Description

Aleris International Inc. is a cheap turnaround situation led by a new management team that is under-recognized by most investors. The company trades at 5.5x 2005 EV/EBITDA and 7.1x 2005 EPS, on projections which may be too low. While the stock has appreciated since we got involved in the mid-teens (for full disclosure), there is still significant upside in this name if the market assigns a reasonable multiple to this earnings stream and/or if the management team continues to execute, as we fully expect they will.

Commonwealth Industries and IMCO Recycling announced their merger on June 17, 2004, and in conjunction, announced that Steven Demetriou – a Commonwealth director since 2002 – would be appointed as President and CEO of the combined entity upon completion of the transaction. Demetriou came into the company with an impressive track record as a turnaround expert, having succeeded in making Noveon a competitive specialty chemicals company prior to the company’s sale (announced April 16, 2004) to Lubrizol. On his watch, the former Performance Materials Segment of the Goodrich Corporation had eight consecutive quarters of year/year sales growth prior to the announcement of the sale and shrank its administrative and manufacturing headcount globally by 18%. This performance allowed the LBO sponsors (AEA Investors, DLJ Merchant Banking, and MidOcean Capital) to make a profit of $565mm on their investment of $355mm, in three years. The opportunities at Aleris, as the new entity is named, are of a similar if not greater magnitude, especially when one considers that the difficulties at Commonwealth in recent periods were driven primarily by management missteps.

The new Aleris is a vertically integrated recycler and common-alloy sheet manufacturer. It is the leader in North American (and likely global) aluminum recycling and in rolled products, it is a major player alongside Novelis (recently spun out of Alcan, and trading at 14.6x 2005 EPS, as an aside), Quanex, and Alcoa in North America. According to a recent Alcan presentation, ARS has a 9% share in the rolled products market; Alcoa has a 33% share and Alcan/Novelis has 23%, though these share figures include packaging (e.g. Coke cans), a market in which ARS does not participate. Per Commonwealth/ARS’s figures, it has a 30% share in North American building and construction, 23% in distribution, 9% in transportation, and 15% in consumer durables and other. Note that the Novelis product mix is more skewed towards beverage/food cans (45% of their volumes versus 26% of global volumes; the other segments of the rolled aluminum market are construction/industrial at 42%, foil products at 21%, and transportation at 11%, according to Alcan); ARS is more focused on building and construction, with 43% of its shipments to that market in 2003.

Also note that the industry has undergone beneficial structural change, with major consolidation in the late 1990s and capacity reductions in 2001-2004 (at least three major facilities shuttered)…all leading to more pricing discipline.

[The company also has a leading position in zinc recycling, a business which may or may not be considered core – management is still considering this question.]

A CRITICAL FEATURE of ARS is that it is not exposed to aluminum prices. In the Recycling segment, the aluminum processing volume is provided under contract tolling arrangements that involve recycling of customer-owned materials in return for a fee (59% of the segment’s 2004 revenues, and management intends to grow this proportion) and through product sales carried out by purchasing scrap and dross on the open market, processing it, and selling the recovered material (price risk in the latter is reduced by matching purchases and sales and by hedging open metal positions). Rolled Products is a margin business – contract pricing terms are based on margin per pound, and the metal is just a pass-through. Typical contracts that dictate pricing last from 6 to 12 months, with most contracts this year closer to the 6 month duration (i.e. pricing is set for the first two quarters, providing good visibility). I believe this is one of the important misunderstandings about the company, a point which management will likely make clear over time.

While the lack of true comparative companies makes relative valuation challenging, any asset trading at 5.5x EV/EBITDA and 7.1 P/E (both 2005E) must be considered at least somewhat cheap on an absolute basis. When one further considers that management intends as a first priority to pay down debt with its free cash flow, shareholders will see benefits not only from fundamental improvements at the company and synergies from the merger, but also from de-leveraging to a more appropriate balance sheet. (Note, as of mid-March, the drawn revolver was at $55mm – it is quite likely this can be mostly, if not all paid down this year.) If we apply arguably low multiples of 10x P/E and 6.5 EV/EBITDA on conservative 2005 projections, a price target of $30-32 can be set, for a minimum return of 32-40%. Upcoming catalysts include the announcement of Q1 results, progress reports on synergies, and guidance for the rest of the year which should match/surpass Street estimates. It’s also remarkable that only one analyst has active coverage on a company the size of ARS (mkt cap $702mm) – more research coverage is possible and would likely serve as a positive catalyst.

ARS reported numbers for Q4 which surpassed Street expectations but more importantly, provided guidance for Q1 that was well above recently raised consensus figures. Specifically, excl special items, ARS earned $0.28/share in the quarter while the one publishing analyst (BB&T) had them making $0.24. For Q1, ARS provided guidance of $0.70-0.75/share including a non-cash loss of $0.25/share. This compares to BB&T's then $0.51/share estimate, and most encouragingly, bodes well for the rest of 2005. For the sake of conservatism, I am using BB&T’s $3.21/share estimate for 2005, which has the company earning only $0.91 in Q1, and showing weakness in 2H…given the credibility this new management team seeks to build, and the timing of the guidance (March 15, i.e. two weeks before quarter-end), I suspect the risk is to the upside of guidance. (I am assuming that the $0.94/share Q2 estimate is reasonable…volumes may have been a bit lighter in the quarter vs Q1 due to inventory de-stocking, but we will know more when the company announces results for Q1 next week).

Synergies

Importantly, the guidance for Q1 DOES NOT include any benefits from synergies, which will start becoming apparent in the second half. Mgmt claims it has already achieved ~$12mm of synergies (they projected an initial $25mm of synergies, and a significant part of their bonuses are tied to this achievement), but these will not hit the p&l until after Q1 as this is when certain personnel will be leaving. Considered in the context of 30mm shares outstanding (29.866mm basic, 30.76mm diluted), the impact of this synergy run-rate is impressive. Assuming $25mm run-rate is achieved by year-end, a goal mgmt expects to be reached, the after-tax increase to net is $20mm - a 20% tax rate is projected for 2005 - implying further upside to EPS of $0.66.
There are areas for more synergy: best practices in production, enhanced metal sourcing capabilities, etc., beyond the obvious shared services and purchasing benefits.

In short, ARS is a classic situation where you have a dynamic and proven management team who have been given the opportunity to turn around a badly managed enterprise (actually, two badly managed enterprises combined into one!). Their background is one of LBOs, so cash flow and returns on investment are top priorities. Add an improved industry picture to the mix, and ARS seems worth a look and, in my view, a much higher multiple.

Catalyst

Q1 earnings and Q2 guidance
Update on synergies
Analyst day late-May (help investors understand the story)