Description

Investment Thesis: 

I think Ferro is an actionable investment for VIC readers with a number of near-term catalysts that should drive near-term upside.

Ferro Corporation is an underfollowed, orphan specialty chemical stock that has quietly realigned its business model from an asset intensive commodity chemical business to an asset light specialty coatings business. 

At 9x 2016E P/E, 8x EBITDA-Capex (vs. peers avg. of ~18x P/E, 16x EBITDA-Capex), FOE is in the early innings of a compelling growth story, which offers investors multiple ways to win and a cheap call option on multiple expansion. At current levels, I believe Ferro has limited downside risk and can be worth $20-$22 in the next 12-18 months or a +75% return. Further, as detailed below, there are multiple near-term catalysts which I believe will deliver a significant re-rating to FOE's stock in the next 3 to 6 months - allowing investors to capture a majority of the upside upfront.

For FY16E, I lay out a clear path to $1.26 in FY16 EPS (assuming no growth, no acquisitions or buybacks - despite each being in managements plans) - applying a below peer multiple of 16x (despite in-line margins and an ~18% 3yr FCF CAGR) to get to $20, +75%. If I were to assume incremental acquisitions, in-line with management's stated goal of spending $100m-$150m, (in FY15 YTD, management has spent ~$200m) at an initial 12% after-tax ROIC yields EPS north of $1.40 or 95% upside (note, expectations are for ROIC on acquisitions to go to 15% long-term).

Business Overview (detailed business overview below)

Ferro is the global leader in the functional coatings and color solutions space. The company reports its earnings in three segments: Performance Coatings (53% of FY14 PF sales), Performance Colors & Glass (29%) and Pigments, Powders & Oxides (18%) and holds 1 or 2 market share positions in each of its segment.

Business Transformation / Thesis Inflection Point

Since 2013, when new management was put in place, Ferro has quietly transformed its business by divesting its lower quality, non-strategic businesses (Solar paste, Pharmaceutical, Specialty Plastics, Polymer Additives, and Precious metal powder and flake) creating a more focused cohesive functional coatings and color solutions business. Through this process the company has trimmed its bloated cost structure, deleveraged its balance sheet (~1x PF net leverage) and developed a renewed focus on effective capital redeployment.

Only 2.5 years into the turnaround, management has meaningfully improved gross margins across each of the company's core segments (see table above - including performance coatings despite underwhelming organic growth). Total gross margins has improved by 10% from 21% to 31% (Q312 vs. Q315 run-rate), EBITDA margins have tripled from 5% to 17.4% (2012 vs. Q315 run-rate) and management has created a culture focused on "after-tax" return on invested capital, which has more than doubled in 2 years from 5% in Q312 to 13% Q3-15 (management expects to deliver after-tax ROIC of +15% in 2016). With a significant part of the cost cutting transformation and asset sales done, and limited capex needs ($40m annually with half for growth, ~2% of sales maintenance capex), FOE has clearly reached a timely inflection point as management shifts to stage 3 of FOEs transformation - growth. I expect FOE to generate meaningful free cash flow which I model growing at an 18% CAGR over the next 3 years (9% FCF yield in 2016) and high returns on invested capital (15% in 2016) while continuing to improve margins and returns on capital via acquisitions and pricing improvements.

Multiple levers to drive double digit earnings growth

What makes FOE's growth story exciting is that in addition to internal growth opportunities, FOE's industries are highly fragmented, and the Company's scale (number 1 or 2 market position across each of its products) and balance sheet make it a preferred acquirer. I believe management can continue to create value through organic growth initiatives and incremental bolt-on acquisitions that should provide meaningful upside optionality.

Management believes FOE can grow top-line at global GDP+ or ~4%. With the exception of coatings, (due to capacity constraints) FOE has largely exceeded this goal in 2015 while improving margins across each segment (including Performance Coatings). In addition to underlying global growth, FOE's new product pipeline is expected to add 1% to annual growth. FOE estimates its five year product pipeline at $300m on a risk-adjusted basis. Further, despite the recent weakness in Performance Coatings, growth should resume in 2016 as FOE's new capacity in Indonesia & Turkey comes online and capacity from the company's recent acquisition of Al Salomi is utilized.

Further, I believe FOE can grow organic sales next year due to the PPO and Color & Glass segments continuing to show stable growth (Ex FX and Acquisitions, PPO grew +7% organically ytd and PCG +2%).  For every 1% organic growth out of PPO PCG combined Performance Coatings would have to decline by a comparable amount in 2016 for organic sales growth to be flat. Notably, given the margin differential between the segments (Coatings has lowest GMs) it’s closer to 1.5x to 1.0x ratio in order for organic earnings to be flat. Therefore if PPO and Color & Glass grow 2-3% organically next year Performance Coatings would likely have to decline 3.0%-4.5% organically in order for organic earnings to be flat.

