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%.