Fuchs Is Still A Buy

seekingalpha03-14

Fuchs reported solid fiscal 2023 results, and the stock finally broke out of its sideway range.Due to its wide economic moat, we can expect the company to continue growing at a solid pace, although ...

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In my last article, I wrote: In my opinion, Fuchs is still undervalued and a good buy. Of course, we are faced with the risk of the stock bouncing off the current resistance level (200-week moving average, declining trendline) and if this happens one might buy at the completely wrong time. But as long-term investors we should not care so much about short-term fluctuations. Nevertheless, one can wait before buying if Fuchs is either declining again (and creating another buying opportunity) or if the stock is breaking out of its current range. In the meantime, the stock gained about 15% and is trading for €34 at the time of writing, and therefore broke out of the previous range it was trading in. And considering that Fuchs recently reported its fourth quarter as well as full-year results for fiscal 2023 and the stock is constantly moving higher, it seems like a good idea to look at the stock and company once again. Technical Picture And in this case, it makes sense to start by looking at the chart. Between February 2023 and December 2023, Fuchs was caught in a sideway range, but now it seems like the stock finally broke out from that sideway range and the stock is moving higher. At this point, I would be rather optimistic about the stock, and the next stop for Fuchs could be around €38.50 (one of the previous highs). Overall, I am slightly optimistic about the stock moving higher in the coming quarters and that the long-lasting correction, which started in 2018, might be over. Annual Results Fuchs Petrolub reported solid results in fiscal 2023. Sales in fiscal 2023 were €3,541 million and compared to €3,412 million in fiscal 2022, this resulted in 3.8% year-over-year growth. EBIT also increased 13.2% year-over-year from €365 million in fiscal 2022 to €413 million in fiscal 2023. Diluted earnings per ordinary share increased from €1.87 in the previous year to €2.08 in fiscal 2023 - resulting in 11.2% year-over-year growth. Fuchs March 2024 Roadshow Presentation And finally, free cash flow before acquisitions jumped from only €59 million in fiscal 2022 to €465 million in fiscal 2023. In this case, both numbers are outliers - free cash flow in fiscal 2022 was extremely low and free cash flow in fiscal 2023 was too high. When looking at the three different segments or the three different regions around the world, the segment still responsible for the biggest part of revenue is Europe, Middle East and Africa which generated €2,041 million in revenue, but sales grew only slightly year-over-year (€5 million higher than in fiscal 2022). And while revenue increased slightly, EBIT grew 25.3% year-over-year from €170 million in fiscal 2022 to €213 million this year. The Asia-Pacific region was responsible for €979 million in revenue and compared to the previous year, revenue grew 5.4% year-over-year. However, EBIT declined slightly from €113 million in the previous year to €111 million in fiscal 2023. EBIT was negatively impacted by currency effects and China still being subdued in profitability. North and South America saw revenue increase 5.2% year-over-year to €687 million in fiscal 2023. EBIT increased slightly from €77 million in the previous year to €79 million in fiscal 2023. Growth mostly stemmed from positive business developments and the business expansion in the US, Brazil and especially Mexico contributed to growth in the region. Outlook For 2024 For fiscal 2024, management is slightly optimistic and is expecting the top line and EBIT to grow. But the expected growth rates are rather low. Sales in 2024 are expected to be around €3.6 billion - about 2% higher than in fiscal 2023. EBIT is expected to be around €430 million - an increase of around 4% compared to the previous year. Fuchs March 2024 Roadshow Presentation And of course, free cash flow before acquisition will be much lower - it is expected to be around €250 million, but this was to be expected as free cash flow in fiscal 2023 was extremely high. The company's own metric FVA (Fuchs Value Added) is also expected to increase about 13% to €240 million due to higher earnings and lower capital employed in fiscal 2024. Dividend And Share Buybacks Fuchs is one of only a handful of German businesses that can look back on a long streak of dividend increases. During the Great Financial Crisis, many German companies had to keep the dividend stable or even cut the dividend payments. Fuchs, however, proposed the 22nd dividend increase in a row and will pay an annual dividend of €1.10 for fiscal 2023 (for the ordinary share, the dividend for the preferred share will be €1.11). This leads to a dividend yield of 3.2% and a payout ratio of 53% - both are acceptable metrics. Fuchs March 2024 Roadshow Presentation Aside from increasing the dividend once again, management decided to expand and extend the current share buyback program, which has been in place since June 27, 2022. For the expansion of the share buyback program, an additional amount of €80 million is made available. In total, the share buyback program now includes the acquisition of up to 8 million shares (split between ordinary and preference shares). The share buyback program will run until September 30, 2024. And as I am expecting higher share prices for Fuchs in the years to come, I would like to see the company acting rather fast on its share buyback program to get better prices - as every Euro spent matters. Growth Fuchs was struggling in the last few years - also visible in the chart as Fuchs has been in a bear market for about six years - but it could still grow its top line at a solid pace. It was mostly the bottom line as well as EBIT or FVA (Fuchs Value Added) that was declining or stagnating. But there is a good reason, as management was investing heavily in the last few years to position the company for future growth. Fuchs March 2024 Roadshow Presentation It remains to be seen if the strategy is working out, but the last few years should make us optimistic as the bottom line