Description

Quanex (NX) is trading at a significant discount to its sum of parts value and is in the process of a strategic review which should unlock the value over the next 12 months.

Quanex has three business segments: Vehicular Products, Engineered Products, and Aluminum Sheet. 

Vehicular Products is the largest of the three segments and consists of MACSTEEL and a few related companies.  MAC is a producer of special quality steel bars which are used to produce parts for passenger vehicles (camshafts, crankshafts, CVJs, gears, etc.), and heavy trucks, as well as construction and agricultural equipment, bearings, forgings for the oil patch, etc. Here’s the description from the Quanex website.

“MACSTEEL utilizes three scrap-based mini-mills to produce up to 1.3 million tons of engineered Special Bar Quality (SBQ) steel bars. The mills operate using a low-cost continuous casting process with refined blending and finishing practices including electric arc furnaces for melting, ladle metallurgy injection for refined chemical composition and vacuum arc degassing for metallurgical cleanliness. It is this unique combination of technologies that allows MACSTEEL to produce the ultra-clean SBQ bars demanded by its discerning vehicular powertrain customers.”

Engineered Products consists of three companies that produce parts for windows and doors – Homeshield, Truseal, and Mikron.  Here are descriptions of the three businesses from the Quanex website.

HOMESHIELD designs and manufactures metal, wood and composite window and door components using innovative tool design and processes, including roll forming, slitting, laser welding, laminating, stamping, automated assembly and coating. HOMESHIELD also provides value-added services such as just-in-time shipping and engineering support.

TRUSEAL TECHNOLOGIES utilizes proprietary extrusion techniques to produce spacer products for insulating glass systems and sealants for vinyl, aluminum and wood windows. Its sister operation, Besten, manufactures a complete line of equipment used by window and door fabricators to clean, convey, store and assemble insulating glass.

MIKRON industries designs and manufactures its own tooling to produce a wide variety of vinyl window profiles and blinds used by major window and door OEMs. Through three highly automated extrusion facilities, Mikron uses thermoplastic resin to produce PVC window profiles.

The Aluminum Sheet business is Nichols Aluminum. It recycles scrap to produce aluminum sheet, mainly for construction markets.  Here’s the description from the Quanex website.

NICHOLS ALUMINUM operates one of the largest scrap-based aluminum mini-mills in North America, producing up to 360 million pounds of coated and mill-finished sheet used primarily in the building products and transportation markets. Blended grades of scrap are prepared and refined using a scrap recovery system along with conventional and rotary melt furnaces to both improve scrap yield and minimize metal costs. Nichols Aluminum’s finishing capabilities include cold rolling to specific gauge, heat treating, slitting to width and custom coating.

Strategic Review

In May of this year, Quanex announced that the board was initiating a review of strategic alternatives with respect to the buildings product group, which includes engineered products and aluminum sheet.  The possible outcomes were described as “a tax-free spin-off, sale, or joint venture.”  The stock jumped from $44 to $49 on the news and traded as high as $55 per share in July.  Recently, the stock has retreated along with the market and now trades at $42.50.   During the company’s most recent conference call, management indicated that the review is still underway and that no announcements would be made or questions answered until the review is completed. 

Sum of Parts Valuation

There is very little synergy between the three businesses, hence the strategic review which is intended to release value.  At the current stock price, the steel business is almost as valuable as the entire company, and provides a significant margin of safety.  Upside comes from what the other two businesses might be worth as separate companies, either spun-off or sold to third parties.  Here’s back of the envelope sum of parts valuation.

Vehicular Products (MACSTEEL).  MAC is a consistently strong performer and is on pace to generate close to $160 million of EBITDA this year despite relatively weak conditions in the North American steel market.  Segment results appear in the table below.

The key to valuing MAC is to recognize two things: First, MAC uses a unique manufacturing process to produce very high quality steel bars at a competitive cost, and second, MAC is a very attractive asset in a consolidating industry.  

MAC competes at the top of the SBQ quality spectrum, producing parts for bearings, gears, and other critical drivetrain components, mostly for passenger vehicles.  In this segment of the market, MAC competes with the likes of Timken (TKR) and Republic Engineered Products, both of which use more expensive manufacturing processes.   The main difference is in casting (converting liquid steel to a solid form).  Timken and Republic cast ingots or blooms, both of which cool down and then must be reheated before being rolled into finished bars.  The reheating and rolling is energy intensive and results in significant yield loss.  

