Ormet Corporation ORMT
December 26, 2007 - 5:52pm EST by
ithan912
2007 2008
Price: 2.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 52 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Investment Thesis

 

Ormet Corporation (“ORMT”) is a pure play aluminum producer in Ohio that has seen its equity value drop 90% from its recent highs on liquidity concerns, frustration and what I believe to be pricing inefficiency into year end.  The company recently underwent a recapitalization and is extremely cheap compared to its peers, both on an earnings power basis as well as the replacement cost of its assets.  Not without its issues, I expect the share price to greatly benefit from one of several different scenarios over the next 12 months, as ORMT’s earnings dramatically increase due to its ramp in production coupled with a lower cost structure by the end of next year.  Pricing for aluminum has been volatile but has consistently been at or above producer’s cost per ton the last 2 years and the cycle appears to be just getting started.  As Jim Rogers put it earlier this year, “we are in the first inning of the aluminum cycle and it is one of my favorite metal plays for the next several years.”  In addition, China is now a net importer due to increasing demand and more importantly, high export taxes making it difficult for China producers to ship overseas profitably.  With Mike Tanchuk as the new CEO from Century Aluminum (the division he ran successfully for Century had 15% less production capacity than Ormet) and a new CFO from CSK Auto Jim Riley, as well as energy costs declining dramatically by end of next year, the company and its stock are uniquely positioned to benefit from strong forward pricing, substantial costs savings beginning in 2009, enhanced supply/demand equation, low street/market exposure and dramatic undervaluation. 

 

I expect 1 of 4 scenarios to play out in short order for Ormet, as the investment thesis is really having enough liquidity to get through 2008 without diluting shareholders too much to be able to realize the above investment tenets: 

 

1)      Spot LME aluminum price moves higher in 1Q given contango curve currently, allowing the company to lock in prices for 2008/2009 via a hedging program to guarantee a level of free cash flow and stock flies given inherent leverage – i.e., ORMT was $30/share in July when LME spot last hit $2800;

2)      A rights offering for $25-30mm to prevent shareholder dilution and allow the company to get through 2008 and receive back $22mm of electricity deposits, as well as restructure their power contract with AEP dropping their electricity consumption costs by 30%, resulting in $45-50mm of annual cost savings, all going to bottom line;

3)      File Ch 11 and restructure, trying to preserve equity value and stay operational, re-emerging with equity value in tact and substantially higher than $2.50/share;

4)      File Ch 11 and sell off the assets in pieces resulting in realized value less than current enterprise value, impairing equity value to less than $2.50/share.  Wachovia runs the process and it or the assigned trustee does a poor job of realizing maximum value for assets.

 

The range of outcomes is $0-40/share, and I believe the risk reward at these levels is skewed in the holder’s favor.  This is not just a call option as the company has options and light at the end of the tunnel with a defined time horizon, a key point in this mess.  This is no longer just a bet on Ormet as a producer versus the industry, nor just a bet that management can execute properly.   2008 production is sold out and the smelter is a solid facility run with a market union deal.  This is a bet that they can make it through 2008 without diluting holders too much, if at all.  I believe they can and as a result, I expect the equity to be one of the best investments for 2008 and a multi bagger.  If you don’t like leverage or are uncomfortable with the nuances of commodity businesses, this is not for you.  I believe there is minimal downside also, as the replacement cost of the assets is 3-4x the current enterprise value.  If it wasn’t for this, I would have been hesitant to post this as my first idea on VIC.

 

Caveat:  OTCBB, so pretty illiquid now and highly volatile based on tight float and leverage.  Last Thursday’s volume was the most ever and under 26% of total shares outstanding has traded since high of $32 in July through today.  Average daily volume is less than 10k shares lately, with a day here and there providing decent liquidity.

