Description
I am recommending a long position in Walter Industries, a diversified company comprised of the following operations: (i) Jim Walter Resources – a 6 mm (growing to 8 mm) ton producer of metallurgical-grade coal; (ii) U.S. Pipe – the nation’s largest manufacturer of ductile iron pipe used for underground water transmission; (iii) Jim Walter Homes – a manufacturer of residential homes in the southeast; and (iv) Mid-State Homes/Walter Mortgage Company – a financing business that purchases and services mortgage notes predominantly originated by the homebuilding business.
Based on a sum-of-the-parts valuation, the shares currently offer nearly no downside and up to 60% upside over the next 12 months, and in my opinion, my assumptions are conservative. The main component driving the valuation is the company’s metallurgical coal business, which will enjoy extremely favorable supply and demand dynamics for at least the next three years. While there are other pure-play publicly traded coal companies, WLT offers the cheapest way to gain exposure to the met coal market. I believe the current opportunity exists because (i) it is a complicated company with several disparate parts; and (ii) only 1 regional investment bank covers it from the research side.
Financials:
Stock Price: $31.49
Pro Forma Shares: 45.8 mm (includes shares from in-the-money convert)
Market Capitalization: $1,442 mm
Recourse Debt: $175 mm (convert)
Cash: $48 mm
TEV: $1,394 (includes shares from in-the-money convert; face amount of convert is excluded)
TEV / 2005F EBITDA: 5.2x
Price / 2005F FCF: 7.6x
Business Segments:
JIM WALTER RESOURCES
Jim Walter Resources operates 3 underground coal mines in Alabama, capable of producing around 6 million tons per year. One of the mines is close to being depleted and is planned to be shut down toward the end of this year. All of its coal is metallurgical grade coal (a.k.a. coking coal), the type of coal used to make coke, which in turn is fed into blast furnaces as part of the steel-making process. Currently, there is an extremely tight supply environment as China continues to ramp up its steel capacity, which has caused coking coal exports from the country to decline to keep pace with domestic demand. In 2003, China was a net exporter of 10.5 mm tons of coking coal. For 2004, analysts are forecasting that China will become a net importer of 0.1 mm tons. Through September 2004, Chinese exports of coking coal were down 66% and imports were up 181%. By 2007, analysts are expecting China to be a net importer of over 2 mm tons. In addition, recovering economies worldwide has boosted steel production and thus demand for coking coal. At the same time, the lack of investment in mining capacity for the past decade coupled with the limited available reserves of high-quality coking coal is preventing any meaningful supply response to the record-high selling prices currently being realized. Planned capacity additions are forecasted to be 9 mm tons per year in 2005 and 2006, growing to around 12 mm tons per year in 2007 and 2008 (43 mm tons in total). These increases are benign in light of the forecasted growth in steel production over the same time period. In addition, the potential capacity increases ignore the fact that, in many cases, there is simply not enough infrastructure in place (railroad capacity and port capacity) to deliver the coal from the production site to the port. Morgan Stanley is forecasting that there will be around 94 mm tons of new crude steel production over the next four years (excludes electric arc furnace production, which does not use coke as a raw material input). A rule of thumb is that it takes around 0.8 mm tons of coking coal to make 1 mm ton of steel. Therefore, the 94 mm tons of new steel production implies a need for 75 mm new tons of coking coal, much greater than the planned capacity increases noted above. Not surprisingly, Morgan Stanley is forecasting that there will be a supply deficit of coking coal through 2008. The coal consulting firm, Barlow Jonker, believes that market conditions for coking coal could remain tight into 2010.
Typically, pricing is contracted for 1 year, from April 1 – March 31. Pricing for 2005 (Apr-05 through Mar-06) is settling between $125-$130/metric ton, an increase of over 100% from prior year levels. Jim Walter Resources contracts on a June year-end basis, and they recently announced pricing for most of their available tonnage in the same context. The $125-$130/metric ton pricing is pricing at the vessel; to determine what the coal company realizes at the mine, you have to make two adjustments: (i) convert the tonnage from metric tons to short tons (divide by 1.1); and (ii) subtract transportation costs which is typically paid by the coal producer. In WLT’s case, they ship the coal via rail to the port of Mobile, AL, which costs around $10 per ton. After these adjustments, WLT is realizing north of $100/ton for their available tonnage from July 2005 – June 2006. WLT’s met coal customers are mainly foreign steel companies, including Arcelor, the Corus Group and some of the Brazilian steel mills.
For 2005, WLT will produce around 5.8 mm tons of coal. 1.8 mm tons have been already contracted to a local utility until the end of 2005 @ $35/ton and approximately 1.8 mm tons have been contracted to steel producers through June 2005 @ $54/ton, which leaves approximately 2.2 mm tons of coal being sold @ prices in excess of $100/ton. In 2006, production will decline to approximately 5 mm tons as one of the mines is taken off-line (production is planned to ramp back up to 8 mm tons by 2008 as the company will spend $135 mm over the next four years to take advantage of the current favorable supply and demand dynamics.) What’s important about 2006 is that all of the 5 mm tons will be available to take advantage of the favorable pricing environment.
