Haynes International: Value in Specialty Steel

Includes: CRS, HAYN
by: Tom Armistead

Specialty steelmaker Haynes International (NASDAQ: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 (NYSE: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. (NYSE: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.