 

The Company

 

After filing for bankruptcy in January 2004 due to excessive leverage and a weak pricing environment, the company recapitalized in 2005/2006 with a $50mm rights offering and new $125mm secured credit facility.  The company only operates its Hannibal Ohio facility right now to produce primary aluminum products (blocks and billets) and its full capacity is 267k tons.  ORMT also owns an alumina smelter in Burnside, LA but given weak conditions for alumina, this facility remains idle, but represents upside if it comes online profitably again once conditions improve.  This facility is very close to the Mississippi river and gives them a cost advantage and easier access to materials.  ORMT owns this facility and worst case, could sell it for $8-10mm according to management.    It can produce 540k tons a year of alumina so if pricing improves above the $320/ton breakeven cost (pricing as of 12/19 is $360/ton) assuming $7.50 natural gas, this facility could be profitable.  Given where alumina is trading today, management is considering its options.  There very well may be something done here soon in terms of restarting the facility or selling it given managements’ comments on last week’s call.  It will take 90-100 days to restart and $6-8mm of capital.  To keep the facility mothballed is $9mm annually and the company believes it can reduce this cost to $4mm annually per the conference call.   Given tight liquidity, I don’t expect them to restart the facility unless they raise capital or aluminum prices surge to $2600/ton or better to free up free cash flow to restart the facility.   To put it in perspective, it costs as much as $1000/ton to build an alumina facility….so the $8-10mm sale price may be very conservative in a decent alumina environment for producers.

 

All other assets were sold to Aleris in 2005 while in bankruptcy for $133mm.  The company emerged on 4/1/05 and secured debtholders stayed put while unsecured received reorganized stock.  The company secured a collective bargaining agreement in Dec 06 with unions that saves roughly $20mm annually for the company.  Therefore, the company was able to restart all 6 smelter potlines and is scheduled to have all 6 up and running in the next week or so, allowing it to run at full capacity in these positive market conditions.  The 6th had been delayed for a couple of months as Jamaican alumina supply was disrupted from Hurricane Dean last month.  It is now ready to go online any day now. 

 

Importantly, ORMT will be able to renegotiate its electricity contract next year, resulting in significant cost savings.  Roughly 40% of production costs are electricity.  The wholesale energy deal ORMT has with AEP allows for $50.60/MwH today and drops to $49.50/MwH next year.  The company believes another 15-30% drop could occur in 2009 once AEP renews its industrial omnibus contract.  The 2007 GS-4 tariff rate for industrial users is $35.50/MwH, so huge savings possible here.  Assuming $40/MwH negotiated for 2009, that is $45mm in potential annual savings ($2200/ton current cost * 40% * 20% savings * 267k/annual tons of maximum capacity).   Another way to look at it, Ormet consumes 4.5mm MwH/year so $10/MwH savings is $45mm annually, or $168/ton.  This is critical to the investment thesis.

 

At $2.50/share, the company’s enterprise value is $235mm.  At current Jan 2009 forward prices (which they have yet to lock in with hedges), the company could runrate over $120mm of annual EBITDA by early 2009 (pre pension/VEBA payments) and a corresponding $4.30/share in CASH EPS.  Alcan was just bought at over 9x EV/08EBITDA.  Clearly there is dramatic upside to ORMT equity if they come close to this EBITDA and EPS estimate.  Alcan, Aleris (ARS) & Novelis (NVL) were all recently acquired at substantial premiums…is ORMT next?  It will need to be deemed a full production, profitable and labor friendly facility before maximum value is assigned, but at these recent acquisition multiples, I believe the company could fetch greater than $30/share by the middle of 2009.  This may sound ridiculous given current levels, but the multiples support such a scenario and the stock was in the low $30s a few months ago, before 25% of shares outstanding crushed it to today’s levels and year end tax loss selling/liquidity concerns are hurting the price today.  At first I would say hedge with LME spot or comp stocks like CENX, but at this level and given the embedded leverage, it is not a proper hedge.  However, Kaiser (KALU) and Century (CENX), both of which are trading at over 7-8x EV/08 EBITDA and always the bellwether, Alcoa (AA), are good comps to follow.   By 2009, each turn of EBITDA added to valuation is worth $6/share for ORMT shareholders. 

