Description

Investment Thesis Overview

Ampco-Pittsburgh represents a deep value investment idea in a microcap company that has run into more than its fair share of trouble in recent years in dealing with asbestos liabilities, excessive M&A under prior leadership, and lowered end market demand for multiple years. Most of these issues have been dealt with by new leadership through divestitures of money losing businesses and cost cutting among other things, which have brought the company back from severely unprofitable to just above break-even. AP’s end markets have demonstrated a strong recovery since the start of the pandemic with AP reporting sales growth nearly every quarter since Q2 2020. As AP’s steel mill customers continue to thrive off high steel prices and expand their mill utilization to keep up with booming demand, AP’s sales of roll products should grow appreciably in the coming quarters and years. 

Despite the positive course correction of its business, AP’s stock remains depressed relative to its peers and its near-term future earnings outlook as investors are not quick to forgive and forget. Given the attractiveness of its share price, multiple insiders have made significant open market purchases in recent months. I see immense upside in AP’s stock over the next 2-3 years as the company completes its turnaround initiatives, executes its growth strategy, and realizes its financial targets.

Business Overview

Founded in 1929, Ampco-Pittsburgh Corp. manufactures and sells highly engineered metal parts and equipment through its two segments: Forged and Cast Engineered Products (FCEP) and Air & Liquid Processing (ALP). FCEP mostly manufactures forged and cast rolls utilized by steel mills and has customers throughout the world. ALP manufactures specialized equipment including heat exchangers, heat transfer products, custom air handling systems, and centrifugal pumps, among others that are used in a variety of end markets.  

ALP is the more stable of the two segments, routinely reporting ~$90M in annual sales and an operating income margin of roughly 9-11% with annual capex requirements of <$1M. With high barriers to entry ALP has a track record of generating double-digit returns, which makes it an attractive business to own save for its asbestos-related legal obligations. Asbestos claims had historically resulted in one-off non-cash charges sporadically impacting results. Finally in 2018 Management resolved to do something to reduce these annual charges – they took a $33M non-cash charge recognizing asbestos liabilities. This wasn’t the result of an unforeseen increase in legal claims against the company, but rather an extension of the horizon for claim recognition from 10 years out to the full period of potential claim liabilities to the year 2052. In booking these liabilities, AP provided investors with greater clarity and reduced the future volatility of future liability adjustments. AP was able to estimate all future legal claims thanks to stabilizing case law, claims activity, and insurance reimbursements related to AP’s asbestos liabilities.

FCEP, in contrast to ALP, has seen greater sales and earnings volatility in recent years after a period of inorganic overexpansion during 2015 and 2016, followed shortly thereafter by a subsequent restructuring to right size operations to be overseen by new leadership. Between 2018 and 2019 FCEP divested multiple underperforming businesses and implemented major cost cuts, culminating in restored profitability to the segment by 2020. FCEP is now heading into a period of higher sales growth with a lower cost base, further described below.

Growth Strategy and Financial Targets

After year-over-year sales declines in 2019 and 2020, AP is back on the trajectory of sales growth as evidenced by growing sales nearly every quarter since Q2 2020. Management expects 2022 sales to be in line with 2019’s ~$398M sales, up from ~$329M in FY 2020 and LTM revenue of ~$342M. Some of this growth will result naturally from end market recovery after the initial COVID-related disruption, while some growth will stem from increasing steel mill utilization in AP’s customer base. The current market environment shows many of AP’s steel mill customers reporting record sales and earnings thanks to a >200% increase in the price of steel since the start of the pandemic. The rapid price increase began after steel mills shuttered vast portions of their operations at the start of the pandemic to bring steel production in line with anticipated demand. At the time many producers also took the shut downs as an opportunity to implement overdue facility and equipment upgrades which would limit production capacity for some time. Thanks in part to massive government stimulus spending, demand for steel never dropped as low as originally anticipated - the combination of low steel inventories, low steel mill utilization and high customer demand has acted as an immense tailwind on steel prices since then. Though steel mills are generating record profits, the benefits have not yet trickled down to AP. Being the manufacturer of the rolls used in the mills, AP’s business mostly benefits from higher mill utilization - the higher the utilization, the more rolls consumed. Rolls can last several months to over a year depending on the particular specifications of the roll. Steel mills are indeed ramping up utilization to meet demand, putting AP in prime position for top-line sales growth going forward.

