Sex beats stocks

About a month ago, I contacted one of the founders of Kickstarter about using it to raise funds for a due diligence trip to Alloy Steel International's headquarters in Perth. I wrote,

I know from the Kickstarter site that you're currently only accepting projects through invitations, but I think mine is probably a little different than your typical request, so perhaps you'll make an exception (or connect me with someone who has an invitation to share?). Here's the idea.

I went on to explain that everyone who donated at least $100 to the trip would get a detailed report (one that didn't offer any financial advice and complied with all relevant securities regulations). Those who donated more (say, $300) would get the report along with a conference call with me where they could ask me additional questions, etc. The Kickstarter founder I contacted thought it was an interesting idea referred me to his staff members who review ideas for inclusion on the site.

One of those staff members sent me a rejection note a few days later. She wrote that "projects must also engage the community and offer tangible rewards".

I hadn't thought about that much in recent weeks. I've had my hands full with the launch of Portfolio Armor and a few other things, plus after my conversation with Alloy Steel exec Greg Muller followed by the company's revenue release earlier this month, I feel less of an immediate need to go to Perth. But I was reminded of this by an e-mail from a fellow AYSI shareholder yesterday. So I went to Kickstarter's website to copy its URL to paste in my e-mail reply and saw on the homepage this project, that did pass muster with the staff (and has raised more than double its goal in donations so far):

Coming & Crying: real stories about sex from the other side of the bed

About this project

Meaghan and Melissa (or,¹ "we") met because of the internet and writing, and writing about sex (and blogging about writing about sex). Almost since then, we've been talking about how we need to do a book like this: a collection of stories (and photographs) from the messy, awkward, hilarious, painful, and ultimately true side of sex.

As part of this project, all of the money we raise together will go towards producing the book and to paying its contributors. The more we bring in, the more we can put out -- a prettier book, bigger take-home for our writers and photographers, and fancier packages for all those who pledge.

There's a ~2 minute video at the link above that gives you a better idea of what these two gals are working on.

I feel like a knucklehead now. I could have proposed as a project a documentary about sex in Perth, with its own alliterative title -- "Sexual Perversion in Perth" (betting that none of the Gen Yers on the Kickstarter staff would be familiar with Mamet play that title rips off) -- and then if I got accepted and funded, did my due diligence on Alloy Steel surreptitiously while I was down there.

¹That's a "comma of apposition" for you aspiring grammarians out there.

News from Alloy Steel

Alloy Steel International (OTC BB: AYSI.OB) issued this press release less than an hour ago, "World First Product Secures Growth for Alloy Steel". The full text of it is below, but according to the release, despite shutting down for at least the last week in December, revenues for the company's fiscal Q1 2010 (which corresponds to Q4 calender 2009) were up ~37% sequentially from Q4.

PERTH, AUSTRALIA--(Marketwire - 01/12/10) - The introduction of the new thicker Super Alloy Arcoplate onto the market this year has cemented Alloy Steel's (OTC.BB:AYSI - News) standing as a world leader in bi-metallic overlay technology.

As the first company to develop and manufacture the thicker alloy, Alloy Steel is now in an unrivalled position and set to continue on a growth path in coming years.

The past 18 months have been difficult for mining and mining service companies worldwide due to international economic conditions. However, Alloy Steel has not only weathered the financial storm but has improved and strengthened its market position. The company has increased its market share in Western Australia from 20 percent to an estimated 80 percent in just two years as a result of a concerted effort from the entire team.

According to Mr Kostecki, the company's founder and CEO, this year's result is "truly a remarkable achievement given the difficult times which were experienced by clients and ourselves in the downturned economy.

"The company is now well placed to face 2010 in a very positive manner to achieve increased sales, and continued growth and market share across the entire mining and mineral processing spectrum."

New Super Alloy Arcoplate was developed to solve problems caused by wear and hangup. These two issues can plague mining, quarrying, power generation, cement production and other industries, and can cause immense productivity and profit losses.

Alloy Steel used cutting-edge technology to create an alloy overlay over 3/4 of an inch thick in a single pass operation. Conventional methods involve multi-pass overlays using layer-upon-layer welding methods.

Field trials for the new product show outstanding results. The Super Alloy Arcoplate outperforms conventional weld overlay in abrasive wear applications of similar alloy thickness between two and twelve times.

Alloy Steel is currently negotiating supply contracts with major iron ore mining companies. Super Alloy Arcoplate will be used for upgrades and continuing wear plate requirements. There is increasing demand for the product in Western Australia, an area with vast iron ore resources and home to some of the largest iron ore mining companies in the world.

However, as reported from previous filings, Alloy Steel has not been immune to the effects of the economic crisis. This is evidenced by the depressed commodity markets in the first nine months of the financial year.

Investors should be aware that the new Arcoplate Mill was completed and commissioned in the current financial year. Costs required by accounting standards have been expensed to profits resulting from the operations. This has reduced the company's bottom line result accordingly.

Costs incurred from developments were settled using internal cash flow and cash reserves. Alloy Steel used available staff and facilities, and achieved considerable cost savings by carrying out this work 'in-house.'

The following comments should be considered when considering the company's financial performance for the year.

