CASTLE (A M) & CO CAS
March 04, 2012 - 3:18pm EST by
pathbska
2012 2013
Price: 10.30 EPS $0.55 $1.36
Shares Out. (in M): 23 P/E 18.6x 7.6x
Market Cap (in $M): 239 P/FCF 18.6x 4.6x
Net Debt (in $M): 284 EBIT 10 81
TEV ($): 524 TEV/EBIT 51.3x 6.5x

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  • Distributor
  • Aerospace Parts
  • Oil Price Exposure
  • Deleveraging
 

Description

Business Description

AM Castle is a distributor of metal products (and a small amount of plastics) to a wide variety of industries. Aerospace accounts for approximately 25% of sales and oil and gas post the company’s recent acquisition of Tube Supply also represents around 25% of sales. Outside of these two end markets, various industrial markets, e.g., machine tools, each make up less than 10% of sales. Stainless and nickel products account for around 20% of sales, aluminum products (primarily aluminum plate for aerospace) another 20%, with various alloy products (bars, etc.) and tubular goods (primarily for oil and gas) making up another 15% each, with the balance made up of carbon steel, titanium, and plastics. Our work suggests that AM Castle specializes in products that are at the tail end of the supply chain. They are the supplier of last resort for many of their end markets and in turn are later cycle than most metal distributors. A significant portion of their products involves some value add.

 

High Level Thesis

We have earnings data for AM Castle going back to 1983. The business as changed very little. Historically they have grown both organically (taking share from smaller companies in a fragmented market) and through bolt on acquisitions (their recent Tube Supply purchase is the largest deal they have ever done) and in turn the historical numbers are very clean. In the 1984 peak the company made around $0.50 in EPS. In the 1988 peak they made $1.00. In the 1995 peak they made just under $2.00 and in 2006 they made just under $3.00. We do not see any reason why the next peak will not result in over $3.50 in EPS with the stock trading at $10.30. On any metric we see the potential for the stock price to double or triple over 3-4 years.

AM Castle Past Peak EPS
       
  1984 0.54  
  1995 1.92  
  2006 2.89  

 

Why the Opportunity Exists

As in past cycles AM Castle has been slow to rebound. Investors have become impatient waiting for the steep pickup in earnings typical of CAS’s up cycles. In particular, analysts are focused on the continued overhang in aluminum plate for aerospace driven by stubbornly high inventories that were built through the chain in the downturn. Beyond this the company closed on the Tube Supply acquisition in December 2011. This was a $184m acquisition (including working capital) for a $250m company. To complete the acquisition they issued two tranches of expensive debt: $225m in 2016 senior secured notes at 12.75% and $50m 2017 convertible senior notes yielding 7% that convert at $10.50 (good for those involved in the private financing and likely putting short pressure on the equity; long term can be up to 20% dilutive). The Q4 earnings release last week was messy with some weakness in gross margin from the recent decline in metals prices and considerable noise from the acquisition accounting and new debt (which includes a lot of non-cash components, to be discussed below).

 

Upside Drivers

Gross Margins and Aerospace

AM Castle Gross Margins (ex depreciation) vary from 24% in troughs to just over 30% at peaks. In this cycle margins troughed at 24.7% in 2009, rebounded to 25.7% in 2010, and came off slightly in 2011 to 25.3% (not atypical in rebounds). Management had indicated that legacy business gross margin could get back to 27% by 2012 but guided on the Q4 call to margins “above 26%”. Most analysts are now assuming margins just below 26%. We believe management will achieve its guidance and could do better. The rebounding commercial aerospace cycle alone can get them there as some legacy contracts roll off and aluminum plate inventories continue to normalize (as many players in the aerospace supply chain have acknowledged is occurring). We assume a 26.1% gross margin for 2012 but see upside to this number. Beyond 2012 margins should continue to improve as commercial build rates increase and their contract for the F-35 kicks in in full (defense is 25% of aerospace and should improve even with flat F-35 sales). As the cycle moves closer to peak (continued commercial build rates, general improvement in supplier operating rates) margins can get back to 28-30%.

