2023-09-22 14:19:12 ET
Summary
- RS's revenue doubled in the past 12 years, but growth was driven more by changes in selling price than tonnage. This is not a high-growth company.
- The company operates in a cyclical industry. But it has not been able to mitigate the cyclical effects by diversifying its products, customers, and international presence.
- Despite improvements in operating efficiencies and a strong financial position, the valuation of RS does not offer a margin of safety.
Investment thesis
Reliance Steel & Aluminum Company ( RS ) revenue doubled over the past 12 years. But this was due more to changes in the selling price than tonnage growth. Based on the shipment tonnage, it is not a high growth company. This is despite its acquisitions.
Metal prices are cyclical thus making RS a cyclical company. This is despite its efforts to mitigate the cyclical effect by distributing a variety of metals, serving diverse customers, and going international.
Over the cycle, it has been able to improve its operating efficiencies. It is also financially sound. However, a valuation of RS over the cycle, taking into account the improvements, showed that there is no margin of safety.
Company background
RS is a leading diversified metal solutions provider and the largest metals service center company in North America. This is an 80-year-old company that was listed on the NYSE in 1994.
The company believes it is the industry leader as:
“…our 2022 tons sold from our U.S. locations represented approximately 14.5% of the total tons sold by the U.S. metals service center industry.”
The metals service center industry is cyclical. However, the company believes that its diversification by product, end market, and geography helps mitigate volatility.
- RS distributes a full line of over 100,000 metal products. In 2022, carbon steel accounted for 54 % of its revenue while stainless steel and aluminum accounted for 17 % and 14 % respectively. The balance included alloy, brass, copper, and specialty steel products.
- It has more than 125,000 customers in a variety of industries.
- RS operates through a network of approximately 315 locations in 40 U.S. states and 12 foreign countries. In 2022 the US accounted for 94 % of the total revenue.
Over the past 12 years, the revenue has doubled through a combination of organic growth and acquisitions. But net income increased more than five-fold. This is attributable to its operating strategy which includes:
“… to increase profitability through our customer service, operational efficiencies, pricing discipline, innovation and inventory management as well as by providing increased levels of value-added processing.”
The thrust of my analysis is to assess the trends in the operating efficiencies and build them into my valuation of RS.
Cyclical sector
Steel and aluminum accounted for 86 % of the metals distributed by RS. I thus looked at the cyclical performance of these two metals to get a sense of the impact on RS.
Referring to Chart 1, you can see that the past 2 years were extraordinary. The peak-to-trough prices for the past 2 years (especially for carbon steel) have been much larger than those before 2020.
Prices for the past 2 years were outliers when you look at both metal prices over the past 40 years.
Chart 1: Steel and Aluminum Price Trends (Author based on FRED)
While prices were cyclical, there were underlying long-term price growths. From 1982 to 2022:
- Cold roll steel sheet and strip Producer Price Index grew at 4.1 % CAGR.
- Aluminum sheet, plate, and foil Producer Price Index grew at 1.9 % CAGR.
Valuation of cyclical companies
Damodaran opined that cyclical companies’ performance depends on where they are in the cycle. Extrapolating the performance based on the current earnings and cash flows can lead to misleading valuations.
To overcome the cyclical issue, we have to normalize the performance over the cycle. To reflect the current size of the business, Damodaran suggested that we should take the current revenue and determine the earnings by multiplying it with the normalized margins.
Looking at Chart 1, the normalized margins should not only cover the 2021/22 price outlier cycle but also the “less spikey” periods.
The oldest “less spikey” price peak over the past 12 years was in 2011.
As such I would base my cyclical analysis and valuation of RS from 2011 to 2022. This would cover at least 2 price cycles:
- The price outlier of 2021/22.
- The “less spikey” price cycle from 2011 to 2020.
Performance
I looked at 3 metrics to get an overview of the past 12 years' performances – revenue, PAT, and gross profitability (gross profits/total assets). Chart 2 summarizes the trends.
Chart 2: Performance Index (Author)
Notes to Chart 2:
a) To plot the 3 metrics on one chart, I converted them into indices. I used the respective 2011 value as the base of 1.00.
You can see that despite the company’s efforts, revenue and earnings have been cyclical and volatile. Over the past 12 years, revenue went through at least 2 peak-to-peak cycles (assuming that 2022 would be another peak).
You can see uptrends in the 3 metrics. 2020 was a bad year due to Covid-19. If you ignore this and the 2021/22 outlier and just consider 2011 to 2019,
- Revenue grew at 3.8 % CAGR.
- PAT grew at 9.2 % CAGR.
- Gross profitability grew at 1.8 % CAGR.
You could attribute the higher PAT growth compared to revenue as due to improvements in the operations. However, I was a bit disappointed in the gross profitability growth as this is one measure of operating efficiency.
1H 2023 performance
For the first 6 months ended June 2023, RS revenue declined by 14.4 % compared to the same period in 2022. This was due to an 18.3 % lower average selling price but a 4.5 % higher shipment tonnage.
The result is that its PAT decreased to USD 768 million compared to USD 1,096 million for the first six months of 2022.
