Universal Stainless: Profitable In 2023 Due To High Prices – Not Sustainable (NASDAQ:USAP)

Investment Thesis

Universal Stainless & Alloy Products, Inc. (NASDAQ:USAP) is a cyclical company. At the same time, it is facing declining shipments. Its better performance in 2023 was due to the unusually high product prices that resulted from unusually high raw material prices.

Raw material prices are coming down and there is no evidence that USAP could rebuild back its historical shipment tonnage. I also have concerns about its financial strengths. There is also no margin of safety based on valuing its performance over the cycle. This is neither a wonderful company nor a value investment.

Thrust of my analysis

I last covered USAP in Sep 2023. I had opined then that its poor performance from 2012 to 2022 was due to it operating below its break-even level.

I did not consider it an investment opportunity then. My view was that the market was pricing USAP as it could ship 65% more at 5% higher contribution per ton than its past 2 years’ values for both.

The market price has since gone up by about 80%. Where had I gone wrong?

One reader commented that the way I broke down of the costs into fixed and variable costs overly stated the variable cost.

Another said that the company poor performance was because there was no airline travel during the COVID-19 period. I did not take into account the enormous pent-up demand by the aerospace sector now that COVID-19 is behind us.

I will respond to both of the above comments and show that they do not change the following conclusions:

• USAP is a cyclical company.
• This is not a fundamentally strong company.
• There is no margin of safety based on valuing it as a cyclical company.

In my last analysis, I covered the performance from 2012. For consistency, I will use the same starting year here.

Company background

USAP manufactures and markets semi-finished and finished specialty steel products.

The company reported its sales to 5 categories of customers – service centers, original equipment manufacturers (OEM), rerollers, forgers, and others. As seen from the right part of Chart 1, the steel service centers historically accounted for the bulk of the revenue.

UASP customers processed the products for a variety of industries. Historically, the aerospace sector accounted for the bulk of the end market. Refer to the right part of Chart 1.

Looking at both parts of Chart 1, I would conclude that a big part of USAP products sold to the service centers ended up being processed for the aerospace sector.

Note to Chart 1: USAP first tabulated data by end markets in its 2013 Form 10k and retrospectively to only 2012.

According to the company, its products include stainless steel, nickel alloys, tool steel, and certain other premium alloyed steel. The key raw materials are carbon and stainless scrap metal and alloys, primarily consisting of nickel, chromium, molybdenum, vanadium, and copper.

Performance

Steel is a cyclical sector as illustrated by Chart 2 for two components of USAP’s raw materials – nickel and iron and steel scrap.

Prices for both seemed to have recent peaks in 2022:

• The average nickel price in 2022 was 47% higher than the 2012 average price. But this had declined so that in 2023, it was only 23% higher than the 2012 average price.
• The average iron and steel scrap price in 2022 was 14% higher than the 2012 average price. But this had declined so that in 2023, it was only 3% higher than that in 2012.

The key point is that if you are looking at long-term performance, you should be considering the prices over the cycle rather than looking at the peak or current prices.

Given the cyclical raw material prices, you should not be surprised to see that the performance of USAP was also cyclical. This is illustrated by Chart 3.

• The left part shows the trends for 3 metrics – revenue, PAT, and gross profitability (gross profit/total assets).
• The left part shows the trends for 3 return metrics – operating return (NOPAT/total capital employed), ROE, and ROA.

You can see the cyclical patterns for both groups of metrics.

Notes to Chart 3:

a) Performance Index chart. To plot the various metrics on one chart, I converted the various metrics into indices by dividing the annual values by the respective 2012 values.

b) Returns chart. Operating return = NOPAT/Total Capital Employed. The taxes were based on the actual taxes incurred for the year. For those years with negative operating profit, I assumed zero tax rate. I assumed a nominal 21% tax rate for those years with a negative tax rate.

I would not consider the performance as good from 2012 to 2023.

• With a 1.2% CAGR in revenue, there was hardly any growth.
• The PAT over the past 12 years was never higher than that achieved in 2012.
• The average ROE and ROA over the past 12 years were negative. This meant that USAP did not create any shareholders’ value.

