We see excellent value in going long Metals USA (MUSA) equity, a relatively defensive stock that for several reasons has been ignored by the market, generates huge cash flow, and trades at a very attractive valuation. MUSA is the 12^th largest steel distributor in the US and operates 45 service centers, mostly in the East Coast, the South and the Midwest.

Business Description

As a distributor, the company's business model is above all about inventory management: through its service centers, MUSA purchases steel and other metals on a wholesale basis from mills and foundries, which it stores in its service centers and then sells on short notice through low-volume transactions (the average transaction size is $3,100). MUSA's service centers provide added value to customers by processing the steel to suit the end-user's needs: the company operates machines that saw the metal, punch holes through it, carve specific shapes, etc. The more MUSA processes the raw steel, the higher price it can charge and the higher margins it will earn.

78% of MUSA's 2010 service center sales were derived from carbon steel products, while stainless steel and non-ferrous metals such as aluminum, brass or copper account for 22% of sales. The company reports three segments:

• Flat-Rolled and Non-Ferrous: processes flat steel and non-ferrous products for customers in the industrial, transportation, and aerospace end-markets.
• Plates and Shapes: deals with plates, beams, bars and tubes. It's more exposed to construction, energy and some industrial markets.
• Building Products: makes finished products for roofing and patio contractors and distributors. This is a small business (5% of sales) directly linked to the real estate market, but MUSA has managed to stabilize it and is turning a small profit.

The Flat-Rolled segment is exposed to more early-cycle markets than Plates and Shapes, so demand has recovered quicker after the recession, driving higher growth in volumes and margins. Flat-Rolled accounted for 46% of EBIT in 1H11.

Plates and Shapes generally carries higher margins than Flat-Rolled due to a higher degree of processing and customization of the metal to customer specifications. In maximizing margins, it is obviously crucial to have a good grip on end-market demand and price in order to size inventories appropriately and avoid getting caught with high-cost inventory right before a downturn in metal prices. Margins are also directly correlated to overall steel prices, which explain the record margins achieved in 2008.

MUSA was a private company fully owned by Apollo Management funds from 2005-2010. After last year's IPO, Apollo still controls 64% of shares outstanding.

Valuation

Over the past twelve months, MUSA has traded about in line with steel mills like NUE and STLD, and underperformed service center peers like RS, WOR or RUS CN. Based on consensus numbers, MUSA screens as the cheapest US service center.

What stands out is MUSA's ability to generate tremendous cash (which we define as Net Income - Capex + D&A), as the company spends no more than $9mm in maintenance capex, and charges nearly $25mm in D&A. This is a distribution business and obviously requires additional working capital for the business to grow, but if we were to assume zero growth from 2011, the company would essentially receive its current market capitalization in cash in 4.5 years.

Because 2012 earnings estimates haven't yet adjusted for the recent macro concerns, it's important to estimate what a more conservative level of earnings might be for MUSA. MUSA's top line and margins are largely driven by steel prices, and of course by volumes too. In essence, higher steel prices generally allow MUSA to charge a higher mark-up for processing and re-selling the metal.

Steel prices have been elevated in the past few quarters due to cost support from booming input prices (namely iron ore, scrap and met coal). If cost pressure were to ease, steel prices would likely follow. While market consensus is that iron ore prices should remain elevated for the next 4-5 years until new supply comes on-stream, any macro slowdown in China would likely force input and steel prices down.

We base our "normal" scenario on $650/ton hot rolled coil prices, which out of prudence is below the latest $698/ton. We also assume volumes 5% higher than 2011, which should be achieved through full-year inclusion of the Trident acquisition, the new warehousing facility for Lakeside Steel, and minimal (1-2%) GDP growth. Sell-side estimates currently assume closer to 7% volumes growth. On these assumptions, we arrive to $170mm EBITDA, which is below 2012 consensus of $181mm. With the stock at $9, this implies less than 5x EV/EBITDA, and most importantly, a 16% FCF yield to equity (after accounting for increase in net working capital).

We recognize the huge macro uncertainty, and have modeled two scenarios, one that assumes steel prices 14% below current spot, and a more severe "recession" scenario. Our "lower HRC" scenario results in $140mm EBITDA (implying current valuation of 5.8x and 22% FCF yield).

Our "recession" scenario couples the decline in HRC price with a 10% decline in volumes. Given that volumes typically track GDP growth, this type of a decline would indicate not just a deep recession, but also a reduction in end-market inventory levels that would only be temporary. 2009 shipments fell 28% from 2008, but then bounced 28% in 2010 (around 25% organically). Under this scenario, EBITDA of $77mm would compress EPS to $0.26, but cash generation through working capital release would be huge, covering more than 1/3^rd of current market cap.

So what is fair value for MUSA? Given the company's limited trading history, we turn to its closest peer RS for reference. RS has typically traded at 5-8x forward EBITDA, so we believe a 6-7x multiple for MUSA is reasonable. At 6.5x our "normal" EBITDA of $170mm, MUSA's EV of $1.1bn would imply a $17 stock, or 82% upside. We believe our "lower HRC" scenario is more than priced in, as a 6x multiple on $140mm EBITDA would imply a $10 stock.

Thesis

Above all, the market is overlooking MUSA's cash-generating capacity. On consensus numbers, MUSA is trading at a 21% FCF to equity yield on 2011 estimates, and 25% on 2012 numbers. We define FCF as (Net Income + D&A - Capex). In essence, if MUSA's business grew at a zero rate, you'd get your investment paid back in little over 4 years (in cash, not earnings). We would consider such a low FCF multiple justified if MUSA's earnings were expected to rapidly decline, or if the company allocated capital unwisely, but this is far from the case.

