Is Olympic Steel one of the better Nasdaq stocks?

Value Investing Case Study 22-1. I first covered Zeus in Oct 2021 in Seeking Alpha based on the financial results till Jun 2021. The company has since released its Q3 2021 results. This post is an update incorporating the latest financials.

In my Oct 2021 Seeking Alpha article, I had summarized my view of Olympic Steel Inc (Zeus or the Group) as follows:

• Do not be mesmerized by Zeus YTD June 2021 results. This was due to extraordinarily high steel prices. Steel prices are cyclical and any fundamental analysis should cover the performance over the price cycle.

• Zeus has poor business economics. Its average ROE over the past 11 years (about 2 steel price cycles) is about 1 %.  It had not been able to create shareholders' value. 

• Revenue growth was driven by asset growth. While it had undertaken acquisitions, the investment payback is measured in decades. Furthermore, the reinvestment required for growth is not sustainable.  

Zeus was trading at USD 24.83 per share then and I had concluded that there was no margin of safety. Since then, the market price of Zeus had dropped a bit to USD 22.61 per share (as of 23 Dec 2021).

Are there reasons to revise my investment thesis considering that 2021 would be a bumper year?  In other words, would the Sep YTD 2021 results change the long-term business outlook compared to what I had concluded in Oct 2021?  Correspondingly would there be a significant change in the intrinsic value so that there is now a margin of safety?

Join me as I show that all the answers to these questions are negative. Zeus is not one of the better Nasdaq stocks to invest in.

Contents

• Business profile

• Financially strong

• Volatile revenue and earnings

• Management not outstanding

• Revisiting the Oct 2021 findings

• Valuation

• Conclusion

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Business profile

Zeus is a leading metals service centre that provides metals processing and distribution services for a wide range of customers. The Group operates in three reportable segments; carbon flat products, specialty metals flat products, and tubular and pipe products. 

• In 2010, Zeus was only in the flat products business. But it diversified into tubular and pipe products in 2011 with the acquisition of Chicago Tube and Iron Company. The Group then reported its results based on 2 operating segments.

• In 2015, following increased sales in stainless and aluminium flat products (which Zeus referred to as specialty metals), the Group re-organized itself into the present 3 reporting segments.

Over the past ten years, Zeus has expanded into new product offerings through multiple acquisitions. The Group had stated that its focus has been on achieving profitable geographic and product growth through:

• The start-up and acquisition of service centres, processors, fabricators and related businesses.

• Investments in people, information systems, higher value-added processing equipment and services.

• Continuing its commitment to expanding and improving its operating efficiencies, sales and servicing efforts. 

Despite the acquisitions, the Group revenue had only grown at a CAGR of 4.4 % from 2010 to 2020. Secondly, in looking at the segment growth, it is only meaningful to consider it from 2014/15 onwards. 

You can see from the segment revenue chart that there has been a change in the profile of the business from 2014 to 2020.

• The carbon flat products segment revenue had declined by a compounded annual rate of 5.8 % from 2014 to 2020. During this period the specialty flat products segment had grown at 7.2 % CAGR. The tubular and pipe products segment revenue had declined by 1% compounded annually.

• In 2020, the carbon flat products segment accounted for 56 % of the Group revenue - down from 69 % in 2014.  The specialty flat products segment revenue had grown from 14 % of the Group revenue in 2014 to 25 % in 2020.

Chart 1: Revenue by Segment

Financially strong

As of end Sep 2021, the Group had a Total Capital Employed (TCE) of USD 720 million. Shareholder’s fund accounted for 55 % of the TCE with the balance from debt (including leases).

About 98 % of the TCE has been deployed for the operations with the balance tied up mainly in cash. The Group’s cash to firm value of 2 % is low compared to the steel industry average of 7 % (Source: Damodaran Jan 2020).

Chart 2: Sources and Uses of Funds

Zeus current book debt to TCE ratio of 45 % is comparable to the US steel industry average of 44 % (Industry source: Damodaran Jan 2021).  From a Debt Equity perspective, its Sep 2021 ratio of 0.81 is among its historical highs although it is still lower than its 2018 peak of 0.99. Refer to Chart 3. I would conclude that Zeus is financially sound. 

