Description

GSM is the world's lowest cost producer of silicon metal, a commodity with structurally attractive supply/demand dynamics and high barriers to entry. While the commodity has recently started to move, it has lagged rest of metals space and is relatively near its recent lows. GSM's  considerable earnings power is currently being obscured by underwater contracts that are set to roll off over the next 9 months. At current commodity prices, the stock (net of ~$1.75 of net cash) trades at ~10x forward FCF - too cheap relative the company's competitive position and relative to lower quality commodity stocks that are up dramatically. Stock previously traded on the AIM where it climbed to high of $30. Has been under-covered (4 analysts) and has (relatively) underperformed since NYSE IPO in August of 2009. The company is run by Alan Kestenbaum, a proven dealmaker and the company's biggest shareholder.

Company Description (from equity research)

Bull Case

a) GSM's earnings power is materially higher than it appears - underwater contracts and startup issues at the company's Niagara plan are obscuring the company's earnings potential, which has increased dramatically over the last 2-3 months. Owing to a pre-existing deal, GSM is contracted to supply up to 25% of their silicon metal inventory in 2010 to Dow Corning for approximately ~$1.10/pound vs current pricing of ~$1.40/pound. Silicon metal spot pricing has appreciated 20-25c since February, and GSM's long term earnings power has increased commensurately. At current spot prices (and we believe prices are headed higher, more on this below), GSM's normalized earnings power is well north of $1/share.

b) In silicon metal, GSM is a vertically integrated low cost producer with high barriers to entry:

• High capital costs - greenfield silicon operations are estimated to cost $150 million to build. At current silicon prices payback period for a dual furnace is 9-12 yrs. New facilities entail a long/complex permitting/construction process - commissioning of a new plant takes 3-5 yrs. Implied replacement cost of $1.65b for GSM's 18 furnaces is $21/share (excludes quartz mines, reforestation reserves, cored-wire facilities, Solsil, Yonvey, and equity stake in hydropower facilities).
• Silicon metal production involves expensive raw materials and is capital intensive - production of 1 ton of silicon requires 6.6 tons of raw material inputs: 2.8 tons of quartz, 1.4 tons of coal, and 2.4 tons of wood, amounting to ~ 40% of silicon production costs. Sourcing from three different sources makes freight costs prohibitive for competitors - GSM's owns its own quartz and wood chip supplies that are in close proximity to its furnaces.
• Power intensive production - power usage amounts 1/3 of production costs. GSM has long term (up to 20 yrs) contracts for low cost power. The company's average power cost is $30/MWh. This compares to the estimated average Chinese cost of power at $45/MWh and new capacity in the US costing around $50/MWh.

c) Structurally attractive end markets - company is only merchant supplier in US, and top five Western world producers account for ~75% of supply. 140% tariffs on Chinese silicon protect pricing - less than 1% of Chinese silicon comes to US.

d) Pricing story - In the U.S., silicon metal prices have lagged the rest of the base metals complex. Further, Chinese prices have spiked up 15-30% recently, driven primarily by higher electricity costs. Rumored that Chinese supply that was shut in during last 12 months is unlikely to come onstream as it is likely higher cost and subject to environmental concerns. Price lag owes to a) annual contract pricing nature of the business, and b) lack of futures exchange. Every $0.01/lb change in the silicon metal price translates into roughly $2.5-3.5m in EBITDA, 2-3c of EPS. Commodity got to as high as $1.70 in early 2009, now sits at $1.35-$1.40 (though company saying spot is now as high as $1.50). At $2/lb, company should earn $2/share.

e) Cheap way to play global recovery - end-markets are: silicon chemicals (24% of revenues) - chemicals/healthcare/auto, aluminum (22%) - auto, foundry alloys (17%), photovoltaic (solar) cells/semiconductors (12%), and steel (12%). Company trades at major discount to comparable commodity producers, all of which are pricing in significant snapback in demand.

Bear Case/Risks

a) Leverage to global industrial demand - double dip and another destocking will hurt demand.

b) Customer concentration - both Dow Corning and Wacker are 10%+ of revs

c) Regulatory - antidumping duties against China/Russia up for "sunset review" every 5 years (China - 2011, Russia -2013).

Management

Founder/Chairman - Alan Kestenbaum. Started as trader for Marc Rich. Bought what became GSM out of bankruptcy in 2003, and raised $200m for a SPAC in late 2005. Bought silicon metal plant and hydro plant from Elkem for $135m in Dec 2005, later selling the hydro plant for $135m (effectively getting the silicon metal plant at no cost). Used additional financing from DE Shaw and Plainfield to fund deals to create company in current form. Owns 20% of the company = $150m of stock.

CEO - Jeff Bradley. Lifetime metals executive. 20 yrs at Worthington. Brought in by HIG to run Claymont Steel in 2005. HIG bought company for $70m, sold for $565 2.5 yrs later. Upside on 750K options = ~$8m.

Catalyst