Fellow blogger Nate Tobik recently had a great write-up on Schuff Steel calling it a potential 10-bagger. I really respect Nate and enjoyed the write-up, so I decided to take a deep dive into the company:

Investment Overview

Schuff International is cheap at less than half of book value, ugly as a cyclical and highly levered construction company, and a potential multi-bagger with the continued recovery in construction spending. While casual onlookers of the stock may view it as extremely risky— high debt load, big debt maturity in 2013, and a nano-cap with limited disclosure, this risk is misunderstood, creating an extraordinary cheap stock for current investors. The company’s management seems to agree—having retired over half of the shares in the past year at a huge discount to book value.  I believe the stock is a great risk/reward at current levels and is conservatively worth ~$20, nearly a double from current prices.

Key Metrics

• Market Cap: $42.5, EV: $90.69M
• Price/Book: 0.48
• Price/Sales: 0.11
• EV/EBITDA: 6.85
• Quarterly Revenue Growth: 77.20%
• Debt/EBITDA: 4.22
• Altman Z-Score: 2.82 (within the safe zone)

Business Overview

Schuff International is the largest steel fabricator/erector in the United States. For those unfamiliar with industry, this essentially means that they take steel and alter it to fit the needs of a particular construction project. This is a very fragmented industry because it is very costly to ship large amounts of extremely heavy steel, which is why a $45 mm mkt cap company can be the largest player in the U.S. Schuff operates in Arizona (company headquarters are in Phoenix), Florida, Georgia, Texas, Kansas, California and the New York City area. They typically are paid with a “cost-plus” model and do not have significant customer concentration risk with their largest customer representing 11% of sales in 2011 and no other customers over 10%.

This business is very cyclical, but should be profitable throughout an entire cycle. For example, as recently as 2008, the company made over $97 mm in EBITDA, greater than twice their market cap, and $57 mm in net income. However, the 2008 crash really hurt construction and their latest annual EBITDA and net income is $13.2 mm and ($5 mm) respectively. With such a cyclical industry, investors have seemingly been scared by the company’s high debt load and sold the stock from its $35 high to just over $10, which represents half of book value.

I believe this massive sell-off is undeserved for three reasons:

1) While the company is certainly cyclical, it is also very profitable

From “trough to trough” in the construction market (2003-2011, see chart below), the company’s average unlevered FCF was $20.48 mm, which makes the normalized FCF yield over 22%. Furthermore, the company’s costs are highly variable, which allows them to cut employees and close plants during tougher times in the construction market and thereby avoid disaster years. The company has not had a single year of negative EBIT since 1995 (as far as my data goes back).

2) The cyclicality is somewhat predictable and is currently near a trough

Using national data from the Census Bureau on construction spending, I developed a regression model to forecast Schuff’s quarterly EBITDA. Inputs: Nonresidential Construction Spending and Total Construction Spending. This model is actually very effective in explaining SHFK’s quarterly EBITDA with an R squared of .84

Key Takeaway: Schuff’s quarterly success is so cyclically-based that it is possible to predict their EBITDA using only “national” data suggesting their cyclicality is simply a product of the industry, which should snap back, rather than company specific downturns.

While SHFK has zero analysts covering the stock, is extremely illiquid, and does not offer annual guidance, one can use the model above to predict their EBITDA based on readily available estimates for national construction data. As seen below, analysts are predicting a strong rebound in Nonresidential construction growth in 2012 and 2013.

Below, I include the same model, but it includes a two year projection for EBITDA based on the consensus estimates for national construction data.

3) The EBITDA prediction model, the company’s incredibly aggressive buyback, and the company’s recent moves suggest its debt is manageable and shares are deeply undervalued

The company has nearly $56 mm in debt, which represents over 4X EBITDA. This is a large amount for a cyclical company, leading some people to believe bankruptcy is possible.

Aggregate debt maturities are as follows:

2012: $26,413,000

2013: $4,000,000

2014: $5,000,000

2015: $19,000,000

2016: $1,410,000

First, realize that the debt repayment schedule is somewhat unusual given its lumpy nature. SHFK has over $7 mm in cash on the balance sheet and the EBITDA model predicts $22 mm and $32 mm in 2012 and 2013 respectively, which would be more than adequate to cover debt requirements.