 

Once fully online, the OH facility can produce 267k tons of aluminum annually.   The current cost per ton is $2200 but expects to fall to $2050 by early 2009, assuming the above 20% electricity savings per MwH.  Although a bit higher, this is more inline with Kaiser and Century’s cost/ton, ridding of ORMT’s label as a marginal cost producer.  Although spot prices are at $2415/ton as of tonight’s (12/26) close, the forward curve (15 months and out) is still near $2600/ton.  At current $2555/ton forecast for 12/08, the company could produce greater than $120mm of runrate annual EBITDA (($505/ton *267k tons) - $15mm SG&A) at 100% capacity beginning in 2009.  It is prudent to be conservative in this assumption but $500/ton plus profit seems reasonable for 2009-10 to adjust for unforeseen cost, potline disruptions or sudden inventory build.  This price assumption for 2009 may also be conservative given industry pundits’ expectations…see below.

 

Aluminum pricing and market conditions

 

The current market conditions are much more stable and positive for the industry given stable capacity growth and strong pricing for aluminum as demand from Asia and the global commercial construction boom continue to be robust.  The secular growth trend in aluminum content for the auto industry shows no signs of abating.  In 1978, the average light vehicle in North America contained 100lbs of aluminum.  Last year, it had 320lbs.  This continues to be driven by technology and demand for light, durable metals to better compete with foreign car makers.  According to Ormet, the demand for aluminum just from the Midwest region of the US is outstripping supply and allows them to charge spot and sometime spot+ for its products.  Glencore bought out its 2007 production (also a major shareholder in Century Aluminum CENX) and I imagine is a big customer for 2008 as well.   I don’t have the industry expertise to gauge future pricing so I rely on people who do.  www.aluminumviews.com is a great website run by Harbor Intelligence and it is all things aluminum.  They have dozens of recent articles and industry commentary supporting strong pricing going forward due to the above.  Morgan Stanley among others believes the recent dip in spot prices is short term and spot prices will rally above $2700/ton next year.  That would be a very welcome occurrence for ORMT and give them the opportunity to hedge forward sales and lock in a 2x runrate EBITDA multiple for the equity.  The spring/summer inventory build is being worked off and LME inventory levels are falling slowly.  In addition the forward curve supports much higher prices than current spot prices of $2415/ton, http://www.lme.co.uk/aluminium.asp

 

Given most high cost smelters in Europe were closed in the last downturn, it could be a few years before any of these are back online in production.  Alcoa plant in Trinidad for 314k tones capacity is the only known plant near completion.  The US produced 220k tons of aluminum in August, which is an annual rate of 2.59mm.  Ormet at full capacity should take this to 2.65mm tons and Ormet would represent 9-10% of production.  Alcan on 7/31 said 2007 global use of aluminum will be up 10% year over year, thanks to global infrastructure needs and Alcoa forecasted last quarter a “balanced at best” scenario for the supply/demand situation in 2008.  Ormet stated on last week’s call that 6 of Ormet’s Hannibal plants would need to be built each year to keep up with demand, that is over 1.5mm tones annually…

 

Everyone follows China’s production and how it will affect the market.  The good news for current pricing and the foreseeable future is the high export taxes (raised to 15% in January) in China as well as the recent end of energy subsidies for aluminum producers should limit the damage to pricing if new supply hits the market from China as it will mainly be for China needs.  The US is strong enough to absorb all of Ormet’s supply and without China supply flooding western markets, pricing should stay strong.  In fact, China is now currently running as a net importer of aluminum as China output fell in both November and December.

 

But pricing is a critical assumption obviously for any pure play commodity company and each reader should do his or her own analysis.  If steel pricing was to fall dramatically, that would clearly effect aluminum pricing as steel could be used as a substitute, as could plastic (PET).  Given ORMT’s valuation, which is well below the replacement cost of its assets (see Valuation section below), we are more than being compensated for taking aluminum pricing risk and this is core to my thesis. 

