Description

Thesis: Webco is an extremely compelling net/net opportunity, trading at 34.4% of working capital, 31.5% of our estimated liquidation value, and 18.2% of book value.  The company has also been consistently profitable throughout its history, and is currently generating positive cash flow.  We cannot recall seeing a net/net this cheap.  How could such a bargain exist?  We think it is simple – very few investors are aware of the opportunity.  Webco is an unlisted company that only sends financial statements by request (with press releases available online).  This is the type of company that only a very scrappy value investor tends to come across.

Unlike the vast majority of net-nets, Webco actually has the potential to earn its cost of capital.  Webco has historically traded at a (sometimes meaningful) premium to liquidation value and we believe its under-the-radar nature has created a uniquely asymmetric investment opportunity.

We believe that the unwind of working capital and the end of a temporary gross margin drag from high cost inventory will lead the stock to re-rate in the near term.  Longer term, we believe either the sale of the business (the founder/chairman is 88 years old), an industry recovery, or a decision to extract the capital from the business will drive a more meaningful re-rating.

While the appropriate price relative to liquidation value is difficult to discern, we believe the stock would still be an attractive net/net at 70% of working capital (a price that is 103% higher than the current trading price).

Business Description: Webco manufactures tubing products that are designed and sold to a variety of industries. 60% of the product is welded carbon steel and stainless steel.  Webco’s business model is essentially to source industrial metals, apply heat to change the shape of the steel to meet particular industry/customer specifications, and charge a margin for providing this relatively commoditized service. While the end market industry is diverse, key end markets include downstream energy (refineries), autos, and durable goods (agriculture, chemicals, processing).  We would emphasize that most of the energy business is focused on consumable or replacement parts.

This is a mediocre, cyclical business that has generated modest returns on capital through the cycle.  Webco has grown tangible book value 8.2% annually and net working capital at 11.2% annually.

What is unique is the chance to buy this type of business at such a meaningful discount to liquidation value – even at the 2009 lows, Webco traded at 47% of net working capital.

EV/EBITDA & P/E Understate Value:  These metrics give no credit to the significant asset value of the company.  In addition, these metrics suggest that current profitability is lower than the true economics of the business suggest.

• Leverage/Enterprise Value: Volume declines are causing significant cash releases from NWC, which are being used to pay down debt.  The business has reduced its debt balance by ~$36mm since July 2015 and we would expect continued working capital release.  Currently, working capital is ~36.3% of LTM sales.  We view this figure as well-above normal levels in a trough environment (working capital was ~30.0% of LTM sales in July 2009).  We expect $15-$30mm+ in incremental working capital release this cycle, which would lower net debt balances to $10mm-$25mm (vs. $40mm today on a $70mm EV).  The continuation of this process will cause a reduction in EV and therefore the attractiveness of the business on an EV/EBITDA basis.

• Cash Flow > Earnings: D&A is meaningfully higher than capex.  Depreciation is running at ~$12mm annually vs. capex at ~$8mm.  Our research suggests that maintenance capex is meaningfully lower than $8mm (physical replacement capex is <$2mm).  LTM net income of negative $1.3mm looks more like positive ~$3mm+ (10%+ cash flow yield to equity at near-trough). This is separate from the cash flow benefit of working capital release

• Margins: While this is not a particularly profitable business at the bottom of the cycle, true profitability is currently understated due to the lag between inventory purchases and sales.  While inventory comes from a variety of metals, our understanding from discussions with mgmt. is that inventory costs most closely correlate with US Midwest Domestic Hot-Rolled Coil Steel (HRC1 Comdty on Bloomberg). HRC1 began to decline rapidly at the end of summer 2014; this became problematic because inventory costs generally flow through sales 2-4 quarters later.  The problem was most severe in Q1 16 (10/31/15) and Q2 16 (1/31/16) as HRC1 troughed out but high cost inventory continued to roll through.  Stabilization of HRC1 will result in an expansion in margins.  More recently, we have actually seen HRC1 start to increase, which should result in gross margin expansion.  We believe it makes sense to look through these gross margin fluctuations caused by timing differences.  Webco is trading at 20.1% of EV/Sales, meaningfully cheap to trough 2009 levels of 24%).  We began to see things normalize somewhat last quarter, as gross margins hit 8.0% (vs. 5.4% and 6.0% in the prior two quarters)

At inventory-smoothed EBITDA margins of ~4% and 2016E sales of $325.5mm, Webco would be trading at ~3.0x-4.2x trough EBITDA vs. the 2009 trough multiple of 6.9x EBITDA once we adjust for working capital release.  While EBITDA declines could certainly continue, Webco is extremely cheap to historical levels on an EV/EBITDA basis (vs. relatively fairly valued at the headline multiple of 5.9x LTM EBITDA).

Valuation: We triangulate valuation in a number of different ways here.  Our core valuation technique is liquidation value, as we are focused on the margin of safety to asset value.  We believe we are buying Webco at 31.5% of liquidation value (upside of 217.7% to liquidation). Our liquidation assumptions are as follows:

• Current assets: We value cash at 100%, A/R at 90%, inventories at 75%, and other current assets at 25%.  Current assets constitute $119.4mm of recovery value

• PP&E & Other LT assets: We value PP&E at 50% and other LT assets at 25%.  PP&E constitutes $45.4mm of recovery value and other LT assets constitute $0.3mm of value.  

• Liabilities: We value all liabilities at 100%, aside from the DTL.  We value the DTL as a $0 liability given the tax offset if the PP&E and/or inventory values were impaired

We would highlight that we believe two of the key assumptions are reasonably conservative:

• PP&E: We are valuing PP&E at 50%.  This is likely conservative as there is more than $75mm of real estate at cost.  We understand the company had the ability to get bank financing against 45% of PP&E.  Additionally, Webco recently spent $55mm on a single new manufacturing facility in Oklahoma (vs. our mark of $45.3mm for all of the PP&E).

