2023-11-01 09:00:00 ET
Summary
- Danieli & C. Officine Meccaniche is an Italian steel producer and maker of steel plants, positioned to benefit from the massive shift towards low-emission mills, evidenced by only 30% penetration of EAF.
- The company's business of making steel plants and associated technologies is non-cyclical and has been made relatively stable by secular upgrade and replacement forces.
- The steel production business is more cyclical but slated for major upgrades and investments to meaningfully improve savings and scale, sinking the ignored non-operating assets.
- Danieli is highly undervalued, with a net cash balance that almost matches its market cap, and has significant upside potential due to clear plans to invest this ignored cash balance.
- Backed by resilient longer-term growth and a clear catalyst of profitably investing in the ignored equity bridge, the company is a no-brain buy.
Implicit in the article is that the domestic listing in Milan is being evaluated, not the American one, as it provides ample liquidity. However, the US listings exist for both the savings and the common shares. Do your own due diligence on all elements of the thesis.
Danieli & C. Officine Meccaniche ( DNIEF )( DNIYY ) is an Italian producer of steel and a vertically integrated maker of steel plants that lean into the tectonic shift that will happen over the next decade as steel plants modernise in order to conform with new environmental standards, including the shift from blast furnaces to electric arc and using feedstocks that are renewable such as hydrogen. While they also produce high-quality steel, the majority of their EBITDA is from their business of making steel plants and the associated software and value-added technologies to help operate them. Their customers are tier 1, frequently in the US, and their business has been made relatively non-cyclical by secular upgrade and replacement forces. Most importantly, the company is shockingly cheap with a net cash balance that almost eclipses the market cap. At a multiple less than 1x EV/EBITDA and the trends looking good despite pressures in Chinese steel demand that have already materialised, near-term EBITDA stability and the green case mean this compressed valuation makes it a value-buy. The net cash that forms the valuation case is not farcical money either, as it enables the company to enact catalysts such as their 700 million EUR investment project to modernise and expand their plants, doubling overall steel tonnage produced and reducing emissions from the steel producing business by 30% as well as energy consumption by 10-15%, which could have massive margin effects. Spending this money and turning it into new cash-producing assets and generating savings on current assets will contribute to the bottom line without today's investors having to pay for the privilege since the company is valued as if that money doesn't exist. Moreover, the continued strength of the USD plays into their margin, where business is substantially expensed in Euro. In principle and on fundamentals, non-levered upside is around 200%, and it strictly dominates alternatives in steel like Cleveland-Cliffs ( CLF ) or others thanks to its market cap eclipsing cash balances in terms of value.
The Secular Case
Let's begin with the secular case for Danieli which concerns their plant making business, which is the majority of their EBITDA at over 55% . In this business, they sell steel plant setups for major customers , including Nucor ( NUE ) and Commercial Metals Company ( CMC ). The deals can be of differing complexity , but Danieli has its own technologies for producing steel, including for the EAF furnaces themselves, and its solutions are made with parts that they themselves manufacture to maximise fit and quality. Customers are tier 1, and Danieli is recognised as a leading player in creating mills, including the automation software through Danieli Automation and various other technologies to help run and oversee them. As an example, their already popular Digimelter closed furnace is driven by AI and delivers on massively lower cost of ownership.
In addition to being a leader in terms of technology, they are on top of the key trends around carbon emissions and the associated costs of carbon emissions with the steel industry, a highly polluting industry representing a meaningful amount of the industrial carbon footprint ( 7-11% of overall emissions ). Their systems are firstly not based on blast furnaces, which is a furnace technology that is intensive in metallurgical coal and accounts for 70% of the world's steel production. The remaining 30% is EAF or electric arc furnace-based steel production, systems that Danieli builds, and over time steel mills will have to shift to this technology as per the COP27 objectives. The still low penetration of EAF represents the first secular growth opportunity. EAF is more environmentally friendly because it can use recycled scraps and can also be powered by various feedstocks with either lower or no carbon footprint at all, including green hydrogen and electricity, but also natural gas in the interim - all much better than coal. As an example, their new and innovative system, Energiron, can even work on hydrogen almost exclusively. In addition to the explicit costs associated with carbon emissions that make BF technology less efficient, the cost of ownership would otherwise still be lower for EAF systems which incentivises non-cyclical upgrade and investment by mills looking to grow unit margins.
Danieli even makes energy systems that are specialised for producing electricity that can be used in steel plants. Moreover, their systems are also designed to put as little strain on the electrical grids as possible.
Leading innovation to make systems more environmentally friendly but also more efficient drives replacement and upgrade revenues, which are going to be more reliable than secular investment in more plants to support growing demand for steel, although steel demand is growing secularly as well thanks in part to the needs of steel in the renewable transition . There is a recurring replacement, upgrade and maintenance market in both the steel mills shifting to EAF as well as those already using EAF. The recent contributions from maintenance and service revenues have actually been noticeable and contributed to some of the margin uplift .
Results so Far
The secular case primarily concerns the plant making business, but a reasonably large part of the EBITDA comes from the steel production business as well. We will now discuss both the segments' recent results.
Firstly, on geographical split all from the ESEP FY report ended June 2023 :
Note the substantial exposure to the US at 20%, a major growth market thanks to the top-down Biden administration policy to support the green transition and decaying relations with China on trade causing massive investment into greener home-grown steel mills. These sales will be USD-denominated. All of the Danieli structure, including its manufacturing, is in Europe. A strong dollar means a wedge between USD-denominated sales and EUR-denominated costs. Remember, parts are produced in-house at Danieli to a substantial extent.