After add-backs for once-off items, the company shows an approximate net profit before tax of $2,150,000.

Add-back items include materials and other costs that have been expensed in relation to completion of the new machine and include:

�
-- Commissioning and testing of the new machine
-- Diminution in listed investments
-- Foreign exchange loss due to the appreciating Australian dollar compared
with a small foreign exchange gain in the previous year.


The first quarter of the 2010 financial year (Oct to Dec) has shown sales of:

�
Oct $ 1,910,330 USD
Nov $ 2,997,347 USD
Dec $ 831,639 USD

Total for quarter: $ 5,739,316 USD

December is a short trading month because of Christmas and New Year holidays.

Extrapolating these figures shows an excellent potential result for the full year.

To give 2010 a flying start, the company is pleased to advise that Synohydro Corporation of Beijing - China has confirmed a second supply contract for Arcoplate as part of their dam enhancement program in the Sudan.

This contract to the value of USD 921,000 is a direct result of the performance of the product previously supplied and the ability of Alloy steel to provide on time delivery of quality price/performance product.

The contract is also based on favourable payment terms to Alloy Steel.

The company and the directors are highly confident for the future for Alloy Steel.

For further information please contact CFO Mr. Alan Winduss +61 412949225

An assortment of updates

First, a request: if any of you know of a finance professor who is an acknowledged options expert and might be willing to consider a quick consulting project (shouldn't require more than an hour of his time), please e-mail me at contact[at]shortscreen.com. Thanks.

Now, on to some assorted updates and musings.

Sorry for the lack of posts over the last few days. I meant to post something last night, but after a late, gluttonous, feast at George's favorite New York restaurant (Balthazar) last night I was too beat to post or check e-mails when I got home. Before dinner, I had taken George to meet my developers at Simande. George is considering making some modest updates to his business's computer system (he's currently running it on DOS). I mentioned to the Simande guys that George first set up his system when Tronwas playing in the movie theaters. After a beat, Matt asked, "When did that come out, early 80's?". "Yeah," I replied. "That's when we were born," said Matt. For Matt, here is the trailer for Tron:



I believe a remake of Tron is in the works.

After leaving Simande HQ, we met George's old friend Frank at Balthazar. Balthazar is sort of an upscale version of the French Roast, but Balthazar has its own excellent bakery (located, conveniently enough for us, in nearby Englewood, NJ.). After a few bottles of Bollinger for the table, Frank, an actor/playwright, was in a feisty mood. He launched into some of the political arguments you might expect from a New Yorker, with gusto.

I remembered from meeting him on previous occasions that Frank had mentioned he was friends with Al Pacino, so in an effort to deflect him from politics, I asked him questions about Pacino's performance in Heat (e.g., Why was his character chewing what appeared to be a half-piece of gum throughout the whole movie? Why did he always hang up on everyone without saying "goodbye"?). We probably would have gone through less of the champagne (which was wasted on my palate; I can get heartburn just as easily from a $10 bottle of cava) if George hadn't ordered one of those multi-tiered shellfish appetizers for the table, which the waiters consolidated to lower tiers Tetris-style as we ate). In any case, it was a good dinner with good company, but I ate way too much. Balancing that out today by just having a piece of toast and some ginger ale for lunch. Onto some updates:

Investment stuff:

- AYSI.OB: Got a belated response today from the CEO re the e-mail I sent him when they filed the 10-K on 12/23. I'll post on that separately in a little bit.

- USEG: Up today on this news from yesterday about the latest positive well result from its Bakken deal with BEXP, and this news from today that it received its $1 million option payment from Thompson Creek related to the molybdenum project, and that Thompson creek has budgeted several million more dollars for preliminary work on the project this year.

- The United Airlines puts: These went against me a little this week, a day before Continental announced its positive results. Steady as she goes though.

New blogs:

After e-mailing my logo designer's gal Friday asking her, essentially, "WTF?", she wrote back pleading technical difficulties and saying that if she could crawl into the computer and push the process along she would. The thought of her and him being sucked into a computer Tron-style and forced to play in one of the movie's Jai Alai death matches brings me a small measure of comfort at this point.

What would have been spectacular timing

A day late. Damn. Details later.

Update: Here are the details I didn't have time to write about earlier. Sorry about not writing this out earlier, but it takes me a while to write these posts, and I just didn't have the time to do that earlier today, so I posted that as a placeholder.

As I mentioned in a previous post, the biggest risk I see with Alloy Steel International (OTC BB: AYSI.OB) is, "a nasty exogenous event (e.g., a big fall-off in Chinese demand for industrial commodities¹)". For companies that have options traded on them, you can of course buy puts on the company to hedge your position. How, exactly, to do that in an optimal way is what the next subscription-based site, Portfolio Armor, is about (Portfolio Armor isn't live just yet, but that's its logo above²). Portfolio Armor's proprietary algorithm tells you exactly how many of which put options to buy to give you the level of protection you specify at the lowest cost.

