NUE - Commercial Metals Looking More Interesting After A 25% Pullback

2023-10-16 18:25:25 ET

Summary

• Falling prices and rising costs pose near-term challenges for steel players like Commercial Metals, and those issues helped drive weaker EBITDA in fiscal Q4'23 results.
• Infrastructure projects in the U.S. will start ramping up in 2024 and should drive around 10%-15% incremental demand growth for long steel over the next few years.
• Commercial Metals' European business is struggling due to weak macroeconomic conditions, and North American residential and non-residential markets are also under pressure.
• Trading below 6x forward EBITDA, Commercial Metals looks attractive today, although I do still see above-average price risk over the next 3-6 months.

One of the frustrating and challenges aspects to investing is balancing the near-term and longer-term drivers. That seems particularly relevant with major long steel players like Commercial Metals (CMC) and Nucor (NUE) in light of sizable recent pullbacks. In the near term, falling prices and rising costs are indeed a challenging one-two punch. Even so, infrastructure project activity is starting to ramp up and should drive at least 10% incremental demand growth over the next few years, and given that the U.S. long steel market operates as a generally well-behaved oligopoly (and remains shielded from import competition), I have to think that profitability will be fairly healthy.

Between discounted cash flow and EV/EBITDA, I think CMC is undervalued today, but I also think sentiment is clearly not with this stock right now. While I think fair value is in the mid-$50’s based upon infrastructure, industrial, and residential demand outlooks for the next few years, investors should understand the risk that the shares could see the $30’s before they see the $50’s given those weaker near-term trends.

Mixed Results, With A Bigger Drag From Europe

By the standards of Commercial Metals’ long history, the fiscal fourth quarter was a good one, including around $221/ton of adjusted EBITDA overall and $327/ton in the North American business. Relative to sell-side expectations, the results were more mixed, with okay results in the U.S. offset by weaker results in the European operations.

Overall revenue declined 8% yoy and 6% qoq, still good for a roughly 4% beat versus the Street on stronger shipments. Consolidated adjusted EBITDA fell 19% yoy and 13% qoq, missing by 3%, with margin down 200bp yoy and 130bp qoq, but still at a historically healthy 15.4%.

North American revenue declined 5% yoy and 4% qoq, beating by around 4%, as steel product shipments rose 8% (and fell 4% qoq), while downstream shipments fell 9% and rose 2% qoq. Pricing was challenging for steel products, down 16% yoy and 5% qoq, and weaker than expected, as well as for downstream, where prices rose 6% yoy and fell 2% qoq and likewise missed expectations. EBITDA rose 1% yoy and fell 7% qoq, beating slightly (though there was a service reporting a higher EBITDA consensus than CMC reported); while scrap costs fell 13% yoy and 12% overall costs undermined margins, leading to flat yoy and -5% qoq EBITDA per ton.

Europe was considerably weaker, with revenue down 27% yoy and 15% qoq on shipment declines of 9% yoy and 9% qoq. Prices declined 23% yoy and 9% qoq, missing expectations. EBITDA fell to a loss, with higher costs driving a $216/ton year-over-year decline in EBITDA, and missed by $22M-$34M (around 9% of revenue) depending upon which source you use.

Not Much Joy In Europe

There’s really not a lot to say about the European market that’s positive right now. PMIs are weak across the board, housing prices are sliding, and business investments are down. Europe has also been less aggressive than the U.S. in protecting its steel companies, creating some additional pressures on top of higher operating costs.

At this point, I don’t really have a brighter side to offer for the European business. The business has respectable standalone earnings power when the macro environment is better, and the company has put some effort in recent years into de-bottlenecking and improving its operations. Still, a weak macro is an “is what it is” situation, and I don’t think there’s going to be a major rebound in Europe in 2024.

Better Times Ahead In The U.S. Business

In contrast to the European business, I think Commercial Metals’ North American operations are in better shape both now and for the near future.

To be sure, there are near-term challenges. The residential construction market has slowed significantly in response to higher rates, and I don’t think a meaningful rebound is likely until around the second half (perhaps even the fourth quarter) of 2024. I’m also not all that bullish on the non-residential market. Categories like office, retail, and warehouse are not seeing new investment right now, and while I’m bullish on the company’s leverage to re-shoring and near-shoring (more factories will be built, driving steel demand), that’s not likely a 2024 driver, as I expect more caution on capex given the uncertain economic and political environment going into 2024.

Where I’m considerably more bullish is on the infrastructure side. Through August of this year, the ARTBA has reported a 15% year-over-year increase in contract awards for bridges and highway contracts. Likewise, other metrics of future infrastructure activity (Dodge momentum numbers, state highway/street spending, et al) are pointing up for 2024 and 2025. Given that steel use is far more intensive in roads and bridges than residential or non-residential construction, that’s a powerful driver for CMC. It’s also worth noting that it’s not just roads and bridges – there is considerable spending on the way for water/sewer, transportation infrastructure, and civic buildings (schools, et al), that will further help boost long steel demand.

Last and not least, CMC has broadened some of its leverage to this up-cycle. I like the Tensar deal (products and technologies for pre-construction soil stabilization), as well as the EDSCO Fasteners deal (power transmission/distribution).

The Outlook

Looking beyond the first half of 2024, I like CMC’s leverage to increasing long steel demand and the oligopolist nature of long steel in the U.S. (CMC and Nucor control a large majority of the market). That has led to responsible capacity expansion decisions and should drive good pricing as infrastructure demand strengthens. That said, there is still short-term risk here from a weaker economy in 2024 and more political sclerosis; a U.S. government shutdown would not be helpful to the backlog or new contract awards.

I’m expecting around 2% long-term revenue growth from CMC, as I don’t expect the reshoring or infrastructure project booms to be long-lasting drivers. I do think consolidation and good internal cost management can drive better full-cycle profitability, though, and I’m looking for at least four years of double-digit EBITDA margins and long-term FCF margins in the mid-single-digits.

I value steel companies on discounted cash flow and a modified EV/EBITDA approach that uses both next-year EBITDA and my estimate of full-cycle EBITDA. This tends to temper the boom/bust cycles to some extent. I’m not a strong advocate of discounted cash flow, as accurately modeling future cycles is almost impossible, but my experience has been that if you can buy a quality steel company at/below a fair DCF-based price, it usually works out.

To that end, I do think CMC is around fair value on discounted cash flow, but undervalued on my hybrid EBITDA approach. I’m using a 5x multiple on FY’24 EBITDA and a 6x multiple on my full-cycle EBITDA estimate, with an end result of a mid-$50's fair value.

The Bottom Line

As I said above, I do have some concerns that CMC could see the $30’s before rebounding into the $50’s – the near-term outlooks for demand, pricing, and costs are not in the company’s favor. Still, I do think the shares overly discount those risks relative to the eventual uplift from increased infrastructure spending and eventual recoveries in non-resi and residential construction. This is a stock with above-average risk, but one I think is worth a closer look now.

Readers can read my prior articles on CMC here .

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