How I Learned to Stop Worrying and Love the ZOLT

| About: Zoltek Companies, (ZOLT)

While it's a debatable issue, it's quite possible that carbon fiber is the greatest stuff on Earth! Carbon fiber has tensile strength roughly four times greater than steel despite having a much lighter weight. It is used in many applications ranging from wind turbines to aircraft brakes to bicycles. Over the next few decades, it is almost inevitable that its use will be expanded into even more products. Given the great growth prospects, it makes sense to take a look one of the companies most primed for growth in the industry: low-cost carbon fiber producer Zoltek (NASDAQ:ZOLT)

Zoltek has a handful of competitors in the carbon fiber market including Hexcel (NYSE:HXL), Cytek Industries (NYSE:CYT), and Mitsubishi Rayon (MRYNF.PK); however, most of the competition produces higher-cost carbon fiber primarily used in the aerospace industry. German-based SGL Carbon is ZOLT's major competitor in the lower-cost commercial carbon fiber market. While ZOLT does not have a monopoly, it does have a strong market position in an industry with some significant entry barriers.

In comparison with SGL Carbon, Zoltek actually fares very well and would appear to have significantly better operating margins. An average of the most recent six quarters for Zoltek yields an operating margin of 14.9% and the range has been between roughly 10 and18%.

It's difficult to make a precise comparison to SGL since I only have EBITDA and EBIT figures for the company's carbon fiber segment; the former should yield results that are too favorable and the latter should yield results that are too unfavorable, so the real number lies between the two. If we use EBITDA, SGL has margins in the 9-10% range in its most recent quarters. If we use EBIT, then SGL's operating margins are closer to 4-5%; thus, I'd estimate its operating margin is in the 6-7% range when using similar metrics such as the ones with which I evaluated ZOLT.

On top of producing carbon fiber, Zoltek also makes technical fiber, which is used in flame and heat-resistant applications such as aircraft brakes. While carbon fiber accounted for about 84.4% of Zoltek's sales in the most recent quarter, technical fiber only accounted for 13.2%. Carbon fiber, on average, produces higher margins for ZOLT than technical fiber; over the course of the past year, the gross margin for carbon fiber has been around 29.6% and 22.5% for technical fiber. Carbon fiber sales grew roughly 10.7% per quarter compared to 6.1% for technical fiber.

At the helm of Zoltek is CEO Zsolt Rumy who built the company from the ground up in 1975 and currently holds roughly a quarter of ZOLT's shares. Zsolt is an interesting character to say the least. Reading through the 1st Quarter earnings call was pure entertainment. One gets the sense that Zsolt Rumy is annoyed by some of the analysts and possibly even his own customers. Some might view Zsolt as a bit of a curmudgeon, but sometimes having an old stubborn curmudgeon at the top isn't such a bad thing.

Zoltek's stock has been beaten down this year as it traded around $42 in early January and now sells in the $20-23 range. Given the huge interest in wind power, one might find this surprising; however, the company has failed to meet expectations in a few quarters and has had to deal with the fallout from certain accounting issues. Indeed, in May, CFO Kevin Schott resigned from the company after misstatements were uncovered in prior period results.

As a result, Andrew Whipple was hired on as the new CFO. The market wasn't overly thrilled by the accounting issues and punished the stock accordingly. Was the market overreacting? Apparently, traders came to that conclusion for a brief while as the stock priced suddenly soared back up to $32 in June before retreating back to the $20-25 range.

Many people jumping on the ZOLT bandwagon are looking for investments related to wind energy. Given Zoltek's market position as a leader in providing carbon fiber to the wind power industry; this is certainly a good company to look into if you agree with T. Boone Pickens on the proposition that wind can be "the future" of American energy production.

However, even if you have a more neutral outlook on wind energy, Zoltek still might not be a bad bet. First off, keep in mind that even if wind power does not take off in the next few years, Zoltek is in a safer position on the production chain as it merely sells carbon fiber to wind turbine manufacturers.

There is also a lot of potential for carbon fiber in future applications. Zoltek details a few in its annual report including super-fuel efficient cars, deep-sea exploration and drilling, and construction and infrastructure. I don't necessarily know that the list ends there, either. Given the enormous advantages of carbon fiber, I'd surmise that its usage will continue to grow in more and more application further into the future.

So all in all, this might not be a bad investment even if you are not bullish on wind. As for me, I'm with Boone, and that makes ZOLT an even more intriguing prospect to me. Of course, just because I'm bullish on a particular industry does not mean that price and fundamentals do not matter. Zoltek has traded in the $20-23 range in the past few weeks and I will examine how good of a buy the stock looks at that price point.

