Haynes International: Value in Specialty Steel

Specialty steelmaker Haynes International (HAYN) at yesterday's closing price of 32.08, is interesting as a long-term play on industrial recovery. Attractions include a strong balance sheet, ample cash, technical expertise, and a diversified customer list that is a who's who of global industry. Weighing against that, the specialty alloy business is cyclical and highly competitive, capital intensive, and dependent on aerospace, chemicals and power generation - all areas that have been hard hit by the economic slowdown.

Overview – Haynes International is a leading developer, manufacturer and marketer of high performance nickel-and cobalt-based alloys used in corrosion and high-temperature applications. There is a good recent presentation on their website: rather than rehash that information, here is a link. Recent financial results include a large non-cash write-off of goodwill: future projections are in the break-even area for several quarters forward. However, the stock is attractively priced based on five year average earnings and should perform very strongly in a global economic recovery.

Valuation and target – In 2007, the company earned 5.89 per share and traded as high as 100.10. The 52 week low is10.92, in February this year. Using a mixture of 5 year average earnings and recovery projections, and looking past the good-will write-offs, I see future potential of EPS 3.00 X P/E 15 = 45, within two years. If the global recovery is strong you will be able to get someone to pay you quite a bit more than that for these shares. Tangible book value of 27.36 at y/e 2008 provides margin of security.

Inventory – One of the peculiarities of this situation is the size of inventory compared to quarterly revenue – Q3 09 revenues of 98 million were supported by inventory of 198 million, about 200%, and down from a high of 246% in the previous quarter. These heat and corrosion resistant alloys are very hard to work with, require multiple steps (as many as 44) to create them, and as such work in process is frequently higher than finished goods. The company has multiple service centers, which perform water cutting or other operations on the material for customers. Sales strategy is service-oriented and such strategies may require sizable amounts of inventory.

In any event, inventory has been reduced consistent with reductions in revenue, yielding 84 million of cash as of the end of the last quarter. But, given that the production process is time-consuming, it is not difficult to imagine tight supplies in the event economic recovery proceeds more rapidly than current assumptions. That would mean pricing power and improved margins.

Capex – Management believes that capital equipment is up-to-date, providing for cost-efficient operations. Capex has been ongoing at a measured rate. Cash from operations varies quite a bit due to the cyclical nature of the business: however, capex appears consistent with cash flow over the long term.

Excess Cash – The board is reviewing possible uses, to include accelerated capex, a special dividend, accelerated pension funding, share buybacks, or acquisitions/joint ventures. However, since the cash was raised in the course of shrinking the balance sheet to accommodate reduced revenues, it would seem that the resumption of operations at the former level would require that the funds be put back to use as operating capital. Either the company is confessing operations will not return to former levels or they anticipate tighter control of inventories and receivables going forward.

In the event the board elects to repurchase shares, it should be noted that the company issued shares in March 2007 for 65, using the proceeds to pay off long term debt. So, at prices in the 30 area buybacks would make sense, sell high and buy low. This is the exact opposite of what so many companies have done lately.

Analyst opinion – According to Jaywalk, analyst opinion consists of 4 strong sells, 4 sells, and 7 holds. Nobody likes this stock. Passenger miles are down, airlines are cutting back, and the Boeing (BA) Dreamliner is turning into a nightmare of production delays. On the other hand, the number of aircraft turbine engines in use has been increasing, turbines for power generation can only be expected to increase with the coming popularity of natural gas, and chemical plants require ongoing repair, restoration and expansion. I think it's more about timing – this stock will bounce back, the question is when.

On a five year basis, the demand is there. It just keeps getting pushed out.

Strategy – In 2001-2005 I invested in the somewhat similar Carpenter Technology Corp. (CRS) and waited patiently as it scraped along a miserable two year bottom before making a steady climb from 5 to as high as 75. Of course, being a good value investor, I sold out way early. This time around I have been playing CRS with covered strangles for several months, with good results, and the strategy might also be helpful with HAYN. The thinking is, waiting for the stock to make a move, selling options will provide premium income in the meantime. If the position develops unfavorably, the premiums received will lower the average cost of the holding.

Implied volatility stands at 57%. The stock is optionable, with relatively wide spreads, and it should be possible to buy the shares in the 32 area and sell the Dec09 30/35 Strangle for 5, more if you can get mid bid/ask.

Options presentation - A question that comes up from time to time when describing options strategies is how to compute the rate of return for multiple outcomes. Many of the questions are about accounting for the sale of short puts, but others involve the computation of annualized rates of return for comparative purposes, and the expected rate of return on strategies that are ongoing or repetitiously adjusted.

To address the short put first, I have now come around to the opinion that presentations of this strategy and its rate of return should include consideration of the amount of money required to backstop the put obligation. Otherwise, returns are exaggerated because the amount of money at risk in the strategy is understated. Here is the worksheet I prepared to develop the expected returns on a covered strangle for Haynes:

In addition to the money spent to buy the shares, the investor is assumed to segregate funds to cover the put obligation. Many investors have arrangements with their brokers that do not require cash secured puts, but ultimately the funds at risk are defined by the obligation assumed. When viewed this way the purpose of the strategy is quite clear: it reduces downside risk substantially at the expense of giving away some of the upside potential. The return on both the static and called away cases is respectable when annualized.

