Here I am looking into the Brazilian steel industry, and Bloomberg headlines go like "Global Steel Industry Facing 'Ice Age,' China Mill Warns," "British Steel Is Beyond Saving," "Steelmakers' Megalomania Leads to Misery," "Cameron: Nationalizing Tata Steel Plant Not 'Right Answer'," "Tata's Next UK Problem: Pensions," and "Chinese Mills Will Sustain Steel Exports at High Level for Years."
The steel sector is in crisis worldwide. The main source of steel demand, China, is exporting it and the change in the country's growth model from investment based to consumption based doesn't bode well for the future of the sector.
Brazilian steelmakers, among the most efficient companies of the sector in the world, not only face an adverse operating environment internationally, but the recession in Brazil is making things worse. Since 2008 peak, the shares of the most important companies in the sector - CSN (NYSE:SID), Gerdau (NYSE:GGB) and Usiminas (OTC:USNMY) - fell more than 90%, with Usiminas, which trades OTC in the US, falling 98%.
Is this a good buying opportunity?
The picture drawn from 2015 results release doesn't look good. At bottom line level, the three companies posted net losses on the back of asset impairment recognition and foreign exchange depreciation, which is good for exports but bad for the value of foreign currency denominated liabilities.
At top line level, the picture isn't better, but the environment is more adverse to companies more focused on the domestic market. The revenue drop at Usiminas was larger than at CSN while Gerdau managed to increase revenues. Usiminas, among the three companies, is the one more exposed to the Brazilian local market, which represents 80% of revenues, while it is 62% in the case of CSN and 30% in the case of Gerdau. Gerdau's revenue growth was mostly due to the positive impact of the BRL depreciation against the USD, as quantities sold in the US decreased consistently with the overall trend.
Diversification to other areas of the business like mining, logistics, energy and cement in the case of CSN, and steel transformation, capital goods and mining in the case of Usiminas, has not been positive because the mining sector is suffering from much of the same problems as the steel sector - overall demand is restricted due to the recession in Brazil, and some segments are more an input or a support to the steel business than a segment per se.
CSN remains the most efficient producer among the three and among the top worldwide. While all companies experienced EBITDA margin erosion during 2015, CSN's EBITDA margin remained at 21%, Gerdau's at 10%, and Usiminas at 3%. The erosion is mostly explained by the Brazilian market. Gerdau has lower but more stable margins given the importance of the US operations of the company.
If Petrobras (NYSE:PBR) has high levels of debt and interest burden, please check steel companies. CSN and Usiminas allocate most of their EBITDA to cover financial costs. Gerdau is in a better position, although we cannot say it's good, with EBITDA/net interest at 1.56x. Excluding foreign exchange losses, the picture improves but not much. Gerdau has the lowest net debt/EBITDA at 4.3x.
CSN is a highly leveraged company but Usiminas' situation deteriorated sharply in 2015. That is clearly priced in 5-year bond yields that reach 48% for Usiminas, 30% for CSN and 8.5% for Gerdau.
Going forward, despite the adjustments in the investment plans that are taking place at these companies, Usiminas' free cash flow will remain negative until 2017, while CSN's should move from positive to negative territory in 2017. Gerdau is expected to remain in positive territory, according to several market analyst estimates, for the next 2 years.
Dividend payments at Usiminas are on hold, but not at CSN or Gerdau. Despite losses, these are the type of companies that will skip dividends only in ultimate circumstances, although risking de-capitalization. CSN and Gerdau have been paying dividends justified by the anticipation of 2015 net income, which by the way, was a loss, on the back of reserves and ignoring asset impairments and FX losses that occurred. These items, although being non-cash, show the loss of value in the company's assets that may or may not be priced in equity prices. I think that aggressive dividend policies are a concern in the specific case of CSN given high debt levels, but nevertheless, this has been the norm at the company for a long time.
Dividend policy, Brazil's domestic environment, and rising debt levels are challenges ahead, and despite the sharp fall in equity prices, they still look dear. Dividend yield is low in the cases of those companies paying dividends, between 2-3%. EV/EBITDA current and expected is above 10 for CSN and 20 for Usiminas. Even if Usiminas doubled its EBITDA, it would still be an unattractive stock by that metric. High debt levels aggravate this picture. Gerdau ranks better, with EV/EBITDA at 6-7 expected until 2017, but not enough to say that its equity is cheap.
Usiminas and CSN have a sound cash position, but they will struggle to pay their debts as the operating environment remains challenging. Usiminas should be in a particularly difficult position given the shorter debt maturity profile and 5b BRL (1.5b USD) in contingent liabilities, a scenario that could be softer if the current plans for a capital increase materialize.
The domestic market may remain in contraction according to local institutes that observe the sector, which will make it more competitive. The international environment is also increasingly competitive, with Chinese companies "dumping" and EU and US steel companies struggling. Despite short-term volatility, the BRL should strengthen against the USD in the longer-term horizon, but at a moderate pace, which will be positive for international operations of Brazilian companies, even if not as positive as in the fourth quarter of 2015.
If Brazilian equities pick up, steel companies should also benefit. Nevertheless, shares of Brazilian steel companies are dear. Although Gerdau may appear less so, there are options in other sectors of the economy that offer more value, (Banks, PBR and Fibria). Political noise and the overall domestic situation may affect steel companies more than country peers.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.