Empire Resources ERS S W
April 24, 2006 - 4:41pm EST by
mm202
2006 2007
Price: 45.20 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 440 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

I am recommending a short sale of ERS. I believe that this play offers a rare opportunity to take advantage of momentum buying which should shortly come to an end, and be replaced by panic selling of a stock that is dramatically overvalued and overbought.

The near term catalyst for this stock's fall from grace is very clear and very powerful. But before we get into that, let's marvel a bit at just how extraordinarily overvalued ERS is.

In the last four quarters, ERS has reported total FCF of $4.9M. ERS's market cap is currently about $440M. ERS therefore trades at an astounding 89 times FCF. ERS has shown no sequential growth in the last 3 quarters and won't next quarter either (see below). Amazing for a company trading at 89 times FCF.

ERS is an order taker. They don't treat aluminum, and they don't distribute it either. They just place orders for customers. ERS does not do business in China. They deal with customers in Australia, New Zealand, Canada and US. They have no upside from China's fast growing market.

A few weeks ago, ERS reported a backlog of $88M. Looking back to 2000, only once has ERS reported a Q1 greater then their backlog and that was in 2003 when they had a backlog of $52M and reported $53M in revenues. So again ERS will show no growth this quarter as revenues will likely be < $88M.

Over the last 2 quarters, ERS has seen their gross margins decline from 8.5% to 7.2%. Pricing pressure is growing. This makes sense, given that the company has no barriers to entry.

RYI accounts for 60% of ERS's revenues. Last year RYI bought the steel distribution biz from Alcoa. Given RYI's new relationship w/ Alcoa, they could easily drop ERS as ERS provides no incremental value to them. 60% of ERS's aluminum supply comes from one source. Given aluminum demand, this source could end their relationship with ERS tomorrow and ERS stock would go to $0.

Even assuming that the RYI relationship remains status quo, comparing RYI's and ERS's valuations helps to illustrate just how overvalued ERS is. RYI is in the same business as ERS, is a good comp for ERS, and trades at 8 times earnings. Even companies like CENX that actually produce aluminum trade at less than 10 times forward earnings. Can ERS forever trade at 45 times earnings when their comps all trade at 10 or less? I think not. 10 times ERS's $.98 in earnings would put the stock at $10.

ERS is run by a husband (CEO) and wife (CFO) team. They have 5,000,000 shares. Don't be surprised to see large insider sales after earnings, which will end the stock's current short squeeze induced rally. They had no problem selling 200,000 shares last year at $12 when the stock was trading 200,000 shares a day.

For all of these reasons, ERS is extraordinarily overvalued. But that alone wouldn't be sufficient for me to recommend shorting this stock, absent a near term catalyst. Fortunately there is such a catalyst- ERS's imminent expulsion from the IBD top 10 list.

ERS has been the number 1 ranked stock on the Investors Business Daily top 100 list for several months now. As anyone who follows IBD knows, IBD #1 picks often attract massive momentum buying. That is exactly what has happened with ERS over the last several months, since it moved to #1 on the IBD list.

However, when ERS next reports earnings (due out by May 15). they will lose their IBD #1 rank due to lack of EPS growth...and the impact of this on ERS's stock price will be devastating.

Backlog at the end of last quarter was $88M. Look at the Q4 backlog and resulting Q1 numbers from the last 4 years:

Q404 Backlog: $80M
Q105 Revenue: $80M

Q403 Backlog: $53M
Q104 Revenue: $54M

Q402 Backlog: $52M
Q103 Revenue: $45M

Q401 Backlog: $50M
Q102 Revenue: $40M

I could continue, but I think you get the picture. ERS's revenue number never exceeds their backlog in Q1.

ERS's IBD rank is to blame for this huge run in the stock. Were ERS to lose that rank the bubble would pop and the stock would return to a valuation in line with its peers. The key to ERS and any IBD #1 is its EPS score. The EPS score takes the last two quarters' earnings growth rate and compares that across all stocks. A revenue result of $88M based on ERS's backlog would mean roughly $.24 in EPS. This is inline with Q105, which means 0% EPS growth. Accordingly, its EPS score will drop into the low 90s and ERS will clearly lose its IBD #1 rank.

This will be devastating for ERS, because the stock is in an IBD #1 bubble. Look at past similar examples (HRT, ESMC, LWAY, TZOO, CUTR, NGS, FORD). HRT, NGS, TZOO and FORD are most similar as like ERS they reached ridiculous valuations with no barriers to entry in their businesses. In each case the stocks dropped roughly 75% from their highs.

