Description
SUMMARY: MacDermid has been in existence since 1922 and trades under the symbol MRD (NYSE). MRD describes itself as being in the international business of researching, developing, acquiring, manufacturing, marketing and servicing specialty chemicals and systems for the optimum profit of itself and its customers in the metal and plastic finishing industries, electronics, graphic arts, and offshore oil industries. MRD has ambitious goals: to be one of the world’s great industrial companies and to increase intrinsic value per share, defined as present value of free cash flow, by 25% a year. After a 10x increase in share price from 1994 to 1999, during which time MRD had an average ROE of 22% and EPS growth rate of 37%, the share price of MRD has declined from $46.50 to a low of $15.50 during the past two years. I think the main reasons for this decline have been charges related to a number of mergers and acquisitions that the company made during the past few years, the current economic slowdown, and investor perception that MRD has too much debt. However, I believe that MRD is an outstanding business (razor and razor blade type of company) and an attractive long-term (5 to 10 year) investment at its current price of $17.50 per share. I believe this price reflects a 20% to 40% discount to fair value. Using a conservative 10% per year estimate for earnings per share growth rate, I feel there is a high probability of achieving a pre-tax return of 20% per year over the next five years. If MRD executes as it has in the past, the pre-tax returns could be substantially higher (25% + for much longer periods of time).
THE COMPANY: To show why I think MRD is a good business and has a high probability of being a good long-term investment, this section contains a fairly lengthy of description of MRD, its operating principles, and its recent history.
MRD is in the business of researching, developing, acquiring, manufacturing, marketing and servicing specialty chemicals and systems. Specifically, the company offers consumables, products, systems, and services to different industries that require specialty chemicals and other consumable products. The company seems to concentrate on industries where it believes it can eventually be both the low cost supplier and the technology leader and innovator. The company currently manufactures and sells about 5000 proprietary chemicals. Sales of these chemicals and consumables account for 88% of revenues, 20% of which have patent protection. The remainder of revenues comes from the manufacture and sale of printed circuit boards (4%) and process equipment related to its specialty chemicals and other consumables (3%) and the resale of products of made by other companies (4%). Fifty percent of sales come from overseas as the company operates in 23 countries. As an outsider, it seems that MRD has consciously structured its business as a razor blade company - selling many blades (chemicals and consumables) without having to spend large amounts of money to develop and sell razors (the manufacturing and printing processes).
Currently, the company divides itself into three main groups – Advanced Surface Finishes, Graphic Arts, and Printed Circuit Board Manufacturing. I have further divided Advanced Surface Finishes into two areas: electronic chemicals and industrial products (metal and plastics finishing). Printed Circuit Board Manufacturing is a new, relatively small part of the company that accounts for only $35 M of revenues.
Electronic chemicals are used in the manufacture of printed circuited boards and semiconductors. The market is attractive because its rapidly changing technology and high long-term growth rate (8% to 10% per year mirroring the overall electronics industry) should provide MRD with many opportunities for future growth. Until 1997, this area made up the bulk of MRD’s revenue (~250 M), and it was the only full line supplier to the printed circuit board industry. Although MRD has operated in the electronic chemicals business since the 60’s, the business risk of being made obsolete by a radical innovation made management undertake a strategy of diversification by acquisition and internal investment beginning in 1990.
Through a series of acquisitions and mergers and internal investment, MRD transformed its existing (in operation since 1922) industrial metal finishing business into a worldwide leader (~200 M in revenues compared to $30 M in revenues in 1990). The company believes that its size now gives it a significant competitive advantage over its competitors, especially in terms of R&D investment. MRD’s industrial products division currently supports a full range of processes including surface preparation, cleaning, electroplating, electroprocessing, phosphating, and specialty coating of a wide variety of materials. These processes are mainly used to prepare metals and plastics for further manufacturing processes, provide corrosion protection in automotive, construction, and electronic applications, and put decorative coatings on materials. Although metal and plastic finishing may seem to be a mature, grow-at-the-pace-of-the-economy industry, I believe that as product and manufacturing requirements become harder to achieve, the specialty chemical market for industrial metal and plastics finishing will grow at a slightly faster rate than GDP. Two examples: twenty years ago, cars routinely rusted within ten years, but now thanks to added steps such as galvanizing and electroplating, most cars don’t rust unless damaged. Ten years ago, the heat sink on performance electronics was made out entirely out of aluminum; now most high-end heat sinks are made from copper and aluminum and the aluminum has to be plated to enable it to be soldered to the copper.