seems to be constantly improving. Fuchs March 2024 Roadshow Presentation The company's financial long-term targets include mid-single digit revenue growth, as well as EBIT margin improving to 15% again. And over the long run, Fuchs is targeting a cash conversion ratio of 0.8. And when assuming that Fuchs will use the generated cash to buy back shares, bottom-line growth might even be a little higher. High-Quality Business I have already written this in the past, but I like to point out once again that we are dealing with a high-quality business. This is reflected by the great balance sheet Fuchs has as well as the wide economic moat the company has around its business. Let's start with the wide economic moat. Fuchs has a wide economic moat around its business based on switching costs. In my first article about Fuchs, I wrote: Basically, Fuchs Petrolub is producing a product that is cheap compared to the total costs of a good, but has a huge effect on the end product. Lubricants in a car, for example, are responsible for only a very small fraction of the overall costs but are extremely important for the quality and durability of the product. We have a product with a high benefit/cost ratio when we have a mismatch between the costs (which are very low) and the effect on the end product (very high). In this case, switching costs are extremely effective. When a car manufacturer is using Fuchs Petrolub because of its quality and can save a few dollars (or euros) by using the lubricant of another producer, management won't take the risk of producing a low-quality car that is failing after a few thousand miles because of using the wrong lubricant for saving a few dollars in the production process. These are high economic risk costs for the company, because car manufacturers like Daimler (DDAIF) or BMW (OTCPK:BMWYY) probably would see sales decline if the cars are suddenly not as good as before because of using the wrong lubricant. And as the lubricants are only responsible for a small fraction of the overall costs, Fuchs Petrolub can easily increase its prices in the low single digits without losing any customers (resulting in pricing power for Fuchs Petrolub). The company is also producing an indispensable product that can be found in every machine and in every place with friction, but the product (lubricants) is rather invisible, and customers of Fuchs Petrolub might not even think about it when talking about cost reduction. Fuchs: Gross margin, operating margin and return on invested capital (Author's work) And although we see slightly declining margins in the last decade, which is not a good sign for a business, I still assume Fuchs to have a wide economic moat around its business. And we also see declining RoIC in the last ten years, but Fuchs still reported 14.58% return on invested capital in the last five years - a metric clearly hinting towards an economic moat around a business. Aside from having a wide economic moat around its business, Fuchs also has a great balance sheet. When looking at the asset side, Fuchs has €249 million of goodwill on its balance sheet, which is not great but no reason to worry. Additionally, cash and cash equivalents were €175 million on December 31, 2023. But what is most important is the liabilities side of the balance sheet: Fuchs has little liabilities in total on its balance sheet, and especially in the last ten years, the company hardly had any debt on its balance sheet. Intrinsic Value Calculation A final step is to determine an intrinsic value for Fuchs and find out if the stock is still a good investment at this point or if the time to buy has passed. When trying to answer this question, we can start by looking at simple valuation metrics and at the time of writing, Fuchs is trading for 16.5 times earnings as well as 11.5 times free cash flow. In the case of the P/FCF ratio, we must be rather cautious, as the free cash flow in 2023 was rather an outlier and is not representative of the company's usual free cash flow. Nevertheless, Fuchs seems to be trading for reasonable valuation multiples and considering the high-quality business, it might be rather undervalued. Fuchs March 2024 Roadshow Presentation As always, let's also use a discount cash flow calculation to determine an intrinsic value for the stock. As the basis for our calculation, we use a 10% discount rate and 139 million diluted outstanding shares (the last reported number). For 2024, we assume a free cash flow of €250 million according to the company's own guidance. For 2025, we assume that Fuchs will hit its EBIT target of €500 million and when also assuming a tax rate of 29% (in line with the last few years) we get a net income of €355 million. And when assuming a cash conversion rate of 0.8x, it would lead to a free cash flow of €284 million in fiscal 2025. And for fiscal 2026, we assume that Fuchs will hit its 15% EBIT margin target and under the assumption of 5% revenue growth, 29% tax rate and 0.8x cash conversion rate we get a free cash flow of around €335 million. Following the years after fiscal 2026, we assume 5% annual growth - in line with the company's long-term guidance for sales growth. When calculating with these assumptions, we get an intrinsic value of €43.16 for Fuchs Petrolub and the stock still seems undervalued at this point. Of course, the assumptions for the next three years are rather optimistic and don't really account for the risk of a global recession. However, a lot of negativity is already reflected in the guidance for fiscal 2024. And while we might be too optimistic for the next three years, 5% growth for the years following 2026 seems too pessimistic when looking at past growth rates. Conclusion Fuchs is one of the German companies that many investors, but also the German public, don't know (as the company is not selling to end consumers). But the company is a well-run, high-quality business with a wide economic moat and almost no debt on the balance sheet. In my opinion, the stock is still undervalued and after breaking out of the sideway range it has been caught in for almost a year, we can expect higher stock prices in the coming quarters.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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