Description

Keystone Consolidated Industries (ticker KYCN) is an opportunity to buy a portfolio of investments managed by Dallas investor/businessman and billionaire Harold Simmons at a 55% discount to NAV.  The stock is at about $18 versus book value / NAV of about $43 per share as of 6/30/07.  KYCN has a huge margin of safety and long term growth potential from the continued growth of the investment portfolio.  The company is misunderstood and under-researched because it’s fairly small and the situation is fairly complicated.  The market cap is about $180 mm, with 51% of the stock controlled by Harold Simmons.   The major catch is that most of the value is in an overfunded pension plan.  Due to better disclosure in the 10-K, it’s easier to break down the 12/31/06 book value of about $40:

 

                NAV related to pension plan assets:

                $93 / share of investments in the pension plan

                - $41 / share of pension benefit obligations and OPEB obligations

                $52 / share of pension overfunding

                - $20 / share of deferred tax liability related to the overfunded pension

                $32 / share of after-tax NAV from pension fund overfunding

 

                Value of operating business:

                $8 / share book value of steel wire business

 

                Total NAV / book value of KYCN:

                $40 / share NAV

 

In effect $18 of KYCN stock controls $93 per share of investments and an $8 per share legacy steel wire business.  If KYCN management figures out a way to avoid ever paying the deferred taxes (some possibilities are discussed below), the adjusted book value of KYCN would be more like $60 today, or over 3x the current trading price of KYCN.  The unleveraged return on the investment portfolio itself was 21% in 2004, 72% in 2005, and 37% in 2006.  With the inherent leverage from the pension obligation, the net pension asset which KYCN’s shareholders have a claim to has grown substantially faster than that.  During the 19 year history of this investment portfolio, the average unleveraged annual return has been 14%.  The catch is that assets in the overfunded pension plan are not readily accessible by KYCN, although there are various strategies that can be pursued to unlock this asset (discussed below).  In the case of KYCN, you are a buying a portfolio of investments managed by a guy who knows how to make money, at a deep discount to NAV, which NAV is likely to keep increasing at a decent rate over time.  There is no specific catalyst other than the price of the investment relative to its value, so this is really a long term investment thesis.  Eventually the market will more properly price KYCN, and in the meantime the underlying asset value probably continues to increase.  One potential catalyst is the potential for KYCN management to come up with an innovative transaction to unlock the value of the pension asset, including potentially eliminating the need to ever pay a significant chunk of the deferred tax liability.  Additionally, Harold Simmons is 76, and eventually control of the companies involved will pass to trusts held for the benefit of his children and grandchildren, which could lead to liquidity events regarding KYCN and the pension fund investments.  Ultimately KYCN is a bet on the ability of Harold Simmons to grow the value of the investments in KYCN’s pension fund, with the added benefit of being able to buy this leveraged portfolio at a big discount.  Anyone who finds this idea interesting would be interested in this article on Harold Simmons, which was published in the Dallas Business Journal about a year ago:

 

http://dallas.bizjournals.com/dallas/stories/2006/08/14/story2.html

 

The short story on KYCN is that in 2004, due to a confluence of factors, the company filed bankruptcy.  At that time the only asset here was the steel wire business.  The bankruptcy was caused by a combination of weak wire product selling prices over the prior few years, high increases in ferrous scrap costs (key raw material), and significant liquidity needs to service retiree medical costs.  KYCN emerged from bankruptcy in 2005 with 51% of the new equity controlled by Contran Corp, Harold Simmons’ main company.  (Contran had been a major Keystone shareholder before the bankruptcy and also made DIP loans to Keystone during bankruptcy which converted into equity.)   Post bankruptcy there are 10.0 mm shares of KYCN, so the market cap is about $180 mm.  As part of the reorganization there was a permanent reduction in healthcare payments related to retirees, which reduced a key liability by $100 mm.  KYCN’s pension fund had huge returns of 72% in 2005 and 37% in 2006 – generating profit of $304 mm and $261 mm in those two years, resulting in a pension fund value of $934 mm as of the end of 2006.  Net of the $377 mm pension benefit obligation, the pension fund is now overfunded by $557 mm (or about $57 per KYCN share pre-tax).  Additionally there is a $35 mm OPEB liability, and a $198 mm deferred tax liability (deferred taxes on the pension overfunding).  The $557 mm pension asset less the $35 mm OPEB liability less the $198 mm deferred tax liability results in a $324 mm after-tax NAV related to the pension and OPEB funds, which over 10.0 mm shares is about $32 per share.  Total book value is about $40 per share, implying that the remaining equity associated with the legacy steel wire business is about $8 per share.   The steel wire business is probably worth at least book value, given the major asset is a state of the art steel mini mill which has been completely rebuilt in the last decade.  (Given the major value driver here is the pension plan, this write-up will focus on that, but more information on the steel business is included as Appendix A.) 

