As the second-largest participant in the relatively fragmented adhesives market, there are certainly some positive characteristics to H.B. Fuller (NYSE:FUL). Fuller has historically been good at "sticking to its knitting" and focusing its resources on those markets where it had a strong position, and the company should be able to achieve meaningful operating margin improvements in the next few years from greater manufacturing and operating efficiency. Better still, the company's more recent turn towards engineered adhesives gives the company better exposure to some of the more attractive growth markets within adhesives.
Although Fuller's shares have lagged the local market performance of its major competitors (Henkel (OTCPK:HENKY), Sika (OTCPK:SXYAY), and Arkema (OTCPK:ARKAY)), it's hard to call the shares undervalued, as the price already seems to discount high single-digit/low double-digit growth in free cash flow and EBITDA. On the other hand, industry M&A has established a double-digit multiple on EBITDA as "reasonable" and H.B. Fuller's pivot toward faster-growing segments of the adhesives market could deliver better results than presently expected. On balance, I think Arkema is a more interesting pick today, but H.B. Fuller would be worth reconsideration on a pullback.
A Distant, But Focused, #2
The adhesives market is an unusual one. It's quite large, at over $46 billion in annual revenue, but it is a market with one Snow White (Henkel, with roughly 25% share) and several dwarfs with single-digit market share, including Fuller, Arkema, and Sika. Some markets, particularly industrial-facing markets like adhesives/sealants used in autos, aerospace, and construction, are growing comfortably above global GDP, while markets like packaging are slower-growing and more competitive.
In contrast to Henkel, which spends considerably more on R&D and operates in a large number of market segments, Fuller has historically been more specialized and has focused its resources more intently on those markets. Packaging, hygiene, and "durable assembly" have historically been the company's prime markets, generating close to 70% of revenue, and Fuller has enjoyed meaningful market share (15% to 20% for the most part) and #1 or #2 market positions as a result.
Fuller has used its focused R&D spending to achieve technology leadership in areas like reactive hot melts (a replacement/alternative for epoxies, silicones, and some polyurethanes) and certain polyolefins. At the same time, Fuller management has been pretty consistent in its messaging over the years that it believes that sales execution, not chemistry, wins business. To that end, the company has worked to maintain a focused market-oriented sales approach where many of its rivals use distributors. I think Fuller's approach has at least two potential advantages - the company can more aggressively go after growth opportunities by actively making sales calls, and the company can work more collaboratively with its customers/potential customers (finding out about their needs and developing more customized products/solutions for them).
Shifting Toward Growth
The company has recently started building up a meaningful new growth opportunity in its engineered adhesives business. Between the acquisition of China-focused Tonsan and a greater focus on its own auto and electronics businesses, Fuller now looks better-placed in some of the more attractive growth markets in adhesives.
Adhesives are replacing mechanical fasteners (like screws, bolts, rivets, and welds) in markets like auto assembly, aerospace, construction, and infrastructure as adhesives are typically lighter and can offer other meaningful performance advantages. Adhesives typically handle contraction/expansion (in response to temperature variation) better, they don't require holes to be made in the material(s), they distribute stress more evenly, and they can often be applied much faster (if not through automated systems).
All told, engineered adhesives amount to a market opportunity of over $12 billion growing at a high single-digit rate, as auto, aerospace, energy, and electronics companies switch to adhesives or develop new products (like smartphones and tablets) that are largely held together with adhesives. Fuller already has a strong position in solar panels and auto interiors, and is actively trying to expand into auto structural bonding and electronics. Henkel has enjoyed strong share in electronics for some time, and Fuller has historically had a minimal presence, but many manufacturers want a strong alternate supplier, so the barriers to Fuller gaining share may not be as formidable as you might think.
Fuller is still significantly exposed to markets like packaging and durable assembly (which includes markets like appliances, filters, and furniture) and these markets are not likely to grow all that much in the coming years. What's more, I expect more price competition here as the markets become more and more competitive and commodity-like. Hygiene, though, is still a growth opportunity given global trends like an aging population (incontinence products) and accelerating adoption of disposable diapers in markets like China.
Construction could also be a growth opportunity for Fuller, as the company's revenue exposure to this market is less than half of the industry-wide exposure. On the other hand, a lot of the construction market is commodity-like, so I would expect Fuller to prioritize those opportunities that offer above-average growth and/or margins and they will likely see competition from companies like RPM (NYSE:RPM) for deals.
Margin improvement is another significant driver here. Fuller had its issues with an ERP implementation, but the company has been executing long-term strategies to shift its mix toward higher-margin products, improve supply chain efficiency, and improve manufacturing productivity. Gross margins have often been in the high 20%'s over the last decade, but management thinks they can get those to the low 30% (31%) in 2020. Coupled with ongoing operational expense leverage, management is targeting a nearly four-point improvement in EBITDA margins from FY 2016 to 2020.
I do think that management's target of around 5% annual revenue growth through 2020 is reasonable, as the company's engineered adhesives business is growing well above underlying market growth (which itself is likely to keep growing at a mid-single-digit rate for several years). Hitting those margin targets seems a little more ambitious to me, but I do believe Fuller should be able to get to high single-digit FCF margins in five years and might get into the double-digits down the road.
Discounting those cash flows back, the shares look more or less fairly valued today, although still priced for a roughly 10% total return. My EBITDA-based fair value is a little lower (in the mid-$40's), but if management hits their targets, an EBITDA-based fair value around today's price seems reasonable. I would also note that M&A is a meaningful variable - I think it's a near-certainty that Fuller will continue to do deals in this fragmented market (where the top 10 players have 40% to 45% share), but I expect the deals to generally be small and focused on attractive niches within or adjacent to Fuller's existing target markets. While these deals are likely to add only a couple of percentage points of revenue growth at most, they should offer some worthwhile expense synergy.
The Bottom Line
As an adhesives pure-play, I think Fuller is a good way to play one of the more attractive specialty chemical markets. Considering the valuation, though, I'm not quite as bullish - Fuller certainly deserves some scarcity premium and the company should be able to improve its growth and margin performance relative to the last few years, but the share price already seems to reflect solid near-term growth opportunities, better margins, and a return to healthier ROICs.
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