FRD - Friedman Industries

[west]

A cyclical business (with some enormous sales swings in its history) currently trading at less than book value, and even less than that if you adjust inventory for LIFO.  They have been profitable every year for the last ten years, including 2009 when sales dumped from $208m in 2008 to $65m.  So they handle sudden downturns well.

 

ROE swings between 10% and 17%-18% on average, but it has gone as low as 1.2% (in 2009 when sales dumped) to all the way as high as 24.4% in 2008.

 

No immediate catalysts, and there is expected to be some relatively high capex coming up.  Still, not a bad cigar butt stock.  I hold a small position in them.

 

[jschembs]

A cyclical business (with some enormous sales swings in its history) currently trading at less than book value, and even less than that if you adjust inventory for LIFO.  They have been profitable every year for the last ten years, including 2009 when sales dumped from $208m in 2008 to $65m.  So they handle sudden downturns well.

 

ROE swings between 10% and 17%-18% on average, but it has gone as low as 1.2% (in 2009 when sales dumped) to all the way as high as 24.4% in 2008.

 

No immediate catalysts, and there is expected to be some relatively high capex coming up.  Still, not a bad cigar butt stock.  I hold a small position in them.

 

I owned late last year for a brief period, couldn't get comfortable with the downward trend in performance during what should've been a boom period (benefiting from the domestic manufacturing renaissance). Thanks for posting the name though; surprising it hasn't been discussed before.

[west]

Recently a net-net assuming no discount on Inventories or Receivables.

 

To repeat my original post:

 

A cyclical business (with some enormous sales swings in its history) currently trading at less than book value, and even less than that if you adjust inventory for LIFO.  They have been profitable every year for the last ten years, including 2009 when sales dumped from $208m in 2008 to $65m.  So they handle sudden downturns well.

 

ROE swings between 10% and 17%-18% on average, but it has gone as low as 1.2% (in 2009 when sales dumped) to all the way as high as 24.4% in 2008.

 

No immediate catalysts, and there is expected to be some relatively high capex coming up.  Still, not a bad cigar butt stock.  I hold a small position in them.

[mjohn707]

I own this too and was going to write it up a while back until I realized it was already here  ;)

[bizaro86]

Any idea how much of their cash will get spent on the new facility in Texas to produce threaded pipe? It doesn't seem like an especially opportune time to have entered that business.

[mjohn707]

Any idea how much of their cash will get spent on the new facility in Texas to produce threaded pipe? It doesn't seem like an especially opportune time to have entered that business.

 

$9.2M in total costs and they've paid $5.4M in cash already, and they should finish construction in a year or so.

[Deepdive]

FRD seems like a decent idea as a basket trade for recovery in oil and gas. Seems safe because of it's a net net with a decent balance sheet.

[kab60]

FRD seems like a decent idea as a basket trade for recovery in oil and gas. Seems safe because of it's a net net with a decent balance sheet.

Mccoy Global might also fit in that basket

[samaniv]

I attached the pdf of this write-up since the formatting wasn't copying over well.

 

 

 

Let’s picture what no one wants to own. Thinly-traded, nanocap, commodity business, and (now) negative earnings. But for those of us who fish in this pond, Friedman Industries is a deep value contrarian play.

 

The thesis for Friedman is straightforward. The market is valuing the company at approximately working capital value and attributing no value to the operating business. I believe that the market is extrapolating recent poor market conditions into the distant future and underestimating the likelihood of a return to more normalized conditions over the long-term. This provides us with the opportunity to purchase Friedman for the value of its working capital and retain upside optionality in the event that future business profitability is restored. If the prolonged downtown in energy markets continues, the downside is well protected. Below, I have computed a conservative estimate of liquidation value:

                BV                     %                       Liq. Value

CURRENT ASSETS:

Cash                     $ 1,461,695          100%         1,461,695

Accounts receivable       8,939,051               100%         8,939,051

Inventories         34,918,550           90%       31,426,695

Other             113,540                90%           102,186

TOTAL CURRENT ASSETS 45,432,836             41,929,627

Data from 2017 Annual Report

Total Liabilities     2,906,872.00 100% 2,906,872

 

Net current asset value (NCAV)   42,525,964.00   39,022,755.00

 

Market capitalization (06/30/2017)   39,813,641.92

 

 

 

The liquidation value is computed above under conservative assumptions including:

• The company has a 5.6MN LIFO cost reserve – suggesting the above inventory is likely understated.

• No value is given to 15M of long-term assets, including a 9.4M pipe-finishing facility, which was finished in May 2017.

• The company owns 195 acres of real estate (122 acres in TX, 26 acres in Arkansas, 47 acres in Alabama) which is held at cost on the books. This would likely add a few million.