 

KYCN’s key asset is the pension fund.  While it’s difficult to know exactly what the pension fund is invested in, a great deal can be learned by piecing together data from KYCN’s disclosures, the proxy statements of other companies controlled by Harold Simmons, and from Form 5500 filings (filed with the IRS and DOL by pension funds).  It turns out that about 44% of the KYCN pension plan assets are invested in a public company called Titanium Metals (TIE), which is also controlled by Harold Simmons.  The other key investments of the pension fund include partnerships / JV interests (31% of the fund), other common stocks (12%), and mutual funds and common/collective trusts (10%).  While we don’t know precisely what partnerships the pension plan is invested in, we do know that one of them is T. Boone Pickens’ hedge fund, as mentioned in the article about Harold Simmons linked to above.  (Appendix B details how this information on the specific investments in the KYCN pension fund can be derived.) 

 

TIE is obviously a key investment, so it’s worth exploring TIE a bit, although as a $5 billion market cap company there is plenty of public information and sell side research available on TIE.  Titanium Metals is one of the few vertically integrated titanium producers in the world, and is one of the few titanium producers capable of making aerospace grade titanium.  Titanium in general and TIE in particular have had a huge run the last few years, as titanium prices have increased substantially and demand has been strong.  TIE at $31 is up from under $1 (on a split adjusted basis) about four years ago.  TIE would not qualify as a super cheap stock at this point – the stock is at about 18x expected 2007 EPS and about 15x expected 2008 EPS – but the titanium cycle appears to be very strong and TIE’s fundamentals will likely remain very strong for years to come.  For example, Bank of America suggests TIE could do $4.00 of EPS in 2010, implying the stock is at about 8x 2010 EPS.  Commercial and military aerospace are key demand drivers, and the newer planes are much more titanium intensive (such as the Boeing 787 and Airbus A 380 / A 350).  Commercial aerospace is strong, with very significant order books in place.  Capacity in some parts of the titanium supply chain is growing, so supply may eventually become an issue, but TIE is helped by being one of the few titanium suppliers capable of making aerospace grade titanium and by long term supply contracts.  We are fairly positive on TIE, and think TIE will continue to do well.  Harold Simmons continues to personally buy TIE stock in the open market even though he already controls 52% of TIE, which gives us comfort.  At some point it would make a lot of sense to sell TIE to a growth oriented steel, aluminum or diversified metals producer.  Some obvious potential buyers might be Arcelor Mittal, Alcoa, Alcan, and Allegheny Technologies.  In November 2006 the CEO of Alcan spoke of his interest in buying a titanium producer.  In July 2007 there were rumors that the German metals company ThyssenKrupp was interested in acquiring a US titanium company.  Probably half of Harold Simmons’ net worth is in TIE, and we believe he will do what is appropriate to maximize the value of this investment.  We like owning TIE at a discount to the public price through KYCN, but an investor who is more bearish on TIE could create a very interesting position by buying KYCN and shorting out some or all of the effective TIE exposure. 

