2023-08-15 08:53:25 ET
Summary
- Gerdau has outperformed the market in the past year but underperformed since the last article.
- The company's latest results show a softening sales and shipment trend, even if the results are actually solid given the environment.
- I am considering rotating out of Gerdau due to macro risks and the availability of safer investment options, due to the trajectory of company earnings on a forward basis.
Dear readers/subscribers,
I've only been positive about Gerdau ( GGB ) as an investment in one of my articles. This article remains unequivocally the only market-outperforming article position where you could have bought Gerdau during the past year and more.
In fact, in my last article on the company, I called it a " hold ". Since that article, the company is up 5%, while the S&P 500 is up 8%. Again, underperformance - except if you bought when I, or around the time I considered it "undervalued".
I highlight this because opportunities to pat myself on the back as specifically as this don't come around too often - no more than once a month or so - so I take advantage of them. I consider myself fairly apt at finding targets where a company I have researched is cheap, and where it is not. Gerdau is a success in that context.
Let's see what we have going for us here and review the latest results. It's been almost 4 months since my last Gerdau review here in SA.
Gerdau - A lot to like, but still pricey
When it comes to Steel, you can buy a lot more stable businesses than Gerdau. While metals and basic materials are far from the most stable and uncyclical businesses out there, they are still part of the fabric of overall society, and as such, make for excellent investments if you buy them at the right valuation. I don't say time because I don't believe in "timing" as such - but I do believe in using valuation to make sure you buy it cheap. I actually invest in a few steel businesses, including Reliance ( RS ), Nucor ( NUE ), and more local European ones. I even bought some buy-writes on SSAB, a Swedish steel company, when I could find attractively premium 15% annualized RoR option plays.
That's how I invest. I look for my 15%+, and then I go for it.
Gerdau has a 100+ year history with a significant upside, being one of the 30 largest steel producers on the planet. It's only BBB-, which is less than some of its peers, and it's one of the more cyclical producers due to its geographical exposures. Also, the macro isn't easy here - with inflation, interest, feedstock pricing, and weaker demands in some areas, and because it's actually a Brazilian business , it's exposed to a non-trivial amount of political risk.
I do own Brazilian businesses. It's all about discounting for me - at what point do I see the risk-reward as favorable - but I'm always keenly aware of just what exactly I'm investing in, and that it is in fact far from as safe or as stable as some investments in the US.
We have 2Q23, and these results are now presented here. The overall trends for Gerdau I would characterize as positive. On a global level, overall reductions in inflation and are driving trends favorably in some ways. Feedstock pricing is down, with both coal and iron ore at cheaper levels than in 1Q23.
However, Brazilian interest rates are now at 13.25%, and there's an internal worry about the overall high levels of household debt. There is an expectation for some cuts and some new stimulus programs, which the company expects to have an effect - I wouldn't hold my breath here.
The results show a softening sales and shipment trend. Shipments are down 1.5%, sales are down just over 3%, and we see a double-digit drop in EBITDA sequentially, and over 40% YoY. The equivalent net income drop YoY was 50.1% - but again, this was expected. The YoY results were some of the best in company history, and a net income margin on an adjusted basis of over 18% was never going to be maintained by a company that typically lies around the double-digit level.
The company did not have a bad quarter. In fact, it was great - the comps were just brutal. 2Q23 is one of the highest second-quarter EBITDAs ever, and shipments, on a historical level, were good. Also, the company's debt ratio is at a net debt/EBITDA of 0.37x, which is still very much in line with company policy at this time.
So all of these business-division related drops that we see here, in North America, in Special steel, and in Brazil...
...all of those drops were not just in line with the overall steel macro, they were mostly expected, even if the specific levels weren't.
On a high level, I remain positive about the potential of steel companies - not just steel but metal overall, including Copper and Aluminum as well. That's why I'm investing non-trivial amounts in these companies at this time.
The company is currently "cycling down" as it were, though frankly not even close to as much as I expected. My forecast showed FCF of closer to 700M Brazilian Real for the quarter, and the company beat this handily (I expected more WC and slightly higher CapEx).
The company's fundamentals are vastly improved to previous years. The current level of gross debt, which the company has been able to pay down thanks to the high income, is the lowest it's been since the beginning of GFC. With an average term of 7.8 years and an overall interest rate on an average weighted basis of 5.6%, the company is not any sort of negative outstanding or worth noting, in terms of leverage. This is a significant advantage.
