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RELY - Real Industry


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Real Industry, formerly Signature Group, will up list to the NASDAQ this week. The company is an NOL shell with over $900mm in long dated NOLs. They have just completed an acquisition of Real Alloy, the largest aluminum recycling company in the world. There's all sorts of adjustments that one needs to make from historical filings to the new capital structure, but it looks like the company is trading around 4.5X EBITDA.

 

The company is likely to make further acquisitions over time.

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My partner is doing a q&a with RELY's management and we'll be posting a transcript on The NOL Newsletter. It's a holding of mine and I know the company fairly well. We should have some good questions. That being said, if there are any specific questions you would like us to include in the q&a, please leave them in the comments below and we'll work them in. I'm happy to share the transcript with those who are interested and have questions to ask.

 

I'm not really sure I can add much to the questions you've already got in mind, but here are a few random thoughts.

 

The Global Recycling and Specification Alloys ("GRSA") acquisition from Aleris Corporation was announced before having all the details of the financing finalized: a strategy that caused a drop in the share price at the time, and more dilution than I was probably forecasting. As I expect the company to continue in its acquisition strategy, and I also believe equity might be used again as currency, does management believe that a different strategy might be more rewarding for shareholders and are they planning a different approach?

 

New acquisition targets: I remember a comment in one of the latest presentations along the lines of "away from commodity related businesses, to avoid being associated with the ups and downs related to these companies". Could management elaborate better on this and give more clues about ideal targets?

 

Of course, I would appreciate if you could translate all this into proper English  ;) , and if you could share the transcripts after the Q&A. Thanks in advance.

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What's stopping the primary producers from building up their recycling operations and take share away from RELY?

 

Some of them are building up their recycling ops, notably Novelis. The good thing about Novelis is that it is also an aluminum fabricator - so, it recycles aluminum, and then manufactures its own cans, sheet...e.g., the recycled aluminum is used internally.

 

A couple of things: the big primary producers are under a ton of pressure right now. You've got cheap Chinese imports at the same time LME's warehouse restrictions were relaxed to let more alum vol withdrawals per day. Basically, the midwest premium used to be like $.05-$.10 per lb in the 2000s. Then, coming out of the recession, aluminum was in contango, and traders took advantage to execute risk-free storage trades. This had the effect of locking up inventories and driving up storage costs - even though inventories were 100 tons, 50 of those were locked up in LT contracts, so effective inventory was much less. Additionally, the LME warehouse rules restricted outflows to like 3000kmt per day or something. This basically created a long queue time to receive delivery of aluminum. In fact, due to volume withdrawal restrictions, you couldn't get metal delivered for 15 months in the '11-'13 time frame. What are the implications of this? The buyer who signs into that 15 month contract has to pay 15 months worth of storage fees. So, the delivered cost of aluminum, because of this 15 month wait time, skyrocketed - the deliverd cost includes the storage fees. On top of that, the USA runs at an aluminum deficit. We import from Canada. Right around this time, Canadian imports started to slow down. So, the price of aluminum in the USA had to increase to draw aluminum imports from farther abroad. The MWP encompasses both shipping and handling costs. In order to entice aluminum from further abroad, like Russia, the MWP had to go up to account for higher shipping costs. Aluminum is not dense at all - each lb takes up alot of space (this is why they're using it in cars now). Additionally, it's worth like $.70/lb. So on a per pound basis it is not valuable, and each pound takes up alot of space on whatever ship you're using to get it from Russia to the US. The point is, it costs alot to ship aluminum, and the further you have to ship, the higher the MWP goes. So, MWP increased from like $.05-$.10 to over $.25 cents/lb (peaked in 2013 or 2014...not sure).

 

Then this happened. LME relaxed their withdrawal rules, which meant that wait times declined. Instead of paying for 15 months storage, you had to only pay 10 months (im just making up the numbers). So the MWP fell to reflect lower cost of storage (fewer months). On top of this, the Chinese started dumping aluminum in the USA. Remember how our supply shortage drove the MWP up to attract imports from further abroad? Well, the opposite happens when you have a supply glut - since we no longer needed to entice aluminum from further abroad (e.g., more expensive aluminum on a delivered cost basis), the MWP dropped - this is how supply/demand impacts the MWP.

 

On top of all of this, you cannot effectively hedge MWP as a commercial buyer. You could financially hedge the MWP component (there is one future that allows you to do this), but there were no future contracts that allowed for physical delivery of aluminum out of LME warehouses. So, the primary producers had hedged LME prices, but could not hedge MWP. When MWP fell, they got rocked.

 

So, the primary producers really aren't in a position to spend right now. In fact, they are downsizing/rationalizing their asset bases. Building an aluminum recycling plant is super capital intensive, and they're simply not in a position to do that right now.

 

There's something else - the burgeoning aluminum supercycle is being driven by auto demand for aluminum. So let's talk about that. When you recycle aluminum for an aluminum mill, you can ship cold ingots to them, and they take those ingots and roll them into sheet/plate/foil etc. They don't need hot aluminum. Auto companies do need hot aluminum - in fact, auto oems are the largest market for cast aluminum products. To cast aluminum, you have a mold, and you pour molten aluminum into that mold. Mills don't cast aluminum, but auto companies do. Therefore, auto companies need molten aluminum. They do have furnaces, but they're only big enough to handle their own internal scrap supply, and their demand for molten aluminum is larger than their internal scrap supply. And, auto companies don't want to build more furnaces - they aren't in the business of metal making. It's non-core, capital extensive, etc. In fact, there's a trend currently going on where auto companies are actively looking for ways to minimize their fixed cost base - e.g., by outsourcing capital intensive functions. For example, Tower Int'l has recently indicated that they expect auto companies to accelerate their outsourcing of heavy-duty chassis/body stamping. So the auto companies are not wanting to build big expensive, fixed cost furnaces. What are the implications of this? Currently, the vast majority of RELY's sales to auto companies are in the form of molten aluminum - auto companies don't have the furnace capacity to re-melt it. I'm not sure about this, but it makes sense to me that primary alum producers' major clients are alum mills - they don't currently have the capacity to deliver a molten product (or, not alot of capacity to do so). So, going forward, as demand for aluminum increases, a significant majority of that demand should be for molten aluminum, and that is not Alcoa's core business. If a primary producer wanted to expand their presence in the recycling space to take advantage of growing alum demand, not only would they have the large upfront cap expenditure for the plant, but they'd also have to invest in the logistics/distribution infrastructure - e.g., trucks that can carry molten aluminum. On top of that, the molten alum delivery business is very much a logistics business. RELY does a shipment of molten aluminum every 30-40 min, 24 hours a day, 7 days a week, 365 days a year(almost 365 days) - basically just-in-time delivery. If you miss a shipment, or your delayed, or what have you, and your auto customer has to halt production on a facility with huge fixed costs, that is a disaster scenario. So they would need the recycling plant, the trucks for molten aluminum, the logistics capability to deliver that aluminum on time, and even then, they would still need to demonstrate reliability to their customers - this last part takes time. RELY's avg relationship is 10+ years. Let's say we add 50 tons of aluminum demand, and both RELY and a primary producer build/expand to supply that 50 tons of aluminum. From the POV of the customer (auto oem), why would you switch from a proven partner to an unproven one? There is literally zero upside, and significant and material downside (e.g., new entrant messes up delivery, causing manufacturing plant to halt - we call this interrupting the critical path).

