Description
The stock is $13.92.
I’m proposing a warrant on a steel company that could have 140% upside in the next year. The average dollar volume on the security is only $150k—but you could also consider the underlying stock, which is 4.1x run rate earnings and 0.84x tangible book (0.64x TB if you include an estimate for non written-down PP&E). The underlying stock would offer 75% upside in the same scenario listed above.
MUSA was written up in October 2003 by zach721 at $7, a year after coming out of Chapter 11 from an aggressive acquisition program. It is now $14, after trading as high as $25 in March. It is 90% a metals service centers business (distributing and processing value-added steel products) and 10% a building products group.
Zach721 makes the point that due to fresh start accounting taken in fall of 2002, MUSA emerged from bankruptcy having written down its PP&E to 0 from $108M. However, there was an additional $87M writedown in 2001 on PP&E along with the goodwill writedowns most service centers must have taken. But most service centers are carrying significant PP&E on their balance sheet—therefore, on a relative basis, MUSA’s net worth is understated significantly. In the 0.64x multiple I gave above, I reversed the fresh start accounting, but included the 2001 writedown (many service centers had 2001 impairments). The CFO has said that the replacement value of the property is around $150M, which is consistent with the adjusted P/TB multiple (0.64x) listed above.
The basic point to remember on this story is that it is very cheap on a net worth basis, and would get a hefty premium to the current price in an acquisition. More importantly, even in poor economic conditions (see estimate at write-up end), it is at a 5x P/E of what it should make this year.
Here’s the look of things on a comp basis. Remember that although MUSA is not strikingly cheap in this table, it is really 0.64x tangible book when you include a fair value of PP&E. Others in the table have not had the fresh start accounting.
MUSA RS ZEUS CAS TONS
Q1 Sales 427.0 811.9 284.0 246.0 206.4
P/TB 0.8 2.2 0.8 1.8 1.6
P/Adj TB 0.8 5.5 3.2 2.8 2.8
EBIT Marg 7.3% 10.0% 6.0% 8.4% 8.2%
EBIT/ton 85.5 153.8 47.2 #N/A 82.3
EV/ton 377.4 420 181.9 #N/A 455.9
EV/EB Q1Ann 4.4 4.6 3.9 3.4 5.5
P/E Ann Est 4.2 7.0 4.5 4.5 8.3
MUSA also had at year end a 42.2M reserve against a deferred tax asset that should be reversed as it continues to make money. This should also be added to the off balance sheet PP&E as an off balance sheet source of economic value.
ZEUS might be the best comparable in terms of size and business, but it is more expensive on an adjusted net worth basis, and it has 12% exposure to the Big 3 auto-makers. MUSA’s largest customer is 2% and has less carbon and sheet concentration (the weaker businesses). Some of the ratios above, such as EV/ton, are affected by the carbon or aluminum mix of the company—an all carbon company should be cheaper.
The Warrants:
The 3.5M warrants issued were given to the holders of the MUSA common before Chapter 11. They expire on Oct. 31, 2007 and have a strike of $18.50. If the underlying trades for at least 20 days in a 30 day period above $27.75, management can make the expiration immediate, therefore capping the value of warrants somewhere around $10. Depending on your vol assumptions, you get a $1.70 current theoretical price, but the pricing model is much less relevant for something so long-dated. A week ago, and a point higher on the stock, the Jan 07 call traded for $2.10. So the point is, the warrants are in the right neighborhood of price and offer decently priced leverage to a compelling underlying story.
Business:
For 90% of its business, the metals processing and distribution business, MUSA takes in rough shapes and sheets from primary metal producers and does many procedures to them including cutting, bending, cambering/leveling, etc. This gets the product ready for the contractor or OEM. It also serves the purpose of inventory management and distribution out to the end users, as primary metals producers are near scrap and ore centers and major ports, and most importantly, have contracted their service center business to compete more on the crude steel output level.
Divisions:
Plates and Shapes, 41% of sales:
This division produces beams, tubing, bars, plates for the machinery, construction, energy and transportation sectors—these products have held up relatively well compared to sheet. Almost all of it is carbon steel. There are 21 centers throughout U.S.
Flat Rolled, 47% of sales:
Carbon, stainless, aluminum, etc., products for electrical manufacturing, appliances, and transportation, etc. There are 12 centers in Midwest and South.
Building products, 12% of sales:
Roofing products, commercial awnings, sunrooms, and other residential housing improvements. 26 sales and distribution centers in the South and West.
The need for primary metal producers to remain focused on a few standardized products to remain competitive makes a niche possible for the service centers in terms of value-added processing. At this point, most primary metals producers have left the service center business and the OEMs and end users had to look elsewhere to the service centers for their supplies. Other OEMs that had originally done their own metals processing are realizing the scale benefits of outsourcing to service centers.
Market Conditions:
On Q1 conference calls, managements have noted that Chinese sheet prices are in the $560/ton range, and U.S. spot prices are only slightly higher. However, many U.S. companies did much better ($700+) even in sheet during Q1, because of pre-existing contracts. Plate and shape prices continue to hold up better than sheet prices, but plates may be affected by the 300k ton startup at Mittal. Some CEOs note that consolidation in the industry and new discipline has them hopeful that prices will bottom in the $500 range. There have actually been $30 prices increases in the spring and winter for plate ($700+), and some hint that there may be future surcharges for other steel products.
