VALE - Nippon Steel: Bullish Thanks To The Catalyst Of Operational Investments

Summary

• Nippon Steel has been flying under the radar over the past few years as losses for investments have dropped the valuation.
• However, now undervaluation can be used as a catalyst for strong returns thanks to the company’s global scale.
• Secretly, the company has exposure to the Belt & Road Initiative, along with the West’s counter initiative, the PGII.
• Due to the strength and longevity of the steel market, various operational improvements, and the push for infrastructure worldwide, I am quite bullish.

Summary

Nippon Steel ( NPSCY , NISTF ) is a large industrial producer of steel products, based in Japan, but with operations worldwide. In fact, they are the fourth largest producer of steel worldwide at 50 million tons in 2021, according to the World Steel Association . At the same time, number 15 producer Nucor ( NUE ) is valued 2.5x higher than Nippon Steel at a $36 billion market cap. Regardless of the valuation, secular forces driven by geopolitical tension and global development will continue to drive strong growth in Nippon Steel's end markets. I find the discrepancy is an opportunity, and Nippon Steel should have a favorable investment profile moving forward. Let's dive in.

The Steel Market

Iron and steel are the most important metals on Earth, and even one of the most important materials. With extensive uses across all aspects of life, steel producers are relatively stable companies, as long as they practice conservative financial management. With a significant degree of cyclicality, albeit less volatile than niche metals, it is important to consider the investments into the industry on a periodic basis. However, as recycling increases, emissions are reduced, and the world grows, the thesis for holding a long position increases as cyclicality is reduced. Nippon Steel also has a few plans to increase the stability and quality of their revenue segments.

I am sure many investors have the initial thought of: why invest in a Japanese firm for growth as their economy stagnates? The answer is that exports are increasingly important, and Nippon Steel has operations around the world to drive secular growth. Therefore, the company should have some benefit from increasing production, reducing the effects of volatile steel prices. As I will discuss below, NS wants to grow in line with global production rather than national levels. Thankfully, the company, once the largest steel producer in the world, has a wide range of infrastructure in place and only revitalization of existing assets stands in the way of their success.

While it is one thing to produce cheap steel in Japan, Nippon Steel seeks to drive a more "sophisticated" platform to increase margins and reduce volatility. To this, NS has been busy over the past few years selling or decommissioning lagging assets and investing in future-focused technologies. This includes significant increases in R&D for sustainable products, along with expanding operations abroad.

Moving to the actual production goals, we can see that Nippon Steel seeks to have over 50% of their total production be based abroad. Exports are also expected to continue, but these will focus on local East Asia markets that are slower growing than the emerging markets. The reduction in total production in Japan will also do well to lower the company's breakeven point as production facilities in other countries will have lower operational costs. Do note that the focus is also on downstream processing, i.e., finished products rather than raw steel, and these offer higher margins, long-term contracts, and continual need regardless of the economic environment. All these improvements are favorable for the continued growth of the company.

When looking at the customer mix, a few interesting patterns emerge. First, we can remain confident in NS's local Japanese customers as the majority of revenues go towards automobile manufacturing, a strong export market, and civil engineering & infrastructure. The latter holds important significance because Japan spends billions on natural disaster mitigation and public infrastructure work, and the constant threat of natural disasters, mainly earthquakes and tsunamis, require high-quality steel. We can also see that engineering and construction hold even more weight for exports, highlighting the swift growth of emerging markets based solely around infrastructure development.

As is common in this era, the importance of environmentally friendly products is rising. To reduce the impact of operations, Nippon Steel has a few initiatives that include melting waste plastic within the steel itself, electron arc furnace technologies to reduce emissions, and even using steel slag to potentially capture carbon and build marine environments. Along with initiatives for increasing the efficiency of operations, NS also develops green products to sell. Perhaps most economical is their newly researched steel HRX19 for use in liquid hydrogen applications. There is a strong desire to replace hydrocarbons with hydrogen, and already NS has customers applying this new technology across Japan (see image below).

Global Infrastructure - The Catalyst for Future Growth

As discussed earlier, Japan faces a weak domestic market due to slow economic growth and an aging population. However, Nippon Steel management has strong plans to drive growth abroad. In fact, the company has significant operations across the world, with the highest volume of production in India, Southeast Asia, Brazil, and the U.S./Mexico. There are both short-term and long-term benefits to the global asset base. In the short-term, profits abroad are facing favorable exchange rates, offsetting the swift decline in steel prices in 2022.

In the long-term, Nippon Steel faces strong secular growth due to the continued development of the emerging markets. One of the largest subsidiaries in this regard is the recent 50-50 joint venture in India with ArcelorMittal (MT), the second largest steel producer in the world. Due to a shift in Indian law and business practice, the predominantly small-holder steel production market in India is now able to see investment by foreign entities at scale. Considering there is significant room for per capita increases in steel consumption in the country, the new AM/NS India entity is set to take advantage.

The most important catalyst in the need for steel in emerging markets, especially Southeast Asia, is the strong tug-of-war between China and the West. This has been driven primarily by the Chinese belt and road initiative of the past decade, a large funder of infrastructure development in the Indo-pacific emerging markets. With Chinese investments cooling off in 2022, the US has recently announced a new initiative called the Partnership for Global Infrastructure and Investment ((PGII)). Also, Japan has quietly funded investments in the region to combat the rise of Chinese influence. Combined with rising support to combat China, along with the significant amount of infrastructure in the U.S. itself, steel producers should be seeing a strong back half to the decade.

There is strong bipartisan support in Congress to counter China, and the Biden administration should take advantage of this moment. Communication and cooperation not only within the U.S. government but with other G7 partners and the private sector will be critical to the success of PGII.