 

So, in short, 1) primary alum producers don't have the balance sheet capacity to undertake a large expansionary effort - in fact, they're retrenching. Even if they wanted to expand into the space, there are barriers to entry - 2) sticky customers. rely's reliable delivery of critical raw material inputs has helped it develop customer relationships over many years, and there's no incentive for the customer to switch (zero upside, lots of downside). Also, it's just easier for the customer, on a logistics basis, to increase volumes with a proven supplier rather than add another supplier to the list. Like, if RELY supplies 20 of their factories, and they build a 21st factory, why would they bring in a new supplier for the 21 factory, rather than just expand it's business with RELY? that could only lead to increased costs and inefficiences; 3) developing that logistics/dist infrastructure (not even taking into account the capex for the recycling plant) would itself be prohibitively expensive, and would be way outside their core expertise, and also very risky - you cannot just throw money at this project to make it work - in order to efficiently and profitably deliver molten aluminum on a continuous basis, you really do need to develop process/logistics/distribution know-how. And if you mess up, your customer is going to be really pissed.

 

Anyways, just some thoughts. RELY looks awesome right now. $80m ebitda in first year, and targeting another $17m out of COGS in 2016. Aluminum prices are on the upswing, partially due to the general commodity rebound, but also bc of pending trade action against china. increasing aluminum prices are good for RELY - they don't have to pass on price increases to scrap dealers right away. So, we should expect their scrap spread to improve this year. Additionally, in 2011-2014, volume throughput at RELY in N America declined about 8%. In the first 10 months of ownership under Brouchard, RELY has reversed that trend (or at least stabilized it - I took the numbers for 10 months, which was 1007kmt, and annualized it to get 1208.4 - 2014, volumes were 1204. So it's either up or stable - either way, a good trend. as volumes climb back to their 2011 levels, you'll get better fixed cost absorption and higher gross margins.

 

Basically, Brouchar bought Real Alloy from Aleris for $525m. Today, you can buy RELY for ~$540 million. However, in that time, management has stabilized/increased volumes and decreased COGS by over 1%. So, your effective purchase price for Real Alloy today is actually lower than Brouchard paid when he bought the company. And then, looking forward, you'll get GM expansion from volume stabilization/growth and better fixed cost absorption, and you'll also get GM expansion from management's ongoing lean initiatives (six sigma/hoshin konri - 1% cogs per year is the target - they targeted $13.4m in 2015, and got $15m; now, they're targeting $17m for 2016 -this is what i like to see!).

 

So basically you get to buy Aleris's recycling ops at a lower effective price than Brouchard, and we know that Brouchard paid a fair price for the assets because we also know he's been outbid on like 6 other deals - he is a very disciplined buyer, and if you can get Real Alloy for less than he paid, you;re in a good starting position. and then, you have a clear roadmap to earnings growth - lean initiatives and op leverage from reinflating volumes. In addition, you get Brouchard for free (management is a huge qualitative asset that folks persistently undervalue). And you also get $900 m of NOLs for free. And you get this little CosMedicine thing for free, which I don't think folks are attributing any value to. My view on this is that Brouchard divested NABCO and everything else he didn't want - he kept CosMedicine for a reason.

 

Pay less than Brouchard did for the assets. Clear roadmap to earnings growth. Brouchard management expertise for free. $900m NOLs for free. CosMedicine for free. And platform for free - we know that he's going to acquire more stuff, which is more earnings growth.

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think I found the specific answer to your question. pg 9 of Aleris's 2012 10-k. "Many of our plants are located near our customers' major facilities." We also know that aluminum is expensive to transport (see my write up on midwest premiums, below). It probably doesn't make sense to build a new recycling plant right in RELY's core area. They have a huge competitive advantage in the midwest/Detroit area - their plants are very concentrated geographically, they have long-standing customer relationships, and aluminum demand growth isn't going to skyrocket - it's going to grow incrementally each year. So, if you build a big plant with alot of capacity, you've probably got a couple years where it is running at low utilization, while you wait for demand growth to absorb your supply. Nobody is going to spend $100s of millions on a plant in the middle of the dominant player's core geography knowing, even if they are able to take market share/place volumes (a best case, and totally unrealistic scenario), that there's basically no chance that the thing runs at a respectable operating rate for at least the first couple of years until there's enough demand to absorb the new capacity. Also, from a strategy perspective, if I'm the industry leader (RELY) and someone tried to place a new plant in my area, I would outprice you. Not that my customers, who love me because I'm so reliable, would want to give you business. But if they did want to, I'd just tell 'em - look, whatever Alcoa/Novelis is offering you, I'll do it for 20% less. And, if you're alcoa or novelis or what have you, this is obvious to you. as far as recycling goes, the midwest is a no-go area. it's not worth it.

 

So, you've got massive upfront capex, you've got an 800 lb gorilla that will without a doubt do everything in its power to sabotage your market entry efforts into its core geography, and even if everything works out better than you could hope for, there's virtually zero percent chance that your facility operates at capacity for years. Since the nature of the operation is very high fixed cost, not only would your initial capital expenditure be at risk, but you'd be accruing operating losses for an unspecified number of years. For example, volumes fell by like 20% in 2009, and RELY's segment income dropped from $80-100m to $19m. So, if your new plant only handles 60% as much volume as RELY's in year 1, you're going to see massive losses. If, in year 2, you handle 80% as much volume as RELY, you're still only earning 1/5 of RELY's return on assets (e.g., the $19m in 2009 from -20% vol). And even here, it would be unreasonable to expect your operating rates to match RELY's by year 3. Aluminum demand is simply not coming online that quickly (at least, not yet!). Assuming RELY doesn't lose any of its current business, your capacity utilization rates are constrained by auto aluminum demand growth, which as we briefly spoke to, we would expect to increase incrementally over the next decade or so.

 

Now, you could build your recycling plant somewhere else (e.g., not in RELY's core geography), but then you have a major shipping cost disadvantage. Additionally, leaving the cost of shipping disadvantage aside, but think about the logistics behind delivering molten aluminum every 30-40 min, 24/7/265, to your customers from a facility that's located far away from the delivery point. That's got to be tought even if you're relatively close. If you build your plant far away so as not to draw RELY's ire (and the corresponding competitive response that would kill the plant's investment rationale), managing the molten delivery logistics would be albeit impossible.

 

Man this company really is a fortress

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The biggest "risk" to the thesis is volumetric risk. But this is offset by 2 things.

 

1) Auto aluminum supercycle - Even if total auto sales decline, which they certainly will within the next decade, the amount of aluminum per car is still increasing. So, you could potentially see aluminum sales volumes to auto OEMs grow/stay flat even if auto unit sales plateau/decline, b/c of the dynamic of increasing aluminum/unit. If there's a recesson or something, obviously volumes will decline, but the supercycle will mitigate that to some extent.

