2023-04-21 06:03:20 ET
Summary
- Since my last article on Gerdau, published in December, the company has dropped over 10%, with the S&P up around 5% in the meantime.
- My "HOLD" thesis, has as such proven to be the right short-term strategy for this particular company. The time has come to update it and see where we are.
- This company remains at a solid upside in a world with a need for raw materials, and a demand for steel - but everything needs a fair price.
Dear readers/followers,
To call Gerdau ( GGB ) a "bad business" would be flawed and wrong. To call it a "volatile business", that's closer to the truth, and something I would consider accurate. While in my last article, I made a point to rotate some of my market-beating profits (at the time, things were up almost 35% to an S&P Global return of negative 4.5%), there is a very different thing happening at this point in time. Let's look at the relative performance of the company for the last few months.
Seeking Alpha Gerdau (Seeking Alpha)
it goes to show you that companies move up, and then they move back down. In this specific case, I took advantage when the company moved above the $6/share market, and reinvested in what I saw as being a better value. I did not sell everything - I still long for Gerdau, and I now consider it a more interesting prospect than I did at the time.
Let me show you why. Let me remind you, first of all, that my previous share price for the company was $5/share for the covered ticker - which is when Tangible BV hits about 1x - so let's see what we have here.
Updating on Gerdau for 2023
So, Gerdau is neither the most qualitative nor the most predictable business in the steel sector. This is because comps in steel include businesses like Nucor ( NUE ), ArcelorMittal ( MT ), Nippon Steel, JSW, Tata, Reliance ( RS ), and others. And frankly, many of these have higher market caps, higher profits, and higher predictability than Gerdau has. This is not to say that the steel sector is a place where we have a lot of overall predictability, to begin with. Volatility and ups and downs are the rule here, not the exception.
So if you invest in steel or steel-adjacent companies, you need to put your seatbelt on, because even if you bought cheap, you might very well go cheaper - for a long time.
However, Gerdau is no joke. It's been around for over 120 years, and it's one of the 30 largest steel producers on earth. It manages revenues in the dozens of billions, employs over 30,000 people, and nets over half a billion - which might not sound much in profit, but is actually very good.
Gerdau has a high yield, investment-grade safety at a BBB- and has had an international presence on the market for over 40-50 years at this point, with a very early expansion strategy. Current operations are spread to 13 countries. So while that IG rating isn't as great as we might want, do not underestimate Gerdau. 4Q22 is in - and those results deserve some highlighting.
While overall shipments were down in 4Q22, as we saw in many geographies in the world, the company's fundamentals remain strong.
But let's begin with some risks. Because this company is actually quite exposed to some risks both on the macro and regional level here - which is part of why the company is down as much as it currently is.
Challenges include inflation, high-interest rates, volatility in feedstock prices (such as coal), and seasonally weaker demands in key markets. There was also an election in Brazil which affected the overall demand for the company's products.
On the flip side, we have potential tailwinds like the CN market - and Gerdau and Brazil are improving their Chinese relationships, and the company also expects the heavy vehicle and machinery sector recoveries in the US as well as automotive recovery in Brazil to somewhat add to this recovery.
There weren't many quarterly highlights to point to - or full-year ones. The only advantage Gerdau was clearly able to push is the company's year-over-year net sales numbers.
I've said it before - whenever a company focuses on pushing safety, sustainability, and equality numbers, make sure the profits are still intact. Focus on "soft" KPIs seldom bode well. The positive here was the record net sales - and while results otherwise were down YoY, it's crucial to understand how "good" the 2021 results were. EBITDA on an adjusted basis was the second-highest in company history ever, and its cash flows are at record levels.
Utilization rates for company assets ranged between 55%-85% which in context is quite good. The company's cash conversion cycle saw marked decreases due to seasonal adjustments and overall lower net sales.
Company investments/CapEx plans are increasing going forward, with the ambition of pushing capacity.
Debt meanwhile, remains relatively stable. Net debt to EBITDA is up more than double, but only to 0.33x, compared to a usual range of 0.15-0.3x - not really at any worrying level. The company already has a relatively high cost of debt, with interest rates at 7.2% on average, and terms of 7.4 years W.A, but this is more telling of its home geography than anything else.
Dividends for 2022 will/are expected to be high. The dividend yield which was extremely high last year will be even higher this year, pushing 13-14% and coming to levels seen by Yara ( OTCPK:YARIY ) and other businesses. So, that part has plenty going for it at least. And overall, the company's long-term performance is actually very promising, with the solid returns being able to be rewarded to shareholders not only in -21, but -22 as well.