It is not only Chinese firms that supply the necessary steel for emerging market infrastructure, and a top-five producer such as Nippon Steel is in position to take advantage of both sides. We can already see that NS's global steel production is heavily focused on automotive parts and infrastructure components, all winners in the battle for development. Also, remember that NS is investing and driving growth towards high quality, high margin products, and this may lead to market share dominance in these important revenue segments. Then, reinvestment into R&D, production expansions, and operational efficiency will drive growth for investors well into the future. While in the early stages of establishment, I look forward to the growth catalyst the PGII is likely to provide.

Financials

In Nippon Steel's case, the company has been cyclical over the past decade and a half with large swings in revenues. However, the growth rate remains positive over a longer timeframe as the company balances steel prices and production increases. However, we can see that revenues generally perform in line with steel prices, and this has driven management to seek the ways to reduce revenue volatility I discussed above. However, I expect that the next few quarters will continue to see declines in growth as steel prices fall, and this will allow investors to take advantage of the downtrend.

One important consideration for investors is how the company performs during downtrends. By looking at the profitability of Nippon Steel, we can see that income is quite stable and are not as volatile as revenues. However, over the past few years, earnings were suppressed or even negative as the company made significant investments in operational improvements. Moving forward, I will expect the company to maintain the stable margins that are the key to long-term viability.

Unfortunately, there are many factors that influence the steel prices, and the second image below highlights the numerous risks. Therefore, investors will have to be nimble on their feet when investing in cyclicals, being sure to perform due diligence, be willing to estimate the highs and lows, and focus on quality rather than upside potential. Plenty of gains will be found without the excess risk in volatile assets.

While profits seem stable through even tougher market conditions, Nippon Steel's balance sheet is also an important tool to survive weak economic conditions. While on first glance nothing stands out as a strong point as debt is high, cash is low, and shares are not being reduced with time. However, the steel industry must be measured differently than a normal company.

Instead, Nippon Steel is at a fairly strong debt level due to the fact that debt to equity is below 1.0x. With debt tied to physical assets, yearly depreciation is significant and risk is reduced. Management discusses how they have the goal of maintaining debt-to-equity around 0.5x to 0.7x. Credit agencies also agree that this is a solid position at the moment and have awarded Nippon Steel solid ranks across the board.

Valuation and Comparison to Peers

Due to falling production levels thanks to the slow Japanese economy, Nippon Steel's share price has failed to reach levels seen prior to the financial crisis. However, we now know that growth is being found abroad and revenues will in fact begin to increase in times. Combined with the fact that the balance sheet is in a strong position thanks to favorable steel pricing in 2021/22, one would expect the shares to be performing well. Instead, this is not the case as Nippon Steel has reached almost all-time lows in valuation. If operational goals are met and a favorable cycle begins again in a few quarters/years, shares will have an exponential surge.

I believe this from the valuation pattern over the past 15 years or so. In the image below, I highlight four occasions where either the EV/EBITDA or Price/Sales ratios reached a low point. The best returns can be seen when both metrics reach a low point, although it is important to consider selling when the shares have a strong run. Therefore, Nippon Steel is part value play, part turnaround, all driven by secular growth in higher profit, global operations. However, the valuation is not groundbreaking if comparing to peers.

Due to the falling production over the past ten or more years, investors have frowned upon the company and the last bull market failed to realize strong returns. However, if performance really turns a corner with the new developments, I believe a reset in valuation is necessary. I hope to get in early. But, where will the shares end up? To do so, I will compare the valuation to two peers, Nucor and ArcelorMittal.

The chart below highlights the similar trading patterns, but varying valuations between these three large steel producers. There are multiple takeaways to consider. First, Nucor is significantly different than the two peers due to exposure to the U.S. market. Nucor also operates and obtains revenues from the U.S., for the most part. The company also has far better exposure to high profit segments from recent acquisitions, favoring cheap imports to fill in the lower margin areas of the steel market. This is reflected in the high profit margins and strong balance sheet management, allowing for the elevated Price/Sales ratio.

For Nippon Steel, it will be important to follow this pattern, but I expect NS will move towards tracking with Nucor rather than MT as higher profit revenues are found. MT and NS are also intrinsically bound now thanks to their joint venture in India, but MT's performance will vary due to their large exposure to mining. Although all three companies are also fairly strong and can be considered on their own.

I like the small advantages that Nippon Steel is facing thanks to unique growth catalysts, and I look forward to seeing if this turns into out-performance into the next bull market. If things pan out this way, Nippon Steel could see a doubling in share price from these operational improvements alone.

The images below highlight the similar risks and benefits for both Nucor and Nippon Steel, according to Moody's. I believe the risks brought up for Nippon Steel are becoming less impactful year after year, while Nucor will continue to trade in-line with steel prices as margin efficiency is already at a peak.

Conclusion

No investment can be measured with black or white success. Cyclical steel producer Nippon Steel certainly meets that description as numerous stars have to align efficiently for the full bull thesis to play out. However, recent foreign expansion in key regions is sure to be timed to perfection as the G-7 led fight against China's belt and road initiative begins over the coming years.

While I will begin slowly adding Nippon Steel shares in this current bear market, I would not begin to recommend that we are at a bottom. Therefore, watch steel prices carefully, but take your time to perform your own analysis. I hope my thesis is clear and allows for a high probability opportunity. Risk adverse investors can consider the VanEck Vectors Steel ETF ( SLX ), that offers higher yield but similar capital gains performance thanks to iron ore miners Rio Tinto ( RIO , [[RTNTF]], [[RTPPF]]) and Vale ( VALE ).

Thanks for reading and feel free to share your insights below.

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