While people go nuts over growth stocks like Tesla (NASDAQ:TSLA), LinkedIn (NYSE:LNKD) and Netflix (NASDAQ:NFLX), there is a tiny company that continues to generate cash and shies away from the spotlight. That company is Friedman Industries (NYSEMKT:FRD), a maker of steel sheets and tubes.
The steel business is a commodity and depends on the economy as well as the price of steel, but despite these risks, the business is
- well run
- has a healthy balance sheet
- free cash flow positive
- and most importantly, cheap in this market
Introducing Friedman Industries
There isn't much to brag about Friedman. It is boring, easy to understand and a cheap microcap with limited liquidity. A read through just one annual report will be enough for you to know how the company is run. Until 2010, it was run by the founder Friedman, but he retired and so, the family business retired with him. Now, all management and board members are independent, which is great to see in a microcap, as similar sized companies employ family members and use the company as their piggy bank.
To start you off, here are 6 points why I like Friedman Industries.
- 3.3% yield with a consistent history of dividends
- shareholder friendly giving out special dividends
- solid balance sheet
- no analyst coverage
- zero stock options
- provides 10-year summary of financial data in the 10-K
Of the 6 points, there were two that I found most surprising and pleasing.
- No options
- 10-year financial summary
Regarding the 10-year summary, here's what it looks like.
Friedman Industries 10-Year Financial Summary | Click to enlarge
Nothing special, but the message I get from this is that the accounting is super clean to be able to show a 10-year summary. For a lot of companies, if they adopt new accounting rules or have to restate their financials, providing this type of information is a pain. Also, companies may believe this type of data to be too revealing. Just goes to show that Friedman Industries is also very upfront about their financial situation with nothing to hide. Well done.
Getting Into Friedman's Numbers
The first thing that stands out when you load FRD into the OSV Stock Analyzer is the strength of the financial statements.
- TTM Quick ratio over 3
- TTM Current ratio over 9
- Zero debt
Valuation ratios look very tasty.
Friedman Industries Valuation Ratios | click to enlarge
What makes Friedman Industries quite easy to value is that the financials are squeaky clean. No debt, no options, no preferred shares, no significant off balance sheet liabilities. Nothing. Barely need to make any adjustments at all.
A cash adjusted P/E of 7 and an EV/EBITDA of 4 is super cheap. The ROE is also good for a company with no leverage. To get a true picture of how ROE is achieved, use the DuPont model to analyze the ROE.
Friedman Industries DuPont Analysis | click to enlarge
The tax and interest variable is consistent so the ROE is not getting a boost from either. There is some variance with the equity multiplier, but with zero debt, ROE is not dependent on the equity multiplier. ROE is directly correlated to the margin and asset turnover efficiency. What I want to establish is that Friedman Industries is a solid company. It will never turn heads, but it is predictable, flush with cash and capable.
Friedman Industries is Cheap
At just $9.68, Friedman is trading at tangible book value. Looking at NCAV and NNWC, the current stock price has its downside well protected with tangible assets.
Friedman Net Net Value | click to enlarge
I adjusted the inventory value because Friedman Industries uses the LIFO inventory method for its coil steel business. In the latest 10-K, the "replacement cost exceeded LIFO cost by approximately $6,504,000″ so I increased the inventory value by $6.5m to total $39.4m.
The net net values are:
- NCAV: $7.29, which makes up 75% of the stock price
- NNWC: $4.98: which makes up 51% of the stock price
Using the NCAV value, the market is pricing Friedman's operation to be worth just $2.39 a share. At $2.39, the adjusted P/E comes down to something ridiculously cheap like 1.
Friedman Stock Price Make Up
Discounted Cash Flow Fair Value Estimate
DCF Fair value estimate: $12 – $17. I find the 2013 FCF figure of $11m to be the high side. I'll use a FCF figure of $7m by averaging the past 5 years. With this, I can see that the reverse DCF shows that the current stock price is assuming -1% growth using a 12% discount rate. But I see a higher value for a company in a cyclical downturn that pays dividends, has only had 3 years of negative FCF in a commodity industry and has a rock solid balance sheet.
DCF Valuation for Conservative Assumption | click to enlarge
Earnings Power Value
EPV: $13.56 for 0% growth assumption
Using the default normalized income of $7.5m with maintenance capex of $0.55m, the net reproduction value comes out to be $7.92 and the EPV is $13.56. Even the net reproduction value itself is very close to NCAV, which goes to show how the current stock is very well protected on the downside by assets.
The relationship with EPV also shows that despite the micro size of the company, Friedman is creating value and has a moat. Because EPV is based on 0% growth, I use a 9% cost of capital for all my EPV calculations.
Earnings Power Value of Friedman Industries
To sweeten the deal further, Friedman has a bunch of real estate that it owns. The company has history dating back to 1939 but the company was incorporated in 1965 and the property on the books is depreciated over 20 years. By now, some of the property will be on the accounting books at a value of zero.
EBIT Multiple Valuation
EBIT Valuation: $9.57 – $22.41 with a normal case fair value of $14.38. I also ran the valuation through the EBIT multiples calculator to see what I would get when using the income statement to value the stock.
Here are the values and inputs I used.
FRD EBIT Multiple
Different valuations point to a fair value range around $12 to $15. The upper limit of $17 from the DCF and the aggressive EBIT valuation for $22 is too much on the optimistic side.
What's the Risk?
Friedman has risks that many small companies are subject to, and a few more.
- Customer concentration
- U.S. Steel (NYSE:X) is a supplier and buyer
- Commodity business. Cyclical. Steel prices are outside of their control.
- Unlikely to grow much faster than its cost of capital
I see a lot more good than bad, but the truth is that it just takes one misstep for a company to fall. For Friedman Industries, that just happens to be their customer concentration. In the coil products segment, seven customers accounted for 25% of total sales in 2013 with one customer making up 11% of sales. In the tube products segment, U.S. Steel accounted for 14% of sales in 2013. In 2012, U.S. Steel made up 24%. This is a big difference and not uncommon if you go back to 2009.
U.S. Steel just so happens to be both a supplier and buyer to Friedman and has a plant nearby in Lone Star, Texas. When the economy tanks, they idle the plant. This means a big drop in sales for Friedman. If the economy recovers, Friedman sees a big boost in revenue. At the moment, with U.S. Steel making up 14% of sales, orders are on the low side. The awesome part is that Friedman understands the risks and has armored itself with plenty of cash and no debt to withstand difficult periods.
The other risk to keep in mind that even with a well-managed business, Friedman is still in the commodity business. It can't control steel prices and so, year over year, there will be variance in margins. As a counterpoint to this, take a look at the SG&A. Without regard to revenue, SG&A is consistently at $5, excluding 2010. The 10-year average of SG&A is $5.2m. This again confirms that Friedman is a well-oiled machine. Even a company like Nucor can't achieve that type of controlled cost and consistency.
Lastly, compare how Friedman stacks up against competitors.
Friedman Competitor Comparison | click to enlarge
Friedman can match it with the big boys.
Friedman Industries Summary
Friedman Spider Graph
- Safe stock
- Cheap stock with around 30% upside
- Shareholder friendly management
- Healthy as can be
This will take a holding period of at least 2-3 years and because growth is going to be slow, I've made it a 2% portion of my portfolio. Next thing is to just be patient.
Disclosure: Long FRD