 

Oil and Gas and Tube Supply Acquisition

Tube Supply was a major acquisition for the company. Before the acquisition oil and gas was around 15% of sales and will be 25% post. CAS’s legacy oil and gas sales were more geared to bar products that go into drilling applications. Tube Supply is almost all tubular goods that go into production type applications. Tube Supply has a better margin profile with 30% gross margins and 20% EBITDA margins (legacy EBITDA margins are 5-10%). Management is very optimistic about the oil and gas business and has guided to 15+% sales growth and Tube Supply margins staying at these high levels. The overall rig count in the US bears watching since it may flatten out as the 20% that go into dry gas drilling will likely decrease. However, we believe that well complexity and production from wells drilled as the rig count ramped will still provide robust revenue growth.

 

Operating Cost Leverage and Debt Paydown

Historically for the legacy business management has guided operating costs (including D&A) to grow at 10-12% of sales growth. In 2011 they fell well short of this putting up an incremental 12.5% (adjusting for the two weeks they owned Tube Supply).  They guided on the call to 10-11% for 2012 and analysts are assuming 11+%. We assume 11% but believe we could see an even better number as 2011 was inflated by some ramp-up and overtime costs we do not expect to recur.

 

Cash interest expense post Tube Supply has gone from just under $5m to $33m. The acquisition added $44m in EBIT (and in turn is cash accretive). There is another $8.6m in non-cash interest expense (the debt was issued at a discount etc.) and $5m in intangible amortization. The debt is all secured and requires paydown beyond a certain level of free cash flow. The additional interest expense equates to $0.85 in EPS that will provide an earnings lever in the future (and will more than offset the 20% dilution we will probably see from the convert post 2017).

 

EPS and Cash EPS Expectations

Management guided 2012 sales growth to 10-15% “for all businesses”. We assume 13% topline growth for the legacy business and 10% for Tube Supply. However, we assume lower and decreasing margins for Tube Supply through the period. In turn we do not have any earnings growth for Tube Supply, which we consider conservative (management believes margins will stay flat). Note that the non-cash charges equate to around $0.35 in EPS. AM Castle also has an equity JV that has been doing well. We assume very little growth for it going forward. Our numbers include only $25m in debt paydown at the end of 2013 (to impact 2014). This could also be conservative

 

Drivers and Earnings (Non-Cash and Cash)

   
         

Price

10.30

     

Enterprise Value (000 $)

523,574

     
         
 

2011

2012

2013

2014

Legacy Sales Growth

20%

13%

8%

8%

Legacy Gross Margin

25.3%

26.1%

26.5%

26.9%

Tube Supply Sales Growth

NM

10%

7%

7%

Tube Supply EBITDA Margin

20%

20%

19%

18%

         

EPS

0.55

1.36

1.90

2.54

Cash EPS

1.73

2.26

2.89

3.42

         

EBITDA (Legacy+Tube Supply)

30,676

107,601

130,536

155,128

Equity JV Earnings (Pre-Tax)

11,727

12,020

12,321

12,629

Total EBITDA

42,403

119,621

142,857

167,757

         

P/E

18.6

7.6

5.4

4.1

P/E Cash

6.0

4.6

3.6

3.0

EV/EBITDA (with cash build)

17.1

5.0

3.8

2.8

EV/EBITDA+JV (with cash build)

12.3

4.5

3.5

2.6

 

Even on non-cash numbers we see the stock trading at around 4x 2014 (a year we don’t see as peak on debt paydown alone) and 3x on a cash basis. At 8x the stock is a double but could trade at higher multiples as the non-cash items get closer to cliff ($0.35 of EPS) and debt paydown quickens ($0.85 of EPS to get back to 2011 levels). At 12x you have a triple.

Catalyst

-Tightening in the Aerospace supply chain

-Continued strength in oil and gas

-Other industrial businesses continue to improve with the economy

-Debt paydown starting in 2013 and investor understanding of the non-cash charges

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    Description

    Business Description

    AM Castle is a distributor of metal products (and a small amount of plastics) to a wide variety of industries. Aerospace accounts for approximately 25% of sales and oil and gas post the company’s recent acquisition of Tube Supply also represents around 25% of sales. Outside of these two end markets, various industrial markets, e.g., machine tools, each make up less than 10% of sales. Stainless and nickel products account for around 20% of sales, aluminum products (primarily aluminum plate for aerospace) another 20%, with various alloy products (bars, etc.) and tubular goods (primarily for oil and gas) making up another 15% each, with the balance made up of carbon steel, titanium, and plastics. Our work suggests that AM Castle specializes in products that are at the tail end of the supply chain. They are the supplier of last resort for many of their end markets and in turn are later cycle than most metal distributors. A significant portion of their products involves some value add.

