Description

Rumors of the steel industry’s immediate demise have been greatly exaggerated. As a result, we continue to like Bayou Steel, which runs a steel mini-mill operation based in Louisiana. Based on extremely positive fundamentals for the steel industry and BYUA’s cheap valuation (it trades at a 50% discount compared to other steel producers), we recommend purchase of the shares. We believe a $50 to $55 share price target is reasonable based on comparable company trading levels and discounted cash flow analysis.


Macro Thesis

In 2005, demand for steel is expected to be strong with prices for steel products remaining relatively high. During the recent round of third quarter conference calls, most public steel producers have commented that there may be some seasonal weakness in prices in the fourth quarter, but prices in the first quarter of 2005 should be near third quarter 2004 levels. BYUA management recently confirmed this type of outlook. Many producers believe 2005 earnings will surpass those in 2004. Generally, the tone is very upbeat. We believe a number of factors support this environment:

1. The U.S. economy is relatively strong.
2. Chinese demand continues to be robust.
3. A weak dollar should shield the U.S. industry from imports and aid exports.
4. High shipping costs should also shield the U.S. industry from imports.
5. U.S. steel-making capacity is still well below recent (2000) highs.

The strong global fundamentals and supply/demand dynamics were recently highlighted by Nissan idling plants because of its inability to obtain steel. In addition, prices are rising in international markets, especially in the Far East. Short-term, price increases may be accentuated as a number of Asian producers, such as Posco, perform maintenance. Lastly, consolidation in the industry (ISG/ISPAT/Mittal, Stelco, etc.) seems to be becoming a more prevalent theme. This should support firm steel prices and values for the steel producers.


Micro Thesis

Given the macro environment, even small players like Bayou Steel are experiencing unprecedented results. What makes BYUA interesting is the valuation. Our model projects the third and fourth quarters of calendar 2004 and all of 2005 based upon the consensus estimates for other steel producers. We have assumed 2006-2008 would represent a return to normalized activity in the steel industry. We have also assumed that excess cash is used to pay down debt. The model is summarized below:


Bayou Steel Model

Calendar Calendar Calendar Calendar Calendar
2004E 2005E 2006E 2007E 2008E
Revenues(1) $275,972 $280,500 $223,125 $223,125 $223,125
% growth 2% -20% 0% 0%
COGS(2) 225,989 233,750 191,625 191,625 191,625
% growth 3% -18% 0% 0%
Gross Margin 49,983 46,750 31,500 31,500 31,500
% margin 18% 17% 14% 14% 14%
SG&A(3) 7,733 8,200 8,200 8,200 8,200
Op Inc 42,250 38,550 23,300 23,300 23,300
Depr & Amort(4) 1,399 500 800 1,100 1,400 EBITDA 43,649 39,050 24,100 24,400 24,700
Interest Expense(5) 3,434 3,663 2,438 - - Other Income (Expense) 378 - - - - Pre-Tax Income 39,194 34,887 20,862 23,300 23,300 Taxes(6) 16,118 13,606 8,136 9,087 9,087 Net Income 23,076 21,281 12,726 14,213 14,213
Shares O/S 2,000 2,000 2,000 2,000 2,000
EPS $11.54 $10.64 $6.36 $7.11 $7.11

Capital Expenditures(7) 2,611 11,065 6,212 6,000 6,000
Change in Working Cap(8) 13,499 (3,854) (14,508) - - Non-Cash Taxes(9) 1,757 1,757 1,757 1,757 1,757 Free Cash Flow(10) 10,122 16,328 23,579 11,070 11,370 FCF per share $5.06 $8.16 $11.79 $5.53 $5.68

Tons Shipped(1) 530,429 550,000 525,000 525,000 525,000 Rev per Ton(1) $520 $510 $425 $425 $425 COGS per Ton(2) 426 425 365 365 365 EBITDA per Ton 82 71 46 46 47
Note: -1Q04 excludes reorganization expense of $767, fresh-start adjustments of $79,627 and a gain on reorganization of $98,992
-Shares for market cap include 2 million basic shares and 147,000 in-the-money options
-Debt as adjusted for $5 million legal liability
Enterprise Value Calculation

$75,145 = mkt cap ($35.00 x 2,147)
1,715 = cash (incl. $1,617 from options)
53,004 = debt (as of 6/30/04)
$126,435= total enterprise value


Current Multiples
2004E 2005E 2006E 2007E 2008E
EV/EBITDA 3.0x 3.3x 5.4x 5.4x 5.4x
Market Cap/NI 3.3x 3.5x 5.9x 5.3x 5.3x
Price/FCF 6.9x 4.3x 3.0x 6.3x 6.2x


Notes to Projections

1. We have driven revenues off tons shipped and revenues per ton. We assume that volume and prices increased in the third quarter of calendar 2004 in similar percentages to those experienced by Nucor, Steel Dynamics and other steel mini-mills. Then, we have assumed a bit of seasonal weakness in volume and prices in the fourth quarter. For 2005, we have increased volume slightly for the Company’s first full year out of bankruptcy and have decreased revenues per ton slightly from 2004 levels. We reduced prices further in 2006. Revenues for calendar 2007 and 2008 are assumed to stay constant at “normalized” levels. Note that calendar second quarter 2004 shipments were lowered by the shifting of some purchases to the first quarter owing to price increases that became effective April 1, 2004. Also, calendar fourth quarter production should be boosted by an additional 16,000 billets used in the Company’s finishing mill in Tennessee.

