WESCAST INDUSTRIES -CL A WCS.A
April 07, 2010 - 12:31pm EST by
round291
2010 2011
Price: 4.45 EPS -$1.67 $0.00
Shares Out. (in M): 13 P/E NM 0.0x
Market Cap (in $M): 59 P/FCF NM 0.0x
Net Debt (in $M): -2 EBIT 11 0
TEV ($): 57 TEV/EBIT 5.2x 0.0x

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Description

All monetary values are presented in Canadian Dollars. The exchange rate as of April 5, 2010 was .99751 CAD per USD.

Wescast (TSE: WSC.A) is a survivor in an industry that has been known for eating its young. Moreover, its survival has been secured despite the rinse-and-wash bankruptcy of two of the company's largest customers and, through it all, has managed to sustain investments in new product lines and lower cost capacity, each of which uniquely position Wescast to achieve renewed success in the future.

Wescast designs, casts, machines, and assembles exhaust systems for automobile OEM's and Tier 1 customers for cars and light truck markets in North America, Europe, and Asia. Primary products include cast exhaust manifolds and turbine housing components for turbochargers. Recently the company entered the integrated turbo-manifold and stainless steel exhaust manifold and turbine housing markets (stainless steel better withstands high temperatures associated with high performing and often smaller engines). Shipments into these markets are expected to benefit from trends in engine sizes and increasing adoption of turbocharger technology.

The company serves customers from production facilities located on three continents. Its five legacy facilities are located in Ontario, Canada and Sterling Heights, Michigan. European operations are based in Hungary and launched commercial production in 2003. Asian operations are based in Wuhan, China and began commercial operations in 2008. This facility continues to secure new customers and to ramp up. This broad geographic footprint is expected to enhance customer service (reduce delivery times, speed product design and testing), help diversify its customer base,  and counter a trend, pronounced among the Detroit Three, of component price testing mid-program. It is this trend that largely explains the company's decision to cede unprofitable business and modest market share in North America around 2005 (see below; share loss in 2009 also a function of brand realignment efforts at GM and Chrysler). With lower cost capacity in China the company is better positioned to both maintain share and profitability. 

There are two classes of shares outstanding, as presented: 

 

Shares Outstanding

Economic Interest

Voting Interest

Class A (subordinate voting)

5,841,221

44.2%

13.7%

Class B

7,376,607

55.8%

86.3%

Total

13,217,828

100%

100%

The Class A shares trade on the TSE and closed on 4/5/2010 at $4.45 (shares traded at $5 this morning, 4/7/2010). On outstanding shares the market equity capitalization is roundly $58.8 million. Net cash totaled $1.6 million at year end (12/31/09), and the enterprise value is approximately $57.2 million. The company has lost money in four of the past five years so earnings and EV multiples aren't particularly meaningful. Book value totaled $$214.7 million and the company trades at a measly 27% of book and at 28% of sales. Aside from trade related liabilities and less than $6 million in funded debt the company has approximately $26 million in employee benefit related liabilities. Plant, property and equipment amount to 67% of total assets, with trade and tax related assets representing the balance.

Shares have a 52 week range of $0.64 - $4.65. Solvency fears were pronounced during the period leading up to the GM and Chrysler bankruptcies, driving the shares to their low. Additionally the company had a maturing credit facility in 2009 and uncertainties regarding its renewal prompted some shareholders to flee. The new facility had a one year term and was due to expire on 4/19/2010. On  4/6/2010 it was announced that a two year renewal had been negotiated with Toronto Dominion and the Export Development Canada.

During Q4 2009 the company turned the corner on profitability, generating $0.15 per share. This turn was the result of an aggressive, multi-year facility restructuring and a recent pick-up in orders across the board.

I think Wescast is an attractive buy and has the potential to produce returns on the order of several hundred percent over the next 2-3 years driven by a further rebound in casting and machining volumes, improving relations with and a lesser reliance upon the Detroit Three (i.e. less emphasis on market testing mid-program), the ramp up of the Wuhan facility, and a richer product mix due to increasing market acceptance of newer and likely higher margin product offerings. Getting to book value, currently $16.24, would be quite nice and is a clear possibility given current business profitability trends and the market backdrop.