Chart 3: Debt Equity

Volatile revenue and earnings

For the 9 months period ending Sep 2021, the Group achieved USD 1.7 billion of revenue. This is 87 % higher compared with the revenue for the same period last year.

Zeus achieved a YTD USD 96 million net income for the 9 months ended Sep 2021 in contrast with a YTD loss of USD 7 million last year. 

The Group has attributed the increase in the YTD revenue to a 64.2% increase in consolidated average selling prices compared to the first nine months of 2020, and a 13.8% increase in consolidated volume.  Management expects carbon metals market prices to decrease in the fourth quarter of 2021.

The current YTD performance is in contrast to its historical performance as can be seen from the Performance Index chart below. You can see that revenue and net income were volatile when compared to the gross profitability.

Chart 4: Performance Index

Group revenue had grown at a 4.4 % CAGR from 2010 to 2020.  But the growth was not smooth sailing. The Group revenue declined in 2015 and 2016 mainly due to a decline in steel prices as illustrated below. You can see that the Group revenue better tracked the steel prices compared to the steel consumption. 

Chart 5: Revenue c/w Steel Indices

Net income had been very volatile because in addition to changes in steel prices, there were a number of extraordinary expenditures.

• The net income decline in 2014 was due to a USD 24 million impairment of goodwill. The decline 2015 was due to both a goodwill impairment of USD 25 million and the reduction in revenue.

• The jump in 2017 and 2018 were driven by improvement in the steel prices.

Zeus is in the steel sector. This is a cyclical sector and over the past 11 years, Zeus had gone through about 2 price cycles. Its revenue and ROE had followed the price cycle.

The good current YTD performance is because of being in the uptrend part of the price cycle as acknowledged by management. Thus, any analysis of Zeus long term performance should be viewed through this cyclical lens. 

From 2010 to 2020, Zeus had several years of negative ROE. Its average ROE for the period was about 1 %. Over this period, the cumulative net income came to USD 41.1 m. 

Chart 6: Performance vs Steel Prices

Management not outstanding

I compared Zeus operating performance with those of its peers as shown in Table 1. Five companies were identified as peers in ZEUS 2020 Form 10k.

I would rate Zeus performance as average. This is because for both the revenue growth and average ROA, Zeus ranked No 4 in the panel of 6 companies. (Note that No 1 rank was the best and the worst was No 6.) 

Table 1: Peer Performance

Chart 7: Peer Revenue

Chart 8: Peer ROA

Chart 9: Peer Gross Profit Margin

Note that when it came to gross profit margins, Zeus had one of the higher average margins. Given it poor ROA, it must mean that Zeus had comparatively high selling, general and admin expenses (SGA). Alternatively, Zeus employed relatively higher Total Assets to generate its profits. 

The table below shows that relative to its peers, Zeus had poorer operating ratios.

• It had the lowest Fixed Asset Turnover among the panel.

• It had one of the highest SGA margins.

• It ranked in the middle when it came to Working Capital Turnover.

However, Zeus had the best Total Asset Turnover. When I compared this with the Working Capital and Fixed Asset Turnovers, I took it to mean that:

• The peers had better payables thereby reducing the working capital.

• The peers had better capacity utilization.

Table 2: Peer Asset Turnovers and SGA Margins

As for capital allocation, Zeus generated USD 239 million Cash Flow from Operations from 2010 to 2020. This was not sufficient to funds its capital expenditure and/or acquisitions. As such Zeus had to increase its loans. 

The pay back to shareholders in the form of dividends and share buybacks were relatively negligible from 2010 to 2020.

Chart 10: Deployment of Cash Flow from Ops + Debt

Overall, I would say that Zeus management did not stand out when it came to operating performance and capital allocation.

Revisiting the Oct 2021 findings

In my Oct 2021 Seeking Alpha article, I had shown the following:

• From 2010 to 2020, Zeus had not been able to create any shareholders’ value. Its returns were lower than the cost of funds. 