Another source of cash flow for Jim Walter Resources is their methane gas business. As part of the mining process, methane gas is captured and sold to El Paso pursuant to a 50/50 joint venture. This business is extremely profitable, as most of the costs are incurred as part of the coal mining process. According to management, they make money as long as gas prices exceed $2/mmBTU.
The following is a summary of projected CF for Jim Walter Resources for the next 2 years:
2005 2006
Met Coal Volume:
Contracted Steam Coal 1.8 -
Existing Contracted Met Coal 1.8 -
New Contracted Met Coal 2.2 5.0
Total Volume 5.8 5.0
Sales $ per Ton:
Contracted Steam Coal $35 -
Existing Contracted Met Coal $54 -
New Contracted Met Coal $100 $95
Avg Sales $ per Ton $65 $95
Cost $ per Ton (co guidance): $31 $31
Total Revenue 375 475
Cash Costs 178 155
Gross Profit 197 320
Natural Gas:
Volume (bcf) 7.4 6.8
Price ($/mcf) $5.50 $5.00
Cash Costs ($/mcf) $2.00 $2.04
Revenue 41 34
Cash Costs 15 14
Gross Profit 26 20
Combined Gross Profit 223 340
SG&A 22 22
EBITDA 201 318
Maintenance CapEx 20 21
Expansion CapEx 23 23
JWR Valuation:
Comparable coal companies (including Arch Coal, Peabody, Massey, Consol) trade off of forecasted TEV / 2006 EBITDA multiples in the range of 5x to 5.5x. To varying degrees, these companies have exposure to the met coal market, and the remainder of their production is sold into the domestic utility market. In light of this, I believe the following valuation is very conservative, as Jim Walter Resources is a pure-play met coal producer.
Low Base High
2006 JWR EBITDA 318 318 318
Multiple 3.00x 4.25x 5.00x
Valuation $953 $1,351 $1,589
As you can see, under the base and high cases, the valuation of the coal business is essentially worth the current market cap and you are getting the rest of the company for free.
U.S. PIPE
U.S. Pipe is the #1 ductile iron pipe manufacturer. In addition to pipes, the company produces a full line of valves, hydrants and fittings. The company manufactures 4”-64” pipe, which is primarily used for clean water transmission. The company has a 30% market share, with the remaining business evenly split between 3 other competitors. Demand is driven by residential development and infrastructure spending, as new water systems are installed and existing systems are being replaced. The company estimates that 65% of the business is driven by new construction while 35% is driven by the replacement of aging pipe. There should be steady demand for the company’s products as houses are being built further and further away from existing water supplies. The long-term outlook is favorable. There is forecasted to be approximately $200 billion in domestic clean water projects over the next 20 years. In addition, there is federal legislation pending for another $60 billion over the next five years. Channel checks indicate that U.S. Pipe is the leading company in the industry, and its pipe specifications often set the standard among the industry. The threat of substitute products, such as steel, concrete and PVC, are not that high as iron pipe is considered to be the strongest and most reliable pipe material. Among the alternative materials, PVC is the most competitive, but only for the small diameter products. The threat of imports is low, as the cost of shipping large diameter pipes can be cost-prohibitive.
Recent results have been hampered with rising scrap iron and steel prices, which is the main raw material used in the manufacturing process. There is typically a 3-4 month lag in passing through cost increases; over the past 18 months, there have been 7 price increases. In 2001, the business had sales of $524 million and EBITDA of $83 million (16% margin). On an LTM basis (Sep-04), the business had sales of $523 million and EBITDA of $36 million (7% margin). However, profitability is improving significantly as the price increases ripple through the numbers. For the first 9 months of 2004, EBITDA has grown 30% year-over-year. The company feels that normalized EBITDA margins in the business will be in the high single digits to low double digits. I believe the following valuation for U.S. Pipe is extremely conservative, considering I am using trough-like LTM EBITDA numbers. As another data point, a conversation with a competitor indicated that a strategic acquirer (one of the other 3 players) could pay $450 million for this business.
Low Base High
LTM EBITDA $36 $36 $36
Multiple 5.25x 6.6x 7.25x
Valuation $187 $235 $258
Normalized EBITDA % 9% 9% 9%
Normalized EBITDA $47 $47 $47
Multiple of norm EBITDA 4x 5x 6x
JIM WALTER HOMES
Jim Walter Homes markets and supervises the construction of detached, single-family residential homes, primarily in the southeastern United States where the weather generally permits year-round construction. The construction of a typical JWH home is generally performed on customer-owned land by local building sub-contractors. This business is unique in that the value of the land typically substitutes for the cash down-payment required by most lenders (the company takes no land inventory exposure). The financing for this type of transaction is provided through the Mid-State Homes subsidiary (the financing business, described in more detail below) with no points or closing costs. The target market is the low-to-middle income customer, with a price range of homes between $50,000 and $150,000. You can think of this business as the level above the manufactured homebuilders. Recent results have suffered due to a combination of both external and internal factors. The company believes the low interest rate environment has affected demand, as their prototypical customers migrate to higher price point homes. The business also suffered systems conversion disruptions and experienced significant management turnover. The business also has a significant amount of overhead, as the company operates roughly 80 display locations with sample homes. In order for this business to make money, they need to generate a lot of volume. Management believes that they need to sell 4,000 units to break even. On an LTM basis, they sold 3,560 units and lost almost $20 mm in EBITDA. However, the recent order history in October and November has been very positive (breakeven run-rate levels), and the company believes that they will be on a breakeven run-rate by the second half of next year.
