Recapping the Alloy Steel Situation

What Happened?

Alloy Steel's shares dropped sharply Thursday after the release of the company's 10QSB, which showed $2,541,776 in sales, and net income of $230,946 or $0.014 per share, versus $4,206,235 in sales, and net income of $1,154,206 or $0.068 per share for the previous quarter.

Why did the stock drop so much?

Mainly because the sequential drop in revenue was so steep, and that suggested to some investors that demand for the company's patented Arcoplate alloy steel wear plates had weakened.

Demand didn't weaken? That was a big sequential drop in sales.

Sales were certainly down sequentially, but part of this appears to have been a timing issue. Since the company has profit margins of about 50%, and it showed $785,000 in finished goods on its balance sheet for the quarter, the $785,000 in finished goods listed on the balance sheet represents about double that amount in sales. So had those sales hit in the June quarter, that would have added about $1.57 million to the top line.

So the shares dropped because of that?

They probably would have gone down even if those sales had hit during the quarter, since even with that ~$1.57 million in sales there would have been a sequential decline, but the decline wouldn't have been as steep (e.g., from $4.2 million to $4 million, instead of from $4.2 million to $2.5 million), so the stock probably wouldn't have gone down as much.

Is the investment thesis still intact?

I think so. In addition to the finished goods which represent pending sales, last month the company released an 8-K announcing a $1.8 million order from Fortesque Metals Group in Australia and a $630k order from a client in Malaysia. A month earlier, the company announced that it was in the last stages of negotiating a joint venture with a Mongolian conglomerate (although this probably won't contribute to revenues until sometime next year).

More generally, the company's product has been accepted by the major mining companies operating in Australia, and if it makes sense to use Arcoplate wear plates on mining equipment in Australia, because Arcoplate reduces downtime and increases the efficiency of mining operations, then it makes sense to use it on mining equipment in Brazil, Canada, the U.S., etc., so there is a significant potential international market for the product.

What is the investment thesis again?

Alloy Steel is a 'picks & shovels' play on the mining industry. Its patented alloy steel wear plates reduce wear, which prolongs the life and reduces the downtime of mining equipment. 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" and "carry back" reduce the efficiency of mining operations, because they reduce the volume of ore being produced per truckload, scoop, etc. Arcoplate also has applications in infrastructure, as these wear plates can perform the same function on earth moving and excavation equipment. The company has also developed a computerized process to apply a layer of alloy steel inside pipes, but has put this application on hold due to demand for the Arcoplate wear plates.

How do you know investors won't be disappointed by next quarter's earnings?

I don't, which is part of what makes this interesting. But I am still confident in the Alloy Steel's longer term growth prospects, so I remain bullish on the company.

Update: Due to the price drop last week, which lowered Alloy Steel's enterprise value as relative to its trailing twelve month earnings, the company is now on the Magic Formula top-100 list. I don't expect this will expose the company to a lot of new investors though. Given its performance since the publication of the book, the Magic Formula probably has fewer adherents today, and my sense (from reading Yahoo's Magic Formula message board) is that most of those who still follow it strictly stick with stocks with a minimum market cap of $100 million (Alloy Steel's market cap is about $30 million).