Description

NGA is a bad company with an aggressive valuation that is in the hands of momentum traders.  Its financials have been inflated by higher zinc prices but this will inevitably mean-revert in this difficult and commoditized industry.

North American Galvanizing owns 11 hot-dip galvanizing plants throughout the mid- and south-central United States.  Galvanized steel is primarily used in industrial, energy, and infrastructure end-markets, in order to protect against corrosion and oxidation.  The service they provide is fairly basic, as steel is dipped into large kettles of molten zinc, and NGA participates in the undifferentiated end of the galvanizing market (ie, does not go after large or non-standard shapes or provide a higher service offering).  The industry participants with whom we have spoken do not have a high opinion of the company.

Higher zinc prices provide three sources of benefit to the company.  First, escalating prices provide a pricing umbrella as customers expect significant price increases.  Second, higher absolute prices give significant fixed cost leverage on the gross and operating margin.  Third, the zinc held in inventory appreciates, and while the company uses LIFO accounting, there are opportunities to work down LIFO layers opportunistically if desired (we will have an idea if this happened when the 10q comes out). 

Gross margin has actually stayed fairly constant in 2005-2006, averaging 25% and ranging from 23-26% (of course, gross profit dollars have increased).  The higher levels in 1h06 were from forward purchases that inflated gross margin roughly 10%, and seem to have been used to grab volume (adjusted gross margins are actually 19% for 2q06 if you adjust for this).  The real anomaly is 1q07, where gross margins jumped to 31%.  This argues that margins should mean-revert from their inflated levels in 1q07.

Another anomaly is that while volumes increased 10% in 2006, they dropped 3% in 1q07.  This could either be due to competitive losses, or substitution to paint as galvanizing costs go too high. This substitution naturally puts a cap on how much benefit a galvanizer can realize from higher zinc prices, as users ultimately prefer paint but generally go for the cheaper galvanizing option.  In any case, there are signs of deteriorating fundamentals.

The ebitda margin for this business has averaged 10% through the cycle.  Last quarter the ebitda margin was 23%, close to the highest ever realized.  There is no reason to believe that the economics of this industry have changed dramatically.  I believe that the appropriate valuation for this company is the after-tax gain on their zinc inventory ($8m), plus one year of above-average ebitda margins ($5m), plus 7x normalized ebitda ($90m of sales x 10% x 7 multiple = $63m), less $5m of net debt.  This gives an $8.50 target price on 8.5m shares, or roughly 45% downside.  This is if zinc prices stay high—if zinc retreats significantly then there is further downside.  There has been significant insider selling in the last week or so--  I would not be surprised if this continued.

Catalyst