Description

Thesis

Let’s paint a picture of what nobody wants to own: small/microcap, value, non-indexed, commodity sensitive, cyclical, illiquid. For those of us who fish in this pond, the opportunity set is as good as it’s been since 2008, and in some ways, the small cap infrastructure is as dismantled as it’s been since 1999/2000; client redemptions are inexorable and funds are liquidating. Against this backdrop of woe, valuations are truly enticing. But you have to have a client base that allows you to be early. It seems to us that a true long term orientation is really the only competitive advantage that exists---hedge fund pitchbooks notwithstanding.

If you crack open a copy of Monish Pabrai’s The Dhando Investor, there’s a section on Universal Stainless from the 2002-2006 period.  It is striking how much it rhymes with today’s fact set. The take-away is as much about human psychology as it is about economics. Downturns are always scary, the future is always murky, and when you’re in a cyclical trough nobody can see the light at the end of the tunnel. Yet we muddle through without knowing how a priori. The dollar’s strength, China’s massive capacity expansion, a domestic recession scare…..these are all that investors see right now. We aim to find companies that can weather a protracted period of severe weakness and emerge competitively advantaged. We think Universal Stainless is such a company.

Company Description

Universal, which was incorporated in 1994, and its wholly-owned subsidiaries, manufacture and market semi-finished and finished specialty steel products, including stainless steel, nickel alloys, tool steel and certain other premium alloyed steels.  Our manufacturing process involves melting, remelting, heat treating, hot and cold rolling, forging, machining and cold drawing of semi-finished and finished specialty steels.  Our products are sold to service centers, forgers, rerollers, original equipment manufacturers (“OEMs”) and wire redrawers.  Our customers further process our products for use in a variety of industries, including the aerospace, power generation, oil and gas, heavy equipment and general industrial markets.   We also perform conversion services on materials supplied by customers.

We operate in four locations: Bridgeville, Pennsylvania; Dunkirk, New York; North Jackson, Ohio and Titusville, Pennsylvania.  Our corporate headquarters is located at our Bridgeville location.  We operate these four manufacturing locations as one reportable business segment.

Our products are manufactured in a wide variety of grades and melt qualities including argon oxygen decarburization (“AOD”), electro-slag remelted (“ESR”), vacuum induction melting (“VIM”) and vacuum-arc remelted (“VAR”).  At our Bridgeville and North Jackson facilities, we produce specialty steel products in the form of semi-finished long products (ingots, blooms, billets and bars) and flat rolled products (slabs and plates).  Semi-finished long products are primarily used by our Dunkirk facility and certain customers to produce finished bar, rod, wire and plate products.  Finished bar products that we manufacture are primarily used by OEMs and by service center customers for distribution to a variety of end users.  We also produce customized shapes primarily for OEMs that are cold rolled from purchased coiled strip, flat bar or extruded bar at our precision rolled products department, located at our Titusville facility.  (from most recent 10-K)

End Markets

Aerospace: 60%

Power Generation: 10%

Energy:  9%

Heavy Equipment:   8%

The Balance Sheet

The 2015 10K hasn’t been filed yet so I’ll reference the condensed balance sheet included in the most recent earnings release.  Tangible book value is roughly $26. Importantly, three of their four plants have been depreciated to zero, so this figure is likely substantially understated. Working capital covers short and long term debt and goodwill has been written down to zero, so book value is all tangible.

North Jackson

The company bought the greenfield facility in 2011 for 129mm; since then they have invested roughly 65mm. The purchase was part of the strategic vision towards becoming a specialty alloy company able to charge premium pricing (with premium margins) rather than be beholden to the cycles of a typical steel company. We have toured the facility (and even lost a wedding ring there---better than in Vegas). The plant is clean, quiet, and extremely automated: there were probably 8-10 employees on the floor when we were there. There is lots of excess land should the company decide to expand the facility in the future.