Declining shipment volume

Revenue is dependent on the shipment tonnage as well as the average selling price per ton. Chart 4 shows the trends of these 2 metrics.

You can see that over the past 12 years, there has not been any growth in the shipment volume. Revenue grew in 2022/23 because of growth in the average unit selling price and not because of a big increase in shipment volume.

You may argue that the aerospace sector had pent-up demand. However, USAP does not sell to the sector directly. Its direct customers are steel intermediaries such as steel centers, re-rollers, and forgers to name a few.

I worry that USAP customers are getting supplies from other alloy steel makers to supply the pent-up demand.

This illustrated on the left part of Chart 5 that showed the US stainless steel melt shop production (1,000 metric tons) from Statista. You can see that the production volume in 2022 is about the 2022 level. In comparison, the USAP shipment volume in 2022 was down to 56% of that of 2012.

Furthermore, according to Global Market Insights, this is not a declining sector as illustrated in the right part of Chart 5.

Both of the above are rough analyses, but it showed that USAP growth trajectory was different from the industry. The fact that USAP shipment volume has shrunk may well mean that it has lost market share.

Unfortunately, USAP did not provide shipment tonnage by sector. But looking at Charts 1 and 4, it is hard to imagine USAP shipment tonnage to the aerospace sector in 2023 being higher than that in 2012.

• Revenue to the aerospace sector in 2023 was 67% higher compared to that in 2012.
• Average selling price for all sectors in 2023 was 69% higher compared to the average selling price in 2012.

You can understand why I am skeptical about the pent-up demand from the aerospace sector being the turnaround solution for USAP.

Cyclical sector

I ran a correlation analysis of USAP’s average selling price against the prices of the 2 raw materials. I found that there were significant correlations between USAP’s average selling price lagged by one year with the raw material prices. In other words, I compare USAP’s 2023 average selling price with the 2022 raw material prices and so on. Refer to Table 1.

This meant that changes in the raw material prices accounted for about half of the changes in USAP’s average selling price. This should not be a surprise, given that USAP had sales price surcharges.

Raw materials prices are cyclical. Given the correlation, you can understand why I consider USAP a cyclical company.

If you look at Chart 2, you can see that the raw material prices peaked in 2011. You should not be surprised that USAP’s profit and return performance in 2012 was the peak performance for the past 12 years.

Financial position

I still have concerns about USAP’s financial strengths.

• As of the end of Dec 2023, its cash had reduced to USD 0.4 million compared to USD 2 million in Dec 2022. This is less than 1% of its total assets.
• It has a Debt Equity ratio of 38% as of the end of Dec 2023. This had improved marginally from 45% as of the end of Dec 2022.
• From 2012 to 2023 it generated USD 127 million per year cash flow from operations. This was not enough to fund the cash required for investments of USD 156 million.
• While it had improved its cash conversion cycle in the past 2 years, the average for 2022/23 of 244 days was still high compared to 190 days for 2012/13.

Break-even Analysis

I carried out a break-even analysis previously by assuming the following:

• I defined the fixed costs as Selling, General, and Administration expenses plus Depreciation and amortization (D&A). I assumed that a significant part of the D&A provided in the Cash Flow Statement was captured under the Cost of Sales.
• I defined the variable cost as the Cost of Sales – D&A.

I will now take the extreme position where the variable cost is just the raw material cost. According to the company 2023 Form 10k:

“…The cost of raw materials represents approximately 35% – 42% of the cost of products sold in each of 2023, 2022 and 2021.”

I assumed that the variable cost to be 39% of the cost of sales. The results of my analysis are shown in Chart 6.

You can see that the contribution margin was relative “stable” over the past 12 years, despite the cyclical raw material prices and changes to the product-mix.

Note to Chart 6. I broke down the operating profits into fixed costs and variable costs.

• Variable cost = 39% of the Cost of Sales.
• Fixed cost = 61% of the Cost of Sales + SGA + Depreciation & Amortization.
• Contribution = Revenue – Variable Cost.
• Contribution margin = Contribution/Revenue.

I then carried out the break-even analysis in the same manner as that in my Sep 2023 article. This is illustrated in Table 2.

You can see that the overall break-even volume is about 35,150 tons. In the previous article, I estimated the overall break-even volume to be 35,784 tons.