Organic growth initiatives, is only one small piece of the FOE growth algorithm. FOE has set a clear path to grow earnings double-digits through high quality bolt-on acquisitions. Over the past year, Ferro has made 3 solid acquisitions at very attractive prices, Vetriceramici (2014, 4.9x synergy adjusted EBITDA), Nubiola (2015, 6x) & Al Salomi (2015, 5.7x) (FOE also acquired a very small company called TherMark). Management believes that there are 40-45 bolt-on acquisitions in their pipeline and FOE intends to make "at least" $100m-$150m worth of acquisitions annually (conservatively). Given, my belief that FOE’s management team are thoughtful acquirers, along with its improved Balance sheet / FCF generation and ability to go upwards of 3.5x levered (~1x PF 16E) - I believe Ferro can, for all intents purposes, make these type of acquisitions into perpetuity.

To illustrate, FOEs underwriting criteria assumes a $100m acquisition should provide $12 million of NOPAT, or a 12% ROIC initially, going to 15% over the following few years, and $0.13 accretion to EPS. Assuming a purchase price of 1.4x sales (avg. of the Vetri and Nubiola acquisitions) and simple assumptions for D&A at ~5% of sales (in-line with the Vetri and Nubiola acquisitions), FOE has a clear path to double digit EPS and EBITDA growth over the next 3-5 years if Ferro simply closes just one Vetri or Nubiola-type acquisition per year.

Furthermore, I believe there is upside to Nubiola accretion guidance for 2016. Ferro stated that it expects realize “at least” $0.15 (current street estimates) of accretion from Nubiola in 2016 and for the acquisition to hit an after-tax ROIC of 12% year 1 of ownership (mid-2016) and work towards 15% within a reasonable period of time. As can be seen below, working backwards from $0.15 of accretion to get to a ROIC calculation implies an after-tax ROIC of only ~9%; however, applying a ROIC of 12% and working down implies an accretion of $0.20, working to $.25 cents over time. Therefore, I believe management has guided conservatively and there is likely upside to Nubiola’s accretion targets.

Macro Tailwinds Formulating Will Provide Additional Upside

Another driver to potential upside is macro trends turning into a tailwinds. Investors have been growing increasingly optimistic with respect to Europe, particularly on the automotive industry where Ferro has strong exposure. Europe is FOE's largest geographic end market representing ~45% of sales, and continued improvement in this economy would meaningfully accelerate organic sales growth. There are 3 major catalysts driving my optimism, including the weaker currency improving exports, quantitative easing supporting investment, and low oil prices acting as a stimulus to consumer spending. Notably, this largely resembles what the U.S. looked like back in 2011 right around the time the recovery accelerated with a weak currency, quantitative easing, and low energy prices (natural gas). Furthermore, as previously mentioned the auto industry is coming around with vehicle registrations up 9% in 3Q15. The auto industry was a first mover in the U.S. which could also be happening in Europe.

Event-Driven / Catalyst Path:

Q2 Noise / Conservative Guidance Creates Initial Upside Opportunity

After 9 consecutive quarters of significantly exceeding consensus estimates and raising forecasts, FOE missed consensus EPS numbers in Q2-15, ($.20 cents vs. $.25 cents) and lowered 2015 guidance. This was the first time FOE missed numbers since new management has been in place, the latter sent the stock down 18% with the stock further retrenching when global growth concerns arose in markets August (down -34% since its pre Q2 highs). FOE's results disappointed primarily on weakness in the company's Performance Coatings segment with value-added sales down 7%, as tile manufacturers took downtime. Further, manufacturing capacity constraints which management called out weighed on volumes. I believe this weakness was transitory and should recover during 2016, particularly as FOE plans to add organic capacity in 2016. Further, FOE's most recent acquisition Al Salomi, will bring in additional capacity to FOE's operations in Egypt, where the Company has been running at capacity in the recent past. The transaction will also complement the operations in Turkey, where FOE intends to ramp up its topline growth for tile and porcelain products to cater to the favorable demand trends in the region

Subsequently in Q3-15, management beat consensus ($.24 cents vs. $.22 cents), while maintaining guidance. However, FOE subtly highlighted on its 3Q15 call that Q3 results excluded a non-recurring purchase accounting adjustment of $5.8M, which would have added $0.05/share to EPS and will be a sequential benefit to Q4-15 earnings.

I believe there is significant upside to consensus numbers in Q4. Note, historically, FOE has talked down Q4 numbers and in each of the past 2 years FOEs new management has been in place they have significantly exceed street estimates - notably by 50% and 44%, in Q4-13 and Q4-14, respectively. As I layout below, even assuming the low-end of managements guidance on virtually every metric investors can get to ~$.87 cents (high end of guidance vs. consensus of $.84) in EPS in FY15, this is before assuming a $.03 ($.90 cents) cent accretion from FOEs $33m remaining buyback plan, which management intends to fully utilize. Note, the below will result in a "pre-buyback" Q4-15 EPS of $.20 cents (+18% beat) assuming the low end of each metric of managements guidance and $.23 cents (+35% beat) at the mid-point of FOES guidance. Further, from a margin of safety perspective, even assuming FOE reported organic sales down -5% (vs. 1 to 2% guide) and margins to miss by 225 basis points (vs. midpoint of 10.25%), FOE would still come in at the low end of their 2015 guidance.