At two of its three plants, MAC uses a centrifugal casting process that allows the company to cast a round and put it directly into the rolling mill.  This process results in lower energy consumption, less yield loss, lower labor costs, and less working capital.  The centrifugal casting process has been around for a long time and is mostly deployed to produce rounds for seamless tubes.  As far as I know, MAC is the only company in the world using the centrifugal caster to produce high quality SBQ bars.  Replicating MAC’s business model would be difficult because its success comes from a combination of technology, know-how, and customer relationships.

What I most like about MAC is that they’ve used their substantial cash flows over the years to fortify their competitive advantage.  The company has invested heavily in steel making technology so that they can produce very clean steel with low levels of residuals, oxygen, and other unwanted elements in the finished steel bars.  In addition, MAC has invested downstream in heat treating and cold finishing to provide demanding customers a very high quality, ready to use finished product.

Because of its unique technology, strong financial performance, and very compelling market position, we believe MACSTEEL will be a much sought after acquisition target once the engineered products and aluminum sheet businesses are spun off to shareholders or sold.  Most North American and global consolidators in the steel industry would view MAC as a very attractive asset, not only for its immediate market position and cash flow, but also because its technology and business model could be deployed in fast growing markets like China and India.  

To arrive at an upper value for MACSTEEL, we suggest you look at two recent transactions in the steel space, where strategic buyers acquired companies with excellent assets, strong market positions, and solid financial performance, namely Chaparral and Ipsco.  

We don’t believe MAC will sell for the same multiple of capacity as Ipsco or Chaparral did. Ipsco has substantial pipe & tube assets in addition to its steel making capacity.  Chaparral operates in a very strong portion of the steel market (structural steels used in non-residential construction and infrastructure) and has been generating more EBITDA per ton than MAC has recently.  Therefore, we think MAC is more likely to be worth   $900 to $1,000 per ton of capacity to a strategic buyer and 8 X EBITDA. 

MACSTEEL has 1.3 MT of capacity and LTM EBITDA is on the order of $160 million, implying a valuation of $1.2 to $1.3 billion. 

$160 million EBITDA x 8.1 = $1.3 billion

1.3 million tons of capacity X $950 per ton = $1.235 billion. 

The Engineered Products group of Quanex produces window and door components made from metal and wood.  Segment results appear in the table below.

Despite difficult market conditions in residential construction, the engineered products business is on track to generate $65 million of EBITDA this year.  In the company’s earning release for fiscal quarter ending July 2007 management acknowledged difficult market conditions but was relatively confident: “Housing starts in our third quarter were off 22% compared to the third quarter last year, while our sales for the same period were down only 5%, a testimony to our ability to generate robust organic growth through new programs and product initiatives. We are optimistic that we will hold this sales momentum through the fourth quarter.”

Based on a casual review of companies in the building materials industry, EV/LTM EBITDA ranges from 5 to 9.  At 5 X, the Engineered Products business is worth $325 and at 7X it is worth $450.

Nichols Aluminum melts scrap to produce hot rolled aluminum sheet at its main facility in Davenport, IA.  Finishing operations in IA, AL, and IL cold roll, coil coat (paint), anneal, slit, and level the sheet to customer specifications.   Capacity is 400 million pounds per year and production has been around 360 million pounds.  Segment results appear in the table below.  FY ends October and data are in $ millions.

Nichols Aluminum is on pace to generate around $75 million of EBITDA in the FYE October 2007, down from 2005 and 2006 but not bad in the current environment.  I don’t know of a direct public comp for Nichols.  However, 9 months ago Wellspring capital bought JW Aluminum for $310 million. JW also produces aluminum sheet, sells into some of the same markets as Nichols, and is a similar size, 370 million pounds at the time of the transaction vs. 400 million pounds of capacity for Nichols.

On that basis, one could argue Nichols should be valued at around $300 million.  This seems very conservative given that it represents just 4 X 2007 EBITDA, especially given the recent M&A activity in the aluminum sector.  A more reasonable multiple might be 5 or 6.  At 6 X EBITDA, Nichols Aluminum would be worth $450 million.

Sum of Parts Summary.  The three segments of Quanex have an aggregate value of f$1.83 billion and could be worth than $2.2 billion.

With 37 millions shares outstanding, Quanex stock could be worth $50 to $60 over the next 12 months versus a current price of $42.  At the upper end of the valuation range, this implies 40% upside.  The downside risk is limited by the value of the Vehicular Products segment (MACSTEEL) and the fact that the board has already initiated a strategic review designed to unlock some of the latent value.

Catalyst