LOGO
MACDERMID INCORPORATED
245 FREIGHT STREET WATERBURY, CT 06702
July 25, 2002
A LETTER TO MACDERMID SHAREHOLDERS FROM DAN LEEVER, CHAIRMAN & CEO
Dear Shareholders,
A letter to the shareholders mid year is a bit unusual. However I believe the
times are such that a thoughtful communication directly to you now is important.
The markets are in turmoil; the very fabric of corporate America is threatened
by unscrupulous practices of a few well-known companies. The very world we live
in has been changed forever by the tragic events of September 11. I have spent
many, many hours over the last six months considering the changed environment.
My conclusion is, the world has changed, perhaps permanently. My belief is so
fundamental, I feel compelled to share it with you now because it has profound
impact on our strategy.
A year in review. Several events occurred in the last year that I would have
thought impossible.
- - SEPTEMBER 11. This tragedy was so shocking and unanticipated; it changed
forever our view of previously unthinkable downside risks. These risks were
thought so unlikely that the insurance industry charged no premium for terrorist
coverage.
- - THE "100-YEAR FLOOD" IN THE ELECTRONICS INDUSTRY. I would have bet almost
anything that the end market demand in printed circuits would never decline by
50%. I have been in and around this industry for more than 20 years. During
that time we never saw more than a 15% or so decline.
- - THE TYCO FALL FROM GRACE. Some of the famous corporate failures, most
recently WorldCom and before that Enron were in such different worlds than we at
MacDermid live in that we didn't pay too much attention to their failures. But
Tyco was different. Tyco is a customer of ours, a company I watched carefully.
I believe the ultimate problem Tyco ran into was trying to grow too fast through
acquisitions that weren't accretive enough. Much more on that later.
CORPORATE AND MANAGEMENT INTEGRITY. MacDermid has always taken pride in
maintaining the highest standards of integrity. To me there is nothing more
important than trust in the facts as we present them to you. The MacDermid
philosophy written 40 years ago this year makes this point clearly. "First and
foremost, we expect of you fundamental honesty - honesty with yourself, with
your company and with all those with whom you interact, whether they be
associates within our organization, our customers or society in general. You
can expect from us as a company, complete honesty in whatever we do. Your
assignments will never compromise the principles of honesty and common decency,
which we expect you as an individual to uphold." This is not an equivocal
statement. One can't be partly honest. Either you are honest or not.
CORPORATE GOVERNANCE
Let's review corporate governance at MacDermid. We will submit a more complete
report in the annual report, but here are some of the more important areas
starting with the Board of Directors.
BOARD OF DIRECTORS - All directors except me are completely independent, by
any definition.
BOARD COMPENSATION. The Board currently voluntarily takes 100% of their
compensation in options in MacDermid stock. 100%! I do not serve on any of our
director's boards.
THE AUDIT COMMITTEE. Made up of all five of the outside directors
indicating how important they view it. All members are financially literate,
two work every day in financial services, one is a former auditor. The audit
committee meets regularly with our outside auditors privately.
STOCK OPTIONS ARE RECOGNIZED AS AN EXPENSE. All subject to shareholder
approval. Our current plan is indexed and performance based.
CEO COMPENSATION - 100% performance based. Contract and severance benefit
plan for the CEO? None.
Corporate governance is a serious issue at MacDermid, but it is not new. Our
governance philosophy has been reflected in how our Board of Directors function
for many years, far before my time. We understand clearly, I work for you, and
our directors represent your interests. It's a duty we take seriously.
GAMING THE SYSTEM. I really wonder why we as a society should be so surprised
that there has been a rush of disclosure of corporate improprieties of late.
"Professional investors" have been colluding with corporate management for
years. The most obvious example is analyst's estimates. Analysts ask
management to "give guidance" each year as to expected earnings. To the extent
the actual results "miss analysts projections" by even a penny a share,
management is crucified. As a corporate insider I can assure you there is no
possible way to forecast that accurately. The only way this system can work,
and EVERYONE in the system knows this, is to "game the system". That is, to
build up "cookie jar" reserves and then let them out when needed to "make" the
numbers. Imagine the pressure not to miss the numbers! This happens every
quarter in many, many, public companies in America. The step to fabricating the
numbers isn't a large one. The investing public shares in the blame by
expecting companies to show perfect, linear growth quarter after quarter, year
after year. The real world isn't like that. The more corporate management is
pushed to report unnatural results the closer they inevitably come to the edge
of malfeasance. There are many other examples of practices we should question,
non-recurring charges that happen almost every year, acquisition charges that
sweep costs under the rug, and of course stock options. We continue to practice
the charade that stock options are not an expense. I find the arguments against
expensing options to be laughable, but nevertheless here we have The Business
Round Table making such an argument, and we wonder why there is distrust of
corporate America? A word about pension income recognition in the reported
profits of the company. MacDermid has never, and would never, count pension
income as profit to the company. We find such treatment reprehensible. Our
investment growth rate assumption is regularly reviewed. It was reduced this
year from 9% to 8%.
