Friedman Industries (FRD) is a high quality company with a simple business model. It processes steel, manufactures & processes pipe and distributes steel & pipe. Also, in 2009, it was ranked 59th out of Forbes' 200 Best Small Companies.
Currently, FRD is suffering from temporarily depressed earnings due to the economic environment and naturally, the market has reacted by punishing its stock price significantly below its fair value.
I believe the market has failed to acknowledge that FRD has a strong balance sheet, reliable margins and a history of profitability in good economic times. Holding through to recovery is the key to a solid return in this type of situation.
Let's take a look at the key numbers:
|Mkt Cap||P/E||P/B||P/S||Current Ratio||ROIC (5 yr)|
The first thing that stands out for me is the lack of a P/E. Yes, FRD is losing money. However, its burn rate is fairly low and considering its cash reserves ($20.86m), it can go on like this for a long while.
Secondly, FRD has a great current ratio. This is in large part thanks to its cash reserves mentioned above and minimal debt (Current Liabilities = $4.36m; Total Liabilities = $5.34m). I love it when a company has more than enough cash to cover its liabilities. In this situation, cash minus total liabilities accounts for over 39% of FRD's current market value!
Let's consider the accuracy of the Price/Book Ratio, which sits at 0.7. I don't believe that if FRD closed tomorrow all of its assets could be recovered for 100% of their value, except cash.
Assuming 75% of the value of FRD's non-cash assets could be recovered, shareholders would be left with a total of $45.4m, changing the P/B ratio to a still respectable 0.86.
Using that conservative estimate, FRD's adjusted book value stands at 116% of its current market value. 16% isn't a huge margin of safety but it's nice to know it's there.
Personally, I like to have more breathing room so I should be able to find that in the valuation of FRD's earnings.
Again, I've adjusted operating earnings using the approach recommended in Greenwald's Value Investing to determine the intrinsic value.
Please note that earnings for fiscal 2010 have not yet been announced so I extrapolated the numbers from the first 3 quarters to provide a guesstimate of what they would be for the full year.
Normally, I look at the past five years of earnings but because of the current economic climate, I chose to look back six years as I consider 2010, 2009 and 2008 all "recession" years and wanted to make sure I got a idea of performance during good economic times.
I averaged FRD's operating margin in 2005-2007 to come up with the 5.3% and normalized the earnings accordingly. I didn't use 2008-2010 as these are "recession" years.
As can be seen, FRD has performed reliably over the years, maintaining an income as adjusted margin of around 3-4%. For me, this means that management have kept costs steady and even in periods of decline, they have been able to reduce costs to maintain that same margin. I like this level of predictability as it makes it easier to estimate that this margin will be maintained as the economic situation improves.
The key figure here is the Earnings Power Value or EPV. I applied a 15% discount rate to it as that is the annual return I hope to achieve from any investment.
The Total EPV includes the earnings power, and cash in excess of 1% of sales minus interesting bearing debt, in its valuation. Based on figures for 2010, FRD is current overvalued from a business perspective, not on an asset basis.
Personally, I put this down to current economic conditions. We can reasonably expect normal service to resume as the economy improves over the next couple years.
To estimate FRD's value a couple years down the line, let's make a few conservative assumptions. Firstly, if we look at 2005-2009, we can see that the EPV, discounted by 15%, doesn't dip below $41m. Therefore, we can safely assume that the value of FRD's earnings power, a year or two from now, will be at least $40m. Secondly, let's be even more conservative and assume cash minus interesting bearing debt has been reduced by 50% to $10m.
Putting these two figures together, we can put a conservative price tag of $50m on FRD, which equates to a share price of $7.35. Currently, FRD is trading at around $5.73. This gives us a comfortable margin of safety of at least 28.2%.
Again, I should stress this is a conservative estimate.
The main risk factor here is that in 2009, one customer accounted for 30% of FRD's net sales. That customer is United States Steel (USS) Corporation.
This is concerning because in February 2009, USS idled its nearby plant in Lone Star, Texas. Few orders have since been received from USS. It's expected that the plant will continue to be idled until market conditions improve.
There are two important factors to consider. Firstly, USS bought this plant in 2007 for $2.1 billion so it's unlikely they will disregard that kind of investment. Secondly, they have not shut down the plant, they have merely idled it until the market improves.
I believe that its highly likely that USS will reactivate this plant in the next year or two. Even if it doesn't, at that point, FRD will still be a profitable organization and its unlikely that the market would push its price below its asset value at that point. I say this from looking at the Market to Book Ratio from 2005-2007 in the Earnings Power, Book & Market Value chart above.
Even with the above risk factor, I believe FRD is a solid long-term investment as a result of the margins of safety found in its balance sheet and its earning power.
Note: This is just my opinion. I'm not a professional in the financial world. Please conduct your own due diligence in any decisions to purchase, sell, or otherwise trade any stocks.
Disclosure: Author holds a long position in FRD