 

The liquidation value provides a useful proxy for a worst-case scenario. I believe that the more probable outcome is that Friedman is able to weather the downturn and emerge as a profitable business. The majority of companies trading below Net Current Asset Value (NCAV) have significant cash burns with horrible management teams. Instead at Friedman we find the following:

1. Excluding F’2017, Friedman has been consistently profitable for 51 years

2. Management has run the company conservatively and generated fair unlevered returns on equity (7% average ROE over last 10 years )

3. The company has a solid track record of returning excess cash to shareholders. Annual dividend payments are close to half of yearly earnings

Company Background

Friedman is a steel mill and service center, with two divisions – coil and tubular. In the coil division, the company processes hot-rolled coils into sheet and plate. In the tubular segment, they cut and finish tubular steel goods. The coil segment has historically produced the majority of the revenue, but little in the way of earnings. The tubular segment has been responsible for the majority of historical profitability.

The tubular division produces API line pipe and API oil country pipe – which is used in oil and gas wells as well as oil and gas pipelines

In conjunction with selling tubular products, Friedman has had a sort of third business – revolving around US Steel. Friedman has:

1) Manufactured pipe for US Steel. “Historically, the Company has purchased steel Coils from USS, converted these coils into line and oil country pipe, and sold this pipe to USS pursuant to orders received from USS.”

2) Purchased new mill pipe reject from US Steel: “The Company has also purchased new mill reject pipe from USS and marketed it to other customers for structural and other miscellaneous applications.”

The tubular products division is located in Lonestar, Texas and has operated 2 mills (recently expanded to 3).

• Mill #1 makes 6 5/8” and 8 5/8” diameter pipe

o US Steel was a major customer – permanently shut down their Line #1 which purchased 8 5/8” pipe.

• Mill #2 makes 4 1/2” – 5  9/16” pipe.

o On April 27, 2017 – US Steel announced they are restarting this mill (a significant customer)

• Mill #3 came online in May 2017 (pipe-finishing facility).

The tubular products industry has been extremely volatile historically: sales from 50M in 2004 up to 100M in 2007, down to 28M in 2010, up to 92M in 2012, down to 13M in 2017. The loss of US Steel as a major customer in Mill #1 is likely to make future sales lower than historical. This should be partially offset by the additional earnings from Mill#3.

The above background helps understand Friedman’s low valuation. The volatile tubular segment has been negatively impacted by the energy downturn. In conjunction with the downturn, US Steel’s closure of Mill #1 – represents loss of business from a key customer.  The market has reacted to these negative developments with a significant decline in Friedman’s stock price.

 

 

 

Valuation:

It is hard to estimate what Friedman could earn in a normalized market. As a crude estimate, I averaged the EBITDA for every year since 2004 (when they acquired their second mill). Together, the combined average EBITDA is approximately 10.6M. In recognition of the naivety of blindly extrapolating the past, I assumed future profitability would only be half of that achieved historically - pointing to approximately 5.3MN.  It is important to note that future EBITDA is likely to be lower than historical, given the permanent closure of US Steel’s Mill #1, as noted above.

 

 

  See PDF for including tables.

 

For a comparative EV/EBITDA multiple, a MPI Metals Industry Q4 2014 report pointed to a Median 10x multiple for steel service centers. A Raymond James spring 2016 report suggested a median 10.2x multiple.

Using an arbitrary multiple of 6x (for conservatism), the operating business would be worth approximately 32M or $4.50 per share. Given that Friedman is trading for net current asset value, most of this value represents potential upside. If we assume that Friedman needs approximately 10MN of working capital investment to run its business, then the value of the business could be roughly approximated as 32MN (operating) + 29MN (39 WC – 10 inv in WC) = 61M or approximately $8.70 per share.

Catalyst:

• Rebound in energy activity (higher end-user demand)

• Accretive earnings from Mill #3 or pick-up in US Steel business (Mill #2 recently opened)

Risks:

• Further downturn in energy industry

• Mill #3 may have low utilization and high operating costs initially as processes are being refined

• Sustained downturn in energy industry resulting in Friedman being unable to recover the carrying value of their inventory (ie. impairment)

 

 

 

 

Conclusion:

Even under overly conservative assumptions, Friedman shareholders appear to be getting significant earning power without having to pay for it. This represents a free call option on the underlying business. In the event that future earning power does not materialize, shareholders are protected via hard assets. The underlying fundamentals suggest an asymmetric upside/downside for Friedman shareholders.

 

 

FRD_July_1st_2017.pdf

[wabuffo]

Interesting idea.

