FUL - Macro Risks Loom Larger For H.B. Fuller But Valuation Is Getting Interesting

Summary

• H.B. Fuller reported weaker-than-expected revenue as volumes continue to erode, but Fuller's performance wasn't out of line with those of comparables like Sika.
• The auto end-market should be a healthy one for Fuller in 2023, and packaging and hygiene should be relatively stable, but electronics and construction are likely to be weak.
• Fuller is making demonstrable progress on product innovation and upgrading the portfolio, but it has yet to translate into much-desired margin leverage.
• Valuation is getting more interesting, and I believe H.B. Fuller shares deserve to trade around $75 to $80, but macro headwinds (and pricing leverage) remain a threat.

The macro outlook is about as clear as mud going into 2023, as rate hikes seem to be having a real impact on demand and business capex plans, but a full-on recession may not be in the cards just yet. Looking at H.B. Fuller ( FUL ), this leading manufacturer of adhesives and other specialty chemicals did better than I’d expected in 2022 with pricing, and efforts to drive more innovation seem to be paying off, but weaker volumes and a slowing macro outlook loom as headwinds.

I wasn’t bullish on Fuller last year , and the shares are down a bit since then, doing about as well as the average industrial, but outperforming comparable specialty chemical companies like Henkel ( OTCPK:HENKY ), Arkema ( OTCPK:ARKAY ), and Sika ( OTCPK:SXYAY ). The valuation is more interesting now, and I like the company’s leverage to autos, but I’m also concerned about the exposure to construction and electronics, as well as pricing resilience in the sector. I’m going to stay on the sidelines here for now, but I have to admit that the valuation and signs of improved execution are pushing me toward a more bullish stance.

A Mixed Quarter, With The Street Already Expecting Some Areas Of Softness

Fuller’s results missed expectations at the top and bottom lines, but I believe the muted market reaction came from investors already dialing in lower expectations on weakening volumes – numbers have been coming down across the specialty chemical space and Fuller shares have sold off about 15% since late November.

Revenue rose about 7% as reported and a little more than 6% in organic terms. With few comparables having reported yet – just Sika and PPG ( PPG ) (and that’s a stretch as a comparable) – contextualizing Fuller’s numbers is a little harder. Still, revenue missed by about 5%, versus a 5% miss at Sika (with 8% organic growth) and a 2% beat at PPG (with 6% organic growth), so I’d say Fuller was pretty much consistent.

Pricing continues to be strong, as it was for Sika and PPG, with over 11% growth from pricing this quarter, but demand continues to erode, with volume down 5%. Demand held up better in Engineering Adhesives (revenue up 8.5% organic) and Hygiene, Health, & Consumer (or HHC), up over 12%, but was significantly weaker in Construction (down almost 20%).

Gross margin fell another 90bp from the prior year and 30bp from the prior quarter (to 26.2%) as the company continues to face persistent input costs and other elevated expenses. EBITDA rose 5%, as did operating income, with EBITDA missing by close to 10%, while segment income improved 10%, with margin up 30bp to 10.2%. By segment, Engineering Adhesives saw 36% growth (with margin up 230bp to 13.6%), HHC saw 7% growth (with margin down 390bp to 9.7%), and Construction saw significant profit erosion with margin down 840bp to 0.8%.

Not surprisingly, Fuller also missed free cash flow expectations, as the company continues to see elevated working capital levels. Free cash flow was still up from the prior year, with a below-trend FCF margin of 3.4%.

The Macro Outlook Is, At Best, Cloudy, But There Are Areas Of Sunshine

With PMIs showing contraction in the U.S. and Europe in recent months, the macro outlook for roughly two-thirds of Fuller’s revenue base is not particularly robust today, but I do think there are some important market-by-market considerations.

The auto end-market is a significant (10%-plus) one for Fuller, and the company is well-leveraged to growing production volumes of EVs, as these cars tend to make more use of advanced adhesives and sealants (partly to reduce weight, but also to control temperature, noise, et al). I’m relatively bullish on the auto sector in 2023; I do have concerns about weakening consumer demand, but OEMs still have catching up to do to replenish inventories and I expect ongoing growth in EV production (particularly in China).

I’m considerably less bullish on the Construction segment (around 12.5% of Q4’22 revenue). I expect weaker residential and non-residential activity in 2023, and I expect that to translate into weaker demand for roofing and flooring products. Infrastructure is a wild-card to watch; this hasn’t historically been a large business for Fuller, but the company has been actively developing new products in recent years.

I’m also not bullish on the outlook for electronics, and that’s consistent with the guidance from most chip companies and consumer products manufacturers. I’m more bullish on markets like solar, though, and I think Fuller should see reasonably good demand in packaging and hygiene, as well as better demand in medical devices, but weaker demand from appliance and wood products (furniture, cabinetry) customers.

A few other factors are worth considering. China could offer some upside as it emerges from its COVID lockdowns, but I’m still not particularly bullish on the outlook for construction there. I also believe innovation remains an important potential driver; Fuller has been stepping up its efforts here, and this could be a share driver in areas like autos, construction, and packaging over time. Last and not least is pricing. I think it will be difficult to push through meaningful additional price hikes, and I remain considered that specialty chemical companies are going to have a harder time maintaining price if and when demand erodes in 2023.

The Outlook

It’s worth noting, I think, that Fuller doesn’t have the best track record when it comes to meeting their own internal projections and driving impressive margin leverage. To that end, even with strong pricing actions in FY’22, EBITDA margin was still down from the nearly 15% pre-pandemic level. With that, management’s margin targets for FY’23 could prove too optimistic.

I'm looking for modest year-over-year growth in FY’23 followed by mid-single-digit revenue growth in FY’24 and FY’25. I expect EBITDA margin just a bit above 15% in FY’23, with modest leverage in the near term, but improvements over time as the company continues to upgrade its product portfolio (a richer mix of “highly specified” products). Longer term, I expect organic revenue growth of around 4.5% and FCF margin improvement into the high single-digits, driving mid-teens FCF growth. Fuller has generated FCF margins in the 7% to 9% range in the past, but not on any sustained basis, so I do think my margin/FCF improvement assumptions could prove too bullish.

Discounting those cash flows back, I think Fuller shares could be around 10% undervalued today and priced for longer-term annualized total returns in the high single-digits. Using my margin and returns-driven EV/EBITDA approach (and a resulting forward EBITDA multiple of 10.5x), I get a fair value a bit above $79, and I could see a path that would support a multiple of 11x (and a mid-$80’s fair value).

The Bottom Line

I’ve had my past doubts about Fuller’s ability to achieve sustained pricing, drive meaningful innovation, and produce meaningful margin leverage. I’m more comfortable on the innovation side, but I think pricing persistence has yet to be proven and margin leverage is a work in progress. I find the valuation and risk/reward trade-off more interesting now, but given my weaker-than-average macro outlook, I’m holding off on a more bullish stance for now. Were these shares to continue sliding into the low $60’s, I’d have to take another look.

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