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.

Zinc Again

The collapse in zinc prices last year lead to some mining companies closing their zinc mines. Yesterday, Reuters reported that Hudbay Minerals (TSX: HBM.TO) was considering reopening a zinc mine, "HudBay eyeing restart of Chisel mine-CEO":

TORONTO, June 9 (Reuters) - HudBay Minerals (HBM.TO) could restart its Chisel North zinc mine in Manitoba if the metal's price increase another 10 or 15 percent from its current level, the company's chief executive said on Tuesday.

HudBay shut Chisel North and its Balmat zinc mine in New York last year after zinc prices fell below 50 cents a pound late last year, after topping $2 a pound in 2006.

Cash zinc MZN0 was around 71 cents a pound on Tuesday.

"We think a 10 to 15 percent increase from that price and we will be looking seriously of reopening Chisel, which can be done very quickly indeed," Jones said at a mining conference in Toronto.

That suggests a zinc price of 78 cents to 82 cents a pound would be needed to consider reopening the mine.

Hudbay was prudent enough to have accumulated large war chest of net cash (equal to about a third of its market cap at the time) by the time commodity prices collapsed last year, so it has been able to weather the downturn.

The (modest, so far) rebound in zinc prices this year may be another data point in support of James Kynge's "China Continental" thesis.

Applying the Altman Z-Score Model to Mining Companies

Tools and ideas for short sellers, including an automated calculator and screener based on the Altman models.

In a couple of recent posts ("Using the Altman Z-Score Model to Calculate the Risk of a Company Going Bankrupt" and "Applying the Altman Z-Score Model to a Non-Manufacturing Company") we discussed the use of the original, five variable model for manufacturers and the modified model for non-manufacturers. Recall that the modified Altman Z-score model for non-manufacturers excludes the fifth variable in the original model (sales/total assets), to account for different levels of capital intensiveness among non-manufacturers.

Since mining companies, like manufacturers, are also capital intensive, I asked Dr. Altman via e-mail which of his models would be best for miners. His response:

Try both, but probably the 4 variable model is more appropriate.

The photo above, of a copper smelter, is from the website of the Canadian mining company Hudbay Minerals.

U.S. Energy Corp. Update

A few quick updates:

- U.S. Energy Corp. (Nasdaq: USEG) filed an 8-k and issued a press release today announcing that it had retired its $16.8 million construction loan on its Remington Village real estate project. Since it was unable to get longer-term financing in the current credit environment without paying onerous fees, since it had close to $70 million in low-yielding Treasuries, USEG management figured it was better off using some of that cash to payoff the loan. The press release also added some details about the status of the Remington Village project:

``Remington Village is an excellent asset in an economically sound area that is currently generating in excess of $200,000 per month in revenue and is expected to generate $248,000 in monthly revenues upon stabilization at 95% occupancy,'' [said USEG CEO Keith Larsen]

The project was completed ahead of schedule in early December, 2008 approximately $1.1 million under budget, and is currently 88% occupied. The Remington Village complex consists of nine 24-plexes with a mix of one, two, and three bedroom units, as well as a clubhouse and leasing office.

The Gillette, Wyoming region continues to experience solid growth following record state coal production in 2008, and attracting new residents through a number of infrastructure projects currently under development including a $40 million recreation center, an $80 million hospital renovation, a $1.4 billion mine mouth-feed coal-fired power plant and a soon to be constructed $120 million coal dewatering facility north of Gillette.

- Last week, USEG announced that it had received a scheduled $1 million milestone payment from Thomson Creek as part of the option agreement Thomson Creek signed with USEG in August to pursue development of the Lucky Jack Molybdenum project.

- Earlier this month, USEG announced that it had signed an oil & gas participation agreement with a private company to acquire a 50% working interest in a prospect in Northeastern Wyoming. In this release, USEG's CEO stated that his company's goal was to increase its production from its current level of 1,700 million cubic feet equivalent per day (MCFE/D) to 7,000 MCFE/D by the end of 2009.

The photo above, of the company's Remington Village real estate development, is from the company's website

E-Mail from the CEO of Alloy Steel International, Inc.

During the current market downturn, shares of Alloy Steel International, Inc. (OTC BB: AYSI.OB), have sunk recently along with the shares of other companies in the metals sector. I have had a GTC limit order in for a few days to buy a few more shares below $1, but it hasn't been filled yet. I asked the following questions of the company via e-mail early this morning:

Can you provide an update on the construction of your second mill? If memory serves, you expected to have it in operation by September.

Also, have you succeeded in hiring the sales persons you were recruiting over the summer?

Is your planned joint venture in Mongolia still on track?

I received the following response from Alloy Steel's CEO, Gene Kostecki,

Thank you for your continuing Interest in AYSI. We are about to make a press statement on the company, we were just waiting to get the accounts finished for the 3rd Quarter. I think that every one will be in for a pleasant surprise. We have shelved Mongolia for at least 6 Months till this madness subsides. The 2nd mill is a few weeks behind schedule before we start calibrating and software checking. We are continuing to steer a steady course for the company.

At its current price of $1 per share, Alloy Steel is trading at 6.62x its earnings over the trailing twelve months.

Financial Times: Gloomy Short-Term Outlook for Metals

This article won't be a surprise to anyone who owns or has been following the share prices of mining companies, Financial Times: "Mining and metals prepare for lean times". Excerpt:

The mining and metal industry is bracing for months of price weakness as slowing demand in the US, Europe, Japan and some emerging markets, including China, is likely to push commodities such as copper into surplus.

At the London Metal Exchange annual dinner last night, the premier gathering of the industry in London, the mood among traders, bankers and mining executives was gloomy, particularly with regard to the short term.

"With the likelihood of a global recession rising, industrial metals prices will face further downward pressure," said a report by Francisco Blanch of Merrill Lynch.

[...]

Over the medium-term, some analysts and executives see some bright spots in the market. Leon Westgate, a metal analyst at Standard Bank, said that looking ahead towards the start of the next decade a demand recovery and in some cases the need for restocking by consumers will come into play. "Given the current low price of metals relative to production cost, and the impact of expensive capital, we may see supply retreat further," said Mr Westgate.

Answers from Alloy Steel's CFO

In my previous post on Alloy Steel International (AYSI.OB), I noted that I had asked the following questions of the company via e-mail:

- 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?

Today I received the following response from Alloy Steel's CFO:

Dear David,


I apologise for delay in responding to your email but due to airline delays did not arrive back in Australia until 5 July.

In relation to your queries I advise: -

- We do not declare clients name due to issues of commercial confidentially but suffice to say they include BHP Billiton Rio Tinto FMG, Caterpillar Komatsu and many other major miners and international equipment manufacturers.
- Very hard to give a precise figure because of size of fleets but in most instances in excess of 60%
- The new mill will apart from giving increased capacity with present product range will allow in penetrating new markets with new products and super alloy products.
- We expect to experience a slow down in orders from some mining companies effected by the gas shortage; however the timing of this cannot be determined.
- At this stage we are not intending to license manufacturers of the product.

Overall, this sounds encouraging, particularly the part about the potential of the new mill to produce new products. Regarding the CFO's second point, I assume the 60% estimate he mentions refers only to the clients' fleets in Australia, which would leave the potential to equip their fleets in other parts of the world with wear plates. I'll e-mail him to clarify that though.

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.


Updates

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.