China’s 4 trillion yuan, $586 billion, stimulus program is having a stronger and more immediate effect on its economy than had been anticipated by most commentators, particularly for companies within the infrastructure sector.
Q1’09 represented a terrible time for Chinese steel companies with heavy losses reported. And the start of Q2 saw steel prices trending still lower before commencing a recovery in May that has since gained momentum without pause. As a consequence of firming prices China Iron & Steel Association (CISA) reported in June that its 72 largest members recorded combined profits in May of 1.262 billion yuan, $185 million, after a 7-month losing streak. After better prices in June, CISA members posted combined profits for the month of 3.55 billion yuan, $520 million - almost triple the May profits.
This morning, August 4th, CISA estimated that its members made total profits of 20 billion yuan, $2.9 billion, during the month of July as steel prices accelerated yet again during the month, making July the most profitable single month in 8 years. By the end of July rebar and wire rod prices were 25% higher than those of mid-April with cold-rolled products showing 29% gains. Already in the first few days of August prices have edged up even further and September price hikes were announced last weekend (August 1, 2) by the largest players. All indications at this point are that August and September will also be very profitable months for Chinese steel companies and a good recovery in terms of volumes, pricing and profitability is underway.
The remainder of this note looks at the impact of the recovery on three Chinese steel companies quoted on US exchanges: China Precision Steel Inc (CPSL), Suter Technology Group Inc (SUTR) and General Steel Holdings Inc (GSI). All three should meet or beat brokers’ estimates for the three months ending June 2009. The real story however is about Gross Margin expansion in the July-September quarter and thereafter. Investors should expect big improvements in forward guidance.
All three companies share an important common feature: Their brokers’ estimates have not been updated since mid May 2009 i.e. before the recovery in Chinese steel prices and profitability occurred. Because of this the brokers’ future estimates for all three companies are understated and redundant to a greater or lesser degree. But notable differences also exist with regard to the analyst assumptions, in particular with regard to Gross Margin expansion for the companies. For CPSL, analysts had forecast moderately higher forward sales prices with Gross Margins expanding from 10% in Apr-Jun’09 to 15% thereafter. Below, we assume an additional 5% GM expansion for CPSL.
As for SUTR, analysts saw mild price increases in the coming quarters with Gross Margins going from 8.6% in Jan-Mar’09 to about 10% in FY 2010. We assume a further 2% GM expansion. And for GSI, analysts saw essentially flat sales prices and similarly flat Gross Margins for 2009 and 2010. With Chinese rebar prices up 25% since April we believe GSI’s Gross Margins should expand to 7.5% in Q3’09 and to 8% thereafter, up from 4% in Q1’09, the low point of the business cycle. In looking at the EPS outlook for these three companies we first of all use the same sales estimates provided by the analysts without making any upward adjustment and finally provide an estimate of what EPS would be if sales reflected the higher steel prices that now exist in the marketplace i.e. adding about 20% to sales numbers across the board.
China Precision Steel Inc (CPSL)
CPSL manufactures high precision products for use in the automobile, textile, appliances and micro-electronics industries. Because of the specialist nature of its products CPSL achieves high Gross Margins during normal times i.e. up to 30%. As of May 2009 brokers assumed CPSL would have Gross Margins of 15% for FY June 2010 – giving 2010 EPS of 14 cents on Sales of $80 million – and a forecast GM of 10.2% in Q4 ended June ‘09. On the back of the recovering steel industry, CPSL should be able to expand Gross Margins to 20% i.e. about 2/3rd of its 30% GM Target. This would produce EPS of 21 cents on brokers existing Sales estimates for FY 2010. At the current share price, $3.23 (August 3 close), this represents a 2010 p/e of 15. In this exercise we made no upward revisions to broker’s existing sales estimates. Even if only for steel pricing reasons higher future sales should be expected. Sales 20% higher would give Fy 2010 EPS of 28 cents for a p/e of 11.5. CPSL financial year end is June. Next earnings release, y/e June 2009, expected early September.
Suter Technology Group Inc (SUTR)
SUTR is a manufacturer of high value fine finished steel products and has traditionally maintained healthy Gross Margins i.e. up to about 18%. As of May 2009, analysts assumed SUTR would have Gross Margins of 10.2% for financial year ending June 2010 – giving 2010 EPS of 61 cents on Sales of $389 million – and up from an actual Gross Margin of 8.1% in Q3 ended March ‘09. On the back of the recovering steel industry, SUTR should be able to expand Gross Margins to 12% i.e. about 2/3rd of its 18% Gross Margin Target. This would produce EPS of 77 cents on brokers existing sales estimates for Fy 2010. At the current share price, $4.31 (August 3 close), this represents a Fy 2010 p/e of 5.6. In this exercise we made no upward revision to broker’s existing sales estimates. Again, even if only for steel pricing reasons, higher future sales should be expected. Sales 20% higher would give Fy 2010 EPS of 98 cents for a p/e of 4.4. SUTR financial year end is June. Next earnings release, y/e June 2009, expected early September.
