Description

USAP is a specialty steel manufacturer primarily for the aerospace industry. It has a market cap of ~$77 million, net net current assets of $54 million, and has conservatively another $163 million of PPE on its books (conservative since it includes 2-3 fully depreciated facilities - the company only has 4 facilities). Assuming 33% of the conservative PPE balance sheet figure, you get a "liquidation value" of ~$100-110 million, or ~35%+ upside to the current price.

More importantly, as a result of the return of aerospace from covid (~70% of TTM sales), the company is likely to earn around ~$30 million in unlevered free cash flow and $22 million FCFE in ~2024/2025, putting the company at ~5.5x EV / FCF and ~3.5x FCFE. At 10x the unlevered figure, it's worth ~$24 per share compared to ~$8.7 per share today. The current price offers us a free call option on an aerospace recovery which is (1) already well underway and (2) very unlikely to be derailed over the next few years even assuming a recession. 

So what's the rub? For all intents and purposes, USAP is what many would call a cigar butt:

- It exists in a commodity industry which is cyclical;

- Its results can be subject to significant price swings in related commodities; 

- It has a unionized work force;

- It is capital intensive (there are significant working capital investments required and substantial fixed assets);

- It has some debt (though I think the risk is low);

- and it's historical operating results and returns on capital have not been good (though I think this has been a result of self inflicted issues that are in the process of resolving, as is discussed below)

I think that these risks are more than reflected in the current stock price. For those that aren't thrown off yet, I would point you to blackstone's 2016 post on the company, which broadly covers the events up to 2016. In short, the opportunity we're being presented with today is substantially similar to the circumstances that led to blackstone's post and a substantial increase in the stock price.

(1) Background 

The main part of the USAP story that's relevant is that since the purchase of the North Jackson facility in 2011 (completed in 2014), the company has been trying to pivot to selling more premium/specialty alloys which carry higher margins than traditional products and which are primarily sold into the aerospace end market. It should be noted that North Jackson was purchased as a greenfield facility -- it came with no revenue, and USAP has had to grow this business from $0. As a result, USAP's consolidated operating results have taken a hit for basically the past decade as they have been growing this business, though that should start to change in the next few years as the facility gets more capacity utilization and builds upon progress made leading up to covid.

For some brief history on the facility, Denny (the CEO) initially thought that it would get to ~$100 million in revenue by ~2014/2015, at which point the facility would be operating at ~85% capacity. Clearly his goal was not achieved (see the table below). These premium products take a long time to get approved by the aerospace OEMs, and it seems that this was underestimated by Denny. Rolls Royce, for example, was one of the first key customers to approve of USAP's products and that process alone took 2-3 years (they sent personnel over from the UK to literally come and watch USAP physically produce product across all four of its facilities to make sure it is up to standards). Moving to today, the facility now also has many other blue chip aerospace customers like GE Aerospace and Pratt & Whitney.

While the process has taken a while, organic revenue growth has actually been pretty solid over time, end market cycles notwithstanding. What's also notable to the below is that oil/gas represents a decent portion of premium sales, and anyone following the space knows that capex there took a nose drive from 2013-2019. It's now looking like this part of the business will recover soon too, which I touch on later, and will likely add to the upside (though I have not accounted for it).

 Premium alloys (revenue, % of sales):

2012: $11 million, 4%

2013: $11 million, 6%

2014: $14 million, 7%

2015: $18 million, 10%

2016: $14 million, 9%

2017: $27 million, 14%

2018: $41 million, 16%

2019: $38 million, 16% 

2020: $35 million, 20%

2021: $26 million, 17%

2022: $39 million, 19%

2023E: $50 million, 20%

As I mentioned, over the past decade this acquisition likely resulted in margin erosion. When you're a steel manufacturer and you're operating a facility / furnaces at low utilization levels, your margins are not going to look good, and the business has seen that over the past decade with EBITDA remaining below pre-acquisition peaks (thanks in part also to the oil/gas downturn). In 2018, for example, the business earned EBITDA of $36 million vs. a prior peak in 2011 of ~$39 million (though this was on much lower volumes than in 2011). The result has been much lower returns on capital than has historically been the case (single digits vs. low double digits prior to acquisition) and for longer than has historically been the case.  

