2003:
Dear Shareholders,
For the year 2003, your company reported revenues from continuing operations of $619.9 million compared to $611.5 million in the prior year. Reported earnings were $56.4 million, or $1.80 per share. Included in reported earnings were GAAP profits which we don't think should be used when comparing results. Included in this category is the profit from discontinued operations of $.18 per share which is mostly a "gain" from the sale of our interest in our Spanish Joint Venture. This is only a book gain as it is simply a recovery of a portion of the write down of this asset we booked last year. In our September 2003 quarter we were also required to report a profit of $.07 per share relating to the "put and call" we had with Citicorp Venture Capital Ltd (CVC) during the year relating to our purchase of our stock in which we agreed to a maximum and minimum price at closing. The transaction was agreed to and executed within the same year. We don't take credit for this gain. In the following paragraph I will present the numbers as our Board of Directors views them. This is not a GAAP view, as a GAAP view with all the discontinued operations and gains on the CVC transaction is extremely difficult to understand, and unrelated to the "real" change in operations in my view. We view our earnings per share (EPS) on an ongoing basis of $1.55 rather than $1.80 as reported. $1.55 is also the number we used in computing executive compensation. In 2002 we reported EPS of $.29 per share. If we restate 2002 and adjust for one time costs and discontinued operations, our ongoing, apples for apples EPS for 2002 would have been $1.10 per share. Therefore we view our earnings as increasing $.45 or 41%, not the much larger increase shown in our GAAP results. Yes, 2003 was a good year, but not as good as it appears at first blush. Clearly there were some big positives. Reported Owner Earnings for the year was $80 million. Excluding the effect of the discontinued operations, the "real" Owner Earnings was $83.2 million, 13.4% of sales and $2.65 a share, an excellent result. We were able to reduce working capital by $5.1 million this year. This improvement is nowhere near what we experienced in 2002 because these improvements are cumulative and it is therefore more and more difficult to maintain the same rate of improvement. We ended up the year with $61 million in cash to offset a portion of the $301 million in long term debt due in 2011. This is after spending $52 million to buy back 2.2 million of our own shares. Our net debt to cash flow ratio, known as net debt to EBITDA, ended up at 2.0, a huge improvement over a short time ago. The quality of our earnings was good. Operating profit was 16% of total sales and 17% of proprietary sales, a better measure. This is within striking distance of our 20% stretch target, considered to be quite aggressive in this industry. Return on equity was 20%. Net capital expenditures were a modest $10.7 million. At 1.7% of sales we believe we control capital spending better than anyone. If I stopped right there, one might say this was an extraordinary year. But, alas, there is more to the story. Sales revenues, the engine of any business, were anemic this year. We reported revenues 1.4% higher than 2002, but adjusted for currency effects, constant dollar revenues were down 4.7%. Revenues three years ago were $140 million higher than this year. The revenue story is complex. Firstly, some portion of the responsibility for lack of top line growth can be attributed to poor execution on our part. We have repeatedly said we were carrying more commercial infrastructure than was necessary in an attempt to take advantage of competitors who were cutting back. However, we just haven't yet seen any significant benefit from this investment. There is some hope we will finally see more share gain in 2004. If not, we won't make this excuse again next year, we will take action to reduce this investment. We also know we have to execute in the innovation arena. Our R&D has been emphasized, we have new leadership in several areas, but we are not satisfied we are getting the "bang for the buck" we expect. There are some valid reasons our revenues are not as robust as we would like. We are experiencing headwinds in several of our markets. In Europe, the economies are experiencing slowness. This effects our Printing business and our Industrial Products product lines there. We changed the distribution model in our printing blankets business in the USA. We sacrificed unprofitable sales as we switched to a direct sales model which meant fewer, but more profitable sales. We also exited several small unprofitable product lines. The front cover of this report signifies the beginning of a new chapter for MacDermid. We are opening a new executive headquarters in Denver, Colorado, led by Stephen Largan, our newly appointed Executive Vice President and head of worldwide operations. We have determined it is time to balance the entrepreneurial independence of our operating managers with an execution bias. Stephen will be tackling three processes corporate-wide; the people process, the strategy process, and the operations process, with special emphasis on our innovation capability and performance. Very importantly, Stephen and I will be working together to integrate these processes.