SALES AND MARKET SHARE TRENDS

The following table illustrates key trends, by region, in sales and market share and in gross margins:

(C$ millions)

2003

2004

2005

2006

2007

2008

2009

Total Revenue

         434.2

         408.9

         381.7

         371.0

         386.6

         302.0

         208.3

Gross Margin

         128.0

           94.5

           50.7

           43.1

           44.3

             1.1

             5.9

 

 

 

 

 

 

 

 

Revenue Growth

NA

-5.8%

-6.7%

-2.8%

4.2%

-21.9%

-31.0%

Gross Margin %

29.5%

23.1%

13.3%

11.6%

11.5%

0.4%

2.8%

 

 

 

 

 

 

 

 

% of Total Revenue

 

 

 

 

 

 

 

North America

92%

95%

87%

80%

75%

68%

60%

Europe

8%

5%

13%

20%

25%

32%

36%

Asia

0%

0%

0%

0%

0%

0%

4%

 

 

 

 

 

 

 

 

Exhaust Manifold Market Share

 

 

 

 

 

 

 

North America

55%

55%

50%

50%

51%

50%

41%

Europe

NA

NA

6%

10%

14%

14%

12%

Asia

0%

0%

0%

0%

0%

< 1%

4%

A key takeaway is the significant decline in gross margins during the 2003-2008 periods despite modest unit market share loss in North America and growing share in Europe. Driving this trend is price erosion, largely as a result of the Detroit Three's intensification of its mid-program market testing initiative. Raw materials cost increases also contributed to margin decline (scrap steel and molybdenum; see Annual Information Statement, pg 11 for a graphic representation of price trends) as did losses in Europe and start up costs at Wuhan (specifically in 2008).

Management comments on price-testing as follow:

"Historically, a customer awarded a supplier with the commercial production requirements for a product related to a specific engine program. Assuming delivery, quality, and other performance criteria were maintained, the supplier would retain and supply the product over the life of the engine program. Customers now routinely market test their purchasing requirements globally, and throughout the life of the engine program, to ensure they are continuing to receive globally competitive pricing. This accelerates the timeframe over which the Company's current business can be impacted by global competition, including the Company's ability to recover capital invested."

As mentioned, in the face of this price erosion Wescast management chose to cede modest market share through 2008, restructure manufacturing, invest in lower cost capacity in China, and develop and launch of new products. A highlight of accomplishments includes:

  • Reduction in SG&A from $34.0 (7.8% of revenue) million to $16.7 mm (8.0%)
  • Establishment of a geographic business unit structure with full P/L responsibility and operational accountability in 2005
  • Closure of Brantford, Ontario foundry in 2006, resulting in restructuring charges of $38.3 million in the 2005 fiscal year
  • Closure of Wingham North Huron foundry in 2009, resulting in restructuring costs of $72.7 million in the 2008 fiscal year and an additional charge of $1.8 million in 2009 (at year end a restructuring balance $6.4 million remained to be utilized)
  • Initial shipments of stainless steel exhaust manifolds from a dedicated facility in 2009

The need for further restructuring actions is uncertain at this time. Management has not held a conference call in several quarters and there has been no shareholder communication on the matter. In my assessment, the more costly restructuring actions have been taken. Wescast has two machining, one foundry, and a stainless steel development facility in Ontario. It also has a small machining facility in Michigan and, of course, very promising integrated casting and machining facilities in Hungary and China. I'd guess that the machining operation in MI may become vulnerable, as more volume is transferred to China.

THE PRODUCT - A CRITICAL COMPONENT OF THE MODERN COMBUSTION ENGINE

The exhaust manifold is an absolutely critical combustion engine component as it impacts fuel efficiency, output horsepower, the effectiveness of the catalytic converter, environmental emissions and engine sound. However, there are several materials and/or processes that can be utilized to manufacture a manifold. Additionally, fuel cell technology does not require a manifold. Mass market acceptance of this technology poses a threat to Wescast.

