NWPX - Northwest Pipe

[mjohn707]

Northwest Pipe is a manufacturer of steel pipe that is having a tough year due to weakness in their tubular division combined with a cyclical downturn in their water division.  Despite these problems, I believe the stock at the current price of $14.50 per share has at least a 50% upside with a pretty protected downside.  I’m going to explain how I’m arriving to that conclusion because it’s not apparent by just looking at the historical financials.

 

As it is currently comprised, the company operates in two divisions, water, which represents about 60% of sales, and tubular, which is about 40%.  Over the last 10 years water has produced an average gross profit of about 42M per year, while over the same period tubular has produced an average of only about 12M.  The recent tubular numbers exclude the disastrous results of the oil and gas business that has been accounted for as a discontinued operation since 2012.

 

On July 20th the company announced that it was exploring the sale of the tubular division.  According to management, tubular had net assets of around 57M as of 6/30/15.  I would suspect that the division might sell for a discount to book considering that it loses money and sells primarily to users in the energy market.  If we assume that the company can realize about 80% of book value, the proceeds would come to 46M, or $4.80 per share.

 

After tubular is gone, we’re only left with water, which has produced average gross profits of around 42M per year over the last 10 years, including the two recession years of fiscal 2009 and 2010, which only produced gross profits of 19.4M and 13.8M respectively.  I believe these figures fairly represent the earning power of the business over the cycle.  If we figure that operating profit will continue to run about 79% of gross profit, water should be able to produce about 33M in operating income.  Corporate expense has averaged about 15.5M over the last five years.  If we assume that the company can reduce this expense by 25% or 3.8M after the sale of the tubular division, they should be able to produce about 21M pretax, or 14M after taxes, equivalent to $1.45 per share.

 

If we apply a 12x multiple to water’s earning power (168M or $17.50 per share), add the potential proceeds from the sale of tubular (46M or $4.80 per share), and subtract debt outstanding as of 6/30/15 (7M or $0.73 per share), we get a value of 207M or $21.57 per share.  To go at the number another way, tangible book value as of 6/30/15 was 232M or $24.16 per share, so the company is trading for around 60% of tangible book.  Over the last 10 years the stock has traded for as high as 2.7 times and as low as .58 times tangible book value, for a medium of 1.21.

 

I’m attaching a copy of my worksheet that includes a 10-year earnings summary and some historical numbers from the water division.

northwest_pipe.xlsx

[JayGatsby]

Interesting. Thanks for pointing this one out. This may be a dumb question, but what's the difference between a water pipe, a tubular pipe and an oil pipe other than the sales person? Water had a pretty terrible quarter, so I'm wondering if that market's become more crowded given downturns in the other markets. I would have thought lower steel prices would be good for margins as a %.. raw materials down, earn the same margin per ton = higher margin %.

 

Here's what I was reading: http://seekingalpha.com/article/3416646-northwest-pipes-nwpx-ceo-scott-montross-on-q2-2015-results-earnings-call-transcript?page=4&p=qanda&l=last

[mjohn707]

Interesting. Thanks for pointing this one out. This may be a dumb question, but what's the difference between a water pipe, a tubular pipe and an oil pipe other than the sales person? Water had a pretty terrible quarter, so I'm wondering if that market's become more crowded given downturns in the other markets. I would have thought lower steel prices would be good for margins as a %.. raw materials down, earn the same margin per ton = higher margin %.

 

Well the "OCTG" or oil country tubular goods is the money losing division that was accounted for as a discontinued operation and sold in 2014.  Being that it's already gone, I didn't spend too much time thinking about it. 

 

The remaining tubular division that's up for sale right now operates out of one plant in Kansas and makes smaller diameter pipes sold through distributers mainly to energy market end users.  They're facing lots of competition from foreign companies, which is part of the reason for the weak margins.  As far as declining steel prices being good for margins in this division, it doesn't really work like that.  How it goes is that you buy steel for a certain price and manufacture the pipe that sits in inventory for a while.  Steel makes up a big percentage, something like 90%+ of COGS, and if you're sitting on two months of inventory and steel moves down generally the competitive situation is such that you can't recover your margin on the higher cost inventory.

 

The water division works a little differently.  It doesn't hold a finished product inventory because every job is custom and competitively bid with multi-year lead times.  Water is also a lot more value added.  Steel prices make up less than 50% of COGS, and you have engineers using CAD software designing custom pieces in there instead.  Changing steel prices don't generally have too much of an effect on this division because all steel for the job is usually ordered when the bid is successful and the prices are accounted for in the project bids.  Water operates out of eight plants that are spread out across the country because the finished water pipes can be like 100+ inches in diameter with 1 inch thick walls that don’t ship far economically because of their size and weight.  So each plant only competes for regional jobs with a limited group of competitor, and there are no imports or foreign competitors.  Of course there are a bunch of other water pipe manufacturers using different types of plastic, cements, or other types of metal, but only cement and steel are suitable for the larger diameter high-pressure jobs the company tends to bid for.

