Commercial Metals Earnings and the Domestic Steel Market

by: Energy Solutions Partners

Last month I wrote about the pricing power that many US based steel firms had. I also posted how the weak US dollar and low inventory levels would lead to above average returns for my steel focus list. Here are those steel firms and their price increases since May 2:

  • Gerdau Ameristeel (GNA): 23%
  • Steel Dynamics (NASDAQ:STLD): 20%
  • Reliance Steel (NYSE:RS): 23%
  • Commercial Metals (NYSE:CMC): 28%
  • Insteel Industries (NASDAQ:IIIN):  43%
  • Universal Stainless (NASDAQ:USAP): 9%

That's an average return of over 24%, while the S&P is down over 5% over the same time period. With an annualized return of 144%, one would be a pig not to some take profits; I have sold my position in GNA, but have added to my USAP position.

My research continues to show very low inventory levels, as the weak US economy is moving many industries from just-in-case to just-in-time inventory levels. Let's investigate CMC's latest earnings release and conference call for more insight into the US steel markets.

Commercial Metals Results

CMC reported net earnings of $59.5 million, or $0.51 per diluted share on  2.9 billion of revenue. This eps includes a record .71 eps LIFO expense. Last year CMC had 2.2 billion of revenue with eps of .82 per share, including a .16 LIFO charge. On a comparable basis without the LIFO charge, CMC had eps of 1.22 verses .98 last year, a 25% increase. Sales were up 32%.

As an investor, I would not get too worried about the LIFO expenses. As CMC uses up its inventory, those much lower cost basis inventory units will create LIFO profits in the future. As of the end of the quarter, the LIFO reserve is at $422 million. If you tax effect that, it means that CMC's equity is $2.40 a share lower than what a FIFO reporter would have, according Bill Larson, CMC CFO.

CMC anticipates a fourth quarter LIFO diluted net earnings per share between $0.90 to $1.00, with no LIFO effect. This would be a 10% increase from last year.

CMC President and Chief Executive Officer Murray R. McClean said:

The quarter was marked by unprecedented upward volatility in ferrous scrap and steel finished goods pricing. Following the upward movement in scrap prices, rebar and merchant pricing increased $212 a short ton during the quarter.

The Global Steel Pricing Environment 

Unbelievably, rebar prices in the US rose to about $950 a short ton, 25% in just 3 months. During the conference call it was clear that global economics is affecting US pricing and dynamics for rebar and all semi-finished steel products. This includes blooms, billets, and slabs. As an example, outside the US, rebar prices are ranging from $1200 - $1500 a ton, a 40-50% premium to US pricing.

Many analysts during the call were asking CMC executives why they are not selling into these much higher priced markets? CMC responded that their production was at 100% just to satisfy domestic demand, and if they had any spare capacity they would ship overseas for those much higher margins. The shipping cost are only between $80-100 a short ton.

As a steel investor, I am really liking this changing global environment. China, India, and other foreign steel producers are imposing export tariffs on all their steel products to curb local inflation. Also, China and others are reducing the energy subsidies as energy prices increase. This will also have the effect of shutting off imports into the US.

So with prices much higher everywhere else, and no imports to compete with, you add in record low inventories across the US and you get one thing - future pricing power for domestic steel firms. CMC had the following comments on semi-finished product global demand:

It does appear that the demand for semis in the merchant market will continue because countries like Russia, Ukraine, are using more of their own raw material, also with China basically cutting off the exports of semis, we think globally semis, billets, and slabs are going to be in tight supply for the next two years.

CMC Investments in the Future 

CMC is not idle. They just broke ground on a new facility in Arizona. CMC also has eastern European operations in Croatia and Poland. At the Croatian mill, CMC is to improve the melt shop and also the caster in order to produce round billets that have huge demand, especially in the Middle East. With these capex investments, Bill Larson the CFO sees big improvements in future profitability.

The Polish wire rod block facility will be commissioned by the end of this year. Also the brand new flexible section mill in Poland is expected to be commissioned in early 2010. These are low production cost mills that will be selling into very high priced markets like Europe and the Middle East.

Domestic Steel Demand 

In summary, it has become clear that domestic steel firms will continue to have pricing power and solid margins for a least two years, due to the global pricing dynamics in steel products and low US inventories.

But what about current and future US steel demand? An important factor to point out is that the beleaguered residential housing market does not use much steel. As for CMC, Murray Mcclean the CEO states:

But there is a big sector out there non-residential -- I’m not saying it’s immune but like the highway work, et cetera, and that continues quite strong. The energy sector, clearly anything related to energy is very strong. And maybe we’re blessed in this part of the world being in the Gulf Texas area. Those areas are really quite strong.

It is obvious that CMC is in a sweet spot in the US. As I have written in earlier articles, the steel firms that sell into infrastructure or oil and gas industries will continue to outperform. At this point in time, I feel these steel equities will outperform the market.

US Consolidation in the Steel Industry 

Another factor to consider is consolidation. Many of my favorite steel firms have been bought out at huge premiums over the past few year (IPS, CHAP, OS, MUSA, etc..). This will continue as the global dynamics mentioned above evolve. In just the past week we have seen more acquisitions announced:

Reliance Steel (RS)  will acquire for about $1.1 billion PNA Group Holding Corp, a national steel service center group owned by private equity firm Platinum Equity. RS states the deal will be immediately accretive to our earnings.

Global steel major ArcelorMittal (NYSE:MT) has acquired US-based Bayou Steel, a producer of structural steel products, for $475 million.

Nucor (NYSE:NUE) announced that its subsidiary Harris Steel will pay $185 million to buy the Auburn, Ind.-based Ambassador Steel, which makes steel rods and bars, and its Delta Erecting affiliate.

Remember Nucor raised it forecast to 1.8 a share for the next quarter. Also, Nucor completed its offering of nearly 27.7 million shares, each valued at $74, for combined proceeds of about $2.05 billion, and will use the funds for corporate purposes as acquisitions, capital expenditures, working capital needs and debt repayment. Nucor is on a shopping spree, and any domestic steel firm with a market cap below 2 billion is in play, in my humble opinion.

Nucor states:

Continued strength in our sheet, plate, beam and bar businesses due to the solid global demand for steel and better than expected margins have favorably impacted the second quarter.

I really don't know what more an investor would want - great global pricing dynamics, strong domestic demand, low inventories, and accelerating acquisition is the industry!

I have changed my steel focus list by taking out Insteel Industries(IIIN) due to valuation, and adding in the microcap Friedman Industries (NYSEMKT:FRD). Here is my new steel focus list:

  • Gerdau Ameristeel (GNA): Infrastructure, mining, commercial, rail
  • Steel Dynamics (STLD): Recycle, Infrastructure, fabrication
  • Reliance Steel (RS): Aerospace, fabrication, farm, wind power
  • Commercial Metals (CMC): Recycle, infrastructure, Europe
  • Friedman Industries (FRD): Oil country pipe, structural pipe, finished sheet
  • Universal Stainless (USAP): Power generation, aerospace, oil/gas, tools

Disclosure: Author currently owns stock in USAP and GNA