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Fuchs: Investment For The Long Term

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About: Fuchs Petrolub SE (FUPEF), FUPEY
by: Marathon Investing
Marathon Investing
Long/short equity, long-term horizon, value, quality
Summary

The current profitability is pressured by a high investment program.

Fuchs has changed several times during the year its outlook for 2019.

If Fuchs delivers on its capex program, then the probability to see higher intrinsic value is on the Company side.

Investment Thesis

Fuchs (OTCPK:FUPEF) (OTC:FUPEY) develops, produces and markets high-grade lubricants and related specialties for virtually all industries and areas of application. Fuchs is the world's largest independent lubricant manufacturer. The most important markets in terms of sales revenues are Western Europe, Asia, and North America. The Company manages to achieve high returns on invested capital and at the same time operates as debt-free. The current profitability is pressured by a high investment program which has started in 2016. At top of it, the company feels macro pressures from China and Western Europe.

Business and Industry Overview

Fuchs produces more than 10,000 lubricants and related specialties for hundreds of applications in the key automotive, industrial, metalworking, special applications, lubricating greases and services categories.

There are around 700+ lubricant manufacturers in the world with the top 10 manufacturers taking more than 50% of market share so consolidation will be a way for participants to accelerate top-line & cash flow growth. China and the USA cover more than one-third of the world's lubricants market, but there is a big difference in demand per-capita. Asia-Pacific region still lagging in demand per-capita.

Capacity to Suffer

The term "Capacity to Suffer" was popularized by Thomas Russo. He applies this phrase "Capacity to Suffer" to businesses when they choose to invest in growth which hits profits temporarily. "When you invest money to extend business into new geographies or adjacent brands or into other areas, you typically don't get an early return on this. That means they have to have the capacity to suffer." The businesses willing to invest hard behind growth need management that thinks long term.

In 2016 - 2018 over €300m capex was spent with the focus on the expansion of Mannheim, Kaiserslautern, and Chicago as well as new plants in China, Australia, and Sweden. Capex will peak in 2019 at €180m. In 2020/2021 more than €100+m p.a. will be spent on growth and replacement as well as efficiency improvements due to significant volume increases, technological changes, and a changed product mix. From 2022 onwards, capex should be back on par with the new level of depreciation.

This capex program negatively influences current financial results, therefore Fuchs has lower profitability comparing the status quo.

Key Risk

Although there are many operational and financial risks I will focus on the electrification of cars which is, in my opinion, the most pronounced in Fuchs's case.

The trend towards electric vehicles at the expense of combustion engines appears to be uninterrupted. The Company's management is aware that in the medium and long term, electric vehicles may overtake the market and the combustion engines might go the history books. They are already aware that this will mean a decline in the sales of engine oils. At the moment, there is no need to be alarmist about the decline in sales for automotive lubricants. Regardless of the powertrain type, every car needs a variety of other lubricant applications. EVs will place a whole new demand on gear oils, coolants, and greases. Forecasts are difficult but it could be you lose some of the business, but on the other side, you win as well.

Recent Results

Fuchs has recently published the first nine months' results. Here are the main highlights of the results:

  • Topline flat comparing the same period last year;
  • Europe segment revenues declined by 3% YoY;
  • Asia-Pacific segment revenues declined by 1% YoY;
  • North and South America segment revenues were up by 5%.
  • The income statement for the first nine months was dominated by the planned increase in costs in connection with the growth program (capex program).
  • EBIT was down 17% year-on-year at €246m;
  • Net income declined by 20% to €176m;
  • Free cash flow before acquisitions was significantly lower than in the previous year.

Outlook

Fuchs has changed several times during the year its outlook for 2019. At the beginning of the year, Fuchs expected to deliver growth in revenues between 2 and 4% and EBIT decline of -8% to -5% (based on EBIT 2018 including one-off income). After the first-half results, Fuchs adjusted its outlook for 2019. The new outlook for 2019 was more conservative and the Company expected to post revenues between -3% and +0%. EBIT decline should be between -30% and -20%. Given the results for the first nine months and update in the economic situation, Fuchs now expects both sales and revenues to be at the upper end of the range of the forecast.

To Sum Up

It is hard to put a static price target on a company that is doing business in a volatile industry. The current financials are pressures due to the capex program (growth initiatives) and volatile macro environment. To be more precise, without growth investments Fuchs should have free cash flow around €200m. Therefore, if Fuchs delivers on its capex program, then the probability to see higher intrinsic value is on the Company side. In that case, free cash flow could be around €250m to €300m. If we use mid-range of €275m and the current market cap than we get multiple of free cash flow to a market cap of around 19x.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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