Of course, Alloy Steel doesn't have any options traded on it, so there would be no way to use options to hedge against any purely idiosyncratic risk, but there are ways to hedge against the exogenous risk. I thought about this last night and figured that a way to do that would be to buy puts on a steel company with significant exposure to China. Then I figured, instead of using just any steel company with exposure to China, why not try to find a financially distressed one? I found just such a company using the screener on Short Screen. To give me a rough idea of how many of which of that company's puts to buy to hedge my AYSI position against the specific exogenous risk I mentioned above, I e-mailed my developers at around 8:30 am, asking them to run the algorithm on the steel company I found. When I got the answer from them later, I went to pull up the option and learned that the financially distressed steel company had announced a secondary offering at around 9am today, and on news of that dilution the stock dropped more than 20%, and the optimal put contract spiked more than 50%. Too bad I didn't think of this a day earlier.


¹That's the big question. We presented the positive view on China this post back in September, "China's new self-propelled economy", and the editors of the FT presented the scary view in this editorial last month, "The cost of China’s excess capacity". In a nutshell, the positive scenario: China's big stimulus this year has helped transition its economy to one fueled more by internal demand, in which case there should be continued growing demand for industrial commodities to build infrastructure in underdeveloped parts of China, manufacture first refrigerators for rural Chinese, etc. And the negative scenario: China's stimulus has been mainly hair of the dog, propping up an unsustainable status quo relying on massive trade surpluses that over-extended Western consumers can no longer support.

²Recall our discussion in this recent post of the initial challenges in coming up with this logo.

Alloy Steel's 10-K

Alloy Steel International (AYSI.OB) filed its 10-K today. I haven't had a chance to go over it in detail yet, but it looks like the big BHP deal that was announced during the AYSI's Q4 contributed less to earnings that quarter than expected. If my arithmetic is correct (the company didn't break out the Q4 numbers in its annual), Q4 earnings came in at 1.86 cents, which is well below my guess of record earnings that quarter, and well below the result of my small survey which found that earnings of about 5.6 cents would be needed to support the stock price above $2.20. I would expect the stock to drop below $2 today, but we'll see.

The 10-K does note that,

The gross profit and subsequent operating profit has been affected by the expensing as required under US GAAP of the materials consumed in the testing and tuning of the new mill. This would amount approximately to $900,000.

$900k = ~5.2 cents per share, so it could be we all underestimated how much the testing and tuning would eat into earnings in Q4. Then again, as the company doesn't break the numbers down by quarter, it's unclear how much of that cost was incurred in Q4. Something to consider going forward, considering that the company has announced plans for building additional mills next year: the ramp-up costs for the expansion related to the BHP deal and other business may eat into earnings more than previously anticipated in the next few quarters.

Update: Initially, I wasn't going to mention this, but its mention by a commenter on iHub made me think of something: the company also announced in its 10-K that it anticipated hiring 3 additional manufacturing workers in the next year. That's good news on its face, but it does make me wonder if they are still planning to build additional mills next year -- I'd think they'd need more than three additional manufacturing workers to run one new mill, let alone the two mentioned in September's press release. Just e-mailed the company, asking to confirm if they are still planning on building those two new mills in 2010.

Second Update: Alloy Steel's Malaga headquarters is shut down for its Christmas break, but I was able to get a hold of Alloy Steel's Brisbane-based International Manager Gregg Muller. Gregg says Alloy Steel's domestic sales reps report to him and he also handles international sales, freeing up Gene to focus more on R&D and manufacturing. Gregg was kind enough to spend an hour on the phone with me just now, and he answered a number of questions. Some notes from our conversation follow.

New mills:

- The third mill is currently about 3/4ths built. Gregg says these mills take about four months to build and another two months to test. They take that long to build because Alloy Steel builds the mills itself, partly to protect its proprietary technology, and partly because they have to build components that they can't get off the shelf. Greg estimates the third mill will be producing product by March or April. After that, he believes the company will start building the fourth mill. He says the third mill will be bigger than the second mill. Not sure, but he believes the intent is to finance the construction of mills three and four out of cash flow, as the previous one was.

Additional employees:

- Greg says it only takes 3 employees per shift to run a mill. The mills are computer controlled, and not labor intensive. At maximum capacity, they would run two 12 hour shifts. Prior to the Christmas break, the mills were running about 18-20 hours per day. He anticipates they might approach 24 hours per day by the end of January. Prior to the BHP deal, they were down to about 10 hours per day. Gregg agreed that it would seem the company would need to hire more than three additional workers to run two new mills.

Current international business:

- Greg said the company has been active working with distributers in Chile and India, and he expects to close deal with a Brazilian distributer when he travels there in February. He started talking with this distributer six months ago. That distributer would be supplying Vale in Brazil, in addition to possibly other companies.

Indonesia:

- The outpost in Indonesia will start as a sales office, which is scheduled to open at the end of January. Greg says it only takes about 12 days to ship product there from Perth. If all goes well, Gregg says the company may build a mill in Indonesia toward the end of next year. If so, that would be the company's fifth mill.

Mongolia:

- Greg was last in Mongolia in October. The largest undeveloped copper mine in the world Oyu Tolgoi finally got the go-ahead from the Mongolian government a few months ago, after 7 years of delays. Gregg has heard that they are expecting to be moving dirt by 2011. Alloy Steel is looking to circle back with Geomandel in 2010 so they are ready for 2011. Also talking to OEMs that will be working on the project.

