Description

Chaparral Steel (CHAP) is a specialty structured steel company, recently spun-off from Texas Industries (TXI). Currently CHAP is trading at $18/share, or less than 5x normalized FCF/share of $4.00. We believe it is worth more than $28/sh. The company operates two “mini-mills,” which allows it to keep its cost structure low. Mini-mills use electric furnaces, as opposed to coal fired furnaces, and use scrap steel as their main ingredient as opposed to iron ore. These differences allow the mini-mills to operate with a significantly lower cost structure than their traditional brethren.

The structured steel industry produces medium to heavy structured steel products (beams and bars), which are primarily used in construction of non-residential real estate (stadiums, office towers, warehouses, etc). In the late 1970s traditional steel companies (Bethlehem Steel, etc.) serviced the industry, until Nucor and Chaparral opened their mini-mills. The emergence of the mini-mill and their low-cost operations significantly lowered product pricing, forcing margins lower for traditional steel companies. Slowly, the traditional steel companies exited the industry. By the late 1990s, Steel Dynamics opened their own mini-mill, and the final traditional steel company exited the business. Today, Nucor has 45-50% market share, Chaparral has 25-30%, Steel Dynamics has 10-15%, and the rest is attributable to foreign imports. All three of these companies are characterized as low cost providers.

The structured steel industry tracks non-residential construction growth. This is a highly cyclical business that has suffered significantly since September 2001. At the peak, construction grew by 1.8bn square feet in 2001. In 2005 this growth was 1.5bn sq feet. According to industry insiders, they are seeing construction beginning to pick up again. Historically, construction has grown at a CAGR of 2 to 4% peak to peak. Looking forward, the main driver of this growth is office occupancy rates. 2001 and 2002 saw a peak in vacancies, and vacancy rates have been decreasing ever since.

Foreign competition is a factor in the industry; however, the three leaders are the low cost players globally, which gives some comfort. Foreign competition is not currently prevalent in the US market place. CHAP, Nucor and Steel Dynamics have to keep pricing slightly below that of international prices to maintain their market position. As the US Dollar strengthens, the price of international steel (to domestic customers) becomes cheaper, hurting the domestic industry, despite the international competitors’ higher manufacturing cost. Given today’s current foreign exchange rates, foreign structured steel costs 15% more than the domestic product before factoring in shipping costs to US ports. These shipping costs are roughly $100 to $120 per ton, a material amount on the current US domestic structured steel price of approximately $380 per ton. Essentially, the US dollar needs to strengthen by over 20%, and Baltic dry day rates need to fall by at least 40%, before foreign steel becomes cheaper than US domestic steel.

The three competitors in the industry have very similar cost structures. Each of the companies has tried to cut costs even further through different initiatives. Nucor has made an effort to utilize low-cost barge shipping as a main mode of transport, and Steel Dynamics has located their plant in an underserved geographical locale to lower their cost of transport. Chaparral has cut their costs by scrapping their own steel, resulting in lower raw material costs. These efforts do cut costs, but there is still no clear cost winner. The industry players realize this, and therefore do not directly engage in price wars as no one company can undercut the others and force an exit.

The industry uses metal margins as a primary performance indicator. Metal margins are defined as the price of the products sold less the cost of steel ingredients. Historically, this has been rising over time. In 1992, the metal margin was $210/ton, rising to $260/ton in 1998. Industry insiders say that the current run rate is about $310/ton. The rise is related to the exit of traditional steel competition from the industry, as well as pricing to capture other commodity costs, namely electricity price changes.

CHAP’s position in the industry is relatively secure. When Chaparral was exploring expansion opportunities, the sales and engineering teams both requested an expansion of the existing Texas plant. TXI began exploring alternatives, and ultimately forced Chaparral to build a $500mm state-of-the-art facility in Virginia. It took Chaparral management 4 years to get the plant to a capacity level that allowed it to operate profitably. Given the high cost of a new facility, CHAP’s financial experience with the Virginia expansion (see below), and the ingrained nature of the industry incumbents, it is unlikely that a new competitor will make a material capital outlay to enter the industry. In addition, all of the industry players are currently expanding their product offerings to include other steel products (Special Bar Quality, rail, etc.), an indication that they are unable to grow significantly via market share gains.

