Alloy Steel: A Picks And Shovels Play On The Mining Industry

Sep. 7.11 | About: Alloy Steel (AYSI)

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. The image below, from the company's website, shows a front end loader bucket with Alloy Steel's Arcoplate wear plating installed.

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In addition to protecting against wear, Alloy Steel's wear plates are also designed to reduce "hang-up", which is the tendency of ore to adhere to the surfaces of mining equipment, reducing their efficiency. Some of Alloy Steel's corporate customers have included BHP Billiton Limited (NYSE:BHP), Caterpillar, Inc. (NYSE:CAT), Arch Coal, Inc. (NYSE:ACI), Alcoa, Inc. (NYSE:AA), Rio Tinto, plc (NYSE:RIO), Fortesque Metals Group (OTCQX:FSUMF) and AngloGold Ashanti Limited (NYSE:AU).
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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. Alloy Steel has had some stumbling blocks over the last year and a half though. I recapped most of them in my last article on Alloy Steel in June.

Below is an update on some recent developments. Let's start with the news that knocked shares of AYSI down 11% Tuesday.

New Organizational Structure Further Unravels

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, the company announced, would remain a board member and technical advisor to the company. In addition, the company announced it had hired a new CEO, John Cleland.

In June, the company announced the departure of the new CEO, John Cleland. At the end of August, the company announced that Gene Kostecki had been appointed CEO. And on Tuesday, the company announced the resignations of the chairman of the board, Michael Minosora, and of one of the other three new directors appointed this year, David Mofflin. Alloy Steel shares dropped 11.02% on the news.

Entrepreneur Of The Year For AYSI Founder

In our article in June, we mentioned that Ernst & Young had nominated Alloy Steel's founder, Gene Kostecki, as a candidate for its Entrepreneur of the Year award for 2011. We also noted that, 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). In late August, Ernst & Young named Kostecki Entrepreneur of the Year, in the manufacturing category, for Western Australia.

Macro View For Iron Ore Industry

As a supplier to major iron ore miners, AYSI is positioned to benefit from continued demand for iron ore. Despite the current global economic uncertainty, according to the FT's Lex Column last week ("Iron ore: on a roll"), demand for iron ore is set to remain strong. Lex quoted an estimate by Rio Tinto that,

The world will need an extra 100 million tons a year for each of the next eight years – requiring a near doubling in production from 2010.

Valuation And Looking Ahead

As of Tuesday's close, at $1.05 per share, Alloy Steel was trading at 4.03 times its trailing four quarters earnings. Alloy Steel reported earnings last on June 15th, so it's possible it will report its most recent quarter next week.

Hedging Costs Of Stocks Discussed Above

Unfortunately for Alloy Steel longs, the stock doesn't have options traded on it, but several of its corporate customers mentioned above do. The table below shows the costs, as of Tuesday's close, of hedging those stocks against greater-than-20% declines over the next several months, using the optimal puts. The cost of hedging the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) against the same decline is included as well, for comparison purposes. First, a reminder about what optimal puts means in this context, and a step by step example of finding optimal puts for the comparison ETF listed below.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA, has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web 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.

A Step By Step Example

Here is a step by step example of finding the optimal puts for the comparison ETF listed below, SPDR S&P 500 Trust (SPY).

Step 1: Enter a ticker symbol. In this case, we're using SPY, so we've entered it in the "Ticker Symbol" field below:

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Step 2: Enter a number of shares. For simplicity's sake, we've entered 100 in the "shares owned" field below, but you could also enter an odd number, e.g., 731. In that case, Portfolio Armor would round down the number of shares of SPY you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with seven of the put option contracts that would slightly over-hedge the 700 shares of SPY they cover, so that the total value of the 731 shares of SPY would be protected against a greater-than-20% decline.

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Step 3: Enter a decline threshold. 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, so we've entered 20% in the Threshold field in the screen cap below.

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Step 4: Tap the "Done" button. A moment after tapping the blue button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 100 shares of SPY against a >20% drop between now and March 16, 2012. Two notes about these optimal put options and their cost:

  • To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
  • As volatility has climbed, so have hedging costs. The VIX S&P 500 volatility index closed at 37 on Tuesday. On June 16, when we wrote our previous article on AYSI, the VIX was at 22.73, the cost of hedging SPY against a >20% decline over the same length of time was only 1.64%, as we noted in the article published the following day. As the screen shot below shows, as of Tuesday, the cost as a percentage of position was 3.76%.

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Hedging Costs As Of Tuesday's Close

The data in the table below is as of Tuesday's close.

Symbol

Name

Cost of Protection (as % of position value)

(CAT)

Caterpillar, Inc.

7.29%*

(BHP) BHP Billiton Limited 5.90%*
(ACI) Arch Coal, Inc. 16.3%***
(AA) Alcoa, Inc. 11.6%***

(RIO)

Rio Tinto, plc

14.4%***

(AU) AngloGold Ashanti Limited 6.52%***
(SPY) SPDR S&P 500 Trust 3.76%**
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*Based on optimal puts expiring in February, 2012

**Based on optimal puts expiring in March, 2012

***Based on optimal puts expiring in April, 2012

Disclosure: I am long OTCPK:AYSI.