FRD - Friedman Industries: Time To Take Profits (Rating Downgrade)

2023-12-20 05:44:53 ET

Summary

• The company’s Sinton facility seems to be struggling with the ramp-up of production, and most of the Q2 FY24 net income came mainly from hedging activities.
• The share price has started decoupling from HRC steel prices following a share buyback announcement.
• In my view, this creates a good opportunity for investors to trim or close their positions, as I think the share price could fall below $11.50 over the coming weeks.
• I might open a position here again if the share price falls to around $10 again soon.

Introduction

I've written a total of 5 articles about Friedman Industries (FRD) on SA, the latest of which was in June when I said that the FY23 financial results were strong and I set a price target of just over $14 per share. I ended up exiting my position at $12.47 per share in early July and the share price reached $18.31 in August, the highest in the company's history. It then went below $10 by October and I was tempted to open a new position but I hesitated as the Q2 FY24 results looked somewhat poor. On December 18, Friedman Industries announced that it repurchased just over 400,000 shares for $5.1 million and this boosted the share price by 8.68% on that day.

In my view, the valuation of Friedman Industries is starting to look stretched and I think the share repurchase has created a good opportunity for investors to take profits here. Let's review.

Overview of the latest developments

In case you are unfamiliar with the company or my earlier coverage, here's a quick description of the business. Friedman Industries was established in 1965 and is a steel service center operator with a network of five hot rolled coil processing facilities located on mill campuses across the cities of Hickman, Decatur, East Chicago, Granite City, and Sinton. The company also has a tube mill in Lone Star and all of its facilities are situated near water, thus creating a decent moat in terms of margins.

Today, Friedman Industries is a very different company compared to 2021. The East Chicago and Granite City facilities were bought in April 2022 from a subsidiary of Mitsubishi Corp (MSBHF) and the payment included $63.8 million in cash and 516,041 shares. In October 2022, Friedman Industries opened its $22.3 million Sinton facility which is located on the campus of the $1.9 billion Sinton electric arc furnace ((EAF)) flat-rolled steel mill of Steel Dynamics (STLD). This facility was the main reason why I invested in Friedman Industries in July 2022 as the company said back in October 2021 that it expected it to generate annual EBITDA of $4.5 million to $5.5 million based on historical average margins.

Unfortunately, the ramp-up of the Sinton facility seems to be slow and it's likely operating at a fraction of its capacity at the moment. While Friedman Industries doesn't provide a breakdown of output by facility, the total production of the flat-roll segment has increased by less than 10% since Sinton was commissioned. In Q2 FY24, inventory tons sold in this segment rose by about 12,000 tons year on year to 129,000 tons and Friedman Industries said that the change was primarily related to Sinton (see page 19 here ). What's even more disappointing is that the company expects the sales volume for Q3 FY24 to be slightly lower than Q2 (see page 20 here) which suggests that Sinton is unlikely to achieve large volumes or annual EBITDA of $4.5 million anytime soon. Looking at the margins, Friedman's gross profit related to physical material as a percentage of sales excluding effects improved to 4.5% in Q2 FY24 from 4.1% a year earlier. However, it's hard to compare apples to apples here as both periods were characterized by rapidly falling hot-rolled coil (HRC) steel prices and the majority of net income came from hedging activities once again.

Looking at the balance sheet, the net debt rose to $51.3 million as of September, as it seems that Friedman Industries took advantage of falling HRC steel prices to build up inventories. I expect inventories to fall below $90 million in the near future, which should enable the company to reduce its debt levels.

However, if inventory levels remain at the September levels in Q3 FY24, I think it's possible that the net debt increases as Friedman Industries has just announced that it completed a $5.1 million share buyback. In addition, the company approved a share repurchase program for up to 1,045,774 shares, which represent 15% of its share capital after the share buyback. This announcement has provided a boost for the share price and Friedman Industries closed at $14.90 on December 18, up by 8.68% for the day. In my view, this creates a good opportunity for investors to trim or close their positions. You see, the financial results and share price of Friedman Industries have usually had a strong correlation with HRC steel prices. Considering Sinton seems to be struggling to ramp up production and margins remain low, I expect this to continue to manifest in the foreseeable future. Looking at the charts, I think the share price could return to around $11.50 over the coming weeks if HRC steel prices remain at the current level.

Looking at the valuation, Friedman Industries also doesn't look cheap at the moment from a P/B standpoint as the ratio is approaching 0.9x. The company has rarely traded above this level over the past several years.

Investor takeaway

I think there's a lot to like about Friedman Industries. The company has a decent moat and has rarely been in the red over the past decade despite operating in a cyclical business. Also, the CAPEX requirements are low as this is a relatively asset-light business. However, the performance of the company's new Sinton facility is far below my expectations so far in terms of output and financials and I doubt we're likely to see an improvement in the coming months. With the share price decoupling from HRC steel prices after the share buyback announcement, I think there is a good window of opportunity to trim or close positions. That being said, I might open a position here if the share price falls to around $10 again in the near future.

For further details see: