As a market leader in terms of quantity and product diversity Steico is in a good position to continue prospering in its growing niche markets. Recently, the appearance of new capacities of competitors put pressure on margins. Therefore,the company is currently trading at a large discount to my estimate of replacement costs. However, the time has come that competitors are leaving the market or seem to be unwilling to grant further price reductions to customers. Therefore, I expect that the company will profit from an improvement in the industry’s demand supply situation. On top of that, an optimization of the capital structure and a reduction in growth capex after 2016 should gradually enhance return on equity and free cash flow.
Steico is a German building supplier of wood fiber insulation materials and wood based construction materials operating throughout Europe.
Steico is operating in different niche markets
According to the company, Steico is the European leader in the manufacture and sale of wood fibre insulation materials with a market share of 35%. This niche segment makes up only 4% to 5% of the whole insulation market based on estimates from The German “Institut für Wärmeschutz”. The largest share is represented by organic foams (i.e. polystyrene rigid foam -Styropor) with around 40-45%, glass fibre insulation and stone wool (rock wool) insulation both have a share of around 25-30%.). Natural eco-friendly insulation products such as wood fibre are gaining popularity in the building sector and are more and more in consideration when it comes to renovation work on existing and new buildings. In Germany the awareness to understand wood fiber insulation as a conventional insulation material rose tremendously over the last couple of years. Here, the company has also a strong position in the market for loft conversions. The sale of wood fiber insulation materials in Germany has increased rapidly from 0.1 million m3 in 1990 to 1.25 million in 2011. Over the long term the market share of wood fiber insulation is expected to increase to a level between 9% and 13%.
While Steico generates more than 60% of its revenues with wood fibre insulation, they are also producing wood based construction material. The company is the leading manufacturer of I-joists (Stegträger) in Europe. These are mostly exported to the UK with the country’s strong exposure to timber constructions. In the UK, housing starts are picking up resulting in strong momentum for segment sales in the current fiscal year. Based on the management’s information, they see increasing demand for this type of product not only in the UK but also in the rest of Europe. This segment is currently generating 11% of revenues.
The remaining revenue comes from lumber trade, specialty products, natural fibre boards and laminated veneer lumber (LVL; Furnierschichtholz).
Wide product range, efficient and integrated production and diversified revenue stream
Steico’s strategy focuses on being a system provider, offering a complete building solution for timber construction, which consists of I Joists, LVL, flooring products and different types of insulation materials. For instance, the good positioning in the sale of I-joists in the UK can be used as a door opener for the sale of insulation materials in this market. In addition, each of the company’s plants covers a large part of the total product range allowing merchants to order mixed deliveries to optimize their inventories. This presents an advantage compared to competitors as most of them have single product factories in place.
All Steico products are produced in three relatively new plants of which two are located in Poland (Czarna Woda and Czarnków) and one in France (Casteljaloux). Raw material costs make up roughly 40% of revenue. Raw material is mostly consisting of wood. For the Polish plants the company uses pinewood and has a long term contract with the Polish forestry authority. Wood prices are fixed at the beginning of each year in an auction process. Based on the company’s information prices remained stable in 2014. In France the wood is purchased at the local lumber market.
From a geographical point of view, Germany (35% of revenue) is Steico’s largest market followed by the UK (14%), France (12%) and Poland (8%). Since 2007 most of the 63% growth in revenue has been generated in Germany and UK, while France, Poland and most of the other markets were flat or slightly declining.
Clients are trade intermediaries, construction companies and DIY chains. The largest client contributed 3.3% to revenues in 2013.
Long term catalyst for the industry
Over the long run, demand for Steico’s products should be supported by an EU directive urging member states to ensure that by 2020, all new buildings are nearly zero- energy buildings. In addition, buildings that undergo major renovation have to meet minimum energy performance requirements after renovation. As most new and existing homes are currently unable to meet the future requirements for energy consumption and thermal efficiency, the implementation of the EU directive in the member states might also lead to additional demand for Steico’s products as the year 2020 approaches. The recently completed new headquarters on the outskirts of Munich are already today in compliance with the zero-energy standard. During construction Steico’s construction and insulation products have been used. Hence, the building also provides a state of the art example of the company’s building solution to potential clients how to comply with the upcoming legislation.
Current investment programme targets margin enhancement and extension of product range
So far the company was not able to exploit the full growth potential in the I-joists segment as they faced problems in the supply of laminated veneered lumber (LVL) which is used to produce I-joists. As a consequence, management recently decided to build an in-house production facility for LVL until the end of 2015 to become independent of suppliers and increase margins in this segment. The production line will have a capacity of 80,000 m3 and is expected to break even at a 50% utilization rate. In addition, the company will be able to produce wider LVL’s than the current supplier is able to deliver. This project is the cornerstone of the company’s plan to invest up to EUR 60 m until 2016.