Aside from increasing their roll sales, AP is also pursuing sales growth by entering new end markets to offer FCEP’s open-die forged engineered products (i.e. non-roll products). Though only 4% of FCEP’s 2020 sales (~$10M), these non-roll product sales have been growing rapidly in recent quarters and management expects to be able to triple their current business in the coming years (potentially ~$30M in sales). In supporting their expanded offerings, AP is investing to replace older single-purpose machines with new multi-purpose machines, which will enable a lower cost base and increase non-roll production capacity by ~80%. The plan calls for total investment of $27M, once complete (in 24 to 30 months) the new equipment base will provide $7.5M in annual cost savings (between repair & maintenance, labor, working capital) and an incremental $5M in EBITDA from open die forged product sales expansion.

Based on the factors above, AP has publicly stated financial targets to be achieved in the next three years of $450M in revenue, double-digit EBITDA margins, and net income of $25M (compared to TTM sales of ~$342M, a ~7.7% TTM EBITDA margin, and TTM net income of ~$4.4M).

Valuation and Share Price Upside

With its turnaround efforts bearing fruit through 2020, the share price rallied and reached a peak of $8.81 per share in early 2021. Since then, the share price has lost nearly half of its value to reach today’s price of $4.64. I view this pullback as an opportunity for investors today who can now observe the merits of management’s actions in the trailing 3 year period and the pathway to a much higher valuation in the near term given the strategies being implemented today.

At its current share price AP trades at an EV/sales multiple of 0.7x, compared to a peer group* average and median of 1.1x and 0.9x, respectively. Were AP to trade in line with its peers at say 1.0x EV/sales the equity value would be closer to $9.35 per share for an upside of ~100%. With revenue growth continuing into 2022, this differential will only grow further. Being in the early stages of its turnaround, AP’s LTM earnings are not nearly representative of its forward looking earnings power as the trailing period did not fully reflect the benefits from cost cutting, equipment upgrades, and higher sales volumes driven by the economic boom occurring in AP’s steel mill customer base. The upside return profile over the foreseeable future as these benefits are realized is quite attractive and should position AP to successfully achieve management’s revenue and earnings targets of $450M and $25M respectively. In this scenario a 10x P/E ratio would imply an equity value close to $13.09 per share, generating a return of ~180% over the current share price.

(*Public comps include HAYN, IIIN, NNBR, NWPX, SYNL, THR, TWIN, CRAWA, TMST; included in AP’s enterprise value of $252M is net debt of ~$28M, an asbestos liability of ~$58M, and unfunded pension obligations of ~$77M.)

Insiders Are Buying

Since May 2021, three AP executives have collectively purchased nearly $130k worth of stock in the open market. One director sold ~14k shares in May before buying back ~16k shares in June at a much lower price via conversion of their Series A warrants, resulting in a net increase in their share ownership. Several insiders have been buyers of the stock for years while the company implemented its turnaround initiatives, and nearly every insider participated meaningfully in the company’s 2020 rights offering.

Risks

As a small cap industrial business there are plenty of risks to be aware of, including AP’s exposure to cyclical end markets, potential for supply chain disruption (a growing problem in the current environment), and commodity-related risks pertaining to steel and aluminum. Despite the fact that asbestos claims activity has stabilized, an unforeseen increase in claims and litigation may hurt the future performance of AP. As can be said about most deep value situations, a certain amount of patience and comfort with price volatility may be a prerequisite to owning AP shares.

The main risk to this thesis would be if the booming profits at steel mills never benefits AP. This could happen for a variety of reasons including a near-term steel price correction, a sustained decline in steel mill utilization, or foreign competition, among others.

Catalysts

-          Top-line growth as sales volumes grow thanks to 1) greater steel mill demand for rolls and an upcoming federal infrastructure bill; and 2) AP’s entrance into tangential markets for open die forged products

-          Improving margins from equipment upgrades

-          Achievement of target revenue and earnings ($450M and $25M respectively) in the next three years

-          According to a 13D form filed by Crawford United in October 2020 it was disclosed that Crawford’s CEO had communicated their interest in exploring strategic opportunities involving Crawford’s Air Enterprises business and ALP. Crawford is a frequent acquirer of niche businesses in its sector, but since their initial disclosure no updates pertaining to a potential transaction have been disclosed. Whether or not any transaction moves forward, this indication of interest highlights ALP’s recurring revenue, high ROIC business as an attractive target for both strategic and private equity acquirers. I don’t see AP pursuing add-on acquisitions for ALP but a divestiture would make sense as it would highlight the value of the remaining FCEP business and rid the balance sheet of the asbestos liabilities.

Catalyst

See above.