About Friedman Industries
Friedman Industries, Incorporated (NYSE: FRD) ("Friedman", "Friedman Industries", or the "Company") is a manufacturer and processor of steel products and operates in two product segments: coil products and tubular products. The Company is engaged in a non-seasonal, highly-competitive business and competes with other processors of hot-rolled steel coils. The steel industry, in general, is characterized by a small number of extremely large companies dominating the bulk of the market and a large number of relatively small companies, such as Friedman, competing for a limited share of the market.
The coil products segment processes hot-roll coils into sheet and plate, as well as customer-owned coils on a fee basis; and sells these products on a wholesale basis. It offers its coil products and processing services primarily to steel distributors and customers manufacturing steel products, such as steel buildings, railroad cars, barges, tanks and containers, trailers, component parts, and other fabricated steel products through its own sales force. The tubular products segment uses hot-rolled steel coils that the Company will manufacture into line and oil country pipes, as well as pipes for structural applications. It sells its tubular products principally to steel and pipe distributors through its own sales force. Friedman Industries was founded in 1965 and is headquartered in Longview, Texas. (Source: Annual report fiscal 2019, Finviz)
The Company's results are mostly determined by prices (cost of inputs, selling price), demand and competition. In simple terms, the Company buys "raw steel", transforms it into pipes and sheets, which it then sells at a higher price (reflecting the value added). As a small player in this commodity-based market (offering relatively generic products (rarely specific, although FRD does occasionally process customer-owned coils on a fee basis)) Friedman is a price taker and subject to fluctuations in steel prices. Generally the Company will perform best when prices are rising and demand is strong - then it will be able to purchase inventory at an average cost that is well lower than the eventual selling price, produce more economically at scale and earn more with greater quantities sold. Although FRD will still experience rising costs with higher steel prices those higher costs will be associated with higher selling price (just think about the inventory listed at cost which the Company will then be able to sell at higher prices in a rising market). And with stronger demand the Company is able to produce more economically, achieving lower cost per ton produced that further improves results.
As an example, in fiscal 2017 prices (cost and selling price) rose while energy markets experienced a downturn. This increased the cost of raw materials while sales were simultaneously negatively affected due to lower demand (partially offset by higher selling price, but costs negatively affected by less economical production), causing the Company to report a loss for the year. This was reversed the following year as demand grew while prices rose moderately. All in all, results are significantly impacted by prices, competition, input cost management and demand.
(It is worth noting that the Company shifted its inventory cost accounting method from LIFO to Average Cost in fiscal 2019. With rising prices in 2017 the LIFO method was particularly unhelpful as cost of goods sold rose significantly while low demand further hurt in terms of quantity and selling price.)
In the last 12 months shares of FRD have fallen by approximately 30% and about 16% YTD, of which the majority decline has occurred in the last month. The shares currently sell for approximately $6.18/share, with P/B = 0.6, P/E = 8.5 and dividend yield of 3.1% (based on $0.19/share dividend for fiscal 2019). Average daily volume is generally roughly 12K shares.
The nature of the Company's business - steel production, i.e. commodity-based manufacturing - makes it susceptible to the fluctuating prices of commodities, which as of recently have especially been impacted by imposed tariffs and political turmoil that have created significant uncertainty in the markets.
This uncertainty and fluctuations may have contributed to the decline in FRD's shares, which otherwise generally follow the price of steel relatively closely. Still, in the last month, steel prices have rather been heading upwards while FRD has slid downwards to a point we deem too far (as evident by our valuation estimate in the next section). We believe that this deviation gives rise to an opportunity for a rebound once the market realizes the gap or FRD reports next (better than expected) results.
Primarily due to an impairment charge the Company reported a small loss for the first quarter ended March 31, 2019 (this is the last quarter of fiscal 2019 for FRD; the Company's fiscal year is from "March to March"). Excluding the impairment charge the Company would have approximately broken even for the quarter. Friedman was nonetheless handsomely profitable for the overall year, earning $5.1 million with stockholder's equity at roughly $72 million at year end. (Source) No other factors have specifically impacted FRD negatively, and since other steel companies have generally continued to follow the path of steel prices (and thereby rather rising as of late) we must believe that the market is (wrongly, or at least excessively) punishing FRD for this impairment charge and likely not recognizing the beneficial demand effects from tariffs.
The Company will pay its 190th consecutive cash dividend in July 2019 - it has paid a cash dividend every quarter since becoming public in 1972. Friedman has also delivered positive earnings for every year since inception, except for 2017 when steel prices were coming off of multi-year lows with energy markets experiencing a downturn and steel markets oversupplied.
Recently, Robert Sparkman retired as Friedman's CEO after 39 years with the Company and Dale Ray retired as Vice President at FRD's Hickman, Alabama plant after 47 years with the Company. Michael J. Taylor, Chairman of the Board, assumed the role of (interim) CEO with the intent to thoroughly evaluate the Company’s operations to recognize strengths, capitalize on opportunities and mitigate risks. In his words, "Friedman does a lot of things "right" but there are also areas for improvement that we are actively working to address." (Source)
With that said, we believe that the shares of FRD have dropped by too much in the recent months and are currently undervalued.
