Gerdau - An Attractive Investment

Jun.23.14 | About: Gerdau S.A. (GGB)

Summary

Gerdau has a solid cash flow and falling financial leverage.

Gerdau is trading at low forward-looking estimates which makes it an attractive investment opportunity.

Discounted cash flow analysis implies an upside potential of about 30-40%.

Gerdau (NYSE:GGB) looks like a very attractive risk-weighted investment compared to expected future possible earnings and cash flows.

In this analysis I have used a forecast that is conservative relative to consensus forecast, and I have included risk assumptions in order to analyze upside and downside potential.

Due to solid Q1 2014 earnings, a conservative forecast that shows a falling financial leverage, and a favorable risk-reward valuation I believe Gerdau is an attractive investment.

About Gerdau

Gerdau is the leader in the segment of long steel in the Americas and one of the main suppliers of special long steel in the world. It has also started its own production of flat steel, and expanded its iron ore activities.

With over 45,000 employees, Gerdau has industrial operations in 14 countries in the Americas, Europe, and Asia, which together represent an installed capacity of over 25 million metric tons of steel per year. Furthermore, it is the largest recycler in Latin America and in the world.

Forecast

a) Consensus forecast (source: 4-traders.com)

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b) My forecast

The forecast is based on annualised Q1 2014 numbers, and the following assumptions:

- 3% yearly volume growth, and 3% yearly growth in prices and costs.

- Gerdau North America EBITDA margin increases from 2% in 2014, to 5% in 2020.

- Yearly capex of M BRL 2.500, tax rate of 25%, and dividend as 35% of net income.

The below table summarizes my forecast. The historic numbers are from the 2013 annual report (source: 2013 annual report)

My forecast is supposed to be somewhat conservative, and therefore has a lower expected earnings than consensus forecast.

The increase in earnings are mainly due to volume growth, EBITDA margin gradually back to reported 2013 levels, and positive cash flow which leads to reduced net debt and lower net interest expenses.

Forecast assumptions:

The volume growth of 3% is based on Gerdau's outlook for steel consumption in 2014 (Brazil: 3%, North America: 3%, Latin America: 3.7%), and historical production volumes of steel. In the period 2007-2011 (source:businesswire.com), the overall production volume of steel grew at 3% CARG.

Price and cost growth assumptions of 3% are mainly based on current steel forward curve (source:lchclearnet.com) which implies a yearly steel price increase of about 4% the next 2-3 years, and inflation forecast in Brazil (see below chart).

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The volume, price and cost growth are weighted among the regions where Gerdau has exposure, and then they have been adjusted downwards and rounded so as to hopefully get forecast that is somewhat conservative and with easy-to-follow assumptions.

I have assumed a lower EBITDA margin for North America in 2014 than what was reported for 2013 due to severe winter in the region and imports in Q1 2014 (Source: Gerdau's Q1 2014 presentation). I have then assumed that the EBITDA margin in North America gradually increases to reach is 2013 level in 2020.

For the other regions I have assumed constant EBITDA margins as reported for Q1 2014.

Assumed EBITDA margin:

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Forecasted earnings per share:

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The increase in earnings are mainly due to volume growth, EBITDA margin gradually back to reported 2013 levels, and positive cash flow which leads to reduced net debt and lower net interest expenses.

Current share price (13.9 BRL) relative to forecasted earnings per share:

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Forecasted book value per share:

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Valuation (base case)

Gerdau currently has a somewhat higher P/E ratio than the 2 Brazilian competitors used in this analysis, but a lower P/E than the international competitors used in this analysis. (Source: 4-traders.com)

Valuation based on discounted cash flow (DCF) analysis:

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Assuming a weighted average cost of capital (WACC) of 10%, and perpetual growth from 2020 of 5%. The assumptions implies a fair value of about 19 BRL per share, that is, about 8.5 USD per ADR.

That is, an implied upside potential of about 30-40% from current share price.

Forecast with risk assumptions

In order to analyze the risk-reward I have also included the following risk assumptions:

- 1% yearly standard deviation in volumes.

- 2% yearly standard deviation in prices.

- 1% yearly standard deviation in costs.