Assuming a run-rate level of 4,200 – 4,400 units (the business did 4,396 units in 2000 and 4,267 in 2002), I estimate potential EBITDA from homebuilding in the $10 mm to $15 mm range. The following is my analysis that gets me to those levels:
Break-even Units 4,000
Average Selling Price $75,000
Implied Total Costs $300 mm
% Fixed 35% (management guidance)
% Variable 65%
Fixed Costs $195 mm
Variable Costs / unit $48,750
Contr. Margin / unit $26,250
Units 4,000 4,150 4,300 4,450
Contr. Margin $105.0 $108.9 $112.9 $116.8
Fixed Costs (105.0) (105.0) (105.0) (105.0)
Op Profit 0.0 3.9 7.9 11.8
D&A 5.0 5.0 5.0 5.0
EBITDA 5.0 8.9 12.8 16.8
Don’t get me wrong. I believe this is an unattractive business, and I believe the following valuation assumptions reflect that.
Valuation
Low Base High
Run-rate EBITDA $0.0 $5.0 $15.0
Multiple 5.0x 5.0x 5.0x
Homebuilding Value $0.0 $25.0 $75.0
FINANCING BUSINESS
The financing business is operated through 2 subsidiaries, the main one being Mid-State Homes (“MSH”) and Walter Mortgage Company (“WMC”). This business purchases and services instalment notes, primarily those originated by the homebuilding business. They fund these purchases through various trusts. These trusts acquire the mortgage instalment notes using the proceeds from borrowings secured by the notes. MSH owns all of the beneficial interest in these trusts, and only the notes and MSH’s beneficial interest in the trusts secure the borrowings of these trusts (non-recourse to the Company). MSH has a $1.7 bb non-conforming mortgage portfolio, with delinquency rates of 5-6%. Delinquency rates average 650 basis points better than the FHA. Both the financing assets and the liabilities (mortgage backed securities) are fixed rate with roughly equal duration.
VALUATION
I believe this business is also unattractive, as it is levered to consumers with relatively weak credit profiles (FICO average of 580). Nevertheless, the business has historically generated stable income. For the past 4 years, net revenue (primarily interest income) has been $240 mm per year, and A/T cash operating income (after interest expense but excludes amortization of intangibles) has been $35 mm per year. The risky nature of their customer base has caused me to be very conservative with valuation multiples.
Low Base High
A/T Cash Op Income $35 $35 $35
Multiple 3x 4x 5x
Valuation $105 $140 $175
As one other data point, the 2003 10-K states that the market value of the mortgage notes was $2 bb. Backing out the non-recourse debt of $1.8 bb implies equity value of $200 mm.
SUM OF THE PARTS VALUATION
Low Base High
Coal/Gas 953 1,351 1,589
U.S. Pipe 187 235 258
Homebuilding 0 25 75
Financing 105 140 175
Corp/Other (a) (70) (70) (70)
TEV 1,175 1,680 2,026
Less: Recourse Debt - - -
Plus: Cash on B/S 48 48 48
Plus: Cash Build in 2005 169 169 169
Equity Value 1,412 1,917 2,263
$ / Share $30.82 $41.85 $49.42
% Premium to Share Price (2%) 33% 57%
(a) Includes corporate G&A and other small industrial businesses.
The cash build in 2005 number is my estimate of FCF, which is comprised of the following:
EBITDA 269
Cash interest (8)
Capex (75)
Cash taxes (a) (20)
Other 3
FCF 169
(a) Cash taxes is a rough estimate. Company has NOLs which they believe will last until the latter half of this year.
The last comment I want to make is about the management team. The management team (CEO and CFO) are formerly from Allied Signal (ex GE guys), and they simply view the company as a portfolio of businesses. They have done a very good job in the recent past of shedding non-core operations and simplifying the business. They seem to be good capital allocators, and they have a track record of using FCF for stock buybacks and dividends ($240 mm in share repurchases over the past few years).
Catalyst
Increasing awareness on Wall Street (very scant coverage)
Potential sale/spinoff of met coal business – While I cannot quantify how much the met coal business could go for in a sale to a strategic acquirer, I believe a steel producer would pay a hefty price (especially during this period where coking coal supplies are in such short supply) to lock-in coking coal production. I also believe a spin-off/split-off of the coal business would simplify the story and allow investors to better appreciate the company’s intrinsic value.
Continued share repurchases and increased dividends