|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|
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.
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 (http://steamcatapult.com/2010/08/31/answers-from-alloy-steel/). 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.
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.