Wheeling-Pittsburgh (WPSC), which emerged from Chapter 11 in August 2003, is the sixth largest integrated producer of steel in the United States. WPSC is in the process of transforming itself from a traditional integrated producer to a “hybrid” producer through the construction of a mini-mill (EAF or electric arc furnace) that will replace one of the Company’s blast furnace operations in the first half of 2005. The introduction of the mini-mill will (i) increase WPSC’s overall production capacity, (ii) enable the Company to sell excess coke, and (iii) provide flexibility to optimize raw material costs – e.g. provide the ability to switch to scrap as a raw material when iron ore costs are high and vice versa. The recent S-1 for WPSC gives an excellent overview of the Company.
Based on extremely positive fundamentals for the steel industry and WPSC’s low valuation (it currently trades at 3.7x EBITDA and 3.2x net income using CY2004 projections), we recommend purchase of the shares. We believe a $35.00 to $40.00 share price target is reasonable based on comparable company trading levels and the possibility of an acquisition of the company.
As we emphasized with a recent write-up on Bayou Steel (BYUA), the economic environment for steel producers continues to be strong with steel prices continuing to increase through August. Many points are worth repeating, and it is worth emphasizing that most public steel producers have commented that second half results will continue to be solid. A number of factors support this environment continuing into 2005:
1. The U.S. economy is relatively strong – capital goods orders, industrial production and non-residential construction all have positive outlooks.
2. Chinese demand continues to be robust – this demand is not going to go away overnight. In addition, efforts by the Chinese to limit investment in the steel sector may tighten steel supply in the short run.
3. A weaker dollar (relative to 1999 and 2000) should shield the U.S. industry from imports.
4. High shipping costs should also shield the U.S. industry from imports.
5. Inventories are at (near) record low levels.
6. U.S. steel-making capacity is still well below recent (2000) highs.
Given the macro environment, WPSC remains undervalued despite huge increases in earnings. Our model incorporates WPSC’s results for the second quarter with adjustments to project full-year 2004 results. The model is summarized below:
Revenue: 15% q-o-q Q3 growth (per mgmt comments); Q4 equal to Q3
COGS: $47 million increase in Q3 (per mgmt comments); Q4 equal to Q3
SG&A and Interest: Q3 and Q4 equal to Q2
Depreciation: Q3 and Q4 equal to the average of Q1 and Q2
Other Income: $5 million Q3 and Q4
Tax Rate: 35% in Q3 and Q4
EV:259,200 = mkt cap (10,000 shares at $25.92)
104,767 = cash (incl. value of affiliates(1); excludes restricted cash)
422,645 = debt
$577,078 = EV
1. We have valued WPSC’s JV affiliates, which contributed $4,248 in equity income in Q204, at approximately $100 million using a 6x valuation of 2004 income. We believe this multiple is conservative since the JV’s have been relatively stable earnings generators.
The below chart displays trading multiples for comparable companies:
AKS 6.2x 3.9x integrated
ISG 6.3x 5.0x integrated
NUE 7.2x 3.7x mini-mill
OS 4.1x 3.0x integrated
SCHN 8.7x 5.4x mini-mill
STLD 6.2x 3.5x mini-mill
X 5.9x 3.9x integrated
Average 6.4x 4.1x
Integrated Avg 5.6x 4.0x
Mini-Mill Avg 7.4x 4.2x
Source: First Call
Valuation Multiple 6.4x 4.1x
WPSC EPS/EBITDA $8.12 $156,883
WPSC Target $51.82 $31.88
Blending implied valuations using peer group multiples results in a $41.85 implied valuation. As a result, a price target of $35.00 to $40.00 per share is very reasonable and makes for a potential gain of 35% to 54% from current levels.
1. A take-out. One of the larger steel companies may seek to acquire WPSC in order to broaden its manufacturing and customer base and improve logistics. WPSC’s low P/E multiple makes an accretive transaction possible at a much higher price. In addition, WPSC’s new EAF facility and excess coke production capability are likely to be sought after by potential buyers such as ISG, which is short coke.
2. Based on the current pricing environment and due to the excess production capacity and potential coke sales in 2005, WPSC could potentially produce EBITDA of $250 - $300 million creating a 1.9x - 2.5x EV/EBITDA multiple.
1. Demand for steel slows down and steel prices fall.
2. Announced 3.5 million share follow-on offering may create selling pressure.
1. Publication of strong third quarter results.
2. In 2005, results from EAF mini-mill operation operations and sales of excess coke should drive significant EBITDA and earnings gains.
The Bottom Line
WPSC is a cheap steel producer that should continue to perform well in a decent economy in which steel prices are firm. The Company offers upside from its new mini-mill operations and the possibility of a take-over given continued consolidation in the steel industry. As a hedge against weaker steel prices, a short of one of the more widely followed producers (X or ISG) may make more sense.
1. Publication of strong third quarter results.
2. In 2005, results from EAF operations and sales of excess coke.