3-D cladding process:

- Not currently manufacturing or marketing it; currently focused on wear plates. Believes it could be a logical follow-up product sale to current clients down the road though. Might get more tweaking by Gene before then.

New developments with Super Arcoplate:

- Greg says they can now produce plate with a thickness of 1.25 inches, or 31 millimeters. He says they are trying to perfect producing a plate with 1.5 inch thickness, which will get them into casting, and open up new business possibilities. The 3rd mill is being set up so that it can produce plate an inch and a half thick once that level of thickness is perfected.

The limits of "buy what you know"

Peter Lynch famously advised investors to "buy what you know". For most of us, that generally means looking at companies that produce the consumer products we buy, but for those with specialized knowledge, it opens up other possibilities. One challenge with that is that the company with the best product isn't always the best investment. I was reminded of that by an e-mail this week from occasional commenter Y./The Rivers.

A fellow shareholder in Alloy Steel had mentioned another holding of his to me, a development stage biotech company, so I asked Y., a microbiologist/biotechnologist, his opinion of it. After offering his assessment of the company, Y. added this cautionary note,

I'm a pretty bad judge of stocks, particularly in the biology realm. a few years ago, I bought some shares in Affymetrix (AFFX) because they had the best microarray platform hands-down, and were about to acquire a big new customer (Merck). Then they made some bad business moves and got way behind the up-and-coming tech (next-generation sequencing, NGS). Their main competitor, Illumina (ILMN), with a much inferior microarray platform, did everything else better, and is now the biggest NGS company, I think. If you compare their stocks over the last few years, it's quite disparate.

Stupid Cheap?

That's how Aaron Edelheit ("issambres839") describes shares of Destiny Media Technologies (OTC BB: DSNY.OB) in his latest comment on the Value Investors Club:

I estimate that Destiny can earn 5 cents a share in fiscal 2010 (ending August 31st), on at close to 100% revenue growth. The revenue growth will be driven by more music being sent digitally and an increase in their international business. Destiny only trades at around 8 times my earnings estimate, despite tremendous growth and operating margins around 50%. Operating margins in the last quarter were already 34% and trending higher. That is why the company announced a buyback as well. I expect Destiny to continue to announce great results and the share price to keep bouncing higher.

This stock is stupid cheap.

Attempting to value a company based in its future earnings makes sense, particularly for little-followed micro caps such as DSNY (or AYSI¹, for that matter). If you think you can see future earnings that the market hasn't priced into the stock yet, you can profit by buying the stock now, before those earnings materialize and the market values the stock accordingly. As Niels Bohr said though, "Prediction is very difficult, especially if it's about the future.". For an example of that, let's look back at what Edelheit wrote about DSNY at the beginning of 2008:

Trading at seven times my fiscal 2009 (ends August 31st) earnings estimate, Destiny Media with its 90% plus gross margins and recurring revenue stream is a undiscovered gem for both technology and value investors alike.

[...]

The company currently has a market cap of around $30 million. Assuming my revenue estimate of $11 million is correct, the company will earn $0.10 in pre-tax profits in fiscal 2009. The company should probably be valued at a multiple of 15 to 20 times that number. That would give you a valuation of $1.50 to $2 per share.

Using a price to sales measure on $11 million, 10 times price to sales for a 90% gross margin, highly recurring business seems fair, giving the company a value of $2.11 per share.

[...]

If the company can continue to grow to my revenue estimate of $16 million in 2010, it will earn $0.20 per share, making $4 per share an easy target in 18 months.

[...]

Whether the stock goes to $2 or $4 is really a moot point with the stock at $0.68 per share.

So, two years ago, Edelheit predicted that DSNY would earn 10 cents a share in its fiscal 2009 (and 20 cents in its fiscal 2010). It ended up earning 1 cent per share, in its fiscal 2009, most of which was the result of a refund of previously paid taxes. I don't fault Edelheit for getting those predictions wrong -- like Niels Bohr said, predictions about the future are tough. But I don't see how confident he can be in his current earnings prediction. Edelheit seems unchastened by his 2009 predictions being off by an order of magnitude. I tried to ask him about this on his blog, but for some reason my comment didn't post.

To reiterate a point I've made here before about Destiny Media Technologies, I like the company's story, and it has been moving in the right direction recently by becoming profitable, growing its revenue and earnings, etc. My concern is its price relative to its future earnings.

¹I could certainly be off with AYSI, but the math seems simpler and clearer to me in its case. During its best quarter it earned 6.8 cents per share. That was with one mill running at full capacity. Now it has two mills running at full capacity, spurred in part by a long-term supply deal with one of the largest mining companies in the world. Let's say the company earns 10 cents per quarter next year with two mills running at full blast. Annualize that and give it a 10x multiple and you have a $4 target (that doesn't take into account the other two mills the company says it plans to build, its recent deal in Indonesia, other possible business, etc.). An exogenous event (e.g., China's economy falling off a cliff) could nix that scenario, but in the event that doesn't happen, I doubt my low-end prediction of 40 cents in 2010 earnings will be off by a factor of ten. We'll see though.