MRD has also become a dominant player in two segments of the graphic arts business – flexographic printing and offset printing – through its 1995 acquisition of the electronics chemicals and printing divisions of Hercules Inc. and its 1999 acquisition of PTI (Polyfibron Technologies – a division of W.R. Grace that has been in operation since 1946 and was bought out by the division’s management with backing from Citicorp Venture Capital in 1995). Sales of chemicals and products to the graphic arts industry now make up the largest part of MRD’s revenue (~$300 M). Currently these revenues are split about two to one between flexographic and offset printing consumables, which favors MRD in the long run since the industry is moving from offset printing (growth slightly less than GDP) to flexographic printing (growth at 1.5x to 2x GDP). As in the industrial products group, the company now believes that it has achieved the critical mass in the graphic arts business to give it significant competitive advantages over its smaller competitors, especially in R&D. In a relatively short time, the company has introduced a number of new products for these market segments. The graphics arts division also contains a small business that sells wide format digital printers.
The specialty chemical industry and printing consumables industry is highly fragmented, and MRD has many competitors (over 100 in some product areas). However, most of these competitors are local or regional. Only a few compete globally against MRD, and the company does not believe that any of them competes against all its products. The company now believes that it is a leading worldwide supplier of consumables and systems in both segments of the printing industry within which it operates and is one of the top three worldwide suppliers in both electronic chemicals industry and chemicals for metal and plastics finishing industry. In flexographic printing consumables, MRD and Dupont are the market leaders, each with roughly 30% of the market. In offset printing consumables, Reeves Brothers (16%), Day International (26%), and MRD (16%) are the major suppliers. Specialty chemicals for industrial metal finishing in North America and Europe is split three ways between Elf Aquitaine (Atotech and Atochem divisions), Cookson Group, and MRD, with MRD having about 30% market share in each region. None of the major companies have been able to establish a presence in Japan, and small local “homebrew” companies dominate Southeast Asia although MRD is prepared to enter this market as major manufacturers expand there and local manufacturers demand higher quality processes. In electronic chemicals, there are three major suppliers of approximately equal size: Rohm&Haas (Shipley, Morton, & LeaRonal divisions), Cookson, and MRD. MRD has 14% of the American market, 13% of the European market, and 7% of the Asian market.
I believe the management of MRD is quite good. In the past ten years, they have transformed a small company in the electronic chemicals and electroless nickel-plating businesses into a worldwide company operating in three industries. More importantly, I feel the management has created a company with an outstanding business structure. From the website and the company filings, it is obvious that the management has studied the writings of Buffett. They are focused on creating a high margin business with defendable competitive advantages. On the supply (cost) side of the profit equation, the company lives up to its Scottish heritage. It focuses on and drives to lower costs, both through a lean business structure and by striving to stay ahead of competitors in terms of know-how. On the demand (revenue) side of the profit equation, its focus is on acquiring and retaining customers by building customer relationships, trying to provide the best technologies, customer service and delivery, and providing a full product line for each industry (one-stop shop). With its acquisition strategy of the past few years, I think that the company also understands that acquiring major customers now while the specialty chemical industry is still somewhat fragmented will be much cheaper than trying to convince them to switch after the industry has consolidated. From its filings, it understands the advantages of scale, and the company seems to think it has achieved critical mass in research and development in each of the three industries that it serves. Its institutional knowledge base of chemicals, materials, process engineering, and application specific engineering should provide it with competitive advantages that only increase with time if they are well managed. It was not clear from the company filings whether they had achieved any economies of scale in distribution or purchasing from their acquisitions yet.
Other Berkshire-like characteristics: The CEO, Mr. Leever views shareholders as long term partners whose gains or losses in the market should track the value of MRD’s businesses. He also operates with a long-term investment horizon, attempts to take care of employees, retains about 95% of earnings to grow the business instead of paying dividends, and provides clear and candid accounting and reports (even reporting owner earnings using Berkshire’s definition and reporting earnings per share as if the pro forma cost of stock options had been treated as an expense). Finally, as a long-term investment, MRD is high enough in the supply chain that energy or raw material inflation will have less of a detrimental impact on MRD than on companies further down the supply chain.
The only deviation from Buffett-like principles is the debt the company took on in making 14 acquisitions since 1990. The management of the company believes these acquisitions were necessary to reduce the business risk of being almost entirely dependent on the electronics chemicals business. The CEO may also lose credibility with some investors for his over-the-top references to “clan MacDermid”. However, since I view part of a CEO’s job to lead and not just manage, anything that gets everyone on the same page and working toward the same goals is fine with me.
There were only two things that concerned me about the company: 1. the debt and 2. the recent addition of two product lines that I did not think fit the razor blade business model – wide format digital printers and printed circuit board manufacturing. Even though the company has large, fairly stable cash flows and I agree with the reasons the company took on the debt, my personal preference for a long-term investment is a company with a debt-to-equity ratio less than 0.3. I hope that the company reduces the debt-to-equity ratio as fast as reasonable (preferably through top line growth).
