Steel Dynamics Has Near-Term Challenges, But The Valuation Is Getting Interesting

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

Higher costs chewed into first quarter profits, and the U.S. economy may not be strong enough to support demand and price assumptions for the remainder of 2019.

SDI's decision to start building capacity at the peak of the cycle may help explain the share price underperformance, but it is a strategically sound decision from a longer-term perspective.

Adding long capacity would make sense, but likely isn't a near-term priority.

Steel Dynamics shares look undervalued assuming a peak-to-peak FCF growth rate in the low single-digits and/or using a forward 6x EBITDA multiple.

I was “cautious” on Steel Dynamics (STLD) back in January due to the challenges that come with descending from a cyclical peak, but it has still been among my favorite steel names for some time. To that end, I’m a little surprised that it has underperformed the sector since that last article, though another of my preferred names, Ternium (TX), has done even worse, while Nucor (NUE) has done a little better. On the other hand, a quick look at AK Steel (AKS), ArcelorMittal (MT), Gerdau (GGB), or U.S. Steel (X) and you realize it could still be worse.

I still believe this is a very well-run steel company, but I’m also still concerned about the underlying health of the U.S. short-cycle economy, the prospect of weaker demand and prices, and higher conversions costs. If that weren’t enough, there’s also the matter of meaningful U.S. capacity additions in sheet steel over the next few years. I do believe that Steel Dynamics is undervalued and might have some longer-term appeal now (particularly for investors with a more bullish outlook on the U.S. economy), but I do think Nucor has the better product mix for the next 6 to 18 months.

Costs Take A Bite Out Of Margins

I can’t really say that Steel Dynamics posted a good first quarter. Management guided down during its mid-quarter update and EBITDA still came in lower than expected due to higher conversion costs.

Revenue rose 8% year over year and fell about 3% sequentially, with total shipments close to flat (up/down a half-point or less). External steel shipments rose 1% yoy and qoq, with stronger growth in flat products, and price realizations improved by 10% yoy and contracted 4% qoq. Shipments from the fabrication business declined 3% yoy and 11% qoq, with prices up 17% and 2%.

Higher conversion costs hit profitability in the quarter, with weaker gross margins and weaker margins on down the line from there. EBITDA fell 5% yoy and 17% qoq on an adjusted basis, despite a small decrease in scrap costs. On a per-ton basis, Steel Dynamics’ steel business was basically in line with Nucor, and these remain exceptionally profitable operators within the steel sector.

Utilization remained strong in the quarter at 90%, down only a little from 94% in the year-ago period.

Can The Market Support Management’s Guidance?

Steel Dynamics management believes that the flat steel market inflected in mid-February, and it’s certainly true that the market did improve at that point. Both Steel Dynamics and Nucor managements offered fairly bullish outlooks for the businesses, pointing to healthy demand in markets like construction and energy, ongoing expected share gains in autos, and expectations of healthy pricing.

I’m more skeptical. It’s true that U.S. shipment growth was fairly healthy through March (up 2.9% on a year-to-date basis), but I expect the double-digit growth in construction and energy will slow as the year goes on, and I’m concerned about weakening demand in shorter-cycle manufacturing and heavy machinery. The auto market (where steel shipments were down 10% on a year-to-date basis) should improve as the year goes along, and Steel Dynamics has ongoing share gain opportunities, but I think ArcelorMittal has the right idea with an underlying consumption growth forecast of 1% for North America in 2019.

As far as pricing goes, U.S. sheet prices are down about a quarter from the year-ago period, though more stable on a recent comparison (the last three months). Rebar has held up better, but that is much more advantageous for Nucor and Commercial Metals (CMC). I’m expecting mid-to-high double-digit declines in hot-rolled coil prices relative to 2018, but I expect rebar and structural (beams) to be up slightly. The latter will help Steel Dyanmics; Nucor has better overall leverage to long products and plate, but Steel Dynamics does have good exposure to SBQ, merchant bar, and structural steel (around one-quarter of capacity).

The “but” there is that those long products are used in non-residential construction, autos, energy, and heavy machinery – all areas that could still be disappointing from a demand perspective. The company’s leverage to rail is nice, but not large enough to really make a major difference.

Adding Capacity, But Still Returning Capital

I’ve discussed Steel Dynamics’ plans to add capacity in the past, and the company is moving forward with its plans for a new mill with 3Mtpa of capacity. It looks like the company is considering Texas or Louisiana; either way, the plant will be closer to markets in the Southern/Southeastern U.S. as well as the auto assembly markets in Northern Mexico. This plant will include a 450Ktpa galvanizing line and will also have a thicker cast section – allowing Steel Dynamics to produce more higher-strength steel products for end-markets like auto and energy.

Starting a project to add capacity during the peak of a cycle was never going to go over well with the market in the short term, but like Nucor, Steel Dynamics management runs the business for the long term, and the company needs more capacity. The company has been gaining share in markets like autos and construction, and with capacity utilization of over 90% today, there’s just not much room to service future share growth.

Luckily there isn’t an “either/or” between investing in future growth and sharing success with shareholders. Management announced a 28% increase to the dividend, and although management won’t be able to fully cover the dividend from free cash flow during the peak capex years of 2020 and 2021, the company’s balance sheet is fine and the future FCF generation potential of the business doesn’t give me any concerns about liquidity.

The Outlook

I have an incrementally more bearish outlook for 2019 and 2020 than the Street, so my revision after the first quarter aren’t that significant, though I am reducing my near-term margin expectations on the higher conversion costs. That pushes my fair value range from the mid-$30’s to $40 to the low/mid-$30’s to mid/high-$30’s, but the shares still look undervalued.

Among the assumptions that drive that valuation range, I’m looking for low single-digit peak-to-peak FCF growth, so I think there is room for Steel Dynamics to outperform on revenue (leveraging the new project and share gains) and margins assuming the underlying market cooperates. On EV/EBITDA, I’m still using a 6x multiple – that is below the long-term average, but I don’t believe in using a long-term average multiple at/near a peak in the cycle.

The Bottom Line

I can’t say I’m terribly excited about any U.S. steel company right now, but Steel Dynamics and Nucor are managed so well that I never completely dismiss them as investment ideas. I do like the long-term opportunity to gain share in value-added markets and displace more steel from less efficient operators, but I think there are greater risks that steel demand and prices disappoint than exceed expectations this year. Given what I think are conservative underlying assumptions, the nearly double-digit long-term annualized implied returns implied in my cash flow model today definitely has my attention, and I’m considering adding this stock as a hedge against my own thesis that U.S. growth will disappoint in 2019.

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.