A little more Alloy Steel

Picked up a few more shares of Alloy Steel International (AYSI.OB) today at $2.27 when my limit order hit. I had been trying to pick up a little more at that price for a couple of months.

Alloy Steel expands into Indonesia

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Alloy Steel International (OTC BB: AYSI.OB) filed this 8-K today:

Quantum Leap for New Super Alloy

High demand for new Super Alloy Arcoplate products has prompted Alloy Steel International to expand their operations into Indonesia by the appointment of a company to carry out functions on its behalf and under its direction.

The first overseas engineering office, based in Jakarta, will house both marketing staff and engineering professionals.

The Indonesian capital was chosen as the hub of operations due to its proximity to the expanding South-east Asian market, the lower manufacturing costs and the availability of highly qualified technical staff.

Possible sites for the manufacturing facility are undergoing analysis regarding capital costs of construction and fit out.

The Arcoplate Super Alloy, released in July this year, can be manufactured thinner thus lighter and more durable than older white iron type products. A one inch Arcoplate Super Alloy plate can replace white iron products up to six inches thick. Successful laboratory tests and field trials have shown cost and energy savings by reducing friction, greater ease of handling, and less production shutdown time for plate replacements.

Mining clientele have indicated they will specify Arcoplate in their plant expansions, upgrades and in new mining and mineral processing applications worldwide. The new thicker sizes are in heavy demand worldwide.

The new Indonesian branch of Alloy Steel International will cater for clients extending their mining operations into Indonesia and will allow for further expansion into the Chinese, Indian and Mongolian markets.

Alloy Steel International Chairman, Mr Gene Kostecki, estimates that once the company has the facility to service the Indonesian market from a local base, demand for Arcoplate in Indonesia could exceed $10 million per annum.

There was some question on Alloy Steel's i-Hub message board about whether this is a licensing deal or not. I suspect it isn't, but I sent an e-mail to the CEO asking if he could clarify. If I hear back from him, I'll update this post accordingly.

Update: Alloy Steel International's CEO Gene Kostecki responded via e-mail saying that this was not a licensing deal. He said the company was avoiding those out of concerns about protecting its intellectual property, which he said was the company's highest priority. He said that this expansion would enable AYSI to take advantage of Indonesia's lower labor costs and proximity to markets in China and India. If I get his permission to do so, I will quote his e-mail verbatim here, but those were the key points.

Second Update: I have his permission, so here's his e-mail:

Dear David:

We are all very excited with our expansion program into South East Asia as it will give the company a great stepping stone into the entire ASEAN Market which is one of the fastest growing economies in the world.

The new government in Indonesia is fast tracking all economic development and investment in Indonesia. With Indonesia’s low labour costs and proximity to China and India it will place the company in a very competitive position to capitalize on Asian markets in this part of the world without sacrificing quality and margins, yet still being price competitive against low end products that portray themselves as wear plate.

David, we do not see the need to enter into any licensing agreements with any third party as this could potentially compromise our position in protecting our intellectual property rights in this part of the world. Protecting our intellectual property rights is the company's top priority.

Sincerely,

Gene Kostecki

Response from Alloy Steel International's CEO

In response to the list of questions I submitted to him last week, I got an e-mail from Alloy Steel CEO Gene Kostecki a couple of hours ago. I didn't hear back from him when I asked him if I could share the text of his e-mail on this blog (bear in mind Perth time is twelve hours ahead, so he may have signed off for the night by then), so I won't quote it here verbatim. But this is the gist of it: Gene apologized for not answering the questions by today; he noted that he's been busy drawing up plans for the new mill program, and that CFO Alan Winduss has been busy working on the reports given the recent conclusion of the company's fourth quarter and fiscal year. Gene said that the company planned to issue an interim report that would answer many of the shareholder questions I submitted to him, and that they would be happy to address any questions it didn't answer.

Rumors of the dollar's death: greatly exaggerated

So says Martin Wolf of the Financial Times in his most recent column. Excerpt:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

It's worth reading Wolf's column in full, but he makes a point there similar to one David Merkel made on his Aleph blog¹ recently [Merkel]:

Whatever country of our world has the status of reserve currency must issue debt, and a lot of it, that other countries can invest in to park their idle cash balances.

Wolf sketches out the "Triffin dilemma" this leads to: an overhang of debt that eventually undermines confidence in the reserve currency. Wolf's proposed solution is to look for an alternative to the dollar as a reserve currency, but I wonder if a simpler alternative would make sense in the near-term: instead of having surplus countries buy up U.S. debt to satiate their demand for dollar-based assets, why doesn't the U.S. government offer them an equity-like investment instead? Specifically, why not offer shares in a sort of massive master limited partnership that would invest its assets in nuclear power plants and other infrastructure, and pay dividends out of the revenues generated from those infrastructure assets?

Unlike the proceeds from the sale of Treasuries, which can go to fund transfer payments and health care for retirees, or extended military expeditions, proceeds from the sale of shares in this master limited partnership would go toward increasing productive capacity, which would fuel future economic growth in the U.S. This idea is a similar to (but simpler than) one proposed by Professor Yu Qiao of the School of Public Policy and Management, Tsinghua University, Beijing, in the Financial Times last spring.

