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An investment in Northwest Pipe Company (NASDAQ:NWPX) currently provides an opportunity to earn a moderate return on a valuation basis based on 2013 expectations, with the potential upside of a more speculative type of investment as the new management's initiatives come to fruition possibly as soon as next year. The stock currently trades at a discount to tangible book value and a discount to comparable peer multiples on my 2013 estimate, but the real upside lies in the potential for earnings to nearly triple by as early as next year if a better operating environment materializes for the Tubular segment. The stock has effectively gone sideways over the last two years ignoring the material improvements occurring at the company by new management.

  • New Management deploying unused capital to increase capacity, and upscale product line of Tubular Products to increase margins and Return on Assets.
  • Q2 of 2013 is likely to see a trade case filed against South Korean imports of OCTG pipes. Last time such a case was filed against an importer it lead to a material change in EBIT/Ton profitability of domestic pipe manufacturers.
  • Water Pipeline Segment controls approximately 50% of niche large diameter water pipe market with handful of competitors.
  • Despite financial strains on Municipalities delaying needed infrastructure work; Water segment has largest backlog in place in segment's history.
  • Current stock price reflects none of the material improvement in company earnings, cash flows, leverage position, accounting procedures, capital deployment, or operational efficiencies that have occurred over the last year and a half. New CEO in place experienced in operating a pipe manufacturer; with discount to tangible book value and peer group earnings multiples; this discount is ready to be erased.

NWPX

2010

2011

2012e

2013e

Stock Price

$24.03

$22.86

$22.97

$22.97

Diluted EPS

(.59)

1.35

1.52e

1.60e

P/E

neg

16.9x

15.1x

14.4

P/TBV

1.09x

.98x

.93x

.86x e

Net Debt / Ebitda

6.3x

1.7x

1.5x e

1.4x e

Source:Y Charts Financials, and company SEC filings. All estimates are my own.

This is largely due to unfortunate circumstances surrounding two accounting restatements. The result provides an opportunity to buy into a turnaround story where the heavy lifting has already been completed for a true value discount.

Background History:

One of the primary reasons for this stock's discount is the path by which it has taken to arrive here, and a lot of blame can be laid upon the previous management for two reason: 1.) improper and inadequate accounting, 2.) underutilized capital. In 2009, the trouble began as accounting improprieties were discovered that lead to over a year without filing financials, and the eventual removal of the CEO and CFO followed in 2010. At this time, Richard Roman, who was the independent director in charge of the auditing committee and had previous experience in the accounting industry, took over as CEO. In late August of 2010, James Declusin, was elected to be the Lead Director of the Board. Mr. Declusin had a successful history turning around and selling another Portland Oregon based company called Oregon Steel Mills in 2007 to the Russian steel company: Evraz. Since he joined the board he has been helping NWPX acquire key talent from his previous Oregon Steel team. Shortly after his arrival, Robin Gantt, former controller of Oregon Steel, joined NWPX to lead the audit group responsible for getting the company current with all filing requirements, and subsequently thereafter became the new CFO in 2011. Next came Scott Montross who joined NWPX in May of 2011. Mr. Montross was also a veteran of the Oregon Steel Mills team, and had most recently been the head of the Tubular Mills group for Evraz in North America. Mr. Montross was originally brought in as COO, but just moved into the CEO role as Mr. Roman has stepped down from his temporary position returning to the board of directors.

During this period of management transition, the company has materially altered the earnings and cash flow capability of the business, and has done so with minimal expansion of capital expenditures. This is due to an unusual situation where large amounts of capable fixed capital assets were left essentially underutilized or even idle. In 2010, NWPX started selling Oil Country and Tubular Goods (OCTG) pipe out of their Bossier City LA facility. The mill's equipment for Bossier City actually came from a repositioned pipe mill that had been in Portland OR which was not being utilized. In 2008 the Tubular Segment's estimated capacity in tons was approximately 150,000, and the segment was spending just over 6 million of capital expenditures. If we assume that cap-ex figure was the approximate maintenance level of the segment, then it would suggest that over the next three years it took only about 16.5 million in growth cap-ex to expand the segment's estimated capacity from 150,000 tons in 2008, to 425,000 tons that is available today. The mix of the product was also improved significantly during this process from mostly commodity line pipe into higher value added drilling pipe. Thus, the tubular segment's operating income potential has expanded well beyond just the absolute increase in potential production as will be shown in greater detail in the next section.

