2023-12-19 04:12:28 ET
Summary
- Encore Wire operates in the copper industry, which is expected to see increased demand due to renewable energy and AI.
- The company's business model and vertical integration provide a competitive advantage over competitors.
- Encore Wire holds a call option on copper prices, which is expected to benefit from supply constraints and potential price increases.
Overview
Encore Wire (WIRE), though not extensively covered, operates in an industry that might not be as attention-grabbing as artificial Intelligence, renewable energy, electric vehicles, or solar power. It's simple yet effective business model involves acquiring copper and transforming it into copper wire for various industries. This article aims to explore the intricacies of Encore Wire's business model, shedding light on how emerging technologies like AI and renewable energy contribute to its growth. I will elaborate on why it is one of the companies with a high short interest and explain into the inherent call option it holds on to copper prices. The assessment of its value will be conducted through the discounted cash flow method.
In conclusion, I strongly recommend a buy for Encore Wire due to the highly favorable prospects of the copper industry. Anticipated increases in demand, driven by the shift to renewable energy sources and the expansion of AI and cloud computing, coupled with supply constraints, are expected to propel copper prices upward. With these factors in mind, Encore Wire stands out as a robust business poised to outperform the market.
Copper Demand Is Going To Boost In Coming Years
My projections for copper demand indicate a compounding growth of 4.5% until 2040. These estimates are primarily derived from 'The Future of Copper' study , with subsequent upward revisions after the GOP28 agreement on December 13th to "transition away from fossil fuels". The current interest rate future perspectives and following Powell's comments are expected to create favorable conditions for a brighter future in the sector. Aligning with the study, I foresee steady growth until 2040, reflecting the global efforts toward renewable energy. This, in my view, positions the market as an attractive long-term prospect for investors.
I anticipate that non-energy transition end markets to grow in line with the overall economy, at 3.2% annually. However, uncertainties arise, particularly concerning China , which faces significant economic challenges especially in the construction sector, a copper-intensive industry. Conversely, India is emerging as a production contender , with companies like Apple aiming to produce a third of iPhones in the country.
Within renewable energy, I expect grid transmission and electrical network distribution to experience significant annual growth at 4.6% until 2024, making it the largest market at 4 million metric cubic tons. In contrast to fossil fuel and nuclear power plants, solar and wind projects are commonly situated several miles away from population centers. This structure requires extensive transmission infrastructure, including the utilization of undersea cables, to efficiently transmit electricity generated by offshore wind or solar installations. However, I believe the electric vehicle ((EV)) and charging market will exhibit even more substantial growth at an annual 7.2%. An EV requires 80% more copper than a regular car , presenting a challenge as companies like Tesla (TSLA) seek alternatives to the metal. There is potential for exponential growth in the U.S. electric vehicle charging market, with projections indicating a nearly tenfold increase by the year 2030 .
I estimate that solar and wind energy sources will drive copper demand to annual growth at 6.3%. Considering the current total terawatt ((TW)) solar capacity, there's a prospective scenario where the world may achieve an annual installation rate of 1 terawatt of solar by the end of the decade . This could potentially reach up to 800 gigawatts ((GW)) annually as early as 2027. Global wind turbine market is expected to achieve a valuation of USD 107.1 billion by the year 2032. This marks a substantial increase from its valuation of USD 58.5 billion in 2022, driven by a robust Compound Annual Growth Rate of 6.4% from 2023 to 2032 .
One of WIRE's key clients is the Cloud infrastructure sector. The cloud business has experienced a remarkable 20% growth in recent years, notably fueled by the introduction of Large Language Models (LLMs) in generative AI. Projections for cloud growth are depicted in Figure 2. I anticipate that the demand for copper in this environment will surge to a minimum of 10.1%.
Supply Constraints Are Anticipated To Push Copper Prices Higher
I expect a 10 million metric tons deficit in 2030 because supply will grow to 30.1 million metric tons at that time not coupling with my demand estimates of 40.4. Copper supply has been flat at 20 million metric tons in 2018-2020 and has grown 2.5%-3.0% from 2021-2023.
I anticipate that to pair supply and demand is going to take a while. 40% of copper supply comes from 2 countries (Peru and Chile) with unstable political regimes. And to develop a new mine requires between 15 to 20 years, mainly due to the negotiations with federal and local governments to get permits, besides the construction project by itself.
The consequence will be an increase in the price of copper, and this scenario bodes well for Encore Wire. Encore Wire's business model functions like a call option on copper. During periods of low copper prices, the short lead times facilitated by its vertical integration business model shield it from significant price reductions. Upon receiving an order, the company minimizes the time to convert it into revenues, mitigating the impact of declining prices. And when prices lower, margins for Encore Wire decrease and maintain gross margin at 15% pre-COVID as you can see in Figure 4. Conversely, when copper prices rise, Encore Wire does not face undue stress in its system. When there are delays between order receipt and delivery, margins will improve because of higher copper prices as you can see in Figure 4 in 2021-2022.
Thus, as the anticipated increase in demand drives up copper quantities and the supply deficit enhances margins, I anticipate WIRE's gross margin reaching 40%. This surge is expected to occur around 2025-2026, resulting in gross margins surpassing $300 million within a range of 37-40%, similar to the margins observed in 2022 where copper prices were high (almost 5.0). In the short term (2023-2024), margins will temporarily decrease as part of the process of margin normalization because copper prices are lower (under 3.8). I project the target normalized margin to be 20% above pre-COVID levels, reflecting cost-cutting efforts. In the valuation, I consider the conservative 20% scenario even though we have seen that copper prices will surpass 5.0 and margins will get at least 40%.
