This Alchemy Is No Magic Act

 | Nov 14, 2011 | 2:30 PM EST
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At current prices, Metals USA (MUSA) is a niche, defensive business that offers tremendous upside potential with little downside risk. Through its 45 service centers, it has become the 12th-largest steel distributor in the U.S.

The business model is simple: MUSA purchases steel and other metals wholesale from mills, stores them and then sells them to end users. While the company generates more than $1 billion in annual sales, MUSA sells its finished products in relatively small transactions averaging approximately $3,100. No single customer accounts for more than 4% of the company's business.

While its business is simple, execution is what matters most. As a buyer and seller of metals, Metals USA is all about inventory management. The big risk is buying inventory and not being able to move it in time, thus taking a hit if metal prices decline in the interim. This risk is mitigated by the company's diverse end market. The biggest end market is fabricated metal products, which accounted for 29% of 2010 sales. In total, the company serves nearly a dozen end markets including transportation, industrial machinery and electrical equipment. Construction accounts for only 3% of sales while nonresidential construction commands another 6%, respectively.

MUSA buys materials from giants like Nucor (NUE) and Arcelor Mittal (MT) and then turns them in to things like outdoor grills, oil and gas storage tanks, automotive components and aerospace equipment. Indeed, a growing economy is a strong tailwind for Metals USA. While the U.S. economy is not firing on all cylinders, I believe another recession is unlikely over the next several years. U.S. manufacturing data continues to remain robust relative to expectations while the company's diverse end-markets coupled with small transactions create a defensive business model.

The company has an interesting history. The company emerged from bankruptcy about a decade ago and was essentially taken private by private-equity firm Apollo Group (APOL). In April 2010, MUSA's initial public offering did not go well. The company sold 11.4 million shares at $21 apiece, above the initial range of $18 to $20. A disappointing quarter immediately after the IPO sent shares down. Post IPO, Apollo continues to own 64% of the shares.

The shares now trade for about $10.80, valuing Metals USA at $400 million. The company has $470 million of net debt -- not surprising, considering its private-equity history. While I always am skeptical of highly levered companies, one can get comfortable with MUSA for several reasons. First, its business generates tons of cash. For the first nine months of 2011, adjusted earnings before interest, taxes, depreciation and amortization was nearly $128 million. On an annualized basis ($170 million), the business trades at 5x EV/EBITDA. Second, the company's levered position was stress tested during the recession in 2008 and 2009 when net income dropped to $3.5 million in 2009 from $72 million in 2008. Management prudently reduced working capital, which allowed MUSA to generate more than $230 million in free cash flow in 2009, or a FCF/EV yield of nearly 25%.

This ability to manage working capital quickly, tested and proven during the absolute worst economic scenario, offers a fallback should the economy get ugly again. It should also be noted that the company has no significant debt maturities until 2015, when $226 million is due. Considering that MUSA will churn out more than $170 million in EBITDA in 2011, the debt is easily serviceable. At the current share price, MUSA trades for 7x full-year 2011 earnings-per-share expectations (for the first nine months, diluted EPS was $1.36). That compares with 11x times earnings for Reliance Steel (RS) and Worthington Industries (WOR). MUSA also trades for 5x EV/EBITDA compared with 9x and 7x EV/EBITDA for Worthington and Reliance, respectively.

If the economy continues to improve, which now looks more realistic, MUSA will be a cash-producing machine. If the economy stutters, the company has proven that it can quickly and efficiently adjust its working capital and still generate a ton of cash. 

Either way, the valuation appears compelling.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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