Description
Lydall (LDL) is an opportunistic investment in a high quality business at a very cheap valuation on both an asset and earnings power basis with significant embedded optionality.    

Valuation

Business
LDL has three divisions:
Thermal Acoustic (60% rev/45% profits):  Metal and fiber automobile products that assist in noise and heat abatement.
Performance Materials (36% rev/55% profits):  Media solutions to filtrate air and liquids (2/3); industrial thermal insulation linings used in cryogenics, industrial applications and heat appliances (1/3).
Vital Fluids (4% rev/ no profits):  Blood filtration and transfusion solutions and biotechnology storage containers.

Thesis

LDL is classified as an auto stock as this is the legacy business and majority of revenue but, the real value is in Performance Materials, a low capital intensity, high returns on capital business with a solid growth profile competing in an industry that is growing more than 2x GDP.   

LDL competes in a sub-segment of the filtration and insulation market that is ~$0.5bn and they have anywhere between 15-25% market share depending on the application and only a few peers.    

Peers trade at 7.0x LTM EBITDA, 1.52x P/B and 2.40x TBV (71%, 73% and 135% premium, respectively) and LDL is cheaper by 20+% (LTM EBITDA and TBV) than every peer except a Japanese microcap (it appears to be in decline).   Furthermore, Performance Materials has higher operating margins than every peer except one (PLL) and it grew at a ~4.5% CAGR since 2006 (all organically), which might be the highest in the peer group (can’t exactly ascertain given most of the peers did acquisitions).

Per management, Performance Materials should produce 14 to 18% operating margins.  LTM EBITDA, which is at 12% operating margins, at 6.0x multiple, a 14% discount to peers, and assuming no value for the other two divisions, LDL would be at $9.80 (+13%).  Thermal Acoustic is worth more than $0 and with a better growth and margin profile, Performance Materials should be valued at a minimum in line with competitors.  Other related peers in the filtration space (some are customers but not competitors) such as CLC, DCI, PPO and CCC trade at 12.0x EBITDA.  Finally, there is consolidation as direct competitor Millipore was acquired last year by Merck KGaA at 14.6x EBITDA.

Temporary issues, most notably in Thermal Acoustic, obscure LDL’s true profitability.  In 2010, despite North American auto production at levels last seen in the early 1990’s, the Thermal Acoustic division posted all-time high revenue.  To accommodate this business, LDL added significant assets to their existing facility and incurred premium freight and outsourcing costs to meet customer deadlines resulting in losses in their fiber segment in this division since Q3 2010.    

Per history and management, Thermal Acoustic should be a 5 to 10% operating margin business.  Assuming no revenue growth, this would mean an additional $1 to $13m in operating profit.  Notably, in seasonally weak Q3, the fiber segment broke even and Thermal Acoustic produced 4.9% margins leading me to believe that operating profit upside is at least somewhere in the $4m+ range, which assumes no revenue growth. 

LTM Performance Materials is performing below its 14-18% margin potential and getting to 14% or 16% would mean an additional $2.5m and $5.3m in operating profit, respectively.

Supposedly LDL is on the cusp of landing some material wins in the Vital Fluids division and as such, we think it is likely to break even in 2012 at a minimum.   As an aside, they invested over $3m in this division since 2009 and Management claims that there has been no return yet due to delays in the regulatory and qualification process with customers that is now in the concluding stages. 

Management is working on reducing the Corporate expense line but we have no way to quantify this.

The company had a fourth segment, Affinity, which made chillers for the semiconductor industry.  They owned this business since late 2001 and never realized any profits until recently, which they subsequently announced the sale of the division on June 30, 2011 for $14m (9.2x LTM EBIT).  This is a very favorable transaction as this was a non-core business with no profitability and unpromising growth prospects sold at a nice multiple (higher than LDL’s valuation). 

On July 1, 2010 LDL sold its electrical papers product line for $4.8m cash and $1m more by the end of 2012.  This was a non-core asset that was immaterial to LDL financials (the multiple is so high that it is meaningless).

We would not be surprised if Thermal Acoustic is sold.  On prior earnings calls and investor conferences, LDL indicated that staying in the Thermal Acoustic business is high on their mind regarding overall strategy.  Similar to the playbook on the Affinity sale, once Thermal Acoustic performs at a reasonable level of profitability, it is very realistic for this division to be sold, which would generate much more than  $50m in proceeds. 

We give Management credit for driving organic revenue growth above industry levels and for not using their substantial cash stake to make acquisitions however, from an operations and financial controls perspective, this team is not good.  All three of the segments are operating below potential due to subpar management.  The company had two accounting restatements in 1 year (both restatements considered non-material but material cumulatively). The accounting restatement plus operational mismanagement caused the stock to fall 17% after Q3 earnings results. LDL realizes that Management has underperformed.  Management has no margin of error and if the near term results are weak, we think it is likely that they will be replaced.  New management would be very positive for shareholders.  Many industrial companies are operating near peak performance even in the face of weak revenue growth due to professional management teams driving productivity and efficiency gains (LDL is aware of this).  LDL has excellent growth prospects however, they severely lack a capable management team.  If a new management team came in and applied Management 101 techniques, there would be huge improvement in earnings without needing any revenue growth.   Secondly, LDL realizes it is overcapitalized and does not require much future capital investment as they continue to focus on Performance Materials thus; it is possible that within a year LDL will return cash to shareholders. 

5.  Attractive Standalone Valuation

With two unrelated divisions, LDL has no direct competitors but the peers highlighted in their proxy statement used to determine Executive Compensation trade at 9.1x LTM EBITDA, 1.44x P/B and 2.27x TBV (122%, 64% and 123% premium, respectively).  Of the 14 peers in the proxy, only 1 company is cheaper on P/B and 2 on a EBITDA and TBV basis, respectively. 

Note that current valuation is the result of significant operational underperformance and the company is valued at an extremely low absolute and relative multiple on these results. 

As previously stated, we believe Performance Materials is worth more than the current EV and there is significant value in Thermal Acoustic too.  Peers here trade at 4.5x LTM EBITDA (excludes legacy liabilities - if included would result in a higher multiple), 1.84x P/B and 2.86x TBV (10%, 109% and 180% premium, respectively).  Thermal Acoustic has better operating margins than auto peers and it significantly outperforms global auto production (since 2006 they beat each year by 2% to 32%). 

With better margin and growth prospects, this should trade above peers. 

Furthermore, this division has significantly more than $50m in net tangible assets and most peers trade above 2x net tangible assets. 

There are ~$13m in corporate costs (Corporate line includes owned HQ), which we capitalize at a blended multiple of the two divisions. 

We could make normal assumptions on multiples and improved operating performance in line with history and derive a much higher valuation than the High case however, the point is LDL is significantly undervalued in any scenario at current levels. 

Margin of Safety

1. Valuation
2. Fortress Balance Sheet: 21% market cap in cash, trades at tangible book, book is comprised of cash, other current assets and tangible LT assets (real estate)
3. Business Quality: Performance Materials is a great business.  Thermal Acoustic is an above average auto supply competitor
4. The management team has no margin of error.  If they do not improve, it is likely they are replaced.  New management would be great for shareholders.

  Risks

1. Management is not good.    
2. Management blows the cash on an acquisition. 
3. Significant deterioration in the global economy.