USAP: Another Steel Net-Net

Mark Twain said, “History doesn’t repeat itself, but it often rhymes.” In the case of Universal Stainless, a Pennsylvania-based steel company, history has rhymed four times in the past twenty years. During each of those times, Universal Stainless’s stock, after a stupendous rise, crashed by at least 70%.

Mohnish Pabrai owned it during one of those interludes, from 2002-2006. He wrote a case study about it in his great book, The Dhandho Investor.

In the book, Mohnish discusses why he purchased the stock for about $14 or $15 per share in 2002. At that point, the company had recently purchased its Dunkirk facility for peanuts. The company was losing money and its end markets of aerospace, heavy machinery, and oil & gas, were weak. But the company was employing a “Dhandho” philosophy: i.e., they were making smart moves that cost little, but had optionality for huge upside.

This investment was a testament to Mohnish’s patience and investment skill. The stock had a wild ride. Mohnish survived a 65% drawdown. He doubled-down on the investment after a couple years when business started to improve, and ultimately sold much higher.

Fifteen years later, with a different CEO and a few crises later, Universal Stainless is down again.

One change over the past decade is that the company bet big on aerospace. In 2010, aerospace represented 35% of company sales. By 2019, it had doubled to 70% of sales. Aerospace seemed like a good bet. It requires more specialty alloys which command higher margins. It also has long product cycles and better visibility. But it required expensive investment.

Now the company’s aerospace business is facing a double whammy. First, the FAA grounded the 737-MAX, which had a huge impact on the supply chain. Then, COVID-19 decimated global travel.

Their other end markets, such as oil & gas, also aren’t doing well.

The situation is bleak. The company expects revenues to decline further throughout the end of the year before turning up next year. They said they will try to maintain a positive gross margin. Yikes.

Universal Stainless is trading only a point or two above the level where it bottomed in 2003. Since then book value has grown from around $10 per share to $27, most of it invested (wasted?) in PP&E.

The good news? Universal Stainless has faced these crises before and knows how to survive. They are cutting expenses and capex to the bone. They will generate cash as inventory gets worked down. And despite the haranguing on their $10 million PPP loan, it will probably be forgiven.

And there could be some improvement on the horizon. Street estimates for Boeing and Airbus are not so terrible. It appears 2020 will be the bottom. Industry revenue for 2021 is currently estimated to recover to 2019 levels. The return to service of the 737 MAX alone will have a big impact on the industry. The defense business should be steady. And there should be growth from 2021 onwards.

And what could go right? People could fly again. Recent news suggested that China’s domestic flights are approaching pre-COVID levels. Perhaps there is light at the end of the tunnel for the aerospace supply chain.

Given the amount of PP&E at this company, there is lots of operating leverage if things go right. If history does rhyme again, Universal Stainless could be a multi-bagger.

With that said, the company continues to invest in itself with no apparent return. The current management is a lot less Dhandho than the prior management. Unless things change, you might be a sap to own this long-term. But downside is probably limited below net-net value.

It’s a painful time again for Universal Stainless. But to quote Mohnish’s mother from his book, “Time is the best healer.”

FRD: A Steel Net-Net (Update)

Normally I wouldn’t write an update so soon after my first post, but Friedman announced some interesting news last week along with its fourth quarter earnings.

The results for the quarter itself were mixed, with a $4 million impairment charge hitting their tubular segment. The investment they had made in a tubular facility a few years ago never really worked out. Excluding that charge, net income was modestly positive in the quarter.

For the year, the company posted their worst earnings year in over over a decade, losing about $5 million. The impairment write-off drove the majority of the loss.

While the coil segment is performing fine, I’d expect the tubular segment to struggle for a while. This segment is levered to the struggling energy sector. And they have a good amount of tubular inventory which will take some time to work through. The company also noted that COVID will have an impact across both segments, and they expect to lose money for the June quarter.

On the positive side, it appears that there are operational improvements underway. In my last note, one source of hope for the company was that new CEO Mike Taylor could make long-needed operational changes at the company.

It seems like he is making some of those changes. The company completed a strategic review last year with a few tangible improvements underway.

The first improvement is that they are making capital expenditures to boost capacity where they have been constrained. Overall they will spend $5.8 million, of which $3.8 million has already been spent. Given their last big capex project was just written off with a large impairment charge, we should be a little skeptical. But I also appreciate the initiative to try to grow.

The second improvement is Friedman will start to use price-risk actions to hedge their steel exposure. This hedging will lower their earnings volatility. This makes a lot of sense. As I said before, there is no reason a company like this should not consistently earn money.

