Alloy Steel International AYSI
October 05, 2010 - 8:13pm EST by
2010 2011
Price: 0.49 EPS $0.17 $0.17
Shares Out. (in M): 17 P/E 3.0x 10.0x
Market Cap (in $M): 9 P/FCF 3.0x 10.0x
Net Debt (in $M): -2 EBIT 5 5
TEV ($): 6 TEV/EBIT 1.5x 6.0x

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Alloy Steel is an Australian wear plate manufacturer with a market cap that exceeded $50 million earlier this year but now trades at less than three times trailing earnings with an enterprise value of just $7.2 million. A perfect storm of events have conspired to depress the share price despite excellent growth prospects of a patent-protected high return on equity business. I will describe the business, provide scuttlebutt on the product from customers and engineers, detail the storm of events that have spooked investors, and finally explain my interpretation of those events and why I don't believe the business value has been seriously impaired. While the stock has traded more than $100K a day recently, the liquidity will dry up making this an investment strictly for long-term investors in personal accounts. I believe the stock has potential to trade at 10 or even 20 times the current price within a few years.

Company Formation
Alloy Steel's wearplate, branded Arcoplate, was invented and patented by George Brown and Gene Kostecki.  Alloy Steel was founded by the current CEO, Gene Kostecki, and the recently resigned CFO, Alan Winduss, in 2000. The company acquired rights to manufacture Arcoplate and exploit the patents from Kenside Investments, a company controlled by Gene Kostecki, for shares in the new company and a 2% royalty on sales. At the time of Alloy Steels formation, sales of the product were about $1 million a year on a word of mouth basis. Financing of a higher production capacity mill and office space in Perth Australia was financed through several private placements at $0.16 and $0.25 a share.  A registration statement for the sale by existing shareholders of 5.34 million shares to the public was filed with the SEC in July, 2001 and the shares began trading on the over-the-counter bulletin board.

Products & Scuttlebut
Alloy Steel manufactures and distributes Arcoplate, a wear-resistant fused-alloy-clad steel plate, which is made using a patented production process.  The Arcoplate process enables an alloy overlay to be evenly applied to a mild steel backing, creating a metallurgical bond between the alloy and the mild steel that is resistant to wear caused by impact, abrasion and erosion.  Arcoplate has significantly improved life, on the order of 3 to 6 times, over traditional wear plate.  This has been verified by independent testing laboratories and in field trials.
Mining equipment operators line the high-wear surfaces of mining machines with Arcoplate.  Truck beds, bulldozer blades, mining shovel buckets, and other surfaces that have abrasive materials repeatedly sliding over them can wear away rapidly.  To improve life, wear plate can be welded in place to line the surfaces.  This has, in fact, been done ever since there were mining machines so wear plate manufacturing is a long-established industry.  Arcoplate is a newer type of wear plate, however, so it is important to understand the benefits of longer-lived wear plate and why a mine owner will pay more for it.  Large mining equipment is very expensive.  A 400 ton mining truck runs $5 million, the largest bulldozers are multi-million dollar machines, 100 ton electric mining shovels run $30 million each, and draglines cost in excess of $100 million. Arcoplate lasts longer in these applications and the improved life of Arcoplate saves mine owners money on wear plate.  Arcoplate costs more up front but money is saved over many years from the extended life.  More important than the wear plate cost savings, however, is that Arcoplate doesn't have to be replaced as often.  Downtime on expensive equipment is reduced resulting in significant savings.  Unscheduled maintenance on a mining shovel that is loading a fleet of trucks that are feeding an oil sands separation factory in Alberta, Canada can cost in excess of $100,000 an hour in lost oil production, for example.  That's an extreme example but downtime on capital-intensive equipment is costly and longer living wear plate is worth a premium price.

Lining mining equipment generally requires only the thinner 8mm thick Arcoplate that has been around since the late 1990's.  While Arcoplate's share of this market is growing it is still relatively small.  If Arcoplate is better, why is it so slow to pick up market share?  There are three reasons.  First, Arcoplate costs about 30% more in upfront expense over traditional wear plate. In many situations the buyer of a machine only intends to own it for a few years.  Other machines are only used intermittently so traditional wear plate lasts for many years.  Who wants to pay an extra 30% if they will have sold the equipment before the wear plate needs replaced anyhow.  Who wants to pay 30% extra to extend the life on intermittently used equipment from 15 years to 40?  The second reason is that mine owners have learned that wear properties are very much dependent on what material is being mined.  Wear plate that tests well in a laboratory may not last so long in the conditions of an individual mine.  They won't pay 30% more for a wear plate until you prove it lasts longer in their mine.  This involves providing a sample that they can install on a machine and then waiting for a couple of years to see how it wears.  Sales cycles are therefore very long and it takes a while for any new wear plate product to take market share.  The third reason is that through 2004, Arcoplate's sales never exceeded $3 million.  Marketing resources were therefore very limited.  In North America, Alloy relied on distributors only and they weren't particularly effective penetrating new markets with such long sales cycles.  Finally, in 2008, Alloy Steel hired their own North American sales staff consisting of two people.

