- Reliance Steel has provided shareholders with mostly double-digit returns over the past six years.
- The strong returns appear to be partly due to the share price getting well ahead of itself, with share price declines likely.
- The biggest danger to Reliance Steel's share price, and consequently shareholder returns, is a contraction of its P/E multiple closer to historical levels.
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Reliance Steel: Investment Thesis
Reliance Steel & Aluminum Co. (NYSE:RS), as a business, is operating profitably, although below past performance levels due to the COVID-19 impact. The dividend is safe, and the balance sheet sound. But there appears to be a real danger to the share price from potential multiple contraction.
The present P/E multiple is well above Reliance Steel's historical average. P/E multiple expansion has certainly resulted in strong returns for shareholders over the last six years. With multiple contraction more likely than expansion, negative returns are indicated through the end of 2022, buying at current share price levels. A detailed analysis follows.
Looking for share market mispricing of stocks
What I'm primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the "E" in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.
Table 1 - Detailed Financial History And Projections
Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2023 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note - while estimates are shown for analysts' EPS estimates out to 2023, 2024 and 2025 where available, estimates do tend to become less reliable, the further out the estimates go.
These estimates are only considered sufficiently reliable if there are at least three analysts' contributing estimates for the year in question). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7.5% per year through the end of 2022 (see line 12), based on buying at the Feb. 25, 2021, closing share price level. As noted above, estimates become less reliable in the later years.
I have decided to input a target return based on 2022 year, which has EPS estimates from five analysts, because it allows for the impact of the projected EPS growth rates to be taken account of in the assessment of value of Reliance Steel shares. The table shows to achieve the 7.5% return, the required average yearly share price growth rate from Feb. 25, 2021, through Dec. 31, 2022, is 5.88% (line 49). Dividends account for the balance of the target 7.5% total return. Table 2 below summarizes relevant data flowing from the assumption of a target 7.5% total return through the end of 2022.
Targeting a 7.5% Return
Table 2 - Targeting a 7.5% return
Table 2 provides comparative data for Reliance Steel, assuming share price grows at rates sufficient to provide total rate of return of 7.5%, from buying at closing share price on Feb. 25, 2021, and holding through the end of 2022. All EPS estimates are based on analysts' consensus estimates per SA Premium.
Comments on Table 2 are as follows
Part 1 - Consensus EPS (Case 1.1) (lines 1 to 12)
Part 1 shows the amounts the share price would need to increase to achieve a 7.5% rate of return through the end of 2022. The share price would need to increase by $15.08 from the present $135.42 to $150.50 at the end of 2022, for the 7.5% rate of return to be achieved.
Part 2 - Required change in P/E ratio to achieve target 7.5% return (lines 21 to 23)
Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to the end of 2022, to achieve the share price level at the end of 2022 necessary to achieve the targeted 7.5% return. For Reliance Steel, the P/E ratio at buy date can decrease by (6.3)% through the end of 2022 and the 7.5% return would still be achieved. Being able to achieve a targeted return with a decrease in the P/E ratio would normally be regarded as a positive. However, due to the distortions of earnings and sentiment owing to the COVID-19 pandemic, it's difficult to judge whether the change in P/E ratio is a positive or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre-COVID-19 starting point.
Part 3 - Projected change in P/E ratios from 2019 to 2022 (lines 31 to 46)
In Part 3, I start with the share price at Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The end point is projected share price at the end of 2022, when it's assumed the market and earnings are no longer materially impacted by the pandemic, and EPS growth has brought the P/E ratio back closer to historical levels. For Reliance Steel, the share price needs to increase by $35.70 from $114.80 at Dec. 31, 2019, to $150.50 at the end of 2022, and as detailed in Part 1, at $150.50, the targeted 7.5% rate of return would be achieved. For Reliance Steel, there are a number of givens in our assumptions. Using these givens, the change in the share price from Dec. 31, 2019, to the end of 2022, can be expressed as mathematical formulae as follows:
(A) Change in share price, due to effect of EPS growth rate, equals share price at beginning multiplied by (1 plus average yearly Consensus EPS growth rate) to the power of number of years invested.
