As cars with internal combustion engines (ICE) go the way of leaded petrol and the idea of diesel as an environmental saviour, companies that supply parts for gas-guzzling vehicles have to find a way to survive. One such company is Johnson Matthey (JMAT), a specialist in precious metal sciences. It makes most of its money from its catalytic converter sales. But by current forecasts and government policies, most of its major markets for these product may have all-but-disappeared within a decade. As a result the company is changing tack to benefit from the growth of electric vehicles and the anticipated boom of the hydrogen industry, in which it is already an established player.
Short-term automaker recovery
Hydrogen exposure, established expertise
Emissions standards to boost revenues
Cost-cutting programme in place
Weak Covid-19 car industry has hit sales
Investment needed to transition from catalytic converter as main income source
This shift won’t happen overnight, nor is it a sure thing. But in the meantime new emissions regulations will boost sales from the existing business while reduced investment in the operation mean it should throw off cash, to help fund expansion into growth areas. As such, Johnson Matthey offers a way for investors to both back massive green stimulus spending and benefit from the final payout from a moribund but huge global market.
First, the headlines. Johnson Matthey’s earnings dived this year. It has cut hundreds of jobs, and wants to say adieu to 2,500 workers in total over the next three years. Shareholders have seen the shares fall over a fifth in 2020, which is well ahead of the FTSE 100's decline. And the half-year dividend was cut from 24.5p last year to 20p on the back of the Covid-19 hit to performance.
The 2021 financial year will not have been a total write-off, though. First-half free cash flow was maintained close to last year and there has been a strong sales rebound in recent months. Performance has also benefited from a strong palladium price.
Meanwhile, beyond the factory gates, interest and investment in hydrogen as a low-carbon energy technology has exploded this year. This may not have bought much joy to Johnson Matthey's shareholders, but the excitement is palpable in the soaring share prices of smaller listed hydrogen players.
Johnson Matthey has two major divisions – clean energy and efficient natural resources – that brought in close to £3.7bn in sales last year, over four-fifths of the total. The overall revenue is much larger given the inclusion of pass-through costs associated with precious metal sales.
The biggest and most important part of Johnson Matthey is the ‘clean air’ unit, which accounted for just over half of last year's underlying profit and 61 per cent of underlying sales. Clean air refers to the job done by the catalytic converter in petrol, diesel and hybrid cars and trucks, which pulls emissions and toxic gases from engine exhaust. ‘Cleaner air’ might be a fairer name. Efficient natural resources makes its sales to refineries and other processing plants. The company has a fledgling health business that manufactures “active ingredients” for pharmaceuticals. Its "next generation" interests, meanwhile, are where it hopes the low-carbon future lies.
While hydrogen could offer huge potential for Johnson Matthey, its short- and medium-term cash flows will come from the ICE and hybrid car and commercial vehicle markets.
Margins in this business have run at around 10-15 per cent in recent years, with the company’s target set at around 14 per cent. Profitability had already dropped before Covid-19, with a weaker heavy duty truck market knocking margins down to 11.3 per cent in the year to the end of March 2019, from 14.4 per cent the year before.
But there are green shoots in the car manufacturing sector, even as Europe and North America continue to struggle with Covid-19. In the short term, current demand shows Johnson Matthey’s second-half sales will be a major improvement on the troubled first half. By July and August, clean air booked almost the same amount of revenue as in 2019, and then got into the growth territory by September and October – 17 per cent and 14 per cent, respectively.
This was partly down to automakers restocking, but also driven by new emissions standards in China. Outgoing finance chief Anna Manz told us these new rules – similar to the EU's 'Euro 6' rules – tripled the value of a new truck for the company and doubled the value of a new car. That said, this year it has become beyond doubt that selling catalytic converters to carmakers is not a viable long-term profit source.
There is some scepticism about the pace of mass adoption of EVs, given the need for a much broader charging network and improvement of the power grid to handle the added energy needed by electric vehicles. But government polices from around the globe offer clear signs of ICE cars being on the way out. The UK government has just brought in a policy to ban sales of new ICE cars in 2030, while hybrid sales can continue until 2035. European countries are looking at similar bans, while US president elect Joe Biden has backed a cash-for-clunkers scheme that could see older cars swapped for electric vehicles (EV) or hybrids.
In the short term, though, the tighter emissions restrictions should actually boost sales and profitability for Johnson Matthey. “Tightening emissions regulation means that these assets have a few years of earnings growth left ahead of them," says Berenberg analyst Sebastian Bray. "[They] should be an excellent source of cash as their investment cycle ends [this financial year].”
Fuel of the future
Further out is where it gets murkier. The Johnson Matthey story is currently big on hope for its next-generation products but low on sales. For example, it sold just £19m worth of fuel cells, used in hydrogen-powered transport, in the first half of its 2021 financial year. This was a 30 per cent increase on the year before, driven by a mix of automotive and non-automotive sales in Asia. But when serious change comes it could be seismic. For now, Johnson Matthey is keeping its powder relatively dry, spending £15m to double its fuel cell capacity in the UK and China by the end of March. But it looks well positioned in this exciting market.
Hydrogen has become a green catch-all, because of its broad applications. As well as transport, green hydrogen can be used as a power store, taking variable energy from wind or solar sources and producing hydrogen. When power is needed and the sun is not shining or the wind is not blowing, energy can be released from the hydrogen through chemical reaction. A major drawback currently is that this loses around half the energy, and green hydrogen is currently much more expensive than hydrogen made in dirtier ways (see graph).
Hydrogen can also be used in steel processing and other heavy industry to cut CO2 emissions. This week, Swedish iron ore miner LKAB said it would spend £35bn on a new iron production process to give steelmakers a “carbon-free” feedstock. Made using hydrogen, this is Sweden’s biggest ever industrial investment and would have the same environmental impact as withdrawing all the country’s cars off the road, LKAB said.
Meanwhile, the EU target of 40 gigawatt (GW) of green hydrogen capacity by 2030 and the linked government stimulus means an existing expert such as Johnson Matthey is in the perfect position to benefit. It’s also likely China and the US will up spending. It’s announcements like this that have seen investors flock to pure-play hydrogen companies this year, such as fuel cell maker Plug Power (US:PLUG) and electrolyser firm ITM Power (ITM).
Bigger financial commitments are currently being made by Johnson Matthey to its efforts to produce a critical part of lithium-ion batteries, the cathode. There is a plant in the works in Poland to provide a key part for lithium-ion batteries – although the cost has just gone from £350m to £550m – while design work has begun on a second plant. The company says “at scale” it would be looking at returns of 10-15 per cent from this business.
Chasing both hydrogen earnings, moving into battery technology and keeping overall margins close to historic levels will be tricky for Johnson Matthey. Major spending will be needed on capacity. But the company offers near-term stable cash flow with exposure to an industry that will grow massively within just a few years.
|Johnson Matthey (JMAT)|
|ORD PRICE:||2,245p||MARKET VALUE:||£4.3bn|
|FORWARD DIVIDEND YIELD:||3.1%||FORWARD PE RATIO:||12|
|NET ASSET VALUE:||1,403p*||NET DEBT:||33%|
|Year to 31 Mar||Turnover (£bn)||Pre-tax profit (£m)**||Earnings per share (p)**||Dividend per share (p)|
|*Includes intangible assets of £976m, or 507p a share|
|**Berenberg forecasts, adjusted PTP and EPS figures|