With the exception of fiscal 2005 (year ended May 2005), the prior five years have been fairly dismal; however, there are underlying factors driving this performance that have since been addressed or eliminated. In 1999, the company opened the second of their two mini-mills in Virginia. Through 1997 and 1998 CHAP’s other mini-mill in Texas was operating at full capacity. Chaparral wanted to build an extension to the Texas plant; however, TXI went ahead and built the Virginia facility. The facility was located in an old textile town with little steel manufacturing experience. The result was 40% employee turnover out of the gate. In addition, it typically takes 3 to 4 years for a plant to build its production up to near full capacity. This severely impacted margins from 1999 through 2003. Secondly, in 2003, the company was hit by the 201 tariffs. In a nutshell, CHAP was not given any relief by the tariffs and needed to keep pricing static. On the cost side, scrap steel pricing rose in tandem with the general upward movement in steel prices, which were being forced higher by the tariffs. The resulting margin squeeze was subsequently reversed after public outcries over the 201 tariffs. Therefore, to get a good overview of the potential performance, one needs to look at the 10 years before Virginia came online to get a decent overview. Historically, gross margins have averaged around 17%, while EBIT margins have averaged about 14%.

Fiscal 2005 was a year unlike the preceding five years; in short, it was one of the best years in the industry’s history. Due to the general rise in commodity costs, prices for structural steel shot through the roof. Customers began to panic and purchased as much steel as possible, resulting in increased production at higher prices. The result sent metal margins north of $400/ton. The run on structured steel, the reversal of the 201 tariffs, and the turnaround of the Virginia plant resulted in the best year the company has seen in its 30-year history.

This brings the discussion to the current valuation. Predicting fiscal 2006 is not easy. We expect that it will show declines from 2005’s record performance, but should be better than the previous 5 years. The Virginia plant operations have been effectively turned around, and the 201 tariffs have been lifted after being deemed a net detriment to the US economy. As mentioned above, metal margins should maintain a run-rate of $310/ton, however, 2006 is still getting a residual benefit from the high metal margins in 2005. Assuming that the margin drops from 2005’s $410/ton to $310/ton by the second half of the year, the average for the year will be roughly $345/ton. On the top line, we assume that prices come down from their highs in 2005 ($575/ton) to their 2003-2004 levels ($375/ton) by 2007, with 2006 levels averaging between the two (cost per ton does not include freight and other revenues, which run about $75mm annually). Assuming production running at 2mm tons (capacity is 2.6m tons), which is similar to the output in 2003-2004 when Virginia had built up its production, we feel that the company can do $3.45/shr EPS. The company generates more than this in cash due to a favorable D&A/capex spread of approximately $20mm, or $0.88 per share (due to the continued depreciation on the new Virginia facility). It should be noted that part of this difference is coming from the expensing of part of the maintenance spend on an annual basis, as opposed to capitalizing maintenance with the rest of capex. We have assumed that this can continue for the foreseeable future as most of the maintenance spend is already captured in the P&L.

We assume that 2007 and beyond are similar to 2006, except the company has a run-rate metal margin of $310/ton, and production is slightly higher to reflect the continued growth in the non-residential real estate. On a normalized basis, using these assumptions, the company should able to generate $4.00 of free cash flow per share. Using a 10 year DCF, assuming the company pays down its $350mm in debt, and assuming two significant declines in production (to reflect the cyclicality of the industry), a 12% discount rate yields a fair value of $28/share.

We tend not to focus on comp analysis, but those who do may wish to look at Nucor, Steel Dynamics, Ipsco, and Gerdau.

Risks:

Decline in non-residential real-estate construction

Strengthening of US Dollar and decline in Baltic Shipping rates reduce barriers to entry for foreign competition (we believe the likelihood of this is low – see above).

Virginia margins begin to deteriorate.

Unnatural events cause scrap pricing to rise, with structural pricing held stable.

Catalyst

Typical spin-off dynamics (change in shareholder base, initiation of sell-side coverage, more focused mgmt).

Chaparral Steel is a true pure-play in the industry, and we believe over time that it is an acquisition candidate.

Historical financials skew true potential performance. As the company performs to its capabilities, Wall Street will begin to take notice and assign a more attractive valuation.

Cyclical upturn in non-residential real estate construction