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"Worldly wisdom teaches us that it is far better for reputation to fail conventionally than to succeed unconventionally." - John Maynard Keynes We are ok being lonely and taking an unconventional approach to investing, for that is where we find the greatest long-term success. Although... More
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  • MacDermid Shareholder Letter 2004 0 comments
    Mar 25, 2014 10:38 AM | about stocks: PAH

    2004:

    Dear Shareholder,

    In 2004, net sales were $660.8 million, compared to $619.9 in 2003. Net earnings were $53.2 million, or $1.72 per share. As we pointed out last year, GAAP earnings in 2003 of $56.4 million, or $1.80 per share, included income we do not take credit for. We prefer to compare to the number our board of directors uses both to evaluate the business and for executive compensation purposes. On that basis, in 2003 we earned $1.55 per share(1). We consider the 11% increase to be solid.

    We again reported outstanding Owner Earnings(2), which we define as cash from operations less net capital expenditures. Owner Earnings in 2004 were $76.7 million or 11.6% of sales. This outstanding cash generation enabled us to end the year with $137.8 million of cash on our balance sheet. We have total long-term obligations of $301.3 million (consisting primarily of long-term bonds), resulting in net debt of $163.5 million Earnings quality continues to be good. Operating profit was 16% of sales. Return on average equity was strong at 19.6%. Net capital expenditures were a modest $8.5 million, or 1.3% of sales, a very low amount by any standards. This achievement can be attributed to our constant focus on justifying every cent of your funds before it is spent.

    Yes We Can! You will note throughout this report a new branding initiative for MacDermid. Yes We Can! is designed to send the message to our customers that they can depend on us to solve their production problems, anticipate their future needs, and generally be seen as hyper-responsive. It is also a prime example of differentiating costs. In the paragraph above we mentioned capital spending and the fact that we justify spending every cent of your funds. Yet, here we are embarking on a branding exercise that will be quite costly. So, which is it, to spend or not to spend? The answer is both. Culturally, we think of ourselves as a team of cost-conscious owner operators. Clearly, the difference between "must have" and "nice to have" expenditures are solely in the eye of the beholder. If we are not vigilant, we could easily end up wasting your money. Ask anyone at MacDermid - we are vigilant. Being frugal is one of our core values. Last year we produced $76+ million in owner earnings on $660 million in revenue. This is important to you as a shareholder. The ability to generate owner earnings while producing greater value to our customers gives us options to build long-term value that we wouldn't otherwise have.

    Last year we said we believed MacDermid was entering a new chapter. I believe it is worthwhile exploring the chapters we have completed thus far. Since beginning this journey in fiscal 1991, we have gone through three distinct phases. Phase I, which began in the early 90's, focused on internal restructuring - a rebuilding of our foundation. Phase II started in 1995 and focused on internal growth and acquisition investment. The last phase, which focused on cash flow, began in 2001 when we experienced the 100 year flood in the electronics business, and ended in 2003. Let's review each phase briefly.

    - Phase I - 1991-1995 - Building the foundation. We started this phase in a full blown recession. Our company needed to change. We were far too internally focused. We had enjoyed decades of steady growth, but our markets had become more mature. We were wholly unprepared for this new reality. We responded by restructuring. We closed six of eight plants in the U.S., divested our microelectronics business, and installed new management. The results?

    The defining event of Phase I was the stock buyback in 1994. Before we tendered for our shares there were 3.5 million shares outstanding. It was almost universally believed that with so few shares outstanding, and therefore, so little float, a buyback would not be successful. Even if it was successful, we would have so little float left we would lack viability as a public company. Besides, they argued, the stock hadn't moved in ten years! Why would you want to buy it back? We argued that we had improved the performance of the company in a fundamental way, and that there was uncommon earnings leverage in our business model. We just needed a little help from our end-markets to prove it. Mr. Market (the investment community) still didn't believe us. So, in mid 1994 we tendered for 25% of the outstanding shares. Eight hundred thousand shares traded the day we announced the offer. So much for illiquidity! I will never forget the phone call I received from a representative of the largest U.S.-based mutual fund who was one of our largest shareholders. He was ecstatic we had tendered at $30 a share when the stock had been stuck in the mid $20's for almost ten years. He also told me that with so few shares outstanding, we would be a $20 stock after the tender. A year later in 1995 we finally got some help from our markets. Our EPS was double what it had been the year prior to the buyback and our stock closed the year at $65 a share (prior to a 9:1 split since then). So much for common wisdom.