 

My question is about the inventory (which makes up a very significant part of the current asset value).  Why do you feel you are being conservative when you discount inventory by only 10% in a liquidation scenario?  Usually in these liquidation scenarios you see a markdown closer to 30-40% on inventory liquidation values.

 

This is especially a concern in FRD's case, since most of the inventory is in the tubular segment.  It looks like demand has collapsed in this segment and they are very, very long on inventory.  ($3m per Q avg sales vs $25m of inventory)   

 

So in a liquidation scenario, it would require either:

a) a very sharp mark-down, or

b) a slow-mo liquidation to protect value.  But the second approach would bring another risk which is that in a two-year+ liquidation of the inventory, one would also be exposed to a fall in underlying steel prices (requiring a further markdown of the inventory) despite trying not to flood the market.

 

In either case, I'm trying to understand why you feel a 10% discount on the inventory is conservative.

 

Still could be an interesting situation.

 

wabuffo

[samaniv]

Hey wabuffo,

 

Thanks for the comments. You raise some good points on the inventory valuation. A few comments:

 

1) There is a 5.6MN LIFO cost reserve - and given that weighted average cost more accurately follows inventory movement (hence reason LIFO not allowed under IFRS) - the true inventory carrying value is actually 39.5M. Meaning the discount I have taken is just over 20%.

 

2) Steel does not spoil or go obsolete - so the only real time FRD would sell it below carrying value would be if there was a fire sale. This would probably only happen if there was a forced liquidation (requiring a sharp write-down). I do not see a forced liquidation as likely - given that FRD has no debt.

 

I have noted that this is their "liquidation value" but most companies which we value on a liquidation  basis - never actually liquidate. So this is very much a theoretical exercise to show that something is cheap. Most net-nets don't realize value through liquidation, but through mean reversion, special dividends, or some other catalyst. The exercise of showing that a security trades at a discount to net current asset value is merely just to show that a security is cheap.

 

So yes, I agree that in a firesale a 30-40% markdown on inventory would be required. But a more probable outcome is that Friedman sells  its inventory for above carrying value and is left with an operating business which generates earnings going forward. I view it as unlikely that the inventory ever gets sold at a 30-40% discount.

 

I see how you could make the argument that in a true liquidation a firesale would be required and therefore the downside is not as well protected as I have implied in my article. But I view this as a highly improbable outcome.

 

Rather than computed the "liquidation value", I am really trying to value the redundant assets. I am trying to make the argument that FRD has its market cap in redundant assets which will be sold off, leaving an operating business for essentially free.

 

 

[wabuffo]

1) There is a 5.6MN LIFO cost reserve - and given that weighted average cost more accurately follows inventory movement (hence reason LIFO not allowed under IFRS) - the true inventory carrying value is actually 39.5M. Meaning the discount I have taken is just over 20%.

 

Samaniv,

 

Whether FRD used weighted average or LIFO inventory accounting is irrelevant, IMHO.  The inventory dollar value on their books is just the accounting value of the sunk cost of past cash consumed by the Company for steel purchases and labor embedded in the finished goods.  LIFO/FIFO/weighted avg is just the different flow assumptions of what historical production cost of goods gets allocated to the units when sold. 

 

It is neither a conservative (nor aggressive) indicator of anything that might be useful in estimating economic value.  The true economic value is largely what customers are paying for these goods today.  In a fast-turning inventory environment, you could use the accounting values as a good proxy.  But in this situation. I would argue the value of their "investment" in tubular finished goods is too high under either LIFO or weighted avg accounting since they have over two years supply.  This indicates to me that they are resisting selling below their "conservative" LIFO cost because it would mean realizing a larger accounting loss (even if it means realizing a positive cash flow). The longer they wait, the more risk they take that steel prices fall (for which they would have to write down their inventory values further).  Of course, they could get lucky if steel imports are restricted by the US govt -- but I wouldn't want to build that into an investment thesis.

 

I have noted that this is their "liquidation value" but most companies which we value on a liquidation  basis - never actually liquidate.

 

Well I think that this particular company has a better than 50/50 chance of actually liquidating - so you better start sharpening your pencil!  Its management team sunk almost $10m into expanding its tubular plant just as this business segment collapsed and is very long inventory it can't sell.  That may be a fatal mistake in a tough business with razor thin margins.  Meanwhile its bleeding cash and its "conservative" Grahamian liquidation value per share keeps falling every quarter for the last couple of years.  It sounds like you are making a big assumption that this business is a going concern and you have time to wait.  I'm not so certain of that.

