It’s amazing how people can easily forget the nature of cyclical industries and the risk of using the earnings of glory days to predict the future.
Walter Industries (WLT) experienced its most glorious days in Q4 2008, with metallurgical coal prices surging to $169/short ton and quarterly earning (before adjustment) jumping to $4.68.
The glory started to fade in 2009, with met coal prices reclining to $133/ton and earning declining to $1.36 in Q1. Things went downhill from there. Q2 2009 earnings dropped to $0.21, with met coal prices dropping to $113/ton.
Based on the company's forecast for Q3 operating data, sales are likely to be 1.4-1.6 million short tons, and operating margin in the $14-17 range. Earning will be in the range of $0.20 to $0.39.
Given management's recent conservative stance (guess it's all for "beating" analyst forecasts), I'd say Q3 earning may be as high as $0.60, assuming 1.7 million-ton production and a $125 met coal price. Given its glorious Q4 '08 earning, the trailing P/E may still remain around 8.
However, if using this optimistic quarterly estimate to extrapolate the forward annual earning, the forward earning will be $2.40, implying forward P/E of 22.4, and don't forget that the peak annual production for WLT is only around 6 million tons.
Unfortunately, few people would realize that companies in the cyclical industry are the greatest value trap at the end of a hot run. In the case of WLT, if the trailing P/E is used, WLT would produce an amazing “under-valued’ P/E of 7.8. Some analysts did tout this great “under-value”. It’s not clear whether they are too simple, or they just intentionally overlooked the nature of the cyclic steel making business. Looking at future earning estimates, one cannot help being amazed by the exuberance of the analysts community.
The forward earning for the next year ending December 10 ranges from $2.64 to $7.80, averaging $4.39, exercising another “under-valued” forward P/E of 12.36. At Walter’s peak production capacity, roughly 6 million tons a year, its earning increases by approximately $0.80 if met coal prices increase by $10.
Hence, WLT will need met coal prices to jump to $145/ton on average to achieve the $4.39 earnings forecast. As we know from last year, even though met coal briefly doubled its historical price to $160, it was proved that there is no castle in the air for met coal prices after all. Even combing the most glorious 12 month period of WLT from Q2 2008 to Q1 2009, the average met coal sale price was only $141/ton.
Given that steel production in Europe and Brazil is down 50%, and not likely to reach last year’s exuberant level any time soon, it’s difficult to reach $4 earning. (By the way, WLT's customer base has largely been Europe and South America. WLT has little to do with the recent exuberance in China. China has major met coal production and has seldom imported met coal because the international selling price is simply no match to local low-cost producers.) Barring exuberance at the 2008 level, the long-term annual earnings for WLT will most likely be in the range of $0.90 to $2.10, assuming yearly production of 6 million tons and an average met coal price of $115 to $130.
Given its earnings growth depends largely on the external met coal price, not organic internal growth capability, a P/E multiple of 15 is reasonable, if not excessive, which puts its stock price in the range of $13.5 to $31.5, a far cry from the current $54 price. It remains a question, though, how long WLT can float in the air. As we all know, the market may remain irrational for an extended time, as evidenced by the recent analyst upgrade.
However, the naked truth will come by Q4 2009, when the trailing P/E finally drops the glorious Q4 '08 earning; even more so by Q1 2010, when the $1.36 Q1 '09 earnings is dropped, the tail of the glorious day.
By the way, apart from valuation, I have always been doubtful about management’s ability to secure long-term growth given its recent speculative jumping into the non-core home-building and financing business, and the hasty spin-off in early 2009. This clearly demonstrates rather desperate moves to find the new growth point for a rather mature core business.
Disclosure: Short WLT