 

From what I understand water margins get weak when there is a lack of biddable projects in some of the regions that the company’s water plants operate in and everyone starts bidding really low for what business they can get.  This happened to the company before in 2009 and 2010 in the aftermath of the financial crisis, but I suspect things will improve in water now just like they did after those two bad years.

 

[BG2008]

Interesting. Thanks for pointing this one out. This may be a dumb question, but what's the difference between a water pipe, a tubular pipe and an oil pipe other than the sales person? Water had a pretty terrible quarter, so I'm wondering if that market's become more crowded given downturns in the other markets. I would have thought lower steel prices would be good for margins as a %.. raw materials down, earn the same margin per ton = higher margin %.

 

Well the "OCTG" or oil country tubular goods is the money losing division that was accounted for as a discontinued operation and sold in 2014.  Being that it's already gone, I didn't spend too much time thinking about it. 

 

The remaining tubular division that's up for sale right now operates out of one plant in Kansas and makes smaller diameter pipes sold through distributers mainly to energy market end users.  They're facing lots of competition from foreign companies, which is part of the reason for the weak margins.  As far as declining steel prices being good for margins in this division, it doesn't really work like that.  How it goes is that you buy steel for a certain price and manufacture the pipe that sits in inventory for a while.  Steel makes up a big percentage, something like 90%+ of COGS, and if you're sitting on two months of inventory and steel moves down generally the competitive situation is such that you can't recover your margin on the higher cost inventory.

 

The water division works a little differently.  It doesn't hold a finished product inventory because every job is custom and competitively bid with multi-year lead times.  Water is also a lot more value added.  Steel prices make up less than 50% of COGS, and you have engineers using CAD software designing custom pieces in there instead.  Changing steel prices don't generally have too much of an effect on this division because all steel for the job is usually ordered when the bid is successful and the prices are accounted for in the project bids.  Water operates out of eight plants that are spread out across the country because the finished water pipes can be like 100+ inches in diameter with 1 inch thick walls that don’t ship far economically because of their size and weight.  So each plant only competes for regional jobs with a limited group of competitor, and there are no imports or foreign competitors.  Of course there are a bunch of other water pipe manufacturers using different types of plastic, cements, or other types of metal, but only cement and steel are suitable for the larger diameter high-pressure jobs the company tends to bid for.

 

From what I understand water margins get weak when there is a lack of biddable projects in some of the regions that the company’s water plants operate in and everyone starts bidding really low for what business they can get.  This happened to the company before in 2009 and 2010 in the aftermath of the financial crisis, but I suspect things will improve in water now just like they did after those two bad years.

 

What drives demand on the water side of the business?  Is it the need for replacing aging infrastructure or is it the establishment of new master planned communities?  How many competitors are there typically in a market?  How far is the radius where trucking eats up the differential of the price?  How would gauge the barrier to entry in this business?  I know this is a lot to ask, but I think they are some of the more important data points?

[JayGatsby]

Their shareholder presentations are pretty uninspiring... http://www.nwpipe.com/investor-relations/shareholder-presentations/

 

"Considering a wide range of strategic opportunities"

"Growing through M&A activity"

"We seek to leverage our customer relationships and distribution channels along with our expertise in manufacturing and engineering to provide an expanded portfolio of products to the water and energy markets. We will grow through the continued development of our existing capabilities, as well as through M&A activity of complementary businesses with a strong focus on the water markets." They then go on to define the water market as a $35B market.. steel water pipe is $700M.

 

I like these business line eliminations / restructurings if there's a culture change, but that doesn't seem to have happened here. If they said they wanted to use the current market conditions to focus on large diameter steel water pipe I'd be more interested. My guess is large diameter means more expensive to ship. Their facility map would sort of imply that as well.

 

[mjohn707]

Interesting. Thanks for pointing this one out. This may be a dumb question, but what's the difference between a water pipe, a tubular pipe and an oil pipe other than the sales person? Water had a pretty terrible quarter, so I'm wondering if that market's become more crowded given downturns in the other markets. I would have thought lower steel prices would be good for margins as a %.. raw materials down, earn the same margin per ton = higher margin %.

 

Well the "OCTG" or oil country tubular goods is the money losing division that was accounted for as a discontinued operation and sold in 2014.  Being that it's already gone, I didn't spend too much time thinking about it. 

