Synalloy (ticker SYNL) is an attractive situation to long-term oriented investors seeking a small cap with diversified U.S. industrial exposure and good compounding growth potential. The stock isn’t cheap but I would say reasonable at 8.75x 2013 EV/EBITDA and 7.3x 2014 EV/EBITDA.    

The company operates two principal segments: metals and specialty chemicals.

The metals segment predominately sells welded pipe to the energy, chemical, and power generation industries. Stainless steel pipe is the largest sales volume product; and while it’s a relatively fragmented commodity business, the company is one of the country’s largest producers. It's hard to get really excited about this product though: the steel pipe business is competitive, volatile, and oftentimes foreign imports come in as a threat.  Most of the profit Synalloy realizes in pipe manufacturing actually comes from the higher value products it makes of carbon, chrome and other specialty alloys.  At the moment the company is experiencing an upswing in specialty alloy demand and that is expected to continue into next year. 

I suppose it could be argued that the main investment merit of the steel pipe business is its fixed cost absorption. But at the moment it too is doing well, and international demand for stainless steel pipe is actually fairly strong, in particular for Alberta oil sands projects.

Synalloy’s specialty chemicals business makes defoamers and lubricants principally for the water, petroleum, and chemical industries. It’s a steady business that generates good results. The chemical group has produced an annual 20.8% return on capital over the past 5 years, and an impressively high 27% ROC last year. Specialty chemicals represent approximately 20% of total sales and about 25% of the company EBITDA.  EBITDA margins in this business are on the lower cusp of what you see with other specialty chemical companies, and have averaged in the 11% to 13% range.  The segment should show some growth over the next few quarters. The defoamer product lines are trending well, and tightness in some markets will lead to favorable product pricing.  Margins for the segment will hold near current levels despite some ongoing increases in raw material prices.

Going back to the metals briefly. I want to add that Synalloy’s metal segment is more than just pipe: they also fabricate steel and fiberglass liquid storage tanks that are used in the oil patch. I think this specific business is a lot more interesting than pipe. It's not fully recognized yet as a material growth driver for the next coupole years.  Transporting giant steel tanks is expensive work, and the prospect of deliveries outside of a few hundred miles often become non-competitive solely because of costly logistics. One of Synalloy’s main tank facilities happens to be near the center of the Permian Basin out in West Texas, and that plant enjoys a significant competitive advantage by virtue of its location. Synalloy acquired the tank fabricating business last year, and has invested considerably to gain production efficiencies and eliminate bottlenecks at the main plant to increase tank production.  At the same time backlog has grown noticeably throughout the year, and the company anticipates continued strong sales of fiberglass and steel tanks as oil drilling continues to grow in the Permian Basin and Eagle Ford Shale areas of Texas.

Being in the heart of shale country has allowed Synalloy to cross sell a fair amount of other pipe and chemical products to drillers on favorable terms as well.  A lot of the organic growth in the segment will come from the continued capital investment by the energy sector into unconventional plays; and the success of Synalloy’s metal segment is somewhat tied to its customers’ unconventional drilling budgets.  I think the Eagle Ford and Permian plays will be around for while though, so this exposure is not something I’m particularly concerned with at the moment.

Here are some recent results.  

The 2013 forecasts EPS and EBITDA were taken from a company presentation made earlier this year.  It’s unlikely that those numbers will be met however because the commodity pipe business ran into some trouble earlier this year when stainless steel pipes started entering the U.S from South East Asia in first half of the year at prices below even domestic raw material costs. Synalloy and other US players were compelled to lower their own selling prices to maintain their market share, and the results were ugly:  pipe prices declined by 16%, the company lost significant volume and net sales were cut by $8.9mm. Operating profits fell by $2.7mm in the first two quarters of this year.  Synalloy and other domestic pipe manufactures ultimately responded by filing an anti-dumping petition with the U.S. Department of Commerce and the U.S. International Trade Commission, and although the formal outcome has been postponed by the government shutdown, it looks like there will be a resolution in their favor.  The dumping finally ended over the summer, and since then the company has put through several price increases that seem to have stuck.  I offer the botched 2013 forecast above more as a suggestion of what the company can do next year.  For 2013 I expect Synalloy will be closer to $18mm in EBITDA, which while a bit under forecast does extends the continue the earnings growth record of the past few years.

Synalloy’s potential continued growth is what makes its stock an interesting proposition.  The company has increased its profitability over time through organic growth, margin expansion, and acquisitions.  It’s the last point that is the most intriguing. Management has shown discipline when acquiring new companies: in the past they’ve focused on businesses in niche markets, with some degree of pricing power, stable margins, minimal cyclicality, and cross-selling potential in similar end markets. The acquisitions have generally been accretive and cash flow positive. SYNL has demonstrated an ability to digest small to mid size acquisitions with minimal operational issues on an annual basis. So while not a bargain, I’d say the stock's valuation is reasonable at this time. The company is growth and cash flow oriented.  The expansion strategy should produce long term value as SYNL continues to make small to mid-size accretive acquisitions every six months that complement existing businesses and generate returns above the company’s cost of capital.  A valid concern is how the company’s acquisitive approach might threaten the balance sheet threat, but for the most part management has acted conservatively and kept the balance sheet strong with below average industry leverage. The company recently raised $35mm in an equity offering, so there’s ample if not excessive liquidity available to them at the moment.  I expect they’ll be announcing a deal in the $25 to $30mm range sometime in the next 6 months.