Spinoff & Reorg Profiles
August 2005 Excerpt
Copyright 2005 William E. Mitchell
AN INDUSTRYWIDE SPECIAL SITUATION
An
irony of much of business academia is that its teachings are right for 99% of
real-world situations but all the money is made in the other 1%. Since widespread knowledge is priced into the
market, the profits are generally in the rare and invisible, but systematic,
exceptions.
Commodity
businesses are a case in point.
‘Commodities are bad businesses’ is a mantra drummed into MBA
candidates heads from the first day of class.
And like other generalizations, from efficient markets to CAPM, this
mantra is true. Usually and mostly. For the investor, the rule immediately raises
the question, When is it not
true? It turns out there are at least
two good-sized exceptions.
Commodity
businesses are almost always bad investments because price is the only basis
for competition; as a result, as long as
demand is predictable, supply keeps pace, and competition drives price down to
the market-clearing marginal cost.
Marginal cost includes inputs (materials and labor), but not investments
(capital equipment), so over time, most commodity suppliers fail to generate a
satisfactory return on their plant and equipment. Airlines are the usual example: Buffett has claimed the entire industry has a
lifetime ROI of less than zero.
The
exceptions arise directly from assumptions built into the definition of
commodity. First, the low-cost seller
tends to make money consistently, because the market price can go no lower than
the highest-cost market-clearing supplier.
The popular counterexample in airlines, Southwest, perennially makes
money on the spread between its own marginal cost and that of United, because industry
ticket prices can’t fall below United’s marginal cost.
The
second exception is unexpected change to supply or demand. Certain commodities tend to have inelastic supply
and/or demand in the short run, often due to long production lead times on the
buy or sell side. An unanticipated
change to supply or demand thus causes a price shock. For a time, everyone either goes broke or makes
piles of money, until a Malthusian equilibrium is reached again. For example, oil companies are raking it in
right now, because it takes years for supply to rise and demand growth to slow
in response to unexpected conditions.
Thus
the special-situations investment opportunities in commodity businesses, if
any, are (i) to buy and hold a company with an intrinsic, sustainable cost
advantage, or (ii) to briefly own a financially secure company during a
favorable price shock. This month, we
cover a situation in the latter category.
Recently
there has arisen a sudden, sustained, unreported, global shortage of carbon fiber. Most
commodity shortages are not news, as
oil etc. as fast as they can be produced.
There’s just one unusual thing about this particular shortage: it has not yet been reported in any major
magazine or newspaper. As a result, we
think it’s possible the shortage and resultant price spike haven’t yet fed
through to share prices.
Carbon
fiber is the key input to carbon composite materials used as a lightweight
substitute for steel or fiberglass. The shortage
appears to result from a demand shock in the form of five big new uses: lightweight armor for the Iraq war; production of the new Boeing 7E7 and Airbus
A380; the launch of wind-power
megaprojects in Europe (evidently any propeller blade over 50 meters must be
carbon composite); the rise of China,
including ballistic missile projects;
and new Air Force orders, for example the July 13 order of $272m worth
of unmanned spy drones built almost entirely of carbon fiber composites. These are all actual, not speculative, new
projects. Rapidly rising fuel costs add
a general driver: the material’s primary
industrial purposes are to save fuel (by reducing aircraft weight) and to
generate wind power, so higher fuel costs directly drive carbon fiber demand.
Commercial
shortages have appeared only in the past 2 to 3 months. Here are just a few of the many recently
reported signals from different industries.
–
The
Los Angeles Metro Transportation Authority cannot get new LNG buses, because
its manufacturer has run out of the carbon fiber required to manufacture
storage tanks (
–
Maas
Boats carbon fiber hull sales web page: “Due
to a worldwide shortage of carbon fiber, we cannot guarantee either the price
of carbon fiber boats or delivery times in 2005.
–
Aldila,
a golf club shaft manufacturer, owns half of a carbon fiber production venture
with SGL Carbon Group (see below and next page). Losing money until recently, the joint venture
is now running at capacity, selling the excess to other carbon fiber consumers.
–
U. S.
Composites website: Worldwide carbon
fiber shortage. May not have quantities in stock.
–
Mitsubishi
Rayon (Japan, Jan 2005) is “urging carbon manufacturers to establish their
production systems to ensure a future stable supply” in the face of
increasing demand.
This
month we cover Hexcel, which in our
opinion was the nearest thing to a well-financed, US-based pure play in carbon
fiber manufacturing. For those
interested in ADRs, you might also consider the German firm SGL Carbon Group (NYSE: SGG).
The more adventurous should look at Toray
in Japan.
Hexcel, Inc.
DEAL STRUCTURE
BACKGROUND
Hexcel (NYSE:
HXL) refinanced essentially all its debt in the first quarter of 2005,
reducing costs. Concurrently, a shortage
of carbon fiber arose, placing continued upward price pressure on Hexcel
products.
TERMS
The company issued 6. 75% senior subordinated
notes due 2015, replacing various long-term debt instruments whose blended rate
was over 9. 25%.
CURRENT
STATUS
The debt refinancing has completed. The carbon fiber shortage reached the
non-military sector within the past two months.
