Forum Archive Index - October 2002

["tennyson@caverock.net.nz" <tennyson@caverock.net.nz>]

Apologies in advance for the length and detail of information in this 
post.   It was necessary because I have never seen a thorough 
analysis of 'OneSteel',  before this 'sharechat' exclusive ;-)


-------------

If there is one thing that Warren Buffett hates almost as much 
as airlines, it is old established commodity manufacturing businesses 
with huge capital requirements needed to keep them going.  On initial 
impressions then,  I don't think Warren would be very excited over 
OST.    But on closer inspection of company prof ability, OneSteel is 
a distribution business first and a manufacturing business second.

Furthermore having a 'manufacturing from scratch' arm can be useful.  
It provides a hedge on input costs to the distribution business, 
instead of always being at the mercy of external suppliers.  
Furthermore all the manufacturing plant has all been streamlined and 
modernized under previous BHP ownership.   

 Unusually in the metal processing industry, OneSteel makes special
 mention of their plants being low capital expenditure strong cash 
flow generators.    We can thank previous owner BHP for this as they 
have fully funded the construction of the billet caster and waste gas 
system at OneSteel's 'Whyalla' raw material to ra steel production 
site.    This doesn't mean that no capital expenditure is required.   
Indeed, this year an $80m refurbishment project is getting underway 
at the Whyalla site.   But even with the 'Whyalla' Blast furnace 
refurbishment expenditure, we are l king at a sixteen-year plus 
period where capital expenditure requirements are projected to be 
well below the depreciation rates.  

OneSteel's processing arm, where the long runs of steel sections are 
produced, is named 'Market Mills'.  'Market Mills' gets its raw 
materials in the form of steel billets from two other 'OneSteel' 
owned facilities, the previously mentioned 'Whyalla' and 'Sydney 
Steel Mills'.    This product finds its way to the customer v a 
OneSteel owned distribution company such as Metaland.   From raw 
material to supplying the customer, OneSteel is truly vertically 
integrated.

Both 'Whyalla' and 'Sydney Steel Mills' produce steel billets.   The 
usual bane of big factory production is high fixed costs and small 
variable costs.  High fixed costs means that a small fall in demand 
can easily plunge a once profitable factory deeply into the red.    
'OneSteel' has an interesting solution to this produ ion dilemma.   
The 'Whyalla' plant uses 'BOF' or Blast Oxygen Furnace technology.    
This is an energy labour and capital intensive process, which 
nevertheless if operated at full capacity can produce a highly cost 
efficient per unit product.     Should t Market Mills plant need more 
raw input than 'Whyalla' can provide, then production is cranked up 
at the 'Sydney Steel Mills' plant which works on the EAF process.    
EAF stands for 'Electric Arc Furnace'. 'Sydney Steel Mills' operates 
on recycled steel, d has a competitive variable cost structure.    
Effectively 'Whyalla' provides the efficient base-load production of 
steel billets while 'Sydney Steel Mills' production is varied to meet 
the overall steel billet raw material demand.    This means that alt 
ugh steel billet volumes can vary over the business cycle,  
'OneSteel' can still be profitable over a 'year in' 'year out' range 
of raw material demands.

A principal reason that OneSteel was spun out of BHP was to allow the 
steel market in Australia to rationalize.   During 2001, OneSteel 
(the number one retail player) took an active role in industry 
rationalization.  They made a successful joint bid with rival 
'Smorgon Steel' (the number two player) for the number three pla r in 
the Australian steel distribution business: 'Email'.  Spoils were 
split between the two bidders, but 'OneSteel' ended up acquiring 
business units that represented 10% revenue growth for the company.  
Meanwhile within OneSteel itself, what were 8 busi ss units had been 
reduced to four and duplicate management functions were dispensed 
with.   'OneSteel' is about to make a $30m IT investment over two 
years across the group.   This new system will replace stock control 
systems that have been around for up o 20 years.  It is expected to 
significantly improve inventory control in the sales departments, 
while moving the vertically integrated 'OneSteel' further towards a 
'just in time' production at the manufacturing units.