What is the point of this? We have been criticized for years because we won't
play the game. We don't spend significant time and resources chasing the
"professional investors". We don't give guidance. We recognize stock options
as an expense, and we consistently follow the proper "spirit" of the accounting
rules. Now there is an argument being put forth by some CEO's that they
shouldn't have to certify financial statements? Go figure! The last I heard it
was my primary responsibility to insure integrity in our communication with you
including the accuracy of our reported numbers. O.K, is a slip up possible? Of
course. It is impossible to be absolutely certain every entry is properly
recorded in a multi-national complex company. However, if a material slip up
does occur, I cannot say it's not my fault because I didn't know about it. It's
my job to be as certain as possible that the philosophy of following the spirit
of proper accounting is followed. I reinforce this constantly with Greg
Bolingbroke our Controller, John Malfettone our CFO, and our corporate
leadership team. However I cannot say follow the spirit of the accounting rules
in one breath, and ask them to smooth earnings in the next. You either are
consistent or not.
BALANCE SHEET RISK. What are the implications of the "new reality" of September
11 and 100-year floods? I believe we must be more conservative if there is a
greater likelihood of greater amplitude in the ups and downs of the business
cycle. For ten years we have held a debt to EBITDA ratio policy of 3.5X. This
policy was severely tested during the 100-year flood in the electronics
business. In the end, the strength of our business model showed through. At
the worst period just after September 11, our ratio hit 3.7X. This quarter we
were back under 3.5X. Had the high yield market not welcomed us last year it
would have been far more difficult. Keep in mind our starting point. We are
concentrated owners of MacDermid. Most of us have a large percentage of our net
worth in MacDermid stock. To us it is FAR more important that we survive as an
entity in a generational time frame, than it is to perform at higher levels that
additional leverage might allow. We have always thought capital structure, the
amount of shareholders investment combined with debt, was important. It still
is, but in a different way. I now believe capital structure matters to us most
if we have too much debt. Having too little debt does not appear to be a
problem. Here's our logic. We ran models using modest growth assumptions to
forecast future years under two scenarios, a capital structure with debt to
EBITDA ratios, 3.5X and 2.5X. All else was held more or less equal. The
resulting earnings per share might be surprising to you. The difference in
earnings per share 7 years in the future was not material, primarily due to a
lower interest rate at lower amounts of leverage. I now believe we should
target a ratio of 2.5X debt to EBITDA with a not to exceed of 3.0X. We believe
this financial policy when achieved, could gain us "investment rating" by the
rating agencies. Lower leverage is important for two reasons. It would give us
significant additional comfort regarding survival of the entity even in the
worst imaginable future situation, and our borrowing costs would be lower as
investment grade debt carries lower interest rates.
LOGICAL FALLACY. The Tyco example illustrates what I refer to as a "logical
fallacy". A logical fallacy is something that makes perfect sense but is simply
not true. Much of the herd mentality surrounding the dot com bubble is a good
example. I learned long ago from Tom Smith our retired lead director, that one
must think deeply about "common wisdom" and make your own conclusion. The fact
is, in my view, "common wisdom" while usually logical, is often wrong. The Tyco
example relates to size and acquisitions. Tyco with Wall Street's applause all
along the way, became an earnings growth juggernaut in the 90's by using an
inflated stock as currency to acquire companies. They ultimately acquired more
than 1,000 companies as they grew from less than $3 billion to $36 billion in a
ten-year period. Here's the fallacy. If you are managing from a perspective of
ten years and then bailing out, this approach could work. But, if you are
managing with a generational perspective the power of compounding gets to you.
Here's the logic. The larger you get the larger the acquisitions you have to
make to have an impact, and the more you have to pay for those acquisitions.