 

Given the exposure to TIE and the inherent leverage of the KYCN equity, the sensitivity of KYCN’s book value / NAV to changes in TIE’s stock price (including adjustments to the deferred tax liability for changes in TIE) looks approximately like this:

 

TIE stock price                     $5            $10          $15          $20          $25          $30          $35          $40          $45         

KYCN book value                $18          $23          $27          $32          $36          $41          $45          $50          $54         

 

So effectively the current $18 KYCN price is discounting a TIE price of $5 (down over 80% from the current $31 price), and yet if TIE moves up to say $40, KYCN’s book value (after taxes) moves up to $50.  As mentioned above, if you are bearish on TIE (and/or titanium or commercial aviation) a very interesting stub trade can be created by shorting out the TIE, which can eliminate downside from TIE going down. 

 

Another way to look at the sensitivity here is to look at how KYCN’s book value would look in 3 years, assuming annual pre-tax returns of different rates on the pension fund (net of estimated cash payments each year to pension and OPEB participants and net of adjustment to the deferred tax liability for changes in the net overfunding):

 

Annual pre-tax pension fund return                 -10%       -5%         0%          5%          10%        15%        20%

KYCN after-tax book value in 3 years               $19          $26          $34          $43          $53          $64          $76

 

So the current $18 KYCN price is discounting a loss of roughly 10% annually on the pension fund for each of the next three years.  Note that any reasonable annual increase in the pension fund will materially increase KYCN’s book value due to the leverage effect.  If the pension fund can continue its historical track record of roughly 14% annual pre-tax returns, the after-tax book value of KYCN would be about $62 in three years, up 55% from the currently roughly $40 level. 

 

An important issue here is whether KYCN can unlock the value of the pension asset.  Based on discussions with management, we believe KYCN is very interested in, and actively work on, finding ways to unlock this value.  Some alternatives are:

a)       KYCN could just keep the existing structure, and continue to manage the pension fund as a tax deferred investment fund.  The pension plan is frozen, so no new employees are being added, and 80% of the pension benefit obligation is for employees who have already retired.  Under this route, KYCN could just keep compounding value in the pension fund (while deferring taxes), and continue paying the pension benefits over time.  The pension obligation will decline over time, and if the pension fund continues to generate a respectable return, KYCN’s book value will continue to increase at a good pace.  Eventually when all obligations to retirees end, KYCN can terminate the pension plan and take full control of the remaining assets.  This would take a long time, since the pension benefits will be paid out until all pension plan participants and their dependants die.    

b)       KYCN could split the pension asset by effectively creating a new pension plan with the same benefits as the existing plan, and funding the new plan just to the appropriate point.  The excess assets could be removed from the pension plan, but a 20% excise tax would have to be paid on this amount.  Eventually the deferred taxes would have to be paid as well.  KYCN doesn’t seem inclined to do this, given they don’t want to pay excise taxes or pay the deferred taxes.  Although the excise taxes would be material (probably around $10 per share), KYCN at $18 is still at a big discount to the NAV that KYCN would have if they went this route today. 

c)       KYCN could either acquire or be acquired by a company with an underfunded pension plan.  After such a combination, KYCN’s overfunded pension plan could be merged with the other party’s underfunded pension plan, thereby eliminating or reducing the amount of underfunding in the other party’s plan.  Conceptually a buyer of KYCN might pay say $35 per share for KYCN today, to get access to $40 of value (that buyer would be getting the $8 per share steel wire business plus an overfunded pension asset worth $32, but would only be paying $27 for the pension asset – thus the buyer would be reducing its pension deficit at a discount).  Depending on how the negotiation worked, KYCN could actually be worth significantly more than $40 if sold to a company with an underfunded pension plan, since the buyer would then be able to eliminate KYCN’s $20 per share deferred tax liability.  The buyer wouldn’t need the deferred tax liability if the combined pension plan was then appropriately funded.  In our discussions with KYCN management, we’ve gotten the impression that they believe a transaction like this is the cleanest way to unlock the value, while avoiding paying excise taxes and potentially recapturing some of the deferred tax liability.  We’ve also gotten the impression that KYCN is very actively thinking about and perhaps pursuing alternatives like this. 

