2023-08-06 03:31:29 ET
Summary
- The company's revenues keep increasing boosted by price raises and volume stabilization.
- Profit margins are starting to improve.
- The company's debt exposure remains a concern as interest expenses are reaching a critical point.
- The company may need to issue new shares to fund debt repayment.
- This represents a high-risk/high-reward turnaround play worth the risks.
Investment thesis
Ampco-Pittsburgh ( AP ) is expected to release its Q2 2023 results on August 10, 2023, and the current situation of the company is creating many uncertainties for investors, who remain on the sidelines. The long-term debt is increasing at the same time that inventories do, and the management did not shed much light during the earnings call of Q1 2023 regarding a clear plan to convert these inventories into actual cash. As a consequence of the increase in debt and interest rates, interest expenses are reaching worrying levels, and share dilution is a real risk at this point as the company may need to issue more shares (at depressed prices) in order to reduce its long-term debt to more sustainable levels. For these reasons, the share price has declined by 55% from recent highs and by 93% from all-time highs.
The company is currently making very significant investments to modernize its manufacturing facilities, and profit margins are expected to continue improving in 2024 after recent improvements boosted by product price raises. But to win back the confidence of investors, the company will have to reduce its production capacity in order to partially empty its inventories and thus generate positive cash from operations with which to cover interest expenses and capital expenditures while paying down some debt, and while I believe that the company has enough resources to improve its prospects, I believe that the risks are significant, so only investors with a strong tolerance for risk should venture into this turnaround play as holding the company's shares will likely require strong patience in the short, medium, and long-term.
A brief overview of the company
Ampco-Pittsburgh is a global manufacturer of highly engineered, high-performance specialty metal products and customized equipment used in a wide range of industries, including distribution, oil and gas, aluminum and plastic extrusion manufacturers, OEM/commercial, nuclear power generation, third-party manufacturers, marine defense, and others. The company was founded in 1929 and its market cap currently stands at $76 million.
Ampco-Pittsburgh logo (Ampcopgh.com)
The company operates under two business segments: Forged and Cast Engineered Products and Air and Liquid Processing. Under the Forged and Cast Engineered Products segment, which provided 77% of the company's total net sales in 2022, the company manufactures forged hardened steel rolls, cast rolls, and forged engineered products. And under the Air and Liquid Processing segment, which provided 23% of the company's total net sales in 2022, the company manufactures custom-engineered finned tube heat exchange coils, custom-designed air handling systems for large buildings, as well as centrifugal pumps.
Due to the nature of the industries the company operates for, its cyclical nature is very strong, making Ampco-Pittsburgh a buy low/sell high company whose returns must materialize in the form of capital gains.
Currently, shares are trading at $3.94, which represents a 55.28% decline from recent highs of $8.81 on February 9, 2021, and a 92.77% decline from all-time highs of $54.46 on July 19, 2007, which reflects great pessimism among investors as the company has borrowed cash to offset recent margin contraction and negative cash from operations (caused by an increase in inventories) at a time when interest rates are high enough to make that debt exposure worryingly risky, and this happened despite recent significant revenue growth boosted by price raises and some volume stabilization.
Revenues keep increasing as the company keeps raising the price of its products
Revenues have steadily increased in recent quarters boosted by price raises and some volume stabilization, and trailing twelve months' revenues reached $401 million during the first quarter of 2023. The company supplies major players in the steel industry, including ArcelorMittal ( MT ), U.S. Steel ( X ), and Cleveland-Cliffs ( CLF ). Using 2022 as a reference, 52.53% of revenues are generated within the United States, whereas the rest is provided by operations in foreign countries, including England, Sweden, Slovenia, and China.
Ampco-Pittsburgh TTM revenues (Seeking Alpha)
During the first quarter of 2023, the company reported revenues of $104.8 million, which represents a 10.99% increase compared to the same quarter of 2022 boosted by a 42% increase in the Air & Liquid Processing segment and a 3% increase in the Forged Cast Engineered Products segment, and I expect revenues to keep growing as the company's backlog increased by 16% year over year during the first quarter of 2023 (and by 3% compared to the fourth quarter of 2022) despite weak demand in Europe. Also, the World Steel Association estimates that steel demand is expected to increase by 2.3% in 2023, and by a further 1.7% in 2024.