¹Speaking of Merkel's blog, last month he asked if any readers had any stock ideas to share. I mentioned three: USEG, AYSI.OB, and DSNY.OB. As of yesterday's close, they were up 26%, 390%, and 60%, respectively.

Update on Q&A with Alloy Steel International

I mentioned this in the comment thread of a previous post, but for those who missed it,

The list of questions ended up being fairly long. Gene [Kostecki, AYSI's CEO] wrote back to say that he and Alan [Winduss, the company's CFO] planned to try to answer all the questions by midweek next week. In light of that time frame, I am going to revise my previous comment about not placing any trades until I post their response. I am going to place additional limit buy orders today but I won't modify them if they don't fill until after I have posted AYSI's responses to the questions. The salient point remains that I won't be buying or selling AYSI based on answers received from the company before posting them here.

I put in a GTC limit order in the low 2's this morning, but obviously didn't get it filled today, given today's price action. Speaking of which: commenter J.K. (who, as far as I know, is the only reader to have invested in AYSI after reading about it here), sold his shares at around $2.70 recently, because he felt that the chart suggested the stock would pull back below $2 in the near future. I've held (and added a tiny bit more) because I don't think the stock will drop below $2 before earnings are released absent materially negative news, and I don't want to risk having the stock run away from me if additional positive news is released (e.g., a big supply deal with another multinational mining company).

Essentially, J.K. feels the stock's near-term trajectory will be driven by technical factors and I think it will continue to be driven by fundamentals. It will be interesting to see which one of us turns out to be correct over the next couple of months.

Questions for the CEO of Alloy Steel International?

On the off chance any of you have a question for the Hank Reardon of wear plates, leave it in the comment thread below. Mr. Kostecki has apparently indicated through an intermediary a willingness to chat with me.

Alloy Steel, Altman Z-Scores, China, and Vertical Branding

Connecting the dots between some recent topics:

- Alloy Steel International (Nasdaq: AYSI.OB) is the sort of company that is benefiting from China's New, Self-Propelled Economy.

- The Altman Z-Score model can be used by equity investors to evaluate current long holdings for signs of financial distress, as we did with Alloy Steel most recently back in May. When the model predicted that the company was not at risk of bankruptcy at that point, we added more to our position (at about 23 cents per share), despite the weak quarter the company had just announced.

- The Altman Z-Score model can also be used to look for potential short ideas, as in the previous post re BAGL. We'll see how that one works out.

- Vertical Branding (Pink Sheets: VBDG.PK), retailer of such fine, made-in-China products such as this,



is an example of the sort of company associated with China's pre-self-propelled, more export-dependent economy. When China's exports of these sorts of products started to drop precipitously as the global economy sunk into recession, one of the concerns pundits raised was the plight of the migrant workers from China's rural West who were getting laid off. China decided to address this via its stimulus package by increasing investments in Western China, including job-creating infrastructure projects there. Infrastructure requires steel, and to make steel you need iron ore. Companies that mine for iron ore need wear plates to protect and increase the efficiency of their mining equipment. Alloy Steel International makes best-of-breed wear plates.

China's New, Self-Propelled Economy

A few months ago, we mentioned James Kynge's 'China Continental' thesis. In that post, we excerpted an essay Kynge had written in the Financial Times explicating his thesis for China's continuing growth in the wake of declining exports. This was the excerpt we quoted from Kynge's essay:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

A couple of items that appeared earlier this week in the Financial Times suggest that Kynge's thesis may have been correct. This item from Monday's Lex column, "China's Stimulus" is one, and Martin Wolf's column from Monday's FT, "Wheel of fortune turns as China outdoes west", is another. Here are a couple of brief excerpts from both.

Lex:

There is no precise breakdown of stimulus spending by geography. But $366bn falls under the heading of infrastructure and post-quake recovery; another $113bn under public housing and rural development. Only a small slice – $54bn to stimulate “technological innovation” – seems to explicitly favour developed regions. Output in 12 western provinces grew an average 8 per cent in the first half – a whole percentage point better than 11 provinces in the east.

This structural shift was evident in first-half figures from ICBC, China’s largest commercial lender. Its year-on-year percentage increase in operating income in the Yangtze and Pearl river deltas fell, but rose in central and western regions. In short, China would rather finance roads in Chengdu than sweatshops in Guangdong. Many private, export-led companies in coastal areas, lacking collateral in the form of land or government relationships, are still struggling for funds. Trade data on Friday showed exports and imports falling for the 10th month, year-on-year. Weak external demand is not the only cause; this is an unabashed internalisation of growth.

Martin Wolf:

China has emerged as the most significant winner from the financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy.

[...]

Three immediate questions arise. How has China responded to the crisis? Is its resurgent growth sustainable? How far will its recovery help the world economy?

The answer to the first question is: astonishingly. According to data reported at the end of last week, industrial output expanded 12.3 per cent in the 12 months to August, up from a 10.8 per cent increase in July. This is the fastest growth for a year.

[...]

