Fat Prophets take profits

A key feature of Fat Prophets contrarian and value investing methodology is to identify opportunities that are out of favour with the market and as a result mis-priced in our opinion. Specialty chemicals and paints group, Imperial Chemical Industries (ICI), provides an ideal example of this strategy in action.

As value investors we expect to hear statements like "...XYZ continues to out-perform market expectations" when earnings are released. After all, low expectations are what made the shares out of favour in the first place.

When we originally recommended ICI back in December 2004 (FAT64), the shares had already turned the corner the year before. However, concerns over higher raw material inputs and a creaking balance sheet still weighed on sentiment. We saw things differently.

Changes in senior management are a good first indicator that restructuring programmes are imminent. John McAdam's rise to chief executive in 2003 marks such an occasion. Initiatives targeting annualised cost savings of £140 million began in the same year. Recently, a second programme targeting annualised savings of £170 million by 2011 has followed this up.

Clearly in an environment of rising raw material costs, savings such as these are instrumental in mitigating the impact and helping to support margins. The story did not end there however. ICI was also succeeding in passing along higher prices to customers. This pricing power was critical to the improving fortunes of ICI as costs savings are at the end of the day finite.

More radical restructuring soon followed. A year after taking over, Mr McAdam oversaw the sale of the troublesome food ingredients business of the group's Quest division. Later in 2004, the group reduced their interest in Pakistan PTA, exited the chlorine derivatives business Ineos Chlor and sold Vinamul Polymers, an emulsion polymer maker. Significantly, proceeds from the divestments targeted debt reduction.

Fast forward to today and the progress at ICI is impressive. Management's first round of cost cutting is on schedule to deliver £140 million in savings next year and corporate restructuring has not abated.

In September, ICI completed the sale of oleochemicals and surfactants business, Uniqema for £410 million. Then somewhat surprisingly was last week's sale of the Fragrances and Flavours business, Quest for £1.2 billion. While neither business was marked for divestment, with solid offers in hand, management took the opportunity to crystallise value. In the case of Quest, the sale price was 15 times this year's EBITDA and ICI expects to book a profit of £900 million.

Once again proceeds will reduce debt and improve the company's pension deficit. In fact after the transactions, ICI will not have any debt remaining whilst the pension deficit will be less than £1 billion. This represents a vast improvement from 2003 when ICI's turnaround started.

Meanwhile, turnover, up 7 percent to $4.1 billion through the first nine months, continues to be healthy. Operating efficiencies and price increases drove pre-tax profits 12 percent higher to £363 million.

With such a positive backdrop, it is hardly surprising that strong investor support saw ICI shares break clearly above resistance at 409p last week. This move extended the upward trend to 448p, which is the highest level attained in over five years. However, the subsequent pullback to 409p signals a near term period of volatile consolidation for ICI in our opinion.

There is also now the interesting question of what is next for ICI. Management contend that the group's leaner structure and stronger financial footings will enable the group to pursue opportunities in faster growing coatings, adhesives and specialty chemicals markets. Growth in Asia and Latin America are in the frame, while large acquisitions are to be forgone in favour of smaller strategic bolt-ons.

Alternatively, ICI's two remaining core businesses, Paints and National Starch, could be broken up and sold. This could happen if ICI becomes an acquisition target itself, as existing management has no such plans. However, now much smaller and with no debt, we believe a private equity bid is a distinct possibility. Financing for such a deal could be accomplished by re-gearing ICI's balance sheet.

However, given the strong run the shares have enjoyed recently, continuing pressure exerted by cost inflation and slower growth in key markets such as the US, we believe now is a prudent time to lock in profits. Accordingly, we recommend Members sell half of holdings in ICI at around 416p, to take advantage of the recent rally while maintaining a position for exposure to longer-term gains or a possible takeover.