The Forecasts

In order to forecast ZOLT's future prospects, I came up with a number of possible scenarios. As with any company, there are always some difficulties with forecasting. I like delving through the annual reports to try to get a sense of where those inside the company believe it is heading. In ZOLT's 10-K and 1st Quarter earnings call, Zsolt Rumy gave a few revenue and cost goals for the company; suggesting that he would like to see ZOLT at $225-250 million revenues for 2008, roughly $337.5 million for 2009 (a 50% increase from the prior year), and $500 million revenues for 2010. It is unclear to me whether this was a high-end "goal" or a more cautious projection. Zsolt goes on to suggest he would like to see the company achieve 34-35% gross margins by the end of 2010.

I also took a look at what a few other analysts thought and revenue projections for '08 seem to go between $202-221 million. Projections for '09 seem to be anywhere from $291-321 million. I did not see any figures for 2010. I'm going to take a similar path and use Zsolt's guidance as a "high-end goal". We already have the results for the first half of 2008 (ZOLT made 13 cents per share for Q2 and 8 cents per share for Q1) so we need to only forecast the second half. At the end of each forecast, I have decided to use a 20-25 P/E ratio in order to try to determine a price range at the end of FY 2010.

Steady Assumptions

Due to the inherent difficulties in trying to ascertain a pattern for certain expenses (not related to gross or operating margins), I have made a few steady assumptions for all the scenarios. ZOLT's net interest income for Q2 of 2008 was $473,000. This was a decrease from $514K the previous quarter, and $544K from Q4 of 2007. I start my forecast at $450K for Q3 '08 and decrease the number by $50K for each successive quarter till it drops to $0 in Q4 of 2010.

Amortization of Financing is a particularly difficult number to ascertain. For FY '07, the expense was $9.8 million, a significant decrease from $16.5 million in FY '06. The expense appears to taper off more in '08, so I have projected a $2 million amortization charge for each quarter ($8 million for the year) through the entire forecast. This would appear to be a bit conservative, but it is difficult to tell for certain.

"Other expense" is also difficult to make a guess at since there is no discernible pattern and there could be numerous different expense and income items lumped in there. I play it conservatively and project $300,000 for each quarter in FY '08, $400K in '09, and $600K in '10. I also notice that there is a trend of greater share dilution over time so I increase the number of outstanding shares by 1 million for each quarter.

One more minor note; I noticed that Zoltek's SG&A expenses tend to higher in the 1st Quarter each year. According to Zsolt Rumy, this is due to higher costs incurred during the winter season. Based on this, I decide ­to apply the prior year's (less optimistic) SG&A expense estimates to Q1 of the next year. In all likelihood, the SG&A costs would vary more dramatically from quarter to quarter, but instead of coming up with a number for every single quarter, it's much simpler to come up with an average, and I think extending the prior year's average to the most expense-heavy quarter should help keep the forecasts a little more on the cautious side. Now, on to the scenarios:

Scenario #1: Close to Expectations

For scenario #1, I assume ZOLT comes close to meeting revenue expectations, but I am a bit more conservative on costs. Major assumptions are as follows:

Item: 2008, 2009, 2010

Revenues: $207.7 M, $320 M, $470 M

Gross Margins: 29%, 30%, 32%

Development & Application Costs: 4.7%, 4.6%, 4.5%

SG&A: 9.0%, 8.8%, 8.5%

Based on this forecast I get the following results for Earnings Per Share (NYSEARCA:EPS):

FY '08: $0.61

FY '09: $1.15

FY '10: $1.85

Based on a P/E of 20-25, the stock might trade in the $37-46 range.

Scenario #2: Be Aggressive!

I decide to get a little more aggressive in this scenario, particularly in 2010. In this scenario, we still don't quite achieve Zsolt's $500 million guidance or his 35% gross margin goal, but we come very close. Major assumptions are as follows:

Item: 2008, 2009, 2010

Revenues: $207.7 M, $320 M, $486 M

Gross Margins: 30%, 31%, 33%

Development: 4.7%, 4.5%, 4.4%

SG&A: 9.0%, 8.6%, 8.2%

Based on this forecast, I get the following results for EPS:

FY '08: $0.65

FY '09: $1.26

FY '10: $2.08

With our P/E of 20-25, that gives us a trading range of $41-52.

Scenario #3: Partly Cloudy, Chance of Rain

For this scenario, I decide that ZOLT fails to meet expectations over much of the next 30 months. This is not a disaster/worst-case scenario as the company still has good growth, but it's not quite near Zsolt's guidance either. Assumptions:

Item: 2008, 2009, 2010

Revenues: $203.7M, $300M, $420M

Gross Margins: 29%, 30%, 31%

Development: 4.7%, 4.6%, 4.5%

SG&A: 9.0%, 8.6%, 8.2%

Based on these results, I get the following results for EPS:

FY '08: $0.60

FY '09: $1.08

FY '10: $1.56

With a 20-25 P/E ratio, this gives us a price range of $31–39.