 

2) RELY supplies the lowest all-in, delivered cost aluminum for its customers. As such, when demand rebounds as it did in 2010, RELY's aluminum is the first aluminum that gets purchased. I would argue that RELY's tolling business (for aluminum mills) isn't as affected in downturns - mills that produce aluminum cans, etc, aren't going to see volumes fall off the cliff during a recession. People don't stop buying coca cola in a recession, they stop buying cars. So the tolling business probably didn't see alot of deterioration, at least relative to auto, in '08-'09. What do we know about the auto companies? They have in-house capabilities to produce/recycle their own scrap. Most years, their scrap production is insufficient to cover their supply needs (which makes sense - if, in a normal year, out of 1000 lbs of aluminum, you get 300 lbs of scrap, then internally sourced scrap only covers 30% of your aluminum supply needs). But, in awful years, they might have enough scrap in-house to handle their much lower volumes. So, in 2009, I expect that unit volume production fell off a cliff, and the auto companies did not need externally sourced aluminum. They basically used what they had - inventory destocking. So, if at the beginning of 2009, they had 300 lbs of scrap, and they didn't source any external scrap in 2009 b/c unit production volumes were so low, then in 2010, they need to rebuild that base - essentially, you have a pent up demand dynamic. So in 2010, they need to replenish their stocks, and if volumes are growing (even if growing off a super low base), then their demand is going to be higher than internally sourced supply, and they'll have to resume more-normal purchasing behaviors.

 

In short, it looks like RELY's businesses had one bad year during the recession, 2009, and that was largely because their auto customers were de-stocking. But a demand drop because of de-stocking is the best kind of demand drop - that inventory must be re-stocked. I'll look into it, but there's no way that auto unit sales rebounded in 2010 as quickly as RELY's alum sales to the auto industry. And then, as long as auto OEM unit volumes don't fall off a cliff, they need more aluminum than they create in house. For example, if you sell 1000 cars in 2008, and only 300 in 2009, and for every 1000 lbs of alum, you create 300 lbs of scrap, then the scrap you generated in 2008 is enough to meet your needs in 2009. But then, looking forward, you have zero aluminum inventory. You need to get back to maybe 500-700 cars' worth? So you've got this re-stocking thing, and resumption of unit volume growth, which means you're back to where you consume more alum than you produce, which means normal levels of purchasing activity (or, more normal levels). Additionally, knowing how supply chains work, there is a zero percent chance that RELY is the sole aluminum supplier for the auto OEMs. But, not all suppliers are created equal. RELY is located close (geographically), which means all-in delivered costs are lower than less geographically advantaged aluminum producers. In addition, RELY also supplies that aluminum in molten form, which is by far preferable to cold ingots (for the customer). And, it's geographic proximity enables them to deliver molten aluminum - if they were located further away, delivering molten aluminum just wouldn't be feasible. So when auto demand for aluminum does come back, as the low-cost supplier, RELY's capacity gets utilized first. Alum producers that are further away, or that cannot deliver molten, are cost disadvantaged. Like, if you think of filling a measuring cup with water, and let the lower lines of the measuring cup be the low-cost producers, and let the lines higher up on the cup be the high cost producer, and let the water be defined as aluminum demand...when you pour water into that measuring cup, the water level inside the cup covers the lowest lines first. RELY is the lowest line in that cup, and demand flows to RELY first. If RELY can deliver all-in cost alum at $10, and the next guy's all-in is $12 (b/c of higher shipping, or b/c he sells ingots that need to be re-melted at the auto oem furnace), RELY's capacity is going to be fully utilized before the next guy sees even one single iota of demand. So yeah, particularly in an industry with exposure to the very cyclical auto industry, being the low-cost producer of aluminum is a HUGE advantage. As soon as customer de-stocking runs its course and the unit volume trend reverses from decline to growth, RELY's capacity utilization skyrockets. Let's say RELY, as the lowest cost producer, supplies 20% of its customers' aluminum (im making this # up). Even if auto sales fall by 80%, from 100 to 20, RELY shouldn't see meaningful reductions in capacity utilization. The reason why, in practice, we did see meaningful reductions in RELY capacity utilization in 2009 was because of aforementioned customer de-stocking. But again, if you're going to have a demand shock, de-stocking is the best kind to have.

 

whew that was alot. just learned alot about this company, lovin' it right now

 

 

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yeah it turns out i was wrong about the destocking thing at auto oems, and stable demand from the mills. both of those were totally wrong. The mills have inventory that they can de-stock, and they did in fact de-stock. And also, de-stocking was not the issue in play with auto oems.

 

Alright, ~62%+ of their sales end up with auto customers, directly or indirectly. 23% goes to consumer packagaing (cans), and the rest to aerospace, construction, and steel industries (steel casters need aluminum..it takes oxygen out of molten metal, which otherwise can explode in the die and is really dangerous). Aerospace, construction, and consumer packaging all use sheet aluminum. To make sheet alum, you get an ingot, and roll it out like a baker. This is important bc Im showing that all molten aluminum sales go to the auto industry. 41% of their sales by volume is molten metal, this is also called their specification alloy segment, and it caters to auto OEMs (they specify this). So, 41% of the 62% of sales to auto industry is molten. We also know that of the 59% of sales that are not molten, 55 of that 59% is through tolling arrangements. Tolling arrangements recycle alum scrap for downstream alum companies - the mills, etc. Really, what we know is that 55% of sales are tolling arrangements with mills, 41% are molten sales directly to the auto sector, and we're unsure about the other 4% (either, the 4% is sold to mills on a buy/sell rather than toll basis; or, that 4% are ingot sales to auto OEMs). So we have tolling=55% (which really means mill sales are at least 55%), and we have molten sales at 41% (which really means auto slaes are at least 41%), and the extra 4% is either non-tolling sales to mills, or non-molten sales to auto oems. Whew. once you get here, though, it's really easy. they really only have 2 customers.

 

Auto OEMs cannot hold molten aluminum as inventory. If you don't have inventory, you cannot de-stock. The reason they need molten aluminum in the first place is because auto companies do this thing called continuous casting. Normally, when you think of casting, you picture a mold, and you pour molten metal into the mold (often sand/clay), and you let it cool. That's not what they're doing. They are literally casting a continuous aluminum shape. As more aluminum is added to the cast, the aluminum that was added earlier moves through the device, and it cools along the way. So, the thing here is that you cannot have any interruption in flow of molten metal. If the metal ever stops flowing, you basically have to stop the whole process, replace the tundish (look it up if u want but its expensive and time consuming to do this), and then get it started up again, which takes time, too. And we don't like stopping processes when there are high fixed overhead costs. So, to keep a continuous flow of metal, the meltshop/ladle furnaces have to carefully control the temperature of the aluminum alloy - if it cools, then the metal stops flowing, and that means tundish replacement, underabsorption of manufacturing overheard, etc. But, you don't want to just heat it up as much as you possibly can, b/c it's already super energy intensive. so you want to use as little energy as possible, obviously, but you cannot let the molten metal harden. It's difficult to do this, I think, and according to Wikipedia, two other main things can really impact the continuous cast process: 1) the type of alloy, and 2) slagging/de-slagging. Slag is a layer of impurities that forms in the tundish or at the top of the mold (idk which one), and every once in a while, you have to de-slag. What does this do? It exposes the hot layer underneath to cool air. If that's not taken into account, it can interrupt the continuous casting process. So, very important to control temperature.