• Zeus ROE averaged about 1 % over the past 11 years. The ROE was cyclical and changed in line with changes in steel prices. The few years that it had significant positive ROE were due to higher product prices. They were not due to improvement in the operations or higher tonnage sold. 

• From 2010 to 2020, revenue grew at a CAGR of 4.4 %. This was an asset-driven growth. This meant that even as revenue and profits grew, it was on top of a growing asset base. 

• Over the past 11 years, Zeus had spent USD 201 million on acquisitions. While there had been some revenue growth due to this, we are talking of decades of payback period. Furthermore, the reinvestments required to sustain growth are not sustainable.

• The Book Value provided some margin of safety at the current market price of the stock then. But I could not find a scenario where the Earning Power Value would be the same as the Book Value. In other words, there is no margin of safety for investing based on Earning valuations.

Refer to “Olympic Steel - Not Creating Shareholder Value”  if you want further details.

I had concluded then that Zeus had poor business economics and the analysis in this post is in line with that conclusion. Any investment in Zeus must then be because of one of the following reasons.

• There is a turnaround in its business performance. 

• The price is so low that it outweighs the poor business economics.

Improvements not enough to move the needle

I looked at the prospects of improving the business economics from 2 perspectives:

• Track record.

• Management intention.

In terms of the former, I look at the historical trends of the following key metrics to see whether they point to improvements.   

• Gross profit margins. A more efficient and/or productive operations would lead to better margins.

• SGA margins. Over the last 11 years, SGA averaged about 17 % of the revenue. This is significant and any reduction in the SGA margin would help the bottom line.

• Asset Turnover. Given its average ROA any improvement in the Fixed Asset Turnover or Working Capital Turnover would help the turnaround.

Unfortunately, as illustrated in Chart 11 on the Operating Index there is no strong track record of improvements. However, if you ignore 2020 due to the Covid-19 pandemic, there are improvements to the Working Capital Turnover. But SGA margins did not show any significant change. 

Chart 11: Operating Indices

In 2015, the Group launched its profit improvement programme.

“This program includes many sustainable improvements that will endure long after our markets stabilize. Improvements include: permanent operating expense reductions, margin enhancement initiatives, a sharp focus on controlling working capital and continued growth in strategic areas.” 2015 Letter to Shareholders

The company had claimed that they had achieved improvements:

“…our ongoing profit-improvement efforts produced gross margin expansion, quicker inventory turnover and permanent reductions in operating expenses.” 2016 Letter to Shareholders.

“Financially, we advanced working capital initiatives and strengthened our balance sheet during the year. We turned our flat rolled inventory 4.5 times during 2017, while absorbing 12% more shipping volume” 2017 Letter to Shareholders

“... we focused on controllable factors that allowed us to improve our profitability…include carefully managing inventory and expenses, diversifying products…” 2019 Letter to Shareholders

“…keenly focused on key internal disciplines… controlling operating expenses, turning inventory, and strategically and sustainably growing our business…end the year with consolidated operating expenses down nearly 10% year over year and our flat product inventory turns approached six times…” 2020 Letter to Shareholders

There seem to be a disconnect between what management had reported and the historical trends. This is because I used 2014 as the base year to assess long term improvements. On the other hand, management seemed to talking about improvements from the previous years. 

There are certainly some improvements in Working Capital Turnover if the base year is 2018. But even with this base year, there is no improvements in the Gross Profit Margins, SGA Margins or Fixed Asset Turnover.

I would say that whatever improvements reported by management were not significant enough to move the long-term needle.

Valuation

I valued Zeus on the following basis:

• Asset-based as per the Sep 2021 Balance Sheet.

• Earning Power Value (EPV).

The assumptions for the EPV were:

• I took the average 2014 to 2021 values for the various parameters as representative of the future. This is because Zeus is in a cyclical sector.

• For the 2021 values, I took the YTD Sep 2021 values and divided it by 0.75 to get the full year value.

• The cost of equity and capital were derived as per Damodaran assuming a risk-free rate of 1.9 % and Beta of 0.78 (based on the steel sector). I assumed a tax rate of 27 %.

