Despite significant exposure to the US residential real estate market, I believe that Quanex (NYSE: NX), a recent spin-off, has above-average appreciation potential over the next few years. My optimism is based on the following two factors: the company’s growing presence in the thin film solar market, and a pristine balance sheet ($50 million in net cash, $2 million in debt, and $20 million in cash pending receipt), which should allow NX to pursue highly accretive acquisitions in the current weak operating environment. In addition, the stock’s low valuation, already appears to reflect the well-known problems in US residential real estate. As such, a slight sentiment change in the macro environment, combined with a growing recognition of NX’s solar and other green growth opportunities, could lift the shares.

Background
Quanex Building Products is a recent spin-off from it’s parent Quanex, which sold part of its business to Gerdau, the Brazilian steel giant, earlier this year. The remaining businesses were then spun off to shareholders. The two existing businesses for NX are: Engineered Products (a variety of door and window products) and Aluminum Sheet Products. You can find out more about these businesses at: http://www.quanex.com/index.html. The business that most interests me is the company’s Truseal Division (www.truseal.com) which manufacturers a wide array of green building sealant products, including adhesives for thin film solar panels. It’s difficult to get a ton of information on Truseal, but in the last few conference calls management has indicated that the company is the main supplier of adhesives to the largest US thin film manufacturer, which I assume means First Solar.

The Numbers
Current Price: $16.75
Shares: 38 million
Cash: $54 million (expect another $20 million from Gerdau soon)
Debt: $2 million
EV: $575 million
Estimated Sales: $880 million (these are trough estimates in a weak real estate market)
EV/Sales: 0.65
Gross Margin: 17% (this should improve as capacity is ramped up, and end markets stabilize)
Estimated EBITDA: $90 million (again trough estimates)
Cap-Ex: $20 million per year

What Went Wrong?
US Real Estate Crash.

What Will Change?

Financial Evidence
Despite an extremely tough real estate end market, Quanex continues to generate significant cash, as evidenced in the past two quarterly earnings statements. Notably, in the last quarter the company generated over $22 million in EBITDA and $0.32 per share in EPS. If real estate markets stabilize and assuming continued growth in the company’s solar business, we would expect significant operating leverage to show up at the company in future financial results. In addition, given the company’s financial position, it seems likely to us that NX will soon consummate an acquisition which will significantly increase the size of the company.

The Valuation
As can be seen above NX currently trades at less than 10X depressed EBITDA and less than 1X EV/Sales. As such the stock has significant room to move up should sentiment improve and/or should the company complete announce a major accretive acquisition.

Risks
Real estate market does not stabilize and the US financial system continues to deteriorate (hard to believe that’s now considered a major risk).