Schuff International (SHFK) is the largest structural steel fabricator and erector in the US. The company has 10 fabrication plants located throughout the country, although their largest presence is in the southwest. Because Schuff is traded on the pink sheets and the free float is limited it's presumably a company few investors know, but the buildings Schuff has helped to construct are anything but obscure. This is nicely illustrated on the company's website where they show that almost every building worth mentioning in Las Vegas has at its core steel fabricated and erected by Schuff. Other projects include well known stadiums, bridges and airports.
Schuff caught the attention of investors a couple of years ago when it repurchased in one transaction 58.1% of the outstanding stock. A company repurchasing such a big block of shares is pretty unique, but what made it even more unusual was the timing. While Schuff was struggling to turn a profit at the bottom of the construction cycle they added significant financial leverage to the mix to fund the share repurchase. This is what the CEO said about the transaction at the time:
"By completing this transaction, we are taking advantage of a unique opportunity to enhance stockholder value while demonstrating confidence in the long-term outlook for our business," said Scott A. Schuff, president and CEO of Schuff International.
For a long time the market remained skeptical about the wisdom of the transaction. The company bought the shares from two institutional shareholders at $13.25/share, and it took the market almost two years before it valued the remaining shares at the same price. With the benefit of hindsight we can now confidently conclude that this was a pretty awesome transaction for shareholders. Most of the debt incurred in the repurchase has been eliminated while the construction cycle is turning and as a result the share price is already up to $27/share.
That the non-residential construction cycle finally seems to be turning is obvious when we look at Schuff's backlog of $427 million. This represent an increase of 130% compared to previous year, and it is a level that is even slightly higher than the $417 million record set at the start of 2008. Historical revenue and backlog numbers are illustrated in the graph below:
The cyclical nature of the business is clearly visible in the graph above, but what's also visible is that the backlog at the start of the year has a strong correlation with the revenue realized during the year (should be logical). Thanks to the operating leverage inherent in the business the higher revenues should translate to a meaningful higher earnings number for next year. Based on 2013 results Schuff is already not very expensive: trading at a 9.2x PE-ratio, a 1.05x PB/ratio and a 4.5x EV/EBITDA ratio. Common sense would tell us that the company is trading at significantly lower multiples is we look ahead at 2014, and thanks to the strong correlation between the starting backlog and the subsequent revenues a decent estimate can be made on how cheap the company exactly is.
A regression analysis based on the dataset displayed above finds an R-squared of 0.70, meaning that 70% of the variability in earnings can be explained by the backlog at the start of the year. Using the output of the regression model we find that the expected revenue for 2014 is $570 million: a number that might even be conservative given the fact that the company recorded significantly higher revenue numbers in the past when the backlog was at this level.
I also modeled a 50bps increase in gross margins which I think is reasonable when the economic climate is improving. This is still below the average gross margin of 16.6% for the past 10 years, and it is significantly below the 23% gross margins achieved before the financial crisis. To estimate the general and administrative expenses I used another linear regression analysis because a simple average would not capture the operating leverage that is present in this line item. The regression analysis finds that F is significant at the 0.000236 level, and that the R-squared is 0.79. The analysis suggest that G&A expenses as a percentage of revenue drop from 9.8% in 2013 to 8.8% in 2014 (but are almost $10 million higher on an absolute basis). This has resulted in the following model for next year's earnings:
The model predicts that earnings this year could be 80% higher than those recorded in 2013. This means that Schuff isn't trading at a 9.2x PE-ratio, but probably closer to a 5.1x ratio when we look forward. That sound like a pretty attractive deal in my book!
What is of course a good question is at what point in the construction cycle we currently are. You don't want to pay a high multiple for a cyclical company when the cycle is at the top. Where we exactly are in the cycle is a though question. The CEO of Canam Group (OTC:CNMGF), one of Schuff's biggest competitors, got asked this question on the latest conference call and he answered that he didn't know, although he did note that there could potentially be a lot of upside since non-residential construction activity is still significantly below the peak recorded before the financial crisis.
Just looking at Schuff's historical results (see the appendix below for some key statistics) and the predicted results for 2014 also seems to hint that we aren't at the bottom of the cycle, but also not at the top. The predicted operating income of $35.5 million for 2014 is actually a little bit below the 10-year average and it is just one-third of the peak results achieved in 2007.
The Schuff family owns 60.8% of the outstanding share capital. This should align the incentives of the management to a great degree with that of other shareholders, although management control also implies risks that a potential investor needs to be comfortable with. An unethical management team could for example enrich themselves using related party transactions at the expense of outside investors. Luckily there are no hints in the financials that this is the case, and the track record of management with regards to capital allocation is pretty good. The earlier mentioned share repurchase is of course a big positive, but the fact that the company paid a very big $5.8/share dividend in 2009 is also encouraging to see. They aren't afraid to return cash to shareholders.
What should be mentioned is that Schuff isn't a SEC-reporting company, and because of this they aren't required to report quarterly results. Schuff only publishes their audited financials once a year. I think this is a sufficient level of disclosure, but it is certainly less than what you get from other companies.
Schuff is a cyclical business that is well managed by an owner-operator with a good capital allocation track record. Thanks to the aggressive share repurchase completed a few years ago the company is now in a position to see EPS skyrocket thanks to a low share count, less interest expense and most importantly: a turning construction cycle. Because the backlog has a high predictive value with regards to future revenue we can already guestimate next year's results with a reasonable accuracy.
Because of this I believe that the shares are currently an attractive deal. If we assume that the expected results for 2014 are representative for mid-cycle earnings, and that an earnings multiple between 8x and 10x is appropriate, it would imply an upside between 55% and 95%.
The table below contains historical financial results for the past 11 years including some key financial metrics:
Disclosure: I am long SHFK. 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.