- With the people process we will be spending more time identifying and developing our leaders of the future. We have come to the conclusion that hiring at the most senior levels is simply too risky. However, we have many examples of young people joining the Clan and growing into senior management positions. We have also had notable success hiring mid-career leaders and promoting them, Stephen being the best example. We must have a formal process that doesn't depend on the cream rising to the top on its own.
- The strategy process. We know we have an unusual culture and operating style. We own a collection of tough businesses. The fact that we derive far higher value than others in these businesses is a strategic asset. In our industries, $80 million in free cash flow on $600 million in revenues is unheard of. The million dollar question is, "What do we do with this asset?" I view this as a two part advantage. The first part is the compounded effect of the higher cash flow we generate. The second part is the operating system that allows us to generate this cash. On the first point, a year ago our alternatives were more straightforward. Our market cap at the beginning of 2003 was about $600 million. At $80 million in free cash flow, that equals a 13% cash on cash return. Last year it was simply a "no brainer" for us to buy back our shares. This year, with double the market cap, stock repurchases are less compelling. Now we have to evaluate alternative uses of our cash. Clearly a possible alternative use of our cash flow is acquisitions - applying our model to acquired businesses. The strategy process will ensure that we evaluate acquisitions that have the highest chances of benefiting from our business processes. Allocation of resources between the businesses can either further the competitive advantage of the business, or conversely, if not properly allocated, can be wasteful. Given our range of alternatives, strategy matters at MacDermid.
- The operations process is where all three processes come together. The people process will only yield benefits if we focus on it continually and if the people initiatives become part of the operating system, day to day. Strategy is long-term by its nature. However the long term and short term need to be bridged. The operating process is that bridge. It breaks down the strategic initiatives into a series of shorter term objectives that, taken together, will better ensure that we execute on the longer term initiatives. A comment on Executive compensation. There has been a lot of dialogue recently about the abuses at some companies caused in part by executives having the wrong incentives. In the 1970's when this issue last surfaced publicly, the overwhelming answer was to align the interests of executives and shareholders via stock options. Now we are hearing, "No, we were wrong, options don't align these interests, so we are going to change to another form of long term compensation." I strongly disagree. I believe options plans, properly designed, do work well. The catch is 'properly designed'. Traditional option plans, with a right to acquire shares years in the future at today's price, can miss the mark in aligning executives' interests with those of the shareholders. It doesn't take a genius to make money if all one has to do is wait for the effect of 10 years of compounding. Here's an example. Say you were issued 200,000 options at $20.00 per share, and inflation over the following ten years was 3% on average. Assume your stock price appreciated on average 2% a year. At the end of ten years the share price at 2% average annual increase per year would be $24.37. However, shareholders would experience a loss of about $2.50 a share in real dollars because the stock price 'growth' did not keep pace with inflation. This is not so great for the shareholder. How about the executive? His options would be worth $874,000. Even worse, let's say there was an anomaly in the seventh year where the company announced earnings were going to be much better than expected. Mr. Market all of the sudden bids the stock price up to $30. Since standard options can typically be exercised at any time with no holding requirements, the executive sells all 200,000 shares and walks away with a cool $2 million profit. The only problem is, the company announces a shortfall in earnings the following year and the stock price goes to $15. See why the incentives can be misaligned? Now, the same smart people who brought you standard options are touting the benefits of restricted shares, better referred to in my view as payments for showing up, or payments for breathing. Restricted shares are grants of actual shares with a typically short holding period (two to four years). In the example above, the executive still wins while the shareholder loses. There is no risk for the executive, he only gets more or less wealthy. Restricted shares can have a place in executive compensation in conjunction with, or to balance, a more risk associated feature, or to buy out an executive from vested benefits as part of a hiring package.