Since they hired their own staff they have been making progress, however.  Bud Sprouse, VP of North American Operations, presented data at the Rocky Mountain Master Mechanics Conference recently showing Arcoplate lasting 6 times longer than traditional wear plate on field tests of an electric shovel bucket.  I have since heard from Industry sources that Arcoplate has been specified for a new electric shovel currently being built in Australia.  A second field trial on a Caterpillar bulldozer also showed good wear results for Arcoplate.  Caterpillar has approved Arcoplate for use on their bulldozers as their recommended high-wear package option.  Neither of these deals represents large revenues but they do demonstrate the slow but effective marketing of Arcoplate and the acceptance by customers of the higher-priced product.

A second and newer application of Arcoplate is in lining chutes of mining conveyor systems.  This application demands the newer Super Arcoplate with a 20mm thickness.  Alloy Steel announced Super Arcoplate in 2008 and no doubt had to wait for field trial results to prove its effectiveness. The BHP Billiton deal to be detailed later is for up to $50 million in Arcoplate over 5 years.  This is for lining iron ore mining chutes in Australia primarily using Super Arcoplate.  BHP Billiton operates all over the world and with multiple ores.  Alloy Steel management confirms this is a customer they are trying to further penetrate.  Of course, other mining companies like Rio Tinto are potential customers for this new thicker product and they have mines all over the world too.  Arcoplate samples were also recently delivered to China.

Historical Financials
                                         Sales                                Profit                       Gross profit %
2010 (9 mths)                 $15.74 million                 $2.972 million                  54%
2009                                   8.82                             (0.072)
2008                                 13.51                              2.570
2007                                   8.79                              1.309
2006                                  3.386                             (0.274)
2005                                  3.620                               0.239
2004                                  2.986                             (0.004)
2003                                 1.871                              (0.199)
2002                                 2.116                              (0.799)
2001                                 2.862                              (0.143)


Business Economics


The Arcoplate manufacturing process is automated under computer control and is not labor intense. A mild steel plate and carbide-containing wear material are bonded together using electricity to form Arcoplate.  Electricity costs are significant adding about 15% additional to the raw material costs.  Some engineering resources to build and monitor the automated mills and tune the control software are required.  Gross margin is healthy at 54% in the most recent 9 months.  A mill costs about $1.5 million to $2 million to build and a single mill operating in 2008 produced $13.8 million in sales.  A $2 million dollar mill, therefore, can produce gross profit of $7.5 million a year ($13.8M * 0.54).

Selling costs depend on the customer.  Typically, a mine operator won't buy a new wear plate product without testing it first.  Once accepted, however, repeat sales are not costly at all as wear plate does eventually wear out and needs replaced.  Large customers such as BHP Billiton who may order $10 million a year should result in relatively small sales costs.

Engineering and administrative costs can also be small when the mills are operating properly.  In fact, Alloy's management notes that they intend to monitor the operation of the mills planned for Indonesia from Perth Australia getting data from mill sensors over the internet.  Skilled engineering labor in Indonesia is in short supply but also apparently not needed.

In short, an Arcoplate mill can be a cash machine. A $1.5-$2 million investment can produce $7.5 million in gross margin each year with relatively small selling and administrative costs.  Note for confirmation of this that fully taxed net profit margins in the first 9 months of 2010 was 19%.  You might expect margins like that from a software company but not an ordinary manufacturing operation.  As a second reality check on the attractiveness of this business consider the return on equity.  Annualizing the most recent 9 months earnings of $2.97 million to $3.96 million results in a return on the $8.52 million of equity of 47%.



