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.”