The primary product categories that compete against cast manifolds in the combustion engine include fabricated manifolds and non-manifold or integrated systems. A fabricated manifold is essential bent and welded tubular metal. Non-manifold or integrated systems incorporate the manifold into the cylinder head of the engine as a single, water cooled assembly. Trends in North American shares of these categories are as follows: 

North America Category Shares

2006

2007

2008

2009

Cast Manifold

76%

72%

58%

60%

 

 

 

 

 

Fabricated

NA

NA

29%

28%

Non-Manifold/Integrated

NA

NA

13%

12%

Total Non-Cast

24%

28%

42%

40%

Wescast recently entered the fabricated category with its stainless steel offerings. Customer shipments were started in 2009.

The European market is larger than NA, is less concentrated and features a larger share of fabricated offerings. Wescast is gaining share with its cast offerings and expects to benefit from the markets emphasis on smaller turbocharged engines. The Annual Information Statement provides projections for global turbocharger volumes that indicate a doubling in demand for turbochargers by 2016. Turbo charger housing and integrated turbo-manifolds will find a market there.

A NEW DAY IN SUPPLIER RELATIONS?

Supplier relations have been abysmal for some time, particularly with the Detroit Three. But chinks in the armor are starting to appear as General Motors CEO appoints new management in procurement, realigns incentives and structure, and generally softens its tone.

Please feel free to review these links for more detail on the changes afoot. I believe that Wescast is well positioned against an emerging emphasis at GM on global procurement and closer collaboration on product development. And trends at GM seem to make their way across the industry.

Supplier Working Relations Index

http://www.autolinedetroit.tv/journal-wp-content//uploads/2009/05/2009-wri-news-release-09-25-092.pdf

Whitacare's early management changes

http://wardsauto.com/ar/gm_whitacre_move_091204/

Thomas G. Stephens, who remains vice chairman-Global Product Operations, adds global purchasing to his organization. Robert E. Socia, vice president-global purchasing and supply chain, now will report to Stephens. The move to combine purchasing with product development reflects the changing nature of procurement, Wilkinson says.

"It's no longer about beating up suppliers to get the best price," he says. "It's more about cultivating suppliers and getting the next great technology."

Bob Socia's new approach

http://www.freep.com/article/20100328/COL06/3280541/1012/NEWS10/GM-supply-chief-softens-approach-to-parts-firms

Socia did a lot of listening to suppliers. He brought GM's engineering bosses into the conversations. Soon, he started acting on what he'd heard.

Suppliers had cash-flow problems. Socia cooked up a plan to pay them weekly instead of monthly. Suppliers griped that GM asked for ideas about how to cut costs, but then kept almost all the savings for itself. Socia changed the formula to share savings on a 50-50 basis. And now, Socia is including GM's scores on independent supplier surveys as part of performance reviews for his purchasing staff.

FINANCIAL FOOTPRINT

Wescast has a recent history of losses driven by product pricing pressures. Management decided to restructure operations and invest responsibly through this challenging period and is better positioned competitively as a result. 

 

(C$ millions)

2005

2006

2007

2008

2009

 

Q4 2009

Q4 2008

 Total Revenue

         381.7

         371.0

         386.6

         302.0

       208.3

 

           64.0

           62.2

 Cost of Revenue

         331.0

         327.9

         342.3

         300.9

       202.4

 

           56.2

           68.6

 Gross Profit

           50.7

           43.1

           44.3

             1.1

           5.9

 

             7.8

            (6.3)

 SG&A

           27.7

           28.5

           27.8

           19.5

         16.8

 

             3.6

             4.3

 R&D

             5.7

             6.5

             7.6

             7.3

           3.7

 

             1.0

             1.0

 Operating Income

           17.3

             8.1

             8.9

          (25.6)

       (14.6)

 

             3.3

          (11.7)

 Unusual Expense (Income)

           38.3

               -  

               -  

           72.7

           1.8

 

             0.3

           70.1

 Operating Income, After Rest.

