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  • MacDermid Shareholder Letter 2002 0 comments
    Mar 24, 2014 7:24 PM | about stocks: PAH


    Dear Shareholders,

    What a difference a year makes! Last year we commented about surviving the "100 year flood". We ended 2002 with zero balance on our senior bank revolver and $32 million in cash in the bank. Granted, we still have $301 million in bonds due in 2011 and a small amount of joint venture debt, but in two years we went from $475 million in senior debt to essentially zero. The biggest contributor to 2002's lower debt balance was $121.8 million in Owner Earnings (OE) generated during the year. After the end of the year, our Board of Directors approved a million share repurchase authorization. Yes, a year makes a big difference.

    THE RAW NUMBERS. 2002 revenues were $687.6 million compared to $745.7 million in the comparable prior period. Earnings before charges were $36.1 million or $1.12 per share compared to $27.2 million or $.84 on the same basis in the prior year. After charges, earnings were $9.3 million compared to a loss of $24.3 million in the prior year. Owner Earnings of $121.8 were up 37% from last year's record. One look at the revenues will tell you the external environment continued to be difficult. The worldwide printed circuit market was depressed all year and there has been no sign of recovery. Industrial production in Europe and North America - where 75% of our revenues are derived was anemic all year. The printing and publishing industry experienced another poor year. Like most companies that serve the industrial economy, the reality is that we tend to follow the external environment, at least generally. This is especially true now because we spent the last two years focusing on surviving, not growing. OK, not surviving in the literal sense, but insuring that we would come out the other end of the 100 year flood with our options intact. I would like to be able to say we were successful generating cash, lowering costs, AND focusing on growing, but alas we were not. I was unable to take my eye off the "ensure we survive" ball long enough to give attention to anything else. And like it or not, this organization tends to focus on what I do. I believe our focus over the last two years was appropriate. We practiced the adage, "In order to have a brilliant future, first you have to be sure you have a future". Clearly some of our competitors fared much worse. Several of them had to take dramatic measures including bankruptcy - and serious shareholder dilution that verged on bankruptcy - to "survive". The bottom line is I believe 2002 is yet another testament to the strength of MacDermid's culture and business model. We generated $121.8 million in cash in the midst of one of the toughest market environments I have ever seen.

    A COMMENT ON WEIGHING VS. VOTING: Many of our shareholders know we are long time followers of what I call "Buffett Principles", taken from the business philosophies of Warren Buffett. An important Buffett principle is, "In the short term the stock market is a voting machine and in the long term it is a weighing machine". This means that at any given point in time the market may overreact in it's valuation of a particular stock, either too high or too low. In the case of the late 90's bubble it overreacted towards the whole market. Just because the market says the dot com is worth so much "per hit", it doesn't mean it is so - long term. A business model that generates no cash over time is valueless. Further this principle holds that over time, financial performance and market value tend to converge. This principle is what drives our cash flow discipline. Frankly I wouldn't take great comfort if I thought I had to depend on Wall Street to "vote" on our relative success. Our cash flow in effect allows us to take matters into our own hands. Here's an overly simple example. Say we generate $60 million in free cash flow per year for the next ten years. At the end of ten years we would have $600 million in cash in the bank. Today our market cap is a little over $600 million. Do you think all else being equal, our market value would still be $600 million, or equal to only the cash in the bank? Not likely. Regardless of how depressed Mr. Market felt at the time, one would assume the more objective 'weighing' would have to take over at some point. Maybe a better way to look at it is as follows. Assume Mr. Market was depressed for the whole 10 years, our stock price never moved, and we simply took the cash and bought back our stock each year. In ten years there would be one share left that generated $60 million in free cash! I think Mr. Market, no matter how depressed he was, would offer more than $20 for $60 million in cash flow! So, we believe that it is a mathematical certainty that if we perform we will be rewarded over time. The end result is called intrinsic value, defined as the total amount of cash that can be taken out of a business over its life, valued in today's dollars. The above example is admittedly superficial and overly simplistic. However, we have run detailed and sophisticated models and firmly believe our future is very bright, even using very conservative assumptions. There is simply no peer company of any size large or small that comes anywhere close to our cash flow performance. If you want proof, I recommend you spend the money to come to our meeting for interested shareholders and investors in Omaha, Nebraska on May 2. At this meeting we will go through the detailed models and attempt to compare relative valuations over time between our model and a traditional model.