In this regard, the recent increase in revenues coupled with depressed share prices has caused a steep decline in the P/S ratio to $0.191, which means the company currently generates $5.24 in revenues for each dollar held in shares by investors, annually.
This ratio is 49.60% below the average of the past 10 years and represents a 79.19% decline from decade-highs of 0.945, which means investors are placing significantly less value on the company's sales despite revenue growth expectations as the company is generating negative cash from operations and increased debt is causing an increase in interest expenses that represent a risk to the viability of the company in the medium and long term. Despite this, margins are beginning to improve as price raises are taking effect, and cash from operations is improving as a result.
Margins have significantly improved, but the company is reporting negative cash from operations due to growing inventories
Although the coronavirus pandemic did not have a significant impact on the company's profit margins on its own, subsequent supply chain issues, inflationary pressures, plant downtimes, and labor shortages significantly impacted operations in 2021 and 2022, but the continuous price raises (as well as energy and transportation surcharges) seem to be finally starting to have a positive effect as supply chain issues, as well as inflationary pressures, are finally relaxing. In this regard, the trailing twelve months' gross profit margin currently stands at 16.23%, and the EBITDA margin is at 7.24%.
After some price raises in recent quarters in order to combat inflationary pressures, the company announced a new price raise of 10% to 15%, on February 15, 2023, on all forged and cast roll products globally to offset increased costs derived from these inflationary pressures and wage inflation. Thanks to these price increases, the gross profit margin reached 17.59% during the first quarter of 2023, and the EBITDA margin was 7.39% despite some higher plant downtime during the quarter, and since the price raise was announced in the middle of the first quarter, a further margin improvement could be expected in the coming quarter. Meanwhile, the company continues to invest aggressively in modernizing its manufacturing facilities, which should result in even better profit margins in 2024 and beyond.
But despite recent margin improvement, the trailing twelve months' cash from operations is still negative at -$15.33 million (vs. $34 million during the same quarter of 2022) as inventories increased by $33.7 million during the same period, and this is a cause of concern as interest expenses are increasing at an alarming rate due to increased debt exposure and increased interest rates.
This increase would not be such a significant problem if it were not for the fact that CAPEX is higher-than-usual at $16.92 million ((TTM)), which means the company is currently forced to increase its debt exposure in order to continue operating (and accumulating even more inventories), and interest expenses have increased significantly to $6.51 million ((TTM)) due not only to a higher debt exposure but also higher interest rates. Furthermore, the company reported interest expenses of $2.07 million during the first quarter of 2023, so it is expected to pay over $8 million in annual expenses as of currently, and capital expenditures should remain high for the whole of 2023 as the ongoing equipment modernization program is expected to be completed in the fourth quarter of 2023.
During the first quarter of 2023, the company reported cash from operations of -$4.4 million, but inventories increased by $9.9 million and accounts receivable by $8.3 million while the increase in accounts payable was softer at $6.8 million, and the company reported a net income of $0.7 million (vs. -$0.1 million during the same quarter of 2022 and $0.5 million during the fourth quarter of 2022). This means that the company could (arguably) be currently considered profitable but with serious difficulties turning these profits into actual cash as it keeps accumulating inventories.
The company's debt exposure is worrying investors
The company has gotten significantly indebted in recent years as it acquired Åkers AB for $80 million and ASW Steel for $16 million in 2016, and although the company significantly deleveraged the balance sheet until the outbreak of the coronavirus pandemic in 2020 (in part boosted by the divestiture of ASW steel in 2019 and significant share dilution), depressed margins, a significant increase in capital expenditures and the continuous increase in inventories have once again caused an increase in the long-term debt to $110.8 million at a time marked by high interest rates.