     

    High Level Thesis

    We have earnings data for AM Castle going back to 1983. The business as changed very little. Historically they have grown both organically (taking share from smaller companies in a fragmented market) and through bolt on acquisitions (their recent Tube Supply purchase is the largest deal they have ever done) and in turn the historical numbers are very clean. In the 1984 peak the company made around $0.50 in EPS. In the 1988 peak they made $1.00. In the 1995 peak they made just under $2.00 and in 2006 they made just under $3.00. We do not see any reason why the next peak will not result in over $3.50 in EPS with the stock trading at $10.30. On any metric we see the potential for the stock price to double or triple over 3-4 years.

    AM Castle Past Peak EPS
           
      1984 0.54  
      1995 1.92  
      2006 2.89  

     

    Why the Opportunity Exists

    As in past cycles AM Castle has been slow to rebound. Investors have become impatient waiting for the steep pickup in earnings typical of CAS’s up cycles. In particular, analysts are focused on the continued overhang in aluminum plate for aerospace driven by stubbornly high inventories that were built through the chain in the downturn. Beyond this the company closed on the Tube Supply acquisition in December 2011. This was a $184m acquisition (including working capital) for a $250m company. To complete the acquisition they issued two tranches of expensive debt: $225m in 2016 senior secured notes at 12.75% and $50m 2017 convertible senior notes yielding 7% that convert at $10.50 (good for those involved in the private financing and likely putting short pressure on the equity; long term can be up to 20% dilutive). The Q4 earnings release last week was messy with some weakness in gross margin from the recent decline in metals prices and considerable noise from the acquisition accounting and new debt (which includes a lot of non-cash components, to be discussed below).

     

    Upside Drivers

    Gross Margins and Aerospace

    AM Castle Gross Margins (ex depreciation) vary from 24% in troughs to just over 30% at peaks. In this cycle margins troughed at 24.7% in 2009, rebounded to 25.7% in 2010, and came off slightly in 2011 to 25.3% (not atypical in rebounds). Management had indicated that legacy business gross margin could get back to 27% by 2012 but guided on the Q4 call to margins “above 26%”. Most analysts are now assuming margins just below 26%. We believe management will achieve its guidance and could do better. The rebounding commercial aerospace cycle alone can get them there as some legacy contracts roll off and aluminum plate inventories continue to normalize (as many players in the aerospace supply chain have acknowledged is occurring). We assume a 26.1% gross margin for 2012 but see upside to this number. Beyond 2012 margins should continue to improve as commercial build rates increase and their contract for the F-35 kicks in in full (defense is 25% of aerospace and should improve even with flat F-35 sales). As the cycle moves closer to peak (continued commercial build rates, general improvement in supplier operating rates) margins can get back to 28-30%.

     

    Oil and Gas and Tube Supply Acquisition

    Tube Supply was a major acquisition for the company. Before the acquisition oil and gas was around 15% of sales and will be 25% post. CAS’s legacy oil and gas sales were more geared to bar products that go into drilling applications. Tube Supply is almost all tubular goods that go into production type applications. Tube Supply has a better margin profile with 30% gross margins and 20% EBITDA margins (legacy EBITDA margins are 5-10%). Management is very optimistic about the oil and gas business and has guided to 15+% sales growth and Tube Supply margins staying at these high levels. The overall rig count in the US bears watching since it may flatten out as the 20% that go into dry gas drilling will likely decrease. However, we believe that well complexity and production from wells drilled as the rig count ramped will still provide robust revenue growth.

     

    Operating Cost Leverage and Debt Paydown

    Historically for the legacy business management has guided operating costs (including D&A) to grow at 10-12% of sales growth. In 2011 they fell well short of this putting up an incremental 12.5% (adjusting for the two weeks they owned Tube Supply).  They guided on the call to 10-11% for 2012 and analysts are assuming 11+%. We assume 11% but believe we could see an even better number as 2011 was inflated by some ramp-up and overtime costs we do not expect to recur.