Out of Q1, it seems like most carbon service center inventories were flat to inconsequentially down, and sales for carbon sheet were down 5-10%. Aluminum and shapes, as mentioned before, are the strong parts of the business. Sheet inventory is beginning to be a problem with the prospect of declining sales, but it is not one that is unmanageable.
Threat of imports:
Carbon steel imports to the U.S. at 1.7M tons were down from the 2.5M import peak last fall, when much was made about China’s becoming an exporter in the press. This is almost at the lows of summer 2004 in terms of imports. Imports for us are more likely to come from Europe and Latin America, but the “dumping scenario” hasn’t happened yet. The path of recent total steel alloys imports are below:
3/05 2/05 1/05 12/04 11/04
Imports 2.3 2.2 2.4 2.7 3.1
There have been large increases in the imports of pips and plates (off small bases) and actually decreases of rolled and sheet products for the months above.
Emerging market growth is still very strong, and if China has 20M or so of extra tons of capacity, it is likely to find a home in other emerging markets than in Chicago. The import “dumping” scenario written about in the press that might hit the U.S. in an Asian recession would more likely affect the primary metals producers, the makers of the unfinished, high volume products. The service centers will still be needed for finishing in many cases. The import story seems less relevant than the consolidation story going forward for service centers. Also, high shipping rates and a falling dollar would further protect the U.S. steel business.
MUSA Conditions:
Sheet prices were probably down $100 for the quarter for MUSA, and it managed to keep its operating earnings at $30M, vs. $50M a year ago. MUSA does not do any significant contract business and must match inventories to customer demand. Here is the path of sales, inventories and receivables for the last 4 quarters:
Q105 Q404 Q304 Q204
Sales 427.6 394.4 412.6 383.6
A/R 201.8 174.0 200.0 185.0
Inv 457.6 462.0 378.0 300.0
DSOs at MUSA were 43.1 in Q1, at the average level for the last year, and at the same level as competitors. Inventory turns at 2.9 are worse than most competitors (in the 3 to 4 range), but similar to the largest service center company, RT.
Although the metals service center industry is not as concentrated as the iron ore business or the steel integrated/mill business, consolidation has been the story over the past year. The largest player went from about 4% of the market to about 9% of the market (when viewing all metals mixed together, aluminum, steel products, etc). The 6 largest players now account for about 19% of the industry. In first quarter conference calls, managements expected the consolidation story to continue. Although market share is still scattered, there are advantages that can develop with geographical and product specialization. Managements have also commented on increased service center discipline in this cycle.
Service center inventory is at 3.1 months, slightly below the average for the last 5 years. Smaller mills may be carrying a bit extra inventory, and the auto business is an overhang (more for players like ZEUS, AKS, etc), but highway construction (the transportation bill) and commercial construction have yet to kick in forcefully. These factors should help MUSA’s diverisified product base maintain sales levels close to a year ago during a period of falling auto demand. Even though the Big 3 are having trouble, foreign manufacturers are coming in to build more plants in the U.S.
Here are MUSA’s historical numbers:
Q105 Q404 Q304 Q204
Sales 427.6 394.4 412.6 383.6
GM 21.9% 23.8% 22.7% 24.5%
EBIT 31.2 33.8 53.8 56.5
EBIT Marg 7.3% 8.6% 13.0% 14.7%
Net 17.3 20.5 31.8 33.7
EPS $ 0.83 $ 0.99 $ 1.53 $ 1.63
Mkt Cap 290.9
W.C. 589.7
Debt 274.4
EV 551.0
Com Eq 346.0
P/E (Q1 Ann) 4.1
EV/EBIT (Q1 Ann)4.4
TTM Net 103.3
Here is a pessimistic case earnings scenario for 2005:
Sales 1710.4
GP 350.6
GM% 20.5%
SGA 248.0
SGA% 14.5%
Op Inc 102.6
Int 12.8
Tax 31.4
Net 58.4
EPS 2.79
9x Mult 25.14
I assumed sales were flat from Q1 (Q2 and Q3 are usually stronger), and that GM’s at 20.5% were 3% lower than the last four quarter average, and 1.5% lower than Q1’s number. I assumed SGA% to be flat. With a 9x handle on these earnings, you would get more than a double in the warrants, and an 80% return on the stock. Most service centers have had margins drop from the high 20% range to the low 20% range over the last year. ZEUS and others with more concentrated Detriot exposure had Q1 margins in the high teens.
The other point to keep in mind is that MUSA has tangible book value of $16.56 per share, 3 points above its current price. If you were to give MUSA credit just for the PP&E is has written down due to fresh start, tangible book would be $26.12 a share. If you add the $40M reserve against the deferred tax asset should be reversed as they continue to be profitable, you realize that the market is substantially underestimating the net worth of this company. Most importantly, even with some really negative economic scenarios baked in, this company is very cheap on an earnings basis and should be able to post up to $3 in earnings this year. The warrants are a great way to get leverage on this, but there’s also plenty of upside to the equity.
Catalyst
Earnings of $2.80
Short Position effectively 15% of float
Stabilization of/Sale of Building Products Group