Description

Thesis

Friedman Industries (FRD) is a quiet, thinly-traded microcap (36 million) steel processer that is a slam-dunk play on already-expanding oil and natural gas pipelines.  FRD currently trades around a conservative liquidation value and has the potential for a capital-appreciation return of between 20% - 65% in the near term (under 1 year) with potential to return over 100% in the long term (1 year plus), plus dividends received in between.

The thesis is very simple:  FRD operates an essential service for US Steel that was paused in 2009 because US Steel temporarily idled a nearby facility.  That facility is now back online and orders have resumed at near previous paces, but the stock price has not responded accordingly.  We believe that the market has not yet priced a) the nature and b) the value of this relationship into the stock, which we think will change as the company continues to report higher sales volume quarter-over-quarter in its Tubular segment.  In addition, FRD now trades around a conservative estimation of liquidation value (net-net) which limits downside risk.  So far, we have one quarter of confirmation.  We expect to get another around the mid-August Q2 10-Q release.

We argue that a mispricing has occurred here due mainly to the size of the company.  The company 1) has no analysts following 2) has hardly any institutional interest 3) doesn't hold earnings calls and 4) doesn't release 8-ks announcing its earnings and providing guidance.  The only information gleaned about the company is that reported in 10-Qs and 10-Ks four times a year (and what we can guess from dividend payouts).

Company Details

The FRD story is pretty straightforward.  The company has existed for 45 years as a family-owned/operated corporation doing pretty much the same thing - processing hot-rolled coils into sheet and plate (Coil Segment) and cutting and finishing tubular steel goods (Tubular Segment), both of which it sells wholesale.  FRD owns three factories - hot-rolled processors in Hickman, Arkansas and Decatur, Alabama and a Tubular Goods processor in Lone Star, Texas.  The business as a whole is a good one and run impeccably well, as witnessed by the length of time in operations.  The company has been profitable every year of record (since 1990) and likewise has paid a dividend every quarter, corresponding to profitability. 

FRD also has a sort-of-hidden third business, which is the focus of our report.  From the most recent 10-k: "In recent years, the Company has manufactured and sold substantially all of its line and oil country pipe to US Steel Tubular Products .... Historically, USS has been our primary supplier of tubular products." These quotes suggest that FRD buys (a type of) pipe from US Steel, processes it, and sells it back for a profit.  This is a servicing business, and one with little competition, substitutes, or threats of new entrants.  This is not a commodity business as the market / company reports could lead one to believe.

In other words, this third business - and 30% of the company's revenues in FYE 2009 - is FRD's relationship with US Steel (which is accounted for in the Tubular segment).  FRD can do this because its plants are a) capable (obviously) and b) very close to the US Steel facilities, providing US Steel with a lower cost alternative than building the plant itself or purchasing the pipe from another supplier farther away.  Most significantly, it is likely that the low-cost nature of this relationship is vital to the relative cost position and / or quality of the US Steel product, and it is precisely the resumption of this relationship that we think the market has a) discounted completely or b) not yet recognized.

The following chart shows tonnage sold and total revenues for the past 12 quarters:

Clearly we can see a recovery in the Tubular segment from the FY 2010 lows and a corresponding recovery in revenues.  We attribute this 10,000 ton bump Q-to-Q entirely to the resumption of the relationship with US Steel.  As a reminder, FRD reported that the plant was idled in February 2009 and reopened in February 2010. 

Downside protection

The company's balance sheet is rock-solid, leaning towards cash-heavy.  The company has $2.91 per share in gross cash and $1.64 per share in cash less liabilities.  Our liquidation analysis is as follows:

And, since the company books inventory at the lower of cost or market, it is possible that the market value of the inventory is higher than book value, but not the other way around.  In addition, this liquidation value ascribes hardly any value to the property under liquidation.  Ultimately, this suggests that our liquidation value is conservative.