    CASH FLOW. What drives cash flow? As we have such a strong orientation towards intrinsic value which is driven by cash flow, I believe it is worthwhile to spend a little more time on the subject. The most important driver of cash flow is earnings. It would be very difficult to generate exceptional cash flow over time without earnings. However, earnings don't guarantee cash flow. Another very important driver of cash flow is capital expenditures, that is, the cash spent for large items like land, buildings, equipment etc. From an accounting standpoint, you spend the money up-front for the asset, and then amortize or expense it over its useful life. So whereas you might have "earnings" of $10 million in a given year, if you spend $10 million in capital expenditures you actually generate no cash at all. The last large driver of cash flow is working capital or the funds needed to support revenue. The way most businesses sell to other businesses is on credit. In this case, you sell and ship a product, recognize a profit, but until the invoice is actually paid you generate no cash. Additionally when you sell more, you usually need to have more inventory to support the higher sales. For MacDermid historically we needed 30 cents or more in working capital for every dollar in increased sales. Over the last two years we have brought that number down to more like 25 cents. But nevertheless, unless you earn incremental after tax profits of 25 or 30 cents for every incremental dollar in sales growth (very unlikely), you will have to invest in working capital in excess of the increased profits. This year it worked in reverse. Our sales went down and therefore we had to invest less in working capital. That is why the $121.8 million in free cash flow cannot be used in an intrinsic value calculation. It is simply not sustainable. If we analyze our cash flow this year we find that out of the $121.8 million in Owner Earnings $53 million came from less working capital. Of the $53 million, $17 million was simply a result of lower sales. An additional $38 million came from reducing our investment in inventory and receivables even more than the decline in revenues. Last year we set an objective of improving our working capital management and these are gratifying results. We believe there is still room for improvement, but not at as fast a rate. In 2002 we spent $4.4 million net, in capital expenditures. That is frugal! For next year our OE will greatly depend on the external environment. If revenues improve we will have to invest modestly more in working capital than the additional profits generated. We will certainly spend more in 2003 in capital expenditures, more on the order of $10 to $12 million. If we have to invest to support revenue growth, Owner Earnings could very well be dramatically lower than 2002. All else being equal between 2002 and 2003 (including revenues), simple math indicates OE will be reduced by most of the $53 million in lower working capital, and the higher capital expenditures of say $8 million. So best case our OE next year might come in around $60 million. If revenues and earnings go up, which we sure hope, OE will be even less short term. "Isn't lower OE a bad thing", you ask? Not necessarily. If OE is temporarily reduced to fund growth in working capital that leads to more free cash flow in the future, that can be a good investment. The key is that the future higher cash flow must be sufficient to offset the lower future value of a dollar compared to the current value that is being invested.

    USE OF CASH. As mentioned above the Board of Directors approved a million share repurchase authorization. I view share repurchases as a very attractive alternative to other investments, in many cases. In 1994 we bought back 25% of our shares outstanding for $30 million. Whereas I view the current situation as similarly attractive, we are in a very different situation from a capital structure standpoint. We have a stated target for debt not to exceed 2.5 times cash flow. We ended the year about on target. That means we have choices about future cash flow as we generate it. Given the low capital investment required in our business, we could consider increasing dividends, buying back stock, or making cash acquisitions. At this time dividends are less attractive because they are taxed twice, once at the corporate level and again when you receive them. In addition, dividends are not voluntary, i.e. when we issue dividends, all shareholders must accept them. In a stock repurchase scheme, you have the option of selling a few shares and maintaining your proportional ownership, or not selling and increasing your stake in the future. It is important to understand that an authorization does not necessarily mean we will actually acquire the shares. A million shares may seem small, but over time, if we repeat the process, it can add up. There are some restrictions to acquiring our own shares in our bond covenants as well. The longer the external environment remains difficult, the better the chances of us being presented with a very attractive acquisition candidate. It makes sense to keep some dry powder.

    GUTS TO FAIL. In 2002 we took non-cash charges of $39.2 million. That is on top of $69 million in 2001. Is this an admission of failure? The answer is absolutely yes. In the late 90's we embarked on a purposeful strategic remake. We believed we had little choice if we were to better ensure our survival from a generational standpoint. There is a more detailed discussion of this in the mid year shareholders message reprinted at the back of this report. MacDermid has long had a basic philosophical belief in calculated risk taking called "guts to fail". Basically this holds that one must take risks to gain advantage. We judge ourselves not by our mistakes, but by the end result, in balance. Here's how I look at it. I became CEO in 1990. That year we earned $5.3 million. Owner Earnings were $5.5 million. Shares outstanding were about the same as now adjusted for 9:1 splits since then. In 1998 earnings were $30.5 million and Owner Earnings were $27.6 million. 2002 earnings (not counting the charge) were $36.1 million and Owner Earnings were $121.8 million. By far the most important question you should ask is, what would earnings have been if we had not embarked on the strategic remake? I suggest they would have been back to 1990 levels, perhaps worse. The fact that earnings and cash flow are higher than when we started the remake in 1998 is in my humble view an unqualified success. This is especially true given that we are earning at "trough market levels".

