FRD - Friedman Industries: 5X Growing Earnings 50% Upside To Growing TBV

2023-12-04 07:00:00 ET

Summary

• Friedman Industries has strong financial ratios and is expected to experience significant growth in the next few years.
• The company has about 50% upside to tangible book value, which is growing rapidly.
• The steel industry is likely to see strength in the coming years, providing a favorable market for Friedman Industries.
• Friedman may be able to rerate 100% over the next 2 years and still be trading at TBV at that point.

Friedman Industries ( FRD ) has extraordinary financial ratios as it is, and they are likely to get even more extraordinary over the next few years as the company utilizes recent capacity expansions and the infrastructure bill starts to impact the American economy beginning in the next few months and lasting for likely years. This combination is creating a very well-protected downside and a high chance of at least a 50% gain that is rare.

Friedman is a steel processor. They take recently manufactured steel and process it for downstream customers. This includes things like cutting, stretching/leveling, tempering, and other services. Steel processors are a crucial part of the steel supply chain and Friedman is one of the largest in North America after its acquisition of the assets of Plateplus. The end demand for Friedman's products comes from steel buildings, railcars, barges, and other applications. The infrastructure bill should be a moderate positive for Friedman based on these end markets as it should increase demand for both steel buildings and railcars. Friedman also has a small steel pipe business which is about ten percent of revenue. Friedman may do more acquisitions in addition to Plateplus and highlighted this possibility in their recent earnings release.

Friedman has about 50% upside to tangible book value adjusted for substantial real estate holdings (40% unadjusted). They hold about 200 acres of strategic commercial land outright, and another 25 acres with a 99-year $1 per year lease, all of which is valued at $1.7 million, which is very likely too low by ~$5-10 million, or $.75-1.5 per share, for a total TBV of about $18.3 per share, or ~50% above the current price. Importantly this tangible book value is growing fairly rapidly, having increased by ~$2.7 per share in the past year between the September 2022 quarter , and the September 2023 quarter.

This would not be so extraordinary if the company were unprofitable or speculative, however, this company is highly profitable, and profits are likely to either maintain or grow. If they fully utilize current capacity as they have stated they intend to, profits can grow something like 50-100 %. The recent earnings release stated that they averaged 42800 tons per month and had capacity for an additional 18000 tons per month, or a 42% increase, which they expect to use within the next twelve months. A 42% increase to revenue would likely create a 50-100% increase to earnings.

While this sounds aggressive, it is not that aggressive compared to the management commentary :

In addition to maximizing throughput on our existing assets, we have an active growth strategy. Whether it be an acquisition, a new facility, or an expansion or upgrade to an existing facility, we are actively evaluating which opportunities can provide the most value to the Company and its shareholders. Our recent growth has been transformative for the Company and we look forward to recognizing the additional potential we have in place and executing additional strategic investments.

In other words not only does management think they can fulfill the current unused capacity, but they believe they can sell additional capacity that they have not even built or acquired yet. This may be optimistic of them or it may not, but it’s clear that they currently believe the current revenue and earnings rate has plenty of room to increase.

One issue with valuing the company is that steel prices have recently been highly volatile and that has caused some margin expansion, so for conservatism, you could assume that current earnings are slightly inflated and a more accurate understanding of run rate earnings is about $1.5-2 per share, with occasional periods of ~0 earnings as the steel cycle troughs, and some periods significantly higher.

However, discounting the current run rate to the midpoint of $1.75 per share, and then increasing it by 50% to conservatively account for the earnings benefits of a portion of a 42% increase from current capacity, one arrives at $2.62 per share in earnings in the next 12 months. 4.8x earnings is too cheap for any business that is stable or growing, especially one that is far below book value with two additional sources of earnings support.

First, last quarter, the tubular segment was breakeven. This segment has generally averaged a small profit and should be sold in the long term if it does not. “The tubular segment operated at a break-even level for the 2023 quarter compared to recording operating profit of approximately $3.3 million for the 2022 quarter.”

Financial Snapshot and Debt

Also, deleveraging will provide earnings support. Deleveraging should increase earnings by about $.60 per year once the company has paid off all debt, which could take something like 3-4 years to complete.

