Hercules Bucks the Headwinds

The mythical Hercules had to perform 12 labors to atone for past sins. The labors of the modern-day corporate Hercules number only four: improve free cash flow, reduce fixed costs, pay down debt, and expand geographically.

Craig A. Rogerson, 47, the fourth chief executive officer at the specialty chemicals maker since 2000, has taken on the heroic task of continuing to redeem the venerable firm after its ill-fated acquisition of water treatment firm BetzDearborn in 1998. Rogerson may succeed by talking himself out of a job, or into a bigger one.

He says that five years from now, "Hercules could probably be a very attractive 'partner'--let me put it that way--for somebody. I'd be surprised if we weren't a component of something bigger. Maybe we'll be the surviving component, too, and Hercules would be twice as big as it is today."

With three major units--pulp and paper chemicals, Aqualon water-soluble polymers, and fiber maker FiberVisions--Hercules is a global company with a diverse customer base, Rogerson points out. "They are big, high-volume, and low-cost players," he says of the businesses. "They are innovators." One other unit, Pinova, the only U.S supplier of pine-stump-derived terpenes and rosin, is a small player with niche-market potential.

Hercules is still one of the sicker players in the specialty chemicals sector. Long-term debt exceeds $1.3 billion. Sales in 2003 were $1.85 billion versus $1.7 billion the year before and a far cry from the $3.2 billion it had just after it acquired Betz. Net income for 2003 was $45 million, compared with a loss of $611 million in 2002. Net income was $211 million in 1999.

But Hercules is not on its deathbed. Earnings before interest, taxes, and other deductions were $352 million in 2003, up from $327 million the year before. There is some life left in the 86-year-old firm.

Rogerson isn't blind to his firm's problems. Hercules has a few good businesses, "but we only have three-and-a-half and not seven or eight," he says. A larger company would have an advantage by spreading the fixed costs of its corporate structure over many more businesses.

And then, too, Hercules has to deal with what Rogerson refers to as "headwinds": debt left over from the $3.1 billion BetzDearborn purchase, asbestos liabilities potentially as large as $675 million, and pension liabilities.

The firm reduced debt in 2002 with the sale of part of Betz to General Electric for $1.8 billion. Hercules held onto about a third of Betz--the pulp and paper portion of the business--and recovered nearly 60% of the original cost. Rogerson maintains that "we got a good price for it."

Rogerson, a chemical engineer with a B.S. from Michigan State University, ought to know. He started his career in Hercules' water management chemicals business. And for two years, ending with the sale to GE, he headed Betz. Except for a detour as CEO of Wacker Silicones between 1997 and 2000, he is a career Hercules employee familiar with its operations and its recent troubles. "We made significant improvements in Betz's free cash flow and earnings," he says. The additional value that the change created increased the price GE was willing to pay for the business, he adds.

HERCULES AT A GLANCE

Headquarters: Wilmington, Del.

Sales: $1.85 billion

Earnings^a: $352 million

Capital spending: $48 million

R&D spending: $39 million

Employees: 5,116

MAJOR BUSINESSES (% OF TOTAL SALES):
Pulp and paper (47%)--process chemicals, retention aids, and strength resins used in paper production
Aqualon (33%)--cellulose and guar-based water-soluble polymers used in paints and coatings, in personal care products, and as strengthening agents in mortar and plaster
FiberVisions (15%)--synthetic fibers made from polypropylene and polyethylene used primarily in nonwoven fabrics for disposable diapers and other hygienic products
Pinova (5%)--terpene resins, terpene specialties, and rosin derivatives used in chewing gum and adhesives

Website: http://www.herc.com

NOTE: Data are for 2003. a Before interest and taxes.

HOWEVER, the second headwind of asbestos is too big for Hercules to handle alone, Rogerson says. "It's not going away." It not only affects the companies that mined and sold asbestos, but also those that used the heat-resistant mineral in their products, including W.R. Grace, Honeywell, Dow Chemical, and many others.

"Our exposure is very limited and defined," Rogerson says. Between 1964 and 1980, a Hercules subsidiary made asbestos-containing heat- and corrosion-resistant pipes and tanks for use in petrochemical plants and refineries.

At the end of last year, Hercules counted 33,220 asbestos claims against it. According to a study Hercules commissioned, the firm faces between $220 million and $675 million in asbestos liabilities.

Hercules paid out $40 million in asbestos claims and defense costs last year. Its primary insurance coverage ran out last June. The firm plans to go to court later this year against its secondary insurance carriers if it can't come to terms with them over their liability. Ultimately, Rogerson expects insurers will pick up the largest portion of the tab.

In an odd way, Hercules' asbestos liabilities have ensured its survival as an independent company. Asbestos liabilities are a "natural poison pill" against any takeover, Rogerson points out, although they didn't stop International Specialty Products from trying to take control of Hercules' board. Those liabilities are "not a bad thing from the point of view that it gives us more time to improve value for Hercules' shareholders," he says.

The firm is hoping for a legislative solution and is lobbying government officials in Washington, D.C., to pass a law that would sort out the mess. If legislation occurs, Rogerson expects that "Hercules will have to make some kind of contribution for the next 25 years, but it will be palatable. I won't like it. It will be unfair. But it will be palatable. And it will be a tax, basically." That would put the asbestos issue "in a box," as Rogerson likes to say. The company can deal with the issue and then go on with its business.

PENSION LIABILITIES, the third headwind Hercules has to deal with, is less a concern now than it was a few years ago, thanks to the improvement in the stock market in 2003. "We were up 23% last year," Rogerson says. "We continue to put money into the pension fund to get funding levels up to 100%." It's a much different issue than the asbestos problem, he points out. "I can solve it internally by funding and plan modification."

Rogerson says he is working hard on other internal issues. Like his predecessor at the helm, William H. Joyce, he is trying to lower fixed costs to generate more cash and reduce debt. "The main difference is maybe a little more emphasis on free cash flow for me than for Bill--and pace. Bill was probably more patient than I am." Head-count reductions were the order of the day in 2001 and 2002, he says. Nearly 1,400 employees are gone as a result. Now, the focus is on "getting more out of the people we have."

The firm is also trying to improve revenues through new product introductions. Overall, about 20% of the firm's revenues today come from products five years old or less, Rogerson says. The figure ranges from a high of 35% in FiberVisions to a low of about 12% in Pinova. R&D spending, at roughly 2% of sales, was $39 million last year, down from $42 million in 2002. Include applications development--Hercules has 13 facilities worldwide devoted to it--and such spending rises to 3% of sales, or about $55 million.

Corporate research has come up with a new product line that Hercules may use to fill the Pinova plant in Brunswick, Ga. About 85% of the plant's capacity has not been used since Hercules sold its hydrocarbon resins business to Eastman Chemical in 2000.

The new product line "is not a natural fit for any of our four businesses," Rogerson says. "We have expertise in the area historically, but it's a new product line for the current Hercules, and it could really fill the plant." He won't elaborate further on the line, except to say that it "could be a fifth business."

Hercules also raised cash earlier this year through the sale of its minority stake in CP Kelco to J. M. Huber for $27 million. Hercules had acquired Kelco from Monsanto in 2000 in a partnership with Lehman Brothers Merchant Banking Partners. It then contributed its food gums business to the new Kelco, keeping a small interest for itself.

New threats to the company's longer term survival may still come. Last July, International Specialty Products and its chairman, Samuel J. Heyman, ended a nearly three-year play for control of Hercules when they withdrew a dissident directors slate at the Hercules annual meeting.

Others might try to take control, Rogerson admits. "There is nothing to stop somebody from taking us over, but that would be up to shareholders." Only a rule that places just one-third of board seats up for election annually prevents a swift proxy fight. As Joyce did, Rogerson says he and the current board have an obligation to examine any alternatives, including the sale of businesses, in the interest of shareholders.

Although Rogerson says he's open to some kind of megadeal five years down the road, at the moment his attention is focused on the inside. "We are not actively looking to sell all of Hercules or a part of it," he says. "At a price, Hercules could be sold. At a price, any business could be sold--I guess. But we are not looking to be acquired. We are trying to grow Hercules."

It is important now for Hercules to get back on track. Betz was "a great business and a great contributor to Hercules' profitability," Rogerson contends, but it was never properly integrated. "It was a separate operation. There was Hercules with headquarters in Wilmington, Del., and there was Betz in Trevose, Pa., with separate headquarters."

HERCULES IS STILL "a bit shell-shocked" from what Rogerson says was "the failed integration of Betz." But the firm is developing a new mind-set, he says. It has a conservative acquisition strategy now: Target companies "have to be bite-sized, and we have to know we can derive synergies and integrate them. We learned some hard lessons with Betz."

Acquisitions such as the Merkalon deal announced last August, though it never closed, are just what Hercules is looking for. Integration of the Italian firm would have given Denmark-based FiberVisions better access to Middle Eastern and North African markets while extending its diaper cover stock and hygiene product line to textile and industrial products. German regulatory authorities nixed the deal, Rogerson says with some frustration.

However, Hercules was successful in buying Jiangmen Quantum Hi-Tech Biochemical Engineering for $10 million. The Chinese maker of carboxymethylcellulose proved an ideal fit with Aqualon and gave the business an outlet it didn't have before in the growing Chinese market. "We'll also use Quantum to push other products we make in Europe or North America until we can expand Quantum and produce those products locally," Rogerson says.

Hercules sees its best opportunities for growth in developing countries. About 85% of the firm's sales were in Western Europe and North America last year. Those franchises are mature businesses growing at low single-digit rates annually. However, Hercules "has a whole bunch of opportunities in emerging markets," Rogerson says. "China and Southeast Asia represent a huge opportunity for us."

In the pulp and paper additives business, sales in China grew 29% last year. Even better was a 40% jump in Brazil. And Eastern Europe shows promise as well; pulp and paper sales grew 19% in Russia last year, Rogerson says.

The company plans to build or expand plants in China. But limiting growth in China now is availability of the trained people Hercules stations at its customers' pulp and paper plants. "While we grew at 29% last year, we could have grown at twice that if we had more people."

In Hercules' favor, Rogerson says, energy and raw material costs have not been as burdensome as for other specialty chemicals makers. High propylene costs related to FiberVisions' nonwoven polypropylene fabrics, though a serious concern, can be passed on to most customers through contract provisions. Aqualon uses many natural raw materials, prices of which have remained low. "Energy as a utility cost is not a big issue for us. If prices rise 50%, our natural gas costs increase by about $15 million, not $150 million."

Also in Hercules' favor are currency exchange rates. The weak dollar has helped the firm's bottom line, Rogerson says. "It's something we don't control, but we do take advantage of it." But it's not something he'll count on in the future.

"We have to show consistent improvement," he says. "We have to do that even when the rate of exchange is not helping us. Things are rolling, and people here are motivated to deliver results. It's not real sexy. It's blocking, and tackling, and doing the right things." This Hercules, at least, is not ready to give up the fight to survive and is doing all in its power to atone for past missteps.