The other part of the investment programme comprises the production of very thin wood fiber insulation through eco-friendly wet process, where the company witnesses strong demand and low competition. Completion of the new insulation production line is expected for the end of 2014. This investment will potentially drive revenues and Steico will attain more flexibility on its capacities. Both investments represent extensions of the company’s existing plants.
The investment volume will come through a bank loan financing and operating cash flow. The company is currently very solidly financed. An optimization of the capital structure should have a positive effect on the return on equity and might therefore lead to more attention from financial market participants. In addition, the company can make use of the appealing current interest rate environment given its relatively high solvency.
Attractive access to capital, fierce competition and reverting returns on capital
The table below provides an overview of the key performance indicators since 2007:
In 2007, just at the right time, Steico went public at EUR 17.50 per share (current price EUR 5.50). The company raised roughly EUR 70 m from investors. Most of this capital was used to extend the two existing production sites in Poland and to acquire and modernize the production site Casteljaloux in France.
In 2008, Steico was hit by the crisis, but recovered quickly in 2009 and 2010. In 2011, massive pressure on Steico arose by the appearance of new capacities of competitors in the wood fibre insulation market. The expansion of many players in the market reflected the growing demand for wood fibre insulation in the years to come. As a consequence, though there has been plenty demand for Steico’s products, so far the company has not been able to return to 2009/10 profitability. For instance, the company’s production of insulation material increased by 17% from 158,934 tonnes in 2010 to 185,631 tonnes in 2013. During the same period, revenue per tonne decreased by roughly 7%.
Pricing pressure has been slightly reduced since 2013 as the consolidation process found its first victims. Finish Fibreboard closed a production site and the small competitors Smrecina Hofatex (Slovakia) and KZZP Koniecpol (Poland) both went bankrupt. Even more interesting, Swiss Pavatex, one of the strongest competitors of Steico, recently had to substantially reduce production at a one product plant in France which just had been finished in 2013. At the same time, Steico is producing at full capacity. Steico seems to profit from its large investments in efficiency, growing the product range, improving the distribution network and sales structures and to a certain extent from its larger scale being the European market leader.
From my perspective, management made use of extremely attractive access to equity markets in 2007. In contrast to Francotyp Postalia (one of my other investments), management did not burn the cash proceeds from the IPO by undertaking overpriced acquisitions. To the contrary, management allocated the capital to extend production capacities in order to react to higher demand for wood fibre products and to reinforce the company’s position in its industry.
So far these investments have not produced an attractive return on capital. Nevertheless, the company has been able to weather the overcapacity in its industry relatively well. Once the consolidation process will come to an end, I expect Steico to earn a substantially higher return on assets.
In addition, in spite of the large capital expenditures over the last years, the company’s financial position is very solid. With an equity ratio of 63% and a debt-to-equity ratio of 0.2x, banks are willing to finance the ongoing EUR 60 m investment programme at a relatively low cost of capital. Compare this to one of Steico’s competitors, Homann Holzwerkstoffe. They are currently paying a 7% coupon on their EUR 100 m five year bond which was issued in 2013.
As already mentioned, return on capital is relatively low. It remains to be seen, if Steico can translate the top line growth into an improvement on the margin side. Assuming that the European construction market will remain stable, wood fibre insulation will continue to gain market share from the conventional insulation market and that overcapacity will be reduced, I think that return on assets should easily approach 4% again. Going one step further and assuming that the current investment programme will increase total assets by EUR 40 m to EUR 200 m until 2016, potential net profit can reach EUR 8 m per annum or EUR 0.63 per share. Taking into account an improvement of the capital structure targeting a financial leverage ratio of 2 times, return on equity could reach 8%.
For 2014 management’s guidance is a 10% year on year increase in EBITDA and EBIT to EUR 23.5 m and EUR 10.2 m combined with a slightly lower growth rate in revenues.
Why market participants might hesitate to buy Steico shares
First, Steico is an owner-managed company. Udo Schramek is holding 67.2% of the share capital. This leaves only a small free float of 4.2 m shares or roughly EUR 23 m.
Second, Mr. Schramek’s wife has a board seat. Moreover, members of the board seem to be replaced infrequently.
Third, Steico prepares their consolidated financial statements under German GAAP (HGB) and investor relation material is only available in German.
In addition, the company is listed on the Entry Standard, where the reporting requirements are very low. This is aggravated by the fact, that the Entry Standard is forming a reservoir of potential delisting candidates in Germany. Due to the current legislation an investment in a potential delisting candidate presents a risk to minority shareholders.