    THE QUESTION OF THE YEAR. Is MacDermid a one trick pony? In other words we have proven that we can generate cash like no one else, but can we grow? On the front cover of this report is our corporate strategy in graphic form. We call it the "bookend strategy". The strategy holds that we will preferentially invest in the bookends of R&D on the front end, and technical service on the back end. This is what is most important to our customers. All other costs in between the bookends will be controlled very tightly. It may sound simple, but execution is incredibly difficult, especially for large companies which represent most of our competitors. In fact, this is a long term strategy. It depicts how we have always made strategic decisions. "Yes", you ask, "but what about your admission earlier that you obsessed with keeping your eye on the 'survival' ball"? It's true, we didn't pay as much attention to pushing the bookends as we might have. We did however insure we maintained the bookends.


    The vast majority of our cost reductions over the last two years were between the bookends. We ended this two year period of "surviving" with our bookends very much intact. We believe we are the only competitor who can say that. To emphasize the bookends is a relatively easy switch in prioritization for us. Our R&D as a percent of sales is the highest it has ever been. We have decided to maintain that percentage as revenues recover. We are making modest organizational shifts emphasizing product line management as opposed to having a sole focus on geographic P&L management. The Clan MacDermid is very responsive. Just consider how they responded to the cost and cash flow orientation. I believe the Clan will also respond with vigor to our new innovation and market share gain orientation. One thing is very clear to me. Our competitors in many cases are weak. They cut costs indiscriminately, in some cases significantly reducing the field infrastructure. It should be easy pickings. However, I remain cautioned as market share gain in this business has always been very difficult. Customers are very conservative.

    SEE YOU IN OMAHA. As mentioned above we will hold a meeting for interested shareholders and investors in Omaha, Nebraska on May 2, two days after our normal annual shareholders meeting in Waterbury, Connecticut. In addition we will hold a four day leadership meeting in Omaha at the same time. One hundred of our top managers from around the world purchased a $2,000+ share of Berkshire Hathaway this year in order to attend the meeting. We will attend the Berkshire meeting en masse and then spend a couple of additional days discussing value creation. As much as I respect Mr. Buffett and believe in the "Berkshire Principles", the reason we feel so compatible is due to the MacDermid heritage, most of which was established by my father Harold Leever 50 years ago. If these principles seem familiar, it's because they are the foundation of MacDermid.

    SHAREHOLDER PRINCIPLES. I urge everyone to study the MacDermid Shareholder Principles printed on page one of this report. We take these principles seriously. This year we adopted additional partnership oriented policies to further reinforce our Philosophy. Examples include;

    - Share retention. The Board of Directors decided to require that 75% of the net shares acquired by option or other share plans, after the cost of exercise and payment of taxes, be retained permanently while an executive is an active employee. This applies to Directors as well who are compensated entirely by restricted shares or options.

    - Policy of not repricing options. This should go without saying, but just to be clear we have adopted a policy not to reprice options without shareholder approval.

    - Formal establishment of a Lead Director. The Board appointed Quinn Spitzer as Lead Director charged with chairing meetings of the Board when I am not in attendance, which occurs during a portion of each meeting of our Board. He also meets one on one with other directors as well as with members of senior management to insure an unfiltered flow of information.

    - Stock Options. We attempt to treat stock options as if we were partners in a business. Option holders do not gain unless you do. We may have the only option plan in existence that is both indexed and performance based. The options have no value unless we perform better than the Standard and Poors Specialty Chemical Index. Additionally the number of options goes up or down depending on our achievement of preset financial objectives. You should be cheering for us!

    CONSERVATIVE APPROACH TO ACCOUNTING. MacDermid has long believed in being appropriately conservative in our reporting and accounting. The company has no off balance sheet entities. We have no debt that isn't shown on our books. Our pension accounting is ahead of the pack. You will note that we changed our assumptions for 2002 for return and discount that based on a recent study put us in the most conservative 10% of all companies. We incurred $1 million in higher pension expense in 2002 as a result. The vast majority of companies are changing assumptions for 2003. We took the more conservative approach and reacted early.

    THE CLAN MACDERMID. Clan is the Scottish word for family. We are a classic Scottish family, dedicated, scrappy, and committed to the cause. I'd hate to be a competitor of MacDermid. We just keep on coming at you. We have the unusual ability to rally around the tartan. You as a shareholder are lucky to be partnered with such a fine group of men and women. I am lucky to be their leader. We have come through a trying period. Our strategy going forward is simple, the execution of it is not. I promise you maximum effort from a dedicated Clan MacDermid. Wish us luck. Dan

    Disclosure: I am long PAH.

    Stocks: PAH
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