Wednesday, April 26, 2006

Engelhard Responds to BASF with Recapitalization

Engelhard (EC) has been a decent specialty chemical business with less volatility than most chemical companies. The company has generated free cash flow since 1997, a fairly remarkable achievement given the vagaries of economic cycles and commodity chemicals pricing.

The company makes value added products based on surface and materials science for a large number of customers. Not unlike BASF's motto, they are in the business of making their customers' products better.

Engelhard shareholders should have a look at the company's response, announced this morning, to the BASF bid.

Engelhard Response

The proposed tender for 20% of EC shares at $45 seems to have evoked little response today in the stock market. At $39, assuming that one could sell at least 20% of your holdings into the $45 tender, this implies that the price on the other side of the bid will be about $37.50, essentially where the stock was trading recently but well above where it had been trading pre-BASF.

Clearly, the tender offer is written as an enticement for BASF to step up and pay up. If EC does go ahead with the tender, the company will have a smaller equity base with 26 million fewer shares, but about $1.2 billion in incremental debt. Based on the company's projections, the incremental interest expense of about 52 cents (for 2007) just about offsets the 49 cent benefit of the reduced share count. Cost savings that the company has proposed would add some 9 cents to earnings.

Other assumptions made by EC management seem aggressive. For example, the company assumes that through 2010, North American vehicle production remains flat. It assumes that European penetration of light diesel engines will grow from 24% to 35%. I do not know how realistic these estimates are but they certainly seem hopeful.

EC management seems to be playing up the fact that the company appears reasonably valued relative to its major competitors Johnson Matthey and Umicore. Well on a P/E basis this may be true, but if we delve deeper into the financials, the price being bid for EC appears quite fair, but certainly not generous.

Umicore earns EBITDA margins of about 28% currently and J&M earns just over 23%. EC earns only about 17% in this comparison. Both Umicore and J&M would have more cyclical businesses than EC, so we may be looking at cyclical peak profitability whereas EC's profitability is somewhat steadier.

However, on an EBITDA multiple basis, Umicore sells at merely 8 times EBITDA on an EV/EBITDA basis. Johnson and Matthey sells at about 12 times. Finally, Engelhard is selling at just over 11 times EBITDA based on this measure. All EBITDA's utilize consensus estimates for 2006 earnings.

Of interest, though, is looking at BASF itself. BASF (BF) sells at merely 4 times EBITDA. Rather than chasing after EC, why not buy back stock itself?

One last observation. EC management looks a little silly if not disingenuous in arguing for the "miserly" price that BASF is willing to bid. Take a glance at the insider trading for EC that has taken place in the last year.

Insider sales at Engelhard

As you can see, insider sales have totalled over $8 million. Why is it okay for management to sell out but minority shareholders can't decide on the best bid? Insider ownership totals 0.7% but with options, represents 3.1%.

Disclaimer: I, my family, and clients do not have a position in Engelhard Corp. Some clients do own a position in BASF.


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