The last major improvement is that the company announced a share repurchase authorization of 1 million shares or so, or about 15% of the company over the next three years. This is meaningful–if they actually follow through. Repurchasing shares at 55% of tangible book will be highly accretive.

The company is still in a black-out period. So it wouldn’t be able to purchase shares until mid-August or so after they report their next quarter. Just for reference, the company traded about 2.7 million shares last year. So it would require a daily purchase of 12% of daily volume to complete the buyback.

After the quarter, the company took in a PPP loan for $1.7 million, which will probably be forgiven. This will help offset the loss from the June quarter.

What does all this mean for earnings? It’s hard to triangulate given the information we have. In the past decade the company has earned about $25 million in total, or $2.5 million per year. Most of that occurred in the 2011-2015 period, with virtually nothing earned from 2016-2020.

If we assume 7% gross margins on $150 million of sales less $5 million of opex, we can get a $5 million earnings figure. This could be reasonable given what they have done in the past.

Earning $2.5 million relative to a market cap of $36 million is not particularly enticing value. Earning $5 million would change the equation. And if they return capital via buybacks along the way, the earnings yield would ramp up even more.

Will any of this happen? I can’t say for sure. But the downside does seem limited. As I said two weeks ago, it’s a heads I win, tails I don’t lose much situation. But maybe the odds on the coin flip are no longer less than 50%? As a net-net investor, I can only hope.

FRD: A Steel Net-Net

Steel used to be an industry people cared about. Lost among that disinterest is Friedman Industries, a processor and distributor of coil and tubular steel products. It’s a business that was founded in 1965 and seems to have been built for that era.

What is coil? It is flat sheets of steel rolled up and used for applications like rail cars, truck frames, construction, and containers. The tubular products are essentially pipes.

Friedman buys inventory from the steel mill in bulk, does some processing, and keeps inventory on hand for their customers. Their largest customer is Trinity Industries, a rail-car manufacturer.

Their coil products are made out of hot-rolled steel. Hot-rolled steel is less precise and requires less processing than cold-rolled steel. You can Google the price history of hot-rolled steel which is volatile like any commodity.

Historically this company has done well when they buy inventory at low prices, and prices subsequently increase. In the opposite scenario they don’t do as well. This past year, they had quarters where gross margin was negative. On the other hand, 2017 and 2018 were decent years based on a 60% or so increase in prices.

Right now prices are at lower levels and many of their core end markets are struggling.

On the positive side, Friedman has very little in operating expenses. Opex runs at $4 million per year.

This should be a decent little business. They distribute steel and keep their costs low. And looking over the past ten full years of earnings, their returns look pretty good on average.

But only on average. Here is the earnings history:

Year Ended MarchNet Income (in millions)
2011$8.2
20128.2
20136.1
20141.7
20150.4
20160.3
2017-2.7
20182.8
20195.1
2020 year-to-date (through 12/31/2019)-2.2

The trend is not good.

It not clear to me why a somewhat commodity distributor can’t make a decent ROI. According to the CFO, “It’s a relationship business.” They don’t want to antagonize customers by selling at anything other than current prices.

So their suppliers are big, and the customers are big. They have to have relationships to make this work. This doesn’t seem like a great business.

But everything has a price. So how cheap is it? The company is trading at a $35 million market cap. It currently has $55 million of net-current-asset-value. Of this $22 million is net cash. Friedman owns its facilities and land which is another $15 million. It’s cheap on assets. Less so on earnings.

Also, they have a new CEO. Michael J. Taylor was hired in September of 2019 with solid credentials. He ran Cargill’s Metal Supply Chain business for 10+ years. Could there be operational improvements? It’s too early to tell but there is certainly a possibility.

In a downside case, assume gross margins are 0%. They will burn $4 million per year. It would take a long time to burn net-net value.

But this business should have a higher gross margin (is higher than 0% too much to ask?). And there is always a chance the new CEO can get things going. Or prices spike for some reason. Both of those scenarios could see earnings go up. Tangible book will grow. And there is no reason why Friedman couldn’t trade at tangible book which is 100% higher.

It’s a “head I win, tails I don’t lose too much” situation. But the chance of flipping a heads may be less than 50%.

FLXS: A Furniture Net-Net

There are few industries worse than the furniture business right now. Retailers are closed. There is massive unemployment. Who is thinking, “Let’s make a large, highly discretionary, easily postponable expense!”