 

D&A and Capex

 

D&A is expected to be $14mm annually.  Capex for 2007 will be $20mm and $18mm going forward.  20% of the 1032 pots across the 6 potlines will need to be replaced annually and each pot costs $75k, requiring $15mm of annual capex, plus $3mm for other expenditures. 

 

Net Debt, Pensions and NOLs

 

ORMT has $5.4mm in cash and $123.5mm in debt, consisting of $74.4mm revolver balance, $14.4mm term loan and the recent convert of $35mm.  The recent convert was done in a perfect storm for the company and was not well received by shareholders, which is an understatement.  ORMT needed to raise liquidity in a very short time frame as:

 

  • aluminum was falling (LME spot fell from $2800 to $2300 from July to Sept);
  • ORMT tripped its EBITDA covenant as a result (having such a strict EBITDA covenant for what is pretty much a commodity startup is a bit odd);
  • didn’t receive the $30mm reserve adjustment against their revolver availability.  Ormet received a waiver from the IRS on 8/23/07 in regards to the $33.8mm 2006 pension payment due, as it is now allowed to pay this over 5 years beginning in 2007.  ORMT started paying the new pay structure in July but the lenders have yet to adjust the $30mm reserve it placed on the revolver from this $33.8mm waiver as the intercreditor and pension lien documentation has not been completed.  The company expected this by mid October so not getting this waiver placed some additional liquidity constraints on it.

 

The stock has fallen precipitously since the convert issuance.  It was sold to most likely 1-2 stockholders who stepped in opportunistically to help the company.  It is convertible into 2.333mm shares with $15/share strike and the buyers also got 2.333mm warrants immediately vested at $3/share strike.  The stock was $17.50/share on 11/2 when they announced the convert.  OUCH.

 

The company has an underfunded pension of roughly $120mm as of 12/31/06.  Contributions are tax deductible and as mentioned above, it just received a waiver to allow it to amortize a $33.8mm 06 payment due over 5 years.  $22.5mm has been paid for 2007 already and pension payments going forward to get caught up are expected to be $36.3mm in 08, $35.7mm in 09, $28.8mm in 2010 and $23.1mm in 2011.  These payments include the normal annual pension contributions of $4-5mm per year, which are included in SG&A.

 

Also, ORMT has a $68mm VEBA trust and it pays $6-8mm per year towards that trust through 2018.  If you tax effect the $120mm underfunded pension contributions above (just the underfunded portion of each payment – I assumed $5mm less per annum than the above payment schedule) and the VEBA trust as well, using a 8% discount rate and 40% tax rate, their respective NPVs are roughly $53mm (only did 2008-2012 as the $22.5mm in 2007 has already been paid) and $27mm.  Add them to the $111mm of net debt and there is $191mm of total net debt.  I think this is the best and most conservative way to calculate the debt.  ORMT will need to pay down the revolver and negotiate with convert holders before it is in a position to be flexible with excess capital. 

 

In addition, ORMT has $60mm in NOLs as of 9/30/07 that should be used up by the end of 2009 given my assumptions for income and the $20-30mm annual limitation based on Section 382 as there was a change of control upon emergence.

 

As of the conference call, the company has $5mm in cash and is tapped out on lines of credit and its revolver.  At $2415/ton, it is basically breaking even but wants and needs more wiggle room.  It is trying to cut costs such as the Burnside facility carrying cost, push out its 2008 VEBA contribution and considering other ways to raise capital if needed, without suffering further equity dilution.  THIS IS THE PRIMARY RISK.

 

Valuation (earnings and balance sheet data as of 9/30/07, unless noted)

 

Shares out – 20.833MM as of 12/19/07 (includes 2.33mm $3 warrants but not the convert stock or out of the money employee option pool)

Current price - $2.5/share

Market Cap – $52.1MM

 

Net debt - $191mm ($88.5mm of term loan and revolver, $35mm of convertible sub notes, $80mm of NPV of pension/VEBA obligations minus $5.4mm of cash and $7mm of option proceeds) – this is as of conference call date 12/19/07.