Tyco ended up doing multi billion dollar acquisitions to add a few pennies a
share, proforma! It was simply impossible to keep compounding at that rate
forever. Scale. Would you rather own a $20 share of a $20 billion company or a
$20 share of a $1 billion company? Assume both were equally diversified and had
similar financial characteristics. I believe 9 out of 10 people would give the
logical fallacy answer, the larger company, right? Wall Street's common wisdom
says so, that's why larger companies generally trade at a higher price earnings
multiple. Let's look at little deeper. Say each company can grow 7% internally
and wants to grow an additional 7% through acquisitions. By only the 7th year,
the $20 billion company, now a $50 billion company, would have to acquire
revenues of $3.5 billion PER YEAR to maintain 7% growth from acquisitions.
Meanwhile the $1 billion company, now a $2.5 billion company would have to
acquire $175 million to keep pace. Tyco's reality was frightening. They spent
more that $20 billion in acquisitions in 2001 alone. Actually it is even more
pronounced than that because of what I call illiquidity discount in
acquisitions. I believe acquisition multiples are reduced as the size of
acquisitions go down because there are fewer buyers. For a $1 billion
acquisition many, many buyers will potentially be available, for $100 million
many less, and for $10 million very few indeed. There might be as much as 100%
difference in acquisition multiple from $10 million to $1 billion. Think of the
risks. What can go wrong in a $1 billion acquisition? More than in a $10
million one? Yes indeed. I believe Wall Street's common wisdom has it
completely backwards. The larger a company is, the lower it's multiple should
be.
This theory has profound impact on MacDermid's strategy. We must answer the
question should we gear up to have the capacity for large acquisitions
(relatively)? Or should we concentrate on making the best of what we have
supplementing our current businesses with small bolt on acquisitions from time
to time. I certainly gave away my hand with the preceding discussion. I
believe our road to prosperity lies in building very modestly and incrementally
from our base, especially if we measure success in per share terms, with a
generational time frame. We need to only ask the question, would we rather
MacDermid grow from $700 million to $7 billion in revenues, or grow our stock
price from $20 per share to $200 per share. We had a ten-bagger once, why not
try again, especially if it is an incremental effort! There is a further
complication. MacDermid generates a lot of cash. This year we hope to generate
over $80 million in owner earnings, or free cash flow, for about 11% of sales.
Probably a better number over time is 8%. Why is this? Because we spend less
than others leading to higher margins, and our capital spending is far less than
others. We believe we can operate MacDermid long-term with maintenance cap ex
at 1% of sales and total of 2% of sales. If our competition spends 6% or 8% on
cap ex, we have a 4% to 6% OF SALES advantage. That is huge. That means that
under an incremental approach we can acquire companies for cash, and still
generate free cash either to reduce debt or buy back shares. With a policy of a
ratio of 2.5X debt to EBITDA, we can review the circumstances each year. Excess
cash invest; less excess cash invest less. Once our debt reduction brings us to
our new policy target, internally generated cash is best used in two ways.
Invest in yourself by buying back shares, or making acquisitions. There is one
caveat to this incremental strategy. If the depressed market continues,
especially in electronics, there may be a once in a life time opportunity to
acquire a competitor at a very attractive value. We would be remiss not to
leave open the door in the short term to an opportunity like this. You can be
assured though that if we did vary from this policy, the rationale would be so
clear that any observer would agree with our approach.
I can hear you now, "wait a minute Dan, you tripled the size of MacDermid in the
last three years. What's different now"? In a word, everything. Three years
ago we were very concentrated in the electronics chemical business. As I
described in last years annual shareholders message, we believed we faced a
strategic necessity to spread our cash flows more evenly. That's done. Our
business mix does not require a major adjustment. So, we now have choices that
we didn't believe we had three years ago.
In order to properly decide on a long-term strategy one first has to consider
the starting point. What is the strategic positioning of our businesses? Let's
review each of our businesses.
GRAPHIC ARTS OR AS WE NOW CALL IT, PRINTING SOLUTIONS. This is a fine business,
especially now that it has been "MacDermidized". Stephen Largan and his
management team in the Americas have done an outstanding job of repositioning
this business. With revenues just under $300 million, overall generating high
teens operating margins and excellent cash flow, Printing Solutions is split
three ways. The largest piece by far is flexographic photopolymer plates. We
have leading share in North America and are #2 worldwide. Our strategic
positioning is very strong. We call our strategy bookend; high need for
innovation on the front end and high requirement for technical service on the
back end. The product line should grow faster than GDP as flexo continues to
grow at the expense of other types of printing. Offset printing blankets is
more of a materials business. We are tied for second place in world share, with
a leading share in Europe, where Gerard Loeb and his management team is
struggling to overcome a difficult market. This business is more cyclical and
not as profitable as the plates business, but generates good cash flow. Our
European position is pretty strong and we have an important new type of blanket
being introduced that could make this business much more attractive. Finally in
Printing Solutions is ColorSpan, the digital printing business. It is now cash
flow neutral and generated an operating profit every month of the June quarter.