 

If not a complete liquidation - then at least a partial liquidation of its tubular segment may be likely where they have $37m of assets (capital + inventory) tied up earning less than nothing and consuming cash for over two years now.  Perhaps they get lucky and the business rebounds, perhaps they don't and they take on bank debt to keep the plates spinning in the air...

 

I think it would be helpful to do a deeper-dive on the actual math of what value would be left over if they actually liquidate (or partially liquidate), including one-time exit costs.  I haven't done a detailed analysis but my estimate is less than $4 per share, FWIW.  But I haven't looked closely at it so that's a SWAG and not worth much as an estimate.  As Munger has said about these Graham cigar butts, you think you have this nice net working capital...and then you shut down and the working capital is gone!

 

FWIW, just trying to play devil's advocate...

 

wabuffo

[samaniv]

Wabuffo,

 

I appreciate the comments - in fact - its why I post on here. A couple of points to clarify my thinking:

 

1. Inventory -  of course the economic (net realizable value) is what we care about. The carrying value is merely a proxy. To clarify, it is the coil segment which  uses LIFO. The tubular segment uses weighted avg cost already. Consequently, the entire reserve applies to the coil segment.  They did 65M in coil sales and have 9.5MN of inventory on hand (so don't think there is an impairment issue here).

 

For the tubular segment - I would rather them wait and sell it when steel prices recover - rather than discount it heavily and liquidate it at depressed market prices. Yes, steel prices could decline further - but they could also rise further. There are some positive signs such as increased rig counts and US Steel re-opening mill #2 . In fact, US Steel said in their quarterly statements "Total US rig count stands at 857 in April 21 (2017), 112% increase over lowest point in May 2016. Increase in rig count is related to onshore activity which will primarily benefit Fairfield and Lone Star Welded Operations". The lone-star welded operations it the same market FRD serves.

 

Meanwhile its bleeding cash

 

I don't really think they are "bleeding cash".  200k cash used in operations in F'17 and positive 3M in F"16. There was high cap-ex due to the facility you mentioned, but this is over now. Going forward - I don't see a massive cash burn?

 

I do value the company as a going-concern and do not see a 50/50 liquidation chance. I think the unlevered balance sheet gives them this flexibility to wait it out - and since they are not aggressively burning cash - they have the time to wait.

[wabuffo]

I think the unlevered balance sheet gives them this flexibility to wait it out - and since they are not aggressively burning cash - they have the time to wait.

 

This is the key question - which comes first.....1) recovery of their customers capital spending, or 2) they run out of cash. 

 

Latest Q, they burned through $4m and are down to $1m of cash on the balance sheet as they try to start up their new $9m Mill at their Lone Star plant.  They do have more inventory to liquidate, so perhaps they can get more aggressive in that area in order to generate some cash.

 

What is your estimate of their average earning power over a complete business cycle?

 

wabuffo

[samwise]

This jumped from 6 to 11 after their recent report. I got out by 9.5.

 

[mjohn707]

This jumped from 6 to 11 after their recent report. I got out by 9.5.

 

I sold half of mine, probably will sell the rest of it soon

[BG2008]

It's interesting that this name was stagnant for 2-3 years and then all a sudden this year, it essentially doubled.  I bought a portion in 15 or 16, I don't recall and I bought more earlier this year.  The first batch, it looked like dead money for a long time.  The second batch makes me look like a genius.  Value investing, sometimes  you just don't know and need the patience. 

[samwise]

Admire your patience mjohn. I feel the risk with these names is that they are really bad businesses and ones IRR goes down the longer one holds them. I've leant towards selling earlier than later, although sometimes that looks bad in retrospect. Do you have a target or scaling method that has worked for you.

 

BG2008, yes indeed I think this is common for ignored and less followed names. The market is not active. But if you bought in 2015 at about 6 and sold in 2018 at about 9, thats 50% in 3 years. I'd be happy if I could do that every time.

 

Sorry all for the very late replies.

[mjohn707]

Admire your patience mjohn. I feel the risk with these names is that they are really bad businesses and ones IRR goes down the longer one holds them. I've leant towards selling earlier than later, although sometimes that looks bad in retrospect. Do you have a target or scaling method that has worked for you.

 

BG2008, yes indeed I think this is common for ignored and less followed names. The market is not active. But if you bought in 2015 at about 6 and sold in 2018 at about 9, thats 50% in 3 years. I'd be happy if I could do that every time.

 

Sorry all for the very late replies.

 

I set a goal price and just sell when it hits that goal, sometimes part of a position a little before that and all.  Yep most of these names are bad businesses and they aren't going to be homeruns or anything like that, but sometimes a single or a double is good enough, just depends on your expectations

[Deepdive]

Trading as a net-net again