ANALYSIS
We’re not interested in the new debt as an
investment, but rather in what it does for the company, taken together with an
unexpected recent global shortage of carbon fiber.
The refinancing generated a large cash
expense for Hexcel, depressing earnings and perhaps masking the signals of an
upturn in the embattled carbon composites industry in the first quarter of 2005:
operating income increased from 9% to 11. 3%
of sales in Q1 05 compared to Q1 04.
Meanwhile, refinancing will, according to Hexcel, reduce debt service
costs by $4m per quarter, or about 1. 8% of sales.
The company reports that the lead time to
bring new carbon fiber manufacturing capability on line is about 3 years. Our own source (see below) says 18 to 24
months.
So it appears new supply will not begin to
arrive until early 2006, and may not catch up with demand for a year or more. As a result, we expect Hexcel and its
competitors to make hay for some time before returning to commodity misery.
AUTHOR OWNERSHIP
Author does not own Hexcel.
Company Information
BUSINESS
Hexcel is one of
the world’s largest, most vertically integrated manufacturers of carbon fiber
and carbon fiber composite materials, with sales of just over $1 billion in
2004.
The company
competes in a dismally cyclical commodity industry, and has lost vast sums of
money in the past 5 years. For example,
Hexcel lost over $11 per share in 2001 alone compare this to the current
share price of about $18. Broadly
speaking, sales and operating income are almost unchanged from 2000. Sales have only just recovered from an abrupt
15% decline shortly after 9/11, as a downturn in the aircraft industry fed back
into the supplier base.
Hexcel’s main
competitors in carbon fiber and its precursor, white fiber PAN, are Toray
(Japan), Mitsubishi Rayon (Japan), Amoco, and SGL Carbon (Germany). Of these, Hexcel is the nearest to a US-based
pure play. Not as pure a play as we
would like: it is still a net consumer
of carbon fiber, because it makes more finished composite materials than it can
supply from its own carbon fiber plants.
However, it appears to be the best US-based option to take advantage of
the demand shock.
On August 10, to
verify our theory on the industry, we interviewed a retired senior executive from
the carbon composites industry. He
confirmed that shortages of carbon fiber and its precursors, particularly for
aerospace applications, have been reported in composites industry newsletters
recently, and that prices are up approximately 15% in aerospace composites in
the past year. He was not aware of the
non-aerospace industrial shortages apparent in the past two months.
This source did
offer a reason why the industry may not have anticipated a demand spike: they’ve been burned repeatedly by building
capacity in anticipation of demand that hasn’t materialized. Aerospace customers, chiefly Boeing, first in
1983 and again before 9/11, promised imminent shifts to greater composite use,
only to delay when industry conditions changed.
This time, it appears the industry has overcompensated: a broad range of new applications have reached
the hard order stage at the same time, and the carbon fiber capacity isn’t
there.
Our source also
noted that none of this appears to have been reported in any financial or
general press. You heard it here first.
VALUATION
Hexcel reported
earnings of just 8 cents per share in 2004 on a fully diluted basis, and lost
money in Q1 2005. However, ignoring the cost
of refinancing, Hexcel’s business actually improved significantly — more like
28 cents per share in the first quarter.
This is before considering the effect of the reduced cost of debt
service.
On August 9, Hexcel
released results for the second quarter, ended June 30. This is still too long ago to capture what we
think is a growing shortage, but does report a 250% increase in net profit over
Q2 2004, to 28 cents per share. Given
the current inability of many buyers to get Hexcel’s precursor products at any
price, we think it’s reasonable to assume that earnings over the next 12 months
should at least extrapolate from the last two quarters ($1. 12), and possibly go
much higher. This implies a value of at
least $22. 40, about a 25% premium to the current price, at the low end.
Note the risk: if a major buyer were to drop out, this valuation
would no longer be justified. However,
this looks unlikely, because the new demand all comes from long-term,
large-scale, project-oriented sources.
POSSIBLE TACTIC
Buy and hold for up
to six months. Sell on major press
coverage of the shortage.
ADDITIONAL NOTES ON HEXCEL
Warning: three big investors are currently
selling. On August 9, Goldman Sachs,
Greenbriar Equity Group LLC, and
million shares of HXL in a registered public offering. These shares are dilutive, as they are issued
via the exercise of convertible preferred purchased by the three investors in
2003. However, our diluted earnings
calculation above is net of all the convertible preferred, so this does not
affect our valuation conclusion. Still,
one should ask why they are selling just now.
All three investors
are private equity firms, which often have internal timetables for realizing
investment gains. They may be simply realizing some of their
enormous paper gain, in an industry known for cyclicality. They bought the convertible preferred issue just
over two years ago for only $125 million, and are now selling less than 30% of
it off for over $250 million. We note they
appear to be keeping the rest, at least for now.
A more minor but
salient feature for investors with a dollar-hedge focus is that Hexcel is a net
exporter, manufacturing mainly in the
output overseas. They would benefit from
a falling dollar.
All that said, we return
to the critical set of observable facts:
big new customers want carbon fiber right now, there isn’t enough to go
around, and no one outside the industry seems to be aware of the situation.
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