2023-07-10 22:28:14 ET
Summary
- The market is failing to consider the substantial amounts of operating leverage and backlog the company is operating with, assuming that high ticket prices and margins are here to stay.
- Despite record profits in 2021 and 2022, the company is predicted to face a negative revenue trend in the next two years due to weakening prices for steel, aluminum, and copper, and the risk of a recession.
- The substantial amount of backlog the company has been working through has allowed for its margins and revenue to remain elevated after metal prices fell back to earth.
- I believe a short position at current levels could yield upwards of 20% as the stock falls to 214 or below by 2H23 and/or 2024.
Executive Summary
I am recommending a short position in Reliance Steel ( RS ), which costs only 0.25% per annum to short. Hot rolled steel futures peaked in late August of 2021. In the time since, Reliance Steel's multiple has risen as its earning power has remained more stable than other names in the steel and aluminum business. I believe that RS has been substantially over-earning over the past several quarters and will come back down to earth in 2H23 and 2024. I believe the market is failing to appreciate the substantial amount of operating leverage and variable costs RS has due to the elevated price of steel driving SGA margins down to record lows for the past two years. As the price per ton drops and the amount of tons sold increases , the firm's operating margins will be crushed, resulting in major drops in earnings.
Company Overview:
The steel and aluminum industry is highly competitive, mature, and volatile. RS is one of the best companies in one of the best niches, the metal servicing industry , in the overall metal industry. The company has been engaging in many consolidative and value creating acquisitions over the past several years, increasing its market share to 14.5% of the shipping segment of the metal services industry, being the largest player in its space, and realizing true cost synergies. Reliance Steel also has a remarkably strong balance sheet for the industry, with relatively little net debt, 551 million.
The company also is engaged in high value-add activities in comparison to the rest of the industry. As aerospace, sophisticated warehousing, and semiconductors are coming to the forefront, Reliance Steel is one of the better positioned firms to take advantage of this demand. Its localized economies of scale, cost cutting, and technological advantages has accumulated in potent competitive advantages, and is able to earn on average 14.6% on its invested capital over the past 5 years (including covid). The company trades at the higher part of the range in comparison to its peers, and I believe that the firm has more than earned it.
With the high fixed and semi variable costs the firm operates with, such as employee compensation and incentives, RS has substantial operating leverage. This enabled it to report record profits in 2021 and 2022, with SG&A at 13.5 to 14.5% of sales instead of its pre-covid 18 to 20%. Over the past two years, the firm’s variable costs have also been relatively smaller due to the fact of having record high prices of $3073 and $2594 per ton for 2022 and 2021. For 2018 and 2017, these numbers were $1885 and $1599 per ton respectively. Total tons sold were also down in 2021 and 2022 compared to previous years despite acquisitions adding to capacity due to supply chain issues. This allowed the firm to spend less on inventory and shipping while raking in much higher ticket prices, adding substantially to their top and bottom line.
Investment Thesis:
The prices for steel, aluminum, and copper (in order of decreasing importance to RS) has been weakening since its 2021 peak. Supply chain issues, pent up demand, and the construction of sophisticated warehouses and fabrication facilities led to the metal prices we have seen over the past couple of years. The supply chain issues have been fixed and nonresidential construction and manufacturing demand, which make up the majority of RS’s end markets, has and will continue to weaken due to interest rates and the risk of a recession come 2H23 and 2024. IBISWorld has the value of nonresidential construction value falling by 8.5% and manufacturing falling by 1.5% in 2023. Aerospace manufacturing and fab construction demand makes up a materially significant, yet minority position in RS’s end market portfolio and so I am less concerned with the potential growth that RS may see here.
The general trend of RS’s revenue in the next two years will be negative. The firm is in a much better position than most players to weather the storm, and will likely have somewhat muted hits on its revenue in comparison to the amount the company grew in 2021 and 2022, some of which can be attributed to the sizable number of acquisitions RS has performed in the period, but even small hits to revenue will end up having a large effect on EBITDA.
As mentioned earlier, RS had lower volume but higher ticket prices in 2021 and 2022, moving EBITDA margins up from 10% to 17.4% and 16.1%. We are now moving into an environment where RS will be selling at higher volumes at lower ticket prices. This will both increase variable costs associated with shipping and warehousing and spread less revenue over the high fixed costs RS has. I don’t expect EBITDA margins and revenue to slingshot back to pre-covid levels, but just a 7.5% reduction in revenue and a 2 point increase in SG&A as a % of revenue would result in a 25% reduction of EBITDA.
At a historic EBITDA multiple of 6.5x (currently 5.9x), assuming revenue drops by 7% YoY, and assuming that Warehousing expenses and SG&A as a percentage of revenue expands another 50 bps to 17.5% of revenue, I believe a target price of $214 is fair and quite conservative. This comes out to an upside of -20.7%, which is a little slim, but keep in mind is a very conservative estimate. Revenue and EBITDA (and subsequently its multiple given the uncertainty that will lie ahead for the next couple of years) is likely to fall much more.
It is important to note that 1Q23 came in at -11.6% YoY revenue and -25.9% YoY EBITDA growth, which is just a partial slowdown. RS’s stock is still benefiting from its large backlog of orders from early 2022, when metal prices were still high, keeping its average selling price per ton of $2623 well above its 2019 levels, which is where it ought to be due to steel prices being around 2019 levels. Given the stock is still trading at the levels where it recorded its highest profits, the market is confounding this temporary stickiness in earnings with the market share the firm has taken through acquisition and expanding into new, more expensive, metals like copper. RS has grown via acquisition over the past two years, but by their own admission, the majority of their sales and profit is thanks to elevated metal prices. Steel and aluminum still make up the vast majority of their revenue, and it will stay like this for the foreseeable future.
More importantly, I fear that many investors have failed to fully appreciate the amount of operating leverage the company is working with, attributing the past two years of large margins entirely to cost synergies and pricing power. As mentioned before, margins don’t even have to come close to pre pandemic levels for the short to work. Given the ramp ups in volumes and the current price of steel being back to pre pandemic levels, however, it is totally plausible that they do.
In their unwillingness to give any guidance outside of Q223, management is effectively signaling that the backlog in orders from 2021 and 2022 are coming to its end. We should start seeing orders at a lower price from here on out.
Risks:
Analysts are already predicting the kind of slowdown that I have expressed in my report. Given the fact that the stock is at its all time high despite a massive slowdown is right around the corner, I think the opportunity still exists.
Given the recent job report and inflation data, the economy could continue to run hot and we could even end up avoiding an economic slowdown altogether. I remain unconvinced, however, due to the weakness in the housing market and the drop in hours worked. Regardless of what happens with the economy, the interest rate hikes and overall sentiment have already had material effects on the construction and manufacturing space.
Conclusion:
I believe the market is completely detached from reality when it comes to Reliance Steel & Aluminum. The market is failing to consider the substantial amounts of operating leverage and backlog the company is operating with, assuming that high ticket prices and margins are simply here to stay. This is sadly not the case. EBITDA and earnings margins have already compressed by 200 basis points over the past several quarters, and I believe that there is at least another 300 basis points of compression left. Our price target is $214, and I expect the stock to hit this level by 2H23 or 2024 as the company runs through the remainder of its backlog and starts selling at lower prices with higher volumes.
For further details see:
Reliance Steel: Exuberant Margins Reverting To The Mean