Apart from that, in 2013 the company completed its new headquarter. Investors might ask whether there are better opportunities to allocate capital.
Most importantly, the company faces the risk of entering a period of recession while at the same time adding substantial capacity to the market once the investment programme will be finished.
What does that mean to me?
Generally, I like owner operators and the alignment of interests with minority shareholders. In this case minority shareholders could get screwed for instance by a delisting of the company. However, during my research it became obvious to me that the company pursues a transparent reporting and continuously tries to attract the attention from potential investors. This year the company held presentations at five different financial market conferences. In addition, the company exceeds the reporting requirements of the Entry Standard by releasing quarterly reports. According to the company, one of the reasons why Steico does not upgrade its listing to a higher segment of the stock exchange is the resulting requirement to change the reporting standards from German GAAP to IFRS. From the management perspective this would not be worth the effort.
Of course, a downturn in the construction market would hit the company. However, a diversified product range, broad geographic positioning and very solid financials should ensure that Steico can weather another recession relatively well. Over the long run Steico seems to be part of a growing industry.
First I will focus on what a new entrant will have to spend to reproduce a similar company like Steico:
From my perspective in Steico’s case reported asset values on the balance sheet provide a good proxy for an estimate of reproduction costs for a new entrant.
I know that management has invested roughly EUR 150 m in fixed assets since 2004 to get the company where it stands today (from company reports and the IPO prospectus). Before 2004 they had roughly 30% of today’s production capacity in place. So one could assume that the reproduction of the fixed assets costs EUR 215 m ignoring depreciation. However, net fixed assets on the balance sheet total only EUR 100 m comprising of land and buildings (37%) and machinery and equipment (63%). From my perspective it is questionable, whether the company’s production facilities have already lost EUR 115 m in value since completion. So I feel very comfortable to make the assumption that the reproduction of fixed assets costs at an absolute minimum EUR 100 m.
On top of that, to estimate hidden assets not shown on the balance sheet like the distribution network, customer relationships, IT systems and R&D expenses, I consider the annual expenses in the P&L which are used to create these assets. In 2013, the company spent roughly EUR 5 m on distribution, advertising, IT and R&D/patents. I make the assumption that hidden assets add two times worth of these costs or EUR 10 m to the total reproduction costs. Again a conservative estimate.
Current assets consist of inventory, accounts receivables and other current assets. Days of inventory showed low volatility over the last years and prices for finished goods have been stabilized recently. So I assume that the reproduction cost of inventory is in line with the reported numbers. The cost of reproducing an existing’s firm accounts receivables should be more than the book amount as some customers do not pay their bills. In the footnotes I could not figure out the amount of allowances contained in receivables. So I decided to be conservative and use the book value of receivables. Other current assets are cash or will be due in short term, so book value should be appropriate here as well.
On the liability side we have current liabilities consisting of accounts payable to suppliers and other short term liabilities. I assume that this equals the amount a new entrant would have to pay to duplicate what Steico has.
In conclusion, I come up with the following estimation of reproduction costs for Steico’s operations:
Steico has a market cap of EUR 70 m and net debt is EUR 25 m. So a potential buyer could pay a 69% premium on the current stock price and would still be indifferent between reproducing the business on his own and taking Steico private.
However, obviously the question is whether a potential entrant in the market would be interested to invest that much capital either by reproducing the assets or by acquiring Steico. Based on the current guidance for 2014, Steico would be valued with an EBITDA multiple of 5.9x and an EBIT multiple of 13.6x when using reproduction costs as a proxy for enterprise value. This appears pretty rich for a company currently earning a mid-single digit return on invested capital.
Currently, the market is valuing the company with a price-to-tangible book ratio of only 0.7x, a P/E of 13.1x and an EV/EBITDA of 4.0x. So it seems, that the market is giving the company no credit for its high solvency and asset quality which I expect to be converted in higher earnings and cash flow going forward.
In conclusion, for a potential competitor it is currently not attractive to enter the industry. At the same time there is a number of still existing small players who will potentially leave the industry due to competitive disadvantages in terms of economies of scale, product diversity and dependency on local markets. Steico could profit from this trend in the upcoming years. Combined with a more efficient capital structure and a reduction in growth capex, this should result in a higher return on equity and cash flow yields which should close the gap between market value and reproduction costs over the next three years.
In one of my last posts, I announced that I will start to accumulate a position in Steico. Based on the assumption that I trade one third of the daily volume, my target is to accumulate a 2% position for the virtual portfolio with a stock price limit of EUR 5.70 starting from October 13th, 2014.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!