Buy Price: $3.48
WSP (or "the company") is a Cayman corporation that conducts its operations through Chinese subsidiaries. The company manufactures seamless (as opposed to welded) oil country tubular goods (OCTG), which includes casing, tubing and drill pipes used in the drilling and extraction of oil and natural gas. WSP’s primary customers include the large Chinese oil and gas companies such as CNPC and Sinopec, but in recent years the company has expanded international sales particularly in North America (more on this later in the risks section). WSP manufactures products according to standards formulated by the American Petroleum Institute (API), as well as proprietary non-API products designed according to customer specifications and built to withstand harsher environments than the commodity-like API products. The non-API products are more expensive and generate higher margins than the API products and the company is focusing on developing this side of the business, as demonstrated by the following percentage increase in revenues vs. API products:
2006 API Revs: $299.1M (88%) 2006 Non-API Revs: $41.3M (12%)
2007 API Revs: $288.6M (65%) 2007 Non-API Revs: $152.4M (35%)
2008 API Revs: $505.3M (63%) 2008 Non-API Revs: $294.8M (37%)
Selling OCTG products (and global oil/gas exploration generally) has been an extremely profitable and growing business over the last decade, a trend which we believe has the potential to continue once the current slowdown is played out. We welcome the opportunity to invest in this line of business (especially one with a profitable run-rate) in a time of public disfavor.
Geographic Distribution of Sales: WSP’s international sales have expanded in recent years which has been a positive development for the bottom line, as export sales carry higher prices and higher margins.
The following shows the domestic/export distribution of sales over the prior three years:
2006 Domestic Sales: $187.7M (54%) 2006 Export Sales: $156.2M (46%)
2007 Domestic Sales: $191.2M (47%) 2007 Export Sales: $218.8M (53%)
2008 Domestic Sales: $238M (39%) 2008 Export Sales: $370.5M (51%)
Facilities: The company operates ten threading lines, and two drill pipe production lines in various locations in China for the purpose of manufacturing finished OCTG goods. The company also operates three production lines for the purpose of manufacturing green pipes (unfinished steel pipes later transformed into finished OCTG goods). The company is also working on establishing a US manufacturing facility in Texas. Recently, the Company acquired a majority stake in a steel billet manufacturer (the principal material used in the manufacture of OCTG goods) hoping to exercise greater control over its cost structure. Expansion has been funded largely through operating cash flow and the company's IPO.
Cost Structure: Like many Chinese companies, WSP spends far less on corporate overhead, including compensation, insurance, regulatory compliance, etc. than their American counterparts. The company’s major cost is steel – expenditures on raw material accounted for 77.9% of revenues in 2008, and 80.9% in 2007. A low cost structure has allowed WSP to compete favorably on price in North America (but see litigation section below). Fortunately, when steel prices increase (like in 2008), oil and gas prices generally increase, allowing form some elasticity in the price of OCTG goods. This is not to say that WSP’s margins are immune from input cost pressure (2008 saw a decline in gross margins even with record revenue and net income).
Competition: WSP faces stiff competition in both China and internationally. It should be noted that several Chinese competitors are state-owned-enterprises and therefore have access to the greater resources that come with government support. Internationally, the company faces competition from big names like Tenaris (NYSE: TS), and US Steel (NYSE: X). Tenaris provides an interesting comparison for valuation purposes because they, like WSP, specialize in steel tubes designed for the oil and gas industry (see the valuation discussion below).
Initial Public Offering: WSP completed a sale of 50M shares at $8.50 per ADS on December 6, 2007, the proceeds of which have been used to acquire/construct facilities, for debt repayment and for working capital purposes. WSP’s underwriters exercised their over-allotment option and purchased an additional 2.9M ADSs. Like our investment in China Nepstar, we appreciate the opportunity to purchase a relatively stable and growing company far below its recent IPO price.
Dividend Policy: One thing that gives us comfort when investing in a small cap emerging market stock is dividend policy. WSP's board recently announced a one time special dividend of $.45 per ADR and an ongoing dividend policy of 30-50% of operating profit per year. Management believes that cash from operating activity less the dividend will be sufficient to fund future growth.
Ownership: Like many public Chinese companies, WSP stock is held 50%+ by its founder, Longhau Piao. We have mixed feelings about investing in a controlled corporation, given the potential for insider dealing. However, WSP’s dividend policy and record of insider transactions that actually favor the corporation (loans at below-market rates) demonstrate thus far that Mr. Piao appreciates his role as a fiduciary. We also note that WSP used the proceeds of its IPO for expansion purposes, not to “cash out” Mr. Piao. Nevertheless, we think that any transactions between Mr. Piao (or any of the other business ventures he’s involved in - and there are a few) and WSP should be closely scrutinized for fairness. Anecdotally, we’ve observed that transactions between Chinese companies and their founders is the norm, not an exception, and is something that should and likely will become more rare as the Chinese market develops.