The results indicated that 2022 is likely to be a peak revenue relative to 2021 and 2023.
I am a long-term value investor and especially for cyclical companies, I consider quarterly results “noisy”. Rather, I look at the long-term performance over the cycle.
Financial position
I would rate RS as financially sound based on the following:
It has USD 1.1 billion cash as of the end of Dec 2022. This is about 11 % of its total assets. This is a good cash position considering that it spent about USD 1.4 billion over the past 2 years on dividends and share buybacks.
It has a 0.20 debt-capital ratio as of the end of Dec 2022, down from 0.27 in 2011. The steel sector debt capital ratio was 0.22 as per the Damodaran Jan 2023 dataset .
RS generated positive cash flow from operations every year over the past 12 years. During this period, it generated a total of USD 9.9 billion of cash flow from operations compared to its net profit of USD 7.7 billion. This is a good cash conversion ratio.
However, I have some concerns about its operating efficiencies and inventory management.
- There was not much improvement in the cash conversion cycle. It averaged 86 days in 2021/22 compared to 87 days in 2011/12.
- Inventory turnover in 2021/22 averaged 5.7 compared to 5.5 in 2011/12.
Drivers of growth
From 2011 to 2022, RS revenue grew at a 6.9 % CAGR.
The US accounted for 94 % of this revenue in 2022 as well as in 2011. From a US-centric perspective, the RI market share of the US wholesale metal industry grew from 4% in 2011 to 7 %.
I broke down RS revenue into the selling price and shipment tonnage as per Chart 3. I found that from 2011 to 2022, there were the following correlations with revenue:
- 0.30 for shipment tonnage.
- 0.90 for selling price.
From 2011 to 2022, shipment tonnage grew at 2.6 % CAGR while the average selling price grew at 4.3 % CAGR. But you can see from Chart 3 that the bulk of the average selling price growth was from 2020 to 2022.
Looking at the above, I would conclude that its revenue growth was due more to changes in average selling prices than shipment tonnage growth.
Chart 3: Revenue components (Author)
From 2011 to 2022, the total assets of RS increased from USD 5.6 billion to USD 10.3 billion. During this period RS spent USD 2.5 billion on CAPEX and USD 2.6 billion on acquisitions.
The company provided details on same-store revenue growth for each year. But we can only estimate the revenue growth due to acquisition for the year. The company had acquisitions almost every year. So even with this same-store data, it was difficult to break down the long-term revenue growth into that due to organic growth and that due to acquisitions.
Furthermore, it is not clear whether the CAPEX for the year also included the facilities acquired in the previous years.
But looking at the amount spent on CAPEX and acquisitions, both contributed about the same to the revenue growth.
DuPont Analysis
Despite the almost doubling of the total assets, there were not many improvements in asset utilization. This can be seen from the DuPont analysis shown in Chart 4.
For the first half of the analysis period, there was a decline in asset turnover. The 2011 asset turnover level was only reached or exceeded in the past 2 years when we had the outlier price situation.
Chart 4. DuPont Analysis (Author)
Excluding the past 2 years and the COVID-19 year, the ROE from 2012 to 2019 averaged the 2011 level. This is not exactly a good sign of improved profitability. The only positive sign is the improvements in leverage.
Operating efficiencies
I also looked at the operating efficiencies from a % of revenue and on a dollar-per-ton basis as per Chart 5. I defined
- % Net margin = % gross profit margin – % SGA or Selling, General and Administration margin.
- Dollar margin per ton = Dollar gross profit per ton – Dollar SGA per ton
You can see that even if you ignore the COVID-19 year and the past 2 years, there were uptrends in the % net margin and dollar margin per ton.
Chart 5: Operating margins (Author)
The key takeaways from all the above analyses are:
- The past 2 years' price spikes were outliers.
- In estimating growth, it may be more appropriate to look at shipment tonnage rather than revenue.
- Over the past 12 years, shipment tonnage grew at 2.6 % CAGR. This was the result of both organic and acquisition growth. This is not a high-growth sector but rather a mature one.
- There were improvements in the net margins. But the improvements for other operating parameters such as leverage, gross profitability, and inventory turnover were not so clear-cut.
The implications for valuing RS are.
- I will use a single-stage valuation model as this is not a high growth stock.
- I will use a growth rate of 5%. This is higher than the long-term growth rate of the carbon steel Producer Price Index. The 5 % is pegging it to the long-term US GDP growth rate.
- The normalized margins will have to take into account the improvements in the net margins. But there will be a limit to this and I would model it as a logarithmic trend rather than a linear trend.
Valuation
I valued RS based on the single-stage Free Cash Flow to the Firm model. The key parameters in the model were shipment tonnage, average selling price, gross profit ((GP)) margin, and SGA margin.
I considered 3 Scenarios:
Scenario 1. This is assuming there is no outlier price spike. I used the values from 2019 values to represent the normalized values. This ignores the effect of COVID-19 as well as takes into account the improvements in the net margins.
Scenario 2. This was based on the 2021 to 2022 average values. I consider this an outlier Scenario and does not represent the long-term performance. The average selling price is not only higher than that in Scenario 1. The higher selling price also improves the margins.