          (21.0)

             8.1

             8.9

          (98.3)

       (16.4)

 

             3.0

          (81.8)

 Income Before Tax

          (27.1)

             8.3

             4.3

        (100.0)

       (21.4)

 

             1.7

          (82.7)

 Income After Tax

          (21.7)

             4.9

          (11.6)

        (110.7)

       (22.0)

 

             2.0

          (95.7)

 

 

 

 

 

 

 

 

 

 Depreciation/Depletion

           38.8

           38.0

           33.2

           34.5

         25.6

 

 

 

 Deferred Taxes

            (6.8)

             3.0

             4.1

           15.6

           2.7

 

 

 

 Non-Cash Items

           30.4

             1.7

             9.9

           65.9

           2.2

 

 

 

 Changes in Working Capital

             1.1

           17.3

           12.5

            (9.3)

         (4.7)

 

 

 

 Cash from Operating Activities

           41.9

           64.9

           48.0

            (4.1)

           3.7

 

 

 

 Capital Expenditures

          (22.2)

          (28.5)

          (46.5)

          (10.2)

         (9.3)

 

 

 

 Free Cash Flow

           19.7

           36.4

             1.4

          (14.3)

         (5.5)

 

 

 

 

 

 

 

 

 

 

 

 

 Total Assets

         457.1

         445.0

         444.4

         326.4

       282.2

 

 

 

 Total Debt

           34.0

             6.5

             5.8

             4.7

           5.9

 

 

 

 Total Equity

354.9

368.4

347.7

253.9

214.7

 

 

 

 

 

 

 

 

 

 

 

 

% of Sales Analysis

 

 

 

 

 

 

 

 

 Gross Profit

13.3%

11.6%

11.5%

0.4%

2.8%

 

12.2%

-10.2%

 SG&A

7.3%

7.7%

7.2%

6.5%

8.0%

 

5.6%

6.9%

 R&D

1.5%

1.7%

2.0%

2.4%

1.8%

 

1.5%

1.6%

 Operating Income

4.5%

2.2%

2.3%

-8.5%

-7.0%

 

5.1%

-18.7%

I have no projections to offer as to profits and cash flow in the coming years. Instead I point the success the company has had to date in restructuring its operation, the clear rebound in units of light trucks and cars manufactured globally manufacturing, the company's enhanced product portfolio, its launch of low cost manufacturing in China and, most importantly, its absolutely cheap price.

OWNERSHIP

The LeVan family controls Wescast through its ownership of 100% of the super voting Class B shares representing 86% of the voting and 56% of the economic interest. Major Class A shareholders, according to the most recent information I could find is as follows:

                               

 

Class A Shares

Economic Interest

Voting Interest

 

Edward Kernaghan

1,396,300

24.9%

3.3%

8/2008

Brandes Investment Partners

846,632

14.6%

2.0%

6/2009

Pursuant to the LeVan Voting Agreement, all Class B shares must be voted by their respective holders in accordance with the directions of the holders of a majority of the Class B shares.

The current CEO, Ed Frackowiak is related to the LeVan family through marriage. I know of no relationship between Kernaghan and the LeVan family.

Float is limited with 95.3% of the economic interest in the hands of the LeVan family, Kernaghan and Brandes. Nonetheless, year to date over 350,000 shares have changed hands representing 6% of Class A shares outstanding.

MANAGEMENT

Management appears to be competent and reasonably compensated with limited stock options and such.

RISKS

  1. Continuous restructuring activities and charges
  2. Rapid electric and fuel cell vehicle demand growth
  3. A rapid secular shift away from the usage of cast manifolds in the combustion engine
  4. Problems ramping up the Wuhan facility
  5. A take-under by the LeVan family

 

Catalyst

Continued ramp in North American and global automobile production

Ramp in production at new Wuhan, China facility

Success attacking turbocharger, and stainless steel manifold market opportunities

Continued profitability (even modest profitability is a huge plus)

Analyst coverage

Re-initiation of communications with public and shareholders

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