Description

I am recommending a short sale of ERS. I believe that this play offers a rare opportunity to take advantage of momentum buying which should shortly come to an end, and be replaced by panic selling of a stock that is dramatically overvalued and overbought.

The near term catalyst for this stock's fall from grace is very clear and very powerful. But before we get into that, let's marvel a bit at just how extraordinarily overvalued ERS is.

In the last four quarters, ERS has reported total FCF of $4.9M. ERS's market cap is currently about $440M. ERS therefore trades at an astounding 89 times FCF. ERS has shown no sequential growth in the last 3 quarters and won't next quarter either (see below). Amazing for a company trading at 89 times FCF.

ERS is an order taker. They don't treat aluminum, and they don't distribute it either. They just place orders for customers. ERS does not do business in China. They deal with customers in Australia, New Zealand, Canada and US. They have no upside from China's fast growing market.

A few weeks ago, ERS reported a backlog of $88M. Looking back to 2000, only once has ERS reported a Q1 greater then their backlog and that was in 2003 when they had a backlog of $52M and reported $53M in revenues. So again ERS will show no growth this quarter as revenues will likely be < $88M.

Over the last 2 quarters, ERS has seen their gross margins decline from 8.5% to 7.2%. Pricing pressure is growing. This makes sense, given that the company has no barriers to entry.

RYI accounts for 60% of ERS's revenues. Last year RYI bought the steel distribution biz from Alcoa. Given RYI's new relationship w/ Alcoa, they could easily drop ERS as ERS provides no incremental value to them. 60% of ERS's aluminum supply comes from one source. Given aluminum demand, this source could end their relationship with ERS tomorrow and ERS stock would go to $0.

Even assuming that the RYI relationship remains status quo, comparing RYI's and ERS's valuations helps to illustrate just how overvalued ERS is. RYI is in the same business as ERS, is a good comp for ERS, and trades at 8 times earnings. Even companies like CENX that actually produce aluminum trade at less than 10 times forward earnings. Can ERS forever trade at 45 times earnings when their comps all trade at 10 or less? I think not. 10 times ERS's $.98 in earnings would put the stock at $10.

ERS is run by a husband (CEO) and wife (CFO) team. They have 5,000,000 shares. Don't be surprised to see large insider sales after earnings, which will end the stock's current short squeeze induced rally. They had no problem selling 200,000 shares last year at $12 when the stock was trading 200,000 shares a day.

For all of these reasons, ERS is extraordinarily overvalued. But that alone wouldn't be sufficient for me to recommend shorting this stock, absent a near term catalyst. Fortunately there is such a catalyst- ERS's imminent expulsion from the IBD top 10 list.

ERS has been the number 1 ranked stock on the Investors Business Daily top 100 list for several months now. As anyone who follows IBD knows, IBD #1 picks often attract massive momentum buying. That is exactly what has happened with ERS over the last several months, since it moved to #1 on the IBD list.

However, when ERS next reports earnings (due out by May 15). they will lose their IBD #1 rank due to lack of EPS growth...and the impact of this on ERS's stock price will be devastating.

Backlog at the end of last quarter was $88M. Look at the Q4 backlog and resulting Q1 numbers from the last 4 years:

Q404 Backlog: $80M
Q105 Revenue: $80M

Q403 Backlog: $53M
Q104 Revenue: $54M

Q402 Backlog: $52M
Q103 Revenue: $45M

Q401 Backlog: $50M
Q102 Revenue: $40M

I could continue, but I think you get the picture. ERS's revenue number never exceeds their backlog in Q1.

ERS's IBD rank is to blame for this huge run in the stock. Were ERS to lose that rank the bubble would pop and the stock would return to a valuation in line with its peers. The key to ERS and any IBD #1 is its EPS score. The EPS score takes the last two quarters' earnings growth rate and compares that across all stocks. A revenue result of $88M based on ERS's backlog would mean roughly $.24 in EPS. This is inline with Q105, which means 0% EPS growth. Accordingly, its EPS score will drop into the low 90s and ERS will clearly lose its IBD #1 rank.

This will be devastating for ERS, because the stock is in an IBD #1 bubble. Look at past similar examples (HRT, ESMC, LWAY, TZOO, CUTR, NGS, FORD). HRT, NGS, TZOO and FORD are most similar as like ERS they reached ridiculous valuations with no barriers to entry in their businesses. In each case the stocks dropped roughly 75% from their highs.

It's important to note that, once an IBD 100 stock drops 35% from its all time high, it is removed from the IBD 100 list altogether. In ERS's case, that will happen when the stock drops to around $29 which I expect to occur shortly after the company reports. Being removed from the list entirely will be a further downside catalyst for the stock, as it was for the prior IBD #1 stocks listed above.

Catalyst

1) ERS falling out of the IBD top 10, and then completely out of the IBD 100.

2) ERS's extreme overvaluation being recognized by the market after lackluster Q1 earnings, and the stock returning to a sane valuation.