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H.B. Fuller: Worst Has Likely Passed, No Threats To Dividend

H.B. Fuller Company (FUL), the adhesives and sealants industry heavyweight and a dividend champion with 51 consecutive years of DPS increases, has recently presented its surprisingly strong fiscal Q2 results that offer a glimpse into how the specialty chemicals industry had fared during the challenging quarter when essential end-markets suffered from the effects of the coronavirus pandemic. Importantly, FUL has an atypical fiscal year, so its Q2 encompassed perhaps the toughest months: March, April, and May, when the coronavirus had begun to rapidly expand beyond the Chinese borders and strict lockdowns across the globe were enforced by governments to hinder the spread.

Expectedly, the overall performance was mixed, marred by an 11% total revenue drop (a 7% decline in organic sales), precisely within the range the company mentioned in its Q2 guidance in the presentation. But though consolidated sales tumbled, the segmental performance had asymmetric dynamics because some of H.B. Fuller’s end-markets bear the brunt of the pandemic, while others have even reaped substantial benefits, booking strong profits in the wake of consumer stockpiling spurred by the (groundless and premature) fears of the looming shortages.

Source: UnsplashSource: Unsplash

As a quick reminder, Fuller’s reportable segments are Hygiene, Health, and Consumable Adhesives (or HHC), Engineering Adhesives, and Construction Adhesives. More specifically, HHC, the leading segment regarding revenue, is exposed to the end-markets that are relatively immune to the detrimental ripple effects of the pandemic and the economic downswing, like hygiene, health & beauty, packaging, tissue & towel, etc. In the Q2, it delivered a 7% organic revenue growth undergirded by “double-digit growth in adhesives for essential goods and packaging.” Thanks to the resilience of the HHC segment and swift recovery in Greater China, overall Q2 results were above expectations, as analysts anticipated the top and bottom line to be much more depressed. Surprisingly, adjusted earnings before tax, interest, and D&A even topped FUL’s own estimations for the quarter (a range between $90 million and $100 million) and rose to $101 million, exceeding the fiscal 2Q19 and 1Q20 levels, thanks to cheaper raw materials and scrupulous cost management.

While HHC shone, softness in aerospace, new energy (both solar and wind), and automotive dented sales and adjusted EBITDA of Engineering Adhesives. The division’s revenue fell 20% YoY. Adhesives & sealants produced by EA have a plethora of applications from powertrain (e.g., anaerobic flange sealant) to exterior lightning and friction bonding agents. I reckon that there is some certainty that as automotive companies ponder options to cope with the broad market crisis and cautiously manage inventories in order to preserve cash, the demand for raw materials used in manufacturing processes will remain under strain; so, it will inevitably continue to weigh on the operating results of Engineering Adhesives this year. The sentiment in the aerospace industry that suffers from a sharp reduction in air traffic will add to difficulties.

Finally, Construction Adhesives’ revenue tumbled by 15%, while adjusted EBITDA was also crimped. Construction activity hibernated in the first quarter; while it was resumed in most countries as new COVID-19 cases began sliding lower, the industry is still not in perfect shape, and a destocking trend may still weigh on sales of materials companies. H.B Fuller itself is optimistic as it anticipates the EA and CA results to improve during the second half of the year, as “industrial production and building construction start to ramp up around the world.”

How competitors fared

H.B. Fuller and other key players in the adhesives & sealants market Henkel AG & Company, KGaA (OTCPK:HENKY) and Arkema S.A. (OTCPK:ARKAF) have different reporting periods, thus the comparison of their results is a bit complicated.

During the first quarter (January-March), Henkel suffered from generally the same headwinds. The principal difference worth highlighting is that its Adhesive Technologies’ sales were impacted by the lockdowns in China in January-February, while during H.B. Fuller’s spring quarter, the Chinese economy had been gradually returning to normalcy, as the draconian measures were lifted. Organic revenue of Henkel’s Adhesive Technologies division was down 4.1% vs. 1Q19 (see slide 15), solely because of volumes decline that was precipitated by the powerful headwinds stemming from clobbered activity in the automotive & metals end-market. The German company also noticed stable demand in the packaging & consumer goods area.

Next, Arkema, French specialty chemicals heavyweight that generates around a quarter of the total sales from the Adhesive Solutions division, reported a 3.2% drop in the segment’s volumes in Q1 (see slide 8), even despite higher demand in packaging because of an exceedingly strong slowdown in transportation and a few industrial segments. So, Arkema’s and Henkel’s observations regarding the sentiment in the overall economy chime well with H.B. Fuller’s conclusions.

Free cash flow and capital efficiency. Is the dividend in jeopardy?

While both quarterly and half-yearly consolidated sales tumbled, FUL easily covered half-year capital expenditures of $54.5 million and delivered a cash surplus of $53.88 million, thanks to a hefty improvement in working capital on the back of sizeable reduction in inventory that was a strong tailwind for net CFFO. FCF margin reached 4%, which compares more than favorably with the net margin of only ~3.1%. During the same period, dividends paid amounted to $16.58 million, and hence, rewards were covered by FCF 3.25x. So, I would not say the dividend is in jeopardy. FUL expects FY20 capex totaling $75 million to $85 million; even in the case of a deep reduction in net CFFO, DPS will still be adequately covered.

On an LTM basis, H.B. Fuller’s capital efficiency remains relatively adequate but barely perfect, as, according to my estimations, its LTM Cash Return on Total Capital is approximately 9%. This result is heavily influenced by the burdensome debt on the balance sheet that pushed the denominator to $3.3 billion.

Some flaws of the balance sheet

H.B. Fuller’s total debt specifies a D/E ratio of above 161%, which looks highly inflated. A 6.23x Net debt/Net CFFO is also more than simply worrisome. A 5.1x Net debt/EBITDA is barely better. The silver lining is that FUL has been consistently deleveraging. In the fiscal second quarter, the $45 million debt paydown was above the prior-year Q2 level. The company will likely remain FCF positive in FY20, and its $200 million debt repayment goal can be easily achieved. Let me cite the press release,

The company remains committed to managing working capital and cash costs in order to reduce debt by $200 million in 2020. Contingency plans are available as necessary for adjustments in expenses, working capital and capital expense to achieve this target.

Also, the interest coverage by EBITDA remains adequate, equals to ~10.4x. Besides, FUL has no significant near-term maturities, as comes from the current liabilities section of its Q2 balance sheet (see page 5 of the Form 10-Q).

What may lie ahead

The reasonable portfolio versatility helped FUL to emerge from the tough fiscal Q2 relatively unscathed. The Q2 results illustrated that if FUL was a pure engineering & construction-focused adhesives company, it would face a precipitous revenue decline and, perhaps, liquidity issues. In this case, its dividend would likely be suspended in order to avoid a cash crunch. Thankfully, the flagship HHC segment and strong exposure to the consumer durables/non-durables end-markets saved it from much deeper sales decline and shored up cash flows and dividend coverage.

According to analysts’ consensus estimates, the worst has already passed as Q3 and Q4 revenue contraction is forecast to be less deep than in Q2. At the same time, insider selling points to the fact that the share price has perhaps reached a zenith and its short-term potential is limited. To conclude, I am neutral on FUL.

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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