Also, cash and equivalents are currently very low at $6.1 million, which means that the company will have to continue increasing its debt exposure if it fails to report positive cash from operations (high enough to cover interest expenses and capital expenditures), and for this to be possible, it will need to start making use of its inventories soon, which are at higher-than-usual levels at $131.6 million.
The problem is that reducing inventories will likely not be an easy task, because although steel demand is expected to increase in 2023 and 2024, the high rate of increases in inventories suggests that the cut in production capacity should be drastic so that the level of inventories not only stabilize but begin to decline. Therefore, I consider it quite likely that the management will eventually (soon) decide to issue shares in order to reduce current debt levels, as it already did in 2020, and thus be able to buy some more time until inventory changes can stabilize, that is, until production capacity gets aligned with demand.
Investors can expect more share dilution
In recent years, the total number of shares outstanding has increased by 87.24% as the company issued shares in 2016 to fund the Åkers AB acquisition and in 2020 to reduce debt levels. This means that each share now represents a smaller size of the company.
In this regard, the company received $19.3 million in 2020 and $3.2 million during the first half of 2021 from share issuance for debt repayment, and the management could use this strategy again to reduce debt levels to more sustainable levels, which would mean more share dilution for shareholders in exchange for reduced risks in the long term. This is why investing in Ampco-Pittsburgh will likely require a high degree of patience on the part of investors.
Risks worth mentioning
As we have seen throughout the article, the risks of investing in Ampco-Pittsburgh are significant due not only to the macroeconomic outlook but also to the company's difficulty in aligning production capacity with demand. Next, I would like to highlight the risks that I consider most important for the short and medium term.
- Recent interest rate hikes carried out by central banks to alleviate high inflation rates could cause a recession in the United States and globally, which could negatively impact demand as the company is highly cyclical. This would not only cause a reduction in volumes but also in profit margins due to unabsorbed labor.
- Although the company has enough inventories to pay off a significant part of its debt, it could have difficulty converting said inventories into actual cash as it would have to drastically reduce production capacity.
- Profit margins could fall again if inflationary pressures intensify again, which would have a direct impact on cash from operations.
- As mentioned in the article, the company could issue shares again in order to reduce its current debt levels. This would be positive for the company as cash could be used to reduce long-term debt and thus pay less interest expenses, but it would be painful for shareholders as each share would represent a smaller portion of the company.
- If the company finally fails to partially deleverage the balance sheet and long-term debt continues to grow, interest expenses could spiral out of control making the company's operations unsustainable.
Conclusion
Without a doubt, the situation in Ampco-Pittsburgh is worrying investors, and for good reason. The company is expected to pay more than $8 million in interest expenses per year at current debt levels while trailing twelve months' cash from operations is negative at -$15.33 million due to increasing inventories. Also, trailing twelve months' capital expenditures increased to $16.92 million during the first quarter of 2023, although it is expected to start declining soon as the facility modernization program is expected to finish by the end of 2023.
This catastrophic outlook is the cause of the recent share price decline, which has produced a 79.19% decline in the P/S ratio (from decade-highs) to 0.191 as investors are very pessimistic, but I strongly believe that the company has enough resources to survive in the long run. First, the recent margin improvement took place despite the fact that the latest product price raise took place in the middle of the first quarter of 2023, so the impact of the raise was not fully reflected in the margin improvement. Second, cash from operations is expected to improve in the foreseeable future not only due to the increase in the price of the company's products and high inventories but also due to the ongoing modernization of its manufacturing facilities. Third, the global demand for steel products is expected to grow in 2023 and 2024, so sales should remain, at least, stable. And fourth, as the company does not pay a dividend to its shareholders, the management can issue new shares in order to reduce current debt exposure and buy some time to align production capacity and demand.
For these reasons, I strongly believe that this represents a high-risk/high-reward turnaround play worth the risks, but only suitable for investors with enough risk tolerance (and patience) as the company's prospects are very delicate.
For further details see:
Ampco-Pittsburgh: Only For Investors With High Risk Tolerance