It has been a rough road for Harsco (HSC) over the last two years. While the stock has rebounded some already (up about one-third from its mid-November 2012 lows) on hopes that better days are ahead, the company's sluggish-to-poor revenue, margin, and free cash flow performance since 2009 reflect the challenges in both the global steel market and infrastructure/construction markets.
I do think better days could be on the way. Steel mill utilization in Europe seems to be past its trough and Harsco has been actively turning its focus toward emerging markets. At the same time, management found a good home for the Infrastructure business and has the opportunity to leverage its Industrial and Rail businesses into larger contributors. I have some concerns that the market has been too quick to assume that Harsco's turnaround plans will work (we've heard it before from this company), but I can't argue that a recovery could ultimately take these shares into the $40s down the line.
Making Mills Run Better
Harsco isn't a steel company, nor does it make steel mills. What Harsco's Metals and Minerals business does so, though, is provide an array of services that are vital in the smooth, efficient, and safe operation of mills. Harsco is the largest such provider in the world, though management believes its market share is less than 10%, and boasts large customers like ArcelorMittal (MT) and Gerdau (GGB) and contract renewal rates of over 90%.
Slag is a virtually inevitable byproduct of smelting and while it has its uses, it has to be removed for mills to run efficiently. Harsco not only manages, removes, and disposes of slag for smelters, but it can also reclaim metal from slag - increasing margins in a low-margin commodity industry where every dollar matters. Harsco also manages scrap for its clients and can handle in-plant transportation and semi-finished inventory management. Last and not least, Harsco also repurposes byproducts for use in applications like industrial abrasives.
Harsco's Metals and Minerals business is tied to mill activity (the more a mill runs, the more scrap and slag is produced), and so the lower utilization rates in European mills in recent years has been a real headwind for the company. Although sell-side analysts have gotten more optimistic on steel mill production and utilization rates for 2014 I'm not sold yet - the forward curve on met coal certainly doesn't suggest that it's a universally-held opinion at this point.
The good news, though, is that Harsco is actively working to shift its exposure from Western Europe and North America, where growth in steel and metal production is low and likely to remain so, to the emerging world. Gerdau is a large Brazilian steelmaker and Harsco also boasts relationships with companies like Jindal and TISCO in India and China. At the same time, management is also trying to move its focus away from capital-intensive functions like logistics and towards higher-return functions like resource recovery and environmental services.
Making The Best Of The Infrastructure Business
Next to Metals and Minerals, Harsco's Infrastructure segment is the largest contributor to revenue. This business is built around the rental and sale of scaffolding products, shoring and concrete forming solutions, and powered access equipment for the commercial construction and infrastructure markets. It's also a very Europe-centric business, as more than 50% of revenue in the business has historically come from Western Europe.
As you might imagine, this business has had a rougher go of it recent years, given the weakness in construction and infrastructure spending in the post-bubble American and European economies. Although Harsco boasts a range of service offerings that few of its rivals can match (and can offer them around the world to globally-oriented engineering and construction companies), this has been a loss-making business for several years.
Now things are about to change. Harsco will be selling the Infrastructure business into a joint venture that will be majority-owned by Clayton, Dublier & Rice. In exchange for its interests, Harsco will get $300 million in cash and 29% ownership in the JV. Although some may argue that Harsco is selling at the bottom, this business has been a laggard for quite some time now and I believe that 29% ownership of the new JV (which will generate about two-thirds of its revenue from the energy sector) will be stronger than 100% of the Infrastructure segment.
Can Industrial And Rail Services Become More Significant?
Although Harsco's Industrial and Rail Services businesses generate only half of the revenue of the Metals & Minerals business, they generate much higher operating margins. The Industrial business sells a mix of products like industrial grating, boilers/water heaters, and air-cooled heat exchangers, while Rail Services is a leading provider of railway track maintenance equipment.
Both of these businesses could stand to be larger. Harsco is a pretty small player (or, if you prefer, "focused") in markets like boilers, water heaters, and heat exchangers, and could get a lot bigger before competition with Alfa Laval or GEA Group would become a real limiting factor. Likewise with the rail business, as the growth opportunities in emerging market freight rail maintenance are pretty appealing.
Are They Going To Really Do It This Time?
When approaching a Harsco turnaround, one of the issues is that investors have heard a lot of this before. It feels like everything at Harsco takes longer than it's supposed to - it took them longer to find the new CEO, it took them longer to reach a resolution for the Infrastructure business, and it has taken longer for the Metals business to turn around. Some of this has of course been beyond the company's control (they can't make the European steel industry recover any faster), but the point stands that this has been a turnaround in the making for some time now.
Still, I believe there is meaningful potential here. I think the company's shift toward emerging market steelmakers and higher-return services is absolutely the right move, though it may take some time for Harsco to really sell its potential customers there on the value it can provide/create. I also think that there's real potential in making the Industrial and Rail Services businesses larger contributors, but I wonder if there will be pushback from investors about the company's capital priorities (investing in growing those businesses instead of reducing debt or returning capital to shareholders).
The Bottom Line
For now, I will continue to value Harsco on an EV/EBITDA basis. I do think that Harsco could get back in to the high single-digits with its free cash flow margins, but a lot of that will depend upon just what the company does to grow the Industrial and Rail businesses and how successful the company is in refocusing the Metals business towards those countries where there's still real growth potential.
Looking at EV/EBTIDA, I'm comfortable with an 8x multiple on next year's EBTIDA - that's a little higher than I'd normally go, but I think EBITDA is bottoming and investors often miss cyclical turns on that basis. With an 8x multiple, fair value appears to be around $30. That doesn't leave enormous upside at today's price, but it's good enough to make Harsco worth a closer look from investors seeking out turnarounds and/or plays on a recovery in the metals sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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