It's important to note that, once an IBD 100 stock drops 35% from its all time high, it is removed from the IBD 100 list altogether. In ERS's case, that will happen when the stock drops to around $29 which I expect to occur shortly after the company reports. Being removed from the list entirely will be a further downside catalyst for the stock, as it was for the prior IBD #1 stocks listed above.

Catalyst

1) ERS falling out of the IBD top 10, and then completely out of the IBD 100.

2) ERS's extreme overvaluation being recognized by the market after lackluster Q1 earnings, and the stock returning to a sane valuation.
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    Description

    I am recommending a short sale of ERS. I believe that this play offers a rare opportunity to take advantage of momentum buying which should shortly come to an end, and be replaced by panic selling of a stock that is dramatically overvalued and overbought.

    The near term catalyst for this stock's fall from grace is very clear and very powerful. But before we get into that, let's marvel a bit at just how extraordinarily overvalued ERS is.

    In the last four quarters, ERS has reported total FCF of $4.9M. ERS's market cap is currently about $440M. ERS therefore trades at an astounding 89 times FCF. ERS has shown no sequential growth in the last 3 quarters and won't next quarter either (see below). Amazing for a company trading at 89 times FCF.

    ERS is an order taker. They don't treat aluminum, and they don't distribute it either. They just place orders for customers. ERS does not do business in China. They deal with customers in Australia, New Zealand, Canada and US. They have no upside from China's fast growing market.

    A few weeks ago, ERS reported a backlog of $88M. Looking back to 2000, only once has ERS reported a Q1 greater then their backlog and that was in 2003 when they had a backlog of $52M and reported $53M in revenues. So again ERS will show no growth this quarter as revenues will likely be < $88M.

    Over the last 2 quarters, ERS has seen their gross margins decline from 8.5% to 7.2%. Pricing pressure is growing. This makes sense, given that the company has no barriers to entry.

    RYI accounts for 60% of ERS's revenues. Last year RYI bought the steel distribution biz from Alcoa. Given RYI's new relationship w/ Alcoa, they could easily drop ERS as ERS provides no incremental value to them. 60% of ERS's aluminum supply comes from one source. Given aluminum demand, this source could end their relationship with ERS tomorrow and ERS stock would go to $0.

    Even assuming that the RYI relationship remains status quo, comparing RYI's and ERS's valuations helps to illustrate just how overvalued ERS is. RYI is in the same business as ERS, is a good comp for ERS, and trades at 8 times earnings. Even companies like CENX that actually produce aluminum trade at less than 10 times forward earnings. Can ERS forever trade at 45 times earnings when their comps all trade at 10 or less? I think not. 10 times ERS's $.98 in earnings would put the stock at $10.

    ERS is run by a husband (CEO) and wife (CFO) team. They have 5,000,000 shares. Don't be surprised to see large insider sales after earnings, which will end the stock's current short squeeze induced rally. They had no problem selling 200,000 shares last year at $12 when the stock was trading 200,000 shares a day.

    For all of these reasons, ERS is extraordinarily overvalued. But that alone wouldn't be sufficient for me to recommend shorting this stock, absent a near term catalyst. Fortunately there is such a catalyst- ERS's imminent expulsion from the IBD top 10 list.

    ERS has been the number 1 ranked stock on the Investors Business Daily top 100 list for several months now. As anyone who follows IBD knows, IBD #1 picks often attract massive momentum buying. That is exactly what has happened with ERS over the last several months, since it moved to #1 on the IBD list.

    However, when ERS next reports earnings (due out by May 15). they will lose their IBD #1 rank due to lack of EPS growth...and the impact of this on ERS's stock price will be devastating.

    Backlog at the end of last quarter was $88M. Look at the Q4 backlog and resulting Q1 numbers from the last 4 years:

    Q404 Backlog: $80M
    Q105 Revenue: $80M

    Q403 Backlog: $53M
    Q104 Revenue: $54M

    Q402 Backlog: $52M
    Q103 Revenue: $45M

    Q401 Backlog: $50M
    Q102 Revenue: $40M

    I could continue, but I think you get the picture. ERS's revenue number never exceeds their backlog in Q1.

    ERS's IBD rank is to blame for this huge run in the stock. Were ERS to lose that rank the bubble would pop and the stock would return to a valuation in line with its peers. The key to ERS and any IBD #1 is its EPS score. The EPS score takes the last two quarters' earnings growth rate and compares that across all stocks. A revenue result of $88M based on ERS's backlog would mean roughly $.24 in EPS. This is inline with Q105, which means 0% EPS growth. Accordingly, its EPS score will drop into the low 90s and ERS will clearly lose its IBD #1 rank.