 

While the company is small and Harold Simmons owns 51% of the stock (and is clearly in control), we’ve found the company to be friendly to outside shareholders.  The CFO is responsive to questions about the business and pension fund. 

 

So at the end of the day, here is what we know about KYCN:  The pension fund was worth about $934 mm as of the end of 2006, and from the perspective of KYCN shareholders those assets are essentially being financed by a $376 mm pension benefit obligation, a $35 mm OPEB liability and a $198 mm deferred tax asset, resulting in an after tax NAV of about $324 mm, or $32 per share.  (Plus KYCN owns the $8 per share book value steel business.)  The underlying equity is effectively leveraged by the pension and OPEB obligations and the deferred tax liability.  44% of the $934 mm in the pension fund is invested in TIE, with the balance invested in some partnerships (one of which is Boone Pickens’ energy hedge fund), other common stocks, and mutual funds.  Essentially KYCN is a way to buy into TIE and the other investments in the pension fund in a leveraged way, at a significant discount. 

 

In summary, KYCN is a very interesting opportunity to buy a stock for $18 that has a $40-$43 per share NAV (which has been growing nicely), managed by a billionaire who is a proven money maker.  The equity value of KYCN is effectively leveraged by the pension and OPEB liabilities, but we are buying at such a big discount to NAV that the downside risk seems very low, while a buyer of KYCN will participate in the upside from being leveraged if the pension fund assets continue to perform well.  Also there is some optionality that KYCN figures out a way to unlock the value in the pension fund through a creative transaction, including the potential to recapture part of the value currently represented by the very large deferred tax liability. 

 

 

 

 

Appendix A:  Background on the steel wire business. 

 

Even though KYCN is primarily an investment fund at this point, the company is still known primarily by the steel wire business.  KYCN’s official description on Yahoo Finance, for example, reads: “Keystone Consolidated Industries, Inc. manufactures and sells fabricated wire products, welded wire reinforcement, industrial wire, coiled rebar, and wire rod products in the United States. Its fabricated wire products include agricultural fencing, barbed wire, stockade panels, woven wire mesh, and fabric and netting for agricultural, construction, and industrial applications; and rebar wire and stucco netting for residential and commercial construction. The company's welded wire reinforcement products include wire mesh rolls and sheets that are utilized in concrete construction products, including pipe, pre-cast boxes, and other applications for use in roadways, buildings, and bridges. Keystone offers custom-drawn industrial wire in various gauges, finishes, and packages, which are used in the production of a range of finished goods, including nails, coat hangers, barbecue grills, air conditioners, tools, containers, refrigerators, and other appliances. The company also provides coiled rebar to fabricators for specific reinforcement applications, such as building and road construction; and low carbon steel wire rod to the producers of construction products, fabricated wire products, and industrial wire. In addition, it offers billets to the producers of products manufactured from low carbon steel.”  The core of the steel wire business is a mini-mill in Peoria, Illinois which buys and melts scrap steel, and several other facilities which then process that steel into the various wire products.  KYCN essentially rebuilt the Peoria mini-mill in 1998 for about $100 mm.  Over the past 5 years, the majority of KYCN’s domestic steel wire competitors have either filed bankruptcy and discontinued operations or reduced or completely shut down their operations.  While KYCN believes these shut-downs and curtailments represent a significant decrease in domestic wire rod capacity, worldwide overcapacity continues to exist and imports have had a negative impact on the domestic market. 

 

Here are operating highlights for the steel wire business over the past few years:

 

                                                                2004        2005        2006

 

                                Revenues              364          368          441

 

                                Gross Profit           56            38            35

                                                                15%        10%        8%

 

                                Operating Profit    41            20            17

                                                                11%        5%          4%

 

2004 was an exceptionally good year for the steel business, due to steel shortages (as a result of competitors filing bankruptcy in prior years) and strong demand.  2005 and 2006 are more reflective of what should be normal operations for this business.  2007 is shaping up to be a tough year – shipments are off from 2006 levels and profits are materially down.  In the first half of 2007, operating profit from the business is about $4 mm, versus $14 mm the prior year.  This is partially due to scrap prices being up, and partially due to demand for wire products being down due to price increases and weather causing delays in construction and agriculture projects. 

