Hidden Value

This Rio Tinto mining operation relies on Fenner belting to function.

Flickr. This Rio Tinto mining operation relies on Fenner's belting to function.

Modern industry has, as the saying goes, a lot of moving parts. Inputs and outputs often dominate thinking on the markets. Companies that produce the unsung tools essential to the midstream transformation of raw materials into retail consumer products can be overlooked or misunderstood. We believe that Fenner (FENR:LN), a leading maker of conveyor belting and polymer products used across a wide range of industrial sectors, is one such misunderstood company.

Fenner has a rich history. It began life as a maker of belting and it’s been in that business since the early 1860’s, when it was a small company churning out leather products based in the tiny seaside village of Marfleet near Hull in the U.K. It weathered the massive geopolitical and economic changes that swept over Europe and the rest of the world in the crazily eventful century and a half since its founding. And more than weathering them, it thrived. By the end of the 19th century the company was earning 70 percent of revenues from exports; the First World War put an end to that and forced it to re-strategize its domestic operations and drove a major period of internal innovation. It first listed on the London Stock Exchange in 1937 and has been a fixture there since.

It’s now as thoroughly a global concern as it was in the halcyon pre-War years, with operations in every major geographical region. It owns a chunk of the storied Dunlop brand and does business as Fenner Dunlop in the U.K., U.S., India, Australia, and South America. It has widened its product portfolio by innovating and coming to a position of near-dominance in the belting and related conveying solutions market. It no longer specializes in leather goods, of course — the belting products Fenner makes are on the cutting edge of the industry. Fenner has also built up since the late 1990’s its presence in the precision polymer business through a series of strategic acquisitions including James Dawson (custom hoses), EGC Critical Components (high-performance sealing technology), and Secant Medical (biomaterials).

So it is a firm with deep roots in the past and a strong impulse towards the future. This fact is reflected in the operational structure of Fenner, which works through two main divisions: Engineered Conveying Solutions (ECS) and Advanced Engineered Products (AEP). ECS is the current incarnation of what Fenner began life as; the division contains its belting and conveying business. AEP contains its forward-looking polymer businesses. ECS is a world leader in supplying conveyor belts and the technology that supports and surrounds them, those being monitoring and servicing products. These belts are sizable: Fenner usually fills orders starting by the kilometer. The two biggest geographical segments of the conveying business by revenues are North America and Asia; Fenner’s biggest customers in those regions are coal-mining companies in the U.S. and China, with smaller consumers of their product being found among miners of copper, iron, and other hard-rock ores as well as companies outside the mining sector that still need significant bulk-materials handling products. Fenner is one of the two dominant companies in this space, the other being Contitech (which absorbed the third big player, Veyance/Goodyear, in February 2016).

AEP has a bigger product portfolio than ECS, and is itself broken down into three subdivisions: Advanced Sealing Technologies, which designs and manufactures high-performance seals for the oil and gas industries and for fluid power systems (hydraulics and pneumatics, in other words) across a variety of industrial applications. Precision Polymers manufactures belting for power transmission and specialized machinery (ATM’s, for example) and hoses used in fracking, firefighting, and large scale farming. Solesis Medical Technologies builds products at the opposite end of the size scale: biomedical textiles, blood-management tech, and a plethora of single-use medical devices. This complex set of products and operations is overseen by a board with long service to the company. Current chairman and interim CEO Mark Abrahams has been with Fenner since 1990 and former CEO Nick Hobson (currently out on medical leave with a very uncertain promise of return) has similarly served more than two decades — perhaps another fact of Fenner’s respect for its own corporate history.

Fenner — given that a huge chunk of its ECS business is focused on end-users in the mining and fuel-extraction industries — has been feeling the bite of the commodities slowdown, and their recent numbers show just how deep that bite goes. Results for the first half of its fiscal 2016 showed revenues down significantly year-on-year across ECS, by 26 percent. EBITDA for the division saw an even steeper decline of 59 percent during that same period. This was driven, per Fenner’s management, primarily by a decline in demand for belting products by U.S. and Chinese coal miners — one severe enough that the company shut down most of the capacity in one of its two major belt-producing facilities in North America as part of a still-ongoing cost-reduction program in response. There’s some good news there, namely that the fall in commodity prices depressing demand for Fenner products is also itself helping lighten the cost burden as Fenner pays lower prices for the raw materials it needs for its belts. But ECS is suffering, make no mistake, and the ugly macro picture seems not set to lighten in the near term. AEP is seeing similar problems: this division has some commodities exposure as well — as noted, one of its big customer segments comprises companies in the fuel extraction industry looking for performance critical sealing and hose products. And it too saw a steepish decline in revenue at the six-month results — they were down year-on-year almost 13 percent with EBITDA down 30 percent over the same period. That decline was driven almost entirely by the oil and gas industry’s woes.