While improvements in both management and results were already being manifested in the price of the stock, an unfortunate setback came late in 2011 when the auditing company, Deloitte & Touche, decided that they were concerned about the Depreciation and Amortization schedule which uses both the straight line method and the units of production method. This came less than one year following the restatement work that the company had completed under Deloitte's supervision. I believe that the source of the second issue regarding the company's financials came from a disagreement between the district office and national office of Deloitte. However, forcing the company to go through a second restatement just one year later caused the stock to sink back to below tangible book value. The result has been a stock that has essentially gone sideways over multiple years despite material revenue, earnings, cash flow, and leverage improvements.

Segment Descriptions

Northwest Pipe Company , has two operating segments:

  1. Water Transmission, which manufactures large diameter pipe used in water infrastructure projects. The primary end users are municipalities building infrastructure for drinking water due to either population expansion or replacement of deteriorated pipelines. The Environmental Protection Agency, and the American Society of Civil Engineers, estimates that most of the country's drinking water infrastructure will have to be replaced over the next twenty years. As of 2010, the rate of spending needs to increase by 150% annually in order to meet that goal, but at current trend the need for capital spending will escalate from 96 Billion in 2010, to 126 Billion in 2020, to 195 Billion in 2040. The longer investment is delayed; the higher the cost due to larger portions of the infrastructure failing to meet renewal and repair capabilities. There are limited competitors in the large diameter segment of the drinking water infrastructure market: Ameron International Corporation (NYSE:AMN), (which was purchased by National Oilwell Varco (NYSE:NOV) in 2011 for approximately 20x forward earnings and 7x forward Ebitda), Mueller Water Products (NYSE:MWA), American Spiral Weld Pipe Company, and Hanson Pipe And Precast.
  2. Tubular Products historically manufactured lower margin commodity line pipe used primarily in oil and gas field transmission. Over the last two years, new management has increased capacity of this segment from an estimated annual capacity of 150,000 tons to 425,000 tons by early 2013. The primary sources of increased capacity have come from; unused capital, (new management shipped a pipe mill that was not being used from Portland Oregon to Bossier City Louisiana), increased capital expenditures, (segment cap-ex increased from 6.1 million in '08 to 14.3 mil '09, 9.1 mil '10, 11.4 mil '11), and the offering of higher value added products, (making more pipe that meets drilling standards versus line pipe), and operational efficiency enhancements. The latter of which can be seen more at this point in the improving margins even while capacity utilization has declined in the recent downturn for OCTG pipe:

Est. cap Util

Tubular Seg Ebit Margin

2010

78%

4.2%

2011

74%

5.3%

e2012

53%

6.0%

source: NWPX conference calls, and SEC filings.

With three quarters in the books for 2012, I estimate capacity utilization to be approximately 53%, but for the segment operating margin to again increase to 6%. The Tubular Products segment has historically been an also-ran division for NWPX, but recent maneuvers over the last few years has radically changed the mid-cycle and peak earnings capabilities of this segment and subsequently the company as a whole.

Recent trends in the two segments have been cyclically down, as Municipalities and Water Utilities have continued to push out renewal and replacement work, and foreign imports, (primarily from Korea), have been flooding the domestic market for OCTG pipe while demand has slipped in drilling from low natural gas prices. Despite the general downturn in water transmission business, the segment is one quarter removed from its all-time high in backlog as it declined slightly from 245 million in Q2 to approximately 241 million at the end of September 30th. This is primarily due to the recent addition of Lake Texoma work in Texas. This project has been rushed to the forefront due to the growing population of suburban north Texas, and issues with environmental contamination of other lakes by invasive species. The result is a growing backlog for NWPX with what will likely turn out to be superior margins than normal due to the speed at which the project is needed to be completed. I expect more of these choppy but highly profitable projects to occur in the years to come for NWPX, as the nation slips further behind the necessary capital investment into its aging drinking water infrastructure and is forced to respond by shifts in population demand as well as outright failure of installed infrastructure. The Tubular Products fortunes have recently declined with the domestic OCTG pipe market, as slowing demand and increased import pressure, primarily from Korea, have reduced operating margins per ton for the industry materially. The domestic OCTG pipe market is one of the few steel products that cannot be wholly supplied from domestic mill sources. Historically, about 50% of domestic demand is furnished from local production with the balance supplied from imports. Recently, volumes have slipped with the declining rig count.

