New Contracts and Acquisition Will Strengthen Cash Position of Armco Metal Holdings, Inc. (AMCO)

Armco Metal Holdings has entered into a stock purchase agreement to acquire 100% of Draco Resources for about $46 million. Draco Resources is a wholly owned subsidiary of Metawise Group, and it explores, mines, and trades mineral resources such as metallurgical coal, iron ore, chrome ore, and manganese ore.

Acquisition of Draco will help Armco generate substantial cash flow. Metawise has rights to sell approximately 5 million metric tons of iron ore fines from its facility in Theodore, Alabama. Metawise has entered into a commodity distribution agreement with Draco Resources. Through this agreement, Draco will purchase iron ore fines from Metawise and resell it to third parties. From March this year, Draco has started monthly shipments of 55,000 to 165,000 metric tons of iron ore fines to China. As it can sell 5 million metric tons of iron ore, the company expects to continue shipments to China for at least the next four years.

Demand of iron ore in China is expected to be strong in coming years due to incremental production of steel. For the next four years, China’s steel output is expected to grow at the rate of 4% per annum, which will lead to more iron ore imports. With expected demand, Draco Resources can continue selling its iron ore fines in China, at the similar rate, which will positively impact Armco’s revenue.

Recycling business is another growing story

Armco Metal feels that its metal and steel recycling business will boost the company’s overall revenue. The metal recycling business, which accounts for about 26% of Armco’s total revenue, is expected to grow due to depletion in natural resources, and growing unprocessed scrap metal. Last year, the company sold approximately 154,821 metric tons of scrap metal which helped it to generate a gross profit of about $2.9 million. However, in the first quarter of this year, the company reported a loss of about $1.4 million due to low metal scrap prices and reduced sales. In the first quarter of this year Armco sold only 8,049 metric tons of scrap metal in comparison to sales of 23,001 metric tons in first quarter of last year.

To safeguard its sales margin, Armco started implementing a platform strategy sales model in 2013. Under this model, it is trying to increase involvement of its partners and customers in the complete process, from purchase of raw material to sale of final processed metal scrap. By implementing this model, Armco shares most of the expense required for importing raw material and selling processed scrap steel with customers. Doing so, Armco lowers its market risk related to price of raw material, and it helps to increase sales with less or no additional working capital. It mainly generates profit through fees for processing the unprocessed scraps of customers in its facilities.

The following examples show how implementing its platform strategy will improve Armco’s metal recycling business prospects:

1. Expanding its processing capability:

In May, Armco entered into scrap steel distribution contract with Tewoo Metal International Trade Co. of Tianjin, China. Under this agreement, Armco will source, process, and distribute steel scrap for Tewoo Metals. Initially Tewoo will ship about 2,000 metric tons of steel scrap to Armco, which could further increase.

2. Trying to reduce customer default:

In the second half of last year, Armco’s working capital was hampered due to customer defaults. To reduce such risks, the company is entering into contracts with customers in which most of the cash expense for importing and transporting scrap steel is managed by the customers. In April, Armco entered into an agreement with Midland resources on similar terms. Under the deal, Midland will use its importing licenses to import scrap steel, while Armco will act as a sourcing agent for it, and it will also process the unprocessed scrap steel. Hence, most of the expense will be taken care of by Midland, while Armco will generate profit through its processing capability.

3. Trying to tap opportunities in other parts of the world:

In March, Armco signed a long-term scrap steel supply agreement with another company, Mitsui Shanghai. Armco will source, process, and supply scrap metals with various specifications and standards. Mitsui Shanghai is the subsidiary of Mitsui & Co, Japan, which is one of the largest Japanese trading companies, with trading operations in various parts of world. Hence, by entering into an agreement with Mitsui Shanghai, Armco can get a deal in Japan or Mitsui’s other trading areas, too.

Mitsui Shanghai currently purchases 15,000 to 20,000 metric tons of steel scrap per month, and it has future expansion plans. Another salient feature of the contract is that Mitsui will pay in advance for buying raw materials as well as final product, which will be produced after processing at Armco’s facilities and thus strengthen Armco’s cash position.

Armco expects more such deals this year, which will further improve its processing capability as well as cash flow.

Conclusion

Armco Metal is trying to strengthen its cash position by entering into long-term contracts under its metal recycling business. In addition, acquisition of Draco Resources will positively impact its revenue due to stable demand of iron ore in China. Overall, I recommend investors hold this stock.

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