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Income portfolio swap

Presumably, the £380m acquisition of Mondo Minerals, which brought talc production into Elementis’s speciality activities, was thought out better than the metaphor that mixed talc into a pillar, which was then somehow opened. Yet that’s by no means certain. After all, recall that last summer Elementis’s shareholders told the group’s bosses to wake up and renegotiate the price agreed with Mondo’s private-equity owners, otherwise they would not back the deal.

As a result, chief executive Paul Waterman and co returned with about 10 per cent off. Instead of $600m (£459m) – as originally announced – they settled on $500m plus maybe $50m in performance-based payments. An additional benefit for shareholders was that they were stung with a $230m rights call to help pay for the Finland-based talc producer, rather than the original $280m.

Still, the Mondo moment has dealt a dose of reality to Elementis’s rating. Its share price – currently 152p – languishes 52 per cent below its 12-month high. But it’s an ill wind and, as a result, the stock once more qualifies as a high yielder. Assuming a repeat of 2018’s 8.4¢ dividend (Elementis produces its accounts in US dollars), the yield is 4.3 per cent, just enough for the Bearbull Income Portfolio.

To cut to the chase, I have swapped the income portfolio’s holding in vertically-integrated energy supplier SSE (SSE) – see Bearbull, 15 Feb 2019 – for one in Elementis. If nothing else, this should be a useful bit of income maximisation. SSE’s shares are ‘ex’ 2018-19’s half-year dividend, where the yield on that payout alone is 2.4 per cent. Simultaneously, Elementis's shares come with the final dividend (yield 2.8 per cent). In other words, the portfolio captures both those payouts in the first half of 2019 with the same chunk of capital.

Hopefully, though, there will be more – Elementis is hardly short of merits. Chief of these is that it is a near-monopoly supplier of hectorite, a greasy clay used as an additive to control the flow of products such as paint and cosmetics. Linked to that is the group’s expertise in rheology – or flow dynamics – which, for example, meant that, when the US shale-oil industry boomed, Elementis cashed in because another clay, bentonite, is used in horizontal drilling as a lubricant and a coolant.

So expertise plus supplies of inaccessible raw materials have meant that Elementis, which started life as Harrisons and Crosfield, has been able to command enviable profit margins. Group-wide, in 2018 – a dull year – operating margins averaged 16.1 per cent and were knocking on 25 per cent in personal care, the most profitable division. Generally, these margins have also filtered down to fat returns on capital.

The acquisition of Mondo should be from the same mould. Its access to long-life talc mines in Finland and focus on specialist uses of talc makes it a ‘mini-me’ of Elementis’s hectorite production – supplying customers with ingredients that are low-cost yet critical to the performance of the products they go into, such as paints, cosmetics or technical ceramics.

The chief downside of this is that Elementis is exposed to its customers’ demand cycle. Thus coatings, its biggest division by revenues, was hard pressed in 2018 as demand for paint in China – to coat all those thousands of building projects – continued to moderate and operating profits slipped 4 per cent to $52.5m. Similarly, in energy, drilling activity in the US was down on the year and profits fell 27 per cent to $7.1m.

The year just begun should be better largely because there will be 12 months from Mondo as opposed to two months in 2018. Since Mondo generated $158m of revenue and $25m of operating profit in 2018, its contribution should be a substantial addition for a group whose equivalent numbers without Mondo were about $800m and $130m.

But even at the underlying level Elementis’s bosses expect progress due to the absence of 2018’s production problems in the chromium and energy divisions and to what the chief executive labels “an unrelenting focus on cash generation and de-leveraging”. As a result, City analysts expect 2019’s earnings to return to levels around 2015’s 16p and to climb thereafter. That means the shares trade on a fairly undemanding earnings multiple. More importantly, I can just about justify paying 152p by taking likely free-cash generation and capitalising that Bearbull’s required rate of return, which is 8.5 per cent.

Granted, there is a bit more to valuing a company’s shares than that and my value estimates stumble against Elementis’s declining return on capital, especially in 2018. It is also important that the group can break free of the so-called exceptional items – which have become quite unexceptional – that have dogged its accounts in the past three years.

Still, a stock that I dumped at a rights-adjusted 243p last July is now back in the Bearbull income portfolio at 152p apiece while another, SSE, which had been there since 2003 has finally – and after much threatening – been kicked out. Feels good.