And, of course, the company's main operations, remain very solid overall. Decades of reserves remain, and the company is on par with CO2 reduction.
High-level risks and worries to be concerned about when it comes to Gerdau?
Few, I'd say. Mostly macro. Keep an eye on metal spreads, input pricing, and company price adjustments. With these sorts of companies, it's a never-ending balance of managing output to input pricing and doing so much quicker than your typical company would.
Also, if we do get a recession , either in the US, in US/EU, or even globally, this would obviously impact Gerdau as well. But this wouldn't just impact Gerdau, so I'd view this with a bit less seriousness - because if that happens, the entire paradigm shifts for investing anyways.
Acting on the information I have today, I put a premium on safer and more resilient investments. Gerdau is not one of those investments, not compared to some of the other things I invest in.
However, it's a "worthy" investment at the right time. The obvious issue is, that from any forecast perspective, we're moving down in the cycle, which means that the current forecast calls for an annualized EPS decline of around 23% per year until at least 2025E.
Let's see how this influences the company's overall valuation.
Gerdau Valuation - It's decent, but we still have a fundamental downside based on macro.
When it comes to Gerdau, I always approach such investments with care. I'm very aware that mistakes can cause and likely would cause, years of sub-par returns for any amount of invested capital. The time to buy such companies are few and far between, if you look over long periods of time.
Despite the fact that the company's earnings are likely to stay positive and good compared to the last 10 years, I'm concerned about how the company will be trading on a forward basis. Given that I've already seen returns of over 28% for my position, I'm considering rotation here.
This is not because the company is bad, or that there are outsized risks, beyond the political and sector-specific ones that I've mentioned. It's simply because of the overall macro risks that we're undeniably seeing, compared to the opportunities that are significantly safer, and available out there.
Let me give you an example in context.
You could easily find a pref stock that gives you almost 8%, with a BBB+ underlying safety in the company behind it, or equivalent. Together with the fact that this pref might trade at a historical discount, the upside there could be 14-15% easily, on a yearly basis.
Forecasting Gerdau even at close to its historical premium/valuation of 9-10x, which is a tall order for a company that seems bound to spend the next few years in a negative trend, gives you an annualized rate of return of 10.75%.
Do you see what I am saying? It's an issue of safety and risk/reward. If the highest possible realistic reward I see for investing in Gerdau is no more than 10-14% per year - why would I keep my shares? It was different when macro was favorable, and when we could see above 20% easily. But much of that upside has now been realized, and the simple fact is that I don't view further outperformance as especially realistic here.
Because this is the case, I'm actually strongly considering rotation here. The past half-year has seen me do the equivalent of strengthening the foundation of my "house", building a wall, and flood protection. I've diversified, I've spread risk, and I've moved parts of my capital to debt investments and other things, all to prepare for the eventuality of a downturn. It's not made me stop investing in good upsides when I've found them.
But that is not, as I see it, what Gerdau is any longer.
Also, my points made in previous articles made about the peers remain - all of them are tendentially better capitalized than Gerdau is, and any investment into Gerdau needs to deal with the fact that 50% of the company's EBITDA in fact comes from Brazil, which again isn't exactly stable geography by any means.
For those risk-related reasons, you may see this as my call to consider rotation. The company has fully realized my overall PT of $5/share. I might have been willing to hold it longer if the macro was better.
However, I can get 14-16% annualized with far lower risk elsewhere.
So what do I do?
I follow the data and my estimates. Here is my thesis for Gerdau.
Thesis
- While Gerdau has some appeal from a fundamental point of view, active in good geographies with growth potential, the company still needs to prove consistent returns above the cost of capital and debt. For the time being, this is being achieved thanks to outsized demands due to recovery.
- I view Gerdau as a " hold " here. The company no longer offers compelling value at above $5/share. Together with macro risk, I consider other investment options far more favorable here.
- The price target is below $5/share when tangible book value hits a 1X ratio at this time, but even then I'd give this a fair bit of consideration given the risk I see here.
Remember, I'm all about:
- Buying undervalued - even if that undervaluation is slight and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
- If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
- If the company doesn't go into overvaluation but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
- I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
While the company does come with an upside, I no longer see this upside as being high enough for investing here.
For further details see:
Gerdau: Still Performing, But I'm Still Careful And May Rotate Here