Description

Universal Stainless & Alloy Products, Inc. ($12.40) is a small niche oriented semi-finished and finished specialty steel producer. The company was formed in 1994 when management purchased two previously shut down facilities from Armco (now part of AK Steel) located in Bridgeville and Titusville Pennsylvania.

The product mix is 85% stainless steel, 5% tool steel, 10% other specialties. End markets served are: 34% aerospace, 29% power generation, 13% commodity, 11% petro-chemical, 5% tool steel, 8% other. The company is very customer focused with a blue chip customer list including GE and Carpenter Technology. USAP's management team is highly respected in the steel industry.

USAP was formed in 1994 when current management purchased a shuttered facility in Bridgeville PA from Armco Steel. As part of the original transaction, management negotiated several concessions that have helped make USAP the lowest cost producer in North America (according to the company), including (1) a labor agreement that is flexible, with lower wages (partially offset by profit sharing) and fewer workers; (2) no legacy costs (pension/health care); (3) and no environmental liabilities.

These three items provide USAP a cost advantage over most domestic steel producers. USAP is also one of the most efficient steel produces in the US. Sales per employee are higher at USAP than most domestic producers. Sales/employee in 2001 for USAP were $298,000 vs. $193,000 Allegheny Technologies and $193,000 at Carpenter Technology in 2001. Together these items make USAP the lowest cost producer in the North America, with some of the highest margins in the business. Despite the cyclical nature of the steel business, USAP has made money every quarter since they began operations in 1994. Few steel companies can claim such an achievement.

USAP has one of the best balance sheets in the steel industry. USAP has almost no debt, zero pension or other post-retirement obligations, and zero environmental liabilities. Despite this and one of the best operating records in the business, USAP is one of the cheapest publicly traded US steel companies, when taking into account its balance sheet, contingent liabilities and its steady performance.

Clarence Macaninch, the CEO of USAP, is one of the most respected executives in the steel industry.

Current Valuation:
Share outstanding: 6.35mm shares
Market Cap: $76mm.
Net Debt: $2.9mm net of cash on the balance sheet.

2001 EBITDA: $15.3mm
2001 EPS: $1.26
Maint Cap Ex: $3mm/yr.
Tangible Book value: $9.28 per share. (Historical book value is much higher. USAP significantly wrote down the original plant when they acquired it.)

EV/EBITDA= 5.1x
P/E = 10x
P/B = 1.x3
EV/FCF = 8.4 or an 11% yield.
ROA = 10%
ROE = 15%

But this is not the good part.

The Upside

On February 14, 2002, the company announced the purchase of certain assets formerly owned by Empire Specialty Steel, Inc. ("Empire"), from The New York Job Development Authority (NYJDA). USAP purchased the plant, located in Dunkirk, NY for $4.0 million which was made up of $1 million in cash and a $3 million 10 year note bearing 5% with no payments in the first year. Inventory and excess assets that will be sold at the plant are estimated to be worth about $4 million. So the plant was basically given to USAP for free.

The NYJDA is a public entity that lent Empire money in order for it to emerge from bankruptcy in 1999. Their original investment was not based on financial analysis, but rather on politics and their mission as a government agency to keep jobs at the facility. Empire went bankrupt again last year, and the NYJDA foreclosed on the assets. When they recently tried to find a buyer they were, again, only interested in keeping jobs and not in maximizing a return on their investment. USAP emerged as the best strategic candidate and the NYJDA basically gave the factory to them for free. USAP is reported to have bid $38mm for the assets of Empire the first time it went bankrupt in 1997, but the NYJDA passed on the bid. Three years later, they sold them the business for $4mm, and lent them $3mm of it.

Liabilities such as environmental, pension, and health care have been assumed by the state, PBGC or cancelled. The key to future success of the operation is that the union has agreed to significant concessions identical to the arrangements USAP has at its other facilities. The concessions include a 40% work force reduction, average hourly wage rate reductions of 44% and flexible job assignments. The initial labor contact is for six years. The plant restarted last month (March) is now operating and the backlog is beginning to build.

