BlueScope Steel: 50% Upside In This Aussie Stock

Summary

• BlueScope Steel has successfully diversified into a value-added business, with several unique segments contributing to revenue.
• Today the company has a much lower dependency on export driven commodity sales.
• Despite a large run-up in the stock price since August 2017, it remains conservatively valued with large upside remaining.

The Stock

BlueScope Steel Ltd (OTCPK:BLSFF) is the third largest manufacturer of painted and coated steel products globally. The independent Jacobson survey listed BlueScope's North Star operations as the leading mini-mill in the US based on quality. With its current valuation of a PE ratio of 13, I believe the market is significantly underestimating the effect that several macroeconomic tailwinds will have on growth within the company. The global uplift in growth over the last several years has greatly benefited BlueScope as demand for its value-added steel products increased, and will continue to do so. Recent changes in Chinese steel production/distribution (which resulted in less low quality Chinese steel flooding the international market) have increased prices for high quality Western steel and value added steel products.

(Source: Google Finance)

Steel Price Increases

The decline in Chinese exports is benefiting international producers; ArcelorMittal, the biggest steel maker, reported its best six months' profit in half a decade last month. At the same time, Chinese producers are gaining from surging margins between steel prices and costs such as iron ore and coking coal. The shift, along with plans by China to shutter excess capacity, has blunted accusations by US politicians including President Donald Trump that a flood of cheap Chinese steel is destroying jobs for steelworkers abroad. China plans to close 50 million metric tons of steel capacity this year and as much as 150 million tons in the five years ending 2020 as it seeks to make the industry less dependent on the state.
(Source: AFR - Chinese steel prices forecast to hold steady through September)

Trump's Steel Tariffs

While unveiling BlueScope's half-year results (including a 23 per cent jump in net profit) BlueScope's CEO said the Trump Administration's proposed steel import crackdown would affect its Australian steel exports and US west-coast operations, but would actually benefit the BlueScope-owned North Star steel mill in the US state of Ohio.

BlueScope's North Star mill produces two million tons of steel a year and employs nearly 400 people and is currently an "extremely profitable business".

BlueScope Steel, which has previously argued that it shouldn't be punished by protectionist measures, said it would not know the full impact of any tariffs until more details were revealed. ​"We are still hopeful of an exemption given our compelling case," a spokesman said.
But the steelmaker has been pushing hard in the US to be considered a special case because it employs 3000 people and owns $3 billion in American assets. It says it is not a traditional steel exporter because it has operations in California and Washington that coat hot rolled coil brought in from its Port Kembla operations in NSW.
If Australia is hit by tariffs, BluesScope's US operations are expected to benefit.
(Source: Australian Financial Review)

It currently remains unknown if Trump's steel tariffs will even apply to Australia, given Trump's previous communication with Australian Prime Minister Malcolm Turnbull:

Donald Trump "emphatically" promised to exempt Australian steel and aluminium from US tariffs during a meeting with Prime Minister Malcolm Turnbull last year, it can be revealed.
The ABC understands the promise was witnessed by high-ranking officials on both sides of the meeting, which was held on the sidelines of the G20 meeting in Hamburg, Germany, in July 2017.
(Source: ABC News)

While I believe it is unlikely Trump will break such a promise with a major ally, his personality makes it difficult to be completely sure, and BlueScope's USA operations limit any damage to the company's revenue caused by Trump's tariffs.

BlueScope's Growth

A Significantly Improved Company

Over the past 10 years, the company has undergone a major transformation which both diversified the company (reducing exposure to commodity prices) and created new growth opportunities;

If you look closely at BlueScope today, you can see a vastly different company from that of 10 years ago when Paul (O' Malley -Ex CEO) assumed the job. Ten years ago the world could not supply enough steel to meet the growth in China. As undersupply changed to significant oversupply over that time, BlueScope had to change also. Today the Company has a much lower dependency on export driven commodity sales. Today BlueScope has refocused the Company to serve the changing needs of its domestic customers in Australia, New Zealand and the United States, where it has primary steel making facilities. Service and cost competitiveness are key.
(Source: BlueScope 2017 AGM)

As we can see, while the Australia Steel Products segment provides the largest amount of revenue, the other segments provide substantial revenue streams:

(Source: BlueScope 1H18 Update)

BlueScope's outlook for 2H FY2018 (after deducting the one-off benefit of the $32.1M coal settlement from 1H FY2018 underlying EBIT) for the second half is for underlying EBIT to be around 25% higher. This is of course dependent on FX and market conditions, and BlueScope has assumed the following:
-East Asian HRC price of ~US$600/t
-62% Fe iron ore price of ~US$70/t CFR China
-Index hard coking coal price of ~US$210/t FOB Australia
-U.S. mini-mill spreads to be US$40/t higher than 1H FY2018
-AUD:USD at US$0.79.

(Source: BlueScope 1H18 Update)

I have highlighted the impact of changes in the AUD/USD exchange rate on BlueScope's earnings. This is significant, as I believe the forecast exchange rate they have listed of AUD/USD 0.77 is highly overestimated, as I forecast AUD/USD to average closer to 0.72 due to changing yield differentials between the two nations (I have detailed this thesis in my blog). This would increase BlueScope's earnings by around $30M AUD due to the indirect impact this exchange rate would have on the combined groups' earnings.

Dividend/Share Buyback

BlueScope's capital management includes both a dividend distribution and a share buyback through 2017 and 2018:

"The Board was pleased to approve the return of $340 million to shareholders during CY2017 through dividends and the on-market buy-back, while at the same time investing capital in growth and reducing net debt. In light of the Company's strong cash position, the Board has approved the payment of a partially franked interim dividend of 6.0 cents per share. As well, the Board has extended the on-market share buy-back by a further $150 million.
(Source: BlueScope 1H18 Update)

Financial Performance

Over the last 6 years, BlueScope has increased is revenue y/y. Management has displayed their ability to diversity and expand, and I believe over time the company will undertake more strategic acquisitions, which will lead to further growth:

(Source: Commsec Research)

Conclusion:

BlueScope Steel has successfully diversified into a value-added business, with a much lower dependency on export driven commodity sales. Despite a large run-up in the stock price since August 2017, it remains conservatively valued with large upside remaining. I recommended entering a long position at today's price and holding for a minimum of 3 years.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s 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.