= $114.80*(1-4.1%)^3 = $101.26
(B) Change in share price due to change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio).
= $101.26*(1+48.6%) = $150.50
The decrease of $13.54 ($114.80 minus $101.26) due to the average yearly EPS growth rate is cumulative, and share price will continue to decrease the longer the shares are held and the decline continues. The increase of $49.24 due to a change in the P/E ratio ($150.50 minus $101.26) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.
Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.
Understanding The Dividend Growth Income+ Club Approach
Dividend Growth Income+ Club logo Copyright: Robert Honeywill 2020
Total Return, Dividends, Share Price
The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.
Changes in Share Price
Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock specific.
Earnings are tipped into the "Equity Bucket" for the benefit of shareholders. It's prudent to check whether distributions out of and other reductions in the "Equity Bucket" balance are benefiting shareholders.
Reliance Steel's Projected Returns Based On Selected Historical P/E Ratios Through the End Of 2022
Table 3 below provides additional scenarios projecting potential returns based on selected historical P/E ratios and analysts' consensus, low, and high EPS estimates per Seeking Alpha Premium through the end of 2022.
Table 3 - Summary of relevant projections Reliance Steel
Table 3 provides comparative data for buying at closing share price on Feb. 25, 2021, and holding through the end of 2022 (or longer if sufficient analysts' estimates are available). There's a total of nine valuation scenarios for each year, comprised of three EPS estimates (SA Premium analysts' consensus, low and high) across three different P/E ratio estimates, based on historical data. Reliance Steel's P/E ratio is presently 17.61.
This is considered distorted by the impact of COVID-19, and it's assumed in due course the P/E ratio will revert to the much lower historical levels per Table 3 above. Table 3 shows a reversion to historical level P/E ratios in 2022 would result in negative returns, under all scenarios. This analysis, from hereon, assumes an investor buying Reliance Steel shares today would be prepared to hold through 2022, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2022 follow.
Consensus, low and high EPS estimates
All EPS estimates are based on analysts' consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely, to high based on analysts' assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as Reliance Steel. I believe the "low" estimates should be considered important. It's prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.
Alternative P/E ratios utilized in scenarios
- The actual P/E ratios at share buy date based on actual non-GAAP EPS for Dec. 31, 2020, TTM.
- A modified average P/E ratio based on 18 quarter-end P/E ratios from Q4 2016 to Q4 2020 plus the current P/E ratio in Q4 2020. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
- A median P/E ratio calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded.
- The actual P/E ratio at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic.
Reliability of EPS estimates (line 17)
Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are four analysts covering Reliance Steel through the end of 2023. In my experience, a range of 3.4 percentage points difference in EPS growth estimates among analysts is not overly high, suggesting a reasonable degree of certainty, and thus reliability.
Projected Returns (lines 18 to 39)
Lines 25, 32 and 39 show, at a range of historical P/E ratio levels, Reliance Steel is conservatively indicated to return between negative (15.5)% and negative (11.1)% average per year through the end of 2022. The negative (15.5)% return is based on analysts' low EPS estimates and the negative (11.1)% on their high EPS estimates, with a negative (12.8)% return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios.
At the high end of the projected returns for Reliance Steel, the indicative returns are still negative, ranging from (5.8)% to (0.9)%, with consensus (2.8)%. But those higher returns require a P/E ratio of 13.42 at the end of 2022. That is equivalent to the median P/E ratio for 2016 to 2019, when the company achieved high EPS growth rates, per Table 1 above. In contrast, analysts estimates for EPS growth from 2019 to 2022 are negative, with 2022 consensus EPS estimate of $9.12 compared to $10.34 for FY-2019.
