Gerdau: A Study In Risk Vs. Opportunity

About: Gerdau S.A. (GGB)
by: Stephen Simpson, CFA

A desperately weak home market in Brazil has weighed heavily on Gerdau, as domestic demand shrank more than 20% in 2015 and could shrink by double digits again in 2016.

The North American operations are doing quite a bit better on strong auto and construction demand and actions to reduce Chinese production/imports ought to help firm up pricing.

GGB looks undervalued, but the timing of a Brazilian rebound is uncertain, and the company's uninspiring record of economic profits doesn't inspire confidence.

Brazilian steel giant Gerdau (NYSE:GGB) has seen its ADR share price double in the last month and a half, helped by better currency and the prospect that the political mess in Brazil may be heading toward a resolution that will allow those who remain in charge to start tackling the significant economic challenges facing the company. There has also been more optimism lately on steel, as the U.S. passed a highway bill and has been taking on low-priced imports through tariff actions, and as the Chinese may actually be serious about shutting down a meaningful amount of capacity.

I know readers don't want to see a cop-out like "valuing Gerdau is really hard right now," but it is the truth. A significant chunk of the negative movement in my fair value from last year can be tied to the movement in currency that sapped the value of the company's real-dominated cash flows and increased the debt burden, but there's no certainty that reverses. Likewise, while Brazil has significantly under-invested in infrastructure and has a low level of steel consumption that suggests very large growth potential, there's no guarantee that happens in what I'd consider to be a reasonable investment time frame.

I do believe these shares are undervalued, but management has made some questionable moves. That only adds to the already risky macro picture. There could be money yet to be made here, but this is making money the hard way.

Some Good News, But Mostly Bad From The Fourth Quarter

As bad as things are in the Brazilian steel sector (or the global steel sector, for that matter), I think it's important to note that Gerdau and CSN (NYSE:SID) are still profitable and that Gerdau is still generating positive cash flow. ArcelorMittal (NYSE:MT) (a global player with sizable Brazilian ops) and Usiminas (OTC:USNMY) aren't faring as well, though ArcelorMittal's Brazilian operations were profitable in the fourth quarter of 2015 and full year absent an impairment charge. Therein lies part of the problem - producing steel in Brazil is still basically a profitable enterprise, so production discipline has been lacking and pricing has stayed under pressure amid tough domestic conditions.

Gerdau saw its fourth-quarter sales fall 4%, meaning the year was bracketed by two down quarters (sales were down 1% in the first quarter) with 3% and 11% growth in the other two quarters. While realized prices were up 11% on average, shipments declined 12% as Gerdau was one of the few to actually behave responsibly in my view.

Revenue in Brazil fell 29% on a 40% decline in domestic steel shipments and a 52% increase in exports. Realized domestic prices rose 3% from last year while domestic prices fell 12%. Profitability plunged, with EBITDA down by almost three-quarters.

Revenue in North America rose 17% on a 3% decline in shipments, as some of the company's lines are running almost all-out keeping up with demand in auto (SBQ) and construction markets. EBITDA nearly doubled from last year, and this is one of the relatively rare periods where Gerdau's North American results compare pretty favorably to Steel Dynamics (NASDAQ:STLD), one of the best-run steel operators.

All told, Gerdau's revenue came up about 5% short of expectations while EBITDA was almost 15% below expectations. Profitability was sapped by the weak results in Brazil, as well as weak energy demand for specialty steel in North America. On the bright side, the company posted a surprisingly large amount of free cash flow (due to reductions in working capital) and management guided for a one-third reduction in capex in 2016.

Not All Of The Moves Have Been The Right Ones

Gerdau's management generally gets praised for its operating performance, but there have been some troubling developments. The "Operation Zelotes" investigation drags on, with an arrest warrant issued for the CEO over allegations of bribery and tax evasion, though the company continues to maintain its innocence.

More concerning was a mid-2015 decision to spend almost R$2 billion (more than $500 million at current exchange rates) to acquire a slew of minority interests (between 2.4% and 4.9%) in various subsidiaries. While I can generally appreciate the idea of simplifying the corporate structure and I will note that the actual cash outlay was low (R$399M), the company paid a nearly 100% premium for these stakes and used its already-undervalued shares to fund about 10% of the purchase price. This wasn't a make-or-break transaction, but it was an unneeded waste of money.

