Description

PW Eagle is 100% overvalued and should reflect this within six months. The company is the third largest manufacturer of PVC pipe in the US. The stock has gone from $4 to $26 in the last year (I was long it for part of that run) and is now firmly in the hands of momentum-driven day traders. Part of this increase is deserved, but most is not.

PVC pipe is a processing business. Resin is purchased, pipe is extruded, and a .03/lb profit is retained. Historically, PWEI’s EBIT margin has centered in the high teens, which makes sense on a resin price that is .30-.40 a pound, though it has ranged from -4% to 13%. The industry is characterized by overcapacity and inherent cyclicality, exacerbated by the fact that the top two producers of pipe are vertically integrated, and thus will cut pipe margins to maintain resin production in more difficult environments.

Currently, PWEI is enjoying a stupendous margin of around .40/lb. The reason for this is two-fold: first, resin prices spiked from .45 to .83 in the aftermath of the Gulf hurricanes (both because of natural gas and because of shuttered production) and PWEI kept the inventory mark-up and second, processing margins inflated as supply became very scarce and buyers scrambled for supply to finish projects before winter. The unparalled strength of the market surprised even PWEI, which had to revise guidance twice within one week.

There are many reasons to think that this margin will return to normal, but like one would expect it mainly has to do with supply and demand. Demand will drop for the next 5 months, because construction always drops off during the winter (a decline in housing demand will dramatically exacerbate this dynamic) and builders have the option to substitute ductile iron pipe. Supply will increase as natural gas and resin processing capacity comes back on-line (should be fully restarted by end of January) and imports fill the gap. These forces are already starting to play out, and the recent proposed price increases for resin were rejected by buyers. The industry will have to deal with a 10% capacity increase in January of 2007 in addition to these dynamics.

PWEI has 800m pounds of capacity. At .03/lb of ebit, this translates to roughly $1.15 of eps after the recent “windfall” profits are used to pay down debt, as the company has stated it will do. Commodity processors should trade at around 10x midcycle profits, so this gives a $12 target price. Another way of looking at this is that the hurricanes added $200m of market value to the company but roughly $50m of windfall profits, so this excess (around $15/share) should eventually work its way out of the capitalization.

Catalyst

PE resin prices soften
Momentum falters