 

alloys have different compositions. One alloy might need to be at a higher temperature to remain in a molten state. If you think you have alloy A, and you keep it at 1000 degrees, but really you have alloy B, and it needs to be kept at 1050 degrees, you just blew it. So, not only do the auto companies need molten aluminum, but the composition of the alloy needs to be in a really tight range - not just for quality control reasons, although that would be enough, but also so as not to interrupt the manufacturing process. I guess what I'm saying is, if the alloy composition is a little off, there's a bigger impact than just having components with slightly different alloy compositions - it can also lead to actual manufacturing downtime. So, it's important to have precisely the right alloy, and where there is precision, there is value add. Everyone knows they deliver molten metal, but I think folks overlook the specification alloy part.

 

How important is it that these continuous casters have a constant flow of metal? It's so important that RELY sends out trucks full of it every 30-40 minutes, day in and day out, almost every single day of the year - that means 12 am, 1230 am, at 1 am, at 5 am, at 9 am, at 3 pm. The flow of molten metal goes on. starting to piece it together.

 

but i digress. so, obviously cannot have molten metal inventories. auto companies probably do have some ingot inventories, but working cap mgmt is important in auto mfring, so I cannot imagine it would be a huge number. If auto companies weren't de-stocking, why did demand go down? Because the number of continuous casters decreased - or, in Aleris's words "because of customer shutdowns/large scale cut-backs." I mean, duh, but yeah so that explains that. So Detroit auto companies shut down a lot of manufacturing facilities, and that meant less demand.

 

So, the auto shutdowns caused part of the drop. The other part was alum mills. Alum prices fell 34% in like the last 2 months of 2008 alone, and all these aluminum companies had serious inventory risk. Not only were prices low, but demand was low - what do you do in this situation? De-risk. Or, in the case of the mills, de-stock. So, 55% of their customer base went through a destocking cycle all at once. The good thing is that aluminum is like the only metal in the world without a demand problem. Like, aluminum demand in N Am is supposed to increase by 4% I think this year? You'd think they were used for semiconductors or somethign. Anyways, the good thing here is that there's limited import competition - not only do you have the whole shipping cost disadvantage if you're trying to ship aluminum here, but we also tariff finished aluminum products. Demand for aluminum is increasing, low risk of supply shocks for all the aforementioned reasons. Demand was coming back, american mills aren't vulnerable to imports...it stinks that their mill customers de-stocked, but really what they did is deferred demand for a year. So, all that demand was building up, and it came roaring back in 2010. and you can see that in the #s - I think 2010 volumes in the US increased 32% over 2009. So, to me, that's totally fine - I'm okay if my company's customers de-stock during a difficult year. who cares? as long as the industry structure isn't permanently impaired, that's really not a big deal. As long as tariffs aren't lifted, which is basically a zero percent chance (thanks bernie and donald), american mills should keep rolling out sheet. For me, that's a good start point to be comfortable with demand for recycled aluminum from their mill customers.

 

Now, what about auto? If we forget about the whole "supercycle" thing for a minute, it doesn't seem like being the alum provider to this industry would be a very advantageous position. After all, in the last downturn, a ton of auto manufacturing capacity was shuttered, which significantly reduced aluminum demand. But there's a nuance here - the way it's worded in their S-4, the "shutdowns and large scale cut backs" were responsible for the drop off in demand - not bc of lower capacity utilization at the auto factories that remained in business. Let's be clear - if more auto factories shut down, that's not good for RELY. BUT, the auto companies' demand for molten aluminum is totally inelastic compared to consumers' demand for cars. In other words, the factories that kept running continued to purchase similar quantities of molten aluminum - why? because they just can't decide to run the continuous casters for 12 hours! You HAVE TO run them for 24 hours! Or halt/pause/shut down manufacturing capacity. You don't shut down the continuous caster unless you decide to shut down the plant, or pause operations or whatever. So again, plant closures=bad, but if the plant is running break even or at a minor loss, and the auto oem doesn't want to shut it down, they'll continue to purchase molten aluminum.

 

Its like, you dont have to worry about the mills going anywhere (shipping costs of alum + finished alum. product tariffs). But, you do have to worry about the mills de-stocking. You don't have to worry about autos de-stocking, but you do have to worry about the auto plants going somewhere (getting shut down in down cycle).

 

So, the big vulnerability here is clearly auto OEM shutdowns. In a hyppothetical world, if the auto industry went into the down cycle, but did not shut down any capacity, RELY would not lose any business with the auto OEMs. Clearly, though, companies will shut down capacity in the next auto down cycle.

Which is why it is so important that we have this auto aluminum demand super cycle thing going on. What does it really mean? It means that car companies are starting to use super hard alum alloys as body panels. Which means each manufacturing facility will use more continuously casted aluminum.

 

Example: today, we have 10 auto plants, each one has 1 continuous caster. RELY has the capacity to supply enough molten alum for 10 continuous casters to run full-time. If in 5 years, each car produced has twice as much aluminum in it, that means each of our 10 auto plants has 2 continuous casters. Unfortunately, RELY only has a certain amount of capacity, and doesn't want to do the greenfield expansion thing (Brouchard wants to acquire big companies to burn the NOLS, not spend capital on incremental recycling plants). So, RELY will continue to supply enough molten alum for 10 continuous casters to run full time, even though the plants use 20 (maybe RELY supplies enough for 12 of the casters, who knows). And then, the next down cycle hits. And what happens? Let's say 50% of our plants shut down. That means we have 5 plants, each with 2 continuous casters. Even though the number of auto plants has halved, b/c each plant has 2x continuous casters instead of 1, we still have 10 continuous casters worth of aluminum demand. And, because Aleris did not increase its capacity on the upswing, it doesn't have to pare capacity on the down part of the cycle. RELY still has 10 continuous casters worth of capacity, and although auto demand has halved from 20 to 10, RELY (as the lowest cost all-in delivered supplier) is not impacted.

 

Clearly it won't be that clean, but that's the idea. As long as RELY is the low-cost producer, does not increase its capacity, and auto oems increase the amount of alum. per vehicle (and the # of continuous alum casters per facility), RELY should be relatively insulated from auto OEM deterioration in the next downturn. Higher cost suppliers will certainly be impacted, but RELY maybe not so much. They might still have the de-stocking thing with alum mills, but im fairly comfortable with a transitory business condition (e.g., de-stocking activity b/c of volatile commodity prices and inventory risk).

