Description

Here is an idea which is still attractive even though it is now obvious (at least on a macro level based on what industry comps have been doing) that the fundamentals are on a rapid upswing. It is an opportunity to buy a small/micro cap pure-play high performance specialty alloys company at 6.5x-7.0x likely FY06 EPS (and about 8.5x CY05 EPS), with additional earnings growth opportunities depending upon the success of future capacity-enhancing capital expenditures and a decline in the price of nickel and other primary raw materials (lag benefit from materials pass-through). That the current $17 share price is materially below what we think is at least a mid $20’s ($24-$26) target price, is largely due to the current confusion over the true strength in current run-rate operating trends, as well as general obscurity from the mainstream investment community.

Stock price: $17.00
Current f.d. shares: 10.9
Equity cap: $185
Current net debt: 105
Option exercise cash (12)
Adjusted net debt 93
EV $278
* As of 9/04 Co. currently has under-funded pension of about $29 million. Offsetting this figure is the approximately $2.6 million annualized of non-cash pension-related charges as well as about $1.7 million annualized in non-cash OPEB (above actual annual cash healthcare exp) which are penalizing EBITDA figures mentioned in this write-up.

Haynes International ("HYNI") is a specialty-alloy (mostly nickel and some cobalt-base) producer with 20+ million lbs of capacity of high performance alloys and another 5-6 mil pounds of stainless/nickel wire capacity. The Company’s primary products are high temperature alloys (“HTA”) and corrosion resistant alloys (“CRA”). HYNI’s HTA products are used by manufacturers of equipment that is subjected to extremely high temperatures, such as jet engines for the aerospace industry, land-based gas turbine engines for power generation, waste incineration, and industrial heating equipment. The Company’s CRA products are used in applications that require resistance to extreme corrosion, such as chemical processing, power plant emissions control and hazardous waste treatment. The Company produces its high performance alloy products primarily in sheet, coil and plate forms, which in the aggregate represented approximately 70% of the Company’s net revenues in 1H05. In addition, the Company produces its alloy products as seamless and welded tubulars, and in bar, billet and wire forms.

We believe that HYNI has about a 5% worldwide share (10K tons) of an approximately 215K ton nickel alloy market. Other industry players (none of whom is exclusively nickel alloy) include: Krupp VDM (40K tons); Special Metals (30K tons); ATI (22K tons); Hitachi (15K tons). HYNI maintains what we have been told is one the few modern four-high Steckel mills for alloys in the industry. At an original cost (for equipment only) of $60 million in 1982 and with significant upgrades over time, we believe that the replacement cost of such a facility is approximately $130-$150 million (at the mid-point of that range about $12.85/share in value to an acquirer).

End market exposure, although somewhat diversified, is basically concentrated among three groups: aerospace (particularly commercial engines) 37% of revenue; chemicals 23% of revenue; and land-based gas turbines 23% of revenue. HYNI has significantly built up its internal salesforce and owned-service center footprint over the past several years such that 77% of '04 sales were sold via Company centers.

Blackstone bought the Company in 1/97 in a transaction which we believe ascribed an enterprise value of approximately $250-$260 million on run rate EBITDA of about $32 million). Following a severe downturn in FY03 – where both aerospace and land-based turbine markets experienced sharp corrections concurrent with rising raw materials prices – EBITDA fell into the teens and the Company filed for bankruptcy in 3/04. The emergence plan became effective 8/31/04. Pursuant to the plan of reorganization, the $140 mil of old 11.625% bonds converted into 96% of the new equity while the old equity (mostly Blackstone) got the remaining 4%. Since the public debt converted to equity, there have not been any public filings/financials since the June ’04 Q3 – until the 5/16/05 S-1 filing.