With that, I wonder how seriously to take management's comments that it is looking for value-enhancing asset sales. Selling the forestry ops would be fine and selling the often-unimpressive non-Brazilian South American steel operations makes sense, but will the company select the right assets to sell and will it get good value? Selling the North American operations would, for instance, be a very short-sighted move in my opinion.

Times And Conditions Are Changing, But Will They Change Fast Enough?

There are a lot of things that Gerdau needs to really prosper again. With the Brazilian operations still making up over 35% of full-year EBITDA, Gerdau really needs to see a healthier Brazilian economy. Domestic demand declined more than 20% in 2015 according to management, and another significant drop could be on the way this year as key steel-using markets like construction and autos look weak.

Assuming that the Brazilian economy can get back on track in 2017/2018, there are reasons for long-term optimism. According to an analysis run by Leonardo Correa at BTG Pactual, Brazil's investment to GDP ratio is a startlingly low 19% versus 25% for Latin America, 32% for India, and 50% for China. Likewise, the steel intensity in Brazil is just 120kg per person versus 160kg for Latin America and 560kg for China. Given the comments by companies like Cosan (NYSE:CZZ) and Adecoagro (NYSE:AGRO) on the limitations created by the inadequate infrastructure in Brazil, this looks like a key area to address if and when the government is serious about stimulating and supporting sustained economic growth.

Gerdau also needs to see an overall stronger market for steel worldwide, and particularly in the U.S. The U.S. has actually been relatively healthy recently given the strength in auto production and construction, but weak prices brought on by excessive unprofitable Chinese production has been a global issue for the industry. It's finally sounding as though China might be serious about curtailing uneconomic production - not only has the U.S. government stepped up anti-dumping actions, but also the Chinese government has instituted a fund to support the shutdown process (assistance to displaced workers and so on) and made it illegal for state banks to renew the loans of so-called "zombie" producers. All told, there's optimism that a high-single-digit percentage of Chinese production could get shut down and remain shut.

While arguably more of a throw-in relative to recoveries in Brazilian demand and global prices, the possibility of iron ore exports is still noteworthy. Gerdau is self-sufficient in iron ore by way of company-owned mines in Minas Gerais, but the company is producing only a little over a third as much iron ore as it expected to a few years ago; the fall in iron ore prices has made mining and exporting surplus ore unattractive. While it would probably take prices of $80/t or higher to make this truly exciting, management said it may start exporting at prices above $60/t, and recent prices have been in the mid-$50s.

Estimating Fair Value

Gerdau's currency-driven year-end debt revaluation stripped out around $0.80/ADR of fair value, so that's hardly trivial. Likewise, another $1.00 or so vanishes by virtue of the different exchange rate between now and my last article on the company. Removing $1.80 from a $4.50 to $5.50 fair value is pretty damaging, and given the magnitude of the numbers we're talking about, the $0.15/ADR that I estimate Gerdau overpaid for its subsidiary consolidation effort is arguably material.

My overall underlying cash flow estimates haven't changed quite so much, though, as I still believe that Gerdau can generate mid-single-digit long-term revenue growth on the back of better global steel prices and an eventual recovery in Brazilian demand. Although I expect free cash flow generation to be weaker in 2016 on Brazilian margin weakness and weak in 2017 and 2018 as a Brazilian recovery leads to net working capital investment, I'm still sticking with long-term FCF margin assumptions that work out to about 4.5% over the long term.

While both my discounted cash flow and EV/EBITDA processes suggest the shares are undervalued by more than 20%, I'm not sure that's enough given the outsized risks with Brazil right now. Here again, currency matters, but there is no guarantee that the Brazilian real regains what it has lost, let alone does so as quickly as it lost it.

The Bottom Line

I realize that this is heresy to value investors, but I do agree that sometimes you can lose the forest (is the stock going to go up from here?) for the trees (the minutiae of year-by-year modeling). If Brazil reaches a bottom in 2016 or 2017 and the government gets behind a meaningful program of infrastructure improvement/modernization, I think Gerdau's shares will be higher in three to five years' time.

The problem is that Brazil could remain an underperforming mess longer than anyone cares to think (look back on those projections for African countries from the '90s, '80s, '70s, and '60s) and Gerdau hasn't always run itself as a top-notch player. As a spin of the roulette wheel, I think Gerdau may still be something to consider even after the 100% bounce off the bottom. As a true "investment," though, there are a lot of risks to digest for a commodity company with no control over its demand environment and a record of economic profits that is far from flawless.

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.