General Steel Holdings Inc (GSI)
GSI has four separate business units and generates 95% of its sales from rebar steel and other building infrastructure products via its Longman unit. Prior to Q4’08/Q1’09 GSI had a Gross Margin Target of 9-10%. However, having replaced half its old legacy lines with modern efficient furnaces via a $216 million investment during Q4’08/Q1’09, GSI now has Target Gross Margins of 13-14%. As of May 2009 analysts assumed GSI would have Gross Margins of only 4.5% for Fy December 2009 and only 4.8% for Fy December 2010, giving full-year 2009 EPS of 24 cents on Sales of $1.53 billion and 2010 EPS of 57 cents on Sales of $2.24 billion. With Chinese rebar and wire rod prices up 25% between mid-April and end-July – compared to a zero price increase assumed by GSI’ brokers - it is inevitable that GSI’s future EPS estimates will expand by several % points.
GSI’s actual Gross Margin in Q1’09 was 4% and the company recorded a small Net Income for the quarter. Assuming GSI achieves a Gross Margins of 6.1% for full year 2009, being 2.1% above its Q1’09 actual GM, this would produce 2009 EPS of 55 cents. And a GM of 8% for 2010 would give EPS of $1.50, or $1.29 if GSI issues 6m new shares at y/end 2009 – see below. A 2010 Gross Margin of 8% is under 2/3rd of GSI’s Target Gross Margin of 13-14%. At the current share price of $5.29 (August 3 close), the stock has a 2009 p/e of 9.6 and a 2010 p/e of 3.5, or 4.1 for 2010 if GSI issues 6m new shares at end y/end 2009. Again in this exercise we made no upward revision to broker’s exiting sales estimates. Sales 20% higher for the balance of 2009 and 2010 would give 2009 EPS of 71 cents for a p/e of 7.5 and EPS of $1.95 for a 2010 p/e of 2.7, or a 2010 p/e of 3.2 if GSI issues new shares.
Tentatively, we believe that GSI will expand Gross Margins by 3% in the July-September quarter, that the company will make more than 20 cents EPS and that, cautious as ever, the company will guide about 10-12 cents in the upcoming earnings release. Broker’s existing Q3 EPS estimate is 6 cents. Next earnings report, Q2’09, is due August 10 before the market opens.
Investors should also be aware that GSI’s Balance Sheet is highly geared and that in Q1’09 the company made a shelf filing relating to up to $60 million of new equity. For many reasons we consider that any overhang concerns about Balance Sheet gearing and the shelf filing are very much overdone: (a) The Chinese steel industry has already passed the worrying loss-making period when liquidity and funding is more scarce; (b) GSI has a tradition of keeping shareholder dilution to a minimum; (c) GSI’s short-term borrowings which matured in Q2’09 will by now already be refinanced; (d) EPS of 71 cents in 2009 translates to approx $50 million positive cash-flow for GSI (bear in mind that customers make advance payments) with a further cash from operations of $100 million generated in 2010; (e) GSI entering a period of high profitability later in 2009 enables it to raise funds with relative ease and finally; ( f) even assuming that GSI may issue as much as 6 million new shares around y/end 2009 - we believe the company does not need to raise this much new equity and we use this figure so as remain conservative – it still leaves the 2010 EPS estimates at $1.67, giving a p/e of 3.2.
For all three companies, CPSL, SUTR and GSI we have looked at the forward earnings viewpoint as they are being positively affected by the steel pricing improvements that already exist. What we have not yet done is make assumptions about continuing pricing improvements during the remainder of 2009 and in 2010. We believe there are further steel price hikes on the horizon and agree with sentiments expressed by Nouriel Roubini on August 3rd: “As the global economy goes towards growth as opposed to recession, you are going o see further increases in commodity prices especially next year”. After reviewing earnings reports and subsequent broker updates for these three companies we will update our forecasts and publish them here on Seeking Alpha. What is clear in the meantime is that broker estimates in the case of all three, and particularly in the case of GSI, face upward revision.
Disclosure: Long GSI. Have CPSL and SUTR on buy-watch with preference towards SUTR on valuation grounds.