Description

I wish Dan Loeb would stop dinking around with SFBC International and take a 5% position in WPSC. He could turn $6mm into $18mm by June of 2006 by forcing a sale of the company.

OVERVIEW
Wheeling-Pittsburg Corporation is a U.S. producer of finished, flat-rolled steel products (the expensive stuff) with both blast furnaces and a state-of-the-art electric arc furnace that can burn either scrap or liquid iron. This should allow WPSC to arbitrage on the raw materials side of the equation. WPSC also owns its own coke batteries and will be upgrading its capacity through a joint venture with Severstal – this should allow it to continue to self-supply coke and generate a saleable surplus. WPSC is also completing a state-of-the-art finishing facility that will allow it cold roll more metal than it can currently heat (the highest margin segment of the domestic steel industry). By the time WPSC gets it act together in Q1 2006, it will have 2,900,000 tons of annual slab production capacity and over 3,000,000 tons of finishing capacity making it the 6th largest domestic steel manufacturer, and an ideal take-over target.

WPSC is run by the bad news bears of steel management that has earned the distinction of being the only steel company in the country to lose money in 2004. They managed to pull this off by: (1) having a duct work collapse in the beginning of the year that shut down their integrated furnace, (2) having trouble ramping up their new electric-arc furnace that is, I believe, the largest in the country, (3) having to purchase coal on the spot market at astronomical prices because of a contract dispute with Massey, and (4) the general market squeeze in Q2-Q3 caused by lower prices and higher raw materials prices (coal, natural gas, ore) … at least ¼ of the problems were systemic.

INVESTMENT THESIS
A sum of the parts analysis reveals that WPSC is worth many multiples of its share price on conservative valuations for market value of manufacturing capacity plus several other tangible and intangible assets. For purposes of this write-up, I will omit all the gory historical and pro-forma financial statements and address both income statement and balance sheet issues with a few more general comments.

Sum-of-the-parts
The sum of the parts includes the following (details to follow):

Assets:

Low High
Slab/Finishing Capacity $750mm $1,200mm
Insurance Claim $20mm $40mm
Massey Lawsuit $20mm $90mm
Cash Value of NOLS $65mm $80mm
Other $0mm $100mm
Total: $855mm $1,425mm

Liabilities:

Existing Debt: $322mm $322mm
Pension/OPEB $134mm $134mm
Total: $456mm $456mm

Value of Equity $400mm $800mm
Shares Outstanding 25mm 15mm
Value per share $16/share $50/share

Slab/Finishing Capacity: WPSC has 2,900,000 tons of slab capacity and over 3,100,000 of finishing capacity (based on completion of Q4 2005 finishing capacity expansion and Q1 2006 completion of Electric Arc Furnace (EAF) ramp-up. WPSC’s average selling price in Q3 2005 was $623/ton due to its high quality ultra-thin, cold rolled, and galvanized steel while generic hot-rolled steel sold for only $432/ton.

For a low-end market comp, I chose the purchase of Roanoke Electric Steel Corporation (RESC) by Steel Dynamics. RESC did not file a Q3 10-Q because it was acquired before the deadline, but it produces the lowest end products including re-bar and rod making its selling price much closer to the $432/ton, and during Q2 when pricing was better it earned about $500/ton. The transaction was for $237mm plus assumption of liabilities making for a total EV of about $279mm. RESC’s 1,100,000 tons value the capacity at about $250/ton. The RESC transaction was consummated on 10/18/2005 at the trough of sector valuations which have since rallied over 30%.

For a high-end market comp, I selected $400/ton of capacity. This is significantly below the US steel valuation of $420/ton after backing out $2,500mm for the value of its captive iron ore (estimate of value by Goldman Sachs) and even AK steel (most hated company in the sector other than WPSC) when its pension/OPEB liabilities are considered.

Insurance Claim: WPSC has claimed both property damage and business interruption losses resulting from the ductwork collapse last year. The property damage claim of $9mm was paid in two installments, $4mm in Q3 and another $5mm in the last month. The company also has a business interruption claim in excess of $40mm that is currently being negotiated. The most recent S-3 seems to indicate that the negotiation is about “how much” rather than “if any.”

Massey Lawsuit: On April 27, 2005, WPSC filed a lawsuit against Massey Energy alleging that Massey breached its long-term supply agreement to WPSC beginning in 2003 and continuing until the present causing WPSC to, among other things, have to purchase coal on the spot market at prices far above its contract price. Several rounds of sparring related to the assignment of this contract from WPSC’s predecessor company to WPSC and from WPSC to the WPSC/Severstal coke plant JV, SNA Carbon (more later), have already occurred with WPSC winning every one. A trial is set for July, 2006 and discovery is ongoing. The value of this lawsuit is in excess of $90mm. Given how far it has progressed, I find it hard to believe WPSC would settle it for less than $20mm and that Massey would jump at that number.

