Olympic Steel (ZEUS) has seen steady bottom line growth over the last four years before taking a slight dip in QoQ net income in Q1 2019. Olympic Steel has a steady business model as well as a strong reach across the United States. However, if they want to take the next step and compete with the likes of Reliance Steel & Aluminum (RS) and Ryerson Holdings (RYI), I believe that they need to expand globally. A merger with Oak Brook, Illinois’ A.M. Castle & Co. (CTAM) would be mutually beneficial to both companies. Olympic Steel would expand outside of the United States and A.M. Castle would be able to refinance their debt and decrease their overhead expenses. In order to prove the benefits that each company would net from this deal I have created a pro-forma balance sheet, accretion/dilution model, and an explanation for the synergies of the two companies. This evidence can be seen below.
Olympic Steel will benefit from A.M. Castle’s global reach. A.M. Castle currently has locations in Europe, Mexico, Asia, and California. These are all locations where Olympic Steel has none and could certainly benefit from entering these high grossing regions. When looking at competitors such as Ryerson Holdings and Reliance Steel & Aluminum, Olympic Steel can compete in America but these other companies blow ZEUS away abroad. Olympic Steel’s quality financial standing at A.M. Castle’s pre-existing warehouses abroad provides a synergy that will certainly increase Olympic Steel’s top and bottom lines.
A.M. Castle features increasing debt levels which are not sustainable under their current business operations. The company flaunts an impressive TTM gross margin of 25.2% while Olympic Steel is only generating a gross margin of 19.1%. This is one of the significant benefits that A.M. Castle can bring in the merger with ZEUS. A.M. Castle is not able to take advantage of their impressive gross margin because they have very high overhead expenses. As can be seen in the chart below their warehousing/delivery expense and SG&A expense are 14.3% and 11.8% of sales, respectively. Olympic Steel’s warehousing/delivery expense and SG&A expense are 8.4% and 6.8%, respectively.
A.M. Castle’s high overhead expense is the reason that they are not able to generate a profit. In a merger, Olympic Steel would be able to influence the operations of A.M. Castle and decrease their overhead. It is very possible that a merger could completely eliminate A.M. Castle’s $68.8 million in SG&A expense, however, I took a more conservative approach and simply decreased the expense down to the percent of sales that Olympic Steel’s SG&A is responsible for, 6.8%. This leads to $39.2 million in annual savings. The second element of this high overhead is the warehouse, processing, and delivery expense. In the last 12 months, A.M. Castle incurred $83.6 million in warehouse and delivery expenses. I believe that this expense would decrease significantly upon the sale to Olympic Steel because of the two companies’ overlapping warehouse locations. Both companies have warehouses in Bedford Heights OH, Charlotte NC, and Hammond IN. A.M. Castle has 743,495 square feet worth of warehousing in these three locations which makes up 35% of their total blueprint. These three warehouses account for approximately $30 million of all warehousing expenses so I estimate that a consolidation of the two companies at these locations would save Olympic Steel an additional $10 million (this low-side estimation is another attempt at conservative expectations). These two adjustments combined result in the $49.2 million in annual synergy benefits that will come from this deal.
PRO-FORMA BALANCE SHEET
Below I have attached my pro-forma balance sheet and accretion/dilution model. I created a model that assumes Olympic Steel will pay a 25% premium on A.M. Castle’s stock in a deal that is 60% stock/40% cash and they will finance the cash with 80% debt. I determined that Olympic Steel would refinance all of A.M. Castle’s debt in the deal and as you can see on the far right this leads to a significant increase in leverage for the combined company. However, the combined company still sports a strong current ratio and I believe that their improved ability to generate cash moving forward will allow them to comfortably handle this high debt level.
The accretion/dilution model below proves that under the current assumptions the deal is accretive to Olympic Steel. The increase in net income outweighs the 289,000 shares that must be issued as part of the transaction. The EPS forecasts that I got from FactSet lead to the expectation that in FY 2019 and 2021 this deal will be more than 21% accretive and approximately 16% accretive in 2020.
As can be seen below in the sensitivity analysis the offer price, % stock, and % cash that is financed with debt only shift the EPS ever so slightly. Given the small size of the deal in relation to the size of Olympic Steel these assumptions have very little sensitivity to the resulting EPS. However, in the bottom data table it is clear that synergy value plays an enormous role in whether this deal is accretive or dilutive.
If Olympic Steel is confident they can get the $49.2 million in synergy value that I assumed (with conservative measure) they should acquire A.M. Castle. A.M. Castle’s global presence will fill a void in Olympic Steel’s portfolio and allow them to broaden their success around the world. The acquisition will also give A.M. Castle the freedom to refinance and better take advantage of their high gross margin by decreasing the overhead expenses that are dragging them down. If Olympic Steel wants to be on the level of their competitors such as Ryerson Holdings and Reliance Steel & Aluminum they need to succeed abroad and I believe that the acquisition of A.M. Castle under my model’s assumptions allows them to do so in a way that is accretive to their shareholders.