 

Also, the recycling and specification alloy business were both ebitda positive in 2009, which was like the worst year ever for a metals company. And they also shut four underperforming facilities in tennessee and indiana, which had been acting as a drag on earnings for a while (without these facilities, which were presumably underabsorping their fixed costs and generally not profitable, ebitda would not have been impacted as much). And ALSO, Aleris didn't even go bankrupt because of the business model. Some MIT nerds took out a crap ton of debt and levered the hell out of the company. basically, the borrowing base on their revolver decreased by 50% in the 6 months before they called BK, at the same time alum prices decreased 34%. They had letters of credit outstanding > new borrowing base, so they had to put up capital. They couldn't come up with the money to pay back Letters of credit and come into compliance with borrowing base, nor could they find any capital, anywhere - they basically couldnt fund their working capital requirements, and that triggered the bankruptcy. It also didn't help that in their rolled products business they had LT hedges protecting them against rising alum prices - when prices fell by 34%, i think their counterparties became concerned and made 'em post collateral. So just a perfect shit storm.

 

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What do you mean by getting Bouchard for "free"?  Isn't there a ~$15 million per year drag from corporate overhead that isn't included in the Real Alloy segment EBITDA numbers?  I don't think any of that is going away in light of the need to make additional acquisitions to use up the NOL as fast as possible. 

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Haha, I meant you get a really, really good manager, and don't have to pay a premium for it.

 

In 2003, Bouchard started Esmark with 4 million USD in sales. That's right, 4 million. He sold the company in 2008 for $775 million (I think 775 to equity holders). no matter how you spin that, it is an awesome success story, and i would recommend reading about it.

 

3 more things i need to get in here. 1) RELY's recycling plants will never be replaced, I don't think. Upgraded yes, replaced, no. B/c of fresh start accounting, they removed accruded depreciation from PP&E post-bankruptcy. So, the undepreciated fixed asset value of the recycling plants and spec alloy operations if $590 million. You can find this in Aleris's s-4 filed in 2010 or 2011. The replacement cost of the plants, today, is probably alot higher than $590 million.

 

2) Aleris was started by a guy who ran Lubrizol. Lubrizol bought out by Berkshire - not a bad thing. What happened was TPG couldnt put up more capital after their levered buyout, and creditors came and took the company. My point is, it was a capital structure issue, not a business model issue. And the guy who literally created the RELY asset base from scratch (acquisitions/mergers) has a not-too-shabby track record. He has a greek name, forget what it is.

 

3) Oaktree, Howard Marks, bought this company out of bankruptcy. So, the assets are valuable.

 

So, the guy who created the company has a great track record (Lubrizol). The guy who bought it out of bankruptcy has a great track record (Howard Marks). And the guy who acquired it from Aleris and plugged it into his NOL vehicle has a great track record (Bouchard). Those are nice data points to have

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And lastly, the scrap spread dynamic. So, a ton of primary smelters in the US have been shut down, and we have some potentially pending trade action against China - both of these bode well for LME prices. RELY's buy/sell business makes $ on the scrap spread.

 

Scrap spread is basically the difference between what they pay for scrap and what they sell their specification alloys for. Specification alloys are tied to LME/MWP prices. Scrap prices are somewhat correlated to LME prices, but not very. According to Aleris 10-k, and then I saw it again in the q3 transcript, scrap prices do move in the same direction as LME prices. But, the correlation is not tight. Why? Because supply and demand for scrap has different dynamics than supply/demand for aluminum.

 

There is a huge supply of scrap in the US. Every month, we recycle enough alum cans to rebuild the entire US commercial airplane fleet. So, lot's of supply. How about demand? Demand comes from 2 places: recyclers (and maybe smelters - if smelters do have scrap demand, that's good, because all the smelters just shut down) and exporters.

 

RELY is by far the largest recycler. And geographically, their facilities are pretty close together. So, in that area, I don't think they have alot of competition for scrap from any other recyclers. Unlike Europe, the US has no commodity scrap market (this is why the hedge European buy/sell volumes, but not US buy/sell volumes - they cannot hedge US buy/sell volumes with a derivative). This means that the price of scrap varies regionally, and is especially responsive to changes in supply and demand. think about it - there's only one thing alum scrap can be used for, and thats aluminum recycling.

 

So, over the past 5 years, China has been exporting a ton of scrap from the US to China to build up it's aluminum base. Remember, aluminum can be recycled for basically ever, so having a large alum base that can be recycled is important. But, two things: 1) last year, China added 6 million tons of alum smelting capacity, while the rest of the world took 6 million tons of capacity offline. So smelting capacity, globally, didn't decrease, and China is saturated. Thus, LME prices are super low. Basically, if LME prices are really low, and the only thing you can do with scrap is turn it into LME, it's just not economically feasible to export it. I need to check the export numbers, but I believe Chinese buyers have really pared back on scrap purchases/exports. In effect, RELY's competition for aluminum scrap just disappeared.

 

Normally, there is a lag between LME price changes and scrap price changes. This is why they say that there is a directional correlation, but it's not very tight. I think, b/c this huge source of demand has basically disappeared, that this dynamic should blow out. If RELY doesn't have any competition for alum scrap, they won't have to pay more for their scrap as LME prices go up. So, on top of the -1% cogs initiative, and generally getting N Am volumes back to where they were historically (e.g, more volumes = more fixed cost absorption), and everything else that we've talked about, this spread dynamic should seriously benefit their earnings. Like, alot. If your cost basis stays stable, and LME prices increase 10%, and you do $500 million in buy/sell biz in North America, then post-10% increase, you'll do $550 in buy/sell biz in North America, but your costs won't increase. Every cent of scrap spread expansion drops straight to the bottom line. Awesome

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Bringing it all together...$81m EBITDA in 2015. Assuming constant volumes, and another 17m of COGS, we get to $98 m EBITDA. they guided to 17m, and ill take their word for it. they might not get it. But, they guided to 13.4m last year, and did 15. Additionally, if you read through their website, the kinds of deals they're after aren't exactly high-growth. they want to buy companies where they can expand margin - e.g., apply six sigma/lean initiatives. So, that's their strategy, and they beat their own guidance last year, so yeah give 'em the 17m.

 

So, $98m EBITDA, constant volumes, and another 1% out of COGS.

 

Let's talk about gross margin (which is basically contribution margin from incremental vol) and volumes.

 

GM was 7.3% in 2015 after adj for purchase accounting. if they do another 1%, GM will be 8.3% at YE 2016 - the avg GM will be 7.8%.

 

Let's say volumes increase 5% in 2016 over 2015. This might seem like alot, but US alum demand is set to increase 4% in 2016 (I think), and auto significantly faster (especially in the 2nd half of the year - I think Tower Int'l recent contract wins in the US are for aluminum body-in-white, and theyve indicated that's happening in H2). Since RELY is over-exposed to auto, 5% is conservative.

 

Since we're accounting for better fixed cost absorption in our gross margin expansion already (the 1%, from 7.3% to 8.3%), we don't need to worry about impact of volumes on fixed cost absorption/gm expansion. If vol go up by 5%, gross profit will go up by 5%, too (again, GM will actually increase faster than that, but we've accounted for this in our 1% cogs removal). So, $66m increase in revenue, at 7.8%, gets us another 5 million in EBITDA.

