I’m going back to investing in the US stock market and my first position is Friedman Industries (NYSE: FRD). The reason I chose this company is that they have a good moat and recently announced the the purchase of two coil processing facilities from Plateplus, which will more than double its production. Additionally, Friedman looks cheap at the moment as falling hot-rolled steel coil prices have put significant pressure on the stock price. Let’s review.
Overview of the acquisition
I covered Friedman on SA in January and in case you haven’t read that article here is a brief description of the company. The company has been in existence since 1965 and currently operates two hot rolled coil processing facilities located near the Nucor (NUE) steel mills. They have a combined annual production capacity of 310,000 tons and Friedman also owns a tube mill in Texas that can produce 60,000 tons per year. In FY22 ended March 31, the sales volume of the coil segment was 152,000 tons, but this figure is expected to skyrocket in the future for two reasons.
First, Friedman is building an on-campus facility at Steel Dynamics’ new flat-rolled steel mill (STLD) in Sinton, and the company says it will be the world’s largest electric arc furnace mini-mill. advanced in the world. It will have the largest line of stretcher levelers in North America and its annual capacity will be 180,000 tons per year. This facility will cost approximately $21 million and is expected to open in August 2022. Friedman expects a quick return on investment, as EBITDA is expected to be in the range of $4.5 million at $5.5 million based on historical average margins and annual production of 110,000 tonnes to 140,000 tonnes.
Second, Friedman recently purchased two coil processing facilities for $63.8 million in cash and 516,041 shares of Plateplus, which had a combined production volume of 163,000 tons for the fiscal year ended March 31, 2022. The agreement also includes steel inventory and customer relationships for two other facilities. , which had a combined production of 113,000 tonnes for the same period. This part is crucial because a large number of orders will be transferred to nearby Friedman’s Decatur and Sinton sites, allowing the latter to quickly ramp up production.
In my opinion, this is a good deal considering that the steel inventory represents approximately $45 million of the purchase price. The 516,041 shares and the remaining $18 million are for facilities with an annual production capacity of 512,000 tons, and one of them has a factory that has undergone an 8 million ton upgrade. dollars in 2021. Both facilities should be easily integrated into Friedman’s business as the company’s CEO. Mike Taylor already knows them. You see, he served as President of Cargill’s Metals Service Centers business between 2002 and 2014, when those assets were part of the group’s Metals Service Centers portfolio.
Overall, I expect to see cost and operating synergies and there could also be an increase in order flow, as a company taking a 7% stake in Friedman under this deal is a large Japanese steelmaker named Metal One. Thanks to this transaction, Friedman will soon have 6 strategic locations, all located near the water. In addition, 5 of them have rail access. And the proximity of the factories of Nucor and Steel Dynamics gives them a solid moat from a logistical point of view.
So how are the financial results looking? Well, it’s hard to predict, but I think the annual net income could exceed $10 million in a normal market thanks to the Sinton plant and the acquisition of Plateplus. The reason I say this is that hot rolled steel coil prices have been very high and very volatile over the past two years.
This resulted in the best financial results in Friedman’s history, and the company expects to record net income of approximately $14 million for the fiscal year ending March 31, 2022.
The problem here is that the net income for the past two years is eaten up by inventory and there is no free cash flow. On the other hand, Friedman uses hedging contracts and the resulting gains or losses are reflected in other comprehensive income. In the fourth quarter of 2021 alone, gains from cash flow hedges were $13.8 million.
What I mean here is that lower hot rolled steel coil prices could be good for the business as hedges come into effect and impact cash flow. Additionally, lower prices are expected to boost customer orders. However, the net profit line will suffer and you can see that Friedman’s net profit for the first nine months of his fiscal year was about $7.5 million higher than his expected annual profit of $14 million.
On a more stable period, the average annual net profit between FY12 and FY19 was $2.9 million. Given that the Decatur facility underwent a $7.2 million renovation in early 2021, I think we can push the net profit figure up to $3.5 million when building guidance . Add an additional $3 million for the Sinton facility and maybe an additional $3.5 million for the two Plateplus sites plus synergies, and we arrive at my figure of $10 million. Overall, I think Friedman should be worth at least $15 per share, as that would mean he is trading at around 10x P/E based on my earnings expectations.
So what are the risks for the bull case? Well I think the main thing is that investors might focus their attention on falling hot rolled steel prices and falling earnings rather than cash flow from operations and gains from hedging cash flow, which puts increased pressure on the share price. Additionally, Friedman is a microcap with low trading volume and the lack of net income on a quarter or two could cause him to fall out of some investors’ stock pickers.
Takeaway for investors
I consider Friedman a small company with a good moat that has helped it weather the financial storms of the past five decades. The future looks bright as the new Sinton plant is expected to generate EBITDA of around $5 million per year and the deal for the Plateplus properties will more than double production and bring synergies.
I think Friedman has the potential to generate more than $10 million in annual net income and the recent drop in hot rolled steel prices creates a window of opportunity to buy the stock cheap. My price target is $15 per share.