AM Castle is a distributor of metal products (and a small amount of plastics) to a wide variety of industries. Aerospace accounts for approximately 25% of sales and oil and gas post the company’s recent acquisition of Tube Supply also represents around 25% of sales. Outside of these two end markets, various industrial markets, e.g., machine tools, each make up less than 10% of sales. Stainless and nickel products account for around 20% of sales, aluminum products (primarily aluminum plate for aerospace) another 20%, with various alloy products (bars, etc.) and tubular goods (primarily for oil and gas) making up another 15% each, with the balance made up of carbon steel, titanium, and plastics. Our work suggests that AM Castle specializes in products that are at the tail end of the supply chain. They are the supplier of last resort for many of their end markets and in turn are later cycle than most metal distributors. A significant portion of their products involves some value add.
High Level Thesis
We have earnings data for AM Castle going back to 1983. The business as changed very little. Historically they have grown both organically (taking share from smaller companies in a fragmented market) and through bolt on acquisitions (their recent Tube Supply purchase is the largest deal they have ever done) and in turn the historical numbers are very clean. In the 1984 peak the company made around $0.50 in EPS. In the 1988 peak they made $1.00. In the 1995 peak they made just under $2.00 and in 2006 they made just under $3.00. We do not see any reason why the next peak will not result in over $3.50 in EPS with the stock trading at $10.30. On any metric we see the potential for the stock price to double or triple over 3-4 years.
AM Castle Past Peak EPS
Why the Opportunity Exists
As in past cycles AM Castle has been slow to rebound. Investors have become impatient waiting for the steep pickup in earnings typical of CAS’s up cycles. In particular, analysts are focused on the continued overhang in aluminum plate for aerospace driven by stubbornly high inventories that were built through the chain in the downturn. Beyond this the company closed on the Tube Supply acquisition in December 2011. This was a $184m acquisition (including working capital) for a $250m company. To complete the acquisition they issued two tranches of expensive debt: $225m in 2016 senior secured notes at 12.75% and $50m 2017 convertible senior notes yielding 7% that convert at $10.50 (good for those involved in the private financing and likely putting short pressure on the equity; long term can be up to 20% dilutive). The Q4 earnings release last week was messy with some weakness in gross margin from the recent decline in metals prices and considerable noise from the acquisition accounting and new debt (which includes a lot of non-cash components, to be discussed below).
Gross Margins and Aerospace
AM Castle Gross Margins (ex depreciation) vary from 24% in troughs to just over 30% at peaks. In this cycle margins troughed at 24.7% in 2009, rebounded to 25.7% in 2010, and came off slightly in 2011 to 25.3% (not atypical in rebounds). Management had indicated that legacy business gross margin could get back to 27% by 2012 but guided on the Q4 call to margins “above 26%”. Most analysts are now assuming margins just below 26%. We believe management will achieve its guidance and could do better. The rebounding commercial aerospace cycle alone can get them there as some legacy contracts roll off and aluminum plate inventories continue to normalize (as many players in the aerospace supply chain have acknowledged is occurring). We assume a 26.1% gross margin for 2012 but see upside to this number. Beyond 2012 margins should continue to improve as commercial build rates increase and their contract for the F-35 kicks in in full (defense is 25% of aerospace and should improve even with flat F-35 sales). As the cycle moves closer to peak (continued commercial build rates, general improvement in supplier operating rates) margins can get back to 28-30%.
Oil and Gas and Tube Supply Acquisition
Tube Supply was a major acquisition for the company. Before the acquisition oil and gas was around 15% of sales and will be 25% post. CAS’s legacy oil and gas sales were more geared to bar products that go into drilling applications. Tube Supply is almost all tubular goods that go into production type applications. Tube Supply has a better margin profile with 30% gross margins and 20% EBITDA margins (legacy EBITDA margins are 5-10%). Management is very optimistic about the oil and gas business and has guided to 15+% sales growth and Tube Supply margins staying at these high levels. The overall rig count in the US bears watching since it may flatten out as the 20% that go into dry gas drilling will likely decrease. However, we believe that well complexity and production from wells drilled as the rig count ramped will still provide robust revenue growth.
Operating Cost Leverage and Debt Paydown
Historically for the legacy business management has guided operating costs (including D&A) to grow at 10-12% of sales growth. In 2011 they fell well short of this putting up an incremental 12.5% (adjusting for the two weeks they owned Tube Supply). They guided on the call to 10-11% for 2012 and analysts are assuming 11+%. We assume 11% but believe we could see an even better number as 2011 was inflated by some ramp-up and overtime costs we do not expect to recur.
Cash interest expense post Tube Supply has gone from just under $5m to $33m. The acquisition added $44m in EBIT (and in turn is cash accretive). There is another $8.6m in non-cash interest expense (the debt was issued at a discount etc.) and $5m in intangible amortization. The debt is all secured and requires paydown beyond a certain level of free cash flow. The additional interest expense equates to $0.85 in EPS that will provide an earnings lever in the future (and will more than offset the 20% dilution we will probably see from the convert post 2017).
EPS and Cash EPS Expectations
Management guided 2012 sales growth to 10-15% “for all businesses”. We assume 13% topline growth for the legacy business and 10% for Tube Supply. However, we assume lower and decreasing margins for Tube Supply through the period. In turn we do not have any earnings growth for Tube Supply, which we consider conservative (management believes margins will stay flat). Note that the non-cash charges equate to around $0.35 in EPS. AM Castle also has an equity JV that has been doing well. We assume very little growth for it going forward. Our numbers include only $25m in debt paydown at the end of 2013 (to impact 2014). This could also be conservative
Drivers and Earnings (Non-Cash and Cash)
Enterprise Value (000 $)
Legacy Sales Growth
Legacy Gross Margin
Tube Supply Sales Growth
Tube Supply EBITDA Margin
EBITDA (Legacy+Tube Supply)
Equity JV Earnings (Pre-Tax)
EV/EBITDA (with cash build)
EV/EBITDA+JV (with cash build)
Even on non-cash numbers we see the stock trading at around 4x 2014 (a year we don’t see as peak on debt paydown alone) and 3x on a cash basis. At 8x the stock is a double but could trade at higher multiples as the non-cash items get closer to cliff ($0.35 of EPS) and debt paydown quickens ($0.85 of EPS to get back to 2011 levels). At 12x you have a triple.
-Tightening in the Aerospace supply chain
-Continued strength in oil and gas
-Other industrial businesses continue to improve with the economy
-Debt paydown starting in 2013 and investor understanding of the non-cash charges