H.B. Fuller (FUL): A Small Cap Stock With Big Long-term Dividend Growth Potential

H.B. Fuller (FUL) is a small cap dividend growth stock that few investors are familiar with. However, this dependable business has increased dividends paid for 46 consecutive years and is worth some attention.

 

The company operates in a large and stable industry with strong growth prospects. Management is also shifting more of H.B. Fuller’s mix into higher-margin applications, which is expected to drive profits higher over the next five years.

 

Given the company’s potential for meaningful income growth and capital appreciation, H.B. Fuller is the type of investment we look for in our Top 20 Dividend Stocks and Long-term Dividend Growth portfolios.

 

Business Overview

H.B. Fuller is a leading provider of specialty adhesives used to create hundreds of brand name goods around the world. An adhesive is any substance applied to the surfaces of materials that binds them together and resists separation. Just about everywhere you look you will find adhesives and sealants produced by H.B. Fuller – baby diapers, apparel, toilet paper, cereal boxes, shoes, bags of chips, tile flooring, magazines, cars, tablets, refrigerators, and more.

 

H.B. Fuller has been producing adhesives for nearly 130 years since its founding in 1887. The company focuses primarily on hygiene (20% of sales), packaging (20%), durable assembly (20%), and engineering (10%) markets. By geography, approximately 69% of H.B. Fuller’s sales are in developed markets with the remaining 31% from emerging and developing economies.

 

Business Analysis

Our interest in H.B. Fuller begins with our attraction to the global adhesives market. While not the most exciting of markets, adhesives have been in use of more than 200,000 years. We like industries that are characterized by a slow pace of change, and adhesives certainly appear to fit that profile.

 

H.B. Fuller, Henkel, and Bostik (its two largest competitors) all continue to sell the products they were founded on (glue) in 1887, 1876, and 1889, respectively. Talk about resiliency!

 

Adhesives have demonstrated impressive longevity because they are used in almost every end market and have continually evolved from a technological perspective (e.g. become more heat resistant or stronger) to replace mechanical fasteners and improve all sorts of products – adhesives can make disposable diapers thinner yet more absorbent, food packaging safer and fresher, and window more energy-efficient.

 

The market has staying power and should continue to grow in size. Radian Insights expects the global market for adhesives and sealants to reach $43 billion by 2020, with adhesives growing at a compound annual growth rate of 5.6% from 2014 to 2020. Adhesives are growing faster than global GDP because they are increasingly being used in more applications and replacing traditional fastening methods in categories where mobility and light weight are important.

 

For example, a Wall Street Journal article provided a quote from Daniel Murad, chief executive of ChemQuest Group, mentioning that the typical car today uses about 27 pounds of adhesives compared to just 18 pounds a decade ago.

 

With wind at its back and a relatively modest revenue base ($2.1 billion in 2015) compared to the global market, we think H.B. Fuller has plenty of opportunity to continue expanding.

 

Adhesive manufacturers can also be appealing businesses because of their importance to customers. The cost of an adhesive usually represents less than 3% of the customer’s total manufacturing cost for a product, but it provides significant value.

 

Adhesives improve the functionality of a product and can help customers save costs and improve manufacturing efficiency (e.g. faster drying glue results in greater throughput). H.B. Fuller has close to 20 R&D and technical excellence centers around the world where its team of application experts helps customers develop new products and improve their manufacturing processes.

 

As a result of these factors, there are many high-profit niches with good pricing power for the company to pursue.

 

Looking more closely at H.B. Fuller, it’s worth mentioning that the current management team is really the first professional group to run the company. H.B. Fuller was previously family-run until the 2000s.

 

The new team is focused on high value, high margin opportunities. Management has spent the last several years transforming H.B. Fuller’s business in Europe through its $400 million acquisition of Forbo, an industrial adhesives business, and substantial investments in new manufacturing equipment. These moves were meant to improve profits in the region, which had been underperforming.