    Phase II - 1996-2000 - Strategic remake. At the end of Phase I we were almost entirely dependent on our electronic chemicals business. It represented almost all of our earnings. We felt we had little choice but to reduce the concentration of risk. In this regard, we differ from most companies. Our ownership of MacDermid is concentrated. Your CEO and many others own MRD as their primary asset. More than 90% of my net worth is comprised of MRD stock. 100% of my investment and retirement assets are MRD. This is true of many others at MacDermid, especially your more senior executives. Any real risk to the entity is intolerable. Additional and important motivation to expand our horizons came from the belief that we could implant the MacDermid culture and business discipline on acquired businesses to add much more value than would be the norm in acquisitions. Therefore, we embarked on a five year diversification effort. We acquired Hercules' printing business in 1995, the W. Canning metal finishing and Offshore Fluids business in 1998, and PTI's printing business in 1999. The results are impressive.

    Our stock peaked at $46 a share after 9 for 1 stock splits during this period (two separate 3 for 1 splits in 1996 and 1998). On the same share count as we had for the stock buy back, it would be $414 a share! At $46 a share, the PE ratio was 27, quite heady for an industrial company. By 2000, in addition to enjoying much higher earnings, our revenues were much more balanced. Thank goodness. Little did we know that the electronics market would decline by 50% from one day to the next. We were severely criticized for expanding into lower growth businesses and thereby hurting our long term growth prospects. Our view was that we would trade a lower upside for a much more assured survivability every time.

    - Phase III - 2001-2003 - Insure survivability. We entered this period with $461 million in long-term obligations, primarily senior bank debt. The electronics market was a disaster. We had invested millions in a "venture capital like" opportunity called Viatek. This was a revolutionary new technology for producing inexpensive printed circuit boards. We had not been able to demonstrate that Viatek carried production yields high enough to capture the cost advantages. Then when the western market almost evaporated overnight, we were faced with investing even more, and the goal line had been moved as a result of hyper-efficient Asian manufacturers. The big labor savings we planned on were simply less important when confronted with Asian prices. We wrote off a total of $46 million related to these investments at a time when our electronics business was in a free fall and our senior debt was at an all time high. Our earnings tanked. The impact of the volume losses due to the hundred year flood was approximately $1.00 in earnings per share. Not helping matters were integration problems in some of the acquired businesses. We were unable to get all of the acquired management to embrace our culture, especially the accountability and discipline. This turned out to be a mixed blessing. We experienced delays in gaining the value from some of these acquisitions. This was especially true with W. Canning and PTI. But, by going through this exercise we learned a powerful lesson; we have to move quickly to determine if an acquired manager has the interest and ability to step up to our level of intensity. Our culture is unique enough that outsiders often have difficulty fitting in easily. In times of stress this difficulty is magnified. When we found out they could not make it with us, we replaced the acquired managers with our own proven managers. The results were immediate and striking.

    The bad news was that while we were figuring this out, our stock went from $46 to $12 a share. Fortunately, however, our survivability was assured due to the strength of our business model, and the speed at which the new management teams we had placed in the acquired businesses implemented the needed changes. This resulted in positive cash generation throughout this period. Had we been forced to ask for more credit, it could have been a very different picture. We proved beyond any doubt the power of the Clan MacDermid. Between 2001 and 2004 we paid down $160 million in debt, generated $125 million in cash .after buying back $51.8 million in stock. If we told the market in 2001 we would be doubling our dividend soon, most would have laughed. Since then we tripled it. Yes, we proved that the level of ownership and accountability at MacDermid is rare and valuable.

