Wednesday, August 23, 2006

IPS Co is a Steal of a Steel Company - BUY

A value buy in a steel company, who would have thought it?

IPS Co [ticker: IPS] is a steel company providing plates, coils, and tubing to various users mostly located in North America. I came to look at them because they are a core holding of a small cap mutual fund I know of that has been doing fairly well. I went into my research skeptical, but came out with a BUY rating.

We start by looking at the steel industry as a whole. Strong worldwide demand for steel has dramatically improved the scenario for producers. Higher interest rates are bad for companies that need to borrow for capital spending but IPS has annual free cash flow of $686 million and less than half that in debt, so interest rates should hinder competitors without harming IPS. A few years ago (circa 2001) the whole US steel industry almost fell apart, IPS was one of the companies that streamlined operations and came out profitable.

IPS uses modern “mini-mills” that work primarily with scrap steel, but they also have a number of their own scrap metal processing and auto wrecking yards to feed their business. This should help keep them isolated from middlemen and makes their inputs the basic commodities of scrap steel, energy, and natural gas. An earnings dip in 2005 was due to increases in the cost of energy but right now energy is only 10% of the steel mill product cost. IPS also has extended price contracts with energy providers from 2009 for the Regina facility to 2016 for the Montpelier facility. Because of these fixed energy contracts any increase in energy costs hurts competitors more than IPS and shouldn’t hurt their business. Most of the investing public is probably unaware of this so energy-induced sector drops are buying opportunities for IPS.

A net present value analysis turns up some remarkable value. If I demand my usual strict 15% discount value the company can afford to have earnings decline 3% per year for ten years and still justify its present price! Another way of looking at the math is that the company would still have a 15% discount if the stock were at three times its present price ($325 / share!). The company right now has a 35% discount based on the consensus estimates of analysts (who expect an average 13.9% growth rate). I am always suspicious of such rosy predictions though, especially in such a turbulent industry. The Jaywalk consensus rating combines 14 independent research providers and ranks IPS higher than 98.3% of its sector, 97.4% of its industry, and 99.4% of all stocks rated. Overall the average rating is between a buy and a strong buy on their scale.

On a practical level I think that we are likely to see some bumpy profit reports ahead. This year has been very good but I wouldn’t be surprised to see at least one of the next two years witness a profit decrease due to the tough comparisons with current performance. Fortunately the discount is high enough to allow for this so if we are investing for the middle to long term we should be fine.

To make sure the company will stay around I have calculated the Z-score, which is a sort of credit rating to analyze the likelihood of bankruptcy. IPS scores 4.69 on a scale where anything above 3 is healthy and below 1 warns of imminent danger. This is a great score and suggests IPS is fine to hold for the long term.

Oil infrastructure investment comes in waves after big profits so we should smile at the detail that recently about 50% of IPSCOs sales have wound up in the energy end market. There are only three manufacturers in North America capable of making the type of pipes the oil companies need right now and they are all sold out through next year, according to Charles Bradford with Bradford Research/Soleil. IPSCO is first in North American steel plate supply, but only 3rd in energy piping – so there is some room to grow. IPS is also well placed to benefit from the rupture in the Alaskan pipeline.

The Alaska Connection: The news has been full of BP’s problems with their Alaskan pipeline and IPSCO’s spiral mill in Regina, Saskatchewan can make up to 80-inch diameter pipes and the location is perfect for selling to BP’s Alaskan operations. The only problem is that according to Tom Filstrup, spokesman for IPSCO, that facility is booked through the third quarter of 2007. There is always the chance that BP will pay expedite costs to get IPSCO to put in an extra shift or otherwise speed up production to get that pipe out. That would be nice but not a huge event for IPSCO; BP needs about 16 miles of pipe which is about 30,000 tons of steel worth about $15 million. Last year 22% of IPSs’ sales were in “energy tubulars” (read that: “metal pipes and shields for energy companies”), for a total of $660 million. Adding even the entire $15 million BP order to that would not make a very large difference in the financial results of the company, so this one time event probably won’t distort financials too much.

The biggest risk to IPS is probably all those steel plants that went bankrupt in 2001. They are still operating but without the overhead costs that come from building a plant (since those were erased during bankruptcy). When scrap prices and raw iron ore prices get closer together, IPS will suffer margin compression due to competition from the integrated producers.

Most of the employees are covered by a union agreement that runs until 2011, but there are no pension surprises in the annual reports. IPS has cash and cash equivalents on hand sufficient to retire all its debt and then some, so really the company seems very stable.

This company has some risks due to globalization and commodities markets but you couldn’t ask for a better industrial play. The strong balance sheet, electricity contracts, scrapyard integration, and strong market pull spells BUY on this stock.

In accordance with the Finance Wonk policy, I will have a position in this stock within 24 hours of posting a BUY and will publish here when I sell.

Invest Well,

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