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.

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'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.

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.

The Stock Also Rises

As a commenter on the company's Investor Hub message board noted, Alloy Steel International (OTC BB: AYSI.OB) was up 39.29% today on 6x average volume. It's nice to see the stock move up for a change, particularly with its earnings release expected next week, but I think this says more about the inherent volatility of an illiquid, low-float, micro-cap stock than anything else. I still expect the company to post a loss when it reports its quarter. Maybe there will also be some encouraging forward-looking statements though. We'll see.

Run Silent, Run Deep

That is, of course, the title of one of the classic submarine movies¹, but it's also a fitting description of the current investor relations tack of Alloy Steel International (OTC BB: AYSI.OB): as the company's stock price has dived, the company has refrained from releasing any information since its last 10-Q. Over the last few weeks, I tried contacting the company's CEO (who has designated himself the investor relations contact) via the company's website and then via his company e-mail address. After no luck, I trying calling him. Alloy Steel's receptionist in Malaga mentioned he was traveling overseas and, assuming he hadn't had a chance to check his company e-mail address, gave me his personal e-mail address and suggested I try him there. Again, no response. This week, after calling the company's headquarters again and learning that the CEO was again traveling overseas, I sent him the following message:

I understand from Melanie in your Malaga office that you are traveling overseas again. Given your heavy travel schedule and extensive responsibilities, I imagine you must have little time to answer questions from investors. Nevertheless, you have designated yourself as the investor relations contact for your company. Have you considered delegating this role to someone who might have the time to respond to an occasional investor e-mail or phone call?

And received the following response:

Dear Dave.
As a result of the market volatility and the short sellers that have been short selling our stock the board has decided to only release information through the normal reporting channels there will be no separate reports to any investor who we have no record of in our share register.

Kind Regards.
Gene Kostecki
CEO Alloy Steel Int.

Sent via BlackBerry® from Vodafone

This response didn't inspire a lot of confidence in the company's current situation. I can understand the reluctance to communicate with an individual shareholder on Reg FD grounds, but if Mr. Kostecki believes that the market's opinion of his company's prospects is unjustly negative, the best way to counter that would be to release information through "normal reporting channels" proving it wrong. For example, if the company picked up a major order recently, or an order in a new market, it could announce that via an 8-K (as it has done in the past). Since Alloy Steel hasn't released any such updates this year, it's rational for market participants to assume that it has no good news to report.

Judging from the CEO's e-mail above, the break-even numbers it reported last quarter, and its high inventory levels over the last two quarters, my guess is that it will post a loss for the quarter that ended on March 31^st.

I was going to end this post on a positive note, by including a link to Goldman Sachs chief economist Jim O'Neil's column in the Financial Times Thursday, in which he mentioned he had revised upward his growth estimates for China's economy this year and next. If O'Neil's estimates come to pass, that would be good news going forward for mining companies, and, by extension, for Alloy Steel. Unfortunately, after 20 minutes of trying, I was unable to find a link to O'Neil's column using the Financial Times website's search feature.

¹The all time champ of submarine movies is Das Boot, in my opinion.

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.

Alloy Steel's Annual Report

Alloy Steel International (OTC BB: AYSI.OB) filed its 10KSB annual report today.

A few notes on it:

- Fiscal 2008 net income was $0.15 per share¹, versus $0.08 in 2007, an 87.5% year-over-year increase.

- The company's second mill is completed, and the company expects it to go into commercial production in February.

- The company plans to hire two more manufacturing employees in 2009.

- The company is now looking into the possibility of licensing production of its Arcoplate wear plates in other countries².

- The balance sheet shows finished goods valued at $765,446. If this represents sales that will be recognized in the next quarter (as was the case with the finished goods that were listed on the 3Q08 10K), and if the company's gross margins remain stable, this could represent approximately $1.4 million in 1Q09 sales.