    This will be devastating for ERS, because the stock is in an IBD #1 bubble. Look at past similar examples (HRT, ESMC, LWAY, TZOO, CUTR, NGS, FORD). HRT, NGS, TZOO and FORD are most similar as like ERS they reached ridiculous valuations with no barriers to entry in their businesses. In each case the stocks dropped roughly 75% from their highs.

    It's important to note that, once an IBD 100 stock drops 35% from its all time high, it is removed from the IBD 100 list altogether. In ERS's case, that will happen when the stock drops to around $29 which I expect to occur shortly after the company reports. Being removed from the list entirely will be a further downside catalyst for the stock, as it was for the prior IBD #1 stocks listed above.

    Catalyst

    1) ERS falling out of the IBD top 10, and then completely out of the IBD 100.

    2) ERS's extreme overvaluation being recognized by the market after lackluster Q1 earnings, and the stock returning to a sane valuation.

    Messages


    SubjectAluminum Prices
    Entry04/24/2006 05:35 PM
    Memberscott265
    I assume the relationship is fairly direct between aluminim prices and revenues? Is there a particular grade you use to track this.

    I understand this is distribution biz but how do you think about chance of higher op income from greater absolute $ leveraging the SGA base.


    SubjectBorrow?
    Entry04/24/2006 06:10 PM
    Memberhao777
    Any idea where to find stock? So far no luck on our end...

    SubjectSales increase
    Entry04/24/2006 10:53 PM
    Memberdj927
    How much of the $ volume increase in revenues in 2005 vs. 2004 was due to higher steel prices and how much was due to increased volume? Thanks for the idea

    SubjectAluminum prices/ scott265
    Entry04/25/2006 09:38 AM
    Membermm202
    Traditionally ERS has enjoyed almost a 2:1 operating leverage in their business model. This has not been not been case the last two quarters as it appears they are having a harder time passing their commissions on to their customers in the face of sky high aluminum prices. Last quarter, for example, operating margins dropped by almost 20% versus the previous quarter. Operating margins dropped in Q3 as well. I believe this trend will continue in the coming quarters if aluminum prices continue to rise.
    MM

    Subjectdj927
    Entry04/25/2006 09:39 AM
    Membermm202
    Volumes shipped last year were up 35% while sales were up 68%, so increased prices for aluminum accounted for roughly half of the revenue increase.

    As for "what went right" last year, remember that free cash flow in 2005 was actually meager. Overall, 2005 was fine....if ERS were still trading under $10. But the stock is trading over $45 currently and has to be considered outrageously overvalued compared to its peers, even on a trailing PE basis. When you consider how feeble ERS's current growth trajectory is, the stock's valuation looks even more appalling.
    MM

    SubjectBorrow
    Entry04/25/2006 09:40 AM
    Membermm202
    Hao,
    I've found shares to short at Interactive Brokers.
    MM

    SubjectEarnings Ramp
    Entry04/26/2006 09:09 AM
    Memberjuice835
    thanks for the idea and i agree that it seems overvalued. That said, can you explain why their earnings have increased so much in the past few years? Is it just that they take a % based on aluminum sold and so that number grows with price or is that they are able to exploit a steady inventory in a tight environment? their 10K is pretty useless as relates to these issues.

    SubjectEarnings Ramp
    Entry04/26/2006 10:28 AM
    Membermm202
    Juice,
    They charge a straight commission, so as prices increase so does their commission revenue. However, it appears from their gross margins that they are having to reduce their commission rates.
    MM

    SubjectBorrow
    Entry04/26/2006 12:44 PM
    Membermm202
    Hao,
    I was able to get a borrow through Ameritrade today.
    MM

    Subjectquestion
    Entry04/26/2006 04:28 PM
    Membergearl1818
    why did it go up so much today

    SubjectQuestion
    Entry04/26/2006 05:02 PM
    Membermm202

    "why did it go up so much today"

    LOL. That's a very good question, Gearl. I don't really have a very good answer. I can tell you that a lot of the low floaters I was watching ran absurdly wild today, as they have the last few days....and I do think that ERS has been caught up in that mania. Couple that with metals mania and IBD mania...and, well, there's a lot of mania surrounding this pig right now.

    Today certainly wasn't fun for me, with respect to my ERS position. But this stock will have its comeuppance imho.

    When the company reports roughly flat earnings within the next three weeks it should become clear to even the most obtuse ERS longs that this stock is not a good way to leverage potential metals upside (even assuming that upside exists for aluminum prices, which have already run wild) and that the company is not growing (which makes its PE absolutely insane versus any comparable or semi-comparable). The metal mo-mo contingent should run screaming at the same time that the IBD mo-mos abandons the stock. At that point, ERS's low float-induced volatility should work against the stock...as the exits suddenly become very crowded.

