CMC - Commercial Metals: Recommending A Hold Rating With A Cautiously Optimistic View

2023-03-29 12:27:30 ET

Summary

• Stronger steel margins in North America contributed to CMC's 2Q23 EBITDA beat, while higher costs in Europe impacted earnings.
• The outlook for steel demand in North America is optimistic.
• The demand outlook for Europe is more cautious due to weak economic sentiment and energy concerns, although there are signs of improved demand.
• The impact of Turkey's reconstruction on the scrap and rebar markets remains unclear.

Thesis

Stronger Steel Products margins in North America contributed to Commercial Metals ( CMC ) 2Q23 EBITDA beat , which was partially offset by higher costs in Europe. Despite widespread investors' concern that the current tightening credit lending and interest rate environment will have a negative impact on steel demand, I continue to be optimistic about the future of the steel industry in North America thanks to the continued strength of non-resi construction and the rising demand for infrastructure as more and more publicly funded projects are announced. In contrast, I would be more cautious about the prospects for demand improvement in Europe given the current political climate, despite the lower costs ahead as gas prices decline. Overall, I remain optimistic about the company's 2H23 outlook, with expectations of seasonally stronger shipments and flattish margins in Q3, as well as volume growth from the startup of the AZ2 mill by Q4. However, I remain cautious about the situation in Europe and Turkey. For the time being, I'm maintaining my hold rating.

NA demand outlook

Management's optimistic view on shipments reinforces my faith in CMC NA's demand outlook. Management is optimistic about the rebar market's future and has seen no signs of slowing customer activity in the wake of rising banking sector uncertainties. In the near-term, I look to CMC financials to support my view – which the current order book is still very strong, currently 20% higher than the prior year levels. Furthermore, downstream bidding activity is still robust, which is a key indicator of the future project pipeline in my opinion. Most importantly, management has noticed a 30% increase compared to the same period last year. Strong secular demand for e-commerce facilities, warehouses, and datacenters, I believe, is driving this bidding activity. Bidding activities are also anticipated to benefit from large-scale reshoring projects, which, thanks to the health of corporate balance sheets, should be less sensitive to interest rate fluctuations. Finally, bidding activity on federally funded infrastructure projects is expected to rise throughout the year. Regarding the latter, management has pointed out that infrastructure end markets require five to six times as much rebar as residential and non-residential buildings.

Europe demand outlook

Despite the consensus that things could improve on lower energy and gas costs, my confidence in Europe's demand is lower than the NA's. Even though construction activity has increased in 2Q23 compared to last year, I am still worried due to management comments about the continued uncertainty in Europe. In particular, weak economic sentiment and energy concerns have led to a slowdown in industrial activity, and rising mortgage interest rates have contributed to a slowdown in residential demand. However, I am keeping an open mind because I see signs of improved demand, such as the proposed government support for first-time homebuyers in Poland and moderating energy costs in Europe, which could lead to an uptick in manufacturing activity. Aside from that, management also note Europe will benefit from the April contract reset - which reflects lower gas prices.

Turkey?

The effects of Turkey's reconstruction are still unclear. Management anticipates some market disruptions at the largest rebar exporter and scrap importer in the world due to changes in supply and demand brought on by the Turkey earthquake and rebuild. Management now estimate that Turkey will need between 5.5 and 6.0 million tons of steel for its ongoing reconstruction efforts, with rebar accounting for between 3.9 and 4.4 million tons of that total. However, depending on how quickly debris is collected, plans are made, and construction begins, I anticipate that the impact to the scrap and rebar markets may be spread out over a greater period of time. There were no import licenses recorded from Turkey in the month of March, but management has noted that since the earthquake, additional Algerian supply has helped to sustain Turkish rebar exports to the US. In my opinion, domestic rebar prices could benefit from the tightness of the seaborne rebar markets caused by decreased Turkish exports. However, increased domestic scrap prices may result from a more congested market.

Conclusion

While CMC 2Q23 earnings were impacted by higher costs in Europe, stronger steel margins in North America contributed to an EBITDA beat. Despite concerns about steel demand due to tighter credit lending and interest rate environment, I am optimistic about the future of the steel industry in North America. The strength of non-resi construction and rising demand for infrastructure projects, including large-scale reshoring projects and federally funded infrastructure projects, are expected to drive demand. However, I remain cautious about the prospects for demand improvement in Europe due to the current political climate. The effects of Turkey's reconstruction on the scrap and rebar markets remain unclear as well. Overall, I maintain my hold rating on CMC for now until there is more evidence to underwrite a bullish view on Europe and Turkey.

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