by Travis Johnson, Stock Gumshoe | July 31, 2008 5:35 pm
This one will probably not be a shock to you, because unlike some of the others I’ve featured in this space it is a company that I wrote about on StockGumshoe.com fairly recently, and fairly positively.
I’ve since had some time to look over the company’s fundamentals and market more thoroughly, and I think now my best idea for a new investment is General Steel Holdings (GSI).
Shares closed today at $15.50 but fell significantly in after hours trading as I was writing this, to under $15 … it is in an uptrend at the moment, and has been for months — if you ignore the significant up and down volatility. You could have bought shares at $6 in March, or $16 in June before it dipped to $10 on their latest acquisition announcement and then climbed back to the current price within a couple weeks (thanks to increasing press coverage and attention from pundits and newsletters, and their big earnings growth).
I’d ideally like to pick up shares in the $13 range, and I think it’s probably likely we’ll see that price or lower again at some point this year, but I would start to build a position here, around $15, and wait for likely dips to add to that position. Closing price was $15.43 today, and it has traded down below $15 after hours for some unknown (to me) reason. The shares got as high as $20 when they got their Amex listing last Fall, and as low as $5 when all things China were hated over the Winter.
I do not own the shares now, and per my rules will not buy them within the next 72 hours. Given the short term performance of the two prior stocks I’ve featured in this space (both down significantly so far), I want to make clear that while the shares are currently moving up, I am not promising that they will be higher a month or two from now — I do expect them to be significantly higher in two or three years.
General Steel is a smallish company that is rapidly becoming a force for consolidation of small state-owned firms in the Chinese steel industry — they are growing by acquiring poorly run, undercapitalized, small, and/or inefficient state-owned or formerly state-owned steel companies in China, mostly at what seem to be fairly cheap prices (especially if we assume that GSI can — as they have in recent years — improve their results with stronger oversight and management).
They pick up these steel companies at single-digit multiples, often in the range of 2-5X earnings, and use a joint-venture structure for the acquisitions, which means they buy a controlling interest in the company and the prior owners or management generally end up owning the rest (the ratio varies widely — one is 99%, another is 51%). This is appealing for managers of state-owned enterprises or for owners of smaller mills that might otherwise fight acquisitions, or for the regional governments that still want to profit from these companies that they formerly controlled — it means they get to keep exposure to the company and the industry, and, one assumes, keep their jobs.
There are a few reasons why I think this stock has a positive future — one is that it has been featured quite heavily in the investment press over the past month, which in part is the source for the recent share price recovery. That means the company is getting more attention, and growing a new crop of shareholders who are interested in their long-term story … which is probably positive. This can backfire, too, because sometimes this kind of attention drives the price up only to see a subsequent dip when the talking heads move on to a different topic. In this case, however, I think we’re looking at a company that is reaching a significant turning point in terms of profitability, and one that is now trading — if the analysts are correct with their guesses, at a forward price/earnings ratio of about 11. That’s a bit of a premium to similarly sized steel companies globally, probably, since established steel companies have historically usually traded with single digit PE ratios, but GSI is growing much, much faster than the average steel company … and times are good for steel companies in general.
And the second reason is that the combination of business model and sector seems to be extremely well suited for the current environment — GSI is consolidating a poorly run and fragmented industry that is crucial to China’s future, with encouragement from the government, and it is also enjoying high prices for their products, as are all steel producers. That means they can potentially outperform the broader industry, so this is a company that is certainly dependent on a robust market for steel, but it is not simply a play on steel prices since they are also increasing productivity.
Now, this is the second company I’ve featured that does business primarily in China — and the first one has fallen quite a bit since I wrote about it. It is also the third one (out of three) that has some relationship with the Chinese boom, since Hanfeng is a fertilizer company benefiting from spending power of farmers, and Seadrill is a drilling rig owner that benefits from the thirst for oil, a thirst that is coming, at the margins, from new consumers in China.
GSI is also quite like Hanfeng in another way — like Hanfeng Evergreen, General Steel is a small and fast-growing company that is in part riding a political mandate in China; Hanfeng is profiting from the government’s push for better fertilizers and “greener” crop yield improvement; GSI from the Chinese desire to have local companies consolidate the steel industry. Both companies are playing it smart, too, by fostering close ties to the government to curry favor and participate in rulemaking that will be to their benefit. Both are also competing with much larger state-owned firms and international giants to some degree, with their appeal coming from the fact that they are able to operate more efficiently than these competitors, and that they can grow much faster from a smaller base to take advantage of significant secular growth in their sectors.