We like to take a conservative approach to valuation, especially when considering the valuation of a company engaged in the commodities market. While FRD has a long-standing record of dividend payments these dividends have not been of a consistent amount - they have rather fluctuated some, which shouldn't come as a surprise as the Company is a price taker.
For that reason, and since we cannot reliably count on a steady earning power, we feel it prudent to use the value of assets (in orderly liquidation) as an indication of what FRD should be worth to a conservative investor.
Below we have listed the most recent balance sheet according to Annual Report 2019 (fiscal year ended March 31, 2019) with reasonable estimates for what each asset can be expected to recover in orderly liquidation:
|(USD in Thousand)|| |
March 31, 2019(year-end fiscal 2019)
|Accounts receivable, net||13,183||100||13,183|
|Other current assets||544||50||272|
|Total current assets||74,456||64,372|
|Property, plant and equipment|
|Buildings and yard improv.||8,821||20||1,764|
|Machinery and equipment||38,177||20||7,635|
|Total stockholders’ equity (liquid. value)||72,482||53,914|
As of March 31, 2019 the Company had (weighted average) outstanding shares of 7,010,266. Net current asset value (NCAV) is $60.3 million ($8.6/share).
Based on the above estimate and the number of outstanding shares, FRD has an asset (liquidating) value of nearly $54 million, or $7.69/share. This is significantly above the current market cap of approximately $43.7 million and market price of $6.18/share. That is, we believe FRD to be worth nearly 25% more than it is currently selling for in the market.
Note on the above estimate: Given that Friedman is very conservatively financed with nearly no debt we think it makes good sense to consider any kind of liquidation of its assets to be fair and orderly. Therefore, FRD shouldn't have any problem collecting its receivables (it usually does so within 30 days), while inventories should be expected to fetch close to market value (note: we would recommend hedging any investments in FRD by taking an opposite position in another relevant steel security to protect against drop in value).
The Company owns the land, buildings and machinery on all its manufacturing sites. While the accumulated depreciation is nearly equivalent to the cost of machinery and equipment we think it is reasonable to assign a moderately low recovery estimate of 20% for other property (these are mostly warehouses in industrial sites or in open territory where they may be of little if any use to other parties). Land is set at 100% (it might very well fetch more), and other assets (non-significant) are set at 50%.
What are the main risks? (i.e. the risks of not getting at least liquidating value)
- Steel Price: FRD is a commodity producer. Hence it is a price taker and largely subject to fluctuations in steel prices (tariffs included). Just like with other steel companies, the value of the Company is therefore likely to follow the price of steel (e.g. value of inventory to be sold falls with lower market prices). However, this risk can be hedged and the value "locked in" by taking a short position in a relevant steel security (e.g. SLX ETF, a portfolio of other steel companies, or any other relevant securities).
- Size: FRD is small. With a market cap of under $50 million and annual sales around $100 million it faces great competition and may not have the same market share or "staying power" as other larger competitors. However, Friedman has been around for a long time, paid dividends for 190 consecutive quarters, been profitable every year but one since 1965, and is very conservatively financed. Despite a small size, its customer base is still quite large (over 125 customers "located primarily in the midwestern, southwestern and southeastern regions of the United States", with no customer accounting for more than 10% of sales (except for Trinity Industries, which accounted for 21% of sales in fiscal 2019), source). Tariffs also provide additional protection by directing customers away from foreign producers and increasing demand to the US-based Company (FRD has mentioned this as a significant driver of increased demand during fiscal 2019). These are all factors that diminish the risk and enable it to manoeuvre changes in demand, supply chain, and the cyclical and competitive nature of the business.
Other general risk may also apply (see Annual Report 2019).
We believe that shares of FRD are undervalued. Based on our estimate of the Company's asset value (in orderly liquidation), Friedman Industries is worth approximately $54 million, or $7.69/share. This offers nearly 25% upside to the current market value of $43.7 million ($6.18/share).
While the commodity-based nature of the business and the Company's relatively small size may make it seemingly vulnerable, we believe that the conservative management of FRD with debt-free balance sheet, diverse customer base, positive earnings record and long-standing history of consecutive dividend payments, overweigh the risks and lend it a credibility that investors will appreciate. In addition, investors have the ability to hedge against fluctuations in steel prices - thereby positioning themselves to capture the asset value spread while protecting against changes in the price of steel.
Although commodity prices will always affect the bottom line, Friedman has started to experience growing demand due to the imposing of tariffs. Since Friedman Industries is US-based and primarily serving customers in the United States it is likely to see further benefit from the tariffs, resulting in improved operating results that may serve as a potential catalyst for a share price reversal.
In addition, noting that recently FRD shares have deviated from their usual following of steel prices (see chart #2 above; price of FRD should be rising as the value of the firm is generally positively associated with higher steel prices), the current uptick in steel prices may further boost earnings and catch investors by surprise as FRD reports better than expected earnings (causing the share price to "close the gap" and revert back to following steel prices more closely).
Simply put, positive demand-effects from tariffs and (currently) rising steel prices are likely to improve earnings and enable FRD to release better than expected earnings (for the current quarter), which again will serve as a catalyst for the undervaluation to correct itself.
Overall, we believe that a (hedged) investment in Friedman Industries offers a great low-risk opportunity that may yield up to 25% return when FRD releases next quarterly results (in August), if not sooner.
Disclosure: I am/we are 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.
Additional disclosure: We are short SLX.