 

Book value of the wire business is about $8 per share or almost $80 mm.  We believe this business is probably worth at least book value, although we haven’t focused on valuing this asset.    

 

 

Appendix B:  Derivation of pension asset details.

 

KYCN’s 10-K discloses that substantially all of the assets of KYCN’s pension fund are invested in something called “The Combined Master Retirement Trust” (the CMRT) which is a collective investment trust sponsored by Contran Corp to invest the retirement assets of various affiliated companies (including NL Industries, Contran, Keystone, and Titanium Metals).  The 10-K further discloses that Harold Simmons is the sole trustee of the CMRT and is one of three members of the Trust Investment Committee of the CMRT, and the CMRT assets are invested both with third party investment managers and in investments selected by Harold Simmons. 

 

Looking at the proxy statements for the various public companies controlled by Harold Simmons (Valhi, Titanium Metals, Kronos, Compx, NL Industries, and Keystone), one can see that Titanium Metals (ticker TIE) is the only one which shows the CMRT as a significant owner.  TIE is 52% controlled by Harold Simmons, including 15.434 mm shares or 9.5% which is owned by the CMRT. 

 

Pension funds file an annual Form 5500 with the IRS and DOL, which the DOL eventually makes public.  (Form 5500s can be found at www.freeerisa.com.)  Looking at the Form 5500 filings, it become clear that the CMRT is actually two different entities – one is called “The Combined Master Retirement Trust” and the other is called “The Combined Master Retirement Trust – Subtrust”.  It turns out that the KYCN pension fund is the primary investor in each of these two entities, and that the KYCN pension fund owns about 70% of the “Combined Master Retirement Trust” and 90% of the Combined Master Retirement Trust – Subtrust”.  The Form 5500s basically provide a balance sheet and income statement for each entity, as well as a breakdown of the types of assets held. 

 

The Subtrust owns only common stock, and if you look at the ending value of the common stock owned by the Subtrust at the end of 2004 and 2005, those values exactly match the value of the TIE stock reportedly owned by the CMRT per the TIE proxy.  Thus, all of the 15.434 mm TIE shares owned by the CMRT are owned by the Subtrust.  (Also, the Titanium Metals retirement plan is not one of the investors in the Subtrust, presumably due to restrictions on pension plans investing a lot of money in the stock of the sponsoring company, so it makes sense that the TIE stock would be in the Subtrust.)  Since KYCN owns 90% of the Subtrust, KYCN indirectly owns 13.9 mm shares of TIE.  Therefore at year end 2006, KYCN indirectly owned 13.9 mm TIE shares times $29.51 equals $410 mm of TIE stock.  $410 mm is 44% of the total KYCN pension fund value of $934 mm at that time. 

 

Additionally the Form 5500s show that “The Combined Master Retirement Trust”, which represents the other 56% of KYCN’s pension fund, is invested 55% in partnership/JV interests, 22% in common stocks, 17% in mutual funds and common/collective trusts, plus a few other areas (all as of the end of 2005, which is the last available Form 5500 at this point).  So looking at the overall KYCN pension plan as of the end of 2006, the breakdown of assets is probably something like 44% TIE stock, 31% partnerships/JV interests, 12% other common stocks, and 10% mutual funds and common/collective trusts.  While we don’t know what partnerships the KYCN pension fund is invested in, we do know that one of them is T. Boone Pickens’ hedge fund, which has done very well the last few years. 

Catalyst

Primarily the valuation gap between stock price and NAV / book value.
Likely continued increases in NAV/book value over time.
Potential for KYCN to do a transaction to unlock the pension asset.