Friedman Industries (NYSE:FRD) is a hot rolled coil processor.The company buys coils from large manufacturers and processes them for further resale to end customers or brokers.
The company has maintained financial and operational prudence so that it will not be severely affected by the industry’s down cycle.In fact, the decade between the end of the financial crisis and the beginning of the COVID crisis wasn’t all that great for commodities overall, but the company’s average net income was $2.8 million.
Inventories of FRDs have always been correlated with steel prices, as higher steel prices mean higher profits and increased demand for FRD products.The last bull run and bust in steel prices over the past 12 months was no different.
The difference this time around is that the economic environment may have changed, suggesting that commodity prices are on average higher than they have been in the past decade.In addition, FRD is ramping up production by building new factories and has begun hedging some of its business, with mixed results.
These changes may suggest that FRD will be able to earn more in the next decade than it has in the past, and thus, justify its current share price.However, the uncertainty has not been resolved, and we believe that the stock with the available information is expensive.
Note: Unless otherwise stated, all information is derived from FRD’s SEC filings.FRD’s fiscal year ends on March 31, so in its 10-K report, the current fiscal year refers to the previous operating year, and in its 10-Q report, the current reporting year refers to the current operating year.
Any analysis of a company that focuses on cyclical commodities or related products cannot exclude the economic context in which the company operates.In general, we prefer a bottom-up approach to valuation, but in this type of company, a top-down approach is inevitable.
We focus on the period from June 2009 to March 2020.As far as we know, the period, although not homogenous, was marked by falling commodity prices, especially energy prices, lower interest rates, and monetary expansionary policies and global trade integration.
The chart below shows the price of HRC1, the domestic hot rolled coil futures contract that FRD mainly supplies.As we can see, the period we decided to analyze covered prices ranging from $375 to $900 per ton.It is evident from the chart that the price action after March 2020 has been quite different.
FRD is a downstream processor, which means it is a processor relatively close to the end customer of the steel product.FRD buys hot rolled coils in bulk from larger mills, which are then cut, shaped or resold as-is to end customers or brokers.
The company currently has three operating facilities in Decatur, Alabama; Lone Star, Texas; and Hickman, Arkansas.The Alabama and Arkansas plants are dedicated to coil cutting, while the Texas plant is dedicated to forming coils into tubes.
A simple Google Maps search for each facility revealed that all three facilities are located strategically close to large factories belonging to well-known brands in the industry.The Lone Star facility is adjacent to a U.S. Steel (X) tubular products facility.Both the Decatur and Hickman plants are very close to the Nucor (NUE) plant.
Location is an important factor in both cost and marketing, as logistics plays a major role in steel products, so concentration pays off.Larger mills may not be able to efficiently process steel that meets end customer specifications, or may only focus on standardizing a few parts of the product, leaving smaller mills such as FRD to handle the rest.
As you can see in the chart below, over the past decade, FRD’s gross margin and operating profit have moved in tandem with steel prices (its price chart is in the previous section), just like any other company working in commodities.
First, there are very few periods when FRDs are flooded.Often, operating leverage is an issue for asset-intensive companies.Fixed costs caused by facilities make small changes in revenue or gross profit have a huge impact on operating income.
As the chart below shows, FRD doesn’t escape this reality, and the movement in revenue widens as the income statement moves down.What’s special about FRD is that it doesn’t lose a lot of money when the prices of its products drop.That said, while FRD is affected by operating leverage, it is resilient to downside business cycles.
The second interesting aspect is that FRD’s average operating income for the period was $4.1 million.FRD’s average net income for the period was $2.8 million, or 70% of operating income.The only difference between FRD’s operating income and net income is the 30% income tax.This means that the company has very few financial or other expenses, and on the other hand reduces leverage (in this case financial).This is due to FRD having no financial debt during this period.
Finally, the annual average depreciation and amortization did not differ significantly from capital expenditures during the period covered.This gives us confidence that the company has not misreported its capital expenditures, and therefore capitalizes costs to improve earnings through accounting.
We understand that conservative capital expenditures and financing have kept FRD profitable during difficult times for the steel industry.This is an important reassuring factor when considering FRD.