Hence the opportunity in Flexsteel, a 126 year-old furniture manufacturer based in Iowa. Sales are probably down 80-90% right now, and they will be burning cash until demand returns.

The company had already been burning cash through 2019 due to a series of restructurings. They rationalized SKUs and shut down facilities with low utilization. Inventory was written down. Flexsteel has also been fixing a disastrous SAP implementation which burned close to $100 million (yes, the market cap is currently $70 million).

The old management team rode a few product winners to new heights in the 2012-2016 period but left the pipeline dry. They compounded this with the flubbed the ERP implementation. The result of these miscues is the stock is down about 85% from the peak and is trading at 2009 levels.

On the bright side, the company hired a new management team. The new CEO’s primary experience is from a rival furniture manufacturer called HNI. He wrote an annual letter which outlined some ambitious goals. And insiders are even buying some stock.

The only fear: Are they moving too fast? I’m all for moving fast but it came at a large cash cost. Was it necessary to hire Alix Partners? Perhaps I’m just too cheap and short-sighted (I am a net-net investor after all). Regardless, after all the restructuring and cash costs, the core business was on the cusp of profitability.

And then the pandemic struck. Now the question is how much cash will they burn this year before demand comes back? The company is hunkering down. My estimate is that they could burn $30 million this year if demand comes back slowly. So by the end of the year, it goes from a 60% net-net to a 100% net-net. Still cheap, but then we’ll have to worry about 2021.

However, it seems like a company that will last. It’s been around forever. People talk about Flexsteel on BIFL forums on Reddit. It’s not the highest end, but they are known for making decent furniture.

When the dust settles, they should have a leaner operation. They will have flexible sourcing, manufacturing, and distribution. They will have an omni-channel presence. At their goal of 7% margins, this company is trading at about 3x earnings.

With that said, this one is not without risk. It could be down a decent amount in 1-2 years. But it’s a net-net. The odds are good it will be worth more, perhaps much more.

KTCC: An EMS Net-Net

Electronic manufacturing service companies like Key Tronic are frequent guests on Net-Net lists. They have razor thin margins, are asset heavy, and have all the hallmarks of a terrible business.

But things aren’t quite as bad as they seem. EMS companies add value by enabling customers to outsource their manufacturing. Because manufacturing is a core competency and they have scale, they can manufacture at lower costs than the customer can themselves. The key for the EMS companies is to turn the assets fast enough, keep costs low, and not do any bone-headed projects. If following the above rules, companies can churn out relatively consistent profits and even a decent ROIC.

Their balance sheets are usually quite good. They don’t typically have inventory risk due to price-protection or other agreements with suppliers. These agreements enable the company to sell the inventory back to the manufacturer should end demand for the product go awry. The receivables are usually safe since they are working with larger customers.

Key Tronic fits the model of a typical EMS player. It is on the smaller side so doesn’t have the scale to compete with the larger players for the big programs. But it does have the capability of manufacturing a wide range of products from consumer electronics to industrial equipment to fitness equipment.

Key Tronic has missed numbers the past few years and underperformed due to various reasons including program losses and China tariffs. Earnings recently haven’t been good and are there will be puts and takes with the recent pandemic. One customer represents 17% of sales per their last 10-K. As a result, KTCC currently trades at roughly 90% of net-current-asset-value and 42% of tangible book.

It’s not all terrible. The company has diversified facilities in China, Vietnam, and Mexico. When the company normalizes, it could achieve its stated ROE goal of 10%+, a number it has hit in the past. This upside case would imply a P/E of about 4x.

The main risk appears to be management. Craig Gates has been with the company for 25 years and CEO for 11. He owns a relatively modest 2% of the company. Under his tenure, operating results have been mixed, with plenty of disappointing quarters relative to guidance.

Capital allocation has been questionable. They don’t pay a dividend or repurchase shares. In 2014, the company paid $48 million in cash for an acquisition yet the total market cap of Key Tronic is about $47 million today. These decisions appear terrible in retrospect. While it may not be fair to assess total blame on management, this may be enough to pass on the investment here.

On the positive side regarding management, the key metric they are compensated on is ROIC relative to peers. This is a lot better than most alternatives.

Overall, I believe tangible book should be relatively steady, and should be increasing over time. It’s not crazy for this business to earn a decent ROIC over time (as it has in the past), and if there is some normalization, the stock should be worth at least it’s tangible book value.

This stock is relatively low risk, and might be worth trying to squeeze a puff. But I’d sleep better if I felt better about management.