Steico, the producer of wood fibre insulation materials and wood based construction materials, currently represents a 2.4% position of my portfolio. I made the investment 8 months ago based on the thesis that return on capital should increase going forward due to the following expectations:
- Margin enhancement due to cost savings in production;
- Optimization of capital structure due to increase in financial leverage;
- Improvement in industry supply/demand due to competitors reducing capacity.
Ad 1. Two weeks ago, the company announced that the new production facility for laminated veneered lumber (LVL) has been completed according to plan. LVL is being used for the production of wood based construction materials (I-joists for the UK market). So far the company had to buy LVL from third parties at a relatively high cost. The launch of the inhouse facility in autumn 2015 will reduce costs per cubic metre LVL from EUR 400 to EUR 300. Given that material costs make up roughly 60% of revenues and that LVL is the main input for the production of Steico’s I-joists, management expects that to have a substantial effect on the company’s margins in this segment.
Ad 2. Due to the company’s solid balance sheet and attractive terms offered by banks, management made use of debt to finance the new production line. As a consequence, since my original investment net debt has increased from EUR 25 m to roughly EUR 65 m. Still with a debt-to-equity ratio of 0.6x and no goodwill/intangibles on the balance sheet, the company looks financially solvent. At the same time return on equity is going to profit from a more balanced capital structure.
Ad 3. Steico is the dominant player in the market for wood based insulation. The market has been growing for years. However, additions to industry capacity went far beyond demand growth leading to fierce competition and pricing pressure. So far some industry players announced a reduction in capacity. Nevertheless, currently there is no indication that there will be a secular improvement in the industry’s overall supply/demand situation.
Over the last days the stock price soared after the news release regarding the completion of the new production facility. The company is now trading at 0.9x book value and a 15.6x trailing price-to-earnings multiple. The current market cap is roughly EUR 92 m.
From my perspective, for a company of this quality a 10x earnings multiple represents a fair to relatively high valuation given the current mid to high cycle market environment. Hence, this requires an increase in net income by 56% from EUR 5.9 m or EUR 0.46 per share to EUR 9.2 m or EUR 0.72 per share going forward.
Despite the good progress made, reaching this earnings level might be challenging:
In the future the new production line will have a substantial positive effect on material costs. Production costs for I-joists could decrease by up to 15%. Currently, this segment generates an annual revenue of roughly EUR 25 m and is more or less breaking even. So we speak about roughly EUR 4 m increase in EBITDA. With an increase in LVL production – the facility has a total capacity of 90,000 cubic metres which will not be fully used up by the production of I-joists – further upside might be achievable. However, taking into account an increase in depreciation, interest payments and tax payments stemming from the investment in the new production facility, I estimate that a total increase in EBITDA of EUR 7 m to EUR 8 m will be required to reach a 10% earnings yield based on the current share price.
Consequently, I believe that the share price is now fully reflecting the future earnings potential. Therefore, I decided to sell my position in the company at the current price level to realize a total return of roughly 35%.
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