The purpose of this analysis is not to predict what will happen to unpredictable factors such as commodity prices, interest rates and world trade.
However, we would like to point out that the environment we are in and the environment that is likely to develop in the next ten years has shown very distinct characteristics compared to the situation in the past ten years.
In our understanding, while we are talking about developments that are not yet clear, the three things are very different.
First, the world does not appear to be moving towards more international trade integration.This is bad for the overall economy, but good for marginal producers of goods that are less affected by international competition.That’s clearly a boon for U.S. steelmakers, which suffer from low-price competition, mostly from China.Of course, the drop in demand brought on by the trade slump has also had a negative impact on steel demand.
Second, central banks in advanced economies have abandoned the expansionary monetary policies they have implemented over the past decade.We are not sure what the impact on commodity prices might be.
Third, and related to the other two, inflation in advanced economies has already begun, and there is uncertainty about whether it will persist.In addition to inflationary pressures, recent sanctions on Russia have also affected the dollar’s status as an international reserve currency.Both of these developments have had an upward impact on commodity prices.
Again, our intent is not to predict future steel prices, but to show that the macro economy has changed significantly compared to the situation between 2009 and 2020.This means that FRDs cannot be analyzed with a view to recovering to the median commodity prices and demand of the previous decade.
We believe that three changes are particularly important for the future of FRD, independent of changes in price and quantity demanded.
First, FRD opened a new facility for its coil cutting division in Hinton, Texas.According to the company’s 10-Q report for the third quarter of 2021 (Dec 2021), the total facility cost of $21 million has been spent or accumulated by $13 million.The company has not announced when the facility will start operating.
The new facility will have one of the largest cutting machines in the world, expanding not only production but also the product line the company offers.The facility is located on the Steel Dynamics (STLD) campus, which is leased to the company for $1 per year for 99 years.
This new facility expands on the same philosophy of the previous facility and is located very close to a large manufacturer to handle production that is too specific for that manufacturer.
Taking into account the 15-year depreciation period, the new facility will nearly double FRD’s current depreciation expense to $3 million.This will be a negative factor if prices return to levels seen in the past decade.
Second, FRD has started hedging activities since June 2020, as announced in its FY21 10-K report.In our understanding, hedging introduces significant financial risk to operations, makes the interpretation of financial statements more difficult, and requires management effort.
FRD uses hedge accounting for its hedge operations, which allows it to defer recognition of gains and losses on derivatives until the hedged operation, if any, occurs.For example, suppose FRD sells a cash-settled contract for HRC settled within six months for $100.On the day the contract is settled, the spot price is $50.The company then registered $50 in mark-to-market derivative assets and $50 in unrealized derivative gains in other comprehensive income.The actual transaction of the hedge takes place on the same day at a spot price of $50, and the OCI gain is then converted into net income for the year by adding $50 in sales.
As long as each hedging operation eventually matches the actual operation, everything will work fine.In this case, all gains and losses on derivatives are more or less offset by gains and losses on the actual trade.Readers can practice buying and selling hedging as prices rise or fall.
Problems start when companies over-hedge business that won’t happen.If the derivative contract incurs a loss, it is carried forward to the net gain without any physical counterparty to cancel it.For example, suppose a company plans to sell 10 coils and therefore sells 10 cash-settled contracts.A 20% increase in the spot price results in a 20% loss per contract (leverage is not considered for simplicity).If the next 10 coils are sold at the same spot price, there is no loss.However, if the company ends up selling only 5 coils at the spot price, it must recognize the loss of the remaining contracts.
Unfortunately, in just 18 months of hedging operations, FRD has recognized over-hedging losses of $10 million (considering $7 million in tax assets generated).These are not included in revenue or cost of goods sold, but are included in other income (not to be confused with other comprehensive income).In any other case, it would be a horrific mistake to specifically recognize in the financial statements and the company’s commitment to revise its hedging policy.Because FRD has made a lot of money this year and lost relatively little, FRD is only mentioned in one paragraph.
