Brazil’s Gerdau (GGB) offers a curious investment proposition today. Although the shares have lagged Ternium (TX) over the past three months, Gerdau has been the best-performing steel stock of the group I follow closely, and by a fairly wide margin (outperforming #2 Ternium by close to 15%). Gerdau is also one of the few steel companies/stocks where there is basically a unanimous expectation of EBITDA heading higher for the next two to three years, largely on the back of an expected recovery in Brazil.
Metal spreads may well have peaked in the U.S. (where Gerdau generates close to a third of its EBITDA), but volume demand growth is expected to continue and Gerdau has under-utilized capacity it can bring into action. What’s more, spreads in Brazil could still improve and Gerdau is still reaping the cost savings benefits of digital investments. Gerdau’s valuation doesn’t scream “bargain”, but in the real world of stock performance, this is still a name to consider given its potential for further upward earnings revisions and its capacity to grow at a time when many peers will see earnings contraction.
Brazil Should Get Better From Here
Brazil has seen a halting (at best) recovery from a bruising recession, but expectations are that conditions in the country will get better from here. The World Steel Association is calling for better than 6% steel demand growth in Brazil in 2019, and Gerdau believes they could do a little better than that given their skew towards areas like autos, energy, and construction.
EBITDA in Brazil nearly doubled in the third quarter despite a 4% overall shipment decline (domestic shipments were up 11%, while exports were down a third), and the margin exceeded 20% with an EBITDA/tonne more than 10% above ArcelorMittal’s (MT) result in Brazil. And yet, Gerdau is operating at only around 70%-72% capacity utilization in Brazil and could quickly restart additional capacity on improving demand.
Whether that bullish outlook materializes is of course an open question. Weak oil prices aren’t exactly conducive to big energy investments, though the breakeven points for Brazilian projects are still attractive for most operators. On the auto side, car production was down 2% yoy in November (with exports down 58%), but still up 7% on a year-to-date basis. Although 2019 could be a still-challenging year for global auto production, putting Gerdau’s expectations at risk, the longer-term outlook is attractive, and Gerdau is spending $140 million to expand its Pindamonhangaba plant capacity about two-thirds to produce more specialty steels for the auto sector. Gerdau has also recently formed a joint venture with Votorantim and Tigre (“Juntos Somos Mais”) to target smaller construction stores in Brazil.
The U.S. Opportunity Still Attractive For Gerdau
U.S. steel prices have dropped by double-digits from the peak during the summer, and metal spreads have likewise started to contract. Nevertheless, the outlook for Gerdau in the U.S. is still attractive on balance.
Gerdau saw a strong improvement in its U.S. profitability in the third quarter (EBITDA margin up more than four points to over 10%), but still lags Steel Dynamics (STLD) and ArcelorMittal on a per-tonne basis rather substantially. Between divesting lower-margin assets (including the sale to Commercial Metals (CMC) ), boosting capacity utilization (around 80% in the quarter versus nearly 100% for Steel Dynamics), and continuing to leverage digital investments to drive lower SG&A, Gerdau should benefit from not only a lower cost base and richer mix, but also the ability to supply incremental capacity to the market.
While Gerdau management seemed to acknowledge during its recent investor day that U.S. spreads have likely peaked for the cycle, they still expect spreads to remain elevated versus historical levels due to the 232 tariffs. Like Steel Dynamics, Gerdau seems to believe that tariffs could one day be replaced by quotas, but time will tell. In terms of the near-term outlook, Gerdau expects steady U.S. commercial construction activity in 2019 and also expects more government action on infrastructure projects – a view that I believe could be a little optimistic (I expect the government may well talk about it, but whether they do anything is very much up for debate).
Overall, A Better-Run Operator
All in all, I think Gerdau management has been making good decisions here of late. The company’s mix of long versus flat is still not exactly ideal, but like Steel Dynamics, Ternium, and POSCO (PKX), management has been trying to shift more resources towards higher-value areas like auto steel. Management has also executed well on a program to sell lower-quality non-strategic assets, and the new/current asset base should be more profitable in the future due to its lower commoditization.
Looking ahead, management is focused on the things that investors should want them to be – operating profitability and free cash flow generation. Management is expecting to make further investments in digitalization to lower SG&A costs and it doesn’t sound like there’s much inclination to acquire/build assets outside of more specialized/higher-margin products. While the dividend policy is remaining steady with a target of 30% of net income, that net income should head higher in the coming years as Brazil recovers.
My modeling assumptions haven’t changed all that much, and I’m still looking for long-term revenue growth in the mid-single-digits and low double-digit FCF growth driven by the recovery in Brazil, the better mix of business, and the lower operating cost base.
Valuation is challenging, though. The shares look a little undervalued on a DCF basis, but DCF isn’t a favored approach in steel stocks (it’s simply too difficult to accurately/reliably forecast the cycles). Using Gerdau’s long-term average forward EBITDA multiple of 6.75x would support a modestly higher stock price. I also like to use ROE as a valuation driver for steel stocks (particularly international/multinational players), as there are strong long-term correlations between ROE and P/BV in the sector. Unfortunately, Gerdau shares just don’t look all that cheap with this approach; the company’s improvement in ROE is already expected by the market.
The Bottom Line
As I’ve written recently in reference to Steel Dynamics and other steel companies, I’m reluctant to trust those low apparent valuations given the fact that steel stocks don’t tend to do well when prices, spreads, and profits are declining. Gerdau, though, could well be in position to see improving EBITDA over the next few years and improving company-specific spreads (from a better mix and lower SG&A). While that doesn’t trump my concerns about valuations (and I’d still prefer Ternium), it does lead me to believe that this is still a valid way to play a turnaround in Brazil’s economic fortunes.
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.