Friedman (FRD) is a steel company. They deal with 2 different types of steel product. The first is steel coils. Friedman buys big rolls of steel (called hot rolled coils) and then processes these rolls into flat finished sheet and plate steel. It cuts the steel to the length and requirements of the customer, who it then sells the finished product to. As well, some customers give FRD their steel rolls and for a fee FRD processes it for them. It operates this segment of its business out of 2 factories in Arkansas and Alabama. FRD gets almost the entirety of its supply from Nucor Steel. FRD has a large customer base of steel distributors. No single customer makes up more than 10% of sales.
The second industry FRD operates in is called tubular products, which just means steel piping. It’s a pretty straight forward business. This division of the company is located in Texas, in the same city as its biggest customer, US Steel tubular products (USS). In FRD’s record year, 2009, USS accounted for 30% of total sales in tubular products. In 2010 they accounted for just 4% of sales, after idling their plant for most of the year. This had serious adverse effects on Friedman’s profitability and share price. However, USS reopened the plant this past winter and FRD has received a pickup in orders. It is worth noting that USS also supplies FRD with their raw piping materials.
The steel industry is highly concentrated among a few big players. There is room for smaller players such as FRD to carry out certain parts of the value chain process if they can do so at competitive prices and can fill orders quickly. This sounds precarious to FRD’s future as some big players could always elect to do some of this work themselves. However FRD has been doing this for over 60 years and not much of their business has changed in that time. FRD’s proximity to the USS plant in Lone Star, TX gives it a competitive advantage in regards to time and shipping costs that competitors cannot match. This should keep competitive pressures low for FRD in their tubular division. The industry itself is fairly cyclical and pretty responsive to the health of the overall US economy. Finally, bowing to industry pressure, last fall the US government imposed very heavy tariffs on Chinese imports of steel goods. This should prevent margins from eroding due to cheaper imports for the foreseeable future.
Net asset value:
One of the things that attracted me to FRD was its large cash position. The company trades with a market cap of only 40 million yet has 14 million in cash (peaked around 20 million last year) and 10 million in total liabilities. The company has total current assets of 50 million which means assuming they are carrying accounts receivable and inventory at appropriate prices than you can buy the company for NWC. This implies basically a risk free investment. Of course many companies can destroy shareholder value on the way to bankruptcy, eating through large cash positions and turning safe investments into large losses. FRD is not one of these companies.
Last year in the depths of the recession when FRD lost almost all their business from USS, they were able to effectually go into “hibernation mode”, and lower their inventory and administrative costs to levels commensurate with reduced sales. At dec 31, 2009 cash jumped to 21 million, up from 2.5 million in 2008. Inventories got as low as 17.5 million down from 30 million, also in 2008. Thus FRD management greatly reduced risk by properly managing the company into the downturn. In fact, they were able to make it through the year with only moderate losses in the first 3 quarters, before having a nice 4th quarter to actually see a profit on a year when sales fell from 208 to 65 million.
So once I knew that FRD is going to protect shareholder value, I took a look at the balance sheet to determine a net asset value, something I figure is my floor on the value of FRD stock (or at least a price where I would buy up everything I can below this level). Here is a spreadsheet of my calculations. It should be pretty straight forward
click here to enlarge the image
Accounts receivable are discounted another 5% from the company’s historical estimate of bad debt allowance. This number doesn’t have much basis but I would rather be overly conservative.
Inventories were each calculated separately. The company uses LIFO for prime coil inventories (remember, giant rolls of steel, pretty much a generic commodity product). Because of this, inventory is being carried for less than its true value. In 2009 when the company went into hibernation mode, FRD dipped into this LIFO inventory and had a LIFO liquidation. This gave us a chance to see how much less than replacement cost the LIFO inventory is being carried at. Some quick math showed that the bottom 4 million in prime coil inventory should be carried 18% higher than it is currently, for an undervaluation of 744,000.
Non standard coil is custom designed coil only obtained/produced when a customer places an order, thus there is very little risk of it not being sold as a finished product.
The tubular inventory is estimated to be sold at 70% of face. This might seem to be optimistic but it is not. A 30% reduction of current inventory levels means I am taking out 5.5 million from FRDs valuation. At the bottom of the recession FRD was able to get these inventory levels down to about 12.7 million. Thus a 5.5 million hit would mean that actual inventory on hand in such a scenario would only be sold for 57% of carrying value. While less of a commodity type product than hot roll coil, FRD should still be able to find buyers for these products at 40% discounts. Further, FRD already reduced the carrying value of its piping inventory by 4 million in 2009, thus it is already being carried on book at trough prices.