 

In February 2015, H.B. Fuller acquired TONSAN Adhesives, the largest independent engineering adhesives provider in China, for about $216 million. Engineering adhesives is a $12+ billion market and commands much higher margins because they are used in demanding markets such as aerospace, medical, electronics, and automotive. Management hopes to double this $200 million segment by 2020 to improve the company’s mix.

 

As seen below, management is gradually improving the company’s portfolio to focus more on strategic areas with better profits and growth potential.

 

Source: H.B. Fuller Investor Presentation

 

As a result of management’s focus on manufacturing cost savings and shifting mix into higher-growth, higher-margin businesses (e.g. engineering adhesives), the company believes it can expand its EBITDA margins from 12.8% in 2015 to 17% by 2020.

 

H.B. Fuller’s other 2020 goals are to achieve 3-5% organic sales growth per year ($3 billion in revenue by 2020 compared to $2.1 billion in 2015), grow EPS by 15% per year, and improve return on invested capital to 15% (from 8% in 2015). The company also expects to add roughly $100 million of revenues per year via acquisitions.

 

We think H.B. Fuller is extremely durable and believe that management’s actions will further strengthen the company’s moat and opportunities for growth.

 

H.B. Fuller’s Key Risks

H.B. Fuller’s near-term financial results can be impacted by several factors, but we don’t believe they have any impact on the company’s long-term earnings potential.

 

Slower economic growth generally reduces demand for adhesives as fewer goods are manufactured and sold, particularly in durable assembly markets (20% of sales).

 

Raw material cost inflation can also hurt profits because about 75% of the company’s costs of goods sold are raw materials. If costs rise faster than the prices charged by H.B. Fuller, gross margins will compress.

 

Management’s execution on productivity projects can also impact near-term earnings. The company has experienced several cost overruns and delays in recent years, but the bulk of activity and spending is now behind the company and should substantially reduce this risk going forward.

 

Thinking longer term, the biggest risk factors seem to be H.B. Fuller’s ability to grow its high-margin engineering adhesives business (10% of sales; expected to double in size by 2020) and maintain its strong profitability in North America.

 

Engineering adhesives applications are very demanding and require high technical specifications. As one of the newer, smaller players in the market, H.B. Fuller has a lot to prove. It can also take a long time to quality as a supplier in markets such as automotive and aerospace. If management’s growth assumptions turn out to be too optimistic, earnings growth and margin expansion could disappoint. Only time will tell.

 

In the United States, which accounts for about 60% of sales, H.B. Fuller must contend with a rather mature adhesives market. The company will need to lean on its strong customer relationships and technical expertise to reduce potential price pressures.

 

Overall, we believe H.B. Fuller’s fundamental risk profile is very reasonable. The company sells essential products that have been used by manufacturers for hundreds of years; it is well diversified by end market and customer type; and its business model consistently generates cash.

 

Dividend Analysis: H.B. Fuller

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. H.B. Fuller’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

H.B. Fuller’s dividend looks very secure and has a relatively high Dividend Safety Score of 73. The company’s dividend has consumed just 31% of its earnings and 17% of its free cash flow over the trailing 12 months, providing a nice safety net and lots of room for growth.

 

As seen below, H.B. Fuller’s payout ratios have generally remained below 30% most of the last 10 years. The volatility in the company’s free cash flow payout ratio in 2013 and 2014 was due to significant investments the company made to modernize its plants and improve its supply chain. Capital spending should normalize over the coming years and keep the payout ratio very healthy.

 

 

The safety of H.B. Fuller’s dividend is also helped by the company’s performance during the last recession. As seen below, H.B. Fuller’s sales fell by 1% and 11% in fiscal years 2008 and 2009, respectively. The company also generated net income and free cash flow both years.

 

Many businesses fared worse, and FUL’s stock managed to outperform the S&P 500 by about 10% in 2008 as well. While the company is certainly not immune to soft economic conditions, its exposure to stable end markets such as hygiene and packaging provide some cushioning.