The conclusion remains the same:

• The losses for many years were because it shipped below its break-even volume.
• The company was profitable in 2023 as it shipped above the break-even quantities.

This is of course a back-of-the-envelope analysis, as I am constrained by the data available.

But when you think about it, a company will always be profitable only if it operates above the break-even level. This is independent of how you calculate the break-even level.

Valuation

USAP is a cyclical company. According to Damodaran, the value of cyclical companies:

“…is often more dependent on the movement of a macro variable than it is on firm-specific characteristics…the biggest problem we face in valuing companies…is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluations…”

Damodaran opined that we should base the value on the normalized performance over the cycle. In my valuation, I used the 2012 to 2023 average values to represent the normalized values over the cycle.

I look at 2 scenarios in valuing USAP:

• Scenario 1. I assumed that its shipment tonnage would match that achieved in 2012 of 47,802 tons. This is an optimistic scenario.
• Scenario 2. I assumed that its shipment tonnage would be the average shipment over the past 12 years of 35,755 tons.

Under Scenario 1, the estimated intrinsic value was USD 32 per share. Under Scenario 2, I obtained a negative intrinsic value.

The negative arose because the shipment tonnage was around the break-even level. I have valued USAP using the Free Cash Flow to the Firm model. To obtain the value of equity, I had to deduct Debt. This resulted in a negative value of equity.

The market price of USAP as of 11 April 2024 was USD 25 per share.

You can see that there is only a margin of safety if you assume that USAP can rebuild back its shipment volume. There is no evidence of this.

Through reverse engineering, the market is pricing USAP based on the 2023 shipment and assuming the average prices of 2022 and 2023. In other words, the market is not pricing USAP as a cyclical company.

Valuation model

My valuation is based on the single-stage Free Cash Flow to the Firm model, as illustrated in Table 3.

The critical parameters are the shipment tonnage and contribution per ton.

The financial model is based on the operating profit profile, as shown in Chart 6.

The contribution per ton and fixed cost was derived as shown in Table 2.

FCFF = EBIT(1-t) X (1- Reinvestment rate).

The tax rate was based on a 21% nominal tax rate.

The reinvestment rate was based on the fundamental growth equation.

The WACC was based on the first page of a Google search for the term “USAP WACC” as shown in Table 4.

Risks and limitations

My valuation hinges on 2 key factors:

• Shipment volume.
• USAP is a cyclical company

In Scenario 1, I had assumed that USP would be able to build back its shipment volume. As such, with the average contribution over the cycle, there would be a margin of safety.

Unfortunately, the shipment volume over the past 12 years seems to be on a downward trajectory. To be fair, the shipment tonnage in 2023 was higher than that for 2022. But even then, this was lower than the 12-year average breakeven tonnage. The company has a tough turnaround path.

Secondly, if you accept that USAP is a cyclical company, you must value it based on its cyclical performance. Scenario 2 shipment volume was based on the past 12 years’ average volume. Even then, it was higher than that shipped in 2023. This higher shipment volume with a cyclical contribution margin resulted in a negative equity value. It is not a good sign

Conclusion

My analysis hinges on viewing USAP as a cyclical company. I hope I have provided enough evidence to justify this.

• Its past 12 years’ performance as shown by its revenue, PAT, and gross profitability was cyclical.
• There is a strong correlation between its average selling price and 2 raw materials. The raw materials exhibit cyclical prices over the past 25 years.

Over the past 12 years, USAP has not been able to grow its revenue.

• This was because it experienced declining shipment volume. My view is that USAP has lost market share, and any talk of a pent-up demand in the aerospace sector does not address the correct cause.
• Next, the low revenue growth was because the increase in average selling prices was barely sufficient to offset the declining shipment volume.

At the same time, apart from being cyclical, the returns were also declining. Together with my concerns about its financial position, you can see why I do not consider USAP as fundamentally strong.

There is also no margin of safety based on its cyclical performance. You can understand why I would not invest in USAP.

I am a long-term fundamental investor. As such, I try to look at how the business will perform over the next decade or so. My valuation is also from this perspective. This is not an analysis or valuation for those looking for gains over the next few months.