 

The remaining tubular division that's up for sale right now operates out of one plant in Kansas and makes smaller diameter pipes sold through distributers mainly to energy market end users.  They're facing lots of competition from foreign companies, which is part of the reason for the weak margins.  As far as declining steel prices being good for margins in this division, it doesn't really work like that.  How it goes is that you buy steel for a certain price and manufacture the pipe that sits in inventory for a while.  Steel makes up a big percentage, something like 90%+ of COGS, and if you're sitting on two months of inventory and steel moves down generally the competitive situation is such that you can't recover your margin on the higher cost inventory.

 

The water division works a little differently.  It doesn't hold a finished product inventory because every job is custom and competitively bid with multi-year lead times.  Water is also a lot more value added.  Steel prices make up less than 50% of COGS, and you have engineers using CAD software designing custom pieces in there instead.  Changing steel prices don't generally have too much of an effect on this division because all steel for the job is usually ordered when the bid is successful and the prices are accounted for in the project bids.  Water operates out of eight plants that are spread out across the country because the finished water pipes can be like 100+ inches in diameter with 1 inch thick walls that don’t ship far economically because of their size and weight.  So each plant only competes for regional jobs with a limited group of competitor, and there are no imports or foreign competitors.  Of course there are a bunch of other water pipe manufacturers using different types of plastic, cements, or other types of metal, but only cement and steel are suitable for the larger diameter high-pressure jobs the company tends to bid for.

 

From what I understand water margins get weak when there is a lack of biddable projects in some of the regions that the company’s water plants operate in and everyone starts bidding really low for what business they can get.  This happened to the company before in 2009 and 2010 in the aftermath of the financial crisis, but I suspect things will improve in water now just like they did after those two bad years.

 

What drives demand on the water side of the business?  Is it the need for replacing aging infrastructure or is it the establishment of new master planned communities?  How many competitors are there typically in a market?  How far is the radius where trucking eats up the differential of the price?  How would gauge the barrier to entry in this business?  I know this is a lot to ask, but I think they are some of the more important data points?

 

Replacement drives water.  As far as competitors, the company does mention names in the 10-K but they don't disclose it down to the plant level, they just say who's in what region of the country.  Also they're not specific about about shipping distances, and your guess would be as good as mine as far as the barriers to entry. 

 

They way I think about the base case economics of this thing is that it is one of a reasonably small number of companies that produce a capital intensive but essential product with lumpy demand.  And while the product is basic and has substitutes, it's still a fairly high value-added proposition.  Because of the economics of shipping, the odd specifications of the pipe being manufactured, and the unusual sales channel, they're not going to compete with every pipe manufacturer in the world that has an underutilized plant, so over time they should earn resonable if unexceptional returns on capital. 

 

So that's base, and it's possible the situation is better than I think too.  In the worst case you buy a cyclical commodity steel producer at 60% of book, which won't get your rich but you probably won't go bankrupt either.  I would not invest in this thing at 1.2 times book unless I knew a lot more, but at 60% of book I think it makes some sense

[mjohn707]

Their shareholder presentations are pretty uninspiring... http://www.nwpipe.com/investor-relations/shareholder-presentations/

 

"Considering a wide range of strategic opportunities"

"Growing through M&A activity"

"We seek to leverage our customer relationships and distribution channels along with our expertise in manufacturing and engineering to provide an expanded portfolio of products to the water and energy markets. We will grow through the continued development of our existing capabilities, as well as through M&A activity of complementary businesses with a strong focus on the water markets." They then go on to define the water market as a $35B market.. steel water pipe is $700M.

 

I like these business line eliminations / restructurings if there's a culture change, but that doesn't seem to have happened here. If they said they wanted to use the current market conditions to focus on large diameter steel water pipe I'd be more interested. My guess is large diameter means more expensive to ship. Their facility map would sort of imply that as well.

 

Well we really can’t blame current management for all of the allocation problems of the past because they only came in at 2011 or so after the old management went down in an accounting scandal.  Since then they’ve done some stuff that looks good from here like divesting OCTB and two other small tubular businesses, some stuff that doesn’t look so good like the big capital investment at the Kansas plant a few years ago, and some stuff that’s too early to tell like the recent water acquisition.

 

I can’t say that I know how M&A will work out for them either, but they claim that any acquisitions will be in water going forward.  They seem really gung-ho to buy something.  I’m a bit skeptical about M&A considering that the stock is trading way below book, but at least at this price I’m not paying for the next Warren Buffett.

 

If reference to the uninspiring shareholder presentation, I would consider that to be a small net positive.  A business that needs more than 6 slides to describe it is probably too complicated for me.

 

[mjohn707]

Just to update this situation, the company has sold the idled tubular assets for 37.2M, which was the remaining book value of the assets.  I'm still expecting a water turnaround

[mjohn707]

At the current prices of $24.75 or so I think this thing is a sell in case anyone else is in this thing