United States Steel (NYSE:X) Tubular Segment Data

Q1 '12

Q2 '12

Q3 '12

Q4 '12

Tube Steel Shipped Tons:

529

493

457

407

Sequential % Change:

9.8%

(6.8%)

(7.3%)

(10.9%)

Year over Year % Change:

24.5%

16.3%

(5.0%)

(15.6%)

Source: Unites States Steel company reports, and SEC filings.

While imports in OCTG pipe have continued to grow at a rate significantly greater than overall steel imports. The rate of growth in total Korean steel imports has been particularly glaring.

US Imports for Consumption of Steel Products NSA

Q3 '11

Q4 '11

Q1 '12

Q2 '12

Q3 '12

Total Steel in Tons:

6,663,392

5,919,162

7,804,256

8,190,911

7,306,932

Year over Year %:

10.0%

17.6%

33.9%

9.9%

9.7%

OCTG in Tons:

717,005

654,317

853,882

934,916

831,402

Year over Year %:

4.4%

13.3%

42.0%

40.4%

16.0%

Korea in Tons:

650,620

553,634

839,391

871,920

862,037

Year over Year %:

19.1%

11.0%

44.1%

10.7%

32.5%

Source: Unites States Department of Commerce Steel Import report.

Potential Near-Term Catalyst:

There has been significant discussion in the industry regarding the likelihood of a case filing with the International Trade Commission against Korea for dumping OCTG product domestically. The last time such an event occurred it was against China. The trade case was filed in mid-2009. And the ITC found in favor of the United States' complaint in early 2010. The result, as can be seen here in X's Tubular segment's EBIT / Ton calculation, was a significant improvement as soon as the case was filed, and a near tripling of profit per ton once it was found in their favor.

US Steel's Tubular Segment Quarterly Data

Q3 '09

Q4 '09

Q1 '10

Q2 '10

Q3 '10

Q4 '10

EBIT / Ton

(31)

57

63

144

175

144

ASP / Ton:

1,474

1,462

1,389

1,496

1,559

1,504

Ship in Tons:

151

207

310

433

422

386

Tube Seg EBIT:

(21)

39

45

96

112

96

Source: Unites States Steel company reports, and SEC filings.

The result of the case can also be seen in the import data itself as the tons of steel imported from China fell by over (41%), while total tons imported overall increased by over 47% with the rebound in the economy. Note that US Steel's shipments in the second half of 2010 were up 125% over the previous year, while the rate of OCTG imports for all of 2010 were up only 48% implying that domestic producers did indeed gain back significant share of the total pipe market with China's restrictions in place.

US Imports for Consumption of Steel Products NSA:

Total 2010

Total Steel Quantity in Tons:

21,708,178

Year over Year %:

47.6%

OCTG Quantity in Tons:

2,162,732

Year over Year %:

48.8%

China Quantity in Tons:

780,995

Year over Year %:

(41.3%)

Korea Quantity in Tons:

1,851,619

Year over Year %:

54.3%

Source: Unites States Department of Commerce Steel Import report.

I suspect a similar effect for all domestic producers of OCTG product if such a case is filed against Korea in early 2013, which would setup NWPX for a material earnings rebound in the second half of the year.

Valuation

NWPX's stock presents an excellent low risk / high potential reward on a valuation basis. There's no better valuation metric for a cyclical business that encapsulates the asset value of fixed investment better than Price to Tangible Book Value. Over the last ten years there have only been two periods when NWPX's stock traded for a materially lower P/TBV multiple, but both of those periods had extenuating circumstances that dragged the multiple down to such a level. First, during the first half '03, NWPX's P/TBV multiple sunk to a low of approximately .64x. During that first half of 2003 the company had made only 2c in eps and approximately 10mil in annualized Ebitda. Thus, there was legitimate risk to the company's equity as net debt to Ebitda stood north of 8x at that run rate. Current Net Debt / Ebitda multiples are just shy of 2.0, and total Net Debt / Capital is only about 21%. Liquidity risk is currently low given this level of indebtedness. Second, during the summer of '10, the stock again sunk to a low theoretically of about .65x P/TBV. This time the cause was due to the removal of previous management, and the ongoing restatement process of financials. Subsequently, there were no SEC filings of 10Q's or K's during that period. Considering neither of those situations is an issue currently; it can be argued that NWPX shouldn't be trading at such a discount to its tangible equity value providing a Benjamin Graham-esque value opportunity for low risk moderate return.

