In an earlier article, I argued that ArcelorMittal (MT) was both a safer and far more undervalued bet than U.S. Steel (X). In this instance, I was about as optimistic as the Street's "strong buy" rating. My views on Gerdau (GGB) are similar to those on ArcelorMittal and yet the Street currently rates shares only between a "hold" and a "buy." While macro instability and high betas contribute to risk, steel producers are priced at depression levels and will be buoyed up by emerging market construction.
From a multiples perspective, Gerdau and U.S. Steel are very cheap. Gerdau trades at a respective 11.4x and 4.5x past and forward earnings, while U.S. Steel trades at 9.5x forward earnings. The former also has a dividend yield that is 276 basis points higher than the latter at 3.58%. And on the financial side, Gerdau also has a stronger balance sheet with net debt standing at only 39% of market value compared to eclipsing market value for US Steel.
This puts the firm in a stronger position to increase scale through acquisitions that unlock cost and revenue synergies. In the years ahead, I anticipate long rolled steel showing stronger fundamentals than flat rolled, which is more vulnerable to foreign exchange. This will contribute largely to Gerdau being an outperformer in the industry.
At the third quarter earnings call, Gerdau's CEO, Andre Johannpeter, noted:
Now steel production reached 5 million tonnes in the third quarter and that represents a 14% increase when compared to the same period of 2010. Year-to-date that was an 11% growth reaching almost 15 million tonnes.
Net sales 9% higher when compared to the same period a year before, reaching R$9 billion and first nine months of the year, the consolidated net sales reached R$26.3 billion which is 12% growth when compared to the same period the year before. Operating cash generation which is EBITDA was R$1.2 billion, a reduction of 4% when compared to the same period the year before. This is mainly due to cost pressures in raw materials. Now from January to September or year-to-date, EBITDA was R$3.6 billion.
Third quarter results were largely in line with consensus, as net income expanded to $713 million rupees. And although speciality steel and LatAm were disappointing, volumes in the latter are nevertheless showing meaningful improvement. In addition, activity during the quarter was generally stronger than expected with a healthy construction environment in Brazil and price stability.
On the other side of the spectrum is US Steel, which is in a much more precarious position. Ironically, U.S. Steel's greatest liability is the "US" part. Domestic economic stagnation coupled with labor challenges and overly high costs will limit both production and margin expansion.
The reality of the situation is that labor costs are cheaper abroad and allow for more efficient increases to scale. Gerdau and ArcelorMittal are thus in a better position to grow the bottom line as the international economy picks back up. Gerdau has gross margins of 17.6% compared to U.S. Steel's 6.4%. With that said, I believe that U.S. is in less of a predicament than the market currently believes (explained here).
All steel producers face a challenging market in the year ahead with input volatility, low demand, and depressed output prices. A stagnant economy will always hit steel producers hard, but the low multiples are unwarranted based on a long-term value perspective for all players involved. Over the last two months, shareholder value has declined unreasonably by up to 50% in some cases (Gerdau being an outperformer at only -39%).
Accordingly, I am bullish on a recovery of the industry as a whole and recommend investing in at least one steel producer. A very risky strategy would entail opening a long position on X and a short position on the overall market in order to yield returns on the spread. This is recommended only to investors who are more bullish on the US economy than the market is.
Consensus estimates for Gerdau's EPS are that it will decline by 38% to $0.93 and then increase by 45.2% in both of the following two years. Revisions have gone down by 22.3%, which definitely warrants concerns. However, the silver lining is that this will help to generate high risk-adjusted returns as the global economy picks up and closes the discount. Assuming a multiple of 10x - lower than the current one - and a fairly low 2012 EPS estimate of $1.30, the rough intrinsic value of the stock is $13. This implies a 69.9% margin of safety - more than enough to consider it a value play.