Although they are small, niche businesses, before talking with the company, I was concerned about both the wide format digital printer and printed circuit board manufacturing businesses of MRD. Compared to the rest of MRD, they are both low margin business that will require a higher ratio of maintenance capital expenditures to revenues produced. MRD is not a leader in either business and will have a hard time competing with more established, better-financed competitors such as Hewlett Packard or Flextronics. I also thought that MRD’s entry into printed circuit board manufacturing would not sit well with some of its customers in the same business. After talking with the company, I learned that wide format digital printer business was a cheap way of acquiring R&D on digital printing. The company believes that the printing business will eventually go digital and wants to be ready with appropriate consumables and processes. Its goal is to operate the business at breakeven and learn as much as it can about digital printing. As for the printed circuit board manufacturing business, it is basically a demonstration business that the company created in the hopes of steering the low end of the printed circuit board manufacturing industry toward its Via-Tek process. The company’s Via-Tek process can manufacture commodity printed circuit boards (single layer one sided and double sided boards, not the high-end multiplayer backplanes that a company like Teradyne makes) 15% cheaper than the current methods. The company could not get any of its customers to be the first ones to try the process, so through a joint venture with one customer it opened a demonstration plant in Spain and another in Chicago. Due to the economic slowdown and poor management, the Chicago operation lost money and was subsequently closed. The Spanish facility is doing well. Needless to say, I was relieved to hear that the company did not intend to “di-worse-ify” away from its attractive razor blade like business model.
Why did the stock price drop by 60% over the last two years? The simple answer is that after growing rapidly the previous few years, earnings per share dropped from $1.72 in 1999 to $1.40 in 2000 and $1.07 in 2001, and the PE ratio contracted from 24 to 15. This drop in share price was due to costs related to the merger and acquisition activity of the last two years and the lower earnings from the graphic arts business and electronic chemicals due to the slowdown in the economy. MRD has acquired 14 companies since 1990 – the two largest within the last three years. In 2000, earnings were reduced by ~$0.27 per share due to merger costs and extraordinary events while earnings were reduced by ~$0.25 in 2001 for merger, restructuring, and impairment charges. Due to the acquisitions, amortization of accounting goodwill now reduces earnings by about ~$0.38 per share over 1997 levels although I believe the economic goodwill associated with these acquisitions is probably increasing. After the PTI acquisition, the graphic arts business had been managed separately from the rest of the company. When the economy slowed last year, operating profits dropped more than expected in this division, prompting a management shakeup and a restructuring. The CEO took over the management of the graphics arts business to get its cost structure in line with the rest of MRD. After closing the Billerica, MA administration facilities and eliminating 165 overlapping managerial positions, MRD expects to save about $15 million a year. In its printed circuit board manufacturing division, MRD also closed its Chicago Via-Tek operation, which had been losing $8 million a year. These two moves should increase earnings by ~$0.44 per share. Earnings were also reduced because 30% and 15% of MRD’s sales are to the slumping electronics and automotive industries.
Concluding the qualitative description of the company, the main owners of MRD are its management, directors, and employees (16.9%), Citigroup (14%), Ruane, Cuniff, and Company (6.6% - Sequoia Fund holds 4.5%), Vanguard Primecap (6%), Fleetboston Financial Corporation (5.0%) and Tomas W. Smith (5.0%). As a value investor, I should mention that the Sequoia Fund purchased the stock last year at approximately $28 per share.
FINANCIAL ANAYSIS: This section provides my financial analysis of MRD. It includes key financial statistics and analyses of whether the company can easily service its debt, investment margin of safety, and high probability return on investment.
