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.

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.

Applying the Altman Z"-Score Model to a Non-Manufacturing Company

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

In a previous post ("Using the Altman Z-Score to Calculate the Risk of a Company Going Bankrupt") I used Altman's original model on a publicly-traded manufacturing company. On Tuesday I used the Altman Z-Score model on a publicly-traded (micro cap) non-manufacturing firm, Vertical Branding, Inc. (OTC BB: VBDG.OB), the marketer of such fine products as the "MyPlace Cozy" lap table, pictured above. I had seen this company mentioned as top pick by a few regulars on the Investor Hub website. Initially, I used the original Altman Z-Score model -- which was designed for manufacturers -- on Vertical Branding. Recall from our previous post on the subject, that the original Altman Z-Score model uses these five terms:

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

And weights them this way:

Z Score Bankruptcy Model:

Z = 1.2T₁ + 1.4T₂ + 3.3T₃ + .6T₄ + 1T₅

Using an online calculator based on the original Altman Z-Score model, I got a score in the "distress" zone, one that indicated that bankruptcy was likely within two years¹. I mentioned this on Vertical Branding's Investor's Hub message board. Unsurprisingly, I got the penny-ante version of the Enemy of the People treatment for my trouble. I did get one legitimate criticism though, that I had used the Altman Z-score formula designed for manufacturers. So I ran the numbers again using Ironwood Advisory's online calculator, which gives the option of selecting for non-manufacturing companies. That option uses the modified Altman Z"-score model, which uses only the first four terms used in the original multivariate formula, and eliminates the fifth variable, sales/total assets, because this variable varies widely among non-manufacturing firms, which tend to be less capital-intensive. The Altman Z"-score model weights the first four variables differently:

Modified Altman Z"-Score Bankruptcy Model:

Z = 6.56T₁ + 3.26T₂ + 6.72T₃ + 1.05₄

Using the calculator set for non-manufacturing companies produced an even worse Z-score than the original model did. This was consistent with Penn State Accounting Professor Gregory Eidleman's observation that the original Altman Z-score model can under-predict bankruptcy of non-manufacturing companies. After correcting an apparent data-entry error on my part, I got an Altman Z"-score of -4.30 for VBDG. For non-manufacturing firms, any score below 1.1 is an indication that the firm is at risk of bankruptcy within two years.

Coincidentally, on Thursday morning Vertical Branding filed an 8-K noting that it was in continuing negotiations to restructure its debt and that the company's board of directors had authorized its management to

[E]valuate and pursue all strategic opportunities available to the Company, including the potential sale of the Company.

On this news, VBDG dropped 31%.

¹This makes intuitive sense, if you look at the company's income statements and balance sheet: the company has negative earnings before interest and taxes (EBIT), negative retained earnings, and negative working capital; essentially, it's a money-losing, debt-laden company.

Using The Altman Z-Score to Calculate the Risk of a Company Going Bankrupt

The Altman Z-Score is a model developed in 1968 by NYU Finance professor Edward Altman 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.

There are several free Altman Z-Score calculators available online to facilitate the use of the model. There is also a fully-automated Altman Z-Score calculator (where you just need to enter a company's symbol and the calculator does the rest) at Shortscreen.com. I used the one at Ironwood Advisory's website to calculate an Altman Z-Score for Alloy Steel International (OTC BB: AYSI.OB). The calculator gave a Z-score of 4.89, and included this commentary:

Your Z score is in the high range. This company is in good financial health and is predicted to remain solvent for the next two years. Smaller firms should note that these models are based on data from firms with assets in excess of $1,000,000². If it is believed that asset size affects Z scores, then their use may not be appropriate.

The photo above of Professor Altman comes from the CFA Institute.

¹The components and weightings of Altman's model come from Wikipedia.

²Alloy Steel's total assets are approximately $7,030,000 and its net assets are $4,393,000.