Companies use hedging to increase efficiency and sometimes profit by selling at a better price when the product is not available.However, we believe that the additional risk is unnecessary and, as we have seen, it can generate huge losses.If used, hedging activity should have a very conservative threshold policy, not allowing hedging activity to exceed a small threshold of forecast sales until those sales are relatively certain.
Otherwise, hedging operations will take a bigger hit when companies need help most.The reason is that hedge accounting fails when the number of hedges exceeds the actual operation, which only happens when market demand falls, which also causes spot prices to fall.As a result, the company will be in a position of shrinking revenue and profits while having to make up for additional hedging losses.
Finally, to fund its hedging, increased inventory needs and construction of a new factory, FRD has signed a loan facility with JPMorgan Chase (JPM).Under this mechanism, FRD can borrow up to $70 million based on the value of its current assets and EBITDA and pay SOFR + 1.7% on the outstanding balance.
As of December 2021, the company had an outstanding balance of $15 million at the facility.The company doesn’t mention the SOFR rate it uses, but for example, the 12-month rate was 0.5% in December and is now 1.5%.Of course, this level of financing is still modest, as a 100 basis point change would only result in an additional interest expense of $150,000.However, over the next few months, debt levels will need to be closely watched.
We’ve already mentioned some of the risks behind FRD operations, but wanted to put them clearly in a separate section and discuss more.
As we mentioned, FRD has operating leverage, fixed costs, over the past decade, but that doesn’t mean huge losses in even the worst markets.With an additional plant now under construction that could add $1.5 million a year in depreciation, that’s going to change.The company will have to come up with $1.5 million a year in revenue minus variable costs.This risk affects accounting earnings, not cash earnings, as the plant is likely to be fully paid for this year.
We also mentioned that FRD does not have any debt, which means there is no financial leverage on the way up or down.Now, the company has signed a credit facility linked to its liquid assets.The line of credit allows companies to borrow up to $75 million at an interest rate equivalent to SOFR +1.7%.Since the annual SOFR rate at this point is 1.25% (calculated using CME futures, since SOFR still has no term structure), FRD pays $295,000 in interest for every $10 million more borrowed.As the SOFR rate increases by 100 basis points (1%) per year, the FRD will pay an additional $100,000.FRD currently owes $15 million, which translates to an annual interest expense of $442,000, which was not present in the previous decade’s calculations.
Adding those two charges together, and a 1% rate hike for the remainder of 2022, the company would have to come up with an additional $2 million in operating profit compared to what it was before the recent changes to COVID.Of course, that’s considering the company doesn’t pay its debts or borrow more money.
And then we mentioned hedging risk, which is hard to measure but takes a huge hit when companies are most vulnerable.A company’s specific risk depends largely on how many contracts are open at any given time and how steel prices move.However, the unrivaled loss of $10 million confirmed this year should send shivers down the spine of any investor.We recommend that companies set specific policy limits on their hedging activities.This is the biggest risk facing the company right now.
Regarding cash burn, the information we have from the third quarter of 2021 (Dec 2021) is not very good.FRD doesn’t have a lot of cash, just $3 million.The company had to pay $27 million in accruals, most of which came from its new facility in Texas, and had $15 million outstanding on its outstanding line of credit.
However, FRD also increased its investment in inventory and receivables during the year as steel prices soared.As of 3Q21, the company had a record $83 million in inventory and $26 million in receivables.As the company sells some inventory, it should get cash.If demand plummets so much that FRD inventory starts to languish, the company could borrow more from JPMorgan’s line of credit, up to $75 million.Of course, this will incur a huge financial cost, at the current rate of $2.2 million per year.This is one of the key points to assess when new results emerge sometime in April.
Finally, FRD is a thinly traded stock, with an average daily volume of about 5,000 shares.The stock also has an ask/bid spread of 3.5%, which is considered high.That’s something investors should keep in mind, but not everyone sees it as a risk.
In our view, the past decade reflects an unfavorable environment for commodity producers, especially the U.S. steel industry.In this case, FRD’s ability to drive profits with an average annual net income of $2.8 million is a good sign.
Of course, even taking into account the price levels of the past decade, we cannot predict the same income for FRD because of the significant changes in capital investment and hedging operations.That said, even considering a return to the previous situation, the company’s risk becomes greater.