A more general comment, about the prospects of a "picks & shovels" business such as Alloy Steel's during a steep correction in the prices of mined commodities follows. In a recent article in the Financial Times ("Engineers feel impact of cancelled projects"), the reporter asked the CEO of the British conveyor belt manufacturer Fenner about the impact of the decline in commodity prices. This was the CEO's response:

“Conveyer belts carry materials based on volume and tonnage. If you are producing a commodity, we are driven by volume, not its price,” says Mark Abrahams, chief executive of Fenner.

Of course, if the price of a commodity drops far enough, i.e., below its cost of production, production volume will plummet, but above that price point, a picks & shovels business such as Fenner or Alloy Steel International ought to be less sensitive to fluctuations in price of the underlying commodity.

The photo above, of a truck bed lined with Alloy Steel's wear plate, comes from the Investors Hub page for Alloy Steel.

¹This is quite close to a commenter's recent estimate of $0.148, based on the revenue figures in Alloy Steel's last 8K.

²This is a departure from the company's previous position on licensing that we noted in an earlier post ("Answers from Alloy Steel's CFO").

Alloy Steel Breaks Radio Silence

Alloy Steel International (OTC BB: AYSI.OB) belatedly filed an 8-k announcing its preliminary full year sales and pre-tax profit (the company's fiscal year ended on September 30^th):

PRELIMINARY FULL YEAR PROFIT ADVICE
FOR THE YEAR ENDED SEPTEMBER 30, 2008

The Company advises that its unaudited profit before income tax expense for the financial year ended September 30, 2008 is $3,670,000. This is an increase of $1,710,000 over the profit before income tax expense achieved for the year ended September 30, 2007.

This profit has been achieved on sales of $13,500,000, which is an increase in sales of $4,800,000 over the previous year.

While these figures are still subject to final sign off by the Company's Auditors, the Directors do not believe there will be any significant changes to these figures.

The Company is very cognizant of the possible effects of the economic downturn on the world mining market but believes that, with its positioning in the market place, it will not be adversely affected by the possible change in market conditions.

The last sentence above is encouraging.

After subtracting the sales and pre-tax profits from the first three quarters of this year from these preliminary year-end numbers, we end up with 4Q sales of $3,572,000 and 4Q pre-tax earnings of $1,014,000. My estimate was too high on the profit side and a little low on the revenue side: I estimated the firm would generate about $1.3 million in profits on about $3 million in sales in the quarter. After tax profits might end up being ~$700k for the quarter, but that would still be a significant sequential increase from last quarter's profit of $230k.

I got another limit buy order for Alloy Steel filled at $0.451 yesterday; I have another GTC order open at close to that price, but given this 8-k, I doubt I'll get it filled today.

The image above, which shows how Alloy Steel's Arcoplate wear plates minimize hang up, is from the company's website.

Alloy Steel Update

Last month, the CEO of Alloy Steel International, Inc. (OTC BB: AYSI.OB) gave us a brief update on the company and mentioned they were planning to issue a release after they finished their accounting for the quarter ("E-Mail from the CEO of Alloy Steel International, Inc."). Having not seen any update, I followed up with the company again yesterday, to ask if they were planning to file an 8-k or issue a press release before they filed their 10-k at the end of the year. Today I got the following response from the company's CFO, Alan Windus,

The auditors are currently reviewing end of year figures; we should be in a position to lodge a preliminary profit advice late next week.

Alloy Steel shares closed at 72 cents per share today, trading at less than 5x the company's earnings over the trailing twelve months. I have a limit order in to buy a few more shares at a slightly lower price. I don't have a lot of visibility on this one in the near term. The recent strengthening of the U.S. dollar versus the Australian dollar should negatively impact earnings as reported in U.S. dollars, and the global economic slowdown is of course impacting the company's customers in the mining industry. On the plus side, Alloy Steel sells a product that can increase efficiency and reduce costs, and increased efficiency and reduced costs should continue to be a compelling proposition for mining companies. Plus, Alloy Steel is starting from such a small base and has such limited exposure outside of Australia, that it might still be able to grow its business during a slowdown. We'll see. Longer term, if the company makes it through this period, I am bullish about its prospects.