Is this growth surge sustainable? In a word, yes. Inevitably, the torrid growth of bank credit and money is spilling over into asset prices, particularly equities. But there is little danger of excessive inflation in an economy with an appreciating currency, fully embedded in a world economy still threatened more by deflation than by inflation, at least in the near term. Moreover, the government is solvent. As premier Wen Jiabao noted in Dalian, "we . . . kept budget deficit and government debt at around 3 per cent and 20 per cent of the GDP respectively". Should bad loans increase, China is well able to recapitalise its financial system.

This is good news, of course, for companies selling raw materials to China, for vendors to those companies (e.g., Alloy Steel International), and, more broadly, for countries such as Australia and Brazil that export significant amounts of raw materials to China.

The Power of Positive News

Earlier this year, when Alloy Steel CEO Gene Kostecki complained to me via e-mail about short sellers shorting his company's stock, I noted in a post ("Run Silent, Run Deep") that the best way for a company to foil short sellers would be to release positive news. Alloy Steel International (AYSI.OB) did just that today when it issued this press release about an hour ago, announcing it landed a huge long-term contract to supply its proprietary product to BHP Billiton, "Alloy Steel International Signs Supply Agreement With BHP Billiton". From the release:

PERTH, AUSTRALIA--(Marketwire - 09/08/09) - Mr. Gene Kostecki, Chairman and CEO of Alloy Steel International (OTC.BB:AYSI - News), today announced that Alloy Steel Australia (Int) Pty Ltd a wholly owned subsidiary of Alloy Steel International Inc. has signed a long term strategic supply agreement with BHP Billiton to supply Arcoplate Wear Resistant Super Alloy Wearplate for iron ore mining operations in Western Australia.

The initial product taken will be for the multi-million dollar expansion of their operations in the Pilbara area of Western Australia. The first product releases issued by BHP have been for value in excess of $5 million in the past 7 weeks. It is anticipated that over the next five years the value of Wearplate could be in excess of $50 million.

Since the announcement in August 2009 of Alloy Steel's successful commissioning, the increased level of interest in the new production mill shown in Arcoplate has been outstanding, according to Mr. Kostecki. Most of the major iron ore miners in Western Australia have enquired about booking production time for their own expansion programs and maintenance programs and are expected to order the full range of Arcoplate thicknesses.

Since commissioning the new Arcoplate mill, it has been working at full capacity satisfying the demand for the new 3/4 inch or 20mm material whilst the other Arcoplate mill has been fully utilized with the ongoing demand for the thinner overlay materials.

As a result of the increased level of interest in Alloy Steel's Arcoplate product by local and international mining companies, the Directors of Alloy Steel are planning for a further two production mills with substantially increased capacity to come on line in early 2010.

Alloy Steel's 10-Q

The company (OTC BB: AYSI.OB) swung to a loss of ($437,951) on sales of $1,307,160 in the quarter ending June 30^th, but the 10-Q includes this news:

The Company has recently been advised of its successful tender for a significant contract with BHP Billiton Ltd, with the first order release being received by the Company to the value of approximately $3,200,000 subsequent to the reporting date.

Alloy Steel was also the subject of this longer, recent post.

News from Alloy Steel

The company (OTC BB: AYSI.OB) filed this 8-K earlier today:

Mill Commissioning

The company advises that the new ARCOPLATE manufacturing plant specifically designed to produce extra thick (up to 20/11mm) and super alloy wear plate has been commissioned and has commenced production.

The new mill is the only one in the world capable of producing a bi-metallic fused super alloy wear plate in a thickness of application of up to 20 mm (just over ¾ of an inch) in a single continuous casting operation.

The conventional method used to produce a hard surface overlay is by a welding method which can only achieve a weld surface which at best is ¼ inch or 6mm thick in a single pass and is flawed with major quality technical limitations.

The new AYSI new technology has overcome all the known technical difficulties and is capable of fusing 20mm or super wear resistant alloy onto a ½ inch or 12mm steel backing plate.

This is a significant technological breakthrough which should see this plate be specified consistently in new mining projects and become the norm for replacements in upgrades for existing mining operations.

Mr. G Kostecki C. E. O. of the company is very encouraged with the strong interest being shown by all the major producers who have seen the test samples and the technical reports and predicts a large future demand for the product.

Mr. Kostecki was responsible for the technical innovation and development of the new process and alloy formulation.

These reports have been carried out by independent laboratories.

Whether any of the demand predicted above will be apparent in the 10-Q Alloy Steel is going to file next week remains to be seen, but this is good news. More generally, the surge in Chinese steel production and the recovery of iron ore prices has been good news for Alloy Steel's mining company customers (how sustainable Chinese demand will be remains to be seen).

I picked up a few more shares of Alloy Steel at .325 on Tuesday, when the stock dipped about 20% on no news. Still keeping most of my powder dry for investing in another asset class though.

Incidentally, a couple of weeks ago, I mentioned Alloy Steel in a comment thread on Fred Wilson's blog, in response to a comment by Mark Cuban about how he'd be more interested in investing in a Rearden Steel¹ than the next social media start-up. That was a brain cramp on my part: Even if Cuban could buy all of Alloy Steel, it wouldn't be a big enough investment to be worth his time. Plus, Cuban (wisely) likes to invest where he has an information advantage², so unless he has connections in the wear plate or mining industries, he probably wouldn't seriously consider investing in this sort of company.

¹An allusion to Hank Readen's company in Atlas Shrugged.