 

So, starting at 81m ebitda, adding 17m from six sigma/lean (which also includes fixed cost absorption from higher vol), and another 5 million from volume growth gets us to $103m EBITDA.

 

These are all very realistic assumptions, and we're not done. Earlier, I described why I think the scrap market will be good for RELY for at least the short term. on top of my earlier points, the rebound in steel prices is a huge boon for alum scrap supply, which should help keep prices down. basically, steel scrappers were sitting on their car inventory bc steel prices were so low. so, steel scrappers weren't scrapping. But, each car also has 200-300 lbs of alum in it. With recent steel trade actions, and steel prices climbing, steel scrappers should start tearing these cars apart again - each car adds 200-300 lbs of alum to the alum scrap supply. Couple that with the fact that demand for non-ferrous scrap has plummetted (e.g., china scrap buyers pulling back), you have an awesome situation where the supply of alum scrap is about to balloon, and a ton of the historical demand for that scrap is basically gone. So we would expect alum scrap prices to stay low for quite some time here.

 

Second, you have LME prices (or platts, or whatever - finished alum goods). so, i think alum prices have been rebounding in the USA. Alcoa has shut alot of smelters...there isn't a lot of primary alum production in the us anymore. on top of that, as part of Xi jinpings zombie company initiative, china is looking to take out 3m tons of smelting capacity by YE 2016. According to the RELY q4 transcript, Bouchard thinks this could have a slingshot effect on aluminum prices. Basically, aluminum stocks are very low, because in a deflationary environment, you want to de-risk your inventory as much as possible. That, coupled with lower domestic primary production, and capacity shuts in China, leads bouchard to think that we could see a slingshot - where LME prices basically skyrocket, b/c globally we'll have an aluminum production deficit (demand>supply), and on top of that, folks will need to re-stock inventory (1. because inventories are just low, and 2. because if this slingshot thing happens, and deflationary turns to inflationary, you want as much of aluminum as you can get, as quickly as you can get it).

 

To sum up: very good prospects that alum scrap prices stay depressed for quite some time. Also good prospects of aluminum price rebound b/c of capacity closures, and also bouchard seems to think a fairly reasonable chance that alum prices slingshot, b/c of aforementioned aluminum deficit and inventory re-stocking.

 

What does this mean for RELY. it means that their cost basis won't increase, and the prices that they receive will increase. We know that 55% of sales are tolling, and another 15% is hedged w/ derivatives/fin instruments, which basically means that 30% of their volume is unhedged buy/sell.They did ~1207 mil tons of volume in 2015, and 30% of that is 360 tons. This 360 tons is un-hedged buy/sell volumes.

 

For the 10 months ending 12/31/15, they did $70m ebitda on ~1000 mil tons, or $70 ebitda/ton. Now, we wouldn't expect that $70/ton to increase for their tolling and hedged positions (b/c, 55% is cost-plus [tolling] and 15% is hedged). but, we would expect it to increase for buy/sell. The scrap spread was under $700 by aug 2015, and compressed a bit in q4'15 due to seasonal variation (when it's colder, fewer people are out collecting scrap, so scrap flow slows down a little). Let's just set $675 as the current scrap spread (per mt). in the past 5 years, scrap spreads topped out at over $800/mt in 2011. Since then, its bounced around 700 (a little under). If we really think that the scrap and LME/platts prices are going to disconnect, for the aforementioned reasons, I don't it would be unreasonable for the spread to expand above $850/mt. If we just take $800 as our target scrap spread in 1 year, that means that 30% of their volumes are going to see spreads increase from $67.5/ton to $80/ton. $12.5 per ton expansion on ~360 mt, and we get another $4.5-5 m ebitda.

 

to sum up - we get from 81 to 98 w/ the 1% cogs/ceo challenge/six sigma/lean. We get from 98 to 103 from 5% higher volumes. We get from $103 to $108 from wider scrap spreads. And, mgmt had indicated 30m in capex is about right. 108-30=78m FCF (must deduct cash interest expense from this #, but not taxes, bc they dont pay taxes). and it trades for like $250m. So...like a 31% fcf yield, in a pretty reasonable, conservative scenario. could be upside or downside to that #. but these assets, this manager, these nOLs, and add'l acquisitions in the pipeline....and you get a ~30% fcf yield on your purchase price? that's crazy

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  • 2 weeks later...

Wjsco, what's your take on the results? I was very close to pulling the trigger back in february when it was trading around  book value. Even though one might get Aleris for a fair price now the whole  commodity market has crashed, so arguably it's not worth as much today as back then (I'm discounting the imrpovements which is unfair). Anyway, I really appreciate your thoughts on the subjekt,so anything on the results would be appreciated.

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Wjsco, what's your take on the results? I was very close to pulling the trigger back in february when it was trading around  book value. Even though one might get Aleris for a fair price now the whole  commodity market has crashed, so arguably it's not worth as much today as back then (I'm discounting the imrpovements which is unfair). Anyway, I really appreciate your thoughts on the subjekt,so anything on the results would be appreciated.

 

Well, ebitda/ton actually increased in the latest quarter. i think your point about commodity markets crashing is exactly on point - the aluminum market tanked, and RELY is fine. even back in '08'09, Aleris's recycling ops were cash flow positive. so it's just a really defensive business. here's another way to look at it - the current EV of RELY is less than what Bouchard paid for Real Alloy. And as you mentioned there've been operating improvements. but more importantly, he's walked away from like 10 deals b/c price was too high. So I think he got the assets for a good price, and you can get them for cheaper. All of this is sort of supported by the undepreciated value of their fixed PPE - if you look back at aleris's fresh start accounting, it was originally $590 million. And, we know their customer relationships are worth something - 95% renewal, right? So that was historical cost to build their assets, which probably happened a decade ago, and then you tack on these intangibles...replacement value is almost certainly alot higher than 590m. and, to go with your assets, you have this great operations-focused management team - the guys they have doing 6 sigma/hk are basically freaks of nature. and you also have a lot of NOLs. and you have a proven capital allocator who's looking to use 'em. and you ask, how did they come across this great asset? Aleris was divesting everything not mill related. They sold their extrusion business, and their recycling business. So you had a motivated seller, and Bouchard was there to scoop it up.

 

Also, commodity crashes havent really crashed since February, have they? havent they rebounded?

 

basically i think you get a 20-30% fcf yield just from Real Alloy's assets, and that should grow from auto supercycle + operational efficiency initiatives (and theyre only operating 1100 kmt of their 1700 capacity - long runway to ramp op leverage before capacity becomes a constraint). and then you know inorganic growth is on the way, and you also know that these NOLs are worth hundreds of millions of dollars. + great operator and capital allocator. go read the esmark story, it's a good one..

 

is there something you saw in the results you didnt like? and, you mentioned aleris...you're talking about rely, though, yea?

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There's a GAAP loss of 10m - why shouldn't one judge them by that? (this isn't criticism, I'm trying to learn here).