However, what is promising here is that growth in the premium melted products has continued on a relatively steady pace, and more importantly sales are likely to be roughly equal to or eclipse the 2018 peak in 2023 (on a shipped tons basis). This is important because the aerospace industry is going to be operating at well below 2018 levels of production in 2023, so it suggests that if we do return to historical norms of production (which in my opinion is likely), then premium sales would be much greater than in 2018. Once the industry continues to recover in 2024/2025, operating leverage in the facility should begin to show rapid improvement in reported results, and I suspect the company should be setting new records in consolidated EBITDA.

So, at a high level, some may call the bad results of the past decade a result of poor capital allocation. I wouldn't disagree with that. But, it seems to me that its more just a result a slower than expected (though still happening) ramp. Clearly the business has continued to grow - entirely organically I might add - but just not as quickly as planned. Combine that with the fact that oil/gas (which was 20% of the consolidated business in 2012) fell off a cliff in 2013/2014 with the oil price and E&P spend decline and you get investors to give up.

Fast forward to today and it seems like their investment should begin to bear some real fruit over the next few years with the aerospace supply chain picking up steam; more recently, Boeing/Airbus are now starting to plan for increases in widebody production rates, and specifically Airbus just said that they want to get rates up to roughly pre-pandemic rates by 2026. Given the length of the lead times right now in the aerospace supply chain, this means that USAP would start booking orders by around early to mid 2024 (currently, there is a 1.5 year lead time), and as a result backlogs should continue to increase over the next few years. To boot, USAP highlighted that production in January was at the highest volumes they've seen in the last two years.

For reference, here's a quick chart of their backlog: 

As a kicker, more recently the company also mentioned that the oil/gas markets are starting to recover amid an acceleration in E&P capex (management recently described orders in the sector as "panicked"). This is consistent with what other OFS companies are reporting, and should also help improve margins and sales in the coming year/few years.  

So, while the company hasn't generated the most consistent EBITDA in the world (as far as consistent goes with steel producers) and returns on capital haven't been great, I think a lot of this has been self inflicted and largely a result of the long-term view of management trying to get into the premium alloy business (though there are still some lingering effects like the precipitous decline in oil/gas). Just looking at the consolidated results over time doesn't tell the whole story. 

(2) Valuation 

In terms of projections, the company should be able to get to ~$250 million in sales in 2023. Premium alloys should represent roughly 20% of those sales. At roughly a 14% gross margin on $250 million in sales (this gross margin is ~100bps less than what they earned in 2018), operating profit would work out to ~$13 million. There are two key things to note in determining cash flow:

1. The company incurs significant excess depreciation over its actual required maintenance capital expenditures. For example, from 2013-2022, the company spent roughly $11 million on capex but recorded $17 million in depreciation and amortization. In reality, there is probably an even larger discrepancy between the reported figures since during this time they have been engaging in premium alloy growth capex. Denny hinted at this in one of the recent calls stating that he thinks maintenance capex is somewhere between $8-9 million, which is also consistent with what they spent in 2020 when discretionary expenditures had to be cut. I'll use $11 million moving forward to account for some inflation in maintenance capex requirements since then. Current D&A is ~$19 million, so the differential is ~$8 million. 

2. The company has substantial NOLs. As of 12/31/21, the company had state and federal NOLs of ~$40 million which wont start to expire until the early 2030s. 

Together, this means that 2023 cash flow is likely to be ~$21 million ($13 million operating profit + $8 million of excess depreciation - taxes of $0 given NOLs). On a 2023 year end EV of ~$170 million, that's not bad. You could also think about FCFE, which at ~$8 million in interest expense would be $13 million on a market cap of $77 million.

What's even more attractive, though, is that this is far from peak cash flow. Aerospace is only beginning to recover, and sales in 2024 should be meaningfully higher than 2023. I don't see why management's target of $300 million in sales (which would conservatively imply ~40k tons shipped at current pricing vs. 45k in 2018 during the last restocking cycle when oil/gas capex was also below where it will be in 2023/2024) is unachievable. At $300 million in sales and 15% gross margins, the company would likely produce somewhere in the range of ~$30 million in operating profit / free cash flow, with more upside should tons shipped recover to 2018 levels. The resulting stock price at 10x that figure would be ~$24 per share. FCFE would also be ~$22 million on a $77 million market cap. In my view, the probability is decent that the company would outperform those figures, though I have not underwritten such a case to remain conservative.