With economics like that and strong market demand for Arcoplate and especially the new thicker Super Arcoplate, management of course wants to build more mills.  A second mill, manufacturing Super Arcoplate, began operations in the Summer of 2009 in Perth just prior to the announcement of a 5 year supply agreement with BHP Billiton.  Management stated in press releases in September, 2009 that the board of directors had authorized the building of a 3rd mill and possibly a fourth mill in Perth in 2010.  The status of those mills hasn't been communicated to shareholders and management doesn't seem to want to answer questions on this subject citing competitive reasons.  In May, the company announced the purchase of land in an Industrial Park in Indonesia near a steel plant and a sea port for $2.8 million.  Following permitting, the plan is to build additional mills in a modular fashion adding capacity as demand increases.  This plant is to serve the rest of the world while the plants in Perth continue to serve Western Australia.  With gross profit of $7.5 million on a $1.5-$2 million mill investment you can imagine what can happen to the stock price of an $8 million market cap company if they successfully build and operate more mills.

Cheap Because

So why is a growing business with a strong balance sheet sporting a 47% return on equity trading below book value?  I think the root cause is that the CEO is an engineer and not a great public communications expert.  The old CEO, Alan Winduss, was an Australian accountant but perhaps not expert in U.S. securities laws such as regulation FD and Sarbanes-Oxley.  Then there was a recent a change in management from Alan Winduss as a part-time CFO to full-time CFO , Barry Woodhouse.  With the change in CFO came a review of corporate strategy including changes in strategy that haven't been explained to shareholders.  Let me give some specifics in the timeline that follows.

Jan 29th, 2008: Grant Thornton resigns as Alloy Steels auditors.  They later write a letter to the SEC confirming that there was no material disagreements with the company.  Alloy appoints UHY Haines Norton as auditor to replace them.

Feb 26, 2008:  Alloy Steel press release reports progress on a second mill indicating that it is on schedule for completion in August 2008.  The new mill will make the thicker Super Arcoplate product.  Alloy's stock is strong based on strong profitability in 2007 that continues into the Spring of 2008.  The stock reaches a high near $3 a share.

Fall 2008: Work on the new second mill is suspended to save money as new mine construction in Australia is delayed by the financial crisis.  The anticipated demand for Super Arcoplate is gone and the company needs to conserve cash.  The stock withers away slowly to $0.20 at the low in early 2009.

July 2009: Alloy Steel's stock begins to rally after dropping as low as $0.20 in the Spring of 2009.  There's no public news to spark the rally.

Aug 6, 2009: Alloy Steel press release reveals that the new Super Arcoplate mill is completed and running at capacity.  Furthermore, interest in the new Super Arcoplate is high with mines planning to specify the new product.  Management is optimistic that strong demand will develop for Super Arcoplate.  The old thinner Arcoplate mill is also reported to be running at full capacity.  This is all surprisingly good news and the stock rallies on volume.

Sept 8, 2009: Alloy Steel press release reveals that the company has signed a strategic supply agreement with BHP Billiton with orders that could exceed $50 million anticipated over the five year period.  Furthermore, the board of directors has authorized the building of a 3rd and fourth mill to come on line in early 2010.  Of course more mills are very bullish considering their economics and the stock rallies.

Oct 2009: FINRA sends a letter to Alloy Steel inquiring about unusual trading in Alloy Steel's stock in the period July 6th through September 4th. Alloy Steel does not disclose receipt of the letter to the public.

Nov 12, 2009: An Alloy Steel press release announces the opening of an office in Indonesia.  A purpose of the new office is to explore sites for a possible new Arcoplate mill in Indonesia.  Management states that sales of $10 million a year to Indonesia is anticipated in future years.  This is more good news.

February 3, 2010: Alloy steel pre-announces earnings for the first fiscal quarter ended 12-31-2009.  Revenues are $5.2 million with an operating profit of $2.24 million.  Commentary is very bullish noting that this was the seasonally slow quarter due to the Christmas holiday.  Expectations are very high for the coming quarters.

April 8th, 2010: An 8-K announcing the appointment of Alvin Tan to the board of directors.  Alvin Tan is the third member of the board (with Kostecki and Winduss) and is independent.  He is to lead a committee to do an investigation of the unusual trading in the company stock in response to the FINRA inquiry.  The FINRA inquiry letter is revealed at this time and the stock sells off.

April 16th, 2010: Alloy Steel signs a purchase agreement for land in Indonesia.  This was not disclosed to the public until May 18th, however.

May 4th, 2010: Press release with second quarter (ended March 31) results; $5.129 million revenue with 58% gross margins and $1.109 million profit.  Revenues are unexpectedly lower than the Christmas quarter but at least gross margins remain high.

May 18th, 2010: Press release announcing a purchase agreement for land in an Industrial park in Cilegon near Jakarta, Indonesia.  The agreement calls for monthly payments through the end of 2010 for the land while permitting takes place.  Construction of a new modular mill design is planned to begin in 2011.  The acreage purchased is 37,500 square meters which is much larger than their Perth, Australia facility at 4750 square meters.  This marks the end of good news and all press releases since this date have been bad news that has confused and dismayed investors and created distrust of management.

