Is it cheap or just cyclical?

Sometimes I find the stocks that I write up on this blog, other times as with Ampco-Pittsburgh the stock finds me.  A reader emailed asking if I could take a look at the company, I read a quarterly filing but nothing really caught my eye.  Then I saw Geoff Gannon did a post on solid stocks most investors ignore at their own peril.  The post is worth reading if you have time, towards the end Geoff names 15 stocks which exhibit the following characteristics, past profitability, low EV/EBITDA, and little to no analyst coverage.  Lo and behold Ampco-Pittsburgh made number 11 on the list, I decided it was time to look at this company again.

Many long time readers know I'm a sucker for a stock that I have some sort of connection with, and Ampco-Pittsburgh is no exception.  When I stand at the top of my driveway the only building downtown poking above the hills is the one they're located in.  One of their subsidiaries has a terribly ugly sign next to a major highway that I commuted on daily for years.  I can't tell you the number of times I've read "Union Electric Steel Corporation" and thought they should tear the sign down and stick it in a retro museum.

There's the quote "If you don't know where you're going any road will get you there."  I find the quote is true when looking at stocks.  If I just crack open an annual report and start reading without any frame of reference I have a hard time putting things into context.  Sure I learn more about a company or an industry, but I don't have a measuring stick.  My solution is to take a quick look at a company then create a very simple thesis.  As I research this thesis serves as my framework.  Often the thesis will change as I learn more, that's fine, at least I have a starting point.  The thesis tells me why I'm looking at this company, no sense in looking at something if it's pointless.

Here is the quick thesis for Ampco-Pittsburgh:
-$197m market cap of which $77m is cash (39%)
-Selling almost exactly at book value, when I first looked they were at a slight discount.
-EV/EBITDA of 3.28
-EV/EBIT of 4.28

Background

Ampco-Pittsburgh is a holding company for five different companies broken down into two divisions.  The two divisions are Forged and Cast Rolled and Air and Liquid Processing.  The Forged and Cast Rolled segment pertains to steel production.  The Air and Liquid Processing segment deals mainly with refrigeration such as industrial sized systems, heat exchangers and centrifugal pumps.  The company has operations mostly in the US, UK and a joint venture in China.

Is the stock cheap or cyclical?

My first thought when I went to Ampco-Pittsburgh's website was that this must be a cyclical steel company and they were either punished with the rest of the steel producers, or they were at the top of their cycle.  In the 10-K there's a nice graph showing the company's stock along with other benchmarks, follow the Ampco-Pittsburgh line and contrast it to the Morningstar Steel Index line.


If I was a CFA I could run a regression and show that Ampco-Pittsburgh has more in common with the S&P then the steel industry.  Unfortunately I'm not a CFA (failed level 2, decided I'd rather blog than study) and a good old pair of eyes gets the job done in this case.  The company's stock trades closer to the S&P than the steel index. 

While the stock doesn't trade along with the steel industry the results over the past ten years are less conclusive.  Here is a little Excel blurb showing the last decade's worth of results:


This looks a lot more cyclical to me, here's the same numbers in a graph:

 

I'm inclined to say that Ampco-Pittsburgh is a cyclical steel stock due to the fact that 72% of its revenue comes from the forged and rolled steel segment.  The mix of steel vs refrigeration has been increasing in favor of the steel segment in recent years and this is a good thing.  The steel segment has a 15% operating margin whereas the refrigeration has only a 8% operating margin.

The company is a bit cheaper than competitors but nothing significant.  I also noticed the company appears to be struggling with a Chinese joint venture.  The joint venture continues to contribute losses to the equity statement.  The fact that there is a steel glut in China and management continues to hold onto the joint venture isn't an encouraging sign.  While the stock doesn't trade with industry peers the results seem to mirror industry peer results.

Importance of reading

I didn't have a good name for this heading, so I picked something functional.  One of my biggest goals as an investor is to avoid losses, if I can avoid losses gains should take care of themselves.  Many times an investor will be blinded by possible gains and fail to read fine print that could scuttle the entire investment, unfortunately Ampco-Pittsburgh has a bit of that fine print.

I believe a margin of safety is derived from the balance sheet first, income statement second and competitive position third.  A company with a great competitive position that's laden with debt and an inefficient cost structure is an investment to avoid.  Conversely an average company with a strong balance sheet and reasonable earning power can have a strong margin of safety if the price is well below a private market valuation.  When I evaluate a company I look to the balance sheet first, Ampco-Pittsburgh was no exception.

When I read the balance sheet a few lines stood out "Insurance receivables - asbestos", "Asbestos liability".  Now the word asbestos is a loaded word especially amongst lawyers and investors.  Ampco-Pittsburgh had acquired some companies in the past that brought their liability along with them.  One of the subsidiaries was dissolved but the asbestos claims are still outstanding, these things just don't go away.  There are currently 8,145 asbestos lawsuits outstanding.  The company paid $22.7m in 2011 to settle 1,501 claims or about $15,000 per claim.  I won't get into details but this number lines up with the going rate of what companies are willing to pay to settle these claims.

A casual read through the balance sheet results in the conclusion that the gap between what the company is likely to receive from insurance companies and the amount they expect to pay out isn't all that large, especially when paid over twenty or thirty years.  This is where the importance of reading comes into play, the balance sheet isn't the final word on the asbestos, the notes are.

The notes describe a few items I find really concerning, the first is the company sued their insurance carriers in 2011.  This is the result of a dispute about how much should be paid out for claims that occurred from 1981-1984.  I find this concerning because these issues are so long lived, something that happened 30 years ago is having a potentially material ripple effect now.  This has current ramifications as well, the company's balance sheet is modeled using estimated numbers for insurance receivables and potential claims.  If these numbers aren't settled from cases 30 years ago it adds an additional measure of uncertainty for me when I look at the balance sheet.  An uncertain balance sheet requires a greater margin of safety.

The second concerning issue is another asbestos note, the company mentions if they used a slightly different formula for calculating insurance receivables the number would be a lot lower.  This is another item that adds uncertainty to the balance sheet.  At the current price there isn't enough of a discount to account for this uncertainty.

Conclusion

I can't get comfortable enough with Ampco-Pittsburgh to investigate further, the asbestos uncertainty along with the industry position is enough for me.  Industry uncertainty seems like a strange reason to avoid an investment.  Ampco-Pittsburgh is selling in line with industry peers, maybe at a slight discount but nothing extraordinary.  If I was forced to invest in steel I would prefer a tangible asset bargain, or I would prefer to buy the best company in the industry.  If the entire sector is depressed the industry leader will usually have the balance sheet to weather the storm, and they'll recover the quickest and strongest.   Ampco-Pittsburgh could be an attractive investment if steel recovers and the company's share price remains flat while results improve, although that seems unlikely.  Until then I'll keep hunting..

Talk to Nate

Disclosure: None




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