Buy Elementis (ELM) at 61.5p

A tip from SmallCapShares.co.uk

Shares in Elementis were hammered during the recession, falling to near all-time lows of 20p in July 2009 as a poor set of interim results and a strategic review of its struggling Chromium business worried investors. Since the half-year end last June however trading has picked up markedly as restocking resulted in a recovery in demand from its clients. A positive trading update since the year-end has also confirmed that trading remains strong and we think the shares are worthy of a closer look.

THE BUSINESS

Elementis was previously known as Harrisons and Crosfield, a conglomerate involved in building supplies, timber, foodstuff and chemicals. In 1997 however the firm decided to focus on its chemicals business and after returning GBP400 million to shareholders it began acquiring a host of chemicals business that now make up the group. Operating from 30 locations around the world its 1,200 staff are organised into the following three divisions.

Elementis Speciality Products is a leading producer of organoclays (chemicals derived from naturally occurring clay minerals) and other rheological additives (elements that provide levelling and antisettling properties for paints and cosmetics). It also manufactures colourants, specialty additives and polymers. The business' products are used in industrial and architectural coatings, oilfield chemicals, make-up and skincare goods and a variety of adhesive applications in the construction industry.

Elementis Chromium is one of the world's largest producer of chromium chemicals. It has manufacturing facilities in the US and its products are used by leather tanning, timber treatment and metal finishing companies. Chromium applications help extend the life of timber goods by repelling insects and fungi and prevent metals and plastics from being tarnished. They also help boost the durability of leather garments and footware.

Elementis Surfactants (agents used to lower the surface tension of liquids) supplies chemicals to oil and gas firms, pulp and paper product specialists, textile businesses and household product manufacturers.

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CURRENT TRADING

Elementis' most recent results, for the year to 31st December 2009, were poor. Not only was trading severely impacted by falling demand during the recession but the income statement was littered with a massive $73.8 million in exceptional items. $44.5 million of these one-off expenses were related to the closure of its manufacturing facility for its Eaglescriffe Chromium plant in the UK. The remaining exceptional costs were related to provisions for circa $33.5 million in two fines levied by the European Commission. The first fine, which was levied solely on Elementis was paid in February 2010, and the second penalty, that has been levelled on other companies too, is yet to be determined and is being contested by the business.

Group revenues declined by 9.2% to $563.7 million in the year, which triggered a 55% fall in underlying operating profits to $36.2 million. However, the massive exceptional costs mentioned above resulted in the firm swinging from a pre-tax profit of $43.4 million to a pre-tax loss of $48.4 million. A $9 million tax payment dealt a further blow to the bottom line resulting in losses per share of 12.9 cents. Despite the losses incurred over the year the business maintained its 4.5 cent payout.

At the year-end the company held $73.2 million in net current assets with $28.8 million in cash. Net debt at the year end stood at $106.3 million with interest payments on the group's debt covered a comfortable 4 times by underlying earnings.

Elementis' results ended on a bright note though with the firm reporting a continued improvement in sales volumes on the back of restocking by customers in January and February. There was more good news in a first quarter update to 31st March 2010 as the company announced a significant improvement in demand compared with the previous year . Specialty products unit sales were 59% ahead of the corresponding period, oilfield sector sales were "significantly better" than the comparative period and Chromium volumes were 52% ahead of the previous year as well. Despite the good news in trading from all its divisions the business cautioned that growth in sales volumes could moderate as the year continued. Nevertheless, full-year results were expected to be on track to be ahead of market expectations.

OPPORTUNITIES & RISKS

Aside from the improvement in volumes Elementis has entered the new financial year with a significantly lower cost base. Restructuring activities have cut annualised costs by GBP16 million ($23.5 million or 4% of total operating expenses). The positive effect of these measures on both ends of the bottom line, particularly when compared against the particularly weak 2009 half-year results, mean that the company is likely to release a much healthier set of half-year accounts.

Coming to the threats, the group has significant liabilities to service both in terms of its net debt and its $111.7 million pension deficit, which will require it to continue to set cash aside to meet amounts owed to stakeholders and possibly lead to the dividend being slashed. However, the group has a GBP150 syndicated revolving credit facility available which is not up for renewal until July 2011 which gives it the ability to fund operations. Year-end interest payments are well-covered by its underlying profits as well and we expect a further improvement in breathing room on the back of improving sales.

One of the key risks facing the business is changes to chemicals regulations. Adjustments to the EU's REACH regulations could affect group sales and the business has to ensure compliance with health and safety and environmental laws. Furthermore, the group's margins also faces risk from energy price volatility and disruptions in the supply of clay. However this risk is mitigated by the fact that the business mines clay from its own open pit mine in California and uses hedging contracts to secure energy supplies.

VALUATION

A key catalyst for the shares is the release of interim results in August, where we expect Elementis to report a significant turnaround in trading in line with its recent comments. Broker Brewin Dolphin increased forecasts by 10% on the trading update and currently anticipates earnings of 5.81p for the 2010 financial year, rising to 6.34p next year. These estimates put the shares on a current multiple of 10.6 which falls to 9.7 in 2011. The shares also offer a healthy 4.87% yield if as forecast the 3p dividend is maintained. BUY.

Key Data

EPIC: ELM
Market: FULL
Spread: 61p - 62p (1.6%)

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