ColorSpan has a potentially attractive niche position in the wide-format digital
printing market. Overall, Printing Solutions is a very attractive business.
ADVANCED SURFACE FINISHING, our historical business, with revenues of about $325
million is an outstanding business, although the performance isn't as clearly
visible without understanding the current market circumstances. Three world
class managers lead this business, the veteran Pete Kukanskis who is responsible
for Asia and R&D, Massimo Garzone of Europe, and Mike Siegmund who has had the
thankless task of surviving in North America. Each have an outstanding
supporting cast, and has performed better than I ever would have thought
possible. This business is the class of the industry. With revenues split
fairly evenly between printed circuit board chemicals and surface treatment
chemicals this business generated 13% operating profit in the June quarter, in a
market (printed circuits) where demand was 40% to 50% lower than calendar year
2000. Simply, remarkable. Every day this major industry downturn continues, we
strengthen against our competitors. We believe there is more than $50 million
in market recovery potential one of these days. We generated 60% incremental
gross profit this quarter. The upside will be very interesting. Longer term
this will be a very good business. In Surface Treatment we see modest but
attractive trends working in our favor. In printed circuits the long-term
growth will be extremely attractive driven by applications growth and an
expanding share of GDP for electronics over time.
OFFSHORE FLUIDS led by Ray Pickens, is an extremely attractive niche opportunity
with a tremendous team of dedicated clan members.
Finally that leaves ELECTRONIC MANUFACTURING, Eurocir; our 60% owned JV in
Spain. Our partners are the best operators in this business, resulting in a
profitable business even in these difficult times, however it is not core, and
will be monetized at some future point.
A major factor in deciding a more modest, incremental approach, is my thoughts
about management. In the last annual report I mentioned management bench
strength. Management is certainly an issue if we substantially changed the
scale and complexity of MacDermid. In our business model however, we have
battle hardened leaders who in my view, are world class by any standards. This
applies not only to the small hand full of the most senior managers I mentioned,
but many more spread all around the world. With our team, I am extremely
confident we can execute this plan successfully.
Yes, we have great businesses, especially in my view, as measured by the
potential to generate per share intrinsic value. With the very rare exception
of certain direct competitors, we would find it difficult to find larger
acquisitions that would meet our business model standards. I'm not sure how
many other great businesses like ours there are out there. So, from any angle I
can see, our destiny seems clear, build a great enterprise step by step without
any bold fancy moves. What can the future look like? Certainly not the 25%
growth we talked about in the past. I now consider that inappropriate. Is a
15% goal realistic? I believe it is possible, although by no means assured. To
grow by 15% by supplementing our organic growth with small bolt on acquisitions
financed with a portion of our free cash flow appears doable to me. Think of it
as "capital expenditure acquisitions". By that I mean that we can operate our
business reinvesting the "normal" amount others would spend just for cap ex,
only we will spread the investment between cap ex and "operating acquisitions".
In fact, I believe we could not spend all of our free cash flow on acquisitions
without growing at too fast a rate. Therefore we intend to have free cash flow
left over after the cap ex acquisitions to reduce debt or to buy back stock.
We believe there are great opportunities for growth. So many in fact we can
forego the risky "Tyco type" acquisitions for a much more measured approach.
Will we be the next General Electric? Most assuredly not. We will be a highly
principled, disciplined, per share focused, cash flow organism.
We have a very long-term view. As I write this I am 53 years old. I often tell
our management team my personal time horizon is 15 to 20 years. The Board of
Directors however, may have a very different view at any point along the way, as
I am employed at will, as it should be. With my personal net worth almost
entirely made up of MacDermid stock, I can assure you our eye is on the ball.
This has been a great company for most of its 80-year history. There is no
short-term gamesmanship that could possibly make it worthwhile to put all that
at risk. I promise you we will continue to follow the MacDermid philosophy of
honesty and integrity, and while our approach may not be common, we hope it will
be wise.
Sincerely,
Dan Leever
Chairman & CEO