Seeking Alpha contributor Mark Lin recently published a very capable analysis of Haynes, presenting a bullish thesis and a target price of $53 per share. I hold similar views, and rather than rehash the information, I refer readers to his article, and to the company’s most recent investor presentation, which is factual and informative.
This article is intended to provide additional context for the consideration of Haynes as a long-term investment opportunity.
The 10-K provides a substantial amount of information on the effects of fluctuating nickel prices on the company’s operations. Customers have a tendency to retard or advance their orders based on the price of nickel, which is the largest raw material cost. As a way of looking at the relationship, I developed the following chart:
Correlation at 0.63 demonstrates a relationship. Decreasing nickel prices have been headwind: mean reversion (should that occur) will be a tailwind. From the 10-K:
Nickel, a major component of many of the Company’s products, accounted for approximately 65% of raw material costs, or approximately 32% of total cost of sales in fiscal 2014.
The Company values inventory utilizing the first-in, first-out (“FIFO”) inventory costing methodology. Under the FIFO inventory costing method, the cost of materials included in cost of sales may be different than the current market price at the time of sale of finished product due to the length of time from the acquisition of the raw material to the sale of the finished product. In a period of decreasing raw material costs, the FIFO inventory valuation method normally results in higher costs of sales as compared to last-in, first out method. Conversely, in a period of rising raw material costs, the FIFO inventory valuation method normally results in lower costs of sales.
Management is well-versed in the intricacies of the market, and competitors face the same difficulties. As an investor, I look at long term performance, and feather my estimates upward based on mean reversion. Working with the relationship developed in the chart above, if the nickel index reverts to its long term average within the next two years, it would theoretically drive a share price increase of 10% annually.
Balance Sheet Analysis
Haynes has no long-term debt, and no drawings against its $120 million revolver. The current ratio stands at 6.90, well in excess of the 2.0 I consider optimal. Using 2.0 as a target ratio, the company has $21 per share of current assets in excess of what is necessary to operate in a prudent and orderly manner.
Inventory makes up 73% of stockholder’s equity.
As a general rule, companies operating in capital-intensive cyclical industries do well to maintain a cautious stance on long-term debt.
That being said, looking at Haynes’ balance sheet and cash flow over the years, when business slows down, the corresponding decreases in receivables and inventory produce cash. The balance sheet strengthens during tough times. The relatively large inventory makes this effect quite noticeable for Haynes. Of course when business picks back up the cash goes into expanding inventory.
Financial engineering could liberate value here. Bringing in $100 million of long-term debt, and returning the capital to shareholders would increase the share price. The 10-K alludes to discussions of possible acquisitions or joint ventures on a regular basis, and I conjecture that management intends to deploy the excess capital to fund growth.
The company has expended substantial sums improving its information systems. When this project is complete, it may make inventory management more accurate and reliable than it has been in the past. The business model accentuates service and availability, but this imposes a cost in terms of capital tied up in inventory. Perhaps improved information systems can assist the company in managing inventory downward while maintaining service and availability.
Among the benefits cited for the recently completed capex program is the ability to speed the production cycle. This too should manifest in reduced days inventory.
To quantify: days inventory stands at 220.5. Carpenter Technology Corporation (NYSE:CRS), a competitor, maintains days inventory at 140.9. Using these ratios, if Haynes were as efficient by this measure as Carpenter, $92 million or $7.45 per share would be liberated from inventory, and could be deployed to benefit shareholders.
Because margins and earnings vary substantially over the years, long-term average ROIC is relevant to valuing the company. Using ten years of data, and taking out a large goodwill write-down in 2009, a historical average of 8.58% emerges.
Management believes that the recently completed capex program will increase gross margin by 200 to 400 basis points. Taking the midpoint, and applying taxes, ROIC going forward would be 10.53%. Applying that to shareholders equity, the potential to earn $2.96 per share emerges. A small, recently completed bolt-on acquisition should add 13 cents after integration is complete. Applying a multiple of 17 for this high-quality cyclical develops a target price of $52.
There is excess capital here, about $10 per share, in my opinion, which can be added to valuations developed from earnings.
Dividend and Buybacks
A quarterly dividend of 20 cents was initiated in December 2009, and increased to 22 cents in November 2011. Share counts have increased by a trivial amount annually for many years.
At current prices the dividend yields 1.92%. The company has the resources to increase on a regular basis, and should do so. Buybacks should be conducted at a level sufficient to mop up after stock based compensation.
HAYN is suitable for investors who focus on long-term capital appreciation. I’m investing on the basis that total returns will be above the S&P 500 over the long term. The strong balance sheet and predictable ability to generate cash when business declines make it a safe holding for those concerned about market volatility.
Failure to increase the dividend on a regular basis will limit its appeal to dividend growth investors.
Strategy and Tactics
Accumulate while monitoring seems appropriate here. Quarterly results should be examined for evidence that margins are increasing as projected, and that inventory management is being improved as intended.
Patience is in order.
I’m planning a covered strangle: long shares, short a call at $50 and a put at $40. The thinking is, I’m being paid to agree to buy low and sell high. The position is small, to allow room if assigned on the puts. The strategy was extremely effective for this company when last I owned it.