    That's my thesis and I'm sticking with it anyway. LOL
    MM

    SubjectDJ927
    Entry05/02/2006 12:24 AM
    Membermm202
    DJ,
    you're absolutely right about my confusing Ryerson and Hulett. I apologize for the mistake.

    ERS's business model is to handle marketing and distribution for small aluminum producers. As such, they tend to be the primary customer for most of these small producers- but I don't know for certain that ERS is Hulett's exclusive distributor.
    MM

    SubjectOuch!!
    Entry05/02/2006 09:46 PM
    Membermm202
    Yeah, ouch is right. LOL

    Part of the reason for today's huge move was dissemination of buyout rumors by Briefing.com's trading service. They reported unconfirmed rumors of RYI taking out ERS at $65 when ERS was around $50, and the stock subsequently exploded.

    I find this rumor to be absurd.

    ERS is without question massively overvalued, to the extent that no company would pay $30 for them...much less $65. And how would RYI finance this hypothetical takeout?
    RYI's balance sheet is weak- so they can't pay cash.

    Their market cap is only $770 milion. O/S is around 28 million, and it would cost them about 650 million to buy ERS at $65. In other words, they'd have to pay almost their entire current market cap. They'd have to issue about 20 million shares, taking their o/s up by 70%.

    MM

    Subjecthuge premium
    Entry05/03/2006 10:14 PM
    Membergrant387
    I was quoted a 40% premium today to make the trade.

    Is this trade still feasible/viable?

    The idea is compelling and the recent price increase significantly tilts the risk reward ratio in your favor . . . but getting execution . . . argh

    any recommendations?

    SubjectERS/ IBD 100
    Entry05/05/2006 07:01 PM
    Membermm202
    Yes, IBD was booted off of the IBD 100 list. That is just a massive blow for the stock, as it now will have to stand on its valuation....which is patently absurd.

    Normally I'd predict more carnage on Monday...and that might still happen. But note that Louis Navallier's Emerging Growth newsletter- which has a huge following- picked ERS as one of its top picks this month. That will certainly bring a lot of money into the stock on Monday, and offset IBD-related selling to some degree.

    So I have no prediction as to how ERS will trade on Monday. But this is extremely bad news for the stock. Even great earnings (which shouldn't materialize) won't support ERS's valuation.

    The end of this week was ugly for ERS. But that was just the beginning, imho.
    MM

    Subjectmm202: great work
    Entry05/15/2006 07:27 PM
    Memberbibicif87
    Just want to congratulate you on your great call, especially when ERS initially went against you and you totally stuck to your guns. I was going through the same thing at the time, suggesting here a short of BLDP at $10.48, only to have it trade at $13 a couple days later. ERS has practically fallen in half in less than a month since your write-up.

    This, I'll add, is a good example of why the advice one reads everywhere about the necessity of having stop losses is so bogus. Maybe stops make sense for people who don't really understand a story they are involved with, but if one don't really understand something, they certainly shouldn't short it. You knew ERS was overpriced at $45, and the fact that there were some people who were willing to pay higher does not mean that they were right; in fact, they were even more wrong.

    Subjectmm202: great work
    Entry05/17/2006 03:47 PM
    Membermm202
    Much thanks for the kind words, Bibicif. The ride on this stock got amazingly wild for a stretch there. But ERS was simply an incredible pig by any measure- so I was fairly comfortable staying the course and waiting for the market to regain its sanity. LOL

    I covered part of my short today. But I'm still significantly short here, because I expect ERS to trade down into the teens sooner or later.

    I'm traveling in Europe- so if I'm late responding to any additional posts, that's why.
    MM

    SubjectI second the thanks
    Entry05/17/2006 05:29 PM
    Memberdj927
    It was a lot of fun, thank you!

    Subjectif we clap loud enough. .
    Entry05/22/2006 02:16 PM
    Memberbuster736
    will you come out and take a bow?
    great call!

    SubjectCovered ERS short
    Entry05/25/2006 09:41 PM
    Membermm202
    I closed out my ERS short at an average of around $20.50 over the last few days. I do think that ERS should head lower from here (this stock really has no business trading over $15, imho). But I think that the easiest money has probably been made here now...so I decided to book the relatively easy profits.

    I'm glad that some VIC members profited from the idea, and honored by the kind words from Buster736, DJ927, Bibicif87 and others.
    MM
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