A. Schulman, Inc. (SHLM) announced March 4, 2013, that it has made a proposal to the Board of Directors of Ferro Corporation (FOE) to acquire all of the outstanding shares of Ferro common stock for per-share consideration of $6.50. According to Schulman, the offer represents a 25 percent premium over the closing price of Ferro common stock on March 1, 2013, and a 32 percent premium over the volume-weighted average trading price over the preceding 60-day period. The company said its proposed offer price of $6.50 per share includes an immediate cash payment of $3.25 for each Ferro share outstanding and $3.25 worth of A. Schulman common stock without giving further details. Our estimate of the intrinsic value of a share of Ferro in a very optimistic scenario is $9.26. That is 42.5% higher than the offer price. As a result, the offer of $6.50 by Schulman is very reasonable.
A. Schulman, Inc. is an international supplier of plastic compounds and resins headquartered in Akron, Ohio. The Company's customers span a wide range of markets such as packaging, mobility, building and construction, electronics and electrical, agriculture, personal care and hygiene, sports, leisure and home, custom services and others. The Company employs approximately 3,300 people and has 34 manufacturing facilities globally. A. Schulman reported net sales of $2.1 billion for the fiscal year ended August 31, 2012. A. Schulman acts as a manufacturer (65% of 2012 sales), merchant (17%), and distributor (18%). Foreign sales are 83% of 2012 total.
Ferro Corporation is a global supplier of technology-based performance materials for manufacturers. Its materials enhance the performance of products in a variety of end markets, including building and construction, automotive, appliances, electronics, household furnishings, pharmaceuticals, and industrial products. The operating segments are performance coatings, electronic materials, color and glass performance materials, polymer additives, and specialty plastics. The markets include: construction, appliances, household furnishings, industrial products, and automotive and aircraft. Headquartered in Mayfield Heights, Ohio, the Company has approximately 4,950 employees globally and reported 2011 sales of $1.8 billion. Foreign sales are 53% of total.
Finding Superior Companies
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough for a business to be able to declare that it has a competitive moat. As mentioned by Mr. Warren Buffett in a November 22, 1999 Fortune interview: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define moat or sustainable competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage.
Performance Spreads of Schulman, Ferro and Other Industry Members
The following table shows the performance spreads of Schulman and Ferro for the last five years and for three of the giants in the same industry: Dow Chemical Co. (DOW), BASF AG (BASFY.PK), and E.I. du Pont de Nemours and Co. (DD). As shown by the size of the positive spreads of Schulman and Ferro, Schulman is a marginal value generator, and Ferro a significant value destructor. We also present some of Ferro competitors as suggested by NASDAQ on its website: PPG Industries (PPG), $15.3 billion of sales, RPM International Inc. (RPM), $3.9 billion in sales, and Valspar Corp. (VAL), $4.0 billion of sales.
Performance Spread (Trailing 12 months)
E.I. du Pont de Nemours
Value Creation Potential
The largest U.S. company actively producing chemicals, plastics, hydrocarbons and agricultural and specialty products is the Dow Chemical Co. Headquartered in Midland, Michigan, this diversified company is the second largest chemical company in the world behind BASF AG and generated around $57 billion in sales in 2012. Ranked second in the United States is Houston, Texas,-based Exxon Mobil Chemical Co., a subsidiary of ExxonMobil Corp. (XOM), the world's largest oil company. E.I. du Pont de Nemours and Co. ranks third among U.S. plastics producers. This company, based in Wilmington, Delaware, reported 2012 revenues of $35 billion.
Companies that are leaders in value creation, like E.I. du Pont de Nemours and Co., bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry are likely to be successful at implementing and sustaining them. In our case, E.I. du Pont de Nemours and BASF stand out by the fact that their performance spreads are positive. On a much smaller scale, PPG industries and Valspar Corp are noteworthy.
Equipped with the above information on performance spreads that permit to have a serious fundamental view of the industrial economy inside of which the companies compete and the fact that we are in the presence of competitors that are also value creators, at the exception of Ferro, it follows that a breakthrough in value creation by Ferro is far from being achievable. In this competitive landscape, we have simulated the intrinsic value of a Ferro share under three scenarios, which we present in the following table.
In all the scenarios, we assume that Ferro will be able to apply entirely and successfully its proposed strategic plan and divest non-core businesses, streamline operations, reduce operating costs, and pursue high-return growth investment. In the first scenario, we assume that all these implementations have the effect of restoring the profitability of its capital at the highest level achieved during the last five years, or 6.7%. This scenario 1 gives an intrinsic value $9.26. It is a very optimistic scenario that shows clearly that the offer price is fair.
In the second scenario, we suppose that Ferro strategic completion will permit to reach the highest return on capital obtained by Schulman in the last five years that is 9.5%. This second scenario gives an intrinsic value of $15.66 (scenario 2). It is an even more optimistic scenario because Schulman is already in a better value creation position that Ferro.
In the third scenario, we suppose that Ferro will produce strategic achievements which will make it possible to reach a return on capital equal to the best return obtained by Valspar Corp, one the best value creators among the Ferro`s competitors suggested by NASDAQ, or 12%. This scenario is more optimistic that scenario 2. This third scenario gives an intrinsic value of $22.29.
Intrinsic Value (IV) of Ferro Share based on 3 scenarios:
After the impact of a successful strategic plan
(Scenario 1:Best of Ferro)
After the impact of a successful strategic plan
(Scenario 2:Best of Schulman)
After the impact of a successful strategic plan
(Scenario 3:Best of Vaspar)
What can we conclude from our analysis? One, that the materials industry is very competitive as shown by the many performance spreads that we have illustrated for firms of different size. Second, that Ferro is a value destructor, unable to produce a single positive performance spread. Third, that even the best performers in the industry produce modest performance spreads. Fourth, that the chance that Ferro will be able to implement a winning strategic plan in this industrial setting is meager. Fifth, that the price of $6.50 that Schulman offers for Ferro stock is quite reasonable compared to $9.26, one of our optimistic intrinsic value estimations. Finally, any price higher than $9.26 would require unrealistic scenarios like the second and third scenarios that we have illustrated.
Based on our analysis, we believe that the price of $6.50 is fair. So, our first actionable advice is to sell Ferro. The second actionable advice is to buy E.I. du Pont de Nemours. Why not take the opportunity of this change in your portfolio to invest in one of the best value creators above? The materials part of your global portfolio will leave you sleep at night.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.