In essence, all long-term debt has been replaced by equity; only the fluctuating working capital-based revolver remains, and over time has fluctuated between about $40-$80 mil. on average. The current inflation on these levels (currently about $105 mil net revolver debt) is reflective of three major factors: 1) the elevated price of nickel and other metals (probably accounts for $15-$20 million due to the fact that nickel is about 2x it’s long term historical price); 2) about $7 million which was paid out of the revolver to fund some pre-petition bankruptcy liabilities; and, 3) an $8+ million acquisition 11/04. We estimate that debt should decline between now and the end of the year by about $8-$12 million as working capital comes out of the business.

B. Current Situation/Fundamentals

Based on the bankruptcy plan which was done at around 3/04, the projections were as follows (FYE is Sept):
FY05 FY06
Revenue $237.6 $268.0

COGS (192.5) (211.4)

Gross Profit 45.0 56.6

S,G&A (27.8) (29.7)

EBIT 17.2 27.0

Interest Exp (4.1) (4.1)

Pre-Tax Income 13.0 22.8

Taxes (5.2) (9.1)

Net Income $7.8 $13.7

Shares out 10.9 10.9

EPS $0.72 $1.26

D&A 6.0 6.5
EBITDA $23.2 $33.5
Non-Cash Benefits Exp. 5.0 5.0
Adjusted Operating EBITDA $28.2 $38.5


Fast forward about one year later (since the Disclosure Statement projections were completed), and the newly-filed S-1 shows that industry conditions have vastly improved (FY ends Sept):

1H05 Q105 Q205 Q2-Annualized
Revenue $152.2 $66.0 $86.2 $345

COGS (119.3) (51.9) (67.4) (270)

Gross Profit 32.9 14.1 18.8 75

S,G&A (incl R&D)* (16.4) (7.7) (8.5) (34)

EBIT* 16.5 6.3 10.2 41

Interest Exp* (3.1) (1.5) (1.5) (6)

Pre-Tax Income* 13.4 4.8 8.7 35

Taxes* (5.2) (1.9) (3.4) (14)

Net Income* $8.2 $2.9 $5.3 $21

Shares out 10.9 10.9 10.9 10.9

EPS* $0.73 $0.27 $0.49 $1.94

D&A* 1.5 0.8 0.8 3.0
EBITDA* $18.0 $7.1 $11.0 $44.0
Non-Cash Benefits Exp.* 2.1 1.1 1.1 4.3
Adj. Operating EBITDA* $20.1 $8.2 $12.1 $48.3

Lbs (mil.) – Alloys 8.6 3.8 4.8 19.2
Lbs Sold – Wire 0.9 1.3 2.2 5.2
Total Lbs (mil.) 9.5 5.1 7.0 28.0

Non-Operating Ajustments*:
Non-Cash Fresh Start Adj:
Added back to COGS: 27.8 16.7 11.1
Added back to S,G&A: 0.7 0.4 0.4
Other S,G&A One-Time Costs
S-1 Filing Costs 1.4 0.7 0.7
Start-Up Sarbanes Costs 0.8 0.4 0.4


*Individual Q1 & Q2 numbers below gross profit line are estimated, as the Company has not broken down profitability numbers between the first two FY05 quarters from the 1H05 numbers which are reported. Fully taxed earnings assume a 39% tax rate.

Past peak EBITDA was in the $40-$41 million in FY98 on about $250 mil. of revenue. All current metrics are already higher than the prior historic peak and going forward are likely to be considerably higher still. The Company is presently running at annualized rates of nearly $350 million and $45 million of revenue and EBITDA, respectively (there is some but not much seasonality in the business). Obviously nickel has played a big part in the increased revenue, but there has been some real pricing, as well. Also, it appears (as has generally been the case historically) that the Company has had success in passing along the nickel increases to its customers. (Nickel is at about $7.30/lb vs. $3.00 average price in FY98 – we calculate that for every dollar increase in the price of nickel the company must surcharge about $0.60 per finished lb. of alloy sold, or about $12 million annually assuming 20 million lbs. of production; in addition, other metals make up another portion of COGS, including molybdenum, titanium and cobalt). Pass-throughs aside, however, in the very short run, the Company is still likely exposed to sharp swings in the commodity price due to some implementation lag. Accordingly, if nickel were to back off the company would experience short-term additional margin benefits, and we believe that the rise in price since 9/04 through 3/05 has somewhat depressed profitability. Finally, the fact that about 40% of their revenue is purchase-order-generated (non-contract) through service/sales centers helps to mitigate “contract risk” for longer-term supply agreements (list pricing at the service centers changes regularly).