• MUSA is a textbook case of a broken IPO. It IPO'd in April of 2010, issuing new shares worth nearly $250mm to pay down debt. The offering priced at $21, above the $18-20 range. The sponsors were aggressive in pricing and in guiding sell side's estimates, and the company disappointed the Street when it reported its 2Q10 results as the outlook for the US steel industry deteriorated. Couple that with the fact that many early investors were pitched the IPO as a quick flip, and it's no surprise that MUSA quickly sold off and has not revisited its IPO price.

• MUSA aims to grow EBITDA at a mid-teens rate annually on average. The base business grows about in line with GDP, say 2-3%. The company also aims to obtain 1% growth from new investments and/or technology-driven efficiencies. Finally, inorganic growth is expected to bring in about 10% growth.

• Inorganic growth is clearly an important part of the growth story and it's important for the company to get acquisitions right. There is huge potential for consolidation in the service centers industry, given high fragmentation in the sector (the top 20 players in the US only account for about a third of the revenue pie). The company generally looks for 2-3 bolt-on acquisitions each year, and generally seeks to increase exposure to high-margin end-markets that require the metal to be processed at the service center (such as aerospace, defense, energy).

• We like MUSA's record on M&A, and find the valuations paid for targets to be prudent, including the most recent and relatively large Richardson Trident acquisition, for which MUSA paid ($92.5mm EV, likely less than 7x 2010 EBITDA ex-synergies). We are confident management is not into empire building, and interests are well-aligned with CEO Goncalves holding a very significant part of his net worth in MUSA stock. Ultimately, Apollo obviously vets every transaction and wouldn't allow a dilutive deal in the unlikely event that management pushed for one.

• MUSA showed some inexperience in managing expectations following the IPO, disappointing the street for three quarters and with management's communication style clashing with some sell-side analysts. MUSA finally found its stride in 1Q11, and we feel like the company has grown smarter about communicating with the market. With this distraction out of the way, it's becoming increasingly obvious that MUSA's management are operationally very capable, and disciplined about not sacrificing pricing for volume. Working capital levels are centrally determined by the CEO, with local service centers having autonomy to break down the overall inventory levels into whatever products suit market conditions. We find Goncalves to be a very shrewd capital allocator, and one of the best informed (and candid) participants in the US steel industry. It's worth listening to his outlook for the industry in quarterly calls even if you're not interesting in MUSA.

• Consolidation potential in the industry works both ways, and we view MUSA as a highly attractive acquisition target for some of the larger service centers, like Reliance (RS), Ryerson, Russel (RUS CN) or Kloeckner (KCO GY). We regard the service center business as much more attractive than steel mills in the current environment, and it would be very wise for mills to pursue downstream integration, but right now they seem focused on buying mining assets at the peak of the cycle, and so far there doesn't seem to be much interest in getting into the distribution business. It is likely that Apollo will weigh a sale to one of these players as an alternative to potentially floating its shares on the market.

• MUSA's end-market exposure is highly diversified compared to most peers in the service center space. No major market accounts for more than 20% of sales, and the company's exposure to the construction business is much lower than certain peers (RS and WOR are 30-40% exposed to residential and non-residential construction). While the company had limited exposure to some of the highest-growth, high-margin markets, such as energy, aerospace and marine/defense, the company is actively pursuing growth in these segments, and some of its most recent acquisitions such as Trident ship most of their metal to these end-markets.

Risks

• The obvious risk to MUSA is its relatively high level of financial leverage ($468mm of net debt implies 2.9x EBITDA). Of course, this is largely the legacy of private equity ownership. We feel very comfortable with these levels of debt, given
  • 1) If things get ugly, the company will reduce its working capital levels and generate massive cash (in 2009 it reduced working capital by $258mm). MUSA currently holds $477mm in net working capital. Under our "recession" scenario, MUSA would release $114mm in cash by trimming working capital to 80 days of sales from the current 92 days (it reached a low of 72 days in Dec '09).
  • 2) No major maturities until Dec 2015, when $226mm in bonds come due.
  • 3) The company's ability to generate huge cash flow on a "business as usual" basis ($82mm yearly in our "normal scenario").

• A key risk to any distribution business is to get stuck with elevated levels of high-priced inventory right when prices start to decline. Getting working capital levels right depends largely on the ability to gauge customer inventory levels, and on accurately forecasting the direction of steel prices and demand trends. MUSA has a good track record here, and most recently has proved to read the market exactly right, opportunistically increasing or reducing inventory in anticipation of price and demand trends.

• Apollo funds currently hold 64% of MUSA equity. The funds invested in the company are 2001 vintage and invested in MUSA in 2005, so Apollo is eager to cash out in the near-term. While Apollo LPs have pretty much already earned their money back through dividend recaps while the company was private, there has definitely been an overhang when MUSA was trading in the mid-teens that Apollo would sell some or all of its shares in the market. We don't think Apollo is a seller at these depressed levels, so there should be at least $5 of runway before the overhang is an issue again. While a secondary offering from Apollo would no doubt hit the stock in the near-term, it would likely increase liquidity and make the stock attractive to new buyers (MUSA currently trades only $1.5mm daily on average). Of course, Apollo could also monetize its stake by selling the company to a strategic buyer.

• Cash accumulation/debt pay down
• Additional accretive acquisitions
• Getting acquired
• Increased liquidity if Apollo lists its stake