Margins: WSP has healthy but not extraordinary margins for a capital-intensive manufacturing business. Gross margin has floated upwards from roughly 18% in 2005 to 23% in 2008 (albeit down from 2007), which compares unfavorably to Tenaris's mid 40s (WSP’s has lower prices) and slightly better than an American concern like US Steel which operates in the mid to high teens in good years. The company makes up for the cost of raw materials with low operating expenses, which have allowed it to maintain operating margins around 20% (generally low teens for US Steel, and high 20s for Tenaris).
Balance Sheet: WSP operates with a large amount of short term debt used to fund its raw material purchases, resulting in roughly $1B in short term liabilities. However, the company has successfully operated with a proportionally similar capital structure throughout the last five years. A large amount of the company's cash is used to secure the short term financing, and held as "restricted cash" on the company's balance sheet. As of March 31, working capital was $84M, which appears to be adequate to fund ongoing operations. WSP has no long term debt. We think that the company's large level of short term borrowings is a point to monitor going forward but at this piont not a reason to withhold our investment. We would like to see an increase in working capital as the company exits its post-IPO expansion stage.
Revenue/Earnings: WSP's revenue and earnings have grown substantially over the last five years due to the global energy exploration boom and the Chinese growth story. From 2004 to 2008, revenue CAGR equaled 64.2% and net income CAGR equaled 97.5%. We don't anticipate growth of this magnitude over the next five years nor does our investment thesis require this type of growth.
WSP is extremely cheap based on historical earnings and compared to shareholders equity. At the time of writing, shares traded at roughly 3.5x 2008 earnings (less if the business is valued without working capital), or EV/EBITDA of less than 2. We purchased shares at roughly .8x book value. While 2008 may have been the height of the company's growth and earnings, management has forecast solid revenue and earnings for 2009, at around $.70 per ADR, and backed it up with earnings of $.21 for ADR for the first quarter of 2009 during the global financial crisis when oil and gas cap-ex came to a screeching halt. At our purchase price we'd be satisfied with $.50 per ADR for 2009 and moderate growth in the following years.
Tenaris Comparison: Tenaris provides an interesting comparison for valuation purposes. At the time of our purchase of WSP, TS traded at about 2x book, 9x 2008 earnings and about 5x EV/EBITDA. But note that this is a far from perfect comparison - Tenaris is a more established, larger international competitor that isn't facing the litigation described below. We simply feel that WH provides a better risk/reward profile.
Litigation: In addition to the lull in oil and gas prices and cap-ex, the company's shares are in deep-value territory because of two litigation matters in the US. While these matters are certainly not trivial and could result in a very negative effect on earnings, we believe that the most negative of potential outcomes is priced in to our purchase price. First, a number of US steel companies and the United Steelworkers Union has filed a petition with the International Trade Commission and the U.S. Department of Commerce alleging that China-based OCTG manufactures have dumped products into the US market with Chinese government subsidies. We expect that the governmental investigations could take a very long time, and may result in tarrifs or other trade barriers (see the results of a similar Canadian investigation not discussed in this post). The second matter involves the company's relationship with a large US supplier to oil and gas companies, SB International, Inc., which is responsible for a large amount of the company's North American revenue. SB International has alleged that WSP has tortiously interfered with its relationships with oil and gas companies. Our uninformed suspicion is that this matter involves attempts by WSP to engage directly with US oil and gas companies and essentially remove the costly middleman. It should be noted that we believe the Company's greatest growth opportunities come in international markets, especially in China with Chinese oil and gas companies (see the Chinese stimulus package and the Eeast-West Gas Pipeline project). Based on current valuation, we believe that over a long time horizon an investment in WSP at our purchase price will result in market-beating results even in the event US operations were dropped (but we doubt that the result of the litigation will be so extreme).
Other Risks: Global oil/gas prices will continue to affect the level of cap-ex, and in turn, the price and quantity of WSP's goods and sales. Steel is by far the company's largest cost, and rising steel prices in 2008 began to eat into WSP's margins, partially offset by increased selling prices. The ability of the company to procure cheap and consistent supplies will be a key factor in delivering market-beating gains for investors (see the Company's recent acquisition of a steel billet manufacturer). While we prefer to have managers with "skin in the game" we are weary of investing in controlled companies, like WSP. The potential for abuse is considerable and should be monitored.
Depsite these risks, particularly the litigation matters discussed above, we believe that WSP's current valuation presents a favorable risk/reward scenario.
Bottom Line: Long 5%
Disclosure: Long WH