Quanex: A Smart Play in Metals
With its strong position as a supplier of engineered steel bars to the automotive industry and building products for the residential and commercial construction markets, Quanex (NX; recent price, $40.09) is well positioned, in our view, to capitalize on a mild recovery in the automotive market in fiscal 2008 and a more robust recovery later in autos and housing.
Based on our view of the company's low debt levels, strong free cash flow, and relatively stable earnings per share (EPS), we believe Quanex is undervalued compared to most of the metal companies we follow and has solid capital appreciation potential. In particular, we believe the company's niche as a supplier to the auto market will provide a sturdy foundation for future growth in sales, earnings, and free cash flow.
Thanks to Quanex's low costs, its expertise in serving this market, and new products, we see this segment leading the way in boosting future sales and EPS. Moreover, the market for engineered steel bars has little or no competition from imports, and the company's technical capabilities and long-standing relationships with its customers make it difficult for other domestic steel companies to enter this market and compete effectively with Quanex.
Quanex, based in Houston, manufactures engineered carbon and alloy steel bars, aluminum flat-rolled products, flexible insulating glass spacer systems, and precision-formed metal and wood products, which primarily serve the vehicular products and building products markets.
On May 16, the company announced that its directors had initiated a review of strategic alternatives with respect to its building products group. The strategic alternatives under consideration included a tax-free spin-off to Quanex shareholders, a sale, and a joint venture.
Vehicular Products: Vehicular products, which accounted for 48.2% of sales and 53.4% of operating profits in fiscal 2006, includes engineered steel bar manufacturing, impact-extrusion operations, steel bar and tube heat-treating services, steel bar and tube corrosion- and wear-resistant finishing services, and aluminum extrusion and metal products fabricating. The vehicular products segment's primary markets are North American light vehicle production (approximately 65% of sales) and Class 8 heavy-duty truck production (approximately 10% of sales). Quanex has the capacity to ship up to 1.2 million tons per year.
The company's main competitors in this market are Timken (TKR; $32) and Republic Steel, an Ohio-based subsidiary of Grupo Simec (SIM; $10).
Building Products: The building products segment (25.5% of sales; 18.2% of operating profits) produces flexible insulating glass spacer systems, window and patio door screens, window cladding frames, residential exterior products, custom wood window grilles and accessories, engineered vinyl, and thermoplastic alloy composite window components for the window and door sectors of the remodeling and homebuilding markets.
This segment competes with a range of small and midsize metal, vinyl, and wood fabricators and wood molding facilities. The company also competes against sealant firms and insulated glass panel fabricators. Competition is primarily based on regional presence, custom engineering, product development, quality, service, and price. The operations also compete with in-house operations of vertically integrated fenestration OEMs (original equipment manufacturers).
Aluminum Sheet Products: The aluminum sheet segment (26.3% of sales; 28.4% of operating profits) is a leading provider of common alloy aluminum sheet products for the building and construction, transportation, and other consumer durable markets. Its primary markets are housing construction and remodeling activity, which accounts for some 60% of the segment's sales. Products include a broad line of custom-designed, roll-formed aluminum components and stamped aluminum shapes for manufacturers of windows for the home improvement, residential, and light commercial construction markets.
This segment competes with small to large aluminum sheet manufacturers, including Alcoa (AA; $39), Alcan (AL; $101), and Century Aluminum (CENX; $57).
Company and Industry Outlook
Based on the S&P forecast for gross-domestic-product growth of 2.1% in calendar 2008 vs. estimated GDP growth of 2% in calendar 2007, we look for sales growth of 1.3% in fiscal 2008, vs. an estimated increase of 0.5% in fiscal 2007. We anticipate that sales in the vehicular products segment will increase 6% in fiscal 2008, offsetting a projected decrease of 6.9% in building products. Aluminum sheet sales are expected to be down 1.2% from fiscal 2007.
Besides the S&P forecast for U.S. GDP growth, our expectation for a 6% rise in sales of engineered bars rests on the assumption that vehicle sales in calendar 2008 will total 16 million units, vs. 16.1 million units projected for calendar 2007. Given this sales assumption, we believe that auto production will rise slightly in 2008, as car companies cease selling out of inventory due to the fact that production cuts in 2007 have exceeded that drop in sales. According to automotive statistics compiled by Ward's Automotive Reports, a Detroit-based trade publication, vehicle sales fell 2.9% in the nine months through September, 2007. For the same period, total vehicle production declined 3.6%. Based on our assumption for car sales, we think auto production will rise slightly in 2008 as car companies cease selling out of inventory.
An additional positive factor for sales of Quanex's engineered bars in 2008, by our analysis, is the trend of replacing crankshafts made of cast iron with those made of steel. This should lead to additional volume. Based on our expectation for higher volume together with higher prices and less rapid increases in raw material costs, we look for the operating margin to widen to 12.5% in fiscal 2008, vs. 11.5% estimated for fiscal 2007.