The photo above, of a truck bed outfitted with Alloy Steel's Arcoplate wear plates, is from the company's website.

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).

An Update from Alloy Steel International (AYSI.OB)

Recently, on message boards such as the one on Yahoo! Finance and Investor Hub, some investors in Alloy Steel International (AYSI.OB) have expressed frustration that Alloy Steel's management hasn't provided more frequent updates on the company's progress. Today Alloy Steel released its second 8-K in a little more than a month. The previous 8-K announced the formation of a joint venture in Mongolia with Geomandal; below is the text of the current 8-K.

UPDATE OF SALES AND ORDERS FOR ARCOPLATE^TM

Fortescue Metals Group (FMG) has continued its preference for the use of ARCOPLATE in all their mining operations with placement of an order for one million eight hundred thousand dollars ($1,800,000) worth of product this week.

ARCOPLATE was used predominately in the construction of their current mining operations in Northern Western Australia (Cloudbreak mine); the value of product utilised in Cloudbreak mine by FMG was $5.5 Million making total purchases of ARCOPLATE $7.3 Million by FMG (www.fmgl.com.au)

Part of this order is for their existing operation and the balance is for the start of the fit out of their second mine which is currently under construction.

Alloy Steel has been advised it is preferred supplier for this second mine's wear plate requirements.

Following a visit to Perth last week by a group of consultant engineers from Kuala Lumpur, a significant order has been placed for the first major use of ARCOPLATE in Malaysia.

The final order value is expected to be approximately $630,000.

Unlike some of those commenters on the message boards, I'd actually prefer to not hear any updates such as these for a while -- at least until my outstanding GTC limit buy order is filled.

U.S. Energy Corp. (USEG)

I started a position in U.S. Energy Corp. (USEG) last month at $2.85. Today it closed at $2.81. Below is a write-up of the company I initially posted on GuruFocus.com a few days after I bought the stock. I am re-posting it here now because I spoke with the CEO of USEG today, and before I post my notes on our conversation, I wanted to provide some background on his company, for those who may be unfamiliar with it.

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U.S. Energy Corp. (USEG) is an energy and natural resources exploration and development company currently trading for a third less than its book value (it was trading for .57x book when I bought it a few days ago). The management of USEG has a demonstrated track record of acquiring natural resource assets and selling them at opportune times for significant gains; the most recent example of such a successful sale occurred last year, and was the source of most of the company’s current cash hoard. USEG is a compelling value on its discount to book value alone, but four potential catalysts present opportunities for significant additional appreciation.


Valuation


USEG has a market cap of $75,470,000 and an enterprise value of $10,687,000 (subtracting both the company’s cash and its Treasury securities from the sum of its market cap and interest-bearing debt). It currently trades with P/B ratio of .66 and an EBIT/EV ratio of 82% (using trailing twelve-month data). The reason why the company trades at such a high earnings yield is because up until now it has generated its income through occasional deals rather than through consistent earnings. The company’s strategy going forward is to invest in assets that will produce recurring revenues while still pursuing large deals with windfall potential. The catalysts I describe below include examples of both. Note that the data above do not reflect the results of U.S. Energy’s sale, announced today, June 13th, 2008, of 39,062,072 shares of Sutter Gold Mining Inc. (SGM on the TSX Venture Exchange) for approximately $5,281,200 (in U.S. dollars).



Examples of USEG Management’s Timely Sale of Natural Resources Assets


Last year, U.S. Energy sold uranium properties that it had staked claims on during the 1990s, and had held onto as uranium prices dropped from the $ mid-teens per pound to $6.40 per pound in 2001. With uranium prices at uneconomical levels, U.S. Energy turned its focus to developing prospects for coal bed methane, but held onto its uranium properties. Through a subsidiary, Rocky Mountain Gas, U.S. Energy invested $15 million in the exploration and production of coal bed methane assets. Through a series of transactions, by the end of 2005, U.S. Energy had sold these assets for a total of $27.7 million.