This plant produced over $100 million in annual revenue during the late nineties but with labor and legacy costs included was never very profitable. The CEO of USAP was at Armco when the facilities were originally developed and therefore has inside knowledge of the equipment and customers. USAP management believe that with the current employment structure the plant can do a 20% EBITDA margin and the goal is to develop the business back to prior revenue run rates by 2003 and reach $150 million in annual revenue in three years. At approximately $25 million in sales the plant will break even, and at approximately $50 million in sales the 20% EBITDA margin level will be obtained according to management estimates. The incremental EBITDA from this facility could be as high as $30 million in three years. At that level, earnings per share from this facility would be approximately $2.50 per share, in addition to the $1.25 USAP already makes. The company will spend a total of about $15 million in capital expenditures to reach this revenue level (approximately $5 million per year).

There are significant synergies with the existing facility - 100% of the raw steel purchased by Dunkirk will be produced using the Bridgeville melting capacity which is currently running at a 30% utilization rate. This should increase overall margins.

Import Tariffs: The recent adoption of import tariffs for various steel products is very fortunate. The acquisition was negotiated before the import tariffs were enacted, so any affect they have is purely additive to the original plan. While the tariffs may or may not stick, their timing is perfect. Management believes the tariffs will jump-start the process of re-acquiring customers at the new facility. I've heard that early discussions with customers have been well received. If the tariffs and recent price increases stick, USAP's results will be even better than currently projected.

Future Valuation.

'03 '04
EBITDA 26mm 40mm
EPS $2.15 $3.65

EV/EBITDA 3.0x 1.9x
P/E 5.6x 3.2x

In these projections, I assume the new facility will reach the same EBITDA margins as USAP currently produces, approximately 17%. If management can get the new facility margins to 20%, as they believe, EPS will be $2.35 and $4.00 in '03 and '04.

Recent increases in steel prices are not factored into this analysis. If any of the recent increases in steel prices hold, that will be additional upside.

Issues:
The first two quarters of this year will be relatively difficult. 30% of USAP's revenue is to the power generation industry. This business has recently turned down, as evidenced by their recent decline in backlog. The gas turbine business is probably in for a difficult 2003-2004 period as the recently built capacity and collapse of the merchant power business generally hurts GE's gas turbine demand. Management is planning on a decline in 2003 and is actively seeking replacement orders. Management is also seeing an upturn in parts of the business that have been depressed economically over the past six months.

The new Dunkirk facility will incur losses in the first two quarters of this year, which will depress stated results. It should become accretive in the second half of the year.

USAP is a micro cap stock, with all the issues normally attributed to micro caps. However, the new Dunkirk facility will double and could eventually triple the size of the company. In two years, USAP will be a decent sized fully integrated steel producer.

Target
My near term target: $25. A modest 11.5x and 6.8x '03 and '04 earnings (6.4x and 4.1x EBITDA).

The current share price of USAP is modestly undervalued prior to the acquisition. If management can replicate the same formula at the Dunkirk facility as it used with its existing factories, USAP will be generating a run-rate of nearly $4.00/share in earnings in two years. If things go according to plan, USAP should trade north of $40.

USAP is the perfect risk/reward. It has practically no downside (maybe $1-$2 if the world turns upside-down and Dunkirk is a disaster) and 100%-200% upside. With such a spotless balance sheet and the one of the lowest cost structures in the industry the risks are extremely low.

Risks:
There are two risks to the story: (1) the facility does not ramp and requires much more significant investment than is now anticipated. Management knows these assets well and although it has only been a couple months progress to date is very encouraging; (2) the company has a major supply agreement (32% of revenue) with the Talley division of Carpenter Technology Corporation. According to management that relationship is on a solid footing with no known near term issues.

Catalyst

(1) Steep ramp in eps and EBITDA as the Dunkirk facility comes on line
(2) Transformation of the company as a result of the Dunkirk acquisition