company’s shares increased its position by 25% during the past quarter and has filed a 13D on the Company.

Catalyst

Activist involvement, sale to PE, spinoff of divisions, reversal of FX / lapping of FX headwinds, magnesium airplane seat sales