2. We have assumed a quicker rise in COGS per ton than in revenue per ton because of rapidly rising scrap prices in the latter half of calendar 2004. For 2005, we assume that average scrap prices roughly equal 2004. For 2006-2008, we assume a retreat to more “normalized” COGS levels.

3. SG&A assumed to increase slightly to allow for public company reporting and Sarbanes-Oxley compliance.

4. PP&E was written down to almost zero as part of fresh-start accounting so depreciation and amortization in 2004 was very low. However, this will increase as capital expenditures are made.

5. Interest expense is based on an average rate of 7.5% on the ending debt balance of the previous period. All free cash flow is assumed to be used to pay down debt as long as debt is outstanding. We assume no interest income on any cash balances.

6. We assume a tax rate of 39%.

7. We assume that capital expenditures for 2004-2006 are equal to the projections in the Company’s disclosure statement. We assume 2007 and 2008 capital expenditures are approximately equal to 2006 and the historical average before bankruptcy after allowing for inflation.

8. We have assumed that prepaid and accrued expenses do not change for 2005-2008. Days receivable and days payable have been kept constant from the second quarter of 2004. Inventory days is equal to the average of the most recent three reported quarters.

9. Non-cash taxes assume that the Company used the minimum allowable annual NOL in the second quarter of calendar 2004 and that they will use the NOL in 2005-2008 as well.

10. Free cash flow is defined as net income less capital expenditures less change in working capital plus non-cash taxes.


Valuation

The table below displays the implied per share values of our discounted cash flow analysis for discount rates ranging from 10% to 15% and 2008 terminal EBITDA multiples of 6x to 8x without any value attributed to the Company’s NOL’s which could easily be valued at $5-$10 per share:

Discounted Cash Flow Analysis

Discount Rate
Terminal Mult. 10.0% 12.5% 15.0%
6.0x $45.66 $40.58 $36.00
7.0x $53.52 $47.76 $42.58
8.0x $61.38 $54.95 $49.16

The below chart displays trading multiples for comparable companies:

Comparable Company Valuation Analysis

P/E P/E P/E EV/EBITDA EV/ EV/ EV/ Calendar 2004 2005 Calendar EBITDA EBITDA Ton Q304 Ann. Q304 Ann. 2004 2005 2004
AKS 4.8x 9.1x 8.4x 3.9x 5.3x 5.6x $362.1 AGA($Can) 2.4x 3.7x 5.4x 1.3x 2.0x 2.9x 488.5 DFS($Can) 7.1x 9.0x 8.9x 4.7x 4.7x 4.6x 651.9 ISG 4.0x 6.4x 7.1x 2.8x 4.3x 4.2x 262.9 NUE 4.9x 7.4x 9.9x 2.6x 3.7x 5.0x 427.0 OS 1.9x 3.1x 6.0x 2.5x 3.8x 3.8x 473.9 SCHN 7.0x 9.0x 7.0x 4.5x 5.6x 4.3x 468.1 STLD 4.6x 6.8x 7.2x 2.6x 3.7x 3.9x 649.2 X 4.9x 6.7x 7.5x 2.7x 3.3x 3.4x 287.2
Average 4.6x 6.8x 7.5x 3.1x 4.0x 4.2x 452.3
Source: IBES estimates.


Valuation Target

P/E P/E P/E EV/EBITDA EV/ EV/ EV/ Calendar 2004 2005 Calendar EBITDA EBITDA Ton Q304 Ann. Q304 Ann. 2004 2005 2004

Group Mult. 4.6x 6.8x 7.5x 3.1x 4.0x 4.2x 452.3x

BYUA Stats $40,612 $23,076 $21,281 $70,260 $43,649 $39,050 530

BYUA Target $87.34 $72.96 $74.16 $79.06 $60.54 $54.56 $90.18

'04/'05 EBITDA Valuation Avg $57.55

Using implied valuations based on peer 2004 and 2005 EBITDA multiples results in a $58 implied valuation. The Company has reduced depreciation and amortization expenses following its emergence from bankruptcy making peer P/E multiples a less relevant measure of valuation for Bayou. The EV/Ton Shipped ratio may give an indication of the potential take-out value for BYUA.

Combining our comparable company analysis with our discounted cash flow analysis yields a $50 to $55 per share price target.


Potential Upside

1. Increased production. In the past, BYUA has shipped up to 700,000 tons of steel in peak years. We have assumed only 525,000 tons of steel produced in 2006-2008.

2. A take-out. One of the larger steel companies (e.g. Gerdau, Commercial Metals, or Severstal) 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 sold a Decatur mini-mill to Nucor for $129 million in August 2004 (including a working capital adjustment), or about 0.6x 2004 sales. This multiple would imply roughly a $55 price per share for BYUA.


Potential Downside

1. Demand for steel slows down more quickly than anticipated and steel prices crater.


Other Factors

1. BYUA has yet to participate in the recent price appreciation experienced by other steel producers.
2. The only sell side coverage of BYUA that we are aware of (by a high yield analyst at Jefferies) presents outdated projections that focus on fiscal 2004 results with BYUA’s year end at 9/30/2004. This does not give BYUA full credit for a strong calendar second half (including the calendar fourth quarter). Our analysis compares BYUA with its comparables on an apples to apples basis.


Catalysts

1. Publication of strong fiscal 2004 (ended September 30, 2004) results before year end. Management has told us to expect a release in mid-December (probably December 15th or 16th).

Catalyst

Publication of strong fiscal 2004 (ended September 30, 2004) results before year end. Management has told us to expect a release in mid-December (probably December 15th or 16th).