As a result, I believe the sell-off post Q2-15 was significantly overdone and FOE's FY guidance remains largely intact and FOE is setup to significantly to beat Q4 estimates that should deliver a significant re-rating to the stock.


FY2016 Estimates Appear Equally Conservative

Furthermore, I not only believe that the valuation remains attractive on current estimates but there is also likely more upside potential than downside risk to the denominators in the EV/EBITDA and P/E multiples. For instance, FOE has called out that the company can reach +$200m of EBITDA in 2016 (vs. $187m consensus). As can be noted below, given the significant margin improvements to the business, acquisitions and synergy realization, FOE can largely get to $200m in EBITDA on "self-execution" alone - without the help of any organic growth. As a result, the latter de-risks the investment for investors significantly.

Call Options on Value Creation

Tax Inversion Strategy

Another compelling catalyst, which management has mentioned is a tax inversion. Currently, 80% of FOEs business is outside the US and management is intent on "paying their fair share", a tax inversion would make sense Ferro as it could lower its effective tax rate from 27% toward 20% as well as make the company a much more competitive bidder for acquisitions (tax savings will make deals significantly more accretive)

Activists Align Interests

Jeff Quinn and David Lorber, activists from Quinpario Partners and FrontFour, joined the board of FEO in 2014. Quinn was CEO of Solutia from May 2004 through the time it was sold to Eastman Chemical in July 2012. During this time, similar to FOE, Solutia's gross margins improved from 8% in 2004 to 30% in 2011. As part of Quinpario's "Ferro - Path to Value Creation" strategy put out in 2014, both Quinn and Lorber activists discussed similar plans to significantly enhance shareholder value. Given activist Jeff Quinn's track record with Solutia, and FOEs realignment which makes the business much simpler I believe the setup for FOE plays similarly. Note that Ferro was a hostile takeover candidate by A. Schulman (SHLM) in 2013, therefore at current valuations we could see bidders come in for this asset.

Detailed Business Overview:

Performance Coatings: FOE's largest segment includes two main product lines: Tile Coatings and Porcelain Enamels. Within Tile Coatings, product lines include frits and glazes, pigments and colors and digital inks and coatings. The tile coatings business is largely related to building and renovation, with tile primarily used in kitchens, bathrooms and flooring. FOE is the global leader, with an estimated 20%-25% share of addressable market, and competitors tend to be smaller mom and pops. FOE brings strong design and application expertise around the customer process, as well as the broadest product offering in the industry, with a global footprint. In 2014, FOE acquired Vetriceramici to expand its product offering. Vetriceramici is a leading supplier of value, specialty frits and grits (finely milled frits), glazes, digital inks and other specialized tile coatings.

Applications for Porcelain Enamels are primarily in household, appliances and industrial markets, including sinks and bathtubs, ovens and cooktops, washers and dryers, hot water heaters, cookware, chemical storage tanks and pipe linings. FOE is the market leader in this relatively concentrated market, with an estimated 40% to 50% market share, and we believe FOE along with competitors Gizem Frit and PEMCO, account for ~80% of non-captive production.

Performance Colors & Glass: This segment is the leading global supplier of colors, glasses and functional products for a range of ceramics and glass end markets. Within automotive, FOE supplies the frit for the black band around a windshield (which protects the adhesive from ultraviolet light), as well as silver conductive pastes for defrosting. Industrial/construction applications include architectural flat glass, appliances and furniture, roof tile and dental ceramics and pigments. Decorative applications include dinnerware, container glass, glassware and decals. Electronic applications include electronic glasses, multilayer materials and electronic packaging materials

Pigments, Powders & Oxides: This segment is a leader in complex inorganic color pigments (CICPs); it recently received a major boost with the acquisition of Nubiola, which roughly doubled segment sales. CICPs are used in paints, plastics, concrete and automotive applications. Through this segment, FOE also supplies polishing agents used in automotive, plastic and glass lenses and semiconductor (chemicalmechanical planarization) applications. We believe FOE wins business through its expertise around applications and customer processes and bringing functionality to deliver value.

Catalyst

• As laid out above, I believe Q4-15 (similar to Q4-14) will be a significant catalyst for the shares as I believe management has been very conservative
• Incremental acquisitions at appealing prices - management intends to spend $100m-$150m in invested capital
• Management were to execute on its tax inversion strategy bringing down FOEs tax basis and setting a path to more accretive future acquisitions
• Integration of Nubiola business and delivering +15% ROIC sooner than market expectations