• Inventories: Inventory recoveries of ~75% seem reasonably conservative given that gross margins have not gone negative this cycle and appear to be recovering (as of last quarter).

Valuation is also highly favorable on a net working capital basis.  We look at market cap relative to net working capital less net debt ($85.1mm as of 4/30/16).  We are currently able to buy Webco equity at 34.4% of its net working capital.

Finally, as suggested above, Webco is likely to appear cheap on traditional valuation techniques once the working capital release is complete.  We believe we are creating Webco at a $39.4mm-$54.4mm EV on ~$13.0mm of inventory-smoothed EBITDA (4% inventory-smoothed margin on 2016E sales of $325.5mm).  This amounts to 3.0x-4.2x EV/EBITDA on below-normal EBITDA margins (6.3% historically), likely below-normal demand, coupled with very substantial asset protection.  We compare this to historical trough multiples north of 6.0x EBITDA and peak multiples north of 4.0x EBITDA (on 11% EBITDA margins in FY 2011).  Very cheap.

Potential Catalysts: While Webco does not have a hard catalyst, we see a number of positive upcoming events:

1. Release of Net Working Capital: We expect Webco to begin to screen better as net working capital continues to be released over the next several quarters

2. Recovery in Underlying Industries: We would expect the stock to re-rate if we saw a meaningful recovery in the key industrial end markets

3. Sale/Liquidation of Business: The best case outcome is if the story ends with a liquidation or sale.  Bill Weber founded this business in 1969 and is now 88 years old.  His daughter Dana took over the CEO position in 2011 but Bill is still actively involved with the business on a daily basis.  He also functions as Chairman.  Ownership has become increasingly widespread through the Weber family and we believe a monetization event will likely eventually make sense for all parties involved

Other, more minor catalysts include:

1. Improvement in EBITDA Margins: This should flow through over the next several quarters due to the recovery in Midwest Coiled Steel prices

2. Potential Capital Return: The company has never returned capital in the past but it is also cheaper than at any point in history.  The company could choose to begin returning capital to shareholders as margins recover and debt reaches a comfortable level

3. Lower Interest Expense: The company swapped its floating rate debt into fixed rate debt.  The company’s debt is at L+300, so a refinancing of the company’s capital structure could lead to interest savings

Key Risks:

1. Governance: We believe a liquidation today would be in the best-interest of shareholders, but we don’t expect any immediate actions given the Weber family’s relationship with this business.  We see the biggest risk as modest returns due to poor capital mgmt. / mgmt. incentives

2. Cyclical: We have no strong view on the trajectory for Webco’s industrial end markets.  It is possible that end market trends continue to get worse before they get better

3. Illiquidity: The stock is very illiquid and is best suited for PA investments or very small funds

4. Limited Disclosure: As with many non-listed microcaps, disclosure here is not particularly expansive

Concluding Thoughts: We believe that Webco is worth ~3x the current price in a liquidation (218% upside) and is extremely well-protected by asset value.  We believe traditional value techniques (most prominently EV/EBITDA) will continue to look better as working capital is released and margins normalize.  Cash flow will also exceed reported net income as depreciation meaningfully overstates capex (particularly replacement capex).

While figuring out the right price is more art than science, we think the stock should trade meaningfully north of current levels.  We think the stock is comfortably worth ~70% of net working capital (103% upside).  At normalized net debt of $17.7mm and inventory-smoothed EBITDA of $13.0mm, Webco would be trading at 5.3x trough EV/EBITDA.

Disclaimers:

The views expressed herein are for informational purposes only, and are not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose or for legal, accounting or tax advice.  This information does not constitute an offer to sell, or the solicitation of an offer to buy, any security.  The author makes no representation as to the accuracy or correctness of the information contained herein and expressly disclaims any liability to any person from relying on such information.  The information and views contained herein are provided as of the date this summary was posted and present the views of an investor that currently holds a long position in the company’s securities.  The author has no obligation to update any of the information provided herein.  The author reserves the right, in light of, among other factors, its ongoing evaluation of the company’s financial condition, business, operations and prospects, the market price of the company’s stock, conditions in the securities markets generally, general economic and industry conditions, its business objectives and other relevant factors, at any time, to decide to purchase, sell, or engage in any other transaction involving, the company’s securities as it deems appropriate.   Past performance is neither indicative nor a guarantee of future results.  There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.  

Catalyst

1. Release of Net Working Capital: We expect Webco to begin to screen better as net working capital continues to be released over the next several quarters

2. Recovery in Underlying Industries: We would expect the stock to re-rate if we saw a meaningful recovery in the key industrial end markets

3. Sale/Liquidation of Business: The best case outcome is if the story ends with a liquidation or sale.  Bill Weber founded this business in 1969 and is now 88 years old.  His daughter Dana took over the CEO position in 2011 but Bill is still actively involved with the business on a daily basis.  He also functions as Chairman.  Ownership has become increasingly widespread through the Weber family and we believe a monetization event will likely eventually make sense for all parties involved

Other, more minor catalysts include:

1. Improvement in EBITDA Margins: This should flow through over the next several quarters due to the recovery in Midwest Coiled Steel prices

2. Potential Capital Return: The company has never returned capital in the past but it is also cheaper than at any point in history.  The company could choose to begin returning capital to shareholders as margins recover and debt reaches a comfortable level

3. Lower Interest Expense: The company swapped its floating rate debt into fixed rate debt.  The company’s debt is at L+300, so a refinancing of the company’s capital structure could lead to interest savings