Projections and Valuation

We project three cases:

• 1) A base case, where Q4/2010A is a run-rate for the year. In this scenario, we project 92 million in sales and 0.64 in earnings per share. This implies an EV/sales value of 0.18 and a PE ex- gross cash of 3.88.

• 2) A worst case, where revenue dips back to near FYE 2010 values. In this case, we see about 70 million in sales and 0.40 in earnings per share. This implies an EV/sales value of 0.24 and a PE ex-gross cash of 11.84

• 3) A best case, where the Tubular segment sales return to FYE 2008/2009 levels. In this case, we see about 120 million in sales and 0.80 in earnings per share. This implies an EV/sales value of 0.14 and a PE ex-gross cash of 3.11.

In our valuation, we average the price according to the historical average PE ex-cash (8) (plus gross cash) and historical average EV/sales (.27) to each of these scenarios and weight them accordingly.

• 1) Base case : 7.33
• 2) Worst case: 5.14 (note - this is significantly lower than liquidation value)
• 3) Best case : 8.50

In an equal weighted scenario, this stock should trade at about $7 per share, providing 20% upside to the share price.  In an overweight positive scenario (50% best, 50% base, 0% worst), the stock should trade at about $8 per share today.  At the current share price of 5.4, it seems that the market expects a significantly higher percentage chance of the worst case scenario than we do, especially considering what we know about nature of the relationship with US Steel (and its previous resumption).

In addition, US Steel recently reported excellent results and positive guidance for their Tubular segment, mostly due to strong demand and a continuing decrease in supply from Chinese steel manufacturers (got to love protectionist trade rulings).  US Steel did suggest that the market will be maturing soon (1 to 2 quarters out), suggesting that there's still a bit of growth before a run rate is appropriate.

Additional upside

The stock has additional upside in two things:  1) dividend payments and 2) general economic recovery. 

• 1) As previously noted the company has paid out a dividend every quarter for the entirety of its publicly traded history (and longer, according to the company). Currently the company is paying an annualized 0.16 per share, but we expect that to double in the near term and return to more historical numbers. At 0.32 per share, the company would yield an additional 5.9% on top of the expected capital gains. We also think that increases to the dividend will attract investors and provided a catalyst for the stock.

• 2) Should general economic conditions recover (and with them, end-user demand for the non-US Steel businesses) we think the stock could reach as high as 10 per share based on improved volumes over our best-case analysis.

• 3) Huge swings in commodity pricing can become favorable. This happened in the first three quarters of FY 2009, and the company made record profits and, I might add, wisely paid down debt in the fat years to prepare for the lean years. Another testament to wise management perhaps?

Risks to the investment

• 1) Huge swings in commodity prices can hurt profitability. Because FRD buys and sells relatively standardized products, it is at the mercy of supply and demand for these products. However, the prices of both of these products are, for the most part, highly correlated, so that when input costs go up, (hot-rolled coil or unfinished tubes), output prices increase in a similar fashion. In addition, some of this risk is mitigated by the cost advantage FRD possesses in its factory locations.

• 2) A double-dip recession could reduce demand in total, especially for future energy consumption. This could have the effect of lowering CAPEX from oil and gas majors, reducing end user demand for pipes. This could lead to a potential re-shut down of the US Steel plant that resumed in February. We don't think this is likely considering our conversation with the US Steel Investor Relations manager and his confidence in this particular market. However, as previously stated, we think that the liquidation value provides significant downside protection to the stock.

• 3) Additional supply is coming online/being imported (at fair prices) in the Tubular market, which may take market share away from US Steel. We think the effect of this is minimal because US Steel ought to be able to successfully defend their share (supply is not overwhelming, US Steel has great customer relationships, quality of product is better). Nevertheless, this could limit upside somewhat in the long term.

Disclosure:

We own stock in FRD.  Do your own due diligence.

Catalyst

• Continued reporting of higher quarter-over-quarter sales volume in the Tubular segment (and better profitability)
• Increased dividends to correspond to higher earnings