Pipe Dream

By Lawrence Carrel

SmartMoney.com

June 10, 2004

TAKE IT FROM the experts: Inflation is already in the pipeline. Or, more precisely, it's in the increasingly costly water conduits and small-bore pipes of Northwest Pipe (NWPX), one of the many manufacturers now raising prices.

Northwest Pipe shares climbed 7% to a 52-week high of $17.35 Thursday after the company sharply hiked its profit outlook. The Portland, Ore., manufacturer of welded steel pipes said second-quarter earnings will more than double first-quarter results, coming in between 40 cents and 45 cents a share. Wall Street was anticipating 20 cents a share on average, according to Thomson First Call.

"The increase in earnings expectations reflects the company's success in passing along higher steel costs to its customers, particularly in its tubular products segment," wrote D.A. Davidson & Co. analyst John Rodgers in a note Thursday. "We believe the company will continue to benefit from higher steel costs and improving demand for all of its steel pipe product." (Rodgers doesn't own shares of Northwest Pipe; D.A. Davidson doesn't have an investment-banking relationship with the company, but does make a market in the stock.)

In addition to the good news on the earnings front, Northwest reported a pending deal to supply pipes worth $14 million for a Phoenix waterworks project. The city still has to approve the contract, and delivery is scheduled to begin in the first quarter of 2005. The deal is not expected to affect 2004 results.

Northwest's 11 manufacturing facilities in the U.S. and Mexico manufacture two kinds of pipe. Its Water Transmission unit supplies large-diameter, high-pressure steel pipes for municipal drinking water systems. The Tubular Products Group manufactures smaller steel pipes, one half to one-sixteenth of an inch in diameter, for school-room furniture, fence posts, exercise equipment, fire-protection sprinkler systems and traffic signposts.

While the Phoenix contract was a big deal, the earnings surge comes from a turnaround in the tubular business, which is closely tied to the economy. Steel prices have roughly doubled over the last year, raising the cost of the company's inputs and hurting its bottom line. Revenues have dropped for the past three years, and profits for the past two. According to StockDiagnostics.com, Northwest Pipe has posted negative free cash flow in three of the last four years.

Brian Dunham, Northwest's president and chief executive officer, says the 38-year-old company has responded to the hostile climate by slashing costs, reducing staff and consolidating two facilities. Now these efforts are paying off amid a general economic revival.

For the first quarter, the company posted net income of $1.1 million, or 17 cents a share, compared with a net loss of $318,000, or five cents a share, in the year-ago quarter. Revenues jumped 16% to $66.7 million.

Sales in the Water Transmission Group rose 3% to $36.3 million, but group profits fell 11% to $6.6 million on low volume and higher steel costs. Meanwhile, the tubular group's profits jumped to $1.8 million from a $900,000 year-ago loss as sales surged 36% to $30.4 million. It was the group's highest revenue since the third quarter of 2000. Gross margins for the tubular group jumped to 7.1% in the first quarter, from a negative 4.2% a year ago. Margins for all of 2003 were just 1.1%. First-quarter margins for the whole company were 12.6%. Dunham says margins will continue to grow for the tubular group and the company as a whole.

According to StockDiagnostics.com, an independent research house in Sarasota, Fla., free cash flow for the quarter swung to $1.9 million from negative $5.5 million a year ago. It was the third consecutive quarter of positive free cash flow and a seven-year high for the company. For the 12 months ended March 31, free cash flow was a positive $7.6 million, compared with a negative $9.5 million for the previous 12 months.

"The stronger economy has helped business," says CEO Dunham. "Steel prices have gone through the roof, but we've been passing along the price increases and still see strong demand. Water transmission doesn't trend with economic conditions. It has its own cycle, but it is also stronger in 2004 than the last couple years."

Dunham says slowing housing trends and rising interest rates won't affect business, because "water transmission is well ahead of the housing trend. It's at the top end of the pipeline, even before development."

Funding comes more from bond sales than tax receipts. The company, and the industry, sees a long-term growth opportunity along the East Coast, as water systems laid in the first half of the last century wear out.

"For the industry, it will be a substantial change as the replacement market grows," says Dunham. "It's an expensive issue. It's not getting a lot of attention yet, but it will be in several years. Now, it's hard to project."

The backlog for the water transmission group rose by $10 million during the first quarter, reaching $83.8 million. Northwest expects it will continue to grow.

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"We see a positive trend emerging with their cash flow," says Michael Markowski, director of research at StockDiagnostics.com. "Typically, in its third quarter, the company generates negative cash flow and the past third quarter it generated $5.7 million. Most of its previous third quarters were negative. So, a trend is emerging that things are getting better. And three of the past four first quarters posted negative cash flow. With the recent first-quarter revenues up 15.7% sequentially, they also broke the negative cash-flow trend for the first quarter." (Markowski doesn't own shares of Northwest Pipe; StockDiagnostics.com doesn't have a business relationship with the company.)