Scenario 3. This is a weighted average value based on a 95 % probability for Scenario 1 and a 5 % probability for Scenario 2. The probability was based on the past 2 years' price spike compared to the price trends over the past 40 years.
The results and assumptions are summarized in Table 1. You can see that there is no margin of safety under Scenario 1 while there is an exceptional margin of safety under Scenario 2.
I think Scenario 3 is the most likely. The is no margin of safety here.
Table 1: Summary of valuation (Author)
Notes to Table 1:
a) 2011 to 2020 average shipment tonnage and average selling price. But the GP and SGA margins were based on the 2019 values.
b) 2021 to 2022 average values.
c) Weighted average with 95% probability of Scenario 1 and 5 % probability of Scenario 2.
Valuation model
My valuation is based on the single-stage Free Cash Flow to the Firm model as illustrated in Table 2.
I have not attempted to value RS based on a 2-stage growth model. Despite its acquisitions and organic growth, revenue only grew at a single-digit rate over the past 12 years. This is not a sign of a high-growth company.
Table 2: Sample valuation (Author)
The critical parameters in my model are the Revenue, Gross profits, and SGA. These are derived as per the assumptions in Table 1.
I assumed that the tax rate, Reinvestment, and WACC are the same under all the Scenarios.
FCFF = EBIT(1-t) X (1- Reinvestment rate).
The tax rate was based on the past 2 years average tax rate to account for the international operations.
Reinvestment = CAPEX – Depreciation & Amortization + Net Working Capital. I estimated that this is equal to the average 2011 to 2022 Reinvestments.
TCE = total capital employed = Total Equity + total Debt - Cash - Long term investments.
The WACC was based on a Google search for the term “Reliance Steel or RS WACC” as shown in Table 3.
Table 3: Cost of Capital (Various) (Various)
The value of Equity = Value of the Firm + Cash equivalents + Investments – Debt – Minority Interests.
The Cash, Debt, and Minority Interests were based on the Dec 2022 values.
Risks and limitations
There are 3 key issues here:
- The cyclical pattern.
- The normalized margins.
- Reinvestment rate
Firstly, the crux of my analysis is that RS is a cyclical company. As such, I considered the value over the cycle.
The difficulty is determining the pattern of the cycle. In this context, I have assumed that the future cycle comprises 2 components:
- A 95 % probability of the 2011 to 2020 pattern.
- A 5 % probability of the 2021 to 2022 outlier pattern.
The challenge is estimating the probabilities. I have assumed that the outlier probability was 5% based on the past 40 years price record.
To get the market price, the probability of the outlier has to increase to 15%. The market is pricing RS as if there will be more frequent price spikes in the future.
The steel demand may increase due to the Infrastructure Bill, the CHIPS Act, and the Inflation Reduction Act. But there is global excess capacity that would dampen price increases. As such I don’t think a 15% probability is realistic.
Secondly, the EBIT in my model is dependent on the net margin. I have defined net margin as gross profit margin minus SGA margin. The net margins from 2011 to 2020 ranged from 8 % to 11% with an average of 9%.
But I did not use this average as the normalized or cyclical net margin. Instead I assumed that the normalized margin is better represented by the 2019 margin of 11 %. As can be seen from Chart 5, this is the highest value for 2011 to 2019. I considered this optimistic as there is a limit on the improvements.
I do not believe the net margin trend as shown in Chart 5 would be represented by a linear trend. Rather I think that it is better represented by an S-curve pattern. A S-curve is best represented by a logarithmic trendline.
For those mathematically inclined, a logarithmic trend based on the 2011 to 2020 data would tend toward 11% net margin in 30 years.
Finally, in the model, the FCFF would depend in the Reinvestment rate. I estimated the Reinvestment rate as = Reinvestment / EBIT(1-t).
I did not use the fundamental growth equation of growth = Return X Reinvestment rate where Return = EBIT(1-t) / TCE. If I had used this, I would have a higher Reinvestment rate of 47%. In other words the value would be lower. So my current value is an optimistic one.
Conclusion
RS operates in a cyclical sector. The company attempted to dampen the effects of the cycle by offering different metals, serving customers in different sectors, and going international.
However, my analysis has shown that both the top line and bottom line are still cyclical. As such I have analyzed and valued RS as a cyclical company. This meant looking at the normalized performance over the cycle. There were 2 challenges in doing this.
- Over the past 2 years, there was an extraordinary price spike.
- There were signs of improving operating efficiencies.
To address the first concern, I used a probability-weighted average approach to value RS. To address the second concern, I assumed that the 2019 values represent the normalized values. This is an optimistic one.
Even with this optimistic outlook, there is no margin of safety. The market is pricing RS as either a high-growth stock or as if the past 2 years' price spikes would be more frequent.
My analysis shows that both of these are not realistic. As such I would not invest in RS.
I am a long-term fundamental investor. As such, I try to look at how the business will perform over the next decade or so. My valuation is also from this perspective. This is not an analysis or valuation for those looking for gains over the next few months.
For further details see:
Reliance Steel & Aluminum: Not A High Growth Company Despite Acquisitions