As a quick caveat, at the above level of cash flow, the company would be earning roughly low double digit returns on capital and equity. Obviously these are not great figures. That said, I would point out that this analysis assumes ~15% gross margins, which should be conservative since the mix to premium melted products should be higher than it was in 2018. Also, utilization of the premium facility would be higher, which should drive gross margin improvement. Interestingly enough, in Q2 and Q3 of 2022, the company earned gross margins of 12.6% and 12.8% (after backing out some one-time charges like their misalignments and spill), respectively on annualized volumes that represent just 60% of 2018 levels, so that would suggest gross margins should expand more than they did in 2018 as end markets continue to recover. Such gross margins in 2022 were also earned during a litany of issues, ranging from a very limited workforce, downtime on various machinery as the company waits abnormally long for MRO parts, interruptions from a spill, etc. 

So in short this is a lower quality business, and as a result is why I'm giving it just a 10x multiple. That said, you could easily underwrite an even lower multiple and still achieve satisfactory results from the current price. I would also highlight that management is expecting working capital to remain flat this year (working capital has been a major drag over the past few years as the company braces for the upcycle), which means the company will start generating real cash (they hope to pay down some debt this year). I suspect that this has been a concern in the past, but these businesses require significant upfront investment as cycles begin. 

(3) Downside

The most important thing about the idea is that I think the downside is substantially covered, and it should be very hard to lose capital here. Net net current assets accounts for ~70% of the market cap. Working capital is also not likely to be impaired - I don't think raw materials / inventories really go bad in this industry, and they can usually be readily converted into other types of products if the company's end markets for whatever reason are no longer viable and the company needed to liquidate. Assuming just a 10% liquidation value for the remaining PPE covers the market cap (note that most of the facilities were bought decades ago - some for pennies on the dollar - and are fully depreciated).

The debt situation here is also fine. Working capital covers the debt by 1.5x. Interest expense is running at $8 million per year and last year, on very depressed end markets and margins, the company produced $20 million in EBITDA after adjustments for the aforementioned one-time items. $20 million less the $8-9 million of maintenance capex covers interest expenses. I don't think there's much of any risk related to the debt profile. 

It is also worth noting what happened in the Q4 report -- the company reported quite poor figures with gross margins coming in at ~10% normalizing for a few items. This was a decline from the prior two quarters despite management being optimistic about gross margin expansion. The main unforeseen (and in my view, temporary) issue was unplanned equipment outages, namely due to weather as well as supply chain delays. For example, one of their pieces of equipment saw December operating hours decline by 30% sequentially as there was a delay in receiving parts. Other equipment saw freezing pipes as a result of extreme weather, and in the event the equipment needed repairs, there were continued delays in parts. Overall, maintenance and turnaround times are extended, and the company is also still relying on lots of contract labor to make up for the shortfall in employment (though, there have been significant sequential declines here as a result of easing labor conditions). Each of these have likely made the past few quarters bumpy in terms of margins, though I think in a more normal environment margins should be higher and more consistent.

So to sum up I think that this idea is just your classic heads I win, tails I don't lose bet, and the latter is what mostly attracts me to it. 

(4) Risks

Pricing per ton is elevated and could mean revert -- this is plausible, though I would highlight that the company has a history of increasing prices and those increases tend to be somewhat sticky through the cycle. For example, sales price per ton in 2018 was ~$5,750 and in 2011/2012 it was roughly $5,100. During this time, the cost of key raw materials such as nickel and molybdenum declined by 44% and 36%, respectively. Prices per ton should generally hold in line with inflation / wage changes, but will vary with the raw materials and I would find it unlikely that through the cycle base prices decrease without wages and other costs also decreasing. Also, I would find it very unlikely that you would see prices decline during an upcycle for the very thing the company sells.

Management could blow $ on growth capex -- this is certainly a risk, but one that I feel we are well compensated for at the current valuation. That said, it sounds like management is quite intent on premium alloy growth, and I would find it unlikely that there is another company "pivot" to warrant greenfield spend. 

Management could dilute shareholders with an equity raise -- this happened in 2018, when the company issued equity at ~$24 per share (seemingly well timed at that price), all of which was used to pay down debt. The company today is in a different position with its debt profile (there is less debt coming due within the year, all of their debt today is from a revolver while in 2018 there was substantial debt from a term loan and notes, and there is more remaining revolver capacity today than there was in 2018), so I think the risk of this happening is lower. 

DISCLAIMER: The Author currently holds a long investment in the securities of Universal Stainless (Ticker: USAP) and stands to benefit should the price of the security rise. The Author may buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of the Author, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security or as investment advice.

Catalyst

Recovery in aerospace end market (with oil/gas being a kicker)

Generation of cash as working capital investments slow