This China connection remains a significant risk, so I also should make clear to you that I still believe that the rise of China will continue to be the most significant economic story in the world for the next ten years, and that not being exposed to Chinese growth is also a significant risk for any investor who wishes to grow his portfolio — even though, of course, my “best ideas” in this space probably do not represent a portfolio that would be appropriate for any individual (personally, I own the prior two stocks I’ve mentioned, but also several mutual funds and 20+ other stocks, and I believe strongly in the importance of diversification).
That said, the fall of China could also be the story of any of those individual years of the next decade, as the fall of the Chinese stock market has been one of the more compelling financial stories of this past year, so I expect investing in Chinese companies, or companies that depend to any significant degree on China, will probably continue to require antacids and patience.
General Steel is a company that is growing incredibly quickly, with a fair amount of debt, so even though I think it is underpriced relative to its prospects it is far from being a “safe” pick — in the context of the other two stocks I’ve featured here, Hanfeng and Seadril, this is probably the riskiest of the three because it depends so heavily on integrating acquisitions for rapid growth, though I expect all three to be thriving businesses for many years to come — and all three trade at forward PE multiples that are lower than the market average (with the caveat that analysts are probably not very accurate about those forward earnings for any of them).
The market cap is still small for General Steel, especially in comparison to the major international steel companies — you can buy the whole company for about $500 million today if you also take on their $100 million+ of debt, while the dominant steel companies like Arcelor Mittal (MT) and Posco (PKX) are much, much larger (MT is more than 200X larger, well over $100 billion in market cap, PKX is at $40 billion, US Steel $20 billion, just to give some perspective).
That plays into this story a little bit — partly because China wants to allow big steel companies to develop domestically to fight off the influence of the Posco’s and Arcelor Mittal’s of the world (both of which already do a lot of business in China). Steel production is protected in China, with limits on the amount of production that foreign companies can own, and tax incentives for domestic steel producers to expand (particularly Westward, which has been part of GSI’s focus in the past year). That desire from the Chinese government means they’re allowing the state-owned steel mills to consolidate and privatize in order to make them more competitive, and General Steel seems to me to be the firm best positioned to profit from that consolidation.
The Chinese Steel Market
As you might expect, GSI depends on the demand for steel in China — which is huge and has been growing steadily for decades. China is both the largest producer and the largest consumer of steel in the world, using about a third of the steel the world produces every year to build skyscrapers, ships, infrastructure, cars, and what have you — pretty much any kind of steel you can imagine. GSI is strongest in rolled and sheet metal and rebar at this point, though with only four divisions their mix changes appreciably with each acquisition.
If those markets collapse to any appreciable degree — and that will include commercial and infrastructure construction, since rebar is a big part of their business, as well as the utility and energy buildout for their pipe business — then the prices for their products will likely fall and GSI will suffer. Likewise, if steel prices internationally ever come back down to earth, or have a collapse of any kind, GSI’s share price will probably also suffer. I can’t predict the future price of steel, but since GSI is so exposed to Chinese infrastructure growth, and in particular to growth in Xi’an and other fast-growing regions of China, I expect volumes and demand will remain strong. That should, in the absence of external shocks, allow them to keep prices reasonably high and maintain profitability.
Company History and Acquisitions
GSI is a pretty new company — the original venture behind the firm was founded in 1989 by Henry Yu, who is still the controlling shareholder. That first company, Tianjin Daqiuzhuang, was the first private steel company in China, or claims to have been, and it has been under the radar for most of the time since that founding. The company was restructured with a reverse merger, adopted the name General Steel Holdings, and came public in the US in 2004 on the over the counter market. The company that they took under was in construction equipment, and the first division of GSI focused on steel for equipment manufacturing, so you’ll sometimes see the company put into the “construction equipment” sector even though they are a pretty well diversified steel company at this point.