The segment results are the following:
Plant making is up for all the reasons described in the secular case. EBITDA is up even more due to a decent lift in the aftermarket business, caused in part by the general supply chain issues we've been having these last years and the pickup in aftermarket and maintenance activity generally, but also due to generally greater industrial scale and complexity of projects, including more automation and being technologically more advanced and with lower cost of ownership. The MRO impact here should not be understated.
Steelmaking is down in terms of revenues mainly due to lower pricing . Pricing has suffered on lower industrial demand, including from China where the construction contraction has been severe and is not going to be resolved soon, but steel pricing has managed to stabilise and the situation isn't deteriorating further thanks to supply rationalisation as some of the marginal mills become unprofitable.
Margins came down on pricing as well. Volumes and scale actually grew as investment scaled in the business for some new production lines including for spherical products and others. The trade between lower prices but higher scale due to some recent smaller investments into the steelmaking business, EBITDA has only declined in line with revenues by 10%. Note that a lot of the production is in Sisak in Croatia, almost 50%.
Planned Steel Production Investments of 700 million EUR
In fact, the steel making business is likely to be the destination of half of the large cash balance that Danieli holds on the books. Current tonnage is around 1.2 million annually. They plan on investing 700 million EUR to bring that tonnage to over 2 million annual tonnes and also to reduce emissions by 30% on that whole amount, which given the rising costs of carbon means substantial savings on the horizon. It will also be associated with about a 15% decrease in energy bills. With energy being around 20-40% of the costs to produce steel, i.e. the COGS, and with a starting point of pretty thin margins there is substantial scope for savings - it could actually triple normalised operating margins or more for the steel production segment by decreasing energy bills between 10-20%. Revenues should grow by about 33% assuming current prices hold based on volume effects. At higher margins, EBITDA would rocket at the end of this investment project, and the ROI on that 700 million EUR reinvestment would be very substantial, possibly close to 30-50% in 5-year forward post-tax yields based on scale increases and margin growth prospects. These investments will take some time, probably around 5-7 years, which is why we're considering a forward yield of 5 years as an approximate ROI for the project just due to the regular timelines associated with major industrial investment.
Danieli likes to have substantial amounts of gross cash in case it needs to make a sudden major commitment to establish a new plant for steel production or invest for growth in the plant making business - hence the situation of undervaluation. They have for many years had a large cash balance in a similar quantum to now, not really growing or shrinking in an enduring way. That changes with the new 700 million EUR investment project. Note that they do plan on financing the 700 million EUR project with lower-rate green financing from bodies like the EIB in order to improve the costs of capital. The net effect is important to reduce the net cash balance whose lack of acknowledgement by markets is in our opinion fueling the undervaluation, as they still intend to maintain a gross cash balance, but gross doesn't matter for the valuation.
Valuation
The valuation case is very simple, as the net cash balance as of now almost matches the market cap, leading to a multiple closer to 0x than to 1x EV/EBITDA. Therefore, with the application of any non-decimal multiple at all, we end up with a meaningful upside as shown below.
Due to the substantial exposure to plant making, it's tougher to find comps that match Danieli's mitigated cyclical exposures. Therefore, we take an average multiple for some industrial stalwarts together with commodity steel producers. But ultimately the exact multiple used doesn't really matter, as with any multiple above 5x the upside would still be in the triple digits.
The cash balance doesn't seem to be acknowledged by markets at all, despite it being earmarked for a meaningful investment outlay.
There are other quirks to the valuation that should be mentioned. We got the market cap and price figure by doing a weighted average of the market caps of the azioni di risparmio (savings shares) and the regular common stock. The price is a weighted average of each as well. Azioni di risparmio is a concept that seems to be quite unique to Italy. Their terms can depend on the company, but they are shares that don't have voting rights, and in exchange are entitled to have a higher dividend than the common stock by a certain spread. They typically trade at a discount due to the control premium for the company associated with the shares with voting rights. However, they are not preferred shares and are much closer to equity, also trading with a high correlation to the common shares and they don't have a fixed dividend.
Assuming that the control premium of around 25% is justified and would be fixed over time, which is not a crazy assumption especially since a control premium of around 25% would be pretty common, the upside would be the same for both the savings shares and common shares with this approach.
Alternatively, as savings shares are senior to equity in liquidity preference by default, you could also just treat them like debt, offset net cash with them, and use the market cap of just the ordinary shares to get the following even larger upside due to the greater implied leverage:
The savings shares have similar liquidity to the common stock as listed on the MIB, both are close to and often above 1 million EUR in daily traded volume. The US-listed instruments are not as liquid as usual, and the market is made more idiosyncratically. We always suggest going on domestic exchanges for normal liquidity conditions, the same as for almost every other foreign stock.
Bottom Line
Given the fact that the net non-operating balance that is being ignored by markets will actually be converted to cash flow over the course of the company's vision project of 700 million EUR for the steel operations, there isn't any reason such as corporate governance or stale investment plan that would justify not taking into account the balance. This is further supported when you consider that over time the gross cash and securities balance is rather similar over time, except for the recent burgeoning from high steel prices after COVID-19. The situation is much different from Japanese stocks for example, where there often isn't a plan to allocate the capital and the cash has been accumulating and growing for decades.
Then there's the fact that the ESG secular picture is meaningful, and investment into better mills, especially as they increase the currently pressured unit margins for steel makers, is something that is materialising even in the counter cycle with a bumper year in 2023, and good forecast demand in 2024 as of the October ESEP report.
We think the savings shares are more interesting than the common shares, just because we won't need the voting rights as the Danieli family is in control of the company, which is quite a common sight on Italian markets.
Overall, a green thesis that backs the company's growth in plant making and an investment plan for the net-non operating balance which is being completely ignored sets this up to be a no-brain buy.
For further details see:
Danieli: Green Thesis And MRO Story For An Almost 0x Multiple