Non-core assets - $8MM (assumes Alumina facility is sold rather than restarted)

Enterprise Value - $235.1MM

 

 

2008 ESTIMATES

2008 Revenue $654mm, EBITDA $52mm and cash EPS = $1.34/share

 

EV/ 08 EBITDA = 4.5x, 2008 P/E = 1.9x, FCF = $4.5mm and FCF yield = 8.6%

 

Assumptions:

  • Facility is running near 80% now and management expects 100% by year end.
  • 267k tons sold at $250/ton margin ($2450 08 pricing – $2200 cost/ton).  Giving no credit for Midwest market tightening again, which may allow them to sell at premium to spot ($50-100/ton), nor some energy and vendor concessions that may happen early than expected, or spot prices moving higher as most expect.
  • $15mm of SG&A (includes normal quarterly pension payments, 11 corporate employees).
  • $18mm of capex, $14mm of D&A, $10mm of interest expense, $17.5mm extraordinary pension payment ($22.5mm paid minus $5mm normal payment) and no tax due to NOLs.
  • The $7.5mm VEBA trust payment is deferred to 2009.  This is apparently close to being agreed to and completed per last week’s conference call.
  • Don’t need to raise additional equity.

 

Net Income = $52mm EBITDA-$14mm D&A-$10mm interest exp-$0 tax=$28mm

 

FCF =$28mm of NI + $14mm D&A - $20mm of capex - $17.5mm pension payment=$4.5mm

 

2009 ESTIMATES

2009 Revenue $680mm, EBITDA $123mm and EPS of $4.37/share

 

EV/EBITDA = 1.9x, P/E = 0.57x, FCF = $41mm and FCF Yield = 78.7%

 

Assumptions:

  • 100% of production sold
  • 267k tons sold at $515/ton margin ($2550 09 pricing – $2035 cost/ton).  Forward curve for 09 is at $2600/ton so this leaves room.  Giving no credit for Midwest market tightening again, which may allow them to sell at premium to spot ($50-100/ton)
  • Electricity contract is restructured for at $40/MwH, saving $45mm pretax.  Could be as low as $36/MwH, but $40/MwH is conservative.
  • $15mm of SG&A.
  • $28mm of capex, $14mm of D&A, $8mm of interest expense and no taxes due to NOLs and tax deductibility of extraordinary pension & VEBA contributions.
  • $31.3mm of extraordinary pension contribution ($36.3mm payment expected minus $5mm already included in SG&A) & $15mm of VEBA payments (2008 & 2009 payments as 08 deferred). 
  • Again assumes no dilution.

Net Income = $123mm EBITDA - $14mm D&A - $8mm interest exp - $10mm tax ($101mm pretax income – $31.3mm pension - $15mm VEBA - $30mm NOL annual limitation * 40%)=$91mm

 

FCF =$91mm of NI + $14mm D&A - $18mm of capex - $31.3mm pension - $15mm VEBA=$41mm

 

This again assumes no dilution, no asset sales and no additional debt financing raised.  These assumptions may seem aggressive but rather than guesstimate what may occur, I wanted to illustrate that the above earnings power is real and the inherent leverage in the equity if the market is wrong.  The stock appears to be priced very inefficiently given this upside and the uncertainty surrounding the company’s liquidity situation. 

 

NOTE   Prospective investors need to look at the replacement costs of these aluminum smelter assets.  It should be noted that recent announcements to build aluminum smelters are at cost estimates of between $3000/ton for the planned China plant in Iran and $7000/ton for recently announced plans for a 1mm ton plant in Russia.  Replacement cost of a US based 267k ton aluminum smelter is estimated to be as high as $4000/ton, or over $1BB.  This provides tremendous asset support for the ORMT equity given a $235mm current enterprise value.  Of course they wouldn’t receive $4000/ton in a distressed auction, but there is a margin of safety here that does make me ponder a “better dead than alive” scenario!