Just recently, in 2007, they started speeding up their “growth by acquisition” strategy and got a listing on the Amex and then, a few months later, switched to the NYSE. It is no coincidence that these listings happened just as their acquisitions began to accelerate, since one of their key advantages, they hope, will be their access to relatively cheap capital from US equity investors. They now have a viable currency to use for acquisitions in their NYSE-listed shares, though deals to this point have generally been made for cash (and debt). They do have a fair portion of debt on the books right now, a bit over $200 million, much of which is short term (due within a year), so that is one red flag that bears watching — they’ll have to roll that debt over, most likely, or issue new equity to raise funds, although my guess is that they’ll not find it difficult to do so given their high-value assets.
The company currently has four large joint ventures of significance, one of which just closed in June (Maoming Hengda, which owns a hugely undercapitalized plant for rebar and wire in Guangdong). Prior to GSI’s swath of acquisitions in the past year, they were known as a producer of light sheet steel (that’s probably not the right technical term), primarily for agricultural equipment (this is now the Tianjin Daqiuzhuang division). The acquisitions have been in somewhat more promising specialties: new joint ventures made prior to this recent one with Hengda added capacity for rebar in Shaanxi province, near Xi’an (Longmen steel), and pipe, particularly for energy markets (Bautou), as well as access to raw materials (coking coal and iron ore) to help control costs and vertically integrate their operations to some degree.
The two larger joint ventures that were added in 2007, Longmen and Bautou, are the biggest growth engines so far, with Longmen making up the lion’s share of the growth — they allowed the company as a whole to increase production (in tons) by 700% in one year, and to quadruple their number of employees and add significant new product lines. Hengda will have a large impact, too, though it’s expected to take longer — Hengda’s mill is running at only about 10% of their stated capacity of 150,000 tons a month because management has essentially ignored the mill (which is mostly quite new, with equipment installed within the last five years) and starved it of working capital.
GSI will have to commit a significant amount of capital to increase production at Hengda, but analysts seem to like the acquisition a lot (the analyst from Merriman Curhan Ford sees it being accretive in the fourth quarter this year, and thinks it might add 25 cents to EPS in 2009). What seems to be undeniable is that the deal was a bargain, at least on paper — the value of the assets in the mill is reportedly about $100 million, the reported equity book value is $11 million, and the cost to Hengda to acquire was $7.1 million in cash and the assumption of another $14 million or so of debt. Clearly, there is some operational risk here because the mill will have to be quickly brought back up to near-capacity in the next couple years to justify the capital required.
All of this means that we’re dealing with a company that has a proven ability to make acquisitions at reasonable or cheap prices, and of significant size — the stated production capacity of Hendga is 1.8 million tons a year, which would increase overall capacity for GSI by about 50% (it will take a couple years to get to that capacity, probably).
Investing in General Steel is a bet that things will continue to develop as they currently are — China is trying to encourage the consolidation and modernization of the domestic steel industry, and it is companies like General Steel that will make that happen. Do not lose sight of the fact that they are not the only players, however — GSI is one of only a couple Chinese steel makers that trade in NY, but there are literally hundreds of other steel companies in China. Here’s an excerpt from a recent Investors Business Daily article on GSI (read the whole article, too — it’s worthwhile):
“The government’s goal: bring 50% of domestic production under the helm of the top 10 steel outfits by 2010, and 70% by 2020.
“General Steel says that as excess capacity from weaker players is removed, the stronger steel companies will gain clout. More than 1,000 steel firms of all sizes now operate in China.
“General Steel aims to be one of the stronger players left standing. It figures it now keeps company with the top 30.”
So although we don’t hear about them — because they’re not publicly traded in NY, or, in most cases, public at all, there are at least 20-30 steel companies in China that are larger than General Steel. Most of them are not growing at the same pace — revenue has gone up 30-fold for GSI in three years, and earnings are about 70X what they were in 2006.
It appears to me, a non-expert on Chinese industry, that General Steel has also done a very impressive job of targeting acquisitions in strategic areas — owning the lion’s share of the rebar market in the Xi’an area of Shaanxi as they do (70%+, the company claims) is an incredible advantage, given the huge amount of concrete poured in that area as China’s westward development is pushed aggressively by the government (not to mention the rebuilding from the earthquake, though that was mostly out of Longmen Steel’s core market area). It is easy to understate the risks when you see a company in a hot sector with high demand, like steel, acquiring state-of-the-art steel mills at tiny multiples of earnings and reporting earnings growth of several hundred percent, even if we discount that most of that growth rate is from acquisitions.