Encore Wire's Business Stronghold Is Poised For Market Outperformance
To assess competitive advantage, let's focus on a comparison with Atkore Inc. (ATKR). While it's not a perfect comparison since Encore Wire is a pure play in manufacturing copper wire, it is the only company in the stock market we can compare with. After evaluating both companies, the following conclusions can be drawn.
In Figure 6, we delineate the key value drivers. Notably, the ratios for the year 2023 are of a similar magnitude, given that copper and aluminum constitute only part of ATKR's overall business. Encore Wire exhibits a higher EBITDA margin (30.3% vs. 25.4%) and slightly less effective working capital management due to its model (Change in NWC over revenues at -3% vs. -2%). Moreover, it demonstrates more efficient CAPEX over revenues (-5% vs. -6%). Consequently, the resulting value indicator, Free Cash Flow, also favors Encore Wire (17.9% vs. 16.7%).
The remarkable aspect lies in the evolution of Encore Wire. Starting from 2021, all the key value drivers not only show improvement but are expected to continue getting better in the upcoming years. I attribute these positive results to the evolution of Encore Wire's business model, centered around vertical integration, which has a positive impact on gross margin and the change in net working capital. The company maintains a low-cost proposition and efficiently manages inventory with slightly higher levels to ensure fast service. Furthermore, CAPEX remains consistent year on year, contributing to capacity expansion and enhanced operational efficiency.
In the short term, revenues have decreased 16.4% to $637M. The cause is a decrease in selling price of 16.8% offset by a 6.4% increase in copper unit volume. Gross margins lower to $148M from $300M due to a higher buying price at 4.6%. Gross margin reduces from 39% to 23%. The reason is the margin abatement that the company is suffering just because they come from a period of high selling prices due to supply chain disruptions that favor Encore Wire in 2021-2022. As we have talked about, margins are getting to a normal level. That is the reason the company is so shorted.
Some analysts have correctly pointed out that Wire Encore has a significant proportion of shares sold short , accounting for 28% of all floating shares . While this is indeed an issue worth considering, in my opinion, the likelihood of a short squeeze is relatively low. My estimation, based on insights from " Short Squeezes and Their Consequences " by Paul Schultz, University of Notre Dame, suggests it is less than 1%. Therefore, I believe investors need not heavily factor this issue into their investment decisions.
The company is more efficient in reducing operational costs 9.1% to $50M. That brings us to a $98M EBITDA, lowering the margins from 32% to 15%.
I project for Q4 a flat YoY revenue increase due to the incremental demand (about 4,5% for demand increase as I analyzed before) and a similar reduction or less selling price in line with the actual trend in Q3. I do feel more comfortable with the margin abatement that is undergoing in the business as you can see in Figure 4. I estimate a 20% gross margin for the next quarter but also as the new normal gross margin, higher than the 15% before COVID due to CAPEX extensions in order to improve margins. That is the gross margin we will be using in the discounted cash flow valuation for the long term.
Operating expense will be reduced by 10%, in line with what we are seeing in previous quarters, to reach $50M. So EBITDA will be $89M with a margin of 13% vs. 28% in 2022Q4.
Discounted Cash Flow Valuation
I employ the Discounted Cash Flow Method in my analysis (Figure 7). In the discussion, I have outlined my main assumptions about the prospects of the company reflected in the model, which I summarize next.
Revenue growth is projected to initiate at 15%, with an anticipated increase to 18% (+2.5pp). This growth is attributed to the expanding market presence in renewable energy sources and AI cloud computing, coupled with market share advancements by Encore Wire. The margin, calculated as EBITDA/revenues, is set at 15%, equivalent to the previously outlined gross margin of 20%. Net working capital change is expected to align with past years at -3%, while CAPEX remains constant at -5%. The cost of capital for this business stands at 10%, reflective of its risk relative to the market, with a terminal value growth of 3%.
The valuation doesn't account for the potential scenario of significantly higher copper prices, where the call option would be in the money, resulting in a substantially higher valuation. Throughout the article, I have illustrated the high likelihood of this scenario. Therefore, the current business valuation (considering the call option as out of the money) stands at $309. Consequently, the company's intrinsic value is substantial.
Risk Factors
The primary risk factor for Encore Wire is the potential impact of a natural disaster in its unique location in McKinney, Texas. The company's strategy relies heavily on "vertical integration within a single site," emphasizing the significance of this geographic location.
Encore Wire's market share growth is a direct result of its successful implementation of the vertical integrated model. However, if competitors adopt a similar strategy, they may surpass Encore, and revenue growth may not be sustained at the current pace.
While we've previously discussed call option dynamics related to copper prices, a significant disruption could pose a threat to Encore Wire's operations. In the event of a substantial disruption, the company may face challenges in manufacturing wire due to a lack of raw materials, potentially leading to a decline in profits.
Conclusion
I strongly recommend buying the company for several compelling reasons. The business is well-positioned for growth in crucial global sectors like AI and renewable energy. However, potential supply challenges, particularly in the copper market, may lead to significant disruptions in the future increasing its price. These disruptions, in turn, have the potential to bolster profits for Encore Wire.
Its business model, centered on vertical integration within a single site, provides a significant competitive advantage over competitors. The company holds an inherent call option on copper prices, especially in a situation where prices are anticipated to increase due to an imbalance between supply and demand.
For further details see:
Encore Wire: Betting On AI And Renewable Energy With A Call Option On Copper Prices