Friedman Industries Inc. (NYSE:FRD)

Friday, July 20, 2018

Research

**Call To Action Update - FRD

Friedman Industries Inc. (NYSE AMEX:FRD) ($9.24; $64.7M market cap) is a company that engages in steel processing, pipe manufacturing and processing, and steel and pipe distribution activities in the United States.  On June 29, 2018, We established a swing trade position in FRD when the stock was trading at $8.46. After further due diligence, which included reading the 10-K closer and an interview with management, we are moving FRD from our swing trade portfolio to our Select Longs portfolio.  

We are not going to write an extensive report on the Company, but identified some near term positive growth drivers for the Company.  We want to be clear that FRD operates in two highly cyclical commodity type markets where the outlook can change almost instantly.

  1. Coil Products: The coil product segment consists of the operation of two hot-roll coil processing facilities.  The Company maintains an extensive inventory of prime and secondary hot rolled coils ranging in thickness from 14 gauge to ½” and ranging in width from 36” to 72”. Their inventory also consists of both smooth surface and tread plate coils with mill edges or slit edges.  The products serve a variety of customers in the Steel industry, such as steel buildings, railroad cars, barges, tanks and containers, trailers, component parts and other fabricated steel products.

  2. Tubular Products: The Tubular Division operates under the trade name Texas Tubular Products. Texas Tubular manufactures API 5L Line Pipe, ASTM A53B Pipe and ASTM A500B Pipe on its two Electric Resistance Welded pipe mills. Texas Tubular also maintains an extensive stock of new mill reject / new secondary pipe. Texas Tubular also operates a pipe finishing facility that is focused on threading oil country tubular goods with semi-premium connections.  The Tubular segment’s end user is typically in the energy markets.

Here are some of the positive catalysts we see moving forward:

  • Both segments are benefiting from the sharp increase in the price of steel, and a portion of the increase is coming from the tariff sanctions.  

    • Coil: The average per ton selling price related to these shipments increased from approximately $572 per ton in fiscal 2017 to approximately $674 per ton in fiscal 2018

    • Tubular: The average per ton selling price related to these shipments increased from approximately $582 per ton in fiscal 2017 to approximately $651 per ton in fiscal 2018.

  • Even though the company operates in a low gross margin industry, margins can improve when production volumes increase. This is important because over the longer term, an increase in selling prices can not be the sole driver of growth because Company’s inventory will eventually start to reflect higher material costs if steel prices remain elevated. In the short run, the increase in steel prices is benefiting the company because:

    • They are selling off old inventory that was purchased at lower prices.

    • There has been an increase in the average selling price of their products.

      “Management believes this improved demand is primarily related to the sustained recovery in the U.S. energy industry and the segment’s new product offering of API line pipe. Historically, the tubular segment has produced and sold API line pipe through an exclusive customer arrangement. Late in the third quarter of fiscal 2018, TTP began actively producing, marketing and selling line pipe directly to distributors.”

      “Management expects line pipe sales to be a significant component of total tubular segment sales moving forward and expects segment operating results to be positively impacted by the increased sales and mill production related to line pipe.”

  • We learned from management that the average selling price for their products in the early 2000’s was at ~$1000, so there is still room to go if the industries FRD serves continue to improve.
     
  • A positive wildcard catalyst would be if Trump is able to increase the budget for building out U.S. infrastructure.
  • We get most excited with commodity industries when a company experiences higher overall demand for its products (increase in volumes). This is when a company can experience a “double whammy” effect that could impact operating margins in a meaningfully positive way, even if its inventory starts to reflect higher input costs and if gross margins stabilize. This occurs because many commodity companies have decent operating leverage, where SG&A does not rise nearly as fast as revenues. For example, in 2018 on $121.1 million in revenue, SG&A expense was $4.1 million, and on only $77.7 million in sales in 2017 , SG&A was $4.0 million. (Q4 2018 SG&A expenses echoed this trend).

  • After reading the 10-K and talking to the Company, we gather that improvements in the business are not just from the positive pricing environment, but also from the increase in demand/volumes from current and new customers. While management didn’t provide too much color on volume/demand, the 10-K sheds some light on this topic. Both segments are not only experiencing an increase in price, but an increase in volume as well.

    • Inventory tons sold increased from approximately 22,500 tons in fiscal 2017 to approximately 44,500 tons in fiscal 2018.  (Tubular)

    • Inventory tons sold increased from approximately 111,000 tons in fiscal 2017 to approximately 132,000 tons in fiscal 2018. (Coil)

  • Additionally, the tubular segment is benefiting from a new product offering (API line pipe) that the Company recently introduced, giving it greater exposure to the energy market and access to new customers, as well as increased wallet share from current customers.   

Caveats:

  • Inventory - Raw material cost will catch up to the price of steel and, at some point, the increase in cost that the Company can pass on to its customers will have its limits. Ultimately, growth will have to come from continued positive growth trends from its customers (volume).
  • The outlook for both segments can change dramatically and quickly.
  • There is uncertainty over President Trump’s day to day position on tariffs.

For more color on the FRD story, we encourage you to read a Seeking Alpha article titled, “Friedman Industries: Q1 Earnings Should Provide A Major Catalyst For Near Term Share Appreciation”.