Land is carried at historical cost. For parts of the total, the value is fairly accurate as the company bought these properties in recent years. Yet the original land in Lone Star, TX has been owned by the company since 1965 and has not been adjusted on the balance sheet. A friend of mine spoke with a representative of FRD who told him unofficially that the land is probably undervalued by 1 to 1.5 million. So a 50% markup from carrying value (about 540 thousand) is reasonable.
PP&E is assumed to sell for 25% of its carrying value. In determining PP&E the company doesn’t depreciate buildings and yard improvements, and instead depreciates machinery and equipment. Thus in determining total machinery and equipment, I added the two items together and subtracted accumulated depreciation to get a net value of 14.3 million. Then I examined what PPE tends to go for historically in bankruptcies. It came out to about 1/3 of carrying value. Given that FRD is a smaller company I reduced that number to 25%.
Total liabilities were 8.9 million last quarter. Deducting liabilities from the liquidation value of the assets gives us a value of 41.7 million, or 6.13 per share value. This should act as a good floor for FRDs value and any time it drops below this level it should be considered a buy.
For the valuation, I made a few assumptions about the sales levels. I expect sales to come in at 111 million this year, based on extrapolating Q1 sales as a percentage of yearly sales in prior years. Next year, when the economy is hopefully growing again at a normal pace of 2-3%, I forecasted sales of 172 million, the 5 year average of the 2004-2008 period, which was after the 2001-2003 recession had ended and before FRDs banner year caused by the commodities bubble. After this I used the assumption that sales would grow at a rate of 3% until 2015, after which they would taper off to 2.5% growth long term.
In terms of margin levels, I used averages for the next few years such as a 9% gross margin (excluding depreciation). This resulted in a NIM of 3.3% for the normalized years, which is in line with FRDs historical NIM of 3.2%. Thus I am confident enough in my assumptions. This year however, should have a higher NIM as Q1 had a gross margin of 13.3%. So plugging in a 10% gross margin this year, we should expect earnings to be around 4.23 million. In 2012 they should be around 5.89 million and then move slowly higher from there. These all sound fairly cheap for a company with a market cap of around 40 million.
Determining FRDs WACC is fairly simple since the company has no debt. The company trades with a beta of 1.13. Assuming a market risk premium of 5% the cost of equity is 2.75 + 5 x 1.13 = 8.4%. This seems appropriate to me as FRD demonstrated they can stay cash flow positive even in bad economic times.
Cash flows for the next 2 years should be depressed as the company comes out of hibernation mode. Increases in A/R and inventory may drive cash flow negative either this year or next. This is what happened in the first quarter this year as the company used 5 million in cash for operations. Based on my model, and using the 8.4% discount rate, the present value of cash from operations – CapEx for the next 5 years will only be $9.3 million. However the company will be quite profitable and the discounted terminal value, assuming a 2.5% growth rate, is 71.6 million. This gives FRD a valuation of $80.9 million or a per share value of 11.90. FRD traded at that price in early 2007 when its book value was 42 million. Its current book value is 57 million so I feel confident in saying FRD’s intrinsic value is almost double its current share price.
Management is considerate of shareholder needs, which is uncommon in a microcap company. FRD was a family owned business started by the father of Jack and Harold Freidman. Jack Freidman was the Chairman and CEO for many years before he retired. He recently passed away. His brother Harold is the Chairman of the board. William Crow is now the CEO. He has been with the company since 1981 and took over as CEO in 2006. As discussed earlier, management seems to have done an excellent job of avoiding burning through cash in tough times. Escaping 2010 with a net profit is incredible to me considering the collapse of sales, and I have faith in their timing of when to ramp up production and when to slow down.
The dividend policy itself may act as a catalyst for FRDs share price to grow. Historically the company has a dividend payout ratio of 31% of NI. They are not worried about smoothing dividends and will cut them when they feel the need to conserve cash, as they did in 2010, and return cash to shareholders when they feel they have an excessive amount, as they are currently doing now. Yesterday, FRD announced an increase of its quarterly dividend to 8 cents a share, doubling the amount last quarter and up from 1 penny a share last year. This means FRD is yielding over 5%. The stock traded up 6% on the news which is proof that dividends can act as a catalyst.
FRD is a safe company that is selling for roughly the amount it would fetch in bankruptcy. The downside is very limited, and the upside is large given FRDs earning potential. Management acts as owners would and understands their business well. I’ve followed this company for about a year now and it is one of my favorite plays. While it has gone up in the past month, it is still very cheap and I believe its true value is almost double the current price. It is one of my largest holdings.