June 30th: CFO resigns although this isn't disclosed.

August 4th: Director Alvin Tan resigns citing a phone conversation with the CEO.  He expresses regret in his resignation letter and his belief that the company has a great opportunity and future.  This resignation is also not disclosed until the filing of the 10-Q on August 16th.

August 16th: Alloy files the required 10-Q for their 3rd fiscal quarter ended June 30th.  Unlike the prior quarters, there is no press release summarizing results and providing management commentary.  Revenue is just $4.77 million, gross margins were way down to just 45%, and earnings are just $0.02 a share.  No explanations for the unexpectedly weak revenue and much weaker gross margins are given.  No discussion of status of the previously discussed 3rd and 4th mills is given.  The resignations of the CFO and director Alvin Tan are disclosed in the 10-Q but with limited explanation.  The hiring of full-time CFO, Barry Woodhouse, in early August is disclosed.  Investors do not understand the revenue shortfall or the lower margins and the resignations are spooky too so the stock sells off to the $0.90 area.

August 31, 2010: CEO Gene Kostecki and new CFO Barry Woodhouse answer questions in a telephone call with Blog author David Pinsen (  A few of these answers are helpful so I will quote them later below.

Sept 27, 2010: Alloy steel announces they are going dark and will not file reports with the SEC going forward.  The stock stops trading on the over-the-counter bulletin board the next day and now trades on the pink sheets.  The stock cuts in half from $0.90 a share to around $0.45 on very heavy volume.  The Alloy Steel website is also shut down without explanation.

Investors are confused and suspicious.  There is a FINRA investigation and both the long-time CFO and the newly appointed director chairing the FINRA investigation just resigned.  The director who just joined the board in April resigns in August.  The only remaining member of the board of directors is the CEO as the other members have all resigned.  No information on the FINRA investigation is given.  Revenues are well short of expectations.  Gross margins are way lower without explanation.  The status of a third and possibly fourth mill being built in Perth is not updated. From the weak revenue there is certainly no sign that any new mills are operating.  Management's optimism in earlier press releases seems to have been misleading or wrong.  Furthermore, the company is going dark and will not file financials with the SEC any longer which makes one wonder if their isn't something to hide.

The bubble of high expectations has completely popped and investors are bewildered as the stock drops 85% from the highs earlier in the year. There's plenty of reasons to sell.  Lots of momentum investors want out as the momentum is gone.  To investors who bought at $3, the tax loss is worth more than the stock.  Many investors distrust anything the company says.  Potential new buyers look elsewhere when they see the recent bad financial news coupled with FINRA investigations and resignations.  That brings us to today when Alloy Steel trades below book value.

So is something shady going on here? In the telephone call with David Pinsen, Alloy Steels management (Gene Kostecki and new CFO Barry Woodhouse) answers some questions.  Here's an excerpt of the most important questions.

Alloy Steel management answers to questions posed by David Pinsen on August 31, 2010

Q: Why the departures of former CFO Alan Windus and director Alvin Tan (after one quarter, in his case)?

A: At this stage in the company's growth, Alloy Steel needs a full time CFO and is reviewing its personnel requirements for its growth.  Alan Windus was a part-time CFO.  Barry Woodhouse is a full time CFO, which is the main reason he has replaced Alan Windus.  Alvin Tan was a board nominee of Alan's and the company elected to go with a clean slate.

The company is currently in the process of adding appropriately experienced board members (including an independent chairman) who have experience in the management of growing industrial companies, and have industry connections that will enable them to make introductions for the company that can lead to new client relationships.

Q: What is the status of the FINRA investigation and when do you expect it to be finished and the results made public?

A: As outlined in the recent quarterly, Alloy Steel conducted an internal investigation and provided the requested information to FINRA several months ago.  The company has not received a response from FINRA yet, and has not been told if or when it will receive a response.

Q: With the start-up of the second mill and the large backlog reported backlog, why are the total sales still below historical highs that were accomplished with a single mill?

A: Sales have grown steadily on an annual basis and for the 9 months ended 30 June 2010, reported sales are $15.7m compared to the best historical sales annual figure of $13.5m in 2008, prior to the GFC.  We are dealing with new technology that has required numerous adjustments to our manufacturing process (to improve efficiencies and quality) which has led to downtime, limiting our capacity.  Even with constant corrections, you can see quite clearly the increased sales effect of having a second producing mill on the current 9 month period.  We are wary of accepting large orders that we aren't absolutely sure we can fill in a timely fashion, as committing to an order and failing to fill it on time would irreparably damage our credibility with our clients.