But those numbers conceal a more interesting story across both divisions. Let’s start with ECS. Because the products made by that group are used in already operational mines rather than during mine construction, the demand for them is far more contingent on volume of tonnage extracted than on commodity prices. So while prices on iron ore and thermal and metallurgical coal, miners of which form the bulk of the ECS customer base, look set to linger around their current lows for the near term, volumes (according to some analysts) are going to normalize. And ECS will be poised to profit from that normalization. Australia, one of the anchors of Fenner’s Asia Pacific business, is an excellent case in point. Iron ore exports from Australia are forecast by its government to increase at an annual rate of 3.4 percent through 2021 reaching 926 million tonnes at period end, while metallurgical and thermal coal exports taken together are predicted to grow at an annual rate of 1.8 percent over the same period and reach 416 million tonnes annually at period end. Analysts are even predicting growth in China’s thermal coal production as well. And while challenges remain across Fenner’s other geographical sectors, in volume terms things look like they are are bottoming out. Furthermore, the bulk of ECS revenues come not from original sales but from replacement sales to existing customers: in 2014 some 65 percent and in 2015 some 70 percent came from replacement sales. This means that even in macro environments where price pressure is pushing companies to cut or defer costs, there’s a big silver lining for ECS. After all, you can only use belting so long before it breaks, and the longer customers put off replacements the bigger their eventual re-up orders are going to be.

That leads us to the first layer of confusion surrounding Fenner. Investors seem to see ECS as a traditional supplier of capital goods to mining companies. This may explain why Fenner trades at a multiple of 7.6 on depressed earnings. But it is not a supplier of capital goods — as noted above, its products don’t fall into the capex bucket but rather the opex bucket, as the fact that the vast majority of its belting sales are replacements amply attests. And the ECS business, being volume-driven, is much less sensitive than capital-goods suppliers to commodity price fluctuations.

And what about AEP? It’s a hard division to analyze, composed as it is of a diverse and finely targeted product portfolio, but no matter where you end up on it its fundamental disconnect from the other half of Fenner is inarguable. Despite its weak results, that division produced underlying operating profits of £12.8 million in the first half of Fenner’s fiscal 2016 — more than twice the underlying operating profits ECS produced. Which means that AEP is the currently real driver of earnings for the company. And the company’s future as a whole (if the utterances on strategy of its management are to be believed) lies in the polymer side of the business. There we find the second layer of confusion surrounding Fenner: possibly because of the complexity of AEP, and possibly because the company’s seen as being mining-adjunct, there seems to be little awareness of the fact that its polymer businesses are leading the charge at the moment.

It is hard to find good comps to Fenner as a whole, given the complexity of its business. But taken division by division, there are relevant ones. Let’s begin with ECS. Its peers include Austria’s Semperit, a company with roots reaching deep into the 19th century; Finland’s Metso, a supplier of products and services to mining and aggregates firms, albeit in a more traditional capital-goods line; Outotec, another Finnish company operating in similar spaces as Metso, and Denmark’s FLSmidth, which is a big player in supplying various mineral industries. Across those four firms, the median EBITDA multiple is 9.28, to which Fenner currently trades at an 18 percent discount at its price as of press time. Not a huge reach to get there, especially if the normalization in commodities volumes materializes as predicted. Should Fenner manage to improve by 10 percent its current 2016 estimates for earnings, from 57.6 million GBp to 63.36 million GBp, at the median multiple per share value would reach £3.11, an upside of more than 113 percent. Even assuming it fails to hit that median target and instead trades on those improved earnings comparably to Semperit (which is perhaps the most similar company to Fenner among its peer group) at 7.89x, it still sees a per-share value of £2.57, an upside of 76 percent. Another path to value might lie in a breakup of the company to allow the more cash-flow generative side of the business to flourish independently. The chances of that happening are hard to game out, but should Fenner spin off AEP a relevant comp — and by some measures perhaps the only really relevant comp — is Sweden’s Trelleborg. It’s admittedly a lot bigger than AEP, with close to US$3 billion in revenues for 2015, but it plays in a lot of the same product spaces and in the same markets — and it trades at current prices at 10.3x. Assuming an independent AEP reaches a similar multiple, that would imply upside for shareholders of 112 percent, with per-share value reaching £3.06. Keep in mind, by the way, that even these rosier predictions still stand on the conservative side of the scale. Fenner was trading at £4.84 as recently as late December 2013. So there looks like plenty of room to go.

The downside case — pricing in no commodity recovery at all, a further fall in oil and gas, and very anemic growth in the medical segment of AEP— might see Fenner earning a multiple under five, as Semperit did at 4.8x in 2014. This implies equity downside of 65 percent, with share price falling to £.97. But that scenario is pessimistic. And remember that Fenner has already proven via the cost-cutting strategies it has deployed since commodities began their long swoon that it is not afraid to be bloody, bold, and resolute in dealing with adverse environments.

There are, of course, risks. The deep pipeline of medical products that forms a big part of AEP’s future earnings potential might dry up. If the commodity recovery fails to ever materialize, it’s hard to see how Fenner continues to exist. Though even in that scenario a breakup, as noted above, would still salvage value. But the company has survived for a century and a half, weathering two world wars, the economic doldrums of the 1970s and the violent ups and downs of the late 20th and early 21st century with aplomb. One foot in the past and one eye on the future may sound like a difficult balance to strike, but Fenner seems to have seriously gotten the hang of that maneuver.