Key Financial Statistics:
(in millions)
Year 2001 2000 1999 1998 1997
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Net Sales $795 $758 $612 $528 $293
Cash From Operations $ 59 $ 60 $ 80 $ 55 $ 49
EBIDTA $131 $144 $135 $104 $ 86
Capital Expenditures $ 22 $ 24 $ 20 $ 14 $ 7
Net Earnings $ 35 $ 45 $ 55 $ 30 $ 28
Free Cash Flow $ 34 $ 33 $ 58 $ 40 $ 29
“Owner Earnings” $ 43 $ 36 $ 60 $ 42 $ 38
Total Debt $472 $411 $410 $126 $ 92
Equity $231 $213 $163 $106 $ 88
ROE 16% 28% 51% 34% -
ROE based on “owner earnings” 20% 22% 56% 48% -
*ROE calculations are my estimates because I could not figure out how the company or ValueLine obtained their numbers
Book Value per share $7.11 $6.57 $5.04 $3.03 $2.72
Earnings per share $1.07 $1.40 $1.72 $0.92 $0.83
“Owner earnings” per share $1.34 $1.12 $1.87 $1.31 $1.18
Earnings per share if stock $1.01 $1.34 $1.68 $0.92 $0.83
option cost had been expensed
Gross Margin 45% 47% 48% 49% 51%
EBIDTA Margin 16% 19% 22% 22% 20%
Pre-Tax Margin 7% 10% 14% 11% 13%
After-Tax Margin 4% 6% 9% 6% 6%
Price to Sales 0.7x
Price to Earnings 16.7x
Price to Cash Flow 10.5x
Price to Free Cash Flow 17x
Price to “owner earnings” 13.0x
Price to book value 2.4x
Shares Outstanding 31 million (32.4 million fully diluted)
Tax Rate 37%
Cost of Debt ~8 to 9%
Ability to service debt: MRD has a pretty leveraged balance sheet with $460 million in debt, $230 million in shareholder equity, $126 million in working capital, and $13 million in cash. The high working capital is needed because the company carries a significant inventory ($141 million) to meet customer orders in a timely fashion. Despite this degree of leverage, I believe MRD will not run into problems servicing its debt even if the economy goes into an extended recession. The company has stated that they are not comfortable with a total debt to EBITDA ratio much higher than 3.5 and they do not intend on making more acquisitions in the near future although they see many attractive long-term opportunities. In a bad year, the company’s cash from operations was more than twice the interest payment. Also, MRD’s capital expenditures of ~$22 million per year during the past three years are deceiving because only $5 - $8 million was maintenance; most was spent on R&D or investing in new growth opportunities. This also explains some of the discrepancy between MRD’s reported “owner earnings” and the more conventional free cash flow in the table above. The company believes its cash flows should be relatively stable, even in a recession. Fifty percent of its costs are variable, related to raw material for products, and its employee compensation can vary as much as 20% because it depends on bonuses linked to company earnings. In addition, an economic slowdown affects MRD less than its customers. Many of MRD’s products require fixed amounts to be used during production, regardless of production volume. Finally, as mentioned earlier, the restructuring of the graphic arts business, closing of the ViaTek facility in Chiago, and end of acquisition related charges should add $36 million to pre-tax income.
Investment margin of safety: By a number of methods, I obtain a fair value for MRD between $22 and $29 per share. Assuming no change in revenues, when you add back the charges for the mergers ($0.25) and the savings from the restructurings and the closing of the ViaTek facility ($0.44), the adjusted earnings should be ~$1.76. With a PE ratio of 15, I get $26 per share. Adding back the $36 million of charges and saving to EBIDTA to get an adjusted EBIDTA of $167 million, using a 7x multiple, and subtracting debt, I get a fair value of $22 per share. Assuming a 10% earnings per share growth rate (ValueLine estimate), WACC of 9.5%, year 0 “owner earnings” of $60 million (adding back charges and savings yet again), and a terminal value of 15x year 10 “owner earnings”, I get an enterprise value of ~$1.4 billion. Subtracting out the debt results in a fair value of $29 per share. Based on these numbers, the current price of $17.50 reflects a 20% to 40% discount to fair value. Also, you can add ~$5.70 per share to my calculation of intrinsic value by factoring in the ~$0.38 per share reduction in earnings due to the amortization of accounting goodwill.
High Probability Investment Return: If we assume a conservative 10% growth rate of earnings starting from the adjusted level of $1.76 per share, in five years, earnings per share should be around $2.83. With a 15x multiple, the share price would be $43 resulting in a 20% per year pre-tax return. With a 15% growth rate assumption, the respective numbers become $3.53 per share earnings, $53 per share price, and 25% per year pre-tax return. With a 20% growth rate assumption, the respective numbers become $4.38 per share earnings, $65 per share price, and 31% per year pre-tax return. Although the 10% earnings per share growth is the high probability scenario, the 15% or 20% growth scenarios are not out of the realm of possibility if MRD executes as they have in the past; they did grow earnings at 37% per year from 1994 to 1999 using the same type of business model.
I think I am being fairly conservative in my estimates, but I would appreciate feedback from the club since I don’t normally make large, long-term investments in companies with a lot of debt (MRD this year, Tricon and Waste Mangement last year). I would specifically like help with assigning appropriate multiples for EBIDTA-maintenance capital expenditures, cash flow from operations etc. for companies that sell products or services and multiples of EBIT for companies that collect fee income such as royalties or franchise fees. In assigning these multiples, I assume that you already know the appropriate growth rate. I am looking for this help because I normally invest in companies with low debt, and I don’t like discounted cash flow analyses because I find that small changes in assumptions result in large differences in valuation.
Catalyst
CATALYSTS: Nothing in the short-term except a possible earnings surprise when costs related to mergers and acquisitions end and savings from closing the Via-Tek facility in Chicago and restructuring of the graphic arts business are realized. The stock may tread water for a while. Long term – a good business at an attractive price.