    What is the point of going back over all this history? Simply to illustrate why we have confidence in Phase IV. Many counted us out in the early 90's when our revenues were seemingly stuck in a rut. But we did grow. Value was created. We diversified out of a strategic problem of over-concentration. Now we have a very evenly balanced business concentration. Then most recently in Phase III, we fundamentally improved the results of acquired businesses by implementing our strong culture. Each phase required a different set of skills.

    Now we are in Phase IV. Last year we discussed the MacDermid Business Process. This is the blueprint we will use to lead us forward. This is clearly a growth initiative. It has three parts. 1) The strategy process in which we make sure we are investing in the right projects; those projects that address the market needs which are most likely to result in significant growth opportunities. 2) The operations process identifies the 'vital few' initiatives that will insure we bridge from day-to-day projects to the longer term strategy. This insures the organization is appropriately focused both short and long term. 3) Finally the people process is designed to identify and develop management talent and provide bench depth. Given the unique nature of our culture, this is critical. Yes, we have had some success with senior management that came along with acquisitions. But, we have also replaced many that couldn't or wouldn't step up to our culture. As a result we believe it is critical to aggressively build our management capacity from within.

    We are a year into Phase IV, which began when Stephen Largan was appointed President of MacDermid. It is his charge to lead the business processes and lay the foundation for growth. This is a much different direction than we have

    traveled recently, when we were focused on survival. Through this process, we have identified and are tracking 100 initiatives across the corporation. Almost all are directed at innovation or top line sales. This focus on initiatives to drive organic growth is a dramatic and exciting shift in emphasis. The inherent earnings leverage of our business model and our unwavering commitment to discipline on capital expenditure and S G & A costs will give us outsized benefits from any revenue growth.

    In addition to the focus on organic growth, we ended the year with $137.8 million in cash on our balance sheet. It is likely that if we don't make an investment, we will end 2005 with cash approaching $200 million. Clearly this gives us the opportunity to supplement our organic growth with one or more attractive acquisitions. However, our discipline and commitment to ensuring high returns on our invested capital mean that we are extremely picky when we evaluate a potential acquisition. To date we have been unsuccessful in finding one that meets our high threshold for attractive returns on a risk adjusted basis. We looked at several during 2004, but just couldn't make the numbers work. To us, to do nothing is far better than to do something that is ill-advised. We will always err on the side of caution. We need to have a lot of confidence that any deal we make has sufficient margin for error in valuation and execution. It is more likely we would acquire a small business where the competitive landscape is more limited, or the synergies as a portion of value would be higher. We think it is also more likely that a larger transaction will take the form of a stock deal rather than cash. That is because it is extremely difficult for us to win an all-cash auction in this environment of hyper-liquidity from private equity and hedge funds. However, we have something the private world does not - a currency other than cash. We think it is possible that a company may want to ride our equity and corporate management team by accepting our stock for at least a portion of the payment rather than selling their business for cash. By participating in the upside, it is possible, and we believe likely, that they will ultimately receive far more value than an all-cash deal. After all, our compounded return since we began this journey is 21.1%.

    We have $301.5 million face value in 9 1/8% bonds outstanding. They are callable in mid 2006. This is an obvious use of cash if we can't find a higher returning investment before then.

    Whether we grow primarily through organic growth, acquisitions or some combination remains to be seen. For now, we are focused on solidifying our foundation for growth by developing a system to prioritize our internal investments in innovation and top line sales initiatives, by building our bench of talent, and by rolling out a corporate wide brand.

    In this current phase, we are asking for the Clan MacDermid to shift direction yet one more time. They have never failed us, and I fully expect we will be successful this time as well. We haven't forgotten our basic philosophy, printed on the inside front cover of this report. We won't lose sight of our frugal nature that has bought us this far. We will embrace the strengths in our culture and shift our orientation to grow. If we are successful, the future will be bright indeed. Thank you for your confidence.

    Disclosure: I am long PAH.

    Themes: Outsider CEO, Chemical Stocks: PAH
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