Numerous Brazilian industrial companies, not to mention the Bovespa as a whole, have gotten hit hard since the start of 2014. The prior year was a volatile one as investors became more concerned about slowing growth in Brazil and difficult choices for the government regarding inflation, fiscal stimulus, and infrastructure inadequacies. Weak rainfall has exacerbated the problem, raising the prospect of electricity rationing that could lead to a meaningful decline in industrial output.
The Brazilian steel sector has gotten hit hard, with Gerdau (NYSE:GGB), CSN (NYSE:SID), and Usiminas (OTC:USNMY) down 25% to 40% before a recent bounce. Electricity rationing would be bad news for an already-stressed Brazilian economy, but there is more to Gerdau than just one year of performance in Brazil. As non-residential construction picks up in the U.S., Gerdau should see shipments, utilization, and margins improve, and there is at least the possibility that investors have overreacted to the potential downside in Brazil. Assuming that Gerdau deserves a multiple in line with the global average for steel, the shares look about 20% undervalued today.
One Of The Biggest Names In Long Steel
Gerdau is comfortably in the #2 position in terms of global long steel production, with over 25Mt of capacity. ArcelorMittal (NYSE:MT) is more than twice the size of Gerdau, but Gerdau is the largest producer in the Western hemisphere, ahead of ArcelorMittal, Nucor (NYSE:NUE), Usiminas, and so on. More than 70% of Gerdau's steel is produced in electric arc furnaces (like Nucor), and the company has adopted a vertical integration strategy similar to ArcelorMittal and Ternium (NYSE:TX), with substantial iron ore capacity (11.5Mtpa exiting 2013).
Long steel products, including merchant bar, SBQ, rebar, and structural shapes, are used extensively in non-residential construction and infrastructure projects. That means that Gerdau is more sensitive to building activity and has relatively less exposure to auto production or machinery build rates relative to steel companies like Nucor or Ternium.
About 50% of Gerdau's production is in Brazil, but it generates around 70% of the company's EBITDA. Some of this can be tied to better pricing in Brazil (current prices are about $R300/ton higher than global export prices), but I believe weak construction markets and capacity under-utilization in North America is also playing a role. Around 40% to 60% of U.S. production goes to non-residential construction, and margins have been weak in the face of a sluggish recovery.
Recover, Expand, And Grow
Gerdau is pursuing multiple strategies more or less simultaneously. The company is looking to increase its finished steel production (as opposed to semi-finished products) and add hot-rolled and plate capacity, which should diversify and expand the company's revenue base. Gerdau is also looking to expand its iron ore capacity and add production capacity in India.
In the short term, though, it is a recovery in the U.S. construction market that is likely to have the biggest potential positive impact. Bad weather has done the company no favors in the first quarter, but North American volumes were up year over year in the fourth quarter of 2013, with a meaningful improvement in margins. A wide range of companies (from Granite Construction (NYSE:GVA) to Honeywell (NYSE:HON)) have been moving in anticipation of this recovery and if Gerdau can achieve better utilization (say 70% or 80% versus the 60% in the fourth quarter) in North America, EBITDA margins should improve from the mid-single digits to the low to mid teens.
How Bad Could Brazil Get?
A U.S. commercial construction recovery may be the biggest potential positive development for Gerdau, but there is definitely a risk that worsening conditions in Brazil overwhelm those benefits. As mentioned before, Brazil has not only been seeing slower economic growth but more recently the threat of electricity rationing due to weak rainfall.
Brazil went through electricity rationing about 12 years ago and the effects were not pretty - industrial output reversed from 10% growth to a 6% contraction, and steel companies suffered from both lower demand and higher costs. With that, many sell-side analysts have been coming out with reports highlighting the risks to CSN, Usiminas, and Gerdau should rationing happen again.
I'm not going to try to argue that electricity rationing wouldn't be bad, but it may not be quite as bad as feared. Gerdau would see higher costs and may have to reduce production, as it is only about 40% self-sufficient for electricity (CSN is 100% and Usiminas is about 30%), but I wonder if its customer base would see less of an impact relative to auto, appliance, and other manufacturers that use large amounts of steel. To that end, I would note the recent price increase of 6% to 8% for steel rebar in Brazil. If demand did decline, there is the possibility of selling steel on the export market (albeit at a lower price).
The Bottom Line
I'm cautiously optimistic that investors have already priced in a pretty bleak scenario for Brazilian steel companies, and Gerdau in particular. Conditions could get worse and the U.S. non-residential recovery could continue to drag along slowly, but the longer-term picture looks pretty good for this well-run company.
The global steel sector trades at an average 2014 EV/EBITDA multiple of 7.0x, with Brazilian steel stocks trading at a discount (and Argentina-exposed Ternium trading at an even steeper discount). While many sell-side analysts argue that Gerdau should trade at a premium to reflect its higher-growth market positioning and its exposure to a North American construction recovery, I'd note that even a 7x multiple would lead to a $7.50 price target and a nearly 20% move from here. Investors are spoiled for choice with beaten-down Brazilian stocks right now, but Gerdau is at least worth a look for its near-term exposure to North America and its longer-term plans to expand its product offerings, leverage growth in Brazil, and target markets like India.
Disclosure: I 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.