Review Of Historical Performance For Reliance Steel
Reliance Steel: Historical Shareholder Returns
In Table 4 below, I provide details of actual rates of return for Reliance Steel.
For many stocks where I create a table similar to Table 4 above, I find a wide range of returns indicating a degree of volatility and risk. Table 4 above shows the results for Reliance Steel were double-digit returns, ranging from 15.6% to 56.7%, for all of eight different investors, each investing $3,000 over the last six years and holding to the present. These rates of return are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to Feb. 25, 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.
Checking Reliance Steel's "Equity Bucket"
Table 5.1 Reliance Steel Balance Sheet - Summary Format
Table 5.1 shows an increase of $967 million in shareholders' equity, which was used to fund an increase of $122 million in net operating assets, and a reduction of $845 million in net debt, over the four years Jan. 1, 2017 to Dec. 31, 2020. The combination of the increase in equity and the reduction in net debt resulted in net debt as a percentage of net debt plus equity reducing from 30.3% at Jan. 1, 2017 to 15.8% at Dec. 31, 2020. Outstanding shares decreased by 9.1 million from 72.7 million to 63.6 million, over the period, due to share repurchases offset by shares issued for stock compensation. The $967 million increase in shareholders' equity over the 4 years is analyzed in Table 5.2 below.
Table 5.2 Reliance Steel Balance Sheet - Equity Section
I often find companies report earnings that should flow into and increase shareholders' equity. But often the increase in shareholders' equity does not materialize. Also, there can be distributions out of equity that do not benefit shareholders. Hence, the term "leaky equity bucket." I find this is not the case with Reliance Steel.
Explanatory comments on Table 5.2 for the period April 30, 2017, to Oct. 31, 2020:
- Reported net income (non-GAAP) over the four-year period totals to $2,248 million, equivalent to diluted net income per share of $126.96.36.199.
- Net income growth was strong through the end of 2019, but declined in 2020.
- Over the four-year period, the non-GAAP net income excludes a net $69 million (EPS effect $0.71) of items regarded as unusual or of a non-recurring nature in order to better show the underlying profitability of Reliance Steel. These items reduce non-GAAP result below GAAP result.
- Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund - these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders' equity at any point in time. For Reliance Steel, these items were an $18 million gain (EPS effect $0.27) over the four-year period.
- There were share issues to employees. The amounts recorded in the income statement and in shareholders' equity, for equity awards to staff, totaled $121 million ($1.72 EPS effect) over the four-year period. The market value of these shares is estimated to be $153 million ($2.23 EPS effect). The understatement of expense by $32 million is not material in the context of non-GAAP earnings total of $2,248 million over the four-year period, and not of concern from a "leaky equity bucket" aspect.
- By the time we take the above mentioned items into account, we find, over the four-year period, the reported non-GAAP EPS of $32.37 ($2,248 million) has increased to $32.83 ($2,303 million), added to funds from operations available for distribution to shareholders.
- Dividends of $592 million, and share repurchases of $897 million were adequately covered by the $2,303 million generated from operations, leaving a balance of $814 million added to equity. Shares to staff at market value of $153 million further increased this $814 million to $967 million added to shareholders' equity per Table 5.1 above.
Reliance Steel: Summary and Conclusions
Reliance Steel dividend yield is currently 2.03% so for an investor looking for total return of 7.5% per year, most of that return will need to come from share price growth. Share price growth is driven by EPS growth and/or multiple expansion. Based on SA analysts' consensus EPS estimates, Reliance Steel EPS growth rate for the three years 2019 to 2022 is expected to be negative, per Table 1 above. Therefore, a 7.5% return would be reliant on further multiple expansion. The issue for the Reliance Steel share price is the current P/E ratio is already far above historical levels. For shares purchased at current price levels, a return of multiples closer to historical levels is likely to result in negative returns through the end of 2022, based on SA analysts' EPS estimates.
This article was written by
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.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.
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