Risk assumptions:

The volume risk assumption is mainly based on Banco Central do Brasil's assumed possible GDP growth as Brazil is Gerdau's main market (see below chart). I assume that steel consumption is positively correlated with GDP.

The price risk assumption is mainly based on assumed possible future inflation in Brazil (see earlier chart). I have assumed that Gerdau's costs have lower volatility than steel prices.

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The calculations that includes these risk assumptions are based on the same base case as above, but there are calculated multiple scenarios (using Cholesky decomposition) where volumes, prices, and costs are subject to potential changes (the assumed standard deviations).

The sum of all the potential outcomes from these multiple calculations can be summed up in e.g. fan charts and distribution charts.

The below fan chart shows the resulting assumed possible future EBITDA margins.

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The fan chart shows the assumed possible development with included risk assumptions.

The black line shows the historic development, and then the base case forecast.

The darkest blue area shows the range estimated to contain about 75% of the assumed possible outcomes. The 2'nd darkest blue area, together with the darkest area, is estimated to contain about 90% of the possible outcomes. The total blue area is estimated to contain about 95% of the possible outcomes.

It is estimated that there is about 2.5% probability that the future values will be above the shaded area, and 2.5% probability that the future values will be below the shaded area.

The actual values can be both higher and lower than depicted in the fan chart.

The lower part of the EBITDA margin fan range occurs in the scenarios where the Monte Carlo generated prices are low, and the Monte Carlo generated costs are high.

The upper part of the EBITDA margin fan range occurs in the scenarios where the Monte Carlo generated prices are high, and the Monte Carlo generated costs are low.

Assumed possible future earnings per share:

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The lower part of the EPS margin fan range occurs in the scenarios where the Monte Carlo generated prices are low, and the Monte Carlo generated costs are high.

The upper part of the EPS margin fan range occurs in the scenarios where the Monte Carlo generated prices are high, and the Monte Carlo generated costs are low.

Assumed possible development in book value per share:

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Assumed possible operating cash flow:

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Falling financial leverage

Gerdau has experienced a falling leverage (Net debt/EBITDA), and the leverage is expected to fall further due to the expected positive cash flow.

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Gerdau also has a somewhat lower leverage, and expected to have in the future, than the average of a group of competitors (Companhia Siderurgica Nacional, Usinas Siderurgicas de Minas Gerais, United Steel, Nucor, ArcelorMittal).

The company has also stated that it is committed to a conservative capital structure.

Gerdau is the leading geographically diversified long steel producer in the Americas, which cushions earnings from volatility from any single country.

Having a falling leverage ratio, and diversified portfolio, makes Gerdau a less risky investment. The falling leverage can also support repurchase of shares, higher dividend, and opportunistic investments.

Valuation multiples with risk assumptions

Current share price relative to assumed possible future earnings per share:

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Current share price relative to assumed possible development in book value per share:

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Current share price relative to assumed possible cash earnings per share:

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Valuation with risk assumptions

Based on discounted cash flow (DCF) analysis, assuming a weighted average cost of capital of 10%, and perpetual growth from 2020 of 5%.

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The distribution chart shows the assumed distribution of valuations per share (in BRL) based on all the calculated scenarios. The horizontal axis shows the assumed possible value distribution, and the vertical axis shows the assumed probability for each outcome.

The percentage shown on each bar is the accumulated probability, starting from the left.

Based on all the assumptions made there is an estimated 32.6% probability that the implied fair value per share is below 15.3 BRL (USD 6.75), and a 67.4% probability that the implied fair value is above 15.3 BRL (USD 6.75).

Gerdau's current share price is about 14 BRL (USD 6.25).

Conclusion

Gerdau does not seem excessively cheap relative to competitors included in this analysis, but it seems relatively cheap compared to expected future possible earnings and cash flows.

Due to solid Q1 2014 earnings, a conservative forecast that shows a falling financial leverage, and a favorable risk reward valuation I believe Gerdau is an attractive investment.

Base case implied fair value is about 19 BRL per share (USD 8.5) which implies an upside potential of about 30-40%.

I am long GGB.

Disclosure: The author is long GGB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.