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Sunday, September 7, 2008

A short tale.....

Every now and again I stumble across an interesting short. The key to good shorting starts with a top-down approach. First look around for the most hyped industry and then focus in the industry on finding the most overvalued company. Here is one example that has mostly played out but still has some room to run. One sector that I have particularly interested in lately is alternative energy. With the rise in commodity prices a ton of attention particularly in the venture capital community has been given to alternative energy companies. Let me preface this by saying I think there will be some truly great companies that come out of this recent push into alternative energy, but with all that money there is undoubtedly going to be some junk.

One piece of junk that I came across a while back is Zoltek Companies. The company makes carbon fibers that can be used in a variety of applications due to their lightweight, high-strength, conductive, and corrosion-resistant properties. Carbon fibers are most common in aircraft brakes, but Zoltek has been expanding their use by employing them in composites for wind turbine blades (i.e. alternative energy) as well as for use by the oil and gas industry. Zoltek has two segments: heat- and flame-resistant technical fibers (acrylic fibers) and carbon fibers (under the brand name PANEX). In 2007, to concentrate on its carbon fibers business, it discontinued its former specialty products unit. Founder and CEO Zsolt Rumy owns just under a quarter of Zoltek. Historically, carbon fibers have been used primarily for expensive specialty products because acrylic fibers (used as raw materials for carbon fibers) were custom made and expensive. Zoltek's process, however, uses less-expensive, textile-grade fibers, making the use of carbon fibers economical in more applications.

Zoltek had been driving down the price of carbon fiber and racking up losses in the hope that manufacturers would choose it over other materials. Despite price decreases, the company's manufacturing capacity continued for a long while to be under-used.

After experiencing tough business conditions in the aerospace market for its carbon fibers, new aircraft production at Airbus (the A-380) and Boeing (the 7E7) spurred much growth in the industry. The new aircraft went into production in 2006 and, as a result, Zoltek's carbon fiber sales nearly doubled that year. That coupled with a marked increase in demand for wind turbines allowed Zoltek to again double its carbon fiber sales in 2007.

Zoltek also has an agreement with BMW to supply carbon fibers for the production of structural components of a new series of automobile. Still years away from completion, the project is designed to produce a lighter-weight vehicle that allows for the use of alternative fuels. Zoltek projects the automobile industry will eventually provide the largest market for carbon fibers, though it says that development is still years from fruition.

All of these developments led Zoltek to restart a manufacturing facility in Texas in 2004 and then to make plans to add capacity to all of its facilities in 2007. (It increased production from two lines in 2004 to 18 in 2007.) That year it also acquired a Mexican facility from Cydsa that will provide raw materials to Zoltek's carbon fibers manufacturing plants. The positive trends have also led Zoltek to exit some of its traditional acrylic and nylon fibers businesses.
Zoltek’s carbon fiber blades compete with those produced by Toray, and Mitsubishi Rayon (which represent some stiff competition).

Now there is no question that carbon fiber is a strong light material that is a logical fit in both planes and windmills. The issue is it is very expensive and the price differential is too great for its implementation in most applications. That is the reason in case you were wondering why we don’t have carbon fiber mass produced cars.

The current consensus estimates on this company have revenue growing more than 40% his year and 22% next year. With earnings more than doubling from $0.76 to $1.75 in 2010.

Now this may be perfectly feasible if carbon fiber wasn’t such a substitute premium product. In other words I doubt their ability to further push prices without killing demand. Take this coupled with the fact that one of their key customers is the aerospace industry which is going through troubles of its own (strike at Boeing and slowdown in demand for new aircrafts). It is the perfect recipe for a short.
Recently there was decent write up on this company by Carlo Cannell of Cannell Capital a long/short hedge fund. Here is an interesting quote from said article. “Our biggest issue with the company is that they are saying different things than their customers are telling us. Zoltek says they’re completely designed into future wind-turbine plans at Vestas and Gamesa, but we hear from those companies that they’re pursuing other solutions, such as replacing some carbon fiber with glass. The dramatic expected growth would also require making inroads at other large wind-turbine manufacturers like GE, who currently use no carbon fiber at all and doesn’t appear to have any plans to do so.”

Another hit against the company is that they currently trade at 3x EV/R which is a multiple befitting a software company not a cyclical chemical company like Zoltek. Cyclical chemical companies usually trade at a discount to revenue so being generous we will assume that Zoltek given that it’s a “green” or “alternative energy” company should trade at 1.5x-2x ttm EV/R which would give them an implied valuation of $8.50 to $11.11 which is a full 35%-50% below current levels. These are quite attractive returns.

Another interesting quote from Carlo Cannell, “There are several added party favors here. Working capital management is terrible – they have over 100 days of inventory when they should have 20. Insiders are selling. The CFO has resigned and the SEC is investigating unauthorized payments made to third parties that he (CFO) may have been affiliated with. Good companies don’t have their CFOs resign for alleged wrongdoing and then make them sign an iron-clad non-disclosure agreement.”
So take this all together and you have what could be one interesting short.

1 comment:

Fountainhead said...

Bank of America to buy Merrill; Korean bank walked away from Lehman, Fennie & Fredeie...what a mess.. What's your opinion on the general financial crisis? Who can stand alone?