Cash value of NOLs: WPSC ended 2003 with over $280mm of operating losses that transferred to the successor company. These NOLs could not be transferred to an acquirer if WPSC was bought within two years of its exit from bankruptcy (August 2003). This period is now over and WPSC’s NOLs can be used by an acquirer. WPSC earned over $80mm in 2004, but will lose $20mm in 2005 so I estimate the NOLs are about $220mm, or about $80mm cash value.

Other Assets: These assets are not necessary to make the WPSC case and are harder to value, but are worth listing: (1) Owned facilities. WPSC owns most of its facilities and land – granted the facilities are in places like West Virginia, (2) SNA Carbon JV with Severstal to rehabilitate all of WPSC’s coke batteries. WPSC is already self-sufficient in coke and even sells some on the open market. This JV will invest over $150mm into the coke batteries with WPSC picking up less than $20mm and owning 50% of the output plus a management contract, (3) Excess finishing capacity. WPSC is finishing a 350,000 ton finishing plant upgrade. Competitors who only finish steel are making $100/ton with this activity or $35mm per year to WPSC if it can get comparable results.


INCOME STATEMENT
WPSC earned 98mm of operating income in 2004 on 2,100,000 tons of steel, or $50/ton. This was including a period in December where there was no production due to the duct work collapse mentioned above and also included the coal supply problems. During this period, the EAF, 2,500,000 tons of capacity was only operating at 50% output with full depreciation and staffing. WPSC is going to lose about $20mm in 2005. WPSC should easily earn $30-$40/ton going forward after the EAF ramp-up. On 3,000,000 tons, this equates to about $100mm of operating income per year.

BALANCE SHEET
WPSC does have a significant amount of debt, estimated at $322mm by 12/31/05. The cost of servicing this debt is over $25mm per year, but should be easily covered by a $100mm per year in operating income.

CAPX
WPSC has been on a massive CAPX binge since its emergence from bankruptcy including the EAF, the new finishing capacity, the refurbishment of the first coke batteries before the SNA Carbon JV, and regular maintenance CAPX. These expenditures were over $100mm in 2004 and will reach that level again in 2005. Clearly WPSC can’t support its debt and this level of CAPX going forward. And, it won’t have to. With the SNA Carbon JV, WPSC has effectively no more CAPX in 2006 and forward other than maintenance expenditures which will be very low once the EAF is up and running. In their latest 10Q WPSC highlights a CAPX budget of $255.7 million for the three years 2005 – 2007. Subtracting the $100mm in 2005 leaves $155mm for 2006/2007. $117.5mm of this is for the coke battery referb, of which Severstal will pay 80% or $96mm. This leaves WPSC with approximately $60mm in CAPX budget for 2006/2007.

LIQUIDITY
As of 9/30/2005, WPSC had $168mm of liquidity including an undrawn revolver of $150mm.

RISKS
At $8.50/share, the market is clearly pricing in some risk of a bankruptcy/debt related restructuring, but I believe this signal is being exaggerated by investor fatigue and tax loss selling.

Nonetheless, the company is in violation of its debt covenants currently and, based on its recent 8-K where it filed for a $125mm shelf, some of the lenders may be uncomfortable with the company’s prospects. This shelf and these problems are why I have assumed 100% share dilution (15mm to 30mm outstanding) in my low case.

The steel market scared this fall with the idea that China would flood the U.S. with ultra-cheap imports and/or the economy would fall into recession and/or the GM and Ford would stop making cars and/or that spiraling natural gas prices would decimate profits. While these are risks, I would point out that China has effectively curtailed new steel capacity and that it is not exporting any steel right now in part to avoid more trade tensions with the US. I would also point out that everyone now seems to think the economy will do OK in 2006, that WPSC only sells 1% of its output to the auto sector, and finally, that WPSC’s EAF, at full capacity, can melt scrap with little or no natural gas.

CONCLUSION
WPSC should reach sustainable profitability in Q1/Q2 of 2006 at levels that would remove the possibility of debt default and allow significant debt reduction. This swing from loss to profit will be driven by: the EAF at full capacity, falling coal prices, the ability to burn more scrap and use less natural gas, the completion of the new finishing capacity. Further WPSC, should recover significant cash settlements from the insurance claim and lawsuits. I expect this return to profitability and these recoveries even if the bad news bears continue to flail about in the Wheeling headquarters.

But, my Christmas wish is that Dan Loeb ride in on his white stallion, snatch this valuable asset from the clutches of the bad news bears, and deliver me $30+/share in value through a strategic sale.

Catalyst

Return to profitability in Q1/Q2 2006
Receipt of insurance claim & legal settlement in Q1/Q2 2006
Sale of company