Q: What is the status of marketing and orders for Super Acroplate?

A: There is currently high demand for the product, but we are limited by capacity constraints.

Q: Why isn't the AYSI website used to provide updated product, marketing, and shareholder updates? This would seem to be a cost effective manner to share general information.

A: It will be, once the site has been revamped within the next few months.

Q: How many mills in Australia - in operation or being built?

A: There are currently 2 mills in production in Australia, but please note the comments above.


Q: Why were sales lower in the third quarter?

A: This may be a timing issue. In any quarter, revenue figures can be skewed by several factors including timing of shipments and customer delivery and the like.


 My Interpretation

So the sales shortfall appears to be due to technical difficulties with their new mill.  Demand for Arcoplate remains strong but they can't get enough made.  This is a serious issue if they can't fix the mill.  If they resolve their manufacturing issues then the company can return to serious profitability, however.   Problems with the mill may have contributed to the reduced gross margin.  This happened in the Summer of 2009 as the 2nd mill came on line.  Some steel and electricity was wasted as they tuned and adjusted the new mill. 

A third mill is not yet in production and management doesn't want to clarify whether a third mill has been built.  I believe that a third mill has been built but they are having technical difficulties getting it to make a slightly different version of the product.  I do not want to reveal what that difference is to protect the company's competitive position.  I'm not absolutely certain that the third mill has been built, however.

The resignation of the CFO is simply because the growth of the company demands a full-time CEO.  The resignation of Alvin Tan is at the request of the CEO as he was a nominee of the outgoing CFO, Alan Winduss.  This still seems a bit unusual to me but not an incredible explanation.

A response has been made to the FINRA inquiry.  I personally never took the FINRA inquiry too seriously.  A person trading on inside information could be in trouble but I wouldn't expect more than a small fine and a warning to the company if they let some information slip out.

In reviewing 10-K's for the last 10 years I don't see any sign of self-dealing or self-enrichment on the part of the CEO or the CFO.  Gene Kostecki is paid a $150K salary and of course gets the 2% royalty as well.  There's no stock options or bonuses paid to the CEO and the share count has been constant for many years.  The CEO owns over half the shares outstanding and has not bought or sold shares for years.  The outgoing CFO owned 11% of the shares himself and was not a trader of the stock either.  They've had plenty of opportunity to profit as the stock has bounced between $0.20 and $3.00 and they haven't taken advantage of their inside knowledge.  I find their salaries reasonable and believe Gene has done a reasonable job building the business.  I believe Gene's two sons work in the business but I don't know any details on their compensation.

I believe with the addition of the new CFO some changes have taken place.  I suspect he advised that more onerous Sarbanes-Oxley requirements were kicking in beginning with the fiscal 2011 year beginning Oct. 1, 2010.  This explains going dark at the end of September.  The company has decided to use existing cash and cash flow for the Indonesian land purchase and mill construction rather than an equity raise at depressed prices.  In order to self-finance this expansion they're looking to save the cash expenses associated with their otcbb listing.  The website is down because the new CFO is bringing up a new one as discussed in David Pinsen's blog.

There's a lot of smoke here but most likely no fire.  The only serious problem I see for this company is that they're having trouble with their new mills.  The FINRA investigation may be a result of the company not being careful enough with inside information.  I've noted that since the new CFO joined the company employees are more cautious answering questions sometimes referring questions to the CFO.  FINRA is most likely of little financial significance and the resignations are the result of changes at the company to prepare for growth and not indicative of fraud.

In conclusion, I find this situation fraught with uncertainty but not fraught with risk.  The below book value stock price more than reflects the mill performance risk and the resignations and investigations don't amount to much.  Management has skin in the game here too which reduces the risk of long-term self-enrichment without creating shareholder value.  The upside is big as the business can be a cash machine.

1. There may be some fire creating all the smoke

2. Competition could arise especially as key patents expire in about 5 years

3. This is a tiny company run by an Australian engineer and not a professional business manager.  Hopefully the new CFO will mitigate this risk.

4. Rumors are that Australian wear-plate competitors are cutting prices to try to regain some market share in Western Australia.  This may put pricing pressure on Alloy's margins.

5. The apparent difficulties with the new mill could be prolonged or result in poor quality product that damages the company's reputation.



All the smoke associated with FINRA investigations and resignations blow away.
Company gets their mills running at capacity and generates serious cash.
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