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Huge leverage + the steel industry; what's not to like?

October 19, 2012 | About:
whopper investments

whopper investments

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This will be a somewhat quick post. While I think the idea is interesting, it’s also based in the steel industry, making it a quick pass for me. However, the idea is interesting, and some readers may want to dig deeper.

ALJJ (find all of their recent financials / news here) is a heavily levered pink sheet stock. However, the company is extraordinarily cheap and has several catalysts that could propel it to a higher share price.

Let’s start with a quick description. ALJJ owns ~85% of a steel mill in Ashland, Kentucky. They acquired this ownership through an incredibly leveraged transaction in March 2005. Since that time, they’ve focused most operating profits on paying down their huge amount of leverage, and they’ve made quite some progress in that regard- debt has gone from over $100m when the transaction first happened to ~$40m at their most recent quarter (note- this includes preferred stock as debt).

The company’s managed to pay down so much debt mainly because, despite wide revenue swings during the financial crisis, they’ve been consistently profitable for the past seven years (you can find a nice little chart of their income statement over time from this write up). They’ve also been able to repurchase 5% of the mill that they didn’t purchase in the first go around (minority interest was initially at 20%, but has been reduced to ~15%).

So the past looks pretty nice. And the shares are cheap right now. I’m pegging their current EV at ~$65m. Against $17m in EBITDA, that represents a EV / EBITDA of just 3.8x times. To put that into context, US Steel (X) trades at just under 6x EV / EBITDA and Nucor (NUE) trades for just under 9x. So not only is ALJJ way cheaper than them… this ignores the fact that ALJJ has huge NOLs and won’t pay taxes for years going forward (thus, all else equal, their EBITDA should be worth more than EBITDA from a company that pays taxes).

And, because ALJJ is so levered, that means there is tons of potential upside that could flow through to the equity investor. To put it into context, if ALJJ were to trade for 7x EBITDA, that would imply an EV of ~$120m. Backing out the ~$40m in debt, that would leave an equity value of $80m, which would result in a share price over $1.33 per share (under 60m shares out)- well over a triple from today’s share price.

Finally, let’s talk catalyst. There are three big ones I can see.

  1. Most obviously, the company is hugely levered. Simply continuing to pay down debt with cash from ops willdrive the share price higher
  2. The company recently announced a small share buyback. While the amount only represents 3% or so of shares outstanding, and the buyback has about a two year window (kind of a long window for such a small buyback), the fact that they are buying back shares despite such a levered structure tells you how much of a bargain they think their shares are
  3. The company is looking to list on the Nasdaq or another big exchange. Such a listing often allows for bigger investors to come into a stock, improves liquidity, and results in an increased valuation
So those are all the positives, of which there are (obviously) many.

However, there are some downsides.

The company preannounced Q4 revenue results, and the results were absolutely horrific. While revenue for the whole year was flat year over year, Q4 results were down almost 30% from the prior year’s. Looking at past results and annualizing their Q4 revenue, I’d associate that level of revenue w/ ~$10.5m in annual EBITDA. Using a 7x multiple on that would make their current EV look more or less fairly valued.

Next, there’s the question of if all of that EBITDA truly belongs to them. I haven’t investigated how all of holdings and everything are structured, but that minority interest has to on some piece of that EBITDA. Once you start taking out their holdings, the EBITDA levels start coming in much lower.

Also, one catalyst is likely of the table. Because of their huge NOLs, ALJJ has a rights program in place to prevent someone new from acquiring too much of their stock and destroying those NOLs. And because those NOLs have huge value, ALJJ would probably be more likely to be an acquirer than a seller going forward (assuming, of course, the balance sheet could support it).

Finally, there’s the management structure. ALJJ doesn’t actually operate the mines themselves but has Pinnacle run them. Pinnacle makes a base fee plus takes a % of EBITDA over a certain threshold. Potential investor should dig into this structure and make sure they’re comfortable with it before investing.

Ultimately, I think ALJJ would make for a very, very attractive investment; however, that’s with the caveat that you have to believe the steel industry is within your circle of competency. I absolutely do not believe that, and thus it’s a pass for me.

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