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.

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.

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.

China's Economic Transition

China's exports were down 22.6% year-over-year in April, continuing a six month negative trend. That's the obvious cloud in China's economic forecast, but in an article in yesterday's Financial Times ("Chinese tap an inner dynamic to drive growth"), James Kynge highlighted the silver lining:

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. There are caveats, of course, but first the evidence.

Retail sales have held up much better in China this year than in other big economies, growing at a real 15.9 per cent in March year-on-year. But more important than the overall trend is the composition of the retail spending.

The most robust consumer spending figures are coming from inland and lower-tier cities rather than from the traditional growth powerhouses clustered around the Yangtze and Pearl river deltas.

Kynge also notes another sign of this transition, "that domestically bound cargo traffic through ports is increasing year-on-year, while foreign trade volumes are slumping".

The photo above, of a Wal-Mart in Chongqing, comes from the USDA's Foreign Agricultural Service. Chongqing is one of the lower tier cities Kynge referred to in his article.

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.

Two Press Releases from Destiny Media

Destiny Media Technologies (OTC BB: DSNY.OB) issued two press releases within the last several hours.

The first relates to the company's dispute with Yangaroo (TSX Venture: YOO.V), "Destiny Media Responds to Press Release From Canadian Competitor". Excerpt:

VANCOUVER, British Columbia, May 6 /PRNewswire-FirstCall/ -- Destiny Media Technologies, Inc. (OTC Bulletin Board: DSNY - News), the industry's leading secure digital media distribution company, is pleased to respond to a press release issued this afternoon by Yangaroo Inc. (TSX: YOO, Pink Sheets: YOOIF). Yangaroo offers a web based product that competes with Destiny's Play MPE® system in Canada.

According to their release, Yangaroo states that a claim for patent infringement against Destiny was filed in Wisconsin today for a patent issued yesterday. Destiny has not yet been served with this claim but is familiar with this patent and Destiny's management is confident that the claims are without merit. Destiny previously filed a $25 million slander and defamation suit against Yangaroo, for misleading Destiny's customers regarding the limits of Yangaroo intellectual property rights.

Destiny first began offering the MPE® system in 1999 and has its own patent for a Digital Media Distribution Method and System (USPTO 7466823) with foreign priority dating to March 2000. Yangaroo applied for their US patent May 8th 2003, four years after MPE® launched. Yangaroo listed Destiny's MPE® patent as prior art in their own application, clearly admitting that the MPE® system predated their application.

Yangaroo's original patent application was unsuccessful and they received a final rejection on December 15, 2008, forcing them to abandon all 109 of their original claims. They wrote and submitted a new single claim in January 2009 and this single claim patent was granted yesterday. Their new claim describes a method of distributing music that takes a different approach than that used by MPE®.

According to Destiny CEO, Steve Vestergaard, the suit is frivolous and only intended to create confusion in the marketplace. "They say imitation is the best form of flattery, but intellectual property law protects the invention that comes first, so their claims that we might infringe on a claim they only wrote a few months ago are ridiculous. Play MPE® is well on the way to becoming the global standard as over one thousand labels, including all the majors have chosen our system to send their new music to radio and we will protect our customer's ability to use the system they prefer."

The second press release announces a new deal in Australia, "Destiny Media Announces Partnership Between Play MPE(R) and Australian Independent Record Labels Association". Excerpt:

VANCOUVER, British Columbia, May 7 /PRNewswire-FirstCall/ -- Destiny Media Technologies, Inc. (OTC Bulletin Board: DSNY - News), the industry's leading secure digital media distribution company, is pleased to announce that Australian partner, The Shooting Star Picture Company has established a partnership with the Australian Independent Record Labels Association (AIR) to provide media distribution services for Australia's 300+ indie record companies through the Play MPE® music delivery software.

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.

Former Australian PM Blames Financial Crisis on Geithner

Today's Sydney Morning Herald reports comments made by former Australian Prime Minister Paul Keating about Tim Geithner at a recent speech in Sydney ("Obama's economic saviour savaged as Keating lets rip"). Excerpts:

When Barack Obama announced his champion to rescue the world from economic ruin, it was the first time most Americans had ever heard the name Tim Geithner.

The initial impression was good. The stockmarket surged and the pundits swooned.

[...]

If anyone in the US media had thought to ask a former Australian prime minister for his assessment, they would have heard a different view. And they would not have been so surprised at Geithner's performance since.

In a speech to a closed gathering at the Lowy Institute in Sydney on Thursday, Paul Keating gave a starkly different account of Geithner's record in handling the Asian crisis: "Tim Geithner was the Treasury line officer who wrote the IMF [International Monetary Fund] program for Indonesia in 1997-98, which was to apply current account solutions to a capital account crisis."