Last April, when uranium prices were about $110 per pound, USEG sold its uranium properties to Uranium One Inc. (which trades under the symbol UUU.TO on the TSX) in exchange for 6.6 million shares in Uranium One, plus additional consideration, which I will expand on below. Uranium prices peaked in the mid-$130s a few months later, in the summer of 2007, and around that time USEG sold all of its shares of Uranium One Inc. for an average price of $13.68. Today, uranium is trading for less than $60 per pound, and shares of Uranium One Inc. are trading at about $4.30. This is an example of near-virtuosic timing and prudence on the part of USEG management, and one that bodes well for its handling of its current and future natural resource projects.


Catalysts


USEG has four potential catalysts to unlock additional value: One in the near-term (most likely this year), two in the medium term (within the next five years), and another in the longer-term (five years from now).


Near-Term Catalyst

· The Completion of a 216 Unit Residential Real Estate Project in Gillette, WY. Demand for housing in this part of Wyoming has been high recently because of the natural resources boom – the Gillette area produces about 40% of America’s coal, and the town’s population is growing by 7%-10% annually. Of the 216 units, 207 have been pre-leased. If USEG holds onto this property, its CEO Keith Larsen estimates it will generate about $250,000 in monthly revenue. Although USEG management sees promise in targeted real estate developments in regions participating in the natural resources boom, they have decided not to pursue any additional real estate projects, to assuage investor demand that they focus exclusively on energy and natural resource projects.

Medium-Term Catalysts

· Oil and Gas Exploration and Production. U.S. Energy has entered into separate partnership agreements with a private Houston-based oil and gas company and with Lafayette, LA-based Petroquest Energy (PQ on the NYSE). Drilling of the first three natural gas wells with Petroquest is expected to begin in June of 2008, and the drilling program with the private company is expected to begin in 2009. According to a presentation by Petroquest management dated June 2nd, 2008, Petroquest’s drilling success rate over the last 9 years has been 89%. U.S. Energy’s CEO has estimated that his company’s interest in these three wells alone could generate $250,000 in monthly revenue (the CEO estimates that USEG may be able to generate a total of approximately $750,000 in monthly revenue between interest income, income from the Gillette real estate development, and the potential revenue from these initial wells). USEG is evaluating other oil and gas investment opportunities to pursue in partnership with exploration & production companies that have proven, successful track records.
· Additional Payments from Uranium One. The largest part of the additional consideration that USEG received from Uranium One last year was $40 million to be paid contingent on the former USEG uranium properties meeting certain production targets; USEG management expects to receive this $40 million in the next few years as these production targets are met. Since USEG is such a small, little-followed stock, these windfall payments may act as catalysts for the share price as market participants see them appear in USEG’s quarterly filings. More importantly, USEG will be able to reinvest these moneys in energy and natural resource projects with promising returns.


Long-Term Catalyst


· Molybdenum Claims in Colorado. USEG’s patented “Lucky Jack” molybdenum claims near Crested Butte, Colorado, represent its most challenging project and also potentially its most lucrative one. USEG management estimates that a mine here could produce 15-20 million lbs of high-grade molybdenum per year, at a cost of about $10 per lb, and that the mine could have a 50-year life. Molybdenum, the demand for which has been driven partly by the global infrastructure boom, currently trades at over $33 per lb, so the potential profits from a Lucky Jack mine at current prices hold would be over $345 million per year. Currently, USEG has commissioned an engineering study of the project, and intends to submit a plan of operation to the U.S. Forestry Service by the end of 2008. If all obstacles are surmounted, and USEG can build a mine here, it would first start producing molybdenum in 2013. USEG may be able to monetize part of its interest in this project before then though, since it plans to sell a stake in its claim to an established mining company and have that company help develop the project.

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.