It was recently suggested that this year's shareholders letter take the form of a performance review to "my boss". I really liked the idea as I strive to never lose sight of who I work for, you the shareholders of MacDermid.
As usual, this is a lengthy letter. I have long followed the lead of Warren Buffett who suggests that CEOs should communicate with shareholders as they would want to be communicated with if they were a partner in a private company. I can't do that in a few paragraphs. First the numbers.
In 2005, net sales were $738.0 million compared to $660.8 million in 2004. Net earnings were $47.0 million or $1.52 per share down from $53.2 million or $1.72 in the prior year. Earnings per share were reduced by two categories of unusual items. The first we view as one time costs which included $3.8 million in acquisition accounting charges and the settlement of a law suit. The second was restructuring and a divestiture provision of $3.4 million. There were significant costs incurred in 2005 that will benefit future years. A description of those costs follows in the operating review. Owner Earnings (1) were $46.5 million down from $76.7 million in the prior year reflecting the investment in working capital to fund sales growth. Our year end cash holdings were $80.9 million after spending $92 million on the Autotype acquisition.
CEO performance review 2006. I believe my performance should be judged on intrinsic value creation. If we agree that intrinsic value is the present value of future cash flows, then the steps we took to improve the future cash flows are most important. I am the first to agree that if one spends too much of their time in the future, they may lose sight of the present. Wishful thinking has been the downfall of many CEOs. I will therefore make sure to cover the current results, while keeping the perspective that many short terms add up to and become the long term. Value creation in my view occurs at the intersection of long term strategy and short term execution. The old saying, "If you don't know where you are going, any road will take you there," is well suited to our journey. In today's world, strategy is more critical than ever. The world is changing so fast, missteps in direction are compounded, and quickly. Businesses are being destroyed and created at the speed of light. MacDermid is well grounded in the industrial economy and although this suits our long term cash flow orientation, it has provided challenges recently as the world's production moves to low cost developing countries. Let's review how we have coped with this change while we review the strategic positioning of our businesses.
|·||Advanced Surface Finishing. In our Advanced Surface Finishing segment, our largest and most important, we have seen a wholesale shift of industrial production to Asia and other low cost developing areas of the world. Had we stayed firmly rooted in North America and Europe we would be in very tough shape today. Thankfully we anticipated the market movement and today, almost 40% of our revenues in ASF are in those developing parts of the world. We have invested heavily in China. Our staffing in greater China increased by 47% in the last three years, including 60 people this year. We commissioned our new factory (our third in greater China) and our technical center near Shanghai. This represented the largest capital investment in the history of MacDermid, some $10 million. This is a significant commitment by any standard, and even greater when you consider our Scottish heritage which emphasizes frugality. We obviously believe strongly in these moves, especially since not one cent was needed for current production. The entire investment is for the future. Yes, this reduced earnings this year, but I believe this is a prime example of lowering current cash flows in exchange for more cash in the future. We recognized the threat and opportunity early. We then executed the plan to transition our business from the developed West to the new opportunities in the developing world. This investment is a "step investment" that won'tt have to be incurred again in the next few years. As a result we expect the cash flows from this business will increase at very attractive rates over the next few years. I believe we rate an A+/A+ on this one. Great strategy - great execution.|
|·||Printing Solutions - Packaging. Our Printing businesses have also faced changes. In the case of packaging the trend to digital and thermal plate making is pronounced. As one of the four leaders in the analog world of plate making, we are in a race to replace the old technology. We started the race behind the competition in both areas. When we acquired Polyfibron we waited too long to "MacDermidize" the business. As soon as the MacDermidization began, we recognized our position in innovation and began investing in R&D. Only towards the end of 2005 did we start to see the benefits of those investments. Grade B/D. Solid strategy - execution not acceptable.|
