Ryerson Inc. RYI
June 26, 2006 - 9:26am EST by
2006 2007
Price: 26.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 750 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Due to misleading financials, the market has an incomplete picture of the net worth and earnings power of Ryerson. 20% of RYI shares are sold short, and the company trades at a discount to its already cheap and unloved service center brethren. Once RYI’s operating earnings of 2005 are proven to be sustainable, the shares should advance 75% to 100% from these levels.

If valued in line with its peers, RYI would be a $42 stock. At that point, the stock would be 1.5x tangible book and 5x EV/EBITDA on a properly adjusted basis. At $26, RYI is currently well below tangible book value (~$30), 8x EPS (on operating margins with upside), and ~2.6x properly adjusted EV/EBITDA.

RYI’s shut down value (liquidating inventory, taxing LIFO reserve, and settling pensions) is ~$29. While priced as though it will operate at a loss, RYI’s sustainable FCF is in the high teens %, with near-term FCF triple that and the possibility of capital return to shareholders. Steel prices can get cut in half in the next six months and RYI would still be an undervalued, profitable, FCF machine.

Business Description:
RYI is the largest metals service center in the US ($5.8B in sales). The business is 50% stainless and aluminum, 26% carbon flat rolled, 10% bars and tubes, and 14% plate/other. About 50% of the products sold go through some form of value-added processing, and the top 10 customers account for 14% of sales.

LIFO Accounting Vastly Understates Net Worth:
Ryerson’s true net worth and cash earnings potential is obscured by its GAAP financial statements. The footnotes reveal the accumulation of a massive off-balance sheet LIFO inventory reserve in the last few years that has inflated COGS and understated earnings.

All of Ryerson’s competitors use a higher mix of FIFO inventory accounting. In an environment with rising prices, companies on LIFO report lower earnings than their FIFO comps but collect higher cash flows (pay less tax). In 2004, when the price of steel shot from $300 to $750 per ton, RYI’s FIFO comps printed huge EPS numbers, due partially to higher gross profit dollars and partially to inventory gains. RYI, using LIFO accounting, took charges to COGS in late 04 so that the cost of steel sold was recorded at the inflated 2004 prices (last in). RYI’s LIFO charges of 2004 ($274M) completely misrepresented RYI’s increase in net worth for the year. Reported earnings (and increase in shareholder’s equity) were $54M for the year, but the increase in economic net worth was about $328M (LIFO reserve accumulation + earnings). Analysts, however, took RYI’s low margins as a sign of operational weakness.

It should be noted that inventory are added in annual layers as groups of inventory are brought in at new price levels. LIFO reserves are increased and a charge is taken to COGS to offset the inventory profits on old layers that would occur in a FIFO system. Due to a quirk in its accounting, the 2004 LIFO charge actually exceeded RYI’s inventory profits because inventory increased during the year. Unless steel prices fall back to 2003 levels and inventory falls significantly, RYI’s LIFO reserve will never fully reverse and completely flow through the income statement.

While the accounting is complicated, the LIFO reserve is simply the difference between the (understated) book value of inventory and its replacement value. Therefore, to get a true picture of the net worth of the company, the LIFO reserve should be added back to shareholders’ equity. Goldman Sachs argues that RYI should trade close to the on-balance sheet net worth of $20 per share. They neglect to add back the off-balance sheet LIFO reserve, which amounts to about $10 per share ($292M). GS also ignores a further $2 per share in excess undervalued real estate. Note that the above describes Goldman Sachs’ equity analysts. Goldman Sachs Asset Management must feel differently; GSAM is Ryerson’s biggest shareholder owning just a touch under the poison-pill maximum of 10%.

The LIFO reserve should be seen as a permanent tax dodge and a sign of conservatively reported GAAP earnings. RYI’s LIFO reserve is 40% of its market cap (vs 6% for RS and 21% for CAS, the only two competitors with LIFO components).

Debt Creates Further Misunderstanding of Valuation:
Goldman contends that RYI is fully valued at 8-9x EV/EBITDA. However, ALMOST ALL OF RYI’s BORROWINGS TAKES THE FORM OF ASSET-BACKED LOANS AGAINST THE STEEL INVENTORY; WHILE CLASSIFIED AS LONG-TERM DEBT, IT IS REALLY WORKING CAPITAL FINANCING. Service center CEOs do not view their leverage in terms of EBITDA to LTD (cash flow borrowing); they view their leverage in terms of excess availability on the credit facility. As inventories go up, debt naturally increases. RYI is the largest service center with $5.8B in revenues. Because of its size, RYI is obviously going to have significantly more inventory and debt.

Service centers should probably just be compared on a P/E basis (with the assumption that inventory can be funded by revolvers for the larger, quality players). If you are making an EV/EBITDA comparison, you have to include working capital balances when analyzing the EV of service centers. When the comp group is adjusted for LIFO reserves, pension liabilities, and working capital differences, RYI actually comes out significantly cheaper than its peers:

P/E FIFO Price
Ratios Adj FIFO Adj to Revenues
ROCK 11.6 7.4 935 7.4 1200
ZEUS 10.8 3.9 208 1.6 900
RS 8.3 5.3 2081 2.8 5200
CAS 8.6 3.8 324 1.9 950
STTX 18.3 1.3 88 0.8 1000
WOR 13.5 4.7 1553 2.3 3150
RYI 8.2 2.6 504 0.9 5800
Average 11.8 4.4 2.8

Margin Upside Potential / Unrealized Merger Synergies:
RYI also has opportunity to increase its operating margin by about 1 percentage point from remaining synergies on its year-old merger with Integris (the aluminum and stainless component of the business). Management has admitted that they are in the 4th inning of the integration, with more facilities consolidation expected to come. There are about 20 redundant warehouses that will be sold in the next year or so, worth at least $50 million.