     

    Cash interest expense post Tube Supply has gone from just under $5m to $33m. The acquisition added $44m in EBIT (and in turn is cash accretive). There is another $8.6m in non-cash interest expense (the debt was issued at a discount etc.) and $5m in intangible amortization. The debt is all secured and requires paydown beyond a certain level of free cash flow. The additional interest expense equates to $0.85 in EPS that will provide an earnings lever in the future (and will more than offset the 20% dilution we will probably see from the convert post 2017).

     

    EPS and Cash EPS Expectations

    Management guided 2012 sales growth to 10-15% “for all businesses”. We assume 13% topline growth for the legacy business and 10% for Tube Supply. However, we assume lower and decreasing margins for Tube Supply through the period. In turn we do not have any earnings growth for Tube Supply, which we consider conservative (management believes margins will stay flat). Note that the non-cash charges equate to around $0.35 in EPS. AM Castle also has an equity JV that has been doing well. We assume very little growth for it going forward. Our numbers include only $25m in debt paydown at the end of 2013 (to impact 2014). This could also be conservative

     

    Drivers and Earnings (Non-Cash and Cash)

       
             

    Price

    10.30

         

    Enterprise Value (000 $)

    523,574

         
             
     

    2011

    2012

    2013

    2014

    Legacy Sales Growth

    20%

    13%

    8%

    8%

    Legacy Gross Margin

    25.3%

    26.1%

    26.5%

    26.9%

    Tube Supply Sales Growth

    NM

    10%

    7%

    7%

    Tube Supply EBITDA Margin

    20%

    20%

    19%

    18%

             

    EPS

    0.55

    1.36

    1.90

    2.54

    Cash EPS

    1.73

    2.26

    2.89

    3.42

             

    EBITDA (Legacy+Tube Supply)

    30,676

    107,601

    130,536

    155,128

    Equity JV Earnings (Pre-Tax)

    11,727

    12,020

    12,321

    12,629

    Total EBITDA

    42,403

    119,621

    142,857

    167,757

             

    P/E

    18.6

    7.6

    5.4

    4.1

    P/E Cash

    6.0

    4.6

    3.6

    3.0

    EV/EBITDA (with cash build)

    17.1

    5.0

    3.8

    2.8

    EV/EBITDA+JV (with cash build)

    12.3

    4.5

    3.5

    2.6

     

    Even on non-cash numbers we see the stock trading at around 4x 2014 (a year we don’t see as peak on debt paydown alone) and 3x on a cash basis. At 8x the stock is a double but could trade at higher multiples as the non-cash items get closer to cliff ($0.35 of EPS) and debt paydown quickens ($0.85 of EPS to get back to 2011 levels). At 12x you have a triple.

    Catalyst

    -Tightening in the Aerospace supply chain

    -Continued strength in oil and gas

    -Other industrial businesses continue to improve with the economy

    -Debt paydown starting in 2013 and investor understanding of the non-cash charges

    Messages


    SubjectRE: Update?
    Entry08/23/2012 03:14 PM
    Memberpathbska

    ndn86,

    Thanks for the inquiry. Certainly plenty to update!

    Q2 was a splash of cold water, though it wasn't quite as bad as they let on. Clearly the thesis on aerospace improving has been very slow to materialize. I thought the strength we have seen in aerospace build rates along with stable tubular would have offset any weakness that had developed in economy. But not only was growth in the legacy business negligible in the quarter but tubular was down significantly quarter over quarter. On the latter, it appears there is reasonable exposure in Tube Supply to Canada, which is always down a lot in Q2 for seasonal reasons but weak gas is also playing a role. Furthermore, there were $2m in one-time pre-tax costs in the JV and probably some impact from the Hawker bankruptcy. Put together the quarter would have been in the $0.16-$0.19 range depending on the tax rate.