A more detailed discussion of the financials of 'OneSteel' appears 
on the focus investment group.   To summarize 'OneSteel' did not meet 
our very strict criteria.  This doesn't mean OneSteel isn't a good 
investment though.    Steel and Tube shareholders have seen 
significant share price appreciation in the last couple of ears based 
on improved inventory management.  I believe that the distribution 
business of OneSteel has similar potential for improvement, and 
furthermore that any such efficiency gained will be sustained 
indefinitely.    I think there is something very ap aling here for 
Steel & Tube shareholders, who have seen their company improve so 
much in the last two years.  They now have the opportunity to get in 
on the ground floor while the parent company goes through a similar 
process.  So let's do a bit of foreca ing on what might be achieved 
at OneSteel in the next two or three years..

Page seven of the 'OneSteel' 2002 annual review shows the overall 
level of construction activity in Australia rising strongly for four 
years (culminating in a 30% gain in overall activity) before tanking 
in 2007.  I must admit to being deeply suspicious of such 'straight 
lines to the sky' projections given that on the s e page there is a 
graph showing pricing for end line steel products falling way behind 
inflation.   My more conservative outlook is that overall sector 
construction activity in Australia (comprising, residential, 
non-residential, major civil works, mining nvestment, and 
Agricultural Output and Automotive output) steel content will rise by 
only 5% ( which is 1% per year ) by 2007.    If this comes to pass is 
there still a case for investing in 'OneSteel' today?

My calculations will show that an investment in OneSteel is justified 
based solely on the potential the new stock control system has, 
together with synergies squeezed out of the industry by the 
absorption of the number 3 player 'Email'.   Any gain as a result of 
a significant boost in the construction sector will be a bonus  If we 
assume steady revenues for the distribution businesses 'Sheet Coil 
and Aluminium' ($260m), 'Piping' ($190m), 'Metaland' ($390m) and 
'Pipeline Supplies' ($290m), this gives us a revenue base of $1,130m. 
   These businesses operate on an asset base  some $750m (reinforcing 
makes up the other $250m of OST distribution assets).  Assuming half 
of this asset base is funded by debt and half by shareholders equity 
we can now calculate the earnings potential of these businesses if 
they can become as effici t as the OneSteel star child, Steel and 
Tube in New Zealand and earn 15% ROE.

Potential Improved Earnings (before interest and tax) 
= 0.5x $750m x (0.15) = $56.3m.

Compare this to the actual rate of return obtained last year (10.3%) 
if applied to this same amount of equity:

Potential Actual Earnings (before interest and tax) 
= 0.5 x $750m x 0.103 = $38.6m

This represents an increase of $56.3m-$38.6m = $17.6m (before tax) or 
$12.3m after tax (using a 30% tax rate).   This will flow straight 
through to the bottom line.   

Furthermore, if we assume a 5% increase in reinforcing product sales 
this will lift sales in the reinforcing area from $300m to $315m.   
Earnings in reinforcing have traditionally been volatile with the 
construction and mining cycles and occur with a high fixed cost base. 
 But if a modest 10% of this revenue increase flows hrough to the 
bottom line this will boost OST earnings by $1.5m per year.

Finally last years tax rate worked out at 40% of profit (the total 
tax paid being $40m) due to non-deductibles that will not be repeated 
in the long term.   As the Australian corporate tax rate is now 30%, 
this will attach a further $10m to 'OneSteel' after tax revenues in 
all future years.

These three factors will boost after tax profit from $47.1m to $70.9m.
    This will increase earnings/dividends per share from 8.7/6.5cps 
to 13.1/9.8cps.     Based on a share price of $1.96, this gives a 
dividend yield of 5%, (and an earnings yield of 6.7%).    OST closed 
yesterday on the Australian market at $1.57.   I am ojecting a 25% 
increase in share price over 3 years, which works out at 8.35% per 
year (average).   Unfortunately for New Zealanders, who do not enjoy 
the Australian franking credits, the dividend yield is somewhat less 
than the Aussies get: Try 5.0% x 0. = 3.34%.  In all of this analysis 
I have ignored any change in profitability of the manufacturing side 
of the company as over the business cycle I am not sure if any such 
increase in profitability is sustainable.

Now at last, and based on a conservative projection for each of STU 
and OST, we have enough information to judge, which of the two is the 
best investment for the long-term investor.   All will be announced 
in my next post!

SNOOPY



-----------------------------------------------
Message posted by Harry Tennyson
 using Pegasus Mail 2.55
I have Word 97 to read attachments
------------------------------------------------

----------------------------------------------------------------------------
To remove yourself from this list, please use the form at
http://www.sharechat.co.nz/chat/forum/