Thursday, July 3, 2008

Alloy Steel International (AYSI.OB)

Parts of the post below I originally posted on GuruFocus on June 11th, shortly after buying Alloy Steel. Conveniently enough, the stock fell today, closing at the same price I initially bought it for, so the Magic Formula metrics I crunched below are accurate as of today as well. I have also added some additional information and updates below.

About Alloy Steel

Alloy Steel is an Australian company that manufactures its patented "Arcoplate" alloy steel wear plates for various types of mining equipment. In addition to reducing wear, which prolongs the life and reduces the downtime of mining equipment (equipment that is expensive to replace), these wear plates reduce "hang up" and "carry back" -- the tendency of ore and other materials to adhere to the surfaces of truck beds, bulldozer shovels, etc. "Hang up" (see photo below for an example) and "carry back" reduce the efficiency of mining operations, by reducing the volume of product being produced per truckload, scoop, etc. Alloy Steel's website contains this page with handy charts and photos explaining what their wear plates do and the value proposition they offer to mining companies: "Arcoplate Advantages". Take a moment to click on that link, because it will do a better job of conveying what I've tried to summarize above. According to Alloy Steel,

Arcoplate is designed for installation and use where structures and machinery frequently suffer wear problems. Common situations are:

  • the mining of iron, gold, nickel, coal, copper and other ores;
  • brick and cement works;
  • power stations

  • Alloy Steel is building another mill (which should start operating later this summer) to handle additional demand for its Arcoplate wear plates.

    How I Found Out About Alloy Steel

    Researching another company on the Magic Formula list, Manitowoc (MTW), prompted me to start researching steel companies. What I liked about Manitowoc was its exposure to the infrastructure boom overseas through its division that sells enormous cranes. I wondered how its margins would be affected by the rise in steel prices, since steel was obviously a huge input in building those cranes. After asking that question of Manitowoc's investor relations department, they directed me to a presentation their CEO had made at a JP Morgan conference a few days earlier (in early June), noting that the question about steel prices came up in the Q&A.

    The gist of the CEO's answer about dealing with rising steel prices was that Manitowoc would soon add a surcharge to new orders to account for its higher steel costs, and that it was unable to lock in prices with its suppliers for more than a few months out. The questioner asked about an angle I hadn't considered: the effect of higher steel prices on Manitowoc's multi-billion dollar backlog. Ordinarily, having a large backlog is a bullish indicator for a company, but what happens when a company signs contracts to build cranes for $X when steel costs $Y, and then when it's time to actually build the cranes, steel costs $1.5Y? The CEO's answer was that Manitowoc wouldn't attempt to renegotiate the contracts that comprised its backlog, so essentially, Manitowoc would be biting the bullet on the higher steel prices with those contracts. By the end of the presentation, I thought I might be better off owning stock in a company that sells steel than buys it, so I came up with the rudimentary idea of typing the word "steel" into the "get quotes" field on Yahoo! Finance, and looking up info on various steel companies, foreign and domestic.

    What I found, as you might expect, was that most of the steel companies were fairly pricey, since the sector had done well over the last few years (in part, by selling to companies such as Manitowoc, and more generally due to the infrastructure boom in China). Same with the big mining companies that supply the iron ore to the steel companies. Alloy Steel seemed like a great indirect, "picks & shovels" play on the infrastructure boom in China, and the related booms in steel and mining (Alloy Steel also has the potential to be a more direct play on infrastructure, since its wear plates would be of use on excavation equipment used in infrastructure projects, but this isn't currently a significant part of its business). Since, at this point, I was looking at Alloy Steel to fill a place in my Magic Formula portfolio, I decided to run the Magic Formula screens on it.

    Attempting to Apply the Magic Formula Screens to Alloy Steel

    Running the numbers for the first time over the weekend, I got an earnings yield of 12.69% and an ROIC of 93.5%. Rounding them as the Magic Formula list does, that would be an earnings yield of 13% and an ROIC of 75%-100%. Considering that the current MFI top-100 list has companies with both ROIC and earnings yields in that range, AYSI seemed like clear MF-like stock. So I bought it as part of my Magic Formula portfolio.

    Running the numbers again after I bought it, I realized I had made a mistake in getting the trailing twelve month EBIT numbers (the one I used was too high). Using the correct ttm EBIT numbers, I got an earnings yield of 9.6% and a ROIC of about 72% -- probably not high enough in combination for it to be on a Magic Formula top-100 list. With an ROIC in that range, the earnings yield would probably have to be between 15%-20% to be on the MFI top-100 list; i.e., a company as 'good' as Alloy Steel would probably need to be cheaper to be considered a Magic Formula stock.

    I liked the company anyway, so I bought it, but I'll be curious to run the MF screens again when the second quarter numbers are released. If its EV/EBIT and ROIC numbers are in MFI range then, will it appear on Greenblatt's MFI List? On the one hand, it's a foreign company, so maybe not. On the other hand, there have been several foreign Nasdaq-listed stocks on the MFI (e.g., the Chinese ones), and there have been OTC Bulletin Board stocks on the MFI list. I haven't seen a foreign OTC stock on there yet though.


    Shortly after I bought Alloy Steel at $2.28, it traded as high as $2.85. After having done some additional research on the company, I was more bullish than I had been before, and thought perhaps I should have bought more initially. So I placed a GTC limit order to buy more shares at one penny over my initial price. That order was filled today.

    I've also tried to follow that old piece of advice from Charlie Munger, to "invert, always invert". So I tried to shoot some holes in the bullish case for Alloy Steel and came up with the following questions for company.

    Questions for Alloy Steel

    - In your SEC filings, I didn't see any specific clients of yours named. Are you unable to disclose their names due to contractual issues?
    - With respect to your current clients, what percentage (roughly) of their equipment that uses wear plates uses Alloy Steel's Arcoplate wear plates?
    - If it is a small percentage, is this because your clients are using Arcoplate on a trial basis?
    - Is it because they are waiting for you to ramp up capacity with your second mill?
    - Have you been materially affected, or do you anticipate being materially affected by the reduced natural gas supply as a result of the Varanus Island explosion earlier this month?
    - Have you, or would you consider, licensing your manufacturing process to other companies?

    After e-mailing these questions to Alloy Steel, I got a prompt response from the company's marketing coordinator letting me know that the CFO would be in on Wednesday and he would respond to me e-mail then (one plus of investing in companies this small, is that you can often get access to the CEO or CFO directly). I haven't heard from that CFO yet. As I write this it's early Friday morning in Western Australia, and when that marketing coordinator fires up his computer, he'll find a follow-up e-mail from me. If and when I get a response to my questions, I'll post the answers here. Based on the response I get to my questions, I may consider increasing my stake in the company, or I may reevaluate my decision to invest in it.


    kuuks said...

    Hey Dave, just getting back to you on those gurufocus pms that didn't work. You should have a look at the following for Aus infrastructure plays (all listed on ASX):
    DEX, KOV, SND, SRH, and possibly TBG and THO.

    I've given up on PFL (the frozen food company) as they are not able convert a great brand into high ROIC and they spent 25 mil to purchase a caravan park :O Questionable.

    DaveinHackensack said...


    Sorry for the delayed response, but I just saw your comment now. Thanks for those stock suggestions. Do any of those companies have a significant presence in Perth? From what I've read, that seems to be the fastest-growing big city in Oz.