So I’ve told you why I think the company is well positioned, in a strong sector, with rapid growth.
What are the risks?
Earnings are very hard to predict for this firm, partly because they’re growing and acquiring very fast and it’s hard to tell when those acquisitions will impact earnings, and exactly how they will be accretive or dilutive immediately; and partly because input costs have caused some significant volatility to their margins. The last earnings release had them reporting EPS that was about half of the expected 13 cents, and the stock was clobbered. The forward PE is 11, but that’s based on earnings almost doubling next year — and that, in turn, is based in large part on successfully integrating recent acquisitions and improving productivity at those new plants.
This is, as the IBD article aptly quotes the CFO as saying, an “acquisition platform” — they are valued at a higher forward PE than their large international competitors largely because of the rapid growth brought by large acquisitions last year, so if they overpay or fail to integrate acquisitions well they could lose that premium valuation.
And who knows, they may end up a target themselves, even though that seems unlikely with management holding 60%+ of the company — it is important to note that they are playing in a pond that has many fish who could eat them fairly easily.
There are perhaps a thousand steel companies in China, so there are plenty of smallish ones to acquire, including many regional state-owned mills that are probably easy to improve fairly rapidly, and it appears to me that by making relatively small acquisitions as they have been GSI is flying under the radar of the big regional behemoths. That should not distract us from the fact that this industry in China is dominated by huge state-owned companies that are also consolidating. Baosteel and Wuhan Steel, for example, are both state-owned but also both produce well over 20 million tons of steel a year of all types, and the newly created (by merger) state-owned companies Shandong and Hebei each will produce more than 30 million tons — these are the companies with massive scale that help set iron ore prices with Australia and Brazil, while GSI’s influence is quite a bit more restrained. General Steel’s stated capacity is still under 5 tons even after the Hengda acquisition, and actual production is significantly lower than that.
The company has also been underperforming their own aggressive goals, at least informally — they’ve made the circuit of a few investment conferences in the last year and a half, and their expectations for EPS growth have been proven a bit optimistic (in February of 2007, they were apparently predicting $1.81 in 2008, it seems more likely to be in the .80 range this year). This is probably due both to a somewhat lower operating margin than expected, due to higher input costs, and, perhaps more importantly, to a slower pace of acquisitions than they expected. They spoke of two potential new acquisitions at a conference last fall, both of which were “in negotiations” — one was a “coastal steel company” that makes wire, and that acquisition was expected in late 2007 but actually closed at the end of June (Maoming Hengda Steel, noted above). The next big acquisition that was “in negotiations” was was expected to be a large state-owned enterprise, and that acquisition has not yet surfaced. It should not be a surprise that mergers and acquisitions are slow and tedious events in China, and that negotiations can take years, but it is still noteworthy that GSI’s aggressive push for growth by acquisitions can be significantly slowed down from time to time if negotiations fail or transactions are delayed.
And finally, since this company is dominated by its founder we have him to worry about, too — he has been a huge positive for the firm, he is well-connected politically and I don’t doubt that his connections and reputation help to speed up acquisitions and make their targets more amenable and the government more supportive … but he also owns well over 50% of the company and can pretty much do what he pleases. So far, he appears to have resisted diluting his ownership by using shares for relatively small acquisitions, preferring cash and debt, including convertible debt, but if they do end up forming a joint venture or merging with any of the larger state-owned enterprises I wouldn’t be surprised if they had to issue stock to do so, diluting his ownership (and yours), hopefully to good end. With their focus on growth and acquisition it seems unlikely that they’ll pay a dividend at any time in the near future, so if Henry Yu wants to raise money personally he may sell shares, which could also impact the stock price.
If you’re still interested after all that … I do think GSI is well priced today, perhaps a bit more expensive than I’d prefer, and it’s entirely possible that a better price will be available in a month or two if there is a letdown following the Olympics or the company’s next results disappoint. Their next earnings update should come out in a couple weeks, right after the Olympics, so it could be a wild ride for GSI this month, up or down.
I think the growth opportunity is significant, and I like the management focus, and the fact that they have acquisitions already in place that would allow for dramatic EPS growth in 2009 even if no more deals are finalized in the next six months (though I expect we’ll hear of more deals, too).
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