Fitch Ratings has assigned a 'BBB-'/'RR1' Long-Term (LT) issue rating to H.B. Fuller Company's (NYSE: FUL) proposed $800 million senior secured term loan B.

Fitch has also assigned a 'BBB-'/'RR1' rating to the company's new $500 million senior secured term loan and $700 million senior secured revolver. Proceeds are intended to refinance existing senior secured debt. H.B. Fuller's LT Issuer Default Rating is 'BB', and the Rating Outlook is Stable.

The rating reflects the company's leading position in the global adhesives market with a solution- and innovation-oriented product portfolio resulting in relatively high customer switching costs and stable EBITDA margins in the low-mid teens.

Key Rating Drivers

Acquisitions Hinder Financial Structure: H.B. Fuller has proven willing to stretch leverage above its 2x-3x net leverage target in order to execute value-added M&A. In January 2022 the company completed a fully debt-funded acquisition of Apollo Chemicals Limited, Apollo Roofing Solutions Limited and Apollo Construction Solutions Limited for approximately $203 million. With pro forma EBITDA Leverage of 3.9x, the company is expected to similarly allocate capital toward debt reduction over the near term in order to bring its leverage profile back toward its targets. Fitch projects around $200 million in debt repayments over the near term, leading EBITDA Leverage to return to around 3.5x over the forecast horizon.

Given the fragmented nature of the adhesives industry, Fitch believes the company will continue to seek bolt-on acquisitions to further build out its product portfolio, regional exposures or technical capabilities. The company is able to fund small acquisitions with FCF, as evidenced by the recent acquisitions of Fourny NV and Tissue Seal, LLC. Any near-term earnings and FCF deterioration or inconsistent capital deployment policies while leverage is elevated could further hinder H.B. Fuller's financial structure.

Strong Performance Amid Elevated Costs: After effectively navigating the period of rising raw materials and logistics costs seen during 2021 through significant offsetting price increases, where the company generated around $82 million in FCF, strong end market demand in 2022 has supported further price increases and market share gains. This has resulted in yoy growth in year-end 2022 revenues and EBITDA of 14% and 17%, respectively. The company's demonstrated pricing power is supported by typically high switching costs in the industry, coupled with the nature of adhesives typically making up less than 1% of cost of goods sold (COGS) for most of H.B. Fuller's customers.

The company's Construction Adhesives (CA) and Engineered Adhesives (EA) segments could see lower demand from current highs, in-line with Fitch's expectations for weaker macroeconomic growth over the near term to pressure the construction, industrials and transportation end markets. Fitch expects resiliency in the company's Hygiene, Health & Consumables segment to partially offset weaker earnings from the CA and EA segments, leading to muted but positive earnings growth over the medium term.

Leader in Fragmented Adhesives: H.B. Fuller is the number one or two player in most of its markets, and the second largest player, behind Henkel, in the fragmented $50 billion adhesives market, where the top five players account for less than 35% of the market. Benefiting from its size, scale and diversification, the company has a R&D-linked competitive advantage versus global competitors that more firmly places it into its regional and global customers' value chains.

Fitch views long-term trends such as the need for light-weighting and energy efficiency, sustainable packaging, digitization and healthcare related supplies as favorable growth drivers for the company. The 2017 acquisition of Royal Adhesives and Sealants further strengthened H.B. Fuller's ability to address these high-value demand applications across the Engineering Adhesives segment.

Stable, Mid-Teens Margin Profile: H.B. Fuller purchases numerous raw materials, with the top 25 materials making up less than 20% of the annual spend. The company categorizes around 87% of the sourced raw materials as 'Specialty Raw,' which flow through to downstream applications that generate resilient margins, given the low-cost (e.g., less than 1% of customer COGS) but critical aspects of the company's products for its customers.

This diversification and specialization of offerings combined with pass-through clauses with customers helps mitigate cost risk and provides the company relatively resilient, through-the-cycle margins in the mid-teens. In the near term, Fitch forecasts EBITDA margins will remain around 13%, given the company's demonstrated ability to offset rising raw material costs through price increases and assuming realized cost savings from the Operations & Supply Chain project initiated in 2020. EBITDA margins are projected to trend slightly higher thereafter as the company continues to move downstream in its product offerings.

Positive FCF Generation Forecast: H.B. Fuller consistently generates positive FCF given its relatively stable EBITDA margins, limited working capital risk, and low capital intensity with capital spending averaging around 2.0%-2.5% of sales. FCF margin has averaged around 5% dating back to 2016, and Fitch projects the company to continue to generate around $200 million of annual FCF leading to FCF margins of around 5%-6% through the forecast.

Fitch believes FCF will be mainly allocated toward gross debt reduction in the near term, as well as a continued focus on measured shareholder returns and strategic bolt-on acquisitions.

Derivation Summary

H.B. Fuller is larger than equally rated peer Ingevity Corporation (BB/Stable) and smaller than Axalta Coating Systems Ltd. (unrated). It maintains relatively lower EBITDA margins typically in the mid-teens compared with Ingevity and Axalta, which typically see margins ranging from the high teens to mid-high twenties, but has exhibited less variability. Fitch expects margins to continue to expand as the company focuses on downstream growth within Engineering Adhesives.

Additionally, the company consistently generates FCF margins at around 5%-6%, given its typically low capex requirements of around 2%-3% of revenues, versus around 3% of revenues for Axalta and 5%-6% of revenues for Ingevity. Like its peers, H.B. Fuller is a leader in a specialized industry with a similar appetite for debt funded M&A and operates with EBITDA Leverage around 3.0x-4.0x over the forecast period versus Axalta, which is generally at around 4.0x and Ingevity at around 3.0x. Fitch projects Fuller to generate consistent FCF margins in the mid-single digits over the forecast period, given low maintenance capex requirements and relatively stable earnings, which is consistent with Fitch's views for Axalta and Ingevity.

Key Assumptions

Muted revenue growth in 2023 and thereafter driven by lower expected macroeconomic growth leading to lower volumes for the EA and CA segments, partially offset by resiliency in the HHC segment;

EBITDA Margins trending around 14% as the company offsets rising costs with further price increases, continues to move downstream, and realizes cost savings resulting from the Operations & Supply Chain project;

Capex of around $100 million annually;

Continued execution of strategic acquisitions with the assumption that management may temporarily increase leverage.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Sustained adherence to the company's long-term financial policy coupled with continued cash generation and earnings stability, leading to EBITDA Leverage durably below 3.5x;

Continued trend toward higher EBITDA Margins that demonstrates successful execution of the shift towards higher value-add products.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Loss of leading market positions leading to EBITDA Leverage durably above 4.5x;

Reduced ability to pass through costs to customers, leading to less stable EBITDA Margins and heightened cash flow risk;

More aggressive than anticipated M&A activity, including transformative, credit-unfriendly acquisitions, or shareholder return strategy otherwise incompatible with management's articulated capital deployment policy.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Extended Maturities, Sufficient Liquidity: Pro forma for the transactions, the company has approximately $200 million in cash and cash equivalents on its balance sheet, and full availability under the new $700 million senior secured revolving credit facility due 2028. With the refinancing extending its prior near-term maturities, Fuller has no material debt maturities through 2026.

Fitch anticipates solid FCF generation of around $200 million annually through the forecast, which should largely go toward continued M&A and debt reduction over the forecast horizon.

Issuer Profile

H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. The company has three reportable segments: Hygiene, Health and Consumable Adhesives, Engineering Adhesives and Construction Adhesives.

Date of Relevant Committee

18 August 2022

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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