 

17m adj. EBITDA in Q1, but depreciation and interest are real costs, no? Without amortization of intangibles (which might not be a real expense) depreciation and interest alone is still +20m (though depreciation seems to be overstated 3,8m in the Q due to an "immaterial error").

 

I understand and like the story, and I think they're really good at selling it (the Esmark story, the price discipline (saying no to deals), thoughts on capital allocation, the writing in his CEO letters etc), but I'm still struggling a bit with the numbers.

 

It seems cheap on an adjusted Ebitda basis, but I'm not sure if that's a good way to value it. I'm really interested in hearing how you get to a 20-30% FCF yield.

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I'm really interested in hearing how you get to a 20-30% FCF yield.

 

$78mm FCF / $250 mkt cap = 31%.  As wjsco already pointed out you really need to deduct cash interest from fcf, since the $78 is FCFF not FCFE.  I included $2mm in preferred dividends to get roughly $34mm in cash interest.  This puts the FCF yield at 18% (its higher now that the stock has dropped, Im just using wjsco's numbers). 

 

I would figure a way to treat the $40mm pension deficit.  I typically ignore pension deficits bc they usually aren't large enough to move the needle and have associated expenses running through the income statement (and are therefore reflected in FCF).  In this case however, the pension expense is minimal (or it was last quarter) and the deficit is material, so I added it to the market cap before calculating the FCF yield.  Using the $250 mkt cap (bumped up to $290) and $78mm FCFF wjsco used (again, adjust for int exp) gets you closer to 15% FCF yield ($44mm / $290mm). 

 

This is a leveraged operation.  This gooses the FCF yield (not that there's anything wrong with that). 

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For those that are following this closely, what do you think is driving the recent share weakness?

 

One possibility:  take a look at LME price from the 4/29 (recent high in RELY) to today.

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There's a GAAP loss of 10m - why shouldn't one judge them by that? (this isn't criticism, I'm trying to learn here).

 

17m adj. EBITDA in Q1, but depreciation and interest are real costs, no? Without amortization of intangibles (which might not be a real expense) depreciation and interest alone is still +20m (though depreciation seems to be overstated 3,8m in the Q due to an "immaterial error").

 

I understand and like the story, and I think they're really good at selling it (the Esmark story, the price discipline (saying no to deals), thoughts on capital allocation, the writing in his CEO letters etc), but I'm still struggling a bit with the numbers.

 

It seems cheap on an adjusted Ebitda basis, but I'm not sure if that's a good way to value it. I'm really interested in hearing how you get to a 20-30% FCF yield.

 

So, a couple of things. 1) They do have corporate expenses at the parent level. that's $3m per quarter or so, and it is a real cost, but here's what i say: we know the company is a platform to use NOLs. So basically I think of that $3m per quarter as a fixed cost...kinda like operating leverage. After another acquisition it won't have as big of an impact. it is a real cost, i just think it's acceptable, considering we're expecting additional acquisitions, etc.

 

2) On D&A, not necessarily. Depreciation can be higher than capex if you don't plan on replacing the assets. For instance, oil refineries that have been around for 60+ years. In the refinery case, I don't think depreciation is a real expense. I think maintenance expenses, plus maintenance capex, are your real costs. Depreciation is the upfront costs spread out over the useful life. IF the useful life is indefinite (or like 100 years or something), depreciation would go to zero (mathematically....fixed upfront cost divided by infinity=a limit of zero...i just used calculus, that's awesome). Another way to think about it, if they'll keep refurbishing a furnace for 60+ years, but it's depreciated on a 30 year basis, then you're basically accelerating the depreciation expense. So, headline depreciation is overstating the true economic cost, which is lower, b/c the useful life is longer. So I think that's a good way to think about it...if you're thinking of Buffett and them saying Depreciation is a real expense, that's true, but they're saying it in the context of EBITDA. EBITDA is misleading b/c it doesn't account for maintenance capital expenditures. It would be a mistake to count both a) depreciation and b) maintenance capex - in that case, you're double counting. So again, pick your poison - EBITDA is no good b/c it excludes both. But, in the case where a furnace's useful life is longer than the depreciation period, the true cost of that asset is probably closer to the maintenance capex numbers than the depreciation numbers.

 

 

I think the right way to think about it is to look at FCF, but adjust for cash generated from working capital. And then, if they can get maybe $50m total out of working capital (skin the cat kinda thing), account for that separately. So, basically CFO-(change in wc)-capex=FCF. Then add the amoutn of cash they'll take out of wc to your cash balance or something.

 

You'll notice on the earnings ccs that Bouchard mentions Real Alloy wasn't the best vehicle for NOL usage. This, because taxable income is low. This, because depreciation is high. So it has a natural tax shelter...not the best for burning NOLs. But it's a great asset and a good price, so they bought it. I think this is a good data point for what i was saying earlier in this post - it's not a great NOL user b/c it has a natural tax shelter from (D&A>Capex). So management acknowledges that this dynamic is in play

 

also, i think you should separate the corporate expenses from Real Alloy. Corporate expenses are a real cost, but those corporate expenses don't contribute to Real Alloy operations. Philosophically, since the benefit from this corporate expense is going to come in the form of an acquisiton that earns $ over a number of years, the best way to think about it might be to capitalize those costs or something. Idk. just keep 'em separate. if Real Alloy does 50m in FCF, and corp cash costs are $10m, that's 20% of their profits getting eaten at corporate. But, they'll acquire a 2nd company with $50m in FCF, and it'll drop to 10%. And then they'll acquire a third+fourth, and it'll drop to 5%. And we know they're going to buy a 2nd and a 3rd and a 4th.

 

And yes, you're right about the nice story, etc. But, I think a good litmus test for this is, is management doing what they said they were going to do? I think in this case they are...they've smashed every operating benchmark for Real Alloy that they set for themselves. they continue to walk away from prospective deals. Hasn't he been looking for targets for 3 years? And only 1 buy? He's only human - that really takes discipline. You or I would probably get frusturated and impatient and just go pay a little more for an asset. But he's not, and i think it's impressive. So, they're doing what they said they would do, executing well, staying disciplined on acquisitions; management has a great prior track record; Sam Zell is backing them.

 

I mean look - we can all agree that Bouchard is pretty selective with his acquisitions. He won't pay up. Even if you disagree with everything else, that seems to be pretty solid. And he paid more for Real Alloy than the current EV of RELY.

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Oh and the last thing that really piqued my interest, not sure if I mentioned this before, but their bonds went from $90 to $102 in 2015. And I guess not a lot of bonds did that. I do believe that there's information value in the credit markets...if the securities higher up the cap structure improve from 90 to 102, that might be a good indicator about the asset value/earnings power of the issuer. And if asset value/earnings power is getting a thumbs up from senior security holders, should probably get a thumbs up from junior holders, too (stockholders!). I think their debt is secured by Real Alloy...if so, going from 90 to 102 is basically saying that the underlying assets are worth more. So that's a nice confirmation point that bouchard didn't pay too much for those assets. And, again, you can hop in with an EV below Bouchard's Real Alloy purchase price.

