2023-11-16 06:47:37 ET
Summary
- Gerdau's 3Q23 results revealed continued weakness in most operating figures, with a downward trend on both sequential and year-on-year basis.
- Challenges stem from diminished steel demand within Brazil and increased competition from Chinese steel, leading to a pricing battle in the domestic market.
- The company is grappling with increased capital expenditures for maintenance and expansion, contributing to concerns about short-term cash flow generation.
- Despite Gerdau's appealing dividend, the combination of rising CapEx and contracting EBITDA makes the company less compelling for a dividend portfolio, warranting a neutral stance with a slightly more pessimistic outlook.
Brazilian steel company Gerdau ( GGB ) released its 3Q23 results in the first week of November.
The reported figures by the company continued to show weakness, sustaining a downward trend on a sequential basis and even more prominently in year-over-year comparisons. In addition to a modest net profit, cash generation fell short of expectations, especially considering a significant rise in Capital Expenditure (CapEx). Consequently, meeting this year's CapEx guidance could be challenging for the company.
The underlying reason behind this weaker quarterly performance is the diminished demand for steel, even within Brazil, despite a recent environment of declining interest rates. Moreover, the increasing presence of Chinese steel in the Brazilian market, now an integral part of apparent consumption, has triggered a pricing battle that resonates throughout the domestic market.
However, confronted with the challenge of absorbing this supply in the Chinese domestic market, especially given more modest economic growth, the prospects for improvements in the dynamics of flat steel in Brazil appear limited. While the situation for long steel, constituting two-thirds of Gerdau's portfolio, is not as adverse, attempts to increase prices for rebar by more than R$50 per ton are met with resistance. Uncertainty persists, with the Brazilian steel industry facing significant challenges amid Chinese competition and the need to balance internal and external demands.
As my initial article on Gerdau emphasized, despite being a significant player in the Brazilian steel industry, the company has encountered substantial challenges this year due to its cyclical nature. There are no apparent short-term catalysts to boost the company's stock performance, down 6% year-to-date.
While Gerdau still has the potential for offering an appealing dividend and a potentially discounted valuation, I prefer to maintain a neutral position following a quarter that leaned more towards the negative, primarily due to the company increasing CapEx amid a decrease in EBITDA.
Gerdau’s 3Q23 Earnings Results
Reviewing Gerdau's Q3 operating performance, the company faced a declining price scenario with a marginal decrease in Brazil BD to approximately R$5,300/t, marking a 1.5% quarterly drop and a substantial 17.5% year-over-year decline. This reflects the negative impact of robust steel exports from China on the domestic market and Gerdau's exports.
In North America, the downward trend in price realization was slightly more pronounced, reaching around R$6,700/t, representing a 3.8% quarterly decline and a significant 15.3% yearly decrease. This followed the company's implementation of discounts amounting to US$50/t during the quarter. Gerdau's robust portfolio helped mitigate the price decline compared to other industry peers in the US. Special Steel BD experienced a 1.3% quarterly price decline in other business units. In comparison, South America BD was pleasantly surprised with a 4.4% quarterly increase, the only segment to report a sequential rise.
Examining Brazil's BD domestic market volume, it reported a volume of 1,039kt, down 2.5% from the previous quarter and 13.8% year-over-year. In contrast, the external market contracted more sharply to 221kt, representing a 20.9% quarterly decrease and a substantial 75.1% yearly increase. Gerdau delivered a volume of 1.2Mt in the Brazilian operation, down 6.3% from the previous quarter and 5.3% year-over-year.
Conversely, North America BD demonstrated more resilience in terms of volume, partly due to the implemented price discount, leading to relatively stable sales sequentially at 943Kt, falling only 3.3% from the previous quarter and 4.6% year-over-year. Other business units also reported reductions in sales volumes, with South America BD decreasing to 290Kt, representing a 6.8% quarterly decrease and a 2.4% yearly decline, negatively impacted by disruptions in exports from Brazil, as mentioned in our preview report.
Aligned with the tight price dynamics and falling volumes, Gerdau's consolidated net revenue contracted to R$17.0b, reflecting a 6.6% quarterly decrease and a substantial 19.3% yearly decline. Reductions primarily influenced this in all business units, especially in Brazil BD, which reported an 8.3% quarterly decrease, and North America BD, which experienced a 7.0% quarterly decrease.
Regarding cost dynamics, although all units, except Speciality Steel, demonstrated a drop in costs, Brazil BD's standout performance in terms of cost efficiency, with a marginal decline of 0.7% from the previous quarter, reaching a COGS/t of R$4,750/t, is noteworthy. This reflects the moderation in the cost of its main production inputs, such as coal, scrap, and iron ore, considering their delays for the spot curves. Similarly, North America BD reported another reduction of 1.7% from the previous quarter, reaching a COGS/t of R$5,300/t, attributed to lower scrap costs (10.8% year-over-year) and electricity costs (9.4% year-over-year).