Overall, Gerdau is a solid Steel company, that's seen a very impressive couple of years, which has both influenced the share price as well the expectations in terms of what the company can deliver in terms of returns. This makes me more careful than anything else because I know that it's easy for things to go into exuberance here. There are some reasons for positivity. First off, Gerdau is actually one of the most profitable steel companies around, in terms of pure margins. Gross margins, operating margins, net, RoE, RoA, ROIC, and ROCE - all of these are above the 85th percentile in the steel industry - and they're at a level from where they have been growing for the past few years. The company's revenue growth rate is also very solid - naturally, given what we've seen over the past few years.
What's more, the company has been very impressive in reducing its amount of debt in the past decade or so. While CapEx is on the rise, it's unlikely we'll see an increasing debt position to the level we once saw - another positive.
To me, Gerdau is exactly what it seems. It's an above-quality steel company with an eye towards a very high yield during good times. This is something I see as a massive positive - provided you manage to "BUY" the business at an attractive valuation.
This is not as easy.
Gerdau - The valuation is so-so
We're not in a situation or at valuation levels where I could easily tell you that you should definitely "BUY" the company. When it comes to the valuation - let's go ahead and call it very complex.
To clarify it to you, you're investing in a company in a downward trajectory - and one that has a history of staying negative EPS for years. There's very little telling what exactly the share price will do once this becomes clear. Going by straight P/E forecasts,you could forecast it at an average of 10x P/E and still come out with a double-digit upside at today's forecast levels. However, trusting any analyst estimate with a historical accuracy rating of exactly zero percent , even with a 10-20% MoE, isn't easy (even if part of those forecasts were "beats").
Gerdau Forecast Accuracy (F.A.S.T graphs)
So, again, complex.
The company, on most estimates, is decently undervalued at this time, but it also is expecting an EPS decline of no less than negative 23.7% per year , until 2025E. Because this is from such a high level, some investors might nonetheless consider this solid, and it's hard to fault them for being somewhat positive here But the downside risk here is bigger than you might want to admit.
Other contributors have made articles about this company, focusing on singular multiples or what I view as relatively simple forecasts. I argue this cannot be made as simple as that. Forecasting Gerdau on the basis of EPS, or the basis of BV multiples is tricky.
Also, while I am singing Gerdau's praises in terms of profitability, let's make one thing clear. There is also no doubt that Gerdau trades to significantly cheaper multiples on virtually every basis compared to peers at this time, with some exceptions. However, these peers are almost universally better capitalized, with more attractive WACC and more stable fundamentals. And yes, that goes for most of its European peers as well.
I said the following in my first article on the company:
I would want to see a sustained ROCE (NOPAT/LTM Cap. employed) above WACC on a consistent basis.
While we've seen this for the company for 2 years now, The company has been chronically unable to remain profitable in anything except market environments that allow for significant outperformance for steel. As evidence, in any year except 2017, 2021, and 2022, the company's profitability in terms of NOPAT/LTM Cap. employed in terms of WACC has been at a negative relationship - the company hasn't been able to retain profitability next to its weighted average cost of capital.
This is not a good situation to start.
While I was willing to "get" company shares at a cheap price, in this case when the company went below $4.7/share back in August of 2022, I also went ahead and sold much of that position at a superb 35%+ profit in less than 6 months. I know the volatility inherent to these sorts of companies, and for that reason, despite a double-digit realistic upside for 2025E, I'm being careful here.
We're down 10% - but the market has also changed significantly, and not necessarily for the better. The main thesis for Gerdau, which is its expected performance in an EPS downcycle, is still the core question for me that will decide when and if I buy shares.
And for the time being, this dictates that I stay cautious. In the last downcycle back in 2010-2014, the company started out trading at $15+/share, only to drop to its lowest point of below a dollar back in 2015. The same could easily happen again, even if the company's debt situation is now much more in hand.
So, the thesis, despite a drop of 10%, isn't materially more attractive at this point. The current price for Gerdau is $5.12. I'm not lowering my PT here - I see no reason to do so - but I also won't touch Gerdau unless it drops below $5.
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 still view Gerdau as a "Hold" here because the company has outperformed and we're currently above my target.
- The price target is below $5/share when tangible book value hits a 1X ratio.
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 that is high enough, based on earnings growth or multiple expansion/reversion.
I don't see the longer-term forecasts as attractive enough to justify more of a reversal to a double-digit share price. I've rotated part of my position in the company.
For further details see:
Gerdau: Updating The Thesis After A 10% Drop