Profiting from a Herculean Turnaround

09/27/2007 12:00 am EST

Focus:

George Putnam

Editor, The Turnaround Letter

George Putnam, editor of the Turnaround Letter, says specialty chemical company Hercules has remade its business, and its share price doesn’t reflect the improvement.

Over the course of the 20th century, Hercules (NYSE: HPC) grew from a 1912 DuPont spin-off making explosives into a conglomerate with a wide range of unrelated businesses. Management responded in the mid-1990s by liquidating assets in a process that raised cash and boosted profitability.

However, by the late 1990’s management lost interest in downsizing, and it went on an acquisition binge that re-leveraged the balance sheet. In addition to a weaker balance sheet, the company found itself facing asbestos litigation, environmental remediation claims, an underfunded pension, and an IRS audit. Revenues peaked in 1999 and losses were reported by 2001; the stock responded by collapsing 90% from its 1996 peak of 66.

A new CEO, Craig Rogerson, took the helm in late 2003, and under his leadership Hercules has managed to put most of its problems behind it. In 2004 the company reached an agreement with its insurers to settle the asbestos liabilities. It also refinanced its bank debt in 2004, and completed changes to its pension plan the following year. Finally, early this year it resolved substantially all the issues relating to the IRS audits.

With the early 2006 sale of 51% of its FiberVisions business, Hercules refocused its specialty chemicals operations into two operating segments: Aqualon (47.5% of sales) and Paper Technologies and Ventures (52.5%).

Aqualon products help modify the physical properties of water-based systems used to develop a wide range of products, including paints, construction materials, pharmaceutical products, soft drinks, cosmetics and adhesives. Paper Technologies supplies a broad spectrum of water-treatment chemicals to the paper industry.

Both segments have good growth prospects. In addition, Hercules is using its Ventures group as a platform for incubating new products and developing innovations in existing lines. With its narrowed focus, Hercules has been able to reduce costs and improve productivity. From 2001 to 2006, the company was able to more than double its sales per and earnings per employee.

The sale of the interest in FiberVisions also allowed the company to further strengthen its balance sheet. Since 2001, debt has been reduced from nearly $3 billion to less than $1 billion. This has increased management’s ability to invest in the most profitable segments of the business, and should lead to increasing growth. Moreover, the improved balance sheet may encourage management to reward stockholders with dividend increases or stock buybacks.

Despite management’s successes, investors have not yet fully embraced the company’s prospects. While the stock has rebounded from its lows, its valuation is still well below that of most of its peers. As Hercules continues to report improved results, we expect that investors will eventually recognize the value in the stock, and we recommend buying it up to $30. (It closed just above $20 on Wednesday—Editor.)

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