December 11, 2009 - 2:00pm EST by
2009 2010
Price: 6.64 EPS -$0.248 $0.402
Shares Out. (in M): 86 P/E n/a 16.5x
Market Cap (in $M): 570 P/FCF n/a 11.4x
Net Debt (in $M): 327 EBIT 45 105
TEV ($): 897 TEV/EBIT 19.9x 8.5x

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Ferro Corporation, a specialty chemical producer focused on coatings, glass-related materials, and advanced polymers, represents an opportunity to invest in a restructuring story which has been masked by the recent economic downturn. With a material equity issuance now behind the company, its balance sheet has also been fixed, allowing the fruits of the operational restructuring to become more obvious as demand continues to recover. Trading at $6.64 (as of 12/10 close), we view FOE as worth $10-13 per share assuming current profitability and a more reasonable multiple in line with chemical peers, thus providing investors today with a substantial margin of safety. This opportunity exists, in our view, because investors do not yet appreciate the impact of the restructuring to date and give no credit to the operational improvements still to come, and to a certain extent, have not done the work to understand what the balance sheet now looks like post-offering (priced 11/03).

Recent Company Background and Description

FOE is today organized into two broad business segments: Polymer and Ceramic Engineered Materials, and Electronics, Color and Glass Materials. Management, led by CEO Jim Kirsch (more on him below), characterizes the former as a lower-growth, lower-margin, but high FCF set of businesses, and the latter as a higher-growth, higher-margin, and thus higher investment set of businesses. I encourage you to check out the company's website or 10K for a more thorough description, but below is a quick overview of their products:

Polymers and Ceramic Engineered Materials

Performance Coatings - glazes, inks, pigments, and enamels for tiles, cookware, automotive glass, and appliances (such as ovens); competes with companies such as Johnson Matthey and BASF

Pharmaceuticals - pharma additives for drug formulations, etc

Polymer Specialties - split into Polymer Additives (heat stabilizers, plasticizers, and lubricants for end-products such as adhesives, caulks, drilling mud, personal care, etc) and Specialty Plastics (filled and reinforced plastics, plastic additives, thermoplastic materials, etc, for end-products in automotive, wind turbine blades, packaging, furnishing, etc); competes with companies such as Chemtura and Exxon

Electronics, Color and Glass Materials

Electronic Materials - conducive metal paste and powder and dielectrics primarily for electronic applications such as solar cells, semi wafers, capacitors

Color and Glass Performance Materials - glazes, inks, pigments, specialty enamels for automotive glass, tableware, etc

In a nutshell, FOE has had a balance sheet issue since 2006, CEO Kirsch's first full year on the job. He was made COO of the company in late 2004, having been VP of Ballard Power Systems (of long-ago fuel cell mania) and prior to that, having spent 19 years at Dow Chemical. A year later, the CEO/Chairman at the time, Hector Ortino, passed away of natural causes, and Kirsch was named his successor in November 2005. Over the next year, Kirsch started implementing restructuring actions which he had initiated as COO (including returning to timely reporting, filling out the management team, and laying out clear margin goals for newly repositioned business segments). Margins had begun to improve by the middle of 2008 (Q2 and Q3 at 6.8% and 6.2% EBIT margins, vs prior year at 4.5% and 5.4%, respectively), but as with the rest of the economy, growth turned sharply negative starting in Q4 of last year and has not improved materially since, even though we are seeing positive sequential trends this year.

As of 2006, FOE was targeting cost savings of $10mm in 2007, $20-25mm in 2008, and $40-50mm in 2009, and longer-term, EBIT margins of 10+%. Over that time period, the company managed to achieve EBIT margins of 4.7% in both 2007 and 2008, and YTD, the performance has been much weaker (1.4% EBIT), albeit on sales which are down 34%.

The Details of the Opportunity

Clearly, on the surface, FOE appears to be struggling as much it has for some time. But is that a fair characterization?

1) Gross margin is still mostly intact - as with a lot of other companies, FOE is simply suffering from reduced volumes. YTD, FOE has generated 17.8%, compared to 18.7% last year (21.1% in Q3). At some point, this volume will return, at least in part.

2) SG&A is down $37.7mm YoY (16%), suggesting that the restructuring is reducing the fixed cost base, as promised. Many companies have reduced their costs in this downturn, but few to that magnitude. The company also anticipates SG&A will be down again in 2010, which analysts do not appear to be giving them credit for. Note, the company will have some expenses coming back next year (~$20mm), including 401k matching which was suspended, and temporary furloughs, but even with those, management is committed to driving the figure lower.

3) Per the company, global headcount is down 20% since 1/1/08. Most of this is permanent, and translates in part to a fixed cost reduction of $150mm since 2007.