Scenario #4: The Pessimist

I always like to throw in a pessimistic scenario and an optimistic one, as well. For the pessimistic forecast, assumptions are as follows:

Item: 2008, 2009, 2010

Revenues: $201.6M, $292M, $386M

Gross Margins: 28%, 28%, 27%

Development: 4.8%, 4.7%, 4.6%

SG&A: 9.0%, 8.8%, 8.6%

The EPS figures:

FY '08: $0.55

FY '09: $0.87

FY '10: $1.01

With our 20-25 multiple, that gives us a price range of $20-25.

Scenario #5: The Optimist


Item: 2008, 2009, 2010

Revenues: $213.7M, $330M, $490M

Gross Margins: 30%, 32%, 34%

Development: 4.7%, 4.5%, 4.4%

SG&A: 9.0%, 8.6%, 8.2%

EPS results:

FY '08: $0.67

FY '09: $1.39

FY '10: $2.21

Using our well-established multiple, that gives us a trading range of $44-55.

And finally …

Scenario #6: Moderately Conservative

While I've already done more than enough scenarios in actuality, I always like to do what I'd label a "moderately conservative" forecast since I am a bit of a skeptic:

Item: 2008, 2009, 2010

Revenues: $207.7, $314M, $434M

Gross Margins: 29%, 30%, 31%

Development: 4.7%, 4.6%, 4.5%

SG&A: 9.0%, 8.8%, 8.5%

You know the drill by now:

FY '08: $0.61

FY '09: $1.13

FY '10: $1.59

This puts us in a $32-40 trading range at the end of FY '10.

Concluding Analysis

I view Scenario #1 as the most likely scenario, though, for personal use I like my "moderately conservative" scenario. Based on our forecasts, I would suggest a target price at the end of FY 2010 of around $40, which is about an 82% gain. Even going by the "moderately conservative" forecast, we could see a 60% gain.

While it's important to note that anything could go wrong when we are talking about stocks, barring anything catastrophic occurring, I would give a reasonable downside risk at a 20-30% (down to the $15 range); for this to happen, I'd assume that there would be either an oversupply of carbon fiber in the market, Zoltek would have a lot of difficulty increasing its capacity, or the company would be sued even more than it already has.

Analyzing the upside for ZOLT is a little trickier. Going with our optimistic scenario, we could end up at around $50/share, so that's about a 130% appreciation in value. However, a P/E ratio of 20-25 would only be appropriate if the demand for carbon fiber from new applications (such as the ones mentioned earlier) does not significantly increase in the next few years. If there is a greater reason for optimism that carbon fiber's usage will be expanded into more products, we could possibly go with a higher P/E ratio; maybe in the 30-35 range. In that case, the stock could have an upside around $70.

As with all stocks, there are some risks that are difficult to foresee. I don't believe that the carbon fiber market will experience significant oversupply issues in the next 3 years due to the high (and rapidly growing) demand. There's also the fact that any new competitors would probably take a few years to set up shop and get going, which helps insulate Zoltek a little bit more. If I were incorrect in these assumptions, that could alter the results significantly.

If our results look pretty good, then what's dragging this stock down? Is it the accounting? The lawsuits? General pessimism in the market? Is it possible that the market just doesn't like that stubborn old curmudgeon Zsolt Rumy?

It sort of reminds me of a scene from Akira Kurosawa's Sanjuro. In this particular scene, a group of young warriors had talked to both the Chamberlain and the Superintendent about corruption. The Chamberlain was an ugly man who seemed cynical and not as helpful as they would have liked. The Superintendent was an attractive man who was all too eager to help out. The young warriors praised the Superintendent and concluded that the Chamberlain, despite his "good nature" was rotten.

The title character, Sanjuro, interjects in the discussion about the two men and says he believes from their description of the events that the Chamberlain was alright and the Superintendent was no good. Maybe that's not a bad way to view Zsolt Rumy. He has built Zoltek from scratch and guided it through (what he jokingly refers to as) "the Dark Ages" and into the current era with huge growth.

A deep look at the company suggests that he has a very great understanding of his industry and cares about building the company long-term. Compared to competitors, he seems to have this company in an ideal position. Certainly, no one wanted to see the accounting issues and the company needs to get its internal controls in order, but it seems to me that the market might be overreacting to some of the troubles and Zsolt acted quickly in trying to correct the situation.

Maybe it's time to stop worrying and love the ZOLT!

Stock position: None.