In addition, RYI’s operating margin at ~3% is about half the level of its competitors. Differences in customer account size and products explain a large part of the gap, but longer-term moves to bring RYI’s profitability per ton more in line with its comps would result in significant EPS accretion. For example, RYI is currently maintaining 5 legacy ERP systems. As old systems get consolidated into a new SAP system, costs come down while efficiency increases.

Inventory Reduction and Capital Return to Shareholders:
Average turns in the industry are about 5.5x (taking inventory at FIFO), but RYI has recently been stuck in the 4x range. To get to 5.5x turns, RYI would need to reduce inventory at FIFO by about $270M. Management has already committed to getting to 5x.

On the Q3 conference call, 4 out of the 5 questioners were shareholders asking why RYI couldn’t reduce inventory and return cash to shareholders.

CFO Jay Gratz responded that paying down debt was still a priority:

“I think we when get into the 55-60% range [debt to cap] we're roughly about right and that's the appropriate time to consider it [buybacks] along with other things we have to consider...”

Ryerson generated about $290M in FCF last year ($177M from inventory redux), or approx 40% of its market cap. The sustainable forward FCF yield is 15 to 20%, however, there is still $300 to $350M of cash tied up in inventory and excess real estate that can be pulled out of the company and returned to shareholders (42% to 49% of the market cap).

The company is already in the 55-60% range and further increases in RYI’s overcapitalized position should give management room to buy back shares this year. Current conditions make the case made by a Q3 CC questioner even stronger:

“And it looks like, there's a lot more cash to come given the asset sales, you know, the $50 million in asset sales and continued inventory workdown. You really performed for the bondholders over the last six months and you paid down $243 million in debt, and it seems to me that the next $200 million or so of free cash flow should really go to the shareholders. If it made sense to repurchase 26.5 million shares for $30 in a Dutch tender in '98, it seems to make sense to make it a Dutch tender right now for 8 million shares for, I don't know, $25. That would reduce your share count by a third and increase earnings by 50%. I think if you did this, you would get to a valuation of about $40 per share, which we view as conservative. I don't think you're going to find any acquisition opportunities that are going to give you that kind of accretion.”

The increase in the buyback allowance to $200 million under the credit facility in December signals that management is responding to this pressure. If RYI does not repurchase shares, it will become more of a target for activists or from smart money like Apollo Management. (See my writeup of MUSA/MUSAW from last July.) Apollo effectively acquired MUSA at 3.5x earnings and was able to further increase its leverage in the deal at closing. By the way, Apollo has already filed an IPO prospectus for Metals USA (6 months after closing).

Possibility of GAAP Q2 Earnings Miss:
There is a strong chance RYI will miss GAAP reported estimates for Q2. This is because steel pricing has been strong in Q2 and analysts have not modeled in much for LIFO charges in Q2. LIFO always creates unpredictable GAAP results.

RYI economic profits will be very strong in Q2, but they may not show up in the GAAP headline number. Notice what happened to CMC (a minimill and distribution business) on its 6/20/06 earnings report because of a record LIFO charge. The stock rebounded after a very interesting conference call (a recommended read). Here are some of the CEO’s comments:

“It was not a good quarter; it was not a great quarter; it was a stupendous quarter, although it appears the beneficiaries of our earnings report were other companies in the steel and metal sector. Our legendary conservative accounting was on full display, for which we were summarily plastered.”

“...you would think in 2006 people would understand LIFO; but there was even one -- in one of the press reports on interpreting our earnings, the reference is to an inventory write-down of some $20-plus-million post tax, which of course is a complete misrepresentation of what LIFO is...”

“But all segments contributed to the stellar performance... Our prospects remain extremely good. Our end-use markets look good. We said that. I don't know how to keep saying that. But steel markets are firm around the world, virtually every product. There have been significant price increases since February.”

Sequentially, CMC’s revenues were up 23% and the company noted continued strengthening in the domestic steel market.

CMC’s LIFO-based GAAP “miss” turned out to be a buying opportunity. RYI may present a similar opportunity.

Although there is a real risk of RYI “missing” Q2 on a GAAP-reported basis, adjusted for the LIFO charge, the business (like CMC’s) is actually stronger on a sequential basis.

The LIFO reserve has obscured the earnings power of RYI and its net worth. Further, confusion about RYI’s debt has limited RYI’s valuation so that it is trading at levels 30% below the net cash that would be received in a liquidation (sale of all inventory, centers, and settlement of debts and pension liabilities). RYI is the market share leader and should not be trading like it is a small player with visibility of net losses.


-further inventory liquidation and removal of capital from the business
-share buybacks (or threat of activism)
-upside to near term estimates, ex-LIFO
-margin improvement from merger synergies
-further service center consolidation (Apollo buying MUSA, RS buying JOR) and realization that the space is cheap
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