Perhaps even more importantly, the company’s revenue is also tied to a small number of contracts, giving the company much more visibility into future revenue than any investor, especially since the company only files results once per year.

This is why it is so incredibly significant that the company took on MORE debt last year in order to retire 57% of their shares outstanding at less than book value!

Why would management, which owns the majority of the stock, do this if they were worried about their interest payment one year from now? They would be sued, perhaps file bankruptcy, and have their family name and business tarnished.

President and CEO Scott A. Schuff had this to say about the buyback:

“By completing this transaction, we are taking advantage of a unique opportunity to enhance stockholder value while demonstrating confidence in the long-term outlook for our business…Every Schuff International stockholder now owns a greater percentage of the company by a factor of nearly 2.5. The reduction of the total outstanding shares as a result of this repurchase implies a greater share value for the holdings of our stockholders. We believe that the commercial construction market is at or near the bottom, and we are confident that our strategic vision and the disciplined cost controls we instituted nearly two years ago are allowing us to capitalize more quickly on new projects we see in the pipeline”

Also providing further credence to this idea of a bottom, the company recently re-opened their Orlando plant citing demand in 2013: http://finance.yahoo.com/news/schuff-steel-utilizes-downturn-construction-234248740.html

“We are seeing signs of increased market activity and plan on re-opening our Orlando plant in the first half of 2013,” said Ryan Schuff, President and CEO of Schuff Steel. “We have also centralized our Southeast operations and revamped our executive management team by adding and transferring some key employees to our newly renovated Orlando office.”

Furthermore, the company has an Altman Z-Score of 2.82, suggesting bankruptcy is very unlikely:

Altman Z-Score: 2.82 (within the safe zone)

• Formula for predicting bankruptcy
  • Z > 2.6 (“Safe” zone)
  • 1.1<Z<2.6 (“Grey” zone)
  • Z<1.1 (“Distress” zone)

Finally, the company’s balance sheet should protect them from any downturn, making their debt load much less of a concern. Trading below tangible book value, with over $60 mm of that book value in land and buildings is pretty reasonable.

Therefore, while the debt load is a risk and something to watch, everything I have examined suggests it is manageable.

If this sell-off is unwarranted, how much are shares worth?

Valuation Method #1—Value based on mid-cycle FCF

-Note that 2003-2011 was chosen because it represents the last “cycle” from trough to trough (in chart above).

2003-2011 Average Unlevered FCF	$20.48
Discount Rate	15%
Earnings Power Value	$136.51
Value of Debt	$55.82
Equity Value	$80.69
Total Shares Outstanding	4.15
Value/share	$19.44
Current Value/share	$10.25
Premium	90%

Valuation Method #2—Value based on mid-cycle earnings

• From 2003-2011, average net income = $19.2 mm
• I believe 5-10X earnings is reasonable for a mid-cycle cyclical company
• Implied valuation: $23- $46/share, 128%-356% upside

Risks

• Management interests may not be aligned with minority shareholders.
  • The family may be trying to take the company private, and in doing so, may be deliberately trying to lower the share price by performing their own LBO
  • Should the company default on all of its debt within a year or two, lawsuits would definitely be filed and shareholders would have strong claims
• The Schuff Family offered a lowball takeout price in 2006 that was rejected.
• Very illiquid (Average daily volume 1,600)
• As a OTC stock, files financial reports only once/year

Conclusion

• Company is deeply undervalued at .4x book value, 2.2X mid-cycle earnings, and 4.5X EV/ Normalized FCF.
• Industry is very cyclical (currently near trough) with construction spending projected to grow dramatically. This cyclical company should not trade at trough multiples at trough earnings
• Management, who is most knowledgeable about the financials, was incredibly aggressive using debt to buy-back stock at a large premium to the current price, indicating how undervalued they consider current shares.
• The company represents a compelling risk/reward and is conservatively worth ~$20

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.