Which Dog will get the Chew Toy?

Just to settle the argument up front, I think the Golden Retriever wins this race, but what I have been studying this weekend is a race between two other dogs - TIE and RTI. As we enter 2008, the race to the bottom is on!

Titanium prices have begun dropping and expansions are coming on line to meet any demand that is there. Each firm puts it's best face forward and talks about the 787 or the A380 and the upcoming demand as they scramble to expand and hope that volume makes up for the lack of pricing leverage. It is truly a dog-eat-dog competition and I think the entire sector is bracing for some further stock price weakness.

TIE just blew earnings and I have just completed some back of the envelope numbers for 2008 (now revised for the dismal Q3 information just received). I am coming up with a 2008 EPS of $1.74, which gives TIE a forward 2008 PE of 18. The problem is that they also have a trailing PE of 18. This tells me that TIE's stock price will be stuck in the same gear for the next year.

RTI has a similar issue. I am expecting 2008 earnings to be no more than $4.00 (and I think this is generous). This give RTI a forward 2008 PE of just less than 18. Their trailing PE is just over 18 as well. They will also be in the same gear as TIE for a year.

Or will they? The market seems to want to price both companies the same, but I think that 2008 will give TIE some real advantages over RTI for the following five reasons. First, when TIE burns through their inventory, their accounting procedures for tracking inventory (FIFO) will help them as cheap scrap replaces previously expensive scrap.

Second, TIE also has a melt expansion (on top of a new sponge expansion) coming on line (while RTI will have to wait for expansions coming on-line in 2009). While I have factored this into the numbers, I really gave little or no credit for any potential upside for TIE as demand improves during the 2nd half of 2008 (due to aerospace ramps).

Third, management for each firm is not stellar but anyone would have to give TIE the edge there. RTI demonstrates on Conference Calls that they really don't have a good handle on the company. In addition, the relationship between management and labor is still not great with RTI and they really have not integrated the company well since acquisitions in the late 1990's. While TIE has a very major owner that supports the stock (Harold Simmons). Harold is also getting up in age and may sell the company someday (like in 2008) - a bonus for TIE.

Fourth, RTI typically has a pricing lag with its mill product that may affect their next quarter and 1st quarter of 2008 more severely than TIE. They also still have a customs investigation hanging over their earnings.

Finally, does S&P inclusion count for anything? TIE was just added to the S&P 500 and commanded a PE premium before the earnings miss, while RTI beat earnings. This suggests to me that TIE may rebound relative to RTI's current value.

Determining that TIE is a better buy than RTI is fairly easy. Heck, I knew that more than two years ago when it was pretty easy to make money with any titanium stock. The problem now is that both stocks may go lower from here over the next year as the cycle matures and PE's contract.

So should we short the sector? Not with Harold Simmons betting against you with TIE.

So at this point, most folks would just walk away and trade somewhere else, but this is a sector I know and I still think that there is money to be made if the trade is set up correctly. I have posted previously about doing a pairs trade (shorting RTI and going long TIE). This chart suggests the trade is solid when you look at data from 2007:






With a pairs trade, if both stocks go up or down, you don't care (it takes the market tape out of the equation). You are only interested in the difference between TIE and RTI and, to me, it is pretty clear that TIE will do better (relatively) than RTI. They are both high beta stocks, which gives the trade enough juice to make it very profitable.

If I where to tell you that TIE will finish 2008 20% higher than RTI, would a 20% return be good enough to apply the trade? What if I told you that, at certain times, either stock will most definitely deviate from their sector relationship due to earnings events or press releases that could allow you to goose your returns? The chart I attached show multiple occasions in the same year where one stock deviated from the other by 12% or more in a predictable manner and then quickly came back into balance. I plan to take advantage of these differences.

For those that are just long either of these stocks, I think both TIE and RTI are now dead money for the year. In fact, I think that six months from now it is possible that they are both lower. Therefore, for me, the only trade worth doing is a relative (or pairs) trade.

Therefore, TIE is the better looking and faster dog and it gets the chew toy. Of course, Sneakdoggiedog has always been a little biased towards other Golden Retrievers.