I propose taking a substantial stake in WPSC at these levels. The basis of the investment is simple.  Our margin of safety is provided by an almost guaranteed return of at least 24% on half of our position between today and October (144% annualized).  The remainder of our position will be invested in what will be the 5^th largest steel company in the US, which we estimate to be worth at least $32, more than 100% higher than the current share price (~$16), with many opportunities for further upside (for example, a jury award for ~$215mm or $14/share from a recently won lawsuit).

Wheeling-Pitt (WPSC) is a US based steel producer.  This stock has been written up twice on VIC before, and I would encourage readers to skim the prior analysis for a sense of where this company has been.  I hope to give you a glimpse of where I believe it is going.

 

For many years, WPSC was run by the “bad news bears” of the steel industry.  The company’s management achieved the difficult feat of bankrupting itself in one of the greatest steel booms in recent history and managed to destroy shareholder value throughout this most recent up-cycle.  Astoundingly, the same management that ran the company into bankruptcy was able to hold on to their cushy seats as the team selected to run the company after it emerged.  The board clearly did not understand the term, “fiduciary duty.” 

 

Last year, a bidding war for the company began. 

 

The losing proposal: CSN, the Brazilian steelmaker, in a rather complex proposal wanted to infuse capital into the company and eventually take out the majority of shareholders for ~$30/share (I have simplified this some for time’s sake). 

 

The winning proposal: The second proposal came from a private steel service center, Esmark.  Esmark’s proposal was very complex, but I will break down the main points here.  Esmark wanted to achieve the first-ever reverse hostile merger.  In effect, they (a small private company) forced a larger public company (WPSC) to merge with it, handing the keys to the management and directorship over to the hostile company.  They were able to do this by proposing a proxy with their own board of directors, which was voted on by shareholders and was ratified. 

 

Esmark is run by James and Craig Bouchard.  They now run both WPSC and Esmark, as the merger between the two companies will not close until the shareholders vote in Sept/Oct.  Esmark was able to win the bidding war for several reasons:

 

a)       Esmark actively courted the union, and changed a portion of their compensation to a profit sharing structure.  The union played a large role in the negotiations

b)       They promised to bring with them a below-market priced steel slab agreement (the raw material needed to make hot rolled coils of steel, which would dramatically increase the profitability of WPSC)

c)       They also promised a much needed capital infusion which would solve some of the liquidity problems facing the company.

 

The proposal for a WPSC shareholder is relatively simple.  We will vote our shares to support the Esmark merger.  Management just filed their final proxy to the SEC (under the merger shell “Clayton Acquisition Corp.”), and we believe the proxy should be voted on and closed by late Sept / early Oct.  Upon the close of the merger, WPSC shareholders will elect to receive ONE of the following:

a)       1 share of “New Esmark” (the merged entity, which is just WPSC with a new name)

b)       1 share of “New Esmark” and a right to purchase stock in the new co at $19

c)       The right to put your shares back to company for $20

Some more details on this, the rights offering is capped at 10.5mm shares ($200mm).  Franklin Mutual Advisers, who is the majority owner of Esmark, has entered into an agreement to backstop the rights offering, so there is no risk to this capital infusion into the company, regardless of where the stock is trading.  This capital will be used to fund the put provision at $20.  The put provision is capped at half of the shares outstanding ($150mm).  So, in effect, management will buy back half the shares outstanding @ $20 if every shareholder elects to tender their shares.  The excess capital (at least $50mm) will be used to provide liquidity to WPSC. 

 

A thorough analysis of the holders list will yield some important information.  This is a very tightly held company with the majority of shareholders being major institutional investors.

 

 

Clearly, if none of the above investors tender their stock, the proration we will have on the put will be much less than 50%.  We estimate we will be able to put 70% of our stock back to the company if necessary. 

 

Please see the breakeven analysis on this investment below:

 

We propose buying shares in WPSC today.  For simplicity, we will assume a $16 current stock price.  In the worst case, we will be able to put 50% (more likely 70%) of our stock back at $20.  If this case occurs, we will lock in a 24% gain on half our position.  We will then be left exposed to one of the most dynamic and fundamentally changing companies in the metals industry: New Esmark.  We estimate New Esmark to be worth at the very least, $30 per share.  Thus we see ~100% upside and a very sizable margin of safety due to the implied gain on our put provision.

While we have done much more in-depth analysis of the operations, we will simplify for sake of time. 

 

One way we value the company is using a steel company comp multiple of 6x EBITDA.  We use the share count PF for the merger assuming no buyback (to be conservative). 

 

It is also worth noting that WPSC has several “hidden” assets that we feel management may look to monetize (see 2Q earnings conference call Q&A).  The taxed value of all these assets is conservatively $6.21 after-tax.  For instance, the MEE lawsuit they just won was for an award of ~$215mm ($14/share of value!!!), materially more than the $82mm we give them in our analysis. 

 

 

Alternatively, we have analyzed the value the company could be sold for if all operations were liquidated immediately.  Acquisition values in steel over the past 7 years have been on average $600 per ton of capacity.  Mittal just sold Sparrow’s Point for a steal at $350/ton.  Even if we severely impair the value of the steel assets and assume that they sell for $200/ton, you are still looking at a $32 NAV/share, 100% upside.  If you assume they can sell the assets for the same price Mittal just sold their mill ($350/ton), you are looking at a $67 price.  Clearly these assets are not being valued properly by the market. 

 

 

 

 

Here is the real kicker.  As if the prior investment thesis weren’t enough, Esmark recently won another bidding war for Sparrow’s Point (SP), a 3.9mm ton capacity steel mill which they bought from Arcelor Mittal two weeks ago.  They acquired SP with an investment partnership between CVRD, Donbass, Franklin Mutual, and other major investors.  You could not ask for better partners.  CVRD is a $100b market cap iron ore company with the best raw materials supply in the world.  Clearly, Esmark is able to do deals on a global scale, and they have a new view for WPSC/Esmark/Sparrow’s.

 

We would anticipate that the company plans to merge these two entities some time after the WPSC/Esmark merger closes.  We feel this would be an enormous positive for the company, and would serve to drive our valuation even higher, as we currently give no value to this potential combination.

 

Bottom line: this is the most undervalued name in the steel sector, is in the middle of a massive evolution, and has an enormous margin of safety to backstop our investment.  We feel that this should be a tier 1 sized position.   

(+) SEC approval of the meger proxy – Aug/Sept

 

(+) Closing of the WPSC/Esmark merger and ability to put stock at $20 – Sept/Oct

 

(+) Improved sell-side coverage and investor awareness – YE2007

 

(+) Potential for activist involvement as the company could be broken up to enhance value – YE 2007

 

(+) Spin-off or divest non-core assets (Coking Plant) – 2007/2008

 

(+) Merger of the New Esmark with Sparrow’s Point – 2008