²Writer, entrepreneur, and angel investor Tim Ferriss seconded Cuban's point in a post last fall. Ferriss wrote that he feels more comfortable investing in tech companies where he has some inside knowledge and connections than swimming with the sharks in the stock market.

"Yes we Khan"

The other day, when the local Barnes & Noble was sold out of Rolling Stone, it happened to have Monocle as its new, featured title. I'd been curious to see an issue of Monocle since reading its editor Tyler Brûlé's semi-ridiculous Saturday columns in the Financial Times, which generally focus more on the minutia of his globetrotting than on why he's traveling in the first place.

For example, one column described his early-morning routine at a Hyatt in Seoul: ordering a Mandarin orange juice and a cappuccino from room service, before running for an hour on a treadmill, then scrubbing himself with a brush while sitting on a chair in the hotel's fancy shower/sauna, etc. Another column detailed how he ordered a lackey to fly from London to some town in Switzerland to pick up the wallet Brûlé left there, and hop on a train to Paris to get Brûlé his wallet before his scheduled flight to Tokyo.

In any case, Monocle, as it turns out, is chock full of content (an inch thick) and an interesting read. In one feature, an analyst from Jane's Defense Weekly was asked what aircraft he'd buy if he had $15 billion and were tasked with building an air force from scratch for a mid-sized G-20 country. Another article reported on the nascent commodity- and energy-driven boom in Mongolia, "Yes we Khan". The online version of the article is restricted to subscribers, unfortunately, but it offered some color on the situation in Mongolia. There seem to be a lot of opportunities for natural resources companies there, given the amount of resources in Mongolia and its proximity to China, but how much of that money will filter down to ordinary Mongolians is a question the article raises.

The article also reminded me of the joint venture Alloy Steel International (OTC BB: AYSI.OB) was negotiating with Mongolian conglomerate Geomandel last year. Last I heard about this from Alloy Steel's CEO (this was last October, well before he took the "Run Silent, Run Deep" tack toward shareholder communications), he said,

We have shelved Mongolia for at least 6 Months till this madness subsides.

Maybe when the company releases its next quarterly filing in August it will provide an update on this.

The photo above, of the outskirts of Ulan Bator, accompanied the Monocle article and was credited to Andrew Rowat.

Alloy Steel's 10-Q

Alloy Steel International (OTC BB: AYSI.OB) filed its 10-Q today (summary; full filing). Another break-even quarter: $39,000 of net income on $1,479,774 of sales. As I mentioned in a recent post ("Run Silent, Run Deep"), I had expected a loss this quarter, so I'm (mildly) pleasantly surprised the company was able to break even during what might turn out to have been the worst quarter of the current global recession. Judging from the price action today though, others had higher expectations. Management offered this comment on the quarter and the company's prospects going forward:

The decrease in sales for the period is representative of the general downturn being experienced in the world economy. The number of orders received by the Company have declined as demand for our product reduced as various mining companies announced that new mining projects were being delayed and/or existing mining projects were being wound back until demand for commodities increased. The Company has submitted tenders for the supply of Arcoplate where possible and is confident that these will be successful with orders likely to be received in the next three to six months. The Company has continued to promote its product in the market place as a superior option for maintenance, as well as seeking entry into other markets which were previously limited by the Company’s ability to meet the demand existing prior to the economic downturn. The Company is confident of being able to present its product well in these new markets, and anticipates additional orders will be generated from these new locations.

Updated Altman Z-Score for Alloy Steel

In a previous post ("Using the Altman Z-Score to Calculate the Risk of a Company Going Bankrupt"), we described the Altman Z-Score model for manufacturing companies:

The Altman Z-Score is a model developed in 1968 by NYU Finance professor Edward Altman (pictured above) to predict the likelihood of a company going bankrupt within the next two years. According to Investopedia,

[R]eal world application of the Z-Score successfully predicted 72% of corporate bankruptcies two years prior to these companies filing for Chapter 7"

In creating the Z-Score model, Professor Altman studied an initial sample of 66 firms, half of which had gone bankrupt, and looked for the balance sheet and income statement ratios that had the most predictive value. Dr. Altman settled on these five ratios¹:

T₁ = Working Capital / Total Assets
T₂ = Retained Earnings / Total Assets
T₃ = Earnings Before Interest and Taxes / Total Assets
T₄ = Market Value of Equity / Total Liabilities
T₅ = Sales/ Total Assets

He then assigned weightings to them based on their predictive values to create his model:

Z Score Bankruptcy Model:

Z = 1.2T₁ + 1.4T₂ + 3.3T₃ + .6T₄ + .999T₅

Based on this model, a Z-score below 1.8 means bankruptcy is likely within two years; a Z-score between 1.8 and 2.99 is a gray area; and a Z-score above 2.99 means there is little likelihood of bankruptcy within the next two years.

In that post, we noted that the Altman Z-Score for Alloy Steel at the time was 4.89. I re-ran the calculation today using the updated numbers and got an Altman Z-Score of 4.19. Unsurprisingly, it's lower than last time, given the drop off in sales and earnings, but still well above the 2.99 level, above which the model predicts little likelihood of bankruptcy within the next two years.