How is MacDermid different? I believe we are unique in two ways. First your CEO's cash compensation is based entirely on the profits of the company (generally adjusted for non-cash gains or charges). Secondly, with our plan, it's hard to imagine a scenario where our shareholders lose while our executives gain. MacDermid's option plan is different than any other we are aware of. It is indexed against the S&P specialty chemical index. In the example above, the relatively poor performance of the option stock would more than likely not beat the index, as an industry would be expected to at least perform with inflation over time. That being the case, our options would be valueless. In addition, if there were an anomaly such as the stock price spike described in the previous example, our executives are restricted from cashing out and walking away. Our policy requires us to hold 75% of the net proceeds of any option grant until we retire. There is no opportunity to cash out on a major scale when the stock is at a high point. Lastly, our plan has a performance feature. We grant a notional number of shares that are subject to a multiplier or a discount according to pre-set measures. In the previous example, it's hard to imagine the underlying earnings and cash flow growing more than say 5% compounded. In our plan, this is far below our expectations and would result in a 50% discount in the number of notional shares, so the 200,000 grant would be cut in half. There are two reasons we have a stock retention policy. One is to prevent incenting executives to do anything for short term gain. The second is to promote concentration of ownership of MacDermid shares by our executives. In an ideal world, I would like to see our executives have the vast majority of their net worth invested in MacDermid shares. I can tell you from personal experience, it makes a difference. I believe it also helps promote entrepreneurial behavior. For an executive to have all his or her eggs in one basket makes a difference in the amount of attention they pay to that basket. It can also impact risk tolerance when they have a big downside. Options are not the same as stock ownership. They don't carry downside, so there is a real incentive to "swing for the fence." Prudent risk taking is part of any long-term success story. We believe concentrated ownership helps ensure prudence.
A comment on the "weighing" vs. "voting" philosophy. In last year's annual report, we commented on how, over time, the present value of the cash flows of a business will be realized in the value of a stock. Mr. Warren Buffett often refers to weighing as intrinsic value. Voting is the price the imaginary investor, Mr. Market, places on a stock at any point in time, depending on his mood. If he is depressed, he will be obsessed with everything that can go wrong and price the stock very conservatively, often overly so. On the other hand, if he is in a very good mood, he will focus on all the upside opportunities, thereby pricing the stock very aggressively, perhaps overly so, as in the case of the dot coms. When I wrote about this last year, our stock price was around $21. As I write this letter, our stock price is $38. Need I say more? I probably should. OK, our stock price went up 80% in the last year. Did our intrinsic value increase by 80%? Of course not. The question of the day is, was Mr. Market overly depressed last year and therefore discounted our stock against our "real intrinsic value"? Or, is he euphoric at $38, or somewhere in between? $38 a share could be considered a very fair price in a "weighing environment" but it would have to assume a lot more things going right than at $21. A real critical point is, as a long-term shareholder, should I spend a lot of time worrying about this issue? We believe not. If weighing will ultimately establish the long term value, we only need to understand the long-term prospects of our business. I believe we can execute our new direction. If we do we will generate a lot of value. There is risk, however, that we will fall short. That question is your challenge as an investor. The question of the year revisited. Last year we asked, "Is MacDermid a one trick pony?" That is, we can generate cash, but can we grow? We certainly didn't show any new tricks in 2003. I believe the new processes and the addition of Stephen Largan to the corporate team will prove very important. It may take two years to really see the result. We will report to you frequently and openly as to our progress. There are two very important documents at the front of this report. The first is our MacDermid Philosophy, written by our "Clan Members" more than 40 years ago, to describe how we intend to act as colleagues to each other, and externally. This is the MacDermid 'bill of rights' which we strive to follow. We do better some days than others, never losing sight of the ideal state. The MacDermid Shareholder Principles, modeled after Berkshire Hathaway's Owner Related Principles, with permission, lay out how we intend to manage the company and interact with you as shareholders. Frankly, this is an easier standard to achieve than the Philosophy. All we have to do is act as if we were partners with you in a private business and ask the question, "How would we want you to act if the roles were reversed?", and act accordingly. There are more than 2,500 Clan members who make these documents come alive every day. I know I speak for our shareholders in thanking them for the continued dedication to these principles. On behalf of the Clan, thank you for your confidence. We don't take it lightly.
Disclosure: I am long PAH.