2023-09-19 03:31:01 ET
Summary
- Gerdau, a Brazilian steel giant, has faced challenges in 2023 due to a significant slowdown in domestic steel demand and uncertainties driven by China's economy.
- Despite these challenges, Gerdau has managed its finances well, maintaining a healthy balance sheet with a strong focus on capital management and a comfortable debt structure.
- While the company's long-term outlook remains attractive, its stock valuation has risen compared to previous years, making it less compelling for short-term investors.
- GGB has estimated an 8.9% dividend yield for 2023. However, there is a projection of a gradual decrease in dividends for the next two years due to cash generation challenges.
The Brazilian steel giant Gerdau ( GGB ) has experienced fluctuations this year, reflecting a more significant slowdown in Brazilian steel demand in the first half than the company had anticipated .
In my previous article about Gerdau, I maintained a neutral stance for the short and medium term due to uncertainties in steel demand, primarily driven by China's economic struggle and uncertainty about how the company's results would perform amid the low point in the cycle.
However, Gerdau has, so far, managed the steel downturn relatively well and emerged from this period with a healthy balance sheet. The company concluded the second quarter of the year with a leverage ratio of 0.37 times net debt to EBITDA, with the steelmaker's net debt amounting to R$6.5 billion.
Although Gerdau reported a slight revenue slowdown in the second quarter of 2023, and most of its operations experienced decreased EBITDA, there was an exception in the Special Steel segment, which saw a double-digit improvement in its EBITDA.
There are expectations that steel demand in Brazil will improve as early as next year, driven by government programs to boost the economy and the real estate sector's recovery as Brazilian interest rates trend downward. However, these catalysts may take some time to manifest in increased demand, as indicated by the company's recent results, which have not yet shown rising demand.
Despite the improved outlook for the company and expectations of better results in 2024, I see the company's current valuation being traded at levels higher than those seen during periods of cyclical solid upturns, such as in 2021, which makes me prefer to avoid Gerdau's shares in the short term.
Gerdau's Q2 Results
In the second quarter of 2023 , Gerdau faced various challenges and dynamics in its operations. The company reported a consolidated sales volume of 1.3 million tons, showing a slight increase, primarily driven by the foreign market's performance, while the domestic market remained relatively stable. However, the higher sales volume in the foreign market led to lower prices for Gerdau in Brazil, with the realized price decreasing marginally to R$5.380 per ton compared to the previous quarter.
Gerdau's North American unit encountered temporary volume difficulties due to unscheduled maintenance and customers waiting for a narrower metal spread. Despite an increase in prices, the negative impact of the exchange rate reduced the margin, which stood at 26.1%.
Conversely, the Special Steel unit and South America saw improvements in sales volume but experienced a reduction in realized prices. Overall, Gerdau's net revenue saw a slight decrease, with North America being primarily responsible for the drop, reporting revenue of R$6.8 billion, reflecting a 12.7% decrease from the previous quarter.
Production costs varied across different units, with Brazil operations maintaining stable costs, averaging approximately R$4.750 per ton. North America saw increased costs due to maintenance, resulting in a cost per ton of R$5.400. Special Steel costs were reduced by focusing on a mix of higher value-added products, achieving a cost per ton of R$6.550.
The company's EBITDA decreased compared to the previous quarter, totaling R$3.8 billion, with North America experiencing the most significant decline of 24.5%. Gerdau's net profit also decreased, impacted by financial events and non-recurring results, reaching R$2.1 billion.
Overall, Gerdau's performance in the second quarter of 2023 was marked by operational challenges and varying dynamics in its units, reflecting the complexity of the steel market. This resulted in an EBITDA margin of 20.8% and a net margin of 11.7%.
China's Trade Contraction Weighs on Gerdau's Margins
In July, China experienced a contraction in foreign trade, resulting in a trade surplus of US$80.6 billion for the month. In August, the trade surplus was $68.36 billion compared with a forecast of $73.80 billion.
This decline can be attributed to the slowing global demand for Chinese goods and an uncertain economic recovery within the country. Exports decreased 14.5% compared to the previous month, marking the steepest drop since February 2020. Similarly, imports fell by 12.4%, the most substantial decline since January. These figures indicate persistently sluggish consumption and raise concerns about the potential for deflation.
The decline in imports is closely linked to weak domestic demand in China, which is grappling with structural challenges, particularly in the real estate sector. The anticipated economic rebound driven by domestic demand has not materialized, primarily due to longstanding real estate issues exacerbated by the pandemic. The slowdown in the real estate sector has a ripple effect on imports, as China relies on input materials from other countries for construction purposes, such as iron ore for steel production.
