Description

Overview

The Morgan Crucible Company is a UK based producer of carbon and ceramic materials directed towards a wide variety of industrial applications. Since 2003 the company has repositioned itself aggressively toward a broader set of end markets, establishing an attractive mix of businesses with reduced cyclicality. The equity is trading at a low multiple relative to the market and its industrial peers at less than 13x 2010 EPS versus a broad set of global capital goods peers at 17x and in our estimation 8x 2012 EPS versus peers at 12-14x. We believe the opportunity exists due to the market being overly concerned with a 2010 downturn in one of Morgan's defense businesses (19% of 2009 sales), other late cycle businesses, and the level of debt on the balance sheet. As sales and profitability improve we expect the mix of early and late cycle businesses to be seen as a strength and for the equity to be revalued towards 15x 2012 for 90% upside.

Company Structure

Morgan Crucible operates three divisions: Technical Ceramics, Insulating Ceramics, and Carbon.

Technical Ceramics

The technical ceramics division produces specialty ceramics and ceramic materials for customers in industries such as aerospace (20%), medical (20%), petrochemicals (15%), power generation (7%), fire protection (5%), metals processing, etc. Technical ceramics has a mix of early and later cycle businesses making its overall mix early to mid cycle with some less cyclical elements (e.g., medical)

Insulating Ceramics

The insulating ceramics division is broken into thermal ceramics (87% of division sales) and crucibles (13% of division sales). Crucibles are consumables used in metal working and foundry furnaces and are early cycle. Thermal ceramics are used in metal working applications (20-30%), general industrial (20%), petrochemicals (15%), transportation (10%), etc. A good mix of this business is more tied to capex and in turn is more mid to late cycle.

Carbon

The carbon division produces carbon brush and related materials for electrical motor applications. End markets include rail, semiconductors, and other industrial applications. It also houses Morgan's ceramic armor business. Morgan produces ceramic tiles for the US Army's ESAPI body armor. In 2007 they acquired a 49% stake in NP Aerospace, a UK based producer of ceramic tiles for UK military vehicles as well as military and commercial body armor. In January 2009 Morgan increased their share in NP Aerospace to 60%. Morgan will acquire the remaining 40% in four equal installments starting in 2010. In turn, NP's full debt and EBITDA is consolidated in Morgan's accounts without minority interest.

As a whole, then, Morgan Crucible has a very diversified set of end markets, as seen below. 

Defense became the largest segment post the NP Aerospace acquisition. NP Aerospace did 190GBP in revenue in 2009, which was a significant increase on 2008 (note that the 2008 revenue does not consolidate NP) due to sales into the UK Mastiff program. Morgan has guided 2010 NP revenues to120GBP, which would put defense at 15% of revenues in 2010.

Sales are also diverse by geography with the UK at 24% (will be close to 17% in 2010 with the decrease at NP), North America 30%, Europe and Africa 26%, Asia and Australia 24%, and South America 3%. Emerging markets constitute roughly a quarter of sales.

Competition

There are few direct competitors to Morgan Crucible. Publicly traded competitors in carbon include SGL Carbon, Carbon Lorraine, and Ceradyne in armor. Cookson competes against Morgan in insulating ceramics (though more so in crucibles). Saint Gobain also has a division producing ceramics. However, few competitors compete with Morgan across more than a few product lines. In turn, Morgan's markets are not characterized by commodity like competition. 2009's margin pressure came from a 20+% reduction in volume not from negative pricing.

The Opportunity

Given the end market structure and our calls on the various lines of business, we expect the overall business to experience a cyclical rebound on the topline and in margins. The opportunity exists because analysts are concerned about the 30% reduction in NP Aerospace sales in 2010 (6% of sales) and some late cycle elements of the business in both insulating and technical ceramics. Sales in both divisions were down in 2H 2009 versus 1H 2009. However, margins were flat in insulating ceramics and up significantly in technical ceramics on cost cutting and a favorable mix shift. In both divisions, we expect single digit increases in sales overall and flat to slightly up margins versus last year. With a bounce back in the early cycle crucibles business and the non-NP carbon business, sales will be down marginally in 2010 and operating profit will be up slightly. We consider these to be conservative assumptions, and the stock trades at 13x our 2010 number (14.5x trough 2009). By 2012 we believe the company will achieve new peak earnings. In 2008 it earned 23GBp without the full NP. We expect 24GBp in 2012, putting the stock at 7.9x that number. The likelihood of a down year in 2010 versus 2009 assuming an economic rebound is very low.

Revenue Assumptions

We lay out our revenue assumptions in the table below. We consider these estimates conservative. We use management guidance of 120GBP million for NP Aerospace and keep revenues flat from there. This may prove conservative as NP has the potential to win content on the UK's light-protected patrol vehicle (LPPV). 

Note that 2009 sales were helped considerably by the weakness in the pound relative to the dollar (and to a lesser extent the Euro). Sales in 2H 2009 were down 8.4% on 1H due to the late cycle businesses rolling off. We anticipate sales flat to up slightly in 1H 2010 before a more significant increase in 2H. Other revenue growth assumptions could prove conservative.

Margin Assumptions

Our 2012 number does not assume a return to peak margins. NP Aerospace did just under a 15% margin in 2010 and the company has guided to the same margin on the reduced level of sales. We assume the following EBITA margins. 

Technical ceramics did a 13.4% margin in 2H 2009, non NP carbon was at 7.6%, crucibles were at 4% (but is the most early cycle and should rebound quickly), and thermal ceramics was at 7.5%. We don't see any of our assumptions as a stretch with implied incremental margins at 20-30% aside from crucibles (where we assume a quicker ramp in 2010).

Financial Model

The above cash flow assumes a slight drag from working capital in the next several years. Note that the company still needs to pay approximately 40GBP million to complete the NP acquisition between 2010 and 2011. Some analysts still express concerns about the balance sheet. Even in our worse case scenario we do not see any violation of covenants (Net Debt/EBITDA<3x and EBITDA/interest>4x). Finally, the debt is very well termed out with a small slug (11GBP million) due in 2010. The next debt due is not until 2013 (31.6GBP million). The company has a 139GBP million revolver maturing 2012 that they use for working capital needs. With 108GBP million in cash on the balance sheet we do not foresee any issues with the balance sheet.

Catalyst

-Clear evidence earnings have bottomed

-Potential win on the UK LLPV

-Further positive cash flow putting balance sheet concerns in the past