Friedman has assumed ~55m in debt since the acquisition of Plateplus. This should not be a problem whatsoever as the increase in the value of their assets is dramatically higher. They also have access to much more credit if they need it, which they are very unlikely to.

At September 30, 2023 , the Company had a balance of approximately $54.4 million under the ABL Facility with an applicable interest rate of 7.5%. At September 30, 2023 , the Company's applicable borrowing base calculation supported access to approximately $119.3 million of the ABL Facility.

This costs $4.1m per year currently and will be a tailwind to earnings as it is paid off.

Steel Industry Super-cycle

4x is especially too cheap currently because North America is likely in line for a long-term extended period of high earnings in the steel industry. The Biden administration’s infrastructure Bill has not really been reflected in the results of the steel companies yet but should be starting in 2024 and lasting for many years. Notably, the stock prices of both Nucor and Steel Dynamics, both of whom have mills collocated with Friedman, are up 15-20% in the past six weeks.

Nucor Q2 :

On the infrastructure bill, we're really seeing still design and budgetary work being done on those projects. So we expect that would flow our way probably more at the end of this year, beginning of 2024.

Steel Dynamics Q3 :

The infrastructure spending and fixed asset investment related to the IRA programs, along with the reshoring and manufacturing should provide momentum for additional construction spending through 2024, effectively extending the construction cycle.

The benefit from the infrastructure spending will likely be a moderately significant tailwind. Morgan Stanley estimates that the bill will increase steel production by 75 million tons over 10 years, which will be something like a 7-10% increase in total demand for US-made steel (the bill requires all steel be made in the US). Current US steel production is about 6.8 million tons per month.

In addition to the infrastructure bill, the general trend of re-shoring/near-shoring is a positive for both the US steel industry and possibly Friedman in particular as their new facility in Sinton, Texas, is extremely close to Mexico which makes it a prime location for serving re-shoring/near-shoring needs .

Transformative Acquisition

It’s important to understand that the Friedman Industries of today is not at all the Friedman Industries of 2020. After the acquisition of Plateplus from Metal One (who subsequently became a shareholder and has kept their shares, signaling their confidence in Friedman's trajectory), revenue has expanded dramatically, and the scale and distribution advantages have increased dramatically as well. The company is now one of the largest steel processors in North America. Friedman now also operates the largest stretcher leveler in North America, at one of the world’s most advanced electric arc furnaces in Sinton. Management claims there is room for additional expansion of operations but that is hardly necessary for a large return from the current price. Although investors are not used to thinking about businesses in the steel industry having a moat, Friedman likely has a small moat because it has an advantage in size, distribution footprint, and speed of distribution.

In summary, FRD is an opportunity to buy one of the largest steel service center companies in North America at a very large discount to tangible book value while the North American steel industry is likely to see strength over the next few years, possibly the strongest time in the steel industry since the 1950s. This strength may or may not last beyond 2026, but by that point book value should be at least 100% above the current share price and should offer attractive returns on its own.

Why is the Stock Mis-priced?

The stock is mispriced because of the combination of the company’s radical transformation, re-shoring, and the infrastructure spending bill all happening simultaneously. That degree of change is too much for the market to process and is providing an opportunity to buy the stock at a large discount to book value, which is growing rapidly and should continue to as infrastructure spending gets going.

Insiders clearly agree as a broad group of insiders purchased significant amounts of shares at higher prices in August and September. Moreover, there is a multiyear history of insider buying by these same insiders. CEO Mike Taylor is in particular deeply familiar with the assets involved in the transformation as they were previously owned by Cargill who was an executive prior to Friedman .

The steel index has been going straight up for the past six weeks or so, probably as the infrastructure bill starts to get more priced into the industry, and so that should be positive for revenue in the next 1-2 reports. That should give Friedman enough time to hopefully realize some of the increased capacity usage that they talked about confidently in the recent earnings release, which should boost the bottom line and provide downside protection if/when steel prices come down.

Risks

As a company affected by the steel industry, the principal risk is the cyclicality of the steel industry. If prices decline for an extended period or one of the mills that Friedman collocates with is shut down that would be a large negative for Friedman. However, at the current price, the risk is more than compensated for. In the last quarter, there was a sequential decline in revenue but this was due to steel pricing as tonnage volume was identical to the previous quarter.

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