Steel Dynamics Getting No Love Despite Excellent Margins And Cash Flow

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About: Steel Dynamics, Inc. (STLD), Includes: NUE, TX, X
by: Stephen Simpson, CFA
Summary

Record earnings are outweighed by worries that pricing has peaked, particularly with the U.S. steel industry adding/restarting meaningful capacity.

Steel Dynamics' new 3Mtpa plant is the biggest of the capacity expansions announced to date, but the price per ton is reasonable, as is the desire to target attractive markets.

Steel Dynamics looks undervalued on forward EBITDA, but EBITDA is likely to start declining, and valuation norms are less reliable in the wake of cyclical peaks.

These remain tough days for the steel sector. Although protectionist policies and healthy end-markets have significantly improved the price environment for U.S. producers like Steel Dynamics (STLD), Nucor (NUE), and ArcelorMittal (MT), prices have softened and meaningful capacity expansions are now on the board. With Steel Dynamics planning the biggest expansion so far announced, there are renewed risks that this marks the peak of the cycle, even though the capacity expansion makes a lot of sense for the company for the long term.

When I last wrote about steel stocks in late September, I was concerned that the risk/perception of peaking steel prices and EBITDA would make it difficult for these stocks to get ahead, even though I thought Nucor looked a little too cheap relative to Steel Dynamics and other steel stocks. Since then, both stocks have weakened further, but Nucor has noticeably outperformed Steel Dynamics over that limited time period. The nearly 25% pullback in Steel Dynamics does make the stock more interesting today, and the “stronger for longer” bull argument could still prove valid, but this looks like a tough place to earn market-beating returns.

Adding Capacity At The Peak?

Significant capacity expansions have often marked the peaks in past commodity cycles, and the market is clearly worried that that is happening again in the steel sector. Those concerns have only intensified with the late November announcement from Steel Dynamics that it intends to build a new 3 million ton per year plant in a couple of years.

There were already around 8 million tons per year in announced flat capacity expansion/restarts before the Steel Dynamics announcement (including the U.S. Steel (X) Granite City project), with Nucor, JSW, and Big River all undertaking roughly 1.5 million ton/year projects, and Steel Dynamics’ proposed plant alone would increase U.S. capacity by about 2%.

With Nucor management expecting roughly 2% annual growth in U.S. steel demand over the next five years, that means about 6 million tons of steel need to be added to maintain status quo, and the Steel Dynamics plant likely wouldn’t be operational until the second half of 2021. That gives the industry some “wiggle room”, but it remains to be seen whether protectionist measures designed to limit steel imports into the U.S. will remain in place over time.

Even if this isn’t great news for the steel industry in the U.S., it’s a logical move for Steel Dynamics. The company is basically operating at the limit of its capacity, and this new plant would increase its steelmaking capacity by about 29%. Locating the plant in the southwestern part of the U.S. will also give the company the opportunity to target attractive construction and energy markets in the South and West regions of the U.S., as well as expand its leverage to somewhat less commoditized markets like autos and appliances (the new plant will include galvanizing and paint lines). Along those lines, Steel Dynamics also intends to use this plant to export steel into Mexico’s auto and appliance markets - a development that is not exactly welcome news for Mexico’s Ternium S.A. (TX), nor other players in Mexico’s market like Nucor and POSCO (PKX).

I’d also note that this looks like a reasonable use of capital on the part of Steel Dynamics management. The intended cost of the new plant (around $550-600/ton) is higher than Nucor’s Gallatin expansion project (around $465/ton) but attractive next to Big River’s $800/ton Big River project. While Steel Dynamics would almost certainly have preferred to buy underutilized existing assets, it’s a seller’s market in steel, with Big River reportedly looking for a $3 billion valuation or more in recent buyout discussions (for a company with 1.65Mtpa in current capacity) versus the $485/ton that Steel Dynamics paid for its Columbus acquisition back in 2014.

Making Hay While The Sun Shines... But Clouds Are On The Horizon

Third-quarter earnings reports from the steel sector were strong, and Steel Dynamics was no exception. With strong pricing flowing into results, the company posted 32% revenue growth on 9% shipment growth and 81% growth in adjusted EBITDA, with record profits in the steel business (and segment-level EBITDA margin of 25%).

Demand from sectors like construction, energy, and autos remains strong, even though commercial construction activity has moderated and light vehicle unit sales have weakened (down about 1% yoy in November). Steel prices have started to soften, however, with hot-rolled coil prices now down about 15% from the mid-summer peak and down double digits from the third-quarter average. There are multiple reports of “room to negotiate” with mills on larger orders, and Nucor’s guidance for the fourth quarter wasn’t particularly robust.

Metal spreads are still well above historical norms, with recent spreads about 40% above the long-term average. That’s great for near-term profitability for steel producers, but multiple industrial companies have started to report demand pressure due to higher input costs, and I believe sequential price increases are going to be very challenging for the steel industry outside of some specialty products.

On top of all that, it remains to be seen whether the protectionist policies that have helped support prices will remain. Officials from Canada (including the Prime Minister) have made it clear that they expect Section 232 tariffs on steel to be pulled back with the new USMCA treaty between the U.S., Canada, and Mexico (the “new NAFTA”), and there has been pressure from other quarters to reconsider these tariffs. For its part, Steel Dynamics management has said that they’d prefer to see an import quota system (as opposed to tariffs), but there’s still ample uncertainty about what the steel import situation will look like in 2019 and beyond.

The Outlook

I believe Steel Dynamics can continue to modestly outgrow the pace of steel demand growth in the U.S., and I likewise believe there is room and opportunity for the company to generate long-term mid-single digit free cash flow growth. For better or worse, though, discounted cash flow isn’t all that useful with steel stocks (at least for shorter-term horizons).

EV/EBITDA is still the preferred approach of most investors, and Steel Dynamics continues to look significantly undervalued on a 6.75x forward EBITDA multiple. Although this is a reasonable “full-cycle” multiple, steel stocks often trade at discounts to the full-cycle multiple at or near market peaks, and it is quite likely that 2018 will be the peak EBITDA for at least a few years.

The Bottom Line

It’s tough to make money buying steel stocks into expectations of annual declines in EBITDA. There may still be opportunities for the sector - and Steel Dynamics - to extend this peak into a plateau, but the Street remains unconvinced. While I do think there could be a possible rebound trade from these levels, this is a tough call for longer-term investors given the weak sentiment on pricing momentum and growing capacity.

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.