 

PEER GROUP COMPARISON

Per the table below, comps trade at an average of 14x 08 EPS and 13x 09 EPS, as well as 7.6x EV/08 EBITDA and 7.0x EV/09 EBITDA, but their businesses are not ramping like ORMT so ORMT should really be valued on 2009 #s when costs are normalized.  Given the volatility in spot prices and cyclical nature of the business, you could hedge by shorting LME aluminum out on the curve or CENX.  Hopefully the company will short aluminum at the right prices and find it prudent to do that for us.  They have not yet but on last week’s conference call it was addressed and they seem very aware of the benefits, versus market timing.  I believe they will start hedging above as low as $2500-2500/ton. 


But if you believe we are in the early innings of the cycle and don’t wish to hedge, I don’t see any cheaper pure play alternative on aluminum than ORMT, even with the liquidity risks considered.  Please see below comp chart. 

 
12/26 Closing LTM EV/LTM Est Est 08E 08E EV/ Est Est 09E 09E EV/
Company Name Symbol Price Shares Mkt Cap Net Debt TEV LTM Rev EBITDA EBITDA Margin 08E EPS 08E P/E EBITDA EBITDA 09E EPS 09E P/E EBITDA EBITDA
Alcan AL  $                  101.00 372.474  $  37,619.87  $  5,600.00  $  43,219.87  $  24,500.00  $  4,300.00 10.05 17.6%  $         6.04 16.72  $  4,492.00 9.62  $         6.06 16.67  $  4,500.00 9.60
Alcoa AA  $                    37.41 884.034  $   33,071.71  $  6,900.00  $   39,971.71  $    31,170.00  $   5,700.00 7.01 18.3%  $         3.29 11.38  $  6,253.00 6.39  $          3.31 11.30  $  5,987.00 6.68
Century Alum CENX  $                   54.69 41  $  2,242.29  $      700.00  $   2,942.29  $     1,660.00  $      441.00 6.67 26.6%  $           5.51 9.93  $     430.00 6.84  $         4.73 11.56  $      537.00 5.48
Kaiser Alum KALU  $                   80.58 20.575  $    1,657.93  $               -    $     1,657.93  $      1,410.00  $      100.00 16.58 7.1%  $         4.52 17.83  $      198.00 8.37  $         5.30 15.20  $      219.00 7.57
MEDIAN 8.53 14.05 7.61 13.38 7.12
Ormet ORMT  $                      2.50 20.8333  $         52.08  $      183.00  $       235.08 N/M N/M N/M N/M  $          1.34 1.87  $        52.00 4.52  $         4.37 53.79  $      123.00 1.91
Equivalent  $   18.83  $   10.21 Equivalent  $   58.48  $   33.27
Upside 653.1% 308.2% Upside 2239.4% 1230.9%
 
RISKS
  • Aluminum prices fall to prevent profitability. 
  • Need to raise capital if they don’t get waiver from lenders, or are unable to cut costs quick enough.
  • Potential high earnings volatility given no hedging of future pricing (yet).
  • Power contract does not result in savings as expected, or as soon as expected.
  • Liquidity – currently trades 10-20k shares/day or less than $500k/day. 
  • Carbon annode costs rise in 2008 more than forecast, hurting margins.

Catalyst

- Aluminum prices rise as expected, giving company free cash flow ability and relieving liquidity constraints
- Get waiver from lenders in regards to $30mm lien on revolver from pension contributions
- Sell Burnside for $8mm+ to raise liquidity
- With all 6 potlines online and Hannibal running at full capacity, the company may be able to sell itself for a substantial premium to current enterprise value, even with a Ch 11 filing or additional dilution
- Electricity deal is done before Dec 2008, providing substantial cost savings
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