Schuff International was one of the first companies I wrote about when I started this blog way back in January, 2012. Since then Schuff stock is up a bit over 10% but not without a lot of volatility along the way! Shares fell to as low as $6.00 in July, 2012, representing an amazing buying opportunity for anyone familiar with Schuff’s track record.

When I last discussed Schuff, the company had just undergone a recapitalization, taking on debt in order to buy back 57.7% of shares outstanding. I wrote about how the recapitalization, if timed correctly by management, would result in a gigantic increase in earnings per share once the construction cycle eventually turned and Schuff went back to its days of burgeoning profits.

Since its recapitalization Schuff has been silent, claiming that issuing quarterly reports would give away valuable pricing information to competitors. Shareholders had been left wondering if Schuff’s fortunes were on the mend until this week, when Schuff released its 2012 annual report.

Schuff’s 2012 results are as mixed as they come. Revenues, operating profit and net income were all up, and debt was cut almost in half. Free cash flow was strong and leverage decreased. But gross margins hit a decade low, backlog fell to levels below those of year-end 2011 and the company’s accounting was aggressive, billing in advance of costs on work to be completed.

Schuff provides little explanation for the gross margin pressure it is facing. Rising costs for raw materials may play a role, but I suspect competition is the biggest reason. The construction cycle still has not entered a robust phase (as evidenced by Schuff’s revenues which are still 40% below their 2007 peak) and too many firms may be chasing too few projects with the result being lower profit margins for all. Until the demand for new steel construction picks up, Schuff will not be able to win contracts that allow a gross margin in the mid-teens or higher.

Free cash flow production was a bright spot for Schuff in 2012. Free cash flow was driven by a $20 million disinvestment in non-cash net working capital, . This aggressive reduction in non-cash net working capital was largely caused by changes in Schuff’s accounting entries for billings and costs/earnings on uncompleted contracts. Costs/earnings in excess of billings are a current asset, while billings in excess of costs/earnings are a current liability. Costs/earnings in excess of billings decreased, while billings in excess of costs/earnings increased. Remember that a decrease in a current asset is a source of cash and in increase in a current liability is also a source of cash.

By becoming much more aggressive in its billing practices, Schuff was able to create over $30 million in cash flow in 2012. Unfortunately, cash flows created through aggressive working capital management are rarely sustainable or repeatable. Schuff’s 2013 cash flow may suffer if clients push back on payment timing and the net billings/costs/earnings figure swings back toward zero. Another large source of cash flow in 2012 was depreciation and amortization, which ran nearly $5 million higher than net capital expenditure. This is also unsustainable over in the long run.

Schuff used essentially all of its free cash flow to pay off debt associated with the recapitalization. During 2012, the company’s entire $24.4 million bank revolving line of credit was extinguished, and the company made a $3 million principal payment on its GB Merchant Partners real estate-secured note. (Side Note: GB Merchant Partners is the same lender that is currently scalping Great Lakes Airlines for 15%. I still struggle to understand how secured lenders can charge these obscene rates while banks will extend ordinary business loans at LIBOR+5% or so.) Subsequent to year’s end, Schuff paid off the $1.4 million 13% PIK note owned by an inside shareholder.

These actions will substantially reduce Schuff’s interest expense in 2013. Schuff paid $6.48 million to service its debt in 2012, which will drop by more than a third in 2013 assuming no increase in letters of credit outstanding. This calculation does not include the effects of amortizing the GB Merchant Partners real estate-secured note. A $2 million decrease in interest expense will drop another 30 cents per share or so to the bottom line, assuming a 35% tax rate.

After such an aggressive debt reduction effort, Schuff’s solvency and liquidity ratios look good. Net debt now stands at 1.2 times trailing EBITDA and 9.5% of assets less cash, compared to 3.6 times and 19.3% in 2011. The current ratio improved to 1.4 from 1.3 in 2011.

Schuff’s 2013 outlook can be guessed at via the backlog figures disclosed in the annual report, and it’s not encouraging. Total backlog at the end of 2012 was $195 million versus $259 million in 2011. The cycle will eventually turn, but it doesn’t look like 2013 will be the year.

Even though it does not seem that a sharp rise in profits is imminent, Schuff still represents great value. In my initial post on the company, I estimated Schuff’s normalized operating income to be in the neighborhood of $25 million. The $25 million figure was driven by a pre-tax return on invested capital estimate of 15.58%, a 30% haircut from actual historical results. Even if we assume normalized operating income of just $20 million, Schuff’s normalized net income falls somewhere around $10 million after conservatively assuming $5 million in interest expense and a 35% tax rate. At current prices, Schuff still trades for 4.9 times normalized income. Of course, normalized earnings calculations represent an assumption that normal business cycles will continue unimpaired. The next construction boom has not yet appeared on the horizon, but I am willing to bet Schuff will still find opportunities in a nation and world with more people and need for infrastructure than ever.

Until then, Schuff investors enjoy the protection of $21.96 in book value per share, 87% above Schuff’s trading price. Any further share repurchases by the company at today’s prices would create tons of value for remaining outside shareholders.

I own shares in Schuff International.