Friedman Industries (“FRD”) is a steel mill and service center business that trades at $6.62, a 26% discount to tangible book value per share. We think the downside is well protected given ~$6.40 per share of net working capital and we think the downside is a bit above book at close to $10 per share.  The investment thesis is predicated on the fact that the company will likely sell down its tubular inventory (“reject pipe”) and these inventory liquidation proceeds along with the cash on the balance sheet will approximate $30M ($4.50 per share), and we expect the company to ultimately return $20-25M or $3.00-$3.60 per share in cash dividends to shareholders over the next 12-24 months. We then think the company will continue to earn $.50-$.75 per year, putting the stock at 2.4-x3.6x P/E post the dividends.

The company has been profitable every single year for the last 51 years and has continuously paid a dividend for over 30 years. The stock trades for approximately the value of its net working capital of $6.40 per share and is unlevered with just over $1 per share in net cash and pays a small dividend, although it has historically paid out ½ of its annual earnings in cash dividends.

Historical financials

FRD has two segments: Texas Tubular (“TT”) and Coil.

Texas Tubular

The Texas Tubular division sells steel line pipe for energy and industrial applications. TT’s annual capacity exceeds 150,000 tons. Average tons sold and average EBITDA-capex per ton are 108,000 tons and $57/ton. This division markets reject pipe that it receives from the nearby US Steel Lone Star plant and this segment has two electric resistance welded “ERW” pipe mills, Mill #1 makes 6 5/8” and 8 5/8” diameter steel and Mill #2 which makes 4 1/2” – 5  9/16” pipe. TT recently (2014-2016) spent approximately $8M of capex to construct its Mill #3, which will thread OCTG (oil country tubular goods), likely for US Steel as well as other customers. TT is co-located with US Steel’s Lone Star plant and has a rail spur that connects the facilities, so TT is effectively a US Steel service center. Recently, US Steel permanently shut Line #1 that makes large OD (greater than 7” diameter pipe), which means that TT will no longer receive reject pipe and will no longer make its 8 5/8” OD pipe, at least not for US Steel, which is a significant customer. Currently, neither Mill 1 or 2 are running and Mill #3 should be coming on-line in the near future. We believe the loss of the reject pipe business is approximately offset by Mill #3 in terms of profitability, however, total sales and unit volumes will clearly be lower.

We have spoken to the company’s largest customer and a key supplier in the Tubular segment. FRD is considered to be a very reliable supplier and the company is well regarded. A key industry participant did note that the company’s facilities are quite old, which is a fair criticism. Overall, our sense is that management is honest and hard working. The facilities are old, and this is a reflection of management being frugal and spending the bare minimum on capex over the years.

Coil segment

The Coil segment operates two mills in Hickman, AR and Decatur, AL that purchase hot-rolled steel coils from Nucor and processes the coils into finished sheet and plate sold for industrial applications (rail, agriculture, etc.). This division has the capacity to process and sell 170,000 tons per year, but averages 110,000 and EBITDA-capex/ton averages $14/ton.

Valuation

• While similar steel service center businesses have sold for $200-300/ton of capacity, which would value FRD at approximately $12/share, we think each segment should be valued separately:

• Tubular long term EBITDA-capex / ton = $57/ton X 75,000 tons [this assumes the reject pipe business is over by removing it from capacity numbers] = $4.3M and apply a 6x multiple to arrive at Tubular segment value of $25.7M

• Mill #3 valued at $1M of per annum EBIT at steady-state and apply a  4x multiple = $4M

• Coil long term EBITDA – capex/ton  = $14 X 110,000 = $1.5M and apply a 4x multiple = $6.2M

• EV of Tubular + Coil =  $35.9M

• Cash = $7.1M (9/30/16)

• Finished tubular inventory (reject pipe) converting to cash over the next 6-12 months = $23.7M or $3.50 per share

• Total equity value = $66.7M or $9.80 per share

Risks and downside

• The key risks include: continued import pressures, Mill #3 fails to secure sufficient orders to justify its investment

• If everything goes wrong, our sense is that the net working capital would be liquidated and that the 195 acres of owned real estate ( 122 acres in Lone Star, TX, 26 acres in Hickman, AR, and 47 acres in Decatur, AL) which is on the books at cost of $1.0M would be sold, likely netting common shareholders  approximately $6.50 per share.