    The guidance for a flat Q3 and Q4 versus Q2 (adding back the $2m) seems quite conservative. There was significant destocking and tubular in Canada is rebounding for seasonal reasons with stable US rig counts. My view is without much improvement you should be able to see at least $0.15 in each quarter putting full year EPS in the $0.70s. The should generate $30-$50m in cash in H2 that will go towards paying down the 12.75% Senior Secured notes that become callable in December. Each $25m in paydown is around 10 cents.

    Using $25 million in paydown and conservative assumptions on revenue growth I think they can earn $1.20-$1.30 next year, which is where I thought they would be this year. If aerospace finally kicks in and rig counts move up it can be better. This also ignores the huge $40m in cost cutting number the company threw out there on the call (would be $1.00 in EPS). Obviously hard to take this at face value without any details, but this could become a catalyst. Another year of improvement and cost cuts can put you > $2 in 2014 and the stock in the $20’s.

    Post the earnings when the stock went to $7 below liquidation value and expectations were thoroughly reset the risk/reward became very attractive again. Fast forward to today with the stock at $12.30 ($13.00 to start the day) post the 13D… It no longer looks cheap on the near-term earnings metrics relative to other distributors and you can fear the downside. I don't see any additional bear case than the one you laid out, unless one has some type of thesis on tubular goods. The leverage is what makes it more of a target in the distributor space, I would agree. With that said, the cash flow should be significant and would improve that situation meaningfully. If you can substantiate the cost cuts you should be able to take those $7-$9 downside scenarios off the table.

    So then it comes down to the probability you assign to a deal getting done and the price (both of which are a function of another bidder stepping in). My view is that Platinum/Ryerson is serious about doing a deal. Why they went about it this way isn't totally clear (why not make a bid?). Their current stake doesn't seem large enough for this to be some kind of ruse just to make money on a previous position gone bad. Ryerson has been acquisitive since Platinum's purchase. The past several deals have all gotten done around book value, which is about $14.75 for CAS. Depending on which year's EBITDA you use and how much of that $40m you give credit for you can get prices anywhere from $15-$25. Platinum likely won’t make a very high bid without competition, but the Michael Simpson family trust owns just over 20% of the stock, so if they want to go friendly they would need to entice him. A base case for a bid might be $16 with a 50% probability. If the company makes some progress on cash flow and cost cuts you can cap downside at $10. Perhaps you put a 25% probability on a deal falling through. Upside could be > $20 with some competition at 25%. That’s still quite a bit of upside and the probabilities could shift more favorably with any activity.

    SubjectRE: Updated thoughts
    Entry01/25/2013 07:35 AM
    Memberzzz007
    skimmer,
     
    I'm interested to hear pathbska's exit rationale as well, however, thought I'd throw my two cents.
     
    Somebody pitched this one to me recently as a perennial loser that now has an aggressive guy at the helm who is going to restructure and extract huge value.  I've been a long-time shareholder in MUSA, so have followed CAS obliquely.  I listened to the recent restructuring call, and have done a quick back of the envelope.
     
    I decided to pass.
     
    To your comment, I think 10% "normalized" operating margin is aggressive, if not bordering on ridiculous.  10% peak, perhaps, but not normalized.  Giving CAS credit for 7-8% normalized (i.e. midcycle) margins, which I still think is very aggressive, gets you to a valn a couple of years out for CAS that is similar to where MUSA trades.  If I want exposure to infrastructure build, oil & gas, etc. through a service center play, I would much rather own MUSA than CAS.  MUSA has a guy at the helm who is an absolute A-#1 ass kicker, who has proven himself in this industry over multiple cycles.  CAS, on the other hand, has an outsider attempting a turnaround.  I'm a big believer in numbers telling the tale, and while CAS has perhaps been perenially undermanaged, MUSA's superior ROIC over an extended period tells me that they're in better end markets, doing a more favorable range of value-added processing.
     
    I just don't see why I would pay a similar multiple (either EV or EPS-based) for CAS when I'm taking all the risk of a turnaround on an untested CEO, when I can pay the same price today for a proven business with a great CEO.

    SubjectRE: RE: Updated thoughts
    Entry01/25/2013 09:38 AM
    MemberWinBrun
    I'll see ya at the finish line, JR.
     
    CAS already seems to be outperforming MUSA handily.
     
    Imagine if your BYD had a real jockey....
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