Due to China's reduced economic activity, Chinese steel producers have significantly increased their exports to other markets, making their products highly competitive. This has led to an implicit premium for imported products, affecting the ability of local steel manufacturers like Gerdau to raise prices without sacrificing market share.
Although Gerdau is less exposed to flat steel products, it has still felt the impact of these Chinese dynamics, evident in a 12.3% decrease in EBITDA, a margin compression of 6.95 percentage points, and a 33.4% decline in net income, both on a quarterly and yearly basis. This demonstrates that, despite its competitive advantages, Gerdau is not immune to the repercussions of China's influence on the global commodities market.
Operational Challenges Impacting Cash Generation
During the second quarter of 2023, Gerdau encountered operational challenges that substantially impacted its cash flow generation. The decline in EBITDA, which amounted to R$3.8 billion and represented a 12.3% decrease from the previous quarter, was just one facet of the issue.
Other contributing factors also played a role in significantly reducing the operational cash flow generation [FCF]. Firstly, the company made substantial investments in expansion projects, including the sustainable mining platform in Minas Gerais, which alone consumed R$1.2 billion in CAPEX during the quarter. This marked a notable increase of 28.8% compared to the previous quarter.
Furthermore, a slight uptick in the need for working capital resulted in a corresponding cash outflow of R$569 million, a 2.5% increase from the previous quarter. These factors and the EBITDA decline collectively led to a substantial 70.9% reduction in Gerdau's cash generation, which amounted to R$784 million for the quarter.
Dividends Still Attractive, Yet Expected to Decline Gradually
Gerdau has announced a dividend distribution of R$752 million, equivalent to R$0.43 per share, based on the shareholding position as of August 18, 2023. This represents approximately 1.5% of the company's market value. In the previous quarter, the company had announced a payment of R$0.51 per Interest on Shareholders Equity (JCP) share.
Despite the dividend decrease, Gerdau continues to offer an attractive dividend yield, estimated at 8.9% for 2023. The company maintains a strong liquidity position relative to its debt, indicating the potential for future dividend distributions. However, the projection is that shortly, the company will experience a declining yield as it continues to face challenges in generating cash.
During the second quarter of 2023, the company made significant debt payments, including R$931 million in bonds maturing in 2023 and R$600 million in debentures. This increased the proportion of long-term debt to 92%, compared to 78% in the first quarter of 2023.
This reflects a robust commitment to capital management and a healthy debt structure compared to peers in the sector. The net debt-to-EBITDA ratio is also comfortable, with a multiple of 0.37x.
Valuation: Not as Inexpensive as It Appears
Gerdau shares appear attractive when analyzing the company's valuation metrics through the Seeking Alpha ratings . This is likely one of the reasons the stock has experienced significant gains at various points during the first half of this year.
Gerdau's valuation has indeed increased significantly this year compared to the previous year, in line with a more optimistic economic outlook for Brazil as interest rates decline.
The surge in Gerdau's stock price seems to be linked to the market's perception that the company was undervalued. This perception is rooted in the company trading at approximately 2.8x EV/EBITDA just three months ago.
With shares currently trading at a forward EV/EBITDA estimate of 3.3x, Gerdau is moving further away from the 2.3x level seen in 2021, when the company's shares had their best year of performance on the stock exchange since 2012, trading above $6 per share.
This spectacular appreciation performance was driven, among other factors, by the onset of a steel upcycle, unlike the current situation, which is clearly a downcycle for the commodity. In 2021, Gerdau's EBITDA expanded to such an extent that it compressed the multiple, even in the face of a robust increase in EV.
From my perspective, Gerdau's present EBITDA is facing challenges in gaining momentum, whereas its EV continues to ascend.
The Bottom Line
Despite recent fluctuations in its share price, Gerdau maintains a strong fundamental foundation and an attractive long-term outlook, suggesting a probable shift toward a scenario where the "worst is already behind us."
However, it's crucial to acknowledge that Gerdau's stock remains sensitive to developments concerning China, which significantly affect the metals and mining sector. Given the current bearish outlook for commodities and the company's second-quarter performance falling short of expectations, I still advise exercising caution when investing in Gerdau's shares in the short term.
Gerdau was trading at an appealing EV/EBITDA multiple of 2.8x just a few months ago. However, the prevailing commodity demand situation still exerts pressure on the company's profit margins, as evidenced in the second quarter. Additionally, the valuation multiple currently appears to be stretched.
Moreover, while Gerdau is expected to remain a significant income stock for at least the following year, diminishing cash generation could reduce its attractiveness for dividends in subsequent years.
Considering all these factors, I do not see compelling reasons to justify the stock reaching levels close to its 2021 highs during a bullish steel cycle in the short term.
For further details see:
Gerdau: Valuation Matters In The Downturn