Why Management Believes In A Good Future For Webco Industries

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About: Webco Industries, Inc. (WEBC)
by: Ruerd Heeg
Summary

I found Webco Industries with a quantitative algorithm ranking global stocks on retained earnings and momentum.

Webco looks cheap, especially based on EV/EBIT. But could earnings easily mean revert?

Management changes and actions suggest a good future. First, the founder and major shareholder recently died, improving chances on the company being bought out.

Second, if management expected low earnings it would not have been buying back stock but instead it would have been reducing current debts.

Webco Industries (OTCPK:WEBC) is a small and unknown company, trading on the OTC. Despite that it trades on the OTC its market cap is still over $100 million, so small but not really small. Trading is pretty illiquid and many fundamental metrics suggest the company is cheap. On a statistical basis such stocks have high returns.

Since last year earnings have increased much, making the company also cheap relative to earnings. The company has some debts and the current high earnings should continue for a couple of years to pay them back. When the company succeeds in doing this I expect a much higher share price than today. The risk is this will take longer or won't happen at all. In that case the stock will tank. New share repurchases suggest management is confident the future is bright.

Webco Industries manufactures steel tubes for many applications such as industrial, agricultural and for the oil and gas sector. The company is based in Sand Springs, Oklahoma, US also with a factory there. See also here. Among others the company also owns factories in Mannford and Kellyville in Oklahoma and in Oil City in Pennsylvania.

When I research a company I first search for signs suggesting governance problems. With Webco Industries I found 5 minor issues. In 1999 a union accused the company of unfair labor practices. That the company actually did this was also the opinion of the National Labor Relations Board. Webco Industries appealed against that decision but the appeal was dismissed. In 2006 it lost a dispute with a reseller. As a result the reseller did not have to pay an invoice of 300k USD. See also here.

In 2017 it has filed a petition against unfair trade practices (dumping) of German steel tube producers. I do not think German steel producers dump their products in the US. Instead they are probably more profitable than Webco. That said, current protectionist trade policies are probably good for Webco Industries.

Currently the roles of CEO and chairman are combined in one person. I think this increases the risk of bad corporate governance.

Lastly, 4 directors and the COO and CFO are already very long with the company. So the independent directors also have a long tenure with the company. In practice that might be a problem for them acting independently. Also I prefer companies where the CFO changes every 8-10 years.

I found this stock while comparing momentum of thousands of global value stocks. I implement the best returning strategy from the book What Works on Wall Street: the cheapest low P/B microcaps ranked on momentum. Research shows replacing the P/B metric and looking for stocks with lower liquidity should improve returns. Therefore in my implementation I replace P/B with P/8-year accumulated retained earnings and add liquidity to the mix.

This stock had a favorable rank when I discussed it with my subscribers last month, when the stock price was $115. Since then the stock went up (see the chart below), but fundamentals improved as well. See the momentum in the chart below, from Seeking Alpha:

The company does not report with the SEC. It stopped reporting in 2005 after it reduced the number of shareholders with a reverse split. See also here. The company paid a premium for fractional shares that were cashed out. Now disclosure is very limited but the company still publishes quarterly income accounts and a balance sheet. These financial reports on the OTC website do not include a full cash flow statement and financial statement notes or an equity statement.

The lack of equity statements means we do not know how much of the equity is retained earnings and how much is contributed capital. That is useful information because I believe on average retained earnings are invested much better than contributed capital. Furthermore it also makes tracking dilutions difficult. Usually notes to the financial statements contain useful information, such as segment analysis, and give more information on the balance sheet. For example often companies split the inventory in "finished goods" and "raw materials" and current receivables in "trade receivables" and "prepayments". This information can often be used to estimate the liquidation value and to evaluate trust in the company. Finally a relatively high raw materials inventory often suggests the company expects to increase revenue.

