Fuller Expectations – Is SWK the Right Proxy?

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

July 6th 2018

Fuller Expectations – Is SWK the Right Proxy?

  • We expand on the work previewed in the last Weekly Findings and add more depth to the analysis on our positive bias towards HB Fuller (FUL)
    • Our focus is on the limited benefit of the doubt given to the company with respect to the value that can be added from the recent Royal acquisition and the potential upside (100%) if the company can get it right. We use SWK as a possible proxy
  • We also expect further consolidation moves in the chemical industry and especially in the intermediate/functional businesses and FUL would be one of our potential targets.
    • When companies like Dow Materials Science and BASF talk about holistically solving customer problems and providing “one stop” solutions, whether it is paint, engineering plastics, advanced packaging etc., both are lacking good adhesive technology.
    • The FUL portfolio could be equally interesting to an intermediate/specialty company looking to add another vertical to a larger business – EMN, Clariant or Covestro might take an interest.
  • FUL is beginning to show a positive inflection point in its return on capital, which took the expected downswing with the additional capital base at a time when earnings were squeezed by rising raw materials.
    • There was limited investor belief in the recovery in return on capital at SWK in the initial 6 to 9 months, and it was only after consistent earnings surprises, driven by the successful integration of the Black and Decker business as well as fixing mistakes in the company’s security business, that the stock began to react.
  • With the benefit of hindsight, Black and Decker was a great deal for SWK and SWK management was able to manage the business to take full advantage of the opportunity.
    • We don’t have enough data points to draw a direct comparison with FUL yet – one quarter does not make a trend. However, if FUL management is not able to get the most out of the deal, the cheap stock will attract M&A attention from those who believe they can.

Exhibit 1.

Source: Capital IQ and SSR Analysis

Details

Our more bullish stance on FUL earlier in the year was driven in large part by our reversion to mean valuation model and a bit of “we have seen this movie before”! FUL has depressed valuation on a “normal” basis (Exhibit 2) because the capital base has been pulled up by the acquisition of Royal Adhesives – the company has yet to deliver the earning to reflect the synergies and industrial logic of the deal and investors are not giving the company the benefit of the doubt. Instead, the stock was punished for increasing raw materials in Q4 2017 and Q1 2018, a move that has historically been a buy signal for intermediate chemical companies as they can generally pass through more than the raw material increase and gain some margin. Plus, they generally keep some margin when raw materials decline.

Exhibit 2

Source: Capital IQ and SSR Analysis

We are focused on whether FUL can pull its return on capital back to trend (Exhibit 1) – the recovery has started – but it is slow. If the company can get back to trend, earnings jump to $5.40 per share and the share price could double. Our model has trend return on capital of 8% – well below what any good company should be targeting – but just to get back here would generate the EPS suggested above – which is consensus for 2021/2022 – and given past historic relative multiples this suggests a value for the stock of $110 per share – even if it takes 24-30 months to get there, the annualized TSR numbers look good.

Is SWK the right proxy? Maybe – there are other examples of companies that have not been rewarded initially for a good acquisition and there are others who either made a bad acquisition or through poor management have failed to get expected value for it.

We first wrote about SWK in October of 2013, highlighting exactly the same issue that we are discussing with FUL – return on capital chart in Exhibit 1. In this case we had seen a little more improvement in return on capital off the low, but SWK went on to “revert to trend”, and the stock more than doubled – a similar upside to what we see for FUL. The risk is that FUL cannot execute like SWK or that the Royal acquisition does not offer the same potential that the Black and Decker deal did for Stanley. To be clear, Stanley made a couple of smaller acquisition errors after acquiring Black and Decker in 2008, which created earnings and valuation volatility – and it was only after these were fixed (in 2012/13) that the stock began to perform.

FUL is inexpensive and based on its own history at a point where it is hard to resist regardless of the Royal upside opportunity, particularly on a relative basis – Exhibit 3 and similarly discounted to SWK in 2013 – Exhibit 4. SWK made it back to “normal value” at its recent peak, but has since fallen back – peaking as sell side sentiment peaked and despite generally strong revisions. There is also an interesting entry point for SWK again now in our view.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

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