Growing Signs Of A Brazilian Recovery Have Fueled A Nice Rally In Gerdau Shares

Dec. 12, 2019 2:50 PM ETGerdau S.A. (GGB)3 Likes
Stephen Simpson profile picture
Stephen Simpson
17.53K Followers

Summary

  • Steel stocks have been strong on growing optimism that the worst is over for pricing, but Gerdau has been even stronger on growing optimism for a stronger recovery in Brazil.
  • Construction and industrial indicators are pointing higher in Brazil, giving credibility to Gerdau's 6-8% long steel growth forecast, and margin leverage could be meaningful.
  • Gerdau shares are more or less trading in line with my estimate of fair value, but further bullishness over Brazil could fuel further gains.

I liked Gerdau (NYSE:GGB) for its leverage to a Brazil recovery story back in October, and the relatively short time since, that story has really caught on with investors. Between the prospect of significant improvement in Brazil in 2020 and more or less stable (but still quite profitable) conditions in North America, Gerdau is looking at solid bounce in 2020 that should make it one of the better growth stories in steel next year.

With the shares running up a third since my last article, I really can't say these shares are undervalued, though the relative value proposition is still fairly attractive next to the likes of Nucor (NUE) and Steel Dynamics (STLD) and considering the more promising near-term outlook relative to Ternium (TX). I usually like to buy commodity stories with a wider margin of error in the valuation, but as a momentum/trading idea, I can't really say Gerdau is a bad one.

Brazil Isn't Booming, But It's Better

Betting on Brazil has been a frustrating call for some time, but at long last, it seems like there are real signs of improvement in that country, and Gerdau stands to benefit significantly.

Getting up-to-date data on the Brazilian market can be frustratingly difficult, but real estate launches continue to improve nicely - not at the same pace as in the first half of the year (where the year-ago numbers were quite low), but still up around 17%, and sales and cancellation numbers are improving as well. Launches are typically a leading indicator for long steel, and I think Gerdau's call for 6% to 8% growth in long steel demand in Brazil in 2020 is credible.

It's not just construction that's looking stronger. Passenger car sales are up 7% year over year on year-to-date basis through November, making this one of the very few strong auto markets of any meaningful size. Demand for buses and trucks is also coming back strongly, with year-to-date growth of around 36% and 40%, respectively. Exports are noticeably weaker (down 32% on weak demand in Argentina), and so production isn't growing as much (up 3% year-to-date), but that's still a pretty encouraging number. Coupled with a return to growth in 14 of 17 industrial sectors that Gerdau serves, management's call for 2% to 4% flat steel growth in 2020 seems reasonable as well.

With demand seemingly improving, Gerdau is showing that it also intends to be active on pricing. The company recently announced another price hike for long products - an 8% to 12% hike effective in January that followed a 7% hike in September (about half of which stuck).

Better still, it's not just about a revenue recovery. Gerdau's Brazilian operations are under-utilized at present, and as utilization moves from the 60%'s into the 70%'s and perhaps even the 80%'s if the recovery lasts, Gerdau's margins will improve significantly. Likewise, given opportunities to redirect current production from the export market (where prices are substantially lower) to the domestic market.

Stability Is Good Enough For North America

Gerdau's management has more or less my view on the North American steel market for 2020 - that there's likely to be little, if any, demand growth. I believe more weakness is possible over the next three quarters (even with restocking) on slowing short-cycle markets, but I do expect that a recovery/return to growth in the second half should improve demand later in the year. Gerdau does still have some additional cost levers it can pull for the U.S. ops, but more or less stable profitability at around $85/ton wouldn't be a terrible outcome for Gerdau relative to historical norms.

Investors should also note that the threat of renewed tariffs on steel (and aluminum) exports from Brazil and Argentina that President Trump tweeted out earlier this month will have no meaningful impact on Gerdau. The company doesn't export from Brazil to the U.S. Ternium, by comparison, does have some exposure, as its shipments to the U.S. (about 15% of total shipments) are sourced from Brazil, though here too, the company's contract with Calvert is an "under delivery and duty unpaid" type, so Calvert should bear the tariffs, not Ternium.

A Change In Strategy, Or A One-Off Opportunity? The Later, I Think…

In a somewhat surprising move, Gerdau announced in late November that it was acquiring virtually all of Silat, a rebar and wire rod producer in Northeast Brazil. Gerdau is paying just $110 million, or about $185/ton for the 600ktpa rolling capacity of Silat.

After a focused effort to sell off assets, why would Gerdau do this? I can see a few reasons.

First, Silat will add more exposure for Gerdau in the Northeast of Brazil (Silat is in the state of Ceara). Second, this is a good price for long rolling capacity ahead of what should be a multiyear recovery in Brazil. Third, Silat presently uses imported billet from China, but Gerdau can substitute in its own domestically-produced billet and improve margins.

I don't believe this is the start of a new M&A program. Rather I think this was a one-off deal that offered a useful asset at a good price.

The Outlook

Brazil is showing more signs of strength in 2020 than I expected, but then, I was already modeling Gerdau on the basis of a recovery in 2020, so I don't want to get too far ahead of myself with modeling. I'm still expecting Gerdau to generate low single-digit long-term revenue growth and improve its free cash flow margins into the mid-to-high single-digits over time. With my updated free cash flow assumptions, I think $4/ADR is a pretty fair price on a cash flow basis, but I'd note that you can typically only buy commodity stocks below DCF fair value on the downside of the cycle. I do, however, also get a similar result with my EV/EBTIDA model (using my 2020 EBITDA estimate).

The Bottom Line

I believe using a forward EBITDA multiple consistent with the long-term full-cycle average is appropriate, but I'm sure some will argue for a higher multiple to reflect the improving EBITDA growth and margin prospects. So be it. Although I don't think Gerdau shares are much of a bargain on a fundamental/quantitative basis, I recognize that Gerdau is likely to have relatively strong performance relative to its peers in 2020 and that results could exceed expectations. As a value-driven investment, I'm not so positive on Gerdau anymore, but as more of a momentum/trade idea on Brazil's emerging recovery, I can see the logic in holding/buying these shares.

This article was written by

Stephen Simpson profile picture
17.53K Followers
Stephen Simpson is a freelance financial writer and investor. Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds); now a semi-retired raccoon rancher. That last part isn't entirely true. Probably.
Follow

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.

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.