|·||Printing Solutions - Offset. In our Offset printing business, we reviewed our strategy and changed management in 2005. Although we still believe key segments of the Offset world are best served by a "Bookends" model, i.e. dual emphasis on innovation at the front end and technical service on the back end, we now believe this should not be our primary approach. In 2006, we will take steps to modify our strategy and improve the results. Grade D/D. Poor strategy - poor execution.|
|·||There were two very bright spots in the printing business. In Newspaper plates, MacDermid has undertaken a strategy to develop better technology for printing newspapers by improving upon our lexographic technology. 2005 marked a break through year as three new newspaper facilities committed to our offering. Many newspapers want to print specialty publications in addition to their standard newspapers. Flexographic technology is better able to print these publications than the offset technology currently employed. We have also demonstrated the technical viability of a computer-to-plate solution for flexography that provides the digital workflow desired by newspapers and are close to commercial availability of these systems. With the print capabilities of flexography and a digital workflow, we are now well positioned to expand the print capabilities of a newspaper. Not every newspaper is interested in this capability, but the newspaper market is a multi-billion dollar opportunity, so even a small portion of this market is still very attractive. On our performance scorecard I'd give us an A/A. Great strategy - great execution.|
|·||The other printing success story is ColorSpan our wide format digital printing business. Shortly after we acquired this business in 2001 we realized that the prior owner had underinvested in R&D. As a result we missed a generation of technology. That caused a painful retrenchment as we skipped to a third generation development effort without the second generation revenues to pay for it. During this period we wrote off a major portion of the $47 million purchase price. Our patience paid off this year. The third generation technology was well received by the market. As a result the business is making an excellent current return on our investment. Our Grade? Another A/A. Great strategy - great execution.|
|·||Autotype. In 2005 we acquired Autotype, a producer of proprietary films. This represents a good example of our approach in acquisitions. Autotype has an excellent market position in screen printing and hard coated film for membrane switches. These represent fairly stable cash flows. We could get a reasonable return on these businesses by themselves. However, we are looking for more than just a reasonable return. We are looking for some upside that would lead to an enhancement of our overall growth prospects. In Autotype's case, change at the speed of light is a reality. We are commercializing light management films for portable LCD screens that will enhance the screens' performance characteristics. This is a big Asia play. We have assigned one of our long standing experienced senior managers to lead this effort in Asia. The synergy of Autotype's technology, manufacturing and leadership team and our Asia team is exciting to watch. Autotype is a leader in in-mold decoration, a technology that bridges printing and industrial applications, especially automotive. It is too early to be sure how successful these new technologies will become, but they do offer exciting prospects. In the meantime we are ahead of the cost synergies we targeted in the acquisition model, some of which is a direct result of MacDermid's unique management style and identification of "differentiated cost" where we treat costs in between the bookends very differently than the strategic bookend costs. The business is doing well, after a hiccup the first quarter immediately after the acquisition. Scorecard grade? Incomplete - Good strategy - good execution so far.|
|·||Corporate strategy. Early in 2005 your Board of Directors thoroughly reviewed our corporate strategy. We brought in advisors to supplement the data and help us consider our future direction. We considered the cash flow of our businesses and the growth rates. The overarching conclusion was that we believe the MacDermid operating model is unique. The ability to generate high cash flow from businesses that share a need for the "bookend" strategy, i.e. high need for innovation and high technical service is leveragable. We decided to take a more aggressive posture with acquisitions. We considered using our excess cash flow to buy back stock, but determined that applying the MacDermid business model to acquired businesses offers the highest return and best use of your capital. As a result I spent a considerable amount of my time pursuing acquisitions. We'll take an incomplete on this one.|
On the face of it, 2005 was not our finest hour operationally. Operating profit was down by $11.7 million or 11%.