Not shown, returns look much better if the additional 30 at risk due to the sale of the put is not included when computing the rate of return.

Internal Rate of Return – In computing the annualized rate of return, I used the spreadsheet function XIRR. This has the effect of compounding the interest. To illustrate, if 10 is invested for 1 month and returns 1, the yield is 10% for the period. To annualize it, I would normally multiply by 12 and come up with 120%, very good. But the spreadsheet compounds the interest, coming up with 214% annualized, much better. I advocate the use of annualized returns to compare strategies against their alternatives, and compound interest, since it realistically portrays the returns that can be made by reinvesting profits.

The same example works differently on negative returns. Invest 10 and lose 1 in a month is -10%, multiply by 12 and you lost 120%, all your money and more. Compounded it returns -72%, at least you have something left.

Disclosure – Net long CRS. I intend to execute the strategy discussed on HAYN, subject to market conditions.

Comments

[Ricard]

Mr. Armistead,

Very interesting stock, thanks for the presentation.

I like that it has been able to raise cash during this downturn w/o utilizing capital markets and has written off nearly all of its intangibles for a clean book.

That is a very interesting observation regarding the size of the inventory - great sign that it has been able to convert it to cash.

I'll have to look at the 10k for competitive pressures. I've looked at POSCO before, and know that it is China's provider of higher-end steel. I'm not sure it provides this specific type of alloy, but my fear would be that industries like this may be subject to outsourcing to where labor markets are cheaper with corresponding loss of corporate control (this company looks too small to adequately capitalize on intl labor markets)

That, and the company being relatively new to the public arena, are the only things I'd want to look closer at what by all other accounts looks like a great find. Thanks!

PS - you've challenged me to make similar presentations on stock I purchase...probably a great idea just for posterity's sake if nothing else.

2009 Sep 25 10:35 AM

[Tom Armistead]

Ricard, I've found that writing on the stocks I own helps my thinking - from the comments I receive and also from the effort spent researching and putting my ideas in order.

I read a book once that advised investors to make a note of the reason for every buy and sell decision, something I have done for many years now. Exposing my ideas to comment makes me more honest with myself and more demanding.

There is so much market commentary out there, so many professional and paid pundits that on those issues that there is a question as to what the amateur investor can add to the mix. But on individual stocks, particularly those that don't get heavy analyst coverage, simply putting some time into researching and thinking about a stock may provide information that will helpful or useful to other investors.

I look forward to some articles on stocks you own.

Tom

2009 Sep 25 11:25 AM

[User 337068]

Haynes makes excellent products finds extensive application in aerospace industry ( gas turbines). Hence, the prospects will be tied to overall economic recovery, probably lag the recovery quiet a bit. It is possible to catch this stock in mid or lower 20's on severe market corrections

2009 Sep 26 04:25 AM

[H. T. Love]

One potential catalyst that *may* allow (HAYN) to lead the recovry is a large switch to NG electricity generation. If EIA supply, demand and price prognostications for NG hold, we might see a huge switch to NG from coal. Firther, most states a mandating "green portfolios" for their utilities, of which NG is a part.

Add in the energy legislation - what does it end up looking like? - and there could be strong increase for gas turbines.

Pure speculation on my part, but something to keep in mind as to timing an entry.

HardToLove

2009 Sep 26 12:20 PM

[Don-n-ABQ]

Tom,

I have not looked at this company, but after reading your article, I want to know more about who the competitors are and if HAYN's raw materials costs rise can they easily pass on price increases to their customers? Do they have either proprietary end-products or processes that allow them easy pass-through? I want either products you can't easily get elsewhere, or even if you can there isn't enough overall supply to effect pricing?

Thanks....Don

2009 Sep 26 03:27 PM

[Tom Armistead]

Thanks to all who commened. Two issues, ecompetition and entry point.

As Ricard mentions, the 10-K has quite a bit of information on competition, including a list of products for which HAYN has patents (17 in all) and believes they have little competition. Competitors include the likes of Precision Cast Parts and Allegheny Technology, also many stainless steel producers resort to specialty alloys when demand is slack, they price it low, trying to keep their mills running. Eastern European and Asian competition is expected in the 5 to 10 year time frame. A weak US dollar favors HAYN. It's a competitive business.

Entry point. I questioned that myself, feeling that the market may be on the verge of a correction that would give a better entry point. In my own portfolio I am 30% cash, basically playing for a correction, but getting a little nervous that it may not be very deep. So I decided to get a little more money into the market, went with this because I could get some premium for the options, at least I am getting paid to be in...

HardToLove, I also think the NG turbines could be a positive: at a minimum, it says not to think of HAYN as strictly tied to Aerospace.

2009 Sep 26 07:32 PM