 

I'm focusing on the assets because I think that should set a floor for the company's valuation. Undepreciated fixed asset value was like $590m. And then you've got customer relationships, etc., which do have real value, but aren't on the books (or, not to the extent they should be). And Bouchard paid just under that I think, and you can pay way under that. And you get the NOLs, growth by acquisition, good operators at the helm, a good capital deployer, etc.

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So, a couple of things. 1) They do have corporate expenses at the parent level. that's $3m per quarter or so, and it is a real cost, but here's what i say: we know the company is a platform to use NOLs. So basically I think of that $3m per quarter as a fixed cost...kinda like operating leverage. After another acquisition it won't have as big of an impact. it is a real cost, i just think it's acceptable, considering we're expecting additional acquisitions, etc.

 

2) On D&A, not necessarily. Depreciation can be higher than capex if you don't plan on replacing the assets. For instance, oil refineries that have been around for 60+ years. In the refinery case, I don't think depreciation is a real expense. I think maintenance expenses, plus maintenance capex, are your real costs. Depreciation is the upfront costs spread out over the useful life. IF the useful life is indefinite (or like 100 years or something), depreciation would go to zero (mathematically....fixed upfront cost divided by infinity=a limit of zero...i just used calculus, that's awesome). Another way to think about it, if they'll keep refurbishing a furnace for 60+ years, but it's depreciated on a 30 year basis, then you're basically accelerating the depreciation expense. So, headline depreciation is overstating the true economic cost, which is lower, b/c the useful life is longer. So I think that's a good way to think about it...if you're thinking of Buffett and them saying Depreciation is a real expense, that's true, but they're saying it in the context of EBITDA. EBITDA is misleading b/c it doesn't account for maintenance capital expenditures. It would be a mistake to count both a) depreciation and b) maintenance capex - in that case, you're double counting. So again, pick your poison - EBITDA is no good b/c it excludes both. But, in the case where a furnace's useful life is longer than the depreciation period, the true cost of that asset is probably closer to the maintenance capex numbers than the depreciation numbers.

 

 

I think the right way to think about it is to look at FCF, but adjust for cash generated from working capital. And then, if they can get maybe $50m total out of working capital (skin the cat kinda thing), account for that separately. So, basically CFO-(change in wc)-capex=FCF. Then add the amoutn of cash they'll take out of wc to your cash balance or something.

 

You'll notice on the earnings ccs that Bouchard mentions Real Alloy wasn't the best vehicle for NOL usage. This, because taxable income is low. This, because depreciation is high. So it has a natural tax shelter...not the best for burning NOLs. But it's a great asset and a good price, so they bought it. I think this is a good data point for what i was saying earlier in this post - it's not a great NOL user b/c it has a natural tax shelter from (D&A>Capex). So management acknowledges that this dynamic is in play

 

also, i think you should separate the corporate expenses from Real Alloy. Corporate expenses are a real cost, but those corporate expenses don't contribute to Real Alloy operations. Philosophically, since the benefit from this corporate expense is going to come in the form of an acquisiton that earns $ over a number of years, the best way to think about it might be to capitalize those costs or something. Idk. just keep 'em separate. if Real Alloy does 50m in FCF, and corp cash costs are $10m, that's 20% of their profits getting eaten at corporate. But, they'll acquire a 2nd company with $50m in FCF, and it'll drop to 10%. And then they'll acquire a third+fourth, and it'll drop to 5%. And we know they're going to buy a 2nd and a 3rd and a 4th.

 

And yes, you're right about the nice story, etc. But, I think a good litmus test for this is, is management doing what they said they were going to do? I think in this case they are...they've smashed every operating benchmark for Real Alloy that they set for themselves. they continue to walk away from prospective deals. Hasn't he been looking for targets for 3 years? And only 1 buy? He's only human - that really takes discipline. You or I would probably get frusturated and impatient and just go pay a little more for an asset. But he's not, and i think it's impressive. So, they're doing what they said they would do, executing well, staying disciplined on acquisitions; management has a great prior track record; Sam Zell is backing them.

 

I mean look - we can all agree that Bouchard is pretty selective with his acquisitions. He won't pay up. Even if you disagree with everything else, that seems to be pretty solid. And he paid more for Real Alloy than the current EV of RELY.

 

I did some very preliminary due diligence on Bouchard and by every measure he seems like a very energetic executive. One concern is that his background is in steel production, another capital and depreciation heavy industry.

 

I bolded the depreciation issue, as I do suspect that the market isn't going to give the NOLs much credit into we start seeing significant quarterly profits.

 

Either way, thanks for the work you're doing on this name

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wjsco, did you read Bouchard's book on CAT?  He seems to think it's worth $300+ by 2020.  Not sure how I feel about that prediction but I'd need to read his book to find out the logic.  Especially since that's his base case not even the bull case?  I'm just trying to get into his mindset to know how he thinks.  He seems like an optimistic guy that focuses a lot of downside risks.

 

Also I don't see their notes trading up from $90.  There's some REGS estimated pricing that shows it going from $90 to $100, but no actual trades.  The 144A debt traded just over par for all of 2015, and still trades just under par.  Obviously better than a lot of other high yield debt, but it has a 10% coupon and it's 1st lien.  If they can get some traction then that should be some significant interest cost savings as they refinance out those 10% 1st liens into something more flexible.

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Hey, no i did not read it. i do know about it, and it is on a reading list actually. i think he teamed up with one of the Kochs, no?

 

Yeah i agree it would be interesting to see his thought process. I mean, clearly part of it is operations/efficiency, etc. But from a high level, it just sorta makes sense...Caterpillar isn't the biggest US construction equipment company, it's the biggest in the world, right? So you combine scale with other advantages, like product development or R&D proficiency or what have you, and you have a virtuous little thing going on. In short, more construction equipment will be needed by the world in 5 years than is needed now, and Caterpillar is in a position to grow faster than the market. I dont really know, but i would imagine the thought process isn't super complicated. but i think the book could be interesting b/c it seems like he is getting into the nitty gritty, and he certainly knows what he's talking about, so i think it would be just a great educational resource for thinking about industrial/mfring companies.

 

Also, yeah i dont have access to bond information. I just took that from Bouchard's annual letter or earnings ccs, he mentions it...but, nobody (e.g., analyst) had challenged him on it, so i didnt think that was controversial.

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Thanks for the detailed comment, Wjsco. I'm still not quiet sure how you get to a 20-30 FCF yield. Could you post your estimate of 2016 Ebitda as well as projected interest and maintenance capex? They did 81m adjusted Ebitda in ten months of 2015, but I have them pegged at 30m in interest and 30m maintenance capex for FY16.

 

I agree that they do seem to deliver on their SixSigma-program, but did they buy something that was extremely bloated or what? Was there any indication of that? It seems incredible if they can take out as much cost as they say they're striving for. What exactly are they doing? It can't be that they're just getting a helping hand from lower energy and transportation prices? I took a position yesterday, but there's still a couple of things I need to get my head around, your insight is much appreciated.

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