We project that another decline in housing starts in calendar 2008 will result in an additional sales decrease in building products in fiscal 2008, albeit, at a reduced rate of decline. Following an expected decline of 25.9% in 2007, S&P projects a 13.3% drop in housing starts in 2008. We estimate that sales in the building products segment will be down 12.5% in fiscal 2007 and down 6.9% in fiscal 2008. In our view, Quanex's strong position with the major window and door manufacturers, along with an improved product and firm remodeling demand, will cushion some of the impact of lower sales. We see this segment's operating profit recovering in fiscal 2008, mostly reflecting cost cutting.
The fruits of cost cutting became apparent beginning in the second quarter of fiscal 2007. After posting an operating margin of 3.9% in the fiscal 2007 first quarter, margins expanded sequentially to 8.8% in the second quarter and 13.4% in the third quarter. We believe that cost cutting should lift margins in this segment to 11.8% in fiscal 2008 from the 9.9% estimated for fiscal 2007.
Following a forecasted 1.8% decline in aluminum sheet products sales in fiscal 2007, we look for a 1.2% decrease in segment sales in fiscal 2008. We believe the projected decline in housing starts will lead to continued weakness in residential construction spending, which is an important market for this segment. Partly offsetting this is our expectation for continued strength in nonresidential construction. Also, distributor inventories for aluminum sheet products are at unsustainably low levels, in our estimation, given our forecast for 2.1% economic growth in calendar 2008. We see operating margins of 12.3% in fiscal 2008, vs. 12.4% estimated for fiscal 2007, on firm pricing and only a small drop in volume.
For fiscal 2008, we anticipate higher EPS, as a forecasted rise in auto production should lead to enough of an increase in sales and margins of engineered bar products to offset a projected decline in aluminum sheet profits. We anticipate that profits in building products will achieve a small recovery in fiscal 2008 on cost cutting and less downward pressure on sales. We estimate EPS of $3.70 in fiscal 2008, vs. EPS of $3.30 projected for fiscal 2007.
Based on our forecast for higher net income, increased depreciation, higher working capital requirements, and lower capital spending in fiscal 2008, we project that Quanex will generate free cash flow per share of $3.87, vs. estimated free cash flow per share of $4.06 in fiscal 2007.
We see this strong free cash flow generation enabling the company to expand via acquisitions and still increase the dividend and buy back shares at the same time. We note that while Quanex's acquisitions from fiscal 2004 through fiscal 2007 totaled $473.7 million, total liabilities as a percentage of assets declined to 34.4% through fiscal 2007's third quarter from 46.1% at the end of fiscal 2004. For the same period, Quanex was able to raise the dividend to 56¢ a share from 31¢ and used $58.3 million to repurchase stock, thanks to its strong free cash flow.
With Quanex stock recently trading at 10.8 times our fiscal 2008 EPS estimate of $3.70 and 5.1 times our cash and cash equivalents projection of $7.97 per share at Oct. 31, 2008, we think Quanex is attractively valued and warrants a strong buy recommendation.
Our 12-month target price of $60 reflects our view that Quanex should trade at a price-earnings (p-e) of 16.2 times our fiscal 2008 estimate, just above the midpoint of its historical range of the last 10 years and at a premium to its peers, and 7.6 times our estimate for cash and cash equivalents per share at Oct. 31, 2008. We believe a p-e premium is warranted given Quanex's relatively stable earnings for a cyclical metals company. In particular, we view Quanex's steel products unit as less vulnerable to wide price swings typical of metal producers due to the specialized nature of its products and the costs associated with conducting business.
Overall, we have a favorable view of Quanex's corporate governance practices. In our opinion, Quanex rates well on a host of governance benchmarks: Only one inside director serves on the board and no affiliated directors are on the board; the nominating and compensation committees comprise solely outside directors; and the company has only one class of stock.
In addition, the CEO is prohibited from serving on the board of more than two companies and is expected to own, beneficially or otherwise, common shares or common share equivalents of Quanex's common stock of at least 400% of the value of his or her base salary within three years of serving in the CEO role. Senior officers are expected to own, beneficially or otherwise, common shares or common share equivalents of Quanex's common stock of at least 200% of their base salary and officers 100% of their base salary under the same terms.
Several negative factors, in our view: The board is classified, the positions of chairman and CEO are combined, and the company has a poison pill in place.
Risks to our recommendation and target price include the possibility of no increase in automotive production in calendar 2008 and of the company spinning off or selling its building products business.
Insofar as our forecast for higher EPS rests mostly on our assumption for higher sales and profits in the engineered bars segment, a decline in automotive production could derail our fiscal 2008 EPS estimate and affect our valuation analysis.