The results of the valuation are shown in Chart 12. 

• There is a big difference between the Asset Value and the EPV.

• There is only a margin of safety based on the Asset Value.

Chart 12: Valuation

The low EPV relative to the Asset Value implied that the Group had not been effective in using its assets. You should not be surprised given the low ROA. 

I had in my Seeking Alpha article showed that it would be very challenging for Zeus to generate profits such EPV = AV.

If you invest currently, the margin of safety comes from the Asset Value. Indirectly, you are assuming one of the following scenarios:

• The Group would be able to improve its operations quickly contrary to the findings presented in this article.

• The Group would sell off some of the low productive assets. The funds would then be use to retire some of the loans, returned to investors or reinvested in more productive assets.

Case Notes In this case study, I have not bothered to compute the Earnings Value with growth. This is because the returns are lower than the cost of funds. In such a situation, growth would not create value.  “When a company's ROIC is already high, growth typically generates additional value. But if a company's ROIC is low, executives can create more value by boosting ROIC than by pursuing growth. A close look at companies with high price-to-earnings multiples shows that many have extraordinary returns on capital but limited growth. This scrutiny suggests that, contrary to conventional wisdom, investors recognize (and will pay more for) the anticipated returns of companies with a strong ROIC, despite their limited growth prospects. This observation doesn't mean that growth is undesirable; unless companies keep up with their industries, they will likely destroy value. But they shouldn't pursue growth heroically at the expense of improvements in ROIC.”  McKinsey One way to illustrate this is the following simple valuation model: V = Book Value X (ROE - growth) / (WACC - growth) The value is higher than Book Value if ROE > WACC irrespective of the value of growth. If ROE < WACC, the value will always be lower than Book Value irrespective of the value of growth. As you can see, there are several factors to be taken into account when value companies. If you are not familiar with them but yet want to invest based on fundamentals, one way is to rely on third party advisers. There are several financial advisers who provide such analyses.  Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Case Notes

In this case study, I have not bothered to compute the Earnings Value with growth. This is because the returns are lower than the cost of funds. In such a situation, growth would not create value. 

“When a company's ROIC is already high, growth typically generates additional value. But if a company's ROIC is low, executives can create more value by boosting ROIC than by pursuing growth. A close look at companies with high price-to-earnings multiples shows that many have extraordinary returns on capital but limited growth. This scrutiny suggests that, contrary to conventional wisdom, investors recognize (and will pay more for) the anticipated returns of companies with a strong ROIC, despite their limited growth prospects. This observation doesn't mean that growth is undesirable; unless companies keep up with their industries, they will likely destroy value. But they shouldn't pursue growth heroically at the expense of improvements in ROIC.”  McKinsey

One way to illustrate this is the following simple valuation model:

V = Book Value X (ROE - growth) / (WACC - growth)

The value is higher than Book Value if ROE > WACC irrespective of the value of growth.

If ROE < WACC, the value will always be lower than Book Value irrespective of the value of growth.

As you can see, there are several factors to be taken into account when value companies. If you are not familiar with them but yet want to invest based on fundamentals, one way is to rely on third party advisers. There are several financial advisers who provide such analyses. 

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Conclusion

In Oct 2021, I had concluded that Zeus had poor business economics. Zeus was in a cyclical sector and as such, the fundamental analysis should be based on its performance over the cycle.

The sector is currently in the uptrend part of the cycle and as such you would expect relatively good results compared to its past. But cyclical sectors mean revert.

Using the updated financials and digging deeper into the various aspects of the business, I could not find any evidence to change the earlier conclusion.

Could my conclusions be wrong?

• A new CEO took over in 2019 and there are signs of the Group divesting the lower returns business and acquiring those with better margins. 

• The management continue to report progress in improving the operations even though the impact has not been significant. There could be a turning point when there is a spike in operating efficiencies

While there is a possibility that my conclusions are wrong, it is challenging the weight of history. As such Zeus is not one of the better Nasdaq stocks to invest in.

End

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If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

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