Schuff, a potential 10 bagger, or bankrupt?

One great thing about recessions and downturns is they clear out a lot of marginal businesses.  The marginal companies either die at the hands of their bankers, liquidate, or manage to get bought out by a competitor in a stronger financial position.  The strong companies not only survive, but thrive.   From the bottom of the recession many companies that taunted death and survived returned 2x,5x,10x for shareholders with guts, and confidence enough to buy at the bottom.  The common consensus is that those opportunities are gone from the current market.  While there might not be as many as there once were, these sorts of opportunities do still exist, one example is Schuff International (SHFK).

Schuff International is a steel fabrication company.  According to their website they're the largest steel fabricator in the US.  When I first heard of Schuff over at OTCAdventures, I thought they were a smallish regional fabrication company.  After visiting their website I learned I was wrong, the company employs 1600 people and has completed many impressive projects like the Cardinals Stadium, the Bronco's Stadium, Bank One Ballpark, Sprint Arena, the Sacramento Airport, and other large projects such as hospitals, shopping centers, and casinos.  If a building requires structural steel, and is located in the Southwest, there's a good chance Schuff is supplying beams or joists.

The bull case for Schuff is very simple.  The company current trades for around $9 a share with a market cap of $36,314k.  Back in 2009 the company's net income was $18m, and in 2007 it was $59m.  The thesis is simple, Schuff is cyclical, and if their earnings can even come within 50% of peak earnings this stock has the potential to be a 10 bagger.  If they fall short maybe it's only a 5 bagger, or a measly three bagger.  For context here are the results over the last nine years:

Schuff isn't attractive just on peak earning power alone, management is shareholder friendly as well.  Last year they went on a binge and purchased back more than 50% of the outstanding shares at once.  The shares were purchased from two large holders, D.E. Shaw and Plainfield Direct LLC at $13.25 a share.  D.E. Shaw and Plainfield owned 58% of the company before the repurchase with the Schuff family owning 25%.  After the purchase the Schuff family now owns 60% of the company with outside shareholder interest increasing from 15% to 36%.  The repurchase was clearly a way for the Schuff family to regain control of the namesake company, but it also created value for outside shareholders.  Management stated they believe they are at the bottom of the cycle and they wanted to take advantage of the opportunity.

The big effect the buyback had was changing the bogie for earnings.  When the company earns $10m instead of that being $1.02 a share it now results in EPS of $2.41 per share.  I think it's useful to consider what past earnings looked like with the new share count:

If earnings recovered to the 2009 level with a market multiple of 10x, Schuff could be worth $45 per share.  If earnings recovered to the 2007/2008 level, which I feel is unlikely at a 10x multiple, shares could be worth $130.  I don't think Schuff will ever recover to the $13-14 per share level, because at that point in time a lot of their projects were coming through from the housing boom in the Southwest. With that said I don't think it's unreasonable to think that Schuff could earn anywhere between $4 and $8 per share in the next few years as the economy recovers.

Margin of Safety

The bull case is simple, but that doesn't mean this is a simple stock to look at.  If this was a sure fire ten bagger I wouldn't be writing it up, I'd be out mortgaging my house to buy Schuff stock, and telling everyone else to do the same.  When I look at Schuff the question I ask is "can this company survive long enough for the market to turn?"  My biggest question with Schuff is how can they survive, and at this level is there enough protection for me an outside investor against losing my money?

Unlike a lot of companies I look at, Schuff isn't debt free, they're actually the opposite of debt free, they recently accumulated a lot more debt.  The company has ~$30m in long term debt, and an additional $26m of long term debt coming due in 2012.  The buyback was financed by cash on hand, an unsecured loan by Mr. Schuff, and a hit to the Wells Fargo credit line.  The result of this is that Schuff has some incredibly high borrowing costs, almost at credit card levels.  The company has $30m of debt due in 2015 with a rate of 14%.  They have an additional $24m at LIBOR plus 4.25%, and the loan from Mr. Schuff is at 13% a year.  Typically rates at the level Schuff is paying are an indication by the lender that they're concerned about the possibility of getting their money back.

With Schuff facing a debt bill of $26m in 2012 it's worth considering how they're going to pay the bill. This is even more concerning after realizing the company had a negative $3.7m cash from operations in 2011.  In the sheet above I pulled out cash from operations over multiple years, and you can see it's lumpy, very lumpy.  This is because Schuff isn't paid by clients in a straight line basis, they're paid a portion of the cost (sometimes just materials) at different checkpoints of a project, with a final payment coming once the project is complete.  In 2009 the company had $91m in cash from operations, $18m in capex and $73m in FCF.  That's something to consider for a moment, two years ago Schuff generated enough free cash to take their company private..twice.

If one were to only look at the latest annual report and speculate on the debt repayment the obvious conclusion would be that Schuff is bankrupt, unless they can either roll or extend their loan.  This was my initial reaction when reading the latest annual report.  But then I sat and thought about Schuff a bit more and came to a different conclusion eventually.  As outside investors we can only see what the company gives us, yet management can see everything, projected cash flow schedules, project completions etc.  Why would the company management take on onerous short term debt that might imperil the company to buy back shares if they had no way to pay back the debt?  I think Schuff management knew that there would be some projects completing in 2012 with associated cash flows.  The cash flow would provide way to pay back some or most of the short term debt related to the share buyback.  After 2012 the company will owe $4m in 2013, $5m in 2014, $19m in 2015 and $1.4m in 2016.  The payback schedule seems odd, but it also seems to line up with the volatile nature of cash payments the company receives.  It wouldn't surprise me if the loans were tailored to have balloon payments that coincide with the completion of some of the company's larger projects.

Although we can't be quantitatively confident that the debt will be paid off, there is a strong inference that this won't be a major problem in 2012.  While we expect the company to make their payments this year it's always helpful to look at what might happen if the company doesn't pay and ends up in bankruptcy.

Schuff has $258m in assets against $164m in liabilities, for a book value of $92m, or $22.43 per share.  Book value consists of mainly of current assets and PP&E.  The company does have $10m in Goodwill, but even if we remove that from book value the investment is pretty well protected.  Most of the company's assets consist of inventory and receivables, two items that could take a haircut in a bankruptcy situation.

Maybe book value is overstated, or receivables or inventory aren't worth stated book value.  The good news is if any of those things, or something else is the case a buyer at today's price is protected by buying at 40% of book value.  There's room for a lot of error before an investment is at risk.

Conclusion

While I have been looking at Schuff the biggest question has been "can they survive?"  I don't have solid evidence that they can survive until the construction market turns around, and the results are reflected in the financial statements.  But I do have signs, management is bullish on the company, both with buying back shares, and reopening an idled plant in Florida.  I take comfort in the fact that project billings are lumpy, and associated cash flows are irregular as well.  Maybe this year's cash flow will pay the debt and then some.

The bottom line is I really don't know, but I'm not sure how much I need to quantify to invest in Schuff.  At 40% of book value, and at a very low multiple of mid-cycle earnings it's worth taking the speculation.

Talk to Nate about Schuff International

Disclosure: I have an order placed for shares.  I could be long when you read this, or have no position.