Importantly, at the mid-$40 million EBITDA run rate, the Company is still operating below current capacity. Given the operating leverage in the business, another 1-2 million lbs. of annual throughput at current prices should add about $4-$8 million of annualized EBITDA, or $0.22-$0.44/share in EPS. In addition, with the order/backlog strength, HYNI is now able to selectively “high grade” it’s output – that is, increasingly select the most profitable volume for sale. We think FY06 EPS could be in the $2.40-$2.60 per share range (fully diluted and fully taxed) after doing about $1.80-$1.85 in the current FY ended 9/05 (again fully taxed even though there is an NOL which should shield it from most cash taxes this year). CY05 EPS is likely to be about $2-$2.15.

Another facet of the story is a weak dollar benefit. This happens given that HYNI does essentially all manufacturing in the US, the competitiveness of their exports has vastly improved over the past few quarters (one-third of revenue is outside US but quoted in dollars). Industry contacts have confirmed that both US-based and foreign-based customers are starting to place more orders with companies such as HYNI and Special Metals given the price competitiveness afforded to them due to the weaker dollar.

C. Catalysts/Investment Points:

• Formal stock registration and eventual sale of Company: On 3/4/05 the Company announced that it would file an S-1 registration statement in order to formally register the original “affiliate”/restricted shares (originally held by members of the creditors’ committee) as well as to become a regular filer of SEC reports. The initial document was filed 5/16, and should go effective in June or July 2005. In addition to finally giving financial disclosure after almost a year’s hiatus, it will become a much easier stock to buy and sell.

Although speculation on our part, possible acquirers of the Company include Krupp VDM, CRS, ATI, RTI, TIE and some other smaller, cash rich overseas companies who are seeking a North American footprint – particularly in the service centers as well as the modernized Steckel mill facility. This is really the only public company which is a pure-play specialty high performance nickel alloy company with such exposure to the aerospace, chemicals and power markets and which is small enough for several companies to absorb via acquisition. We understand that they have had several discussions to this effect in the past, and now that there will be clean, audited financials available, the story should be less of a “black hole” to potential buyers. Prior to a sale, however, the Company’s CEO, Francis Petro, 65, would presumably want to demonstrate that HYNI is capable of doing well above $50 million in annual EBITDA. This is in addition to the fact that the new trough EBITDA is more likely to be in the mid/high $20 million in EBITDA given the extensive cost restructuring, expanded non-contract after-market business since the last downturn (via the service centers), as well a further end-market diversification (such as into the gas turbine market). Given that a strategic buyer would probably be able to reap $5-$10 million of corporate overhead, the incremental value to shareholders is reasonably an additional $2-$3/share.

• June ’05 quarterly report and greatly improved fundamentals vs. expectations/Plan: As written above, there has been a dearth of information since the Company emerged in 8/04. However, current run rate fundamentals FAR exceed the $28 mil EBITDA number for FY05 which is outlined in the Plan. In fact, FY05 EBITDA number is on track to be as much or greater than what the Company had planned for FY06 – north of $40 million.

In addition to the S-1 numbers being fairly confusing given all the post-reorg fresh start adjustments, they also obscure the huge sequential ramp-up in fundamentals currently taking place. Although the Company is not allowed by the SEC to present un-audited numbers for each of Q1 and Q2 (taken separately), the quarter-over-quarter improvement of adjusted gross profit (which they do break out) is significant - $4.7 million. Given that S,G&A is mostly leveragable to higher sales, it is not unreasonable to assume that EBITDA improved at least $4 million sequentially, implying at least $11 million in Q205 EBITDA ($44 million annualized rate), and potentially greater than that rate. Also, we believe that even within the March '05 quarter, the sequential monthly progression showed marked improvement, consistent with what others in the industry have reported (thus implying an even better June qtr.).