Consolidating an adjusted EBITDA of R$3.3b, Gerdau experienced an 11.7% quarterly decrease and a substantial 37.6% yearly decline, resulting in a margin of 19.6%, down 1.14 percentage points from the previous quarter and a significant 5.76 percentage points year-over-year. The main business units reported weaker figures, with Brazil at R$868m, reflecting a 12.5% quarterly decrease and a substantial 44.5% yearly decline, and North America at R$1.5b, also showing a 12.5% quarterly decrease and a significant 39.7% annual decline, with compressed margins to 13.1% and 24.6%, respectively. Meanwhile, other business units faced challenges, with a 1.2% quarterly decrease for NB South America and a 16.8% quarterly decrease for NB Specialty Steel.
Following a financial result of R$478m, impacted by more intense net exchange rate variations, Gerdau's revenue, partially dollarized due to operations in the US, may have been influenced by foreign exchange instruments. The rapid cycle of appreciation and depreciation of the USD/BRL exchange rate, volatile during the period due to market uncertainties about the Fed's monetary policy in the US and fiscal issues in Brazil, contributed to these results.
Subsequently, the company reported a net profit of R$1.6 billion, reflecting a decline of 26.2% from the previous quarter and a substantial 47.7% decrease year-over-year. In light of these figures, the company also disclosed a net margin of 9.3%, marking a decline of 2.46 percentage points from the previous quarter and a significant 5.02 percentage points year-over-year.
Cash Flow Generation Concerns
The third quarter highlighted a particularly challenging aspect for Gerdau, centered around the company's cash flow. Faced with a decline in EBITDA by 11.7% quarter-over-quarter and a substantial 37.6% year-over-year, the free cash flow generation (FCFE) amounted to R$2.2 billion.
However, this positive outcome was juxtaposed with an acceleration in capital expenditures (CapEx) to R$1.5 billion, marking an increase of 20.9% quarter-over-quarter and a significant 40.7% year-over-year. This affirmed that the surge in investments acted as a short-term cash flow detractor, leading to a year-over-year decrease of 27%. The chart below clearly explains this trend.
Although Gerdau managed to generate more cash flow than the previous quarter, this was primarily attributed to the release of working capital amounting to R$501 million. Consequently, 67% of the adjusted EBITDA was converted into FCF, marking a notable increase of 4 percentage points from that observed in 2Q23.
Gerdau has set a CapEx guidance of R$5 billion for 2023. This implies that to stay within the specified guidance, the CapEx for 4Q23 would need to be R$1.4 billion, necessitating a sequential decrease of 5% quarter-over-quarter. However, this may pose a challenge for the company. The more likely scenario is the gradual investment increase, suggesting that CapEx in 2023 might hover around R$5.8 billion.
Dividends Remain Attractive... For Now
Due to weaker EBITDA and slower cash generation, Gerdau dividends also declined. The company announced a dividend distribution of R$0.47 per share (approximately $0.09), equating to 2% of the current market capitalization or R$822 million.
As my previous article on Q2 earnings highlighted, a trend toward lower dividend payments was anticipated. The seasonal effect on working capital release may have temporarily increased cash flow sequentially. However, to maintain pace with the FCF yield under a similar payout scenario, dividend payments would have needed a significant increase compared to the last quarter.
Contrary to this expectation, in 2Q23, Gerdau announced a dividend of R$0.43 per share. While the 3Q23 announcement reflected a 9.3% increase quarter-over-quarter, cash generation surged 186% quarter-over-quarter, primarily driven by the dynamics of freeing up working capital. In essence, the dividend increase did not align with the sequential cash gain, supporting the likelihood of reduced dividends in relative terms.
Assuming Gerdau reports an annual net profit decrease of 25%, as suggested by one analyst's estimate in the Seeking Alpha consensus , and considering a payout of 34% (close to the minimum of 30% according to the company's dividend policy ), Gerdau would declare an annual dividend per share of $0.32. This implies a dividend yield of 6.5%.
Applying an ROI of 6% would suggest an implied share price of $5.36 for Gerdau, which remains an attractive prospect.
The Bottom Line
In the context of Gerdau's exposure to a downturn in the steel cycle, the company's Q3 report indicates significant challenges for Brazil BD, particularly concerning the continued export of Chinese steel. Due to more competitive prices, Chinese steel is gaining market share from local companies. Conversely, North America BD is in a relatively better position, benefiting from tariff barriers protecting the Chinese market.
Moreover, Gerdau is navigating a period of increased capital expenditures (CapEx) for maintenance and expansion. This, coupled with the deteriorating reported figures due to the low steel cycle, contributes to weakened short-term cash flow generation.
While purchasing cyclical companies during periods of low commodity cycles might make sense for many investors in the short term, there are currently no discernible signs of an improvement in the scenario for Gerdau. This is especially notable as the company continues to increase CapEx amid contracting EBITDA, a challenging combination for a dividend-generating company.
Despite Gerdau trading at an attractive valuation, offering a potential upside of 8%, considering its still appealing dividend distribution, the rationale for holding Gerdau in a dividend portfolio is diminishing. Consequently, I maintain a neutral stance and a slightly more pessimistic outlook for the long term following the Q3 earnings results.
For further details see:
Gerdau: Q3 Earnings, Limited Short-Term Catalysts, Raises Concerns