See the “annual report” for the year ending on July 31, 2018. Also see the subsequent quarterly report. Revenues, earnings and gross margin increased much during the last 3 quarters. I think this explains the good momentum. The company also got a tax benefit of over $4 million as a result of the Trump tax relief.

I made a short overview of essential fundamentals for judging the stock. The numbers for earnings, market cap, enterprise value and cash flows are in millions of dollars. The metric financial strength is a 10-points metric similar to the Piotroski score. See here for details.

Financial Strength

Share Price

Market cap

EV/EBIT

P/Tan B

5

$140

114

6.4

0.57

Enterprise Value

EBIT, ttm

until mrq

Cash flow

from ops (fy)

Free cash

flow (fy)

EV/Revenue

231

36.0

-23.0

-42.1

0.44

Source: combination of data in screener.co and own computations

Leverage is low to moderate with Tangible Assets/Tangible Equity = 1.92. However leverage is mainly financial instead of operational. The company has $111 million of current debt and $12 million of non-current debt. Ultimately this debt needs to be repaid or refinanced.

At the moment the company only has $6.2 million of cash on the balance sheet. Since the debt is current you might think it needs to repaid soon. However I do not think this is necessary because this $111 million is debt drawn from a revolver. The revolver matures in 2022 but is categorized under current assets because of certain conditions that might never trigger. Moreover the company can still draw another $18 million from it. The high current ratio of 1.68 also suggests Webco Industries is unlikely to be financially distressed.

Over 2/3 of the current assets is in inventory which has increased much compared to last year. The investment in inventory is the reason the cash flows were negative. Also other accruals, accounts receivables, and “other current liabilities” increased much, which may not be a good sign. On the other hand management recently gave an optimistic outlook when reporting increased earnings (again). So the increase in inventory and other accruals is probably related to a solid improvement of the core business.

Last reporting year the company bought back some shares but the company also diluted via options. There is a big difference between the actual number of shares outstanding and the diluted number: 810,500 and 931,800 respectively. So websites like Seeking Alpha underestimate the market cap. Last quarter, the first quarter of the new fiscal year, the company spent close to a million dollars on repurchases again. The company may speed up repurchases since the board approved a stock purchase program of $10 million expiring on July 31, 2022.

Insiders prefer to do repurchases instead of decreasing debt. Therefore I think management thinks very positively about the future of the company. If it expected earnings to decrease management would have been using profits to pay off debt.

In 2004 the company reported the founder/chairman and affiliates held over 47% of the shares. I suppose they are now above 50% as a result of the subsequent reverse split, recent repurchases and probably option grants as well. In addition Wells Fargo Fund Management owns the stock. This fund has been a long term holder but the number of shares it owns has been slowly decreasing. In 2014 its last filing showed the fund owns 13.68%.

I have no plans to invest in Webco Industries because of the debt. That said, if current results continue for another 3-4 years the company is able to pay off this debt. Again, the reason for the negative cash flows in the table above is an increase in inventory, so probably related to improved operations. Therefore, if the company is in 3-4 years as profitable as it is now I can easily see a double.

Why could this happen and why not? With its customers in agriculture and energy industries the company benefits from secular trends such as population growth and growing energy consumption. We see this only partly in the numbers. Over the years gross margins have increased but other multi-year metrics were not so good. In particular earnings have not been very stable and the company did not generate much free cash flow. That suggests the company has a hard time competing with other companies. Of course we already knew this from the dumping complaint.

Anyway, if earnings stay firm for the next couple of years I think the stock will go north. This would partly be the result of the market recognizing extra book value from earnings, partly from recognizing lower risks from a deleveraged balance sheet and also from recognizing the company's long term earnings power.

Another catalyst for the stock could be an acquisition by another company. Such a transaction is more likely to occur when the stock of a major shareholder is going into someone else's hands. This is happening with Webco Industries since the founder and chairman, died last September. In fact, the repurchases already suggest things are changing for shareholders at Webco Industries. I would not exclude either that the company will get a normal listing again and returns to reporting to the SEC.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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