• Seemingly Accretive Branford Wire Acquisition: Although this recent (11/04) acquisition by HYNI is relatively small ($15-$20 mil of revs), we think that this transaction will be nicely accretive in FY05 and will help diversify the Company a little into stainless/alloy wire applications. Also, it will allow the Company to move what had previously been a low/no-profitability business in its Kokomo, IN facility to its now-owned North Carolina-based Branford facility – where the consolidated operation is now nicely profitable. Also, this should free up capacity for more alloys production at Kokomo, where the historical capacity can now be expanded.

• Upcoming Investor Exposure: Francis Petro, CEO, is a well-known and well-respected industry veteran. Prior to Joining HYNI, Petro was CEO of Inco Alloys, now a subsidiary of Special Metals. It is likely that once the S-1 is deemed effective, Petro and his team will begin a formal investor relations effort, which should include some sort of roadshow, presentations, sell-side research coverage as well as regular quarterly filings. In fact, this effort will likely coincide with the June ’05 10-Q filing, which will be the first “clean” quarter and one which will show the true operating strength of the business.

D. Comps:

In our opinion the “best” comparables to the Company are other specialty high-grade alloys companies, such as TIE and RTI, as well as Special Metals which is essentially private. Also, these companies have large end market exposure to aerospace, which is currently the leading driver of the upswing in industry fundamentals. Although there are really few estimates out there, TIE and RTI are currently trading at about 7x-8x run-rate CY05 EBITDA and 13x-14x the single EPS estimate for each company. Also, on an EBITDA-minus-capex basis, TIE and RTI are trading at 13x (not including a special one-time project in ’05) and 9x, respectively.

Applying these sorts of multiples to HYNI along with estimated year-end net debt in the low $90’s million (should be FCF positive in the back half of the year as working capital comes back to them as well as the NOL benefits) yields a stock in the mid $20’s, before one takes into account any potential strategic acquirer synergies.

E. Risks

• The price of nickel is subject to sharp fluctuations thus affecting operating performance, at least in the shorter run. Although the Company and industry has historically demonstrated an ability to pass through raw material increases given the high value-added nature of the product, it might be difficult to implement immediate pricing changes to “catch up” with upward moves in the price of nickel or other raw materials.

• The currently robust aerospace, chemicals and power markets could cool down. This one is obvious and the extraordinarily long lead times might be somewhat attributable to double ordering by OE’s. However, all primary market data (i.e.; commercial aerospace build schedules) suggests that the the vast majority of end user orders are real and that the current cycle has staying power. Backlog closed Q205 at $135 million, up from $111 million in Q105 and $70 million in Q204.

• A NOTE REGARDING TRADING OF HYNI STOCK – Since exiting chapter 11 on 8/31/04, the Company has ceased to be a public entity and as such has had no regular public reporting requirements pursuant to the Securities Acts of ’33/’34. Only when the S-1 goes effective will there be “regular” trading of the stock (bulletin board at first and then the Company hopes to meet the requirements of a formal exchange). Also, there are currently two “types” of stock available for purchase: unrestricted and “affiliated.” The affiliated stock, as previously mentioned, was issued to the original members of the creditors’ committee and carries certain trading restrictions (can only be traded among “qualified” institutions). Once the S-1 is effective, all stock will be registered and freely tradable. (Currently, most stock seems to trade through the likes of CRT, Libertas, Imperial and Guggenheim Capital Markets.)

* DISCLAIMER: This does not constitute a recommendation to buy or sell this stock. We own shares of the company, and we may buy shares or sell shares at any time.

Catalyst

*Formal stock registration and eventual sale of Company
*"Clean" June ’05 10-Q and greatly improved fundamentals vs. expectations
*Seemingly Accretive Branford Wire Acquisition
*Upcoming Investor Exposure