In 2005 we incurred one time costs of $0.9 million for purchase accounting for the Autotype acquisition and $2.9 million was expensed to settle a legal issue that related to our printing business before we acquired it. We also incurred $3.4 million in restructuring costs to adjust our cost structure, especially in Europe. Clearly the remaining issues reside in our printing business, especially Packaging. In the Packaging business - as well as playing "catch up" on innovation as discussed above, in late 2004 we also made a strategic decision to terminate a major distributor and take the business direct. The logic was that without a direct presence with the customers, the introduction of new products would be further delayed. The execution on this initiative was less than satisfactory, and as a result, we lost market share. In addition, as we introduced new products, ramping up manufacturing was troublesome and added to costs. Our Corporate President Stephen Largan has taken direct responsibility for the Packaging business on a temporary basis with the intent of getting the business back on track. All of our businesses saw increasing prices of raw materials that accelerated late in the year. Some businesses did a very good job of recovering these costs through price increases; others had to play catch up and will recover the costs in 2006.
In last year's shareholders message I discussed "laying the foundation for growth." This shift in emphasis from "hunkering down" to growth is rather profound. We initiated many projects that will help us grow but inconveniently, in the short term we will spend without a return. In our businesses the investments are modest and the returns normally come quickly - but not in the same year as the investment. The more significant P&L investments were:
|·||$2 million in expenses in 2005 for our China step infrastructure described above.|
|·||$1 million for Middletown Delaware plant conversion costs. This was a decision to convert our dry film plant to a multi-purpose film coating plant. This will enable the plant to produce Autotype products and film for our printing business which we previously purchased on the outside. This conversion required us to take the plant off line for a good portion of the year.|
|·||$1.85 million for increased R&D and European plant start up costs for our newspaper plates business. We added production capability in Europe to support the growing business there. This was all capacity to support growth. We also accelerated our funding for the development effort on our computer-to-plate-project. Our equipment partner was unwilling to fund this investment so we undertook it ourselves.|
|·||$1.8 million in increased R&D for the packaging business. We added an entirely new team in Europe to expand our technological capability. In addition we had a large number of product introductions which consume large amounts of sample materials as products are fine tuned.|
Owner Earnings Management. This year we reported Owner Earnings (1) of $46.5 million. This number is lower than we have come to expect due primarily to increased investment in working capital to fund sales growth. We continue to emphasize working capital management and ended the year with the best ever metrics for accounts receivable and inventory. Capital expenditures were well managed at $14.1 million. Almost all of the expenditure was invested to fund the growth initiatives.
The bottom line is that 2005 was an investment year as we laid the foundation for growth. We believe that at least some of these investments will begin to provide a return in 2006. When we tally up the above, noting the strategic successes and the execution successes, but facing up to the execution misses, I would grade our performance as a C, arguably a passing grade but far from reaching the honor roll. This grade was reflected in my 2005 cash compensation, down 58% and in a commensurate reduction for the executive team, as it should be. Your Board of Directors takes pride in remaining strategically focused. Nevertheless, their patience for operational improvement is not infinite, also as it should be.
The Piper on the front cover of this report, as well as the Corporate Philosophy on the inside front cover, represents far more than a PR image. The entrepreneurial culture is alive and well within MacDermid. If anything, it is stronger than ever. We have only 26 corporate staff at headquarters. This includes all support staff, legal, treasury, SEC reporting, etc. As a result we monitor our units at a very high level. This by necessity requires management of the units to take full responsibility for their results. This structure reinforces the feeling of entrepreneurship. This attracts and promotes independent people, just like the Piper on the front cover. Our entrepreneurial freedom does not translate into flexibility in internal controls. We take pride in coming through the 2005 Sarbanes Oxley 404 audit with no material weaknesses or significant deficiencies. As we grow, we will be successful only to the extent that these operating managers grow and prosper with us. They are guided by the MacDermid Philosophy written in 1962.
In 2005 many of our most senior managers met to revisit our culture and to question what should change. Without exception we agreed that the Philosophy as written fits us as well today as it did when our forbearers wrote it 44 years ago. We did note areas where we could improve in the way we live it each day. We are hard at work trying to honor our heritage by re-pledging to live the Philosophy as an entire document. It is worth looking at. It is a serious, heart felt commitment.
We recognize our progress would not be possible without the support and confidence of you, our shareholders and the efforts and dedication of the Clan MacDermid many of whom are also shareholders. We do not take this for granted.
Disclosure: I am long PAH.