Basically, Elementis is an expert at controlling the flow of highly viscose - ie, stodgy - materials. It helps that Elementis owns the world's major hectorite mine, in California. Hectorite is a greasy clay used as an additive to control the viscosity and flow of products such as paints and cosmetics. Elementis's expertise in flow dynamics - it's called 'rheology' - has also brought it a profitable niche in the US shale-oil industry, where a cheaper clay, bentonite, is widely used in horizontal drilling.
Now, however, shale-oil extraction is tailing off, which is hitting the group's oilfield revenues - in the first quarter of this year they are 37 per cent down on the year. Simultaneously, demand for paint in China - to coat all those thousands and thousands of building projects - is moderating; that was the main factor behind a 1 per cent drop in sales of speciality products to the Asia-Pacific region in the first quarter. A third bearish factor involves the legacy side of Elementis - producing chromium. In the first quarter, export sales at the US-based chromium plant were down 19 per cent, contributing substantially to an 11 per cent fall in the division's revenues.
The good news - at least, it's potentially good - is that these trading difficulties may have hit the shares sufficiently hard - at 207p, the price is 33 per cent off its 12-month high - for the stock to qualify as a high-yield recovery play.
The point here is that Elementis's short-term trading problems don't undermine its long-term merits. These revolve around supplying customers, whose products are diverse and whose locations are widespread, with ingredients that are both critical to performance and low-cost. Add to these factors the barriers that come from some patent protection, long-term customer relationships and - in the case of hectorite production and chromium-making plant in the US - near monopolies of supply and you have a powerful business.
Certainly, that contention is borne out by Elementis's financial returns. Within the speciality products division, which is basically rheology and generates about two-thirds of the group's revenue, operating profit margins in 2015 were at their lowest for five years, but were still 17.7 per cent. The chromium chemicals side produces even fatter margins. The lowest they have been in the past five years is 24.6 per cent in 2011. So, even if 2016's are lower, they will still be plump.
Those margins also translate into highly profitable use of capital. The absence of debt in Elementis's balance sheet means that return on equity is the most useful measure of capital efficiency. Even in 2015, when net profits were at their lowest for five years, return on equity was 17.6 per cent and for the past five years it has averaged over 25 per cent.
Quantifying the value generated by returns such as these is the job of the Bearbull valuation models. These indicate that buying at 207p could well provide a decent margin of safety. Put it this way, based on the five years 2011-15, Elementis has a free-cash-generating capability of about £85m a year - that's the average figure for those years. There is no obvious reason to think that changes in the group's make-up or its prospects make that amount redundant. So we will use it as the core figure from which value will be derived and apply an 8.5 per cent cost of equity as the value driver. Deducting a tiny amount of debt and adding in spare cash gives installed value of 228p. On top, we can add another 33p per share for the group's growth prospects, based on its capital spending in excess of depreciation charged.
Meanwhile, on 2015's payout, the shares yield 5.3 per cent, which is plenty for the Bearbull income portfolio. One concern, however, is that for the past four years an important part of the dividend has come from a special payment, which is quantified as half the company's spare cash at the year-end. The question is whether that formula makes the dividend sufficiently vulnerable to disqualify the shares for an income fund?
Maybe I'm especially attuned to this risk because similar factors prompted Antofagasta (ANTO) to slash its dividend last year, forcing me to sell the Bearbull holding and that loss of income is not something I want to repeat. Against that, I only want to be holding shares in companies that can pay their dividends with cash generated from trading anyway. After all, dividends funded by debt or - worse - recycled shareholders' capital really just destroy value.
There is also the concern that, by adding Elementis shares to the income portfolio, I will have another holding in a company - much like Petrofac (PFC) and Vesuvius (VSVS) - whose immediate trading prospects are dull. True, that may rob the portfolio of some momentum in the coming months, but I've never been much of a momentum investor anyway. Besides, a holding in a chemicals company will diversify the fund's sectors spread. I have bought 8,750 Elementis shares at 207.7p each.
