Description

Bayou Steel, which emerged from Chapter 11 in February 2004, runs a steel mini-mill in Louisiana. Based on extremely positive, short-term fundamentals for the steel industry and BYUA’s cheap valuation (it currently trades at 3.1x EBITDA and 2.2x net income using 2004 projections), we recommend purchase of the shares. We believe a $35 to $40 share price target is reasonable based on comparable company trading levels and the possibility of a sale of the company.

MACRO THESIS

Over the next few quarters demand for steel is expected to be strong with prices for steel products high. Most public steel producers have commented that second and third quarter results will be solid. We believe a number of factors support this environment continuing into the near future:

1. The U.S. economy is strong – capital goods orders, industrial production and non-residential construction all have positive outlooks.
2. Chinese demand continues to be robust – this demand is not going to go away overnight. In addition, efforts by the Chinese to limit investment in the steel sector may tighten steel supply in the short run.
3. A weaker dollar (relative to 1999 and 2000) should shield the U.S. industry from imports.
4. High shipping costs should also shield the U.S. industry from imports.
5. Inventories are at (near) record low levels.
6. U.S. steel-making capacity is still well below recent (2000) highs.

Listening to the first quarter’s conference calls for many steel producers indicates just how positive the outlook has become for the industry. One can debate how long this will last, but we believe the industry should have several quarters of very strong results and that concerns regarding a rapid slow down are unwarranted.

MICRO THESIS

Given the macro environment, even small players like Bayou Steel will have their day in the sun. What makes BYUA interesting is the valuation. Our model incorporates BYUA’s most recently announced results for the first quarter with adjustments to project second quarter and full-year 2004 results. The model is summarized below:


Bayou Steel Model

Notes Calendar 2/18/04- Calendar Ann. Calendar
1Q04 3/31/04 2Q04E 2Q04E 2004E

Revenues 1 $60231 $30014 $75000 $300000 $285000
COGS 2 57566 26347 63500 254000 248066
Gross Margin 2665 3667 11500 46000 36934
SG&A 1809 821 1500 6000 6000
Op Inc 859 2846 10000 40000 30934
Taxes 3 NA NA 4000 16000 12374
Net Income 4 NA NA 6000 24000 18560
Shares O/S 5 NA NA 2717 2717 2717
EPS NA NA $2.21 $8.83 $6.83

Tons Shipped 146695 NA 150000 150000 150000
Rev per Ton $411 NA $500 $500 $475
COGS per Ton 392 NA 423 423 413
EBITDA per Ton 6 NA 67 67 52

Note: 1Q04 excludes reorganization expense of $767,000
Shares O/S includes 2.57 mm shares and 147,000 in-the-money options

Assumptions:
Revenues: 2004 based on $75mm for final three quarters of year
COGS: 2004 based on $63.5mm for final three quarters of year
SG&A: based on projections from disclosure statement (11/24/03)
Taxes: 40%
Tons Shipped: flat with 1Q04 actual of approx. 150,000

Enterprise Value:
Market Cap: $40755 ($15 x 2717)
Cash: 1715 (includes $1617 from options)
Debt: 56182
EV $95,222

Valuation (based on 2004E)
EV/EBITDA: 3.1x
P/E: 2.2x

NOTES

1. We have assumed BYUA’s volumes remain constant and that pricing increases about 25% from the first quarter to the second quarter. As we are almost at the end of the second quarter, we think this is a pretty good bet given two months of known steel pricing. We have assumed BYUA’s sales are at spot prices.

2. We have assumed COGS increase about 21% to give BYUA a gross margin of 15% and an EBITDA level (after deducting SG&A based on the company’s disclosure statement) of about $67/ton for the second quarter, a figure towards the low-end anticipated for comparable companies. We believe our projections may be conservative given that BYUA’s principal raw material is scrap steel, prices for which have been declining.

3. BYUA has NOLs of at least $75 million, the exact nature and amount of which have yet to be determined given BYUA’s passage through bankruptcy. We have assumed fully-taxed earnings in our model.

4. Net income is overstated because PP&E (and resultant D&A) was written down to almost zero as part of fresh-start accounting.

5. Includes 570,000 shares that may be issued to tort claimants in Chapter 11. The principal claimant is a former employee of BYUA who lost a leg in a work-related accident. There is a dispute as to whether or not BYUA’s insurance company is required to pay damages. As a result it is hard to determine whether or not the shares will be issued. To be conservative, our model assumes they will be.

VALUATION

The below chart displays trading multiples for comparable companies:

Comparable Company Valuation Analysis

Company Ticker 2004 P/E 2004 EV/EBITDA Note
AK Steel AKS 9.4x 4.8x integrated
Dofasco ($Can) DFS 11.2x 4.5x integrated
Int'l Steel Grp ISG 7.0x 6.4x integrated
Nucor NUE 8.7x 4.8x mini-mill
Oregon Steel OS 5.9x 4.7x integrated
Reliance Steel RS 11.1x 6.1x integrated
Schnitzer Steel SCHN 8.8x 6.1x mini-mill
Steel Dynamics STLD 6.5x 4.1x mini-mill
US Steel X 7.7x 6.3x integrated

Comprehensive Average 8.6x 5.5x
Integrated Average 8.7x 5.5x
Mini-Mill Average 8.0x 5.0x
Source: First Call

Valuation Target

2004 P/E 2004 EV/EBITDA
Peer Group Multiple 8.6x 5.5x
BYUA EPS/EBITDA $6.83 $30,934
BYUA Target $58.83 $42.65
Average $50.74


Blending implied valuations using peer group multiples results in a $50 implied valuation. This excludes NOL value of some $4 to $5 per share. Applying a 20% to 30% discount for size/liquidity reasons results in a $35 to $40 per share price target range, a potential gain of over 100% from current levels.

Potential Upside

1. Increased production. In the past, BYUA has shipped almost 700,000 tons of steel in peak years. We have assumed 600,000.

2. Increased margins. We have assumed both revenues and COGS increase. With lower scrap prices margins may expand considerably.

3. A take-out. One of the larger steel companies may seek to acquire BYUA in order to broaden its manufacturing and customer base and improve logistics. The location of BYUA’s facilities, which are located on waterways, may be attractive to consolidators in the industry. For a comparable situation, Worthington Industries recently sold a Decatur mini-mill to Nucor for $129 million (including a working capital adjustment), or about 0.6X 2004 sales. This multiple would imply roughly a $45 price per share for BYUA.

Potential Downside

1. Demand for steel slows down.

Catalysts

1. Publication of strong second quarter results.

Catalyst

- Over the next few quarters demand for steel is expected to be strong with prices for steel products high
- Second quarter results