CMC - Commercial Metals Company: Strong Enough Even As Peak Profits Normalize

2024-01-01 03:50:02 ET

Summary

• Commercial Metals Company experienced a profit warning in October, causing shares to fall, but they have since rallied back to $50 per share.
• CMC is a vertically integrated manufacturer of steel and reinforcing bars, with a focus on infrastructure projects, benefiting from long-term demand drivers.
• Despite expected pressure on earnings, CMC remains a decent long-term play with a strong balance sheet and potential for increased valuation.

Early in October, I believed that Commercial Metals Company ( CMC ) was going strong. The vertically integrated manufacturer of steel and reinforcing bars has seen a few very strong years in recent years and projected a rosy long-term outlook, aided by the need and willingness to invest more into infrastructure projects.

Bolt-on dealmaking has added to its capabilities, in order to create a more diversified growth play, although economic headwinds and slower demand in housing markets created a potential overhang as well.

That profit warning came later that month, which triggered shares to fall from $50 toward $40 per share, although a rally in markets at large has taken shares back to the $50 mark here again.

A Business Made Out Of Steel

Commercial Metals Company makes steel and reinforcing bars, among others applied to concrete solutions. Merchant bars, fencing, and wire rods are used in bridges, highways, skyscrapers, and other applications.

The vertically integrated business predominantly has sites in the US and to a smaller extent in Poland as well. The vast majority of sales are generated in the US, with end markets being split across the infrastructure segment, non-residential and residential markets, as well as OEM and agriculture markets.

Ahead of the pandemic, this was a +$5 billion business which posted EBITDA margins in the low double digits. Sales fell from $5.8 billion in 2019 to $5.5 billion in 2020, driven by the pandemic, yet EBITDA improved from $423 million to $577 million over this same period of time, with net earnings of $279 million coming in at $2.32 per share. Valuations were not demanding as this was a $20 stock late in 2019.

The post-pandemic recovery provided a major impetus to the business with 2021 sales advancing to $6.7 billion as EBITDA improved to $754 million, with earnings advancing to $3.43 per share. Growth triggered the company into acquiring Tensar Corporation in a $550 million deal in order to add engineering construction ground reinforcement capabilities to the business.

Through this summer, CMC has posted strong results so far this year. Revenues for the first nine months of the year came in at $6.6 billion already, with earnings reported at $5.69 per share so far this year. Even as earnings were trending at an annualized $7-$8 per share, these earnings were actually down from the year before.

Net debt of $700 million was rather modest, with EBITDA coming in at twice that amount, as shares traded at a non-demanding earnings multiple of 7-8 times, as investors were undoubtedly expecting a normalization of margins and thus a decline in earnings.

In October, when the business was close to reporting its fourth quarter results, I found myself in a tough situation with headwinds on the horizon, yet the valuation being non-demanding. This left me with a full intention to buy a dip in the mid-forties after learning more about the fourth-quarter earnings report.

Buying The Dip

In mid-October, the company reported fourth-quarter revenues at $2.21 billion, down from a $2.34 billion number in the third quarter of this year, and $2.41 billion in the fourth quarter of the fiscal year 2022. Earnings before taxes came in at $238 million with margins coming in at 10% and change, which compares to margins greater than 14% in the same period last year, as these margins indeed did not turn out to be sustainable.

After reporting a $1.56 per share net earnings number for the final quarter, full-year earnings were reported at $7.25 per share on an $8.8 billion revenue number, but of course, the annualized run rate is weakening. Fortunately, net debt has been cut to $562 million, with annualized EBITDA trending in excess of $1.2 billion here, as the European activities have started to post losses in the final quarter.

There was a small caveat to the fourth quarter earnings number, as adjusted earnings were reported at $1.69 per share, with small adjustments made related to charges incurred with the commissioning efforts of the Arizona 2 micro mill.

While the fourth quarter was obviously softer, but still rather solid, the company issued some cautious words relating to a decline in the backlog. While the overall performance is expected to soften on a sequential basis in the seasonally softer first quarter, the company expects $60 million in grants in Europe related to CO2 credits and energy costs reimbursements, a silver lining in a time of weakness.

These comments and performance were largely in line with my expectations, as I was surprised to see such a big sell-off to the earnings report in October, with shares falling to the mid-forties and even the lower forties.

I bought the dip at $44 for that reason, as the uncertain earnings power of nearly $7 per share is still very good, even if more earnings pressure is seen.

And Now?

With earnings expected to come under further pressure, I am assuming a $5-6 earnings per share run rate for the fiscal year 2024, which still looks good, even if shares have rebounded to $50 per share. This has been aided by lower interest rates, which will undoubtedly help the business as well, not in the sense of lower interest payments, but more so spur demand from customers.

Given all this, CMC (as is the official name after a rebranding in October), looks like a decent long-term play, albeit that net cash flow generation is an issue. With capital spending seen at $550-$600 million in 2024, that number looks huge in comparison to a $220 million depreciation and amortization charge in 2023. Net capital investments of over $300 million weigh on free cash flows, equal to about $2.50 per share in net investments (at a minimum), but fortunately, the balance sheet is in pristine shape.

Given all this, I am keeping the position which I initiated in the mid-forties, looking for the valuation multiple to increase over time as the pressure on earnings and margins subsides.

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