4) Q3 earnings, and the implied run-rate, show that FOE is on a much firmer footing: $52.1mm of clean (ex-restructuring) EBITDA translates into an 11.8% EBITDA margin, but more importantly, suggests the company is capable of earning upwards of $180-200mm even at current revenue levels. However, to be conservative, we are assuming that for this profitability to be sustained, the company requires some volume recovery, which we think is a safe underwriting assumption over 2010 to 2011 (though how much sales can recover remains to be seen).

a. Two notes to head off possible questions on Q3 results: no, Q3 is not typically a seasonally strong quarter for them (going back to at least 2003, Q3 has never been their strongest quarter in terms of EBITDA generation); and, yes, they did benefit from a slight lag between material costs and prices, but claim this lag represented only a $2mm benefit and that the Q3 filing represents the company's current cost structure.


Looking forward, what else should FOE be able to deliver? Management has continued taking costs out, and two specific closings (Limoges, France: $14mm; Nules, Spain: $2-3mm) should generate $16mm of cost savings starting in 2010. In addition, in early October, the company initiated another round of cost reductions, to be fully implemented by mid-2010, which will lead to the elimination of 230 positions. This program will cost $19mm in cash outlays over the next three quarters, and management is guiding to a 13 month payback period, in line with the restructuring actions to date. Finally, part of the equity offering in November was to raise capital to undertake the final leg of the envisioned restructuring, and while management would not get overly specific, they did guide to a similar payback (13 months), implying a run-rate of $50mm savings in 2011, reflecting the amount of the offering they allocated towards restructuring. In total, management should be able to reduce costs by a further $85mm by 2011, through site rationalization, target capital investments, and personnel reduction. For now, let's assume they are only partially successful in this regard.


The Offering

On 10/27, the day after releasing Q3 results, FOE announced its intention to issue 29.5mm shares, or $200mm based on the prior closing price of $6.79. Shares outstanding as of the quarter were 44.7mm shares, so this represented significant dilution to existing shareholders. However, with maturities looming in 2011 and questions regarding covenants, this step was necessary. Indeed, the amendment and restatement of the company's credit facility, which would push out maturity of the revolver by one year to June 2012 and relax associated covenants, was conditioned upon the company raising at least $150mm in gross proceeds from the offering. With this $200mm as a targeted capital raise ($150mm for debt reduction plus $50mm for restructuring programs), FOE was in a sense hostage to the market and the price investors were willing to pay, and at $5.60 (the eventual price), the company ultimately issued 41.11mm shares (35.75mm plus greenshoe of 5.36mm). While painful, this move ameliorated a stressed balance sheet and provided funds to complete FOE's broad restructuring. Over the medium-term, we would not anticipate a further need for material capital raises.

In terms of valuation, I am using a base EBITDA of $185mm for 2010 and 2011. I feel comfortable that this figure is somewhat conservative (especially for 2011) as it is in line with what the company managed to generate in 2006, 2007, and 2008 (even including a very challenging Q4), and what they are not able to generate through leveraging higher sales volumes, i.e. if the recovery is tepid, they should be able to drive with the aforementioned cost reductions.


Pro forma for the offering, the company's capitalization looks like this:

Cash:                     $157mm*

Debt:                     $484mm**

Net Debt:            $327mm

Share Count:      85.82mm

Market Cap:       $570mm

Enterprise Value:             $897mm

* Includes restricted cash related to precious metal collateral (of $92.3mm at Q3) which should return to unrestricted status as the balance sheet improvement becomes more evident to counterparties), as well as the $50mm earmarked for additional restructuring

** At Q3, debt included: $172.5mm convertible; $131mm revolver; $290mm term loan; $29mm US a/r program; $13mm EU a/r program; $15mm short-term bank loan and other. Total, $650.5mm. Adjusted for $167mm net proceeds, ex-$50mm held in cash for restructuring, pro forma net debt is $483.5mm


On our base EBITDA assumption, FOE is trading at 4.8x EBITDA - arguably, a depressed multiple in an absolute sense and certainly, relative to peers. We believe a fairer multiple is in the 6.5-7.5x range, implying a share price of $10.20-$12.36. We also believe that for 2011, FOE should be able to earn greater than $200mm in EBITDA ($220mm?), driving further upside. Estimates for 2011 certainly carry some GDP-related risk, but there appears to be sufficient margin of safety without having to stretch that far out.

(For modeling purposes, we would also assume capex of $40-60mm in 2010, suggesting positive FCF even with higher working capital required for growth in revenues. Of that amount, ~$15mm would be considered "maintenance", per the company.)



Q4 may be a bit messy, but at least the balance sheet will be clear; further details on restructuring and 2010 guidance

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