In other words, Geithner fundamentally misdiagnosed the problem. And his misdiagnosis led to a dreadfully wrong prescription.

[...]

Geithner thought Asia's problem was the same as the ones that had shattered Latin America in the 1980s and Mexico in 1994, a classic current account crisis.

[...]

But the Asian crisis was completely different.

[...]

But Geithner, through his influence on the IMF, imposed the same cure the IMF had imposed on Latin America and Mexico. It was the wrong cure. Indeed, it only aggravated the problem.

Keating continued: "[former Indonesian leader] Soeharto's government delivered 21 years of 7 per cent compound growth. It takes a gigantic fool to mess that up. But the IMF messed it up. The end result was the biggest fall in GDP in the 20th century. That dubious distinction went to Indonesia. And, of course, Soeharto lost power."

Exactly who was the "gigantic fool"? It was, obviously, the man who wrote the program, Geithner, although Keating is prepared to put the then managing director of the IMF, the Frenchman Michel Camdessus, in the same category.

Worse, Keating argued, Geithner's misjudgment had done terminal damage to the credibility of the IMF, with seismic geoeconomic consequences: "The IMF is the gun that can't shoot straight. They've been making a mess of things for the last 20-odd years, and the greatest mess they made was in east Asia in 1997-98, so much so that no east Asian state will put its head in the IMF noose."

China, in particular, drew hard conclusions from the IMF's mishandling of the Asian crisis. It decided that it would never allow itself to be dependent on the IMF, or the US, or the West generally, for its international solvency. Instead, it would build the biggest war chest the world had ever seen.

[...]

"These reserves are so large at $US2 trillion as to equal $US2000 for every Chinese person, and when your consider that the average income of Chinese people is $US4000 to $US5000, it's 50 per cent of their annual income. It's a huge thing for a developing country to not spend its wealth on its own development."

[...]

Keating went on to argue that, by frightening the Chinese into building their vast $US2 trillion foreign reserves, Geithner was responsible for the build-up of tremendous imbalance in the world financial system. This imbalance, in turn, according to Keating, contributed to the global financial crisis which has since devastated the world economy.

Hat tip to a couple of commenters in the comment thread of a post ("Should Geithner Go?") on Megan McCardle's Atlantic blog.

The photo above, of Tim Geithner, is from the Affordable Housing Institute.

"While Rome Burns"

John Mauldin's latest Thoughts from the Frontline newsletter, "While Rome Burns", includes the graphic above¹, from BCA Research. The column consists mainly of two sorts of gloom. The second sort, about the negative prospects for buy-and-hold stock investing when earnings are dropping faster than stock prices, so P/E ratios are high despite the recent market action, is generic enough that I won't excerpt it here. The first bit of gloom concerns the banking situation in Europe. From the newsletter,

Austrian banks have lent $289 billion (230 billion euros) to Eastern Europe. That is 70% of Austrian GDP. Much of it is in Swiss francs they borrowed from Swiss banks. Even a 10% impairment (highly optimistic) would bankrupt the Austrian financial system, says the Austrian finance minister, Joseph Proll. In the US we speak of banks that are too big to be allowed to fail. But the reality is that we could nationalize them if we needed to do so. (And for the record, I favor nationalization and swift privatization. We cannot afford a repeat of Japan's zombie banks.)

The problem is that in Europe there are many banks that are simply too big to save. The size of the banks in terms of the GDP of the country in which they are domiciled is all out of proportion. For my American readers, it would be as if the bank bailout package were in excess of $14 trillion (give or take a few trillion). In essence, there are small countries which have very large banks (relatively speaking) that have gone outside their own borders to make loans and have done so at levels of leverage which are far in excess of the most leveraged US banks. The ability of the "host" countries to nationalize their banks is simply not there. They are going to have to have help from larger countries. But as we will see below, that help is problematical.

Western European banks have been very aggressive in lending to emerging market countries worldwide. Almost 75% of an estimated $4.9 trillion of loans outstanding are to countries that are in deep recessions. Plus, according to the IMF, they are 50% more leveraged than US banks.

¹The low ranking here of Australia is surprising to me, considering that up until last year the country had no net federal debt. It looks like the Australian government will run fiscal deficits in the short-term, as it attempts to stimulate its economy, but how that is supposed to make its sovereign debt risk higher than that over already heavily-indebted countries, I don't know. Given what Mauldin has written about Austria above (with public debt equal to about 59% of GDP, according to the CIA World Fact Book), for example, I'm surprised that Austria is considered less of a sovereign credit risk than Australia by BCA.