Friedman Industries: A Sound Micro-Cap Tossed Into The Bargain Bin

| About: Friedman Industries, (FRD)
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(Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.)

Executive summary:

  • Friedman Industries' shares trade at less than book value, and barely above current assets less all liabilities.
  • This micro-cap steel company generates positive cash / earnings, and pays a dividend.
  • In 2014, non-residential construction is expected to show improvement, paving the way to better days ahead for the steel industry.
  • The stock is woefully undervalued, proving an asymmetric investment opportunity.

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Amidst little fanfare, Friedman Industries (NYSEMKT:FRD) reported earnings after the bell on Thursday. Friedman is a niche player in the steel industry; primarily dealing in coiled / tubular steel manufacturing, processing and distribution. The market cap is only ~$56 million.

I find Friedman an interesting stock from a valuation standpoint, primarily as viewed through the balance sheet. The current quarter underlined what appears to be a significant undervaluation investment opportunity.

Here's some highlights:

  • Stock trades about $8.15
  • Price-to-Book ratio less than 1.0
  • Nearly one third of share price is balance sheet cash
  • No debt
  • NCAV per share $7.89
  • Pays a cash dividend

Friedman Industries Stock Trades as if the Company is Winding Up

I like to start analyzing a company by reviewing the balance sheet. There's several investor "attention-getters" in that financial statement.

The Price-to-Book ratio is 0.88. When the P/B is below 1.0, it means shares trade for less than net assets minus net liabilities. This often indicates a company in distress: negative earnings, negative cash flow, heavy pending liabilities, debt problems, or other significant business overhangs. FRD has none of these problems.

According to the most recent 10-Q filing, The company earned $0.07 a share in the quarter ending December 31, and $0.17 in the year-over-year quarter. While the numbers are down significantly from a year ago, they remain positive.

More important for an ongoing industrial concern is operating cash flow and free cash flow. The company generates far more cash than it books in earnings. Here's a table of year-over-year figures:

Note all figures remain positive. Cash flow per share is nearly 2.5 times earnings per share. Additionally, Friedman can run the business at low maintenance capital levels. This is partly due to the business model: while the company manufactures steel products, much of its business entails simply buying and reprocessing steel products supplied by U.S. Steel (NYSE:X) and Nucor (NYSE:NUE). Over 90% of operating cash is converted into free cash flow.

The balance sheet also reflects the company holds $2.51 a share in cash, or nearly a third of its market cap. Indeed, cash rose over $1 million this year from last year. Cash is up; inventory is down.

What's more, despite operating in what's considered a "smokestack" industry, Friedman Industries carries zero debt. Nothing.

Net Current Asset Value per share is $7.89. NCAV is derived by subtracting all liabilities from a company's current assets.

Let's understand what this figure represents. If we take corporate cash, receivables (less provision for doubtful accounts), inventory and other miscellaneous current assets; then subtract all liabilities owed, we find shares may be purchased today for only 3% above that marker. This means that the current share value throws in all company plant, property and equipment for nearly nothing. It also indicates that the Mr. Market assumes shares have little to no ongoing enterprise value.

At today's prices, stock may be bought for little more than cash on hand, outstanding receivables, and current inventory after paying off everything owed.

Yet, as we highlighted earlier, the company continues to generate positive cash flow and earnings. And by the way: the board of directors just announced a $0.02 a share dividend for the most recent quarter.

So What's the Story Line?

The numbers only tell part of the story. The number are not THE story.

Friedman Industries is a micro-cap steel company, driven largely by U.S. mid-continent economic activity. Many FRD products find their way to the the non-residential construction and energy sectors. U.S. Steel and Nucor offer the company off-spec products that may be re-processed and sold; so Friedman also has ties to the general American steel business cycle. An improvement in the general steel businesses cycle should eventually trickle down to Friedman, too.

From the Nucor Corporation 2013 4Q earnings presentation Q&A session held on January 28, 2014:

Michael F Gambardella - JP Morgan Chase & Co, Research Division:

One of your competitors this morning on their call mentioned that in terms of non-res construction, the joist business, they're doing fairly well. The big-box type of builders, really, consuming, pushing up the joist numbers. Are you seeing anything on the non-res construction side other than the joist activity?

John J. Ferriola - Chairman, Chief Executive Officer and President:

Well, we've seen an increase in our backlogs. We've seen a modest improvement in the pricing that we've been able to -- pricing power we've been able to exercise in those areas. But again, it's been a modest improvement. We -- just as we began to see things improve, we saw the weather get a lot worse, and that's impacted some of that. But we believe that there will be an incremental improvement in the nonresidential construction market during 2014. How quickly it ramps up is unclear. But if you read all the projections, we here -- we read there's anywhere from -- some of the projections are 5% to 10% improvement in 2014 over 2013. So we think that that's probably a reasonable number.

There have been other macro data points indicating the United States economy is growing; perhaps weakly, but nonetheless growing. For a long-term investor, the question is not if the economy will reach the mid-cycle phase, but when.

After the most recent quarterly earnings release, Friedman management graciously afforded me a brief interview to discuss the 10-Q SEC filing and general business conditions. The view jibed with the aforementioned: no gangbusters expansion expected, but some optimism their steel coil and tubular markets may have bottomed in the third and fourth quarters of 2013.

Such a view was further evidenced by reviewing Friedman Industries' realized steel prices, margins, revenues, and volumes. In each case, the company experienced a quarter-over-quarter decline. However, the 3-month rate of decline for results ending December 31, 2013 improved categorically versus 9-month figures, indicating business deterioration through most of 2013 may have slowly begun to swing back the other way towards the end of year.

Finally, Friedman management runs a tight ship. Salary, General and Administration (or "SGA") expense as a function of revenues was 4% in the most recent quarter. This number is not remarkable as an absolute; however, when viewed over time Friedman Industries' SGA expense ratio has held steady. It run between 3.3% and 4% over the past 3 years, despite a considerable drop in the business. When times got tough, management "tightened its belt."

Summary

Rarely do stocks of viable concerns that general real cash trade below net book, and more remarkably do they trade for prices nearly equal to NCAV per share. Friedman Industries does both: yet is cash / earnings positive, and continues to pay a dividend. The no-nonsense management team has a demonstrated ability to hold expenses down when business is tight.

The U.S. steel industry is down, but not out. Patient investors may find prospective 2014 improvement in non-residential construction and continued North American energy production activities may provide the company with the spark for multi-year, pull-through growth.

Please do you own careful due diligence before making any investment. This article is not a recommendation to buy or sell any stock, it is for information purposes. Good luck with all your 2014 investments.

Disclosure: I am long FRD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.