John Swift's  Instablog

Friedman Industries (FRD)

Friedman Industries (FRD) is a tiny, obscure and unloved company in an ugly industry: Steel processing. However, it’s been consistently profitable and even growing steadily. It is currently trading at what I believe is a bargain price of about 1x EBIT, less than 1x FCF,  less than 58% of the reproduction value of its assets and about 8% cheaper than it should be worth based on normalized earnings in a worst-case scenario, which would be considerably worse than recent performance.

Company and industry background

Friedman buys raw steel materials (hot-rolled coils) from steel producers like U.S. Steel, and processes them into higher-value but still general-purpose steel sheets, plates and pipes (called “tubular products”). The sheets and plates are used to create a variety of durable goods. Pipes are used in construction and other applications. Both the inputs and outputs of Friedman’s business appear to be thoroughly commoditized.

Friedman competes with steel mills that do their own processing, importers and other steel service centers. Competition is based primarily on price and the ability to rapidly deliver orders to client’s specifications. As a result, the business model requires a large amount of inventory. Not attractive.

To make matters worse, the competition for Friedman’s products is global in nature. In fact, it’s a bit too global for the U.S. government’s taste, which is why US International Trade Commission (ITC) slapped tariffs as high as 616% on steel pipes imported from China on June 2008 (1).

Friedman’s profit margin depends on the spread between its input (steel coils) and output (pipes and plates). This margin has been steadily expanding, from $28/ton in 2004 to $41/ton in 2008, a CAGR of 10.3%. Since the tariffs in 2008, the margin has nearly tripled to $118/ton.

We can also see the spread widening at a macro level: Pipe prices are holding steady while steel prices are dropping (2). This is not good news for steel mills but very good news for processors like Friedman.

Company Financials

From 2000 to 2008, Friedman has not had a single unprofitable year. This is not to say the business was unaffected by the economic cycle: EBIT margins went as low as 1.4% in the 2002 recession, and as high as 5.6% at the peak of the boom in 2006 boom. Revenues and COGS grew at about 5% per year each. Other costs hardly budged, so the full value of the growth pretty much dropped to the bottom line, with earnings growing at a 7.6%/year. Furthermore, Friedman bought back some of its shares, so EPS grew better than 9%/year

Then came 2009, a blockbuster year for Friedman: Net Income more than tripled to $13.7m and free cash flow was $23.5m, higher than the current enterprise value. This was primarily driven by margin expansion, discussed above. Friedman used the profits to retire $6.7M in debt, and the rest went to cash.

Friedman now trades at about 1x the last twelve month’s EBIT:

Shares Out.      6.8m

Price/share       $5.65   7/21 EOD

Market Cap     $38.42m

Debt                 0.07m

Cash                $16.88m

Enterprise Val.  $21.61m

EBIT                $20.82m  FY2009

EV/EBIT                      1.04x  

Why is Friedman so cheap?

So why is a company that just had a blockbuster year trading at 1x EBIT? Because approximately 30% of Friedman’s sales in 2009 go to a single customer: U.S. Steel (USS), and in February 2009, USS stopped buying.

Specifically, USS owns a nearby plant in Lone Star, Texas. It bought the plant from a local owner in 2007 for about $2.1B. In February 2009, it decided to “idle” the plant and lay off most of the workers. Since then, orders from USS to Friedman have substantially stopped.

The disruption to Friedman is serious, but I believe the market has punished the stock too severely (the stock traded at $10 in January 2009). The loss of revenue should not be permanent for three reasons:

1) In its announcement, USS said it was idling the plant temporarily, in response to the current weak demand picture. It did not shut the plant down.

2) I think it would be very difficult for USS to walk away from the $2.1B it spent to acquire the plant just two years ago, and

3) Even if USS decides to shut down the plant altogether, would the revenue to Friedman be irreplaceable? At the end of the day, Friedman sells a commodity: steel pipes. The downside of selling a commodity is the fierce competition among sellers, low switching costs for buyers. The upside: there should be lots of buyers that can cheaply switch to Friedman.

Worst-Case Valuation

Even if we assume USS revenue to Friedman will be permanently lost and Friedman returns to its average historic profitability (including the last recession) and Friedman does nothing with its excess assets (detail below) and there is no more profitable growth, the stock should still be worth more than the current price:

Actual 2009 Sales: $208.8m

Minus USS Revenue: 62.6m (30%)

= “Normalized” Sales: 146.2m

Average EBIT margin 2000-2009: 4.4% (compared to 10% in 2009)

Average Tax rate 2000-2009: 34.9%

Normalized earnings: 4.17m

Shares outstanding:  6.8m

Normalized EPS: 0.61 / 10% cap rate = $6.1/share, 8% higher than current price

Base-Case Valuation

What is Friedman really worth? I would say between $9.5-10.5 per share, an upside of 70-80%. We can triangulate from three approaches:

1) The stock traded at $10 in January 2009, before USS stopped ordering. I think it could easily get back there if/when the plant restarts (in a year or so) or if Friedman finds another buyer.

2) Friedman’s replacement value is considerably higher than the assets shown on the balance sheet for two reasons:

a. Friedman’s inventory is carried at the lower of cost or market. Right now, cost is a lot lower. The market value of the inventory exceeds cost by $5.3m. This value should be realized as Friedman sells its current inventory.

b. Friedman owns the land (and buildings) for most of its mills. The land is carried at cost ($1m) but has probably gone up in value.

If we mark up inventory to market prices and ignore the extra value in the land, Friedman’s assets come to $9.68/share, 71% higher than the current price.

3) Friedman’s nearest competitors trade at 1.31x book and 0.48x sales. If we apply these ratios to Friedman’s actual book value and normalized sales (without USS) we get a value of $10.35 and $10.79, respectively. The competitors analyzed were WOR, ZEUS, NWPX, AKS, PKX and ROCK

Upside

Could Friedman be worth more? Current profit margins per ton are triple what they were last year, partially due to protectionist tariffs against China. If those tariffs are not repealed for a few years, the added profits should be attractive.

This undervaluation has probably not gone unnoticed: Insiders own 8.86% of the company, up 1.7% in the last six months.

Footnotes

1) U.S. tariffs on Chinese pipes: online.wsj.com/article/SB121398920050292...

2) Pipe prices are holding steady while steel prices are dropping: enr.construction.com/economics/materials...

Catalyst

USS restarts the plant
Friedman finds another buyer
Margins on pipe products are maintained
Friedman sells some of its excess assets
Friedman buys back more stock with excess cash
Any ONE of the above should do the trick

Disclosure: No positions