Recent Refinancing

On January 22^nd, the company announced a refinancing of both their credit agreement and their convertible note. PNC and Bank of America entered into a 5 year 95mm facility, split 50/50; PNC was an existing lender while Bank of America put fresh money to work.

For the convertible piece the seller extended out to March 2021. In return for this he demanded a 1mm principal payment at the close. To meet this, and still placate the senior lenders, the company entered into a sales/leaseback on a piece of machinery that netted them roughly 500k. The balance was paid in by insiders as italicized below.

The long and the short of it is that the refinancing gives the company another 5 years of runway and is a testament to the fact that the lenders took comfort in the collateral.

2015

This past year saw a confluence of events that made it one to forget. The company’s service center customers were in destocking mode and the aerospace supply chain took the brunt of this working capital burn-off. To boot, nickel, molybdenum and scrap iron were down 45%, 47%, and 63% for the year. That created enormous p&l pressure as the company is forced to pay market price for their input costs but recognizes sales pricing on a two month lag: a deflationary environment, especially a rapidly deflating one, creates an unfavorable timing mismatch which cost the company about $.50 of earnings.

Earnings History

2015                       ($.52)

2014                       $.58

2013                       ($.58)

2012                       $2.13

2011                       $2.65

2010                       $1.95

2009                       ($.44)

2008                       $2.08

2007                       $3.39

2006                       $3.20

2005                       $2.05

Of note, remember that the North Jackson facility wasn’t really completed until 2014, so the earnings numbers above don’t reflect the potential contribution of their newest, highest margin facility. We don’t endeavor to predict normalized earnings with anything approaching precision (we don’t even have excel spreadsheet models here!), however we’ll take a stab at what the company could earn in a recovery scenario. Simplistically, a commoditized company that can’t earn a double digit ROE in an upcycle probably shouldn’t exist; that would point to at least $2.60 of earnings-a number more than borne out by history.  The company in the fourth quarter was doing roughly 120mm of annualized revenue-down from 185-190mm a year ago. Should the company get back to a 250mm runrate I believe we’d see gross margins in the high teens which implies roughly 45mm of gross profit or about 24mm of pretax income---significant given the current 50mm market cap.

Insider Activity

Ross Wilkin, CFO, buys 1,000 shares on 11/2 @ $8.75

Dennis Oates, CEO, buys 2,500 shares on 11/3 @ $9.42

Mcintosh Graham , VP, buys 2,500 shares  on 11/3 @ $9.16

Christopher Zimmer, VP, buys 3,000 shares on 11/5 @ $11.00

Dennis Oates, CEO, buys 2,500 shares on 11/12 @ $11.16

Dennis Oates, CEO, buys 11,863 on 2/1 @ $6.83

Christopher Ayers, Director, buys 11,859 on 2/1 @ $6.83

Douglas Dunn, Director, buys 11,859 on 2/1 @ $6.83

David Kornblatt, Director, buys 11,859 on 2/1 @ $6.83

Udi Toledano, Director, buys 11,859 on 2/1 @ $6.83

Mcintosh Graham, VP, buys 3,660 on 2/1 @ $6.83

Larry Pollock, VP, buys 3,660 on 2/1 @ $6.83

Christopher Zimmer, VP, buys 3,660 on 2/1 @ $6.83

Paul McGrath, VP, buys 1,464 on 2/1 @ $6.83

Ross Wilkin, CFO, buys 1,464 on 2/1 @ $6.83

Conclusion

Universal Stainless is a well managed niche company that has the balance sheet to survive a protracted downturn in the specialty steel market. It is trading at levels that express doubt as to its viability. However, we believe that its earnings power is not only intact but actually higher than history suggests due to the expansion of its fixed asset base since the last up-cycle.  The combination of operating leverage and lack of financial leverage offers a patient investor the chance to participate in an earnings recovery while having the downside reasonably well protected. 

Catalyst

Trade sanctions are enacted that provide some pricing relief. 

Distressed players file for bankruptcy.

There's consolidation in the space.