When looking at NWPX's valuation on a peer basis, it gets a little more complicated due to the different end markets of the two segments, and the limited number of directly comparable publicly traded companies. The water segment recently had its closest comparable taken out at about 20x forward earnings. If we take the top ten Industrial companies in the Nasdaq US Water Index, (PNR, FLS, PLL, LNN, TTC, WTS, XYL, VMI, TTEK, MWA), we currently get a forward p/e multiple of 17.5x 2013 earnings. There currently are not any pure play OCTG pipe mill stocks after the consolidation wave in the '05-'06 time frame. Back then there were three pure plays that were eventually gobbled up by larger mill companies: Lone Star Steel (LSS), NS Group Inc. (NSS), and Maverick Tube Corporation (MVK). Despite the highly cyclical nature of these companies' businesses, they tended to receive premium multiples for a steel mill business even during peak earnings periods. For example, during the '05-'06 time frame of exceptional strong earnings; these companies as a group traded for P/E multiples between 10-12x, Ev/Ebitda multiples between 7-9x, and were taken out at an overall Ev/Ton of Capacity for the businesses of about $1,500. That equates to over $60 for NWPX's tubular segment alone if they were to receive the same valuation in the future. One might find the market multiples for these businesses excessive even though they were all acquired. These businesses are very volatile as we've already noted. However, this is likely due to the above average ROA profile of this business over the cycle, and given the market's previous willingness to pay higher multiples for this business; I think we could conservatively say that it should at least earn a multiple similar to other industrial businesses and even its sister segment in the Water business. Thus, since the current environment is depressed in terms of Ebit/Ton of profit, a 15x multiple seems a fair estimate during the current part of the cycle this business is in. I estimate total company operating income for the whole year of 2013 is likely to be fairly close to a 50/50 split. Hence, a 16.25x multiple on my 2013 NWPX estimate of $1.60 would put the stock at $26 at a minimum, which is also just over tangible book value of $24.59.

However, owning this stock is about the upside potential as the impact of all of the capital deployments and process improvements are manifested during a period of relative market strength in the Tubular segment. At last year's annual shareholder meeting, the company gave some basic targets for what they think the company can achieve by 2014. Specifically, they provided a slide deck that targeted a doubling of Ebitda. That would equate to approximately 90 million in Ebitda and likely close to $4.50 in eps. If we assume a lower multiple of 11x for the Tubular segment, a 15x multiple for the Water segment, producing a blended 13x for NWPX as a whole; then that would equate to nearly a $60 stock. Given that management has been extremely conservative to date with the little guidance it has provided, I believe that the earnings power is likely higher than these targets in a good operating environment and probably materially so.

Conclusion

An investment in NWPX at current prices gives the investor a safe moderate return in the near term as the stock trades at a discount to tangible book value and appropriate comparative multiples for its current business performance, but provides the opportunity for materially higher returns as the new managements' many improvements in process and capital deployments come to fruition in an improved operating environment. NWPX should be reporting its fourth quarter soon, and given X's tubular performance, the most recent quarter shouldn't provide any upside surprises quite yet. The next catalyst is likely to be an announcement of a trade case filed against Korea sometime this spring or early summer, and as noted before; this is likely to make an immediate improvement in margins for the Tubular segment. While I estimate $1.60 in eps for 2013 as a whole; most of that is likely to come in the second half of the year and show an annual run rate well north of that $1.60 figure. Bottom line, buying this stock has the potential to provide 200-300% return profile in the out year, while taking exceptionally low risk by buying in at a discount to tangible book value and below peer group multiples to current earnings. That's a very unusual opportunity to be able to invest in a true value stock that could provide the return profile of a higher risk speculative investment. That makes NWPX what I would call a great one way trade.

Source: Northwest Pipe: A Value Stock With Significant Return Potential