 

 

H.B. Fuller has also generated free cash flow in 10 of its last 11 fiscal years. The dip in 2013 and 2014 was due to the elevated capital spending we mentioned earlier, but the adhesives industry is otherwise not very capital intensive. Management expects capex to run at 2.0-2.5% of sales going forward, which will continue the company’s track record of generating dependable cash flow, which is needed to pay dividends.

 

 

A company’s return on invested capital can provide clues about its moat and ability to generate economic value for its capital providers. We can see that H.B. Fuller’s return on invested capital has generally hovered in the upper-single digits over most of the last 10 years.

 

While this is an acceptable rate of return, we like management’s plan to shift the company’s mix to higher-margin areas such as engineered adhesives to drive returns higher. As this plays out, H.B. Fuller’s competitive positioning and dividend safety should strengthen.

 

 

Turning to the balance sheet, we can see that H.B. Fuller has taken on a meaningful amount of debt to finance its past acquisitions and capital spending. The company has $119 million in cash compared to $692 million of debt, and it would take about 3.4 years’ worth of earnings before interest and taxes (EBIT) along with cash on hand to retire the debt.

 

H.B. Fuller’s reliable free cash flow generation and improving earnings profile cause us not to lose much sleep over the balance sheet, and we also take comfort in knowing that the company has a $300 million unused line of credit good through October 2019. H.B. Fuller seems well-financed to get through almost any unexpectedly volatile economic period ahead.

 

 

H.B. Fuller’s strong Dividend Safety rating starts with the company’s low payout ratios and consistent free cash flow generation in almost any economic environment. While the balance sheet has a little more debt than we would like to see, it’s hard to imagine a scenario that forces the company to ever reduce its dividend.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

H.B. Fuller’s Dividend Growth Score of 81 suggests that the company stronger dividend growth potential than 81% of the dividend-paying stocks in the market.

 

While H.B. Fuller is too small to join the dividend aristocrats list, it is just four years away from achieving dividend king status. The company has raised its dividend for 46 consecutive years and compounded its payout at a double-digit rate over the last five years (see below).

 

 

Management looks to keep the company’s dividend payout ratio at 20-25% of average trailing three year’s net income, which is close to where the company sits today. As a result, we expect dividend growth to follow earnings growth over the next few years and remain between 8-12%.

 

Importantly, as seen below, H.B. Fuller is poised to generate significantly more free cash flow over the next five years than it did over the prior five years. The company is largely finished making large investments in its property, plants, equipment, and supply chain and will begin to harvest the fruits of its labor as expenses and capital spending normalize. This will result in substantial cash flow that can be used for acquisitions and returned to shareholders.

 

Source: H.B. Fuller Investor Presentation

 

Valuation

Based on management’s 2016 earnings guidance of $2.40 – $2.60 per share, FUL’s stock trades at a forward price-to-earnings multiple of about 16.2. FUL also has a dividend yield of 1.3%, which is slightly higher than its five-year average dividend yield of 1.1%.

 

If management can successfully compound the company’s earnings per share by 15% per year through 2020, the stock could deliver double-digit annual returns with nice dividend growth along the way. Considering today’s market environment, we believe FUL’s valuation is relatively attractive.

 

Conclusion

With nearly 50 consecutive years of dividend growth under its belt, H.B. Fuller should be considered a blue chip dividend stock despite its relatively small size. We like the strategic direction that management is taking the company to improve margins and believe that the 2020 version of H.B. Fuller will be much more profitable than the company we know today. The adhesives market provides an excellent source of reliable cash flow as well, and H.B. Fuller’s diversification by customer and end market should continue serving it well.

 

Although FUL’s dividend yield is relatively low today, we think there is potential for double-digit annualized growth over the next five years and believe the stock’s current valuation is reasonable.