About Alloy Steel International
Alloy Steel International (OTCPK:AYSI) is a nano cap company headquartered in Western Australia that uses a high tech, proprietary process to manufacture protective wear plates for mining equipment. Some of its corporate customers have included BHP Billiton Limited (NYSE:BHP), Caterpillar, Inc. (NYSE:CAT), Arch Coal, Inc. (ACI), Alcoa, Inc. (NYSE:AA), Rio Tinto, plc (NYSE:RIO), Fortesque Metals Group (OTCQX:FSUMF) and AngloGold Ashanti Limited (NYSE:AU).
Essentially, the company is a picks and shovels play on the mining industry, particularly iron ore and coal mining and as such, is positioned to potentially benefit indirectly from Chinese demand for those commodities. This month, two of Alloy Steel's customers -- Fortesque Metals Group and Rio Tinto, plc -- announced plans to significantly expand their iron ore mining capacity, driven in part by Chinese demand. Alloy Steel has had some stumbling blocks in the last year though. Below is a quick recap of the roller coaster ride Alloy Steel shareholders have had over the last year and a half, followed by an update on recent developments, including this week's earnings release.
A huge decline in 2010
On September 3rd of 2010, I wrote a post about why I was adding more shares of Alloy Steel at 90 cents per share, despite the stock having dropped more than two thirds since the beginning of the year. In that post, I wrote:
It looks like I overestimated how much the company would earn this year. My mistake. I thought it would earn over 30 cents this fiscal year, but that appears to have been unrealistic given the capacity constraints the company mentioned in our call earlier this week. Nevertheless, the company has already earned 17.2 cents in the first three quarters of this year, better than the 14.9 cents it earned in its previous best year (2008).
I also noted my rationale for adding more shares at that point:
My general idea regarding small growth companies is that if I can buy shares at a single digit multiple to a conservative estimate of what the company will earn next year, that’s probably a good deal.
Imagine that AYSI earns in all of 2011 what it has earned so far in the first three quarters of this fiscal year (17.2 cents). That seems like a conservative estimate to me (absent macro headwinds from China affecting the mining industry, I would expect the company to add to its 2010 earnings next quarter and grow earnings by a modest amount or more next year). If you estimate that the company will earn ~17 cents next year, at its closing price Thursday (93 cents), the company was trading for about 5.5x that forward earnings estimate. That seems like an attractive valuation to me, even given the current secular bear market.
A few weeks after I wrote that, on September 27th, Alloy Steel announced that it was voluntarily de-listing its shares from the OTC Bulletin Board. AYSI message boards were full of commenters suspecting the worst, some claiming that the company was must be on the verge of bankruptcy. As I noted on my blog at the time, though, Short Screen showed an Altman Z-Score of 5.13 for Alloy Steel. And since scores of 3 and higher indicate a lack of financial stress, bankruptcy didn’t seem to be a likely outcome for AYSI.
The next day, AYSI plummeted by more than half again. Since my investment thesis of September 3rd appeared to still be intact, despite the voluntary de-listing, I added more shares at 44 cents. That was the last time I added to my position in Alloy Steel.
A rebound in early 2011
At the end of January, AYSI finally reported its audited Q4 and annual results for its 2010 fiscal year, which ended on 9/30: record earnings of 10.8 cents for the quarter and 28 cents for the year. In the chart above, you can see the huge spike in volume and price for AYSI shares on that announcement. At the time, I wrote that those results and the management’s comments suggested that the company had resolved the production problems it had experienced with its second mill. Those production problems seemed to be a key issue delaying the company's manufacturing expansion: although the company currently runs a 51,128 square foot manufacturing facility in Australia, it recently completed the purchase of a 403,646 square foot manufacturing facility in Indonesia, giving some sense of its potential for expansion.
At the end of last year, Alloy Steel's founder and majority shareholder, Gene Kostecki, was also the company's chairman, CEO and sole board member. On February 25th of this year, the company announced that it had brought in three new board members, one of whom, Michael Minosora, it had appointed as chairman. Kostecki would remain a board member and technical advisor to the company. In addition, the company announced it had hired a new CEO, John Cleland. Bios of the new board members and CEOs were provided with the announcement.
Less impressive fiscal Q1 earnings
After releasing record earnings in its fiscal Q4 2010, AYSI reported underwhelming Q1 earnings of 5 cents per share, suggesting that perhaps it hadn't fully resolved the obstacles to its expansion. Shares slid on that news.
An unexpected departure
Shares dropped again last week, after the company unexpectedly announced the departure of its new CEO, after only a few months in the position. The company offered little by way of explantion, just the following two sentences:
Following a review of the company organization structure CEO John Cleland has departed the Company effective 27 May 2011. The Company will advise shareholders of the revised organization structure in due course.
Solid Q2 earnings and positive guidance
This week the company announced fiscal Q2 earnings of 8 cents per share, lower than its record Q4 2010 earnings, but a sequential gain over its Q1 earnings this year. The company's CFO, Barry Woodhouse, also offered positive guidance, noting that the company's first two fiscal quarters tend to be its weaker ones:
The Company remains optimistic about sales for the remainder of the financial year and sales are usually lower in the December and March quarters [Alloy Steel's fiscal year begins on October 1st, so the December quarter is its fiscal Q1]. Early indications in the current quarter suggest demand is likely to improve in the coming months.
Ernst & Young nominated Alloy Steel's founder, Gene Kostecki, as a candidate for its Entrepreneur of the Year award for 2011. In its profile of Kostecki, Ernst & Young mentioned that his goal was to increase Alloy Steel's sales to $300 million per year by 2015, after completing Alloy Steel's manufacturing expansion in Indonesia (that would be about a 12x increase in sales from last year's level of about $25 million).
Time will tell whether Kostecki achieves that ambition by 2015, but the company's shares could have some upside before then if investors valued them at something higher than a mid-single digit multiple. As of Thursday's close, at $1.39, Alloy Steel's shares were trading at less than 5.4 x the company's trailing twelve month earnings.
The current low valuation is likely a result of the lumpiness of the company's earnings, uncertainty about when it will expand its manufacturing capacity and the company's tendency to offer shareholders negative surprises (such as last week's departure of its new CEO). It may take a couple quarters in a row of ~10 cent per share earnings before investors begin to value AYSI at a more generous multiple.
Hedging costs of stocks discussed above
Alloy Steel doesn't have options traded on it, but several of its corporate customers mentioned above do. The table below shows the costs, as of Thursday's close, of hedging those stocks against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about what optimal puts mean in this context and why I've used 20% as a decline threshold.
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.
Hedging costs as of Thursday's close
The data in the table below is as of Wednesday's close. I've added SPDR S&P 500 (NYSEARCA:SPY) for comparison purposes.
Cost of Protection (as % of position value)
|(BHP)||BHP Billiton Limited||3.23%*|
|(ACI)||Arch Coal, Inc.||9.35%***|
Rio Tinto, plc
|(AU)||AngloGold Ashanti Limited||8.58%***|
|(SPY)||SPDR S&P 500 Trust||1.64%**|
*Based on optimal puts expiring in November, 2011
**Based on optimal puts expiring in December, 2011
***Based on optimal puts expiring in January, 2012
Disclosure: I am long AYSI.PK.