2023-10-09 06:10:50 ET
Summary
- Steel Dynamics shares have performed well, rising by about 40% in the past year, despite concerns about an economic slowdown.
- The company's circular manufacturing model and strong utilization rate help keep costs low and maintain profitability.
- STLD benefits from strong secular tailwinds, including government policies supporting domestic steel prices and increased nonresidential construction activity.
Shares of Steel Dynamics (STLD) have been a strong performer over the past year, rising by about 40%, despite fears of an economic slowdown. The company has been the beneficiary of the sharp rise in steel prices after the pandemic, alongside a boom in nonresidential construction. While earnings have passed their peak, I expect cash flow to remain elevated, allowing continued share repurchases, making shares attractive.
In the company's second quarter , it earned $4.81 on $5.1 billion in revenue. This was down 25% from last year on 18% lower sales. The company's mills operated with a utilization rate of 93%, similar to last year, vs an industry average of 76%. Its circular manufacturing model, by taking existing scrap metal, recycling it into steel, which it then either sells directly to customers or uses to make its own value-add manufactured steel products enables this strong level of utilization, helping to keep per unit costs low.
Steel Dynamic generates ~55% of its profits from steel production, ~42% from steel fabrication, and about 3% from recycling. While the production business is largely a commodity one, its fabrication unit provides value-add products for use in construction, automobiles, and aerospace that provide higher margins and more stable demand dynamics over time.
As you can see below, prices have fallen over the past year by 10-20%, but shipments have held stable. Supply chain disruptions that limited production industry-wide in 2021 & 2022 have largely abated, bringing prices down, but demand has held up fairly well from last year given ongoing economic growth.
This trend of lower prices and relatively resilient demand appeared to continue in Q3. Recently, Steel Dynamics guided to $3.46-$3.50 in EPS in Q3, below the $3.76 consensus. While steel orders and shipments were flat, realized prices have fallen. Prior to the beginning of the boom in 2021, STLD had earned over $3.50 over an entire year just once - now it is doing that during a down quarter. I highlight this to remind investors that while the company is less profitable than it was at the peak of the supply squeeze, it remains incredibly profitable.
This is why shares have performed well even as earnings have fallen. It was understood that supply chains would gradually improve and that peak results could not be repeated. Just as companies sometimes take one-time charges when they do layoffs, STLD essentially had the opposite occur, enjoying a one-time windfall as it sold steel into a supply-short market. Some of that profit surge was one-time, rather than recurring in nature.
Fortunately, STLD used that windfall to reward shareholders and make the company fundamentally stronger with a balanced capital return policy. Of its $11.5 billion in cash from operations over the past five years, it has spent $4.9 billion on cap-ex and M&A and returned $5.6 billion to shareholders. Trailing net leverage is also just 0.2x EBITDA. With $2.3 billion in cash on hand it will not need to refinance any maturities until at least 2026, greatly reducing its exposure to higher interest rates.
In Q2, it spent $380 million on buybacks, reducing its share count by 2.2%, and since 2017, its share count has fallen by 28%--closer to 40% when excluding share-based M&A. This lower share count is a reason why EPS is structurally higher than it was pre-COVID. As of quarter end, $606 million of its $1.5 billion buyback authorization remains. Management suggested another ~$200 million was repurchased in July and August. I would expect a new authorization to be announced in November, consistent with last year.
While earnings and cash flow are off their peak, they remain very strong. Net of working capital, STLD generated $815 million of free cash flow in Q2 and $1.5 billion YTD. Over the past year, it has $3.2 billion in free cash flow, for a trailing FCF yield of about 16%.
As noted above, this strong free cash flow comes after devoting nearly half of operating cash flow to its cap-ex program.
This cap-ex should continue to drive cash flow growth as 2 more lines come online in its new Texas mill this year, alongside 4 more flat roll finishing lines. It will also have its aluminum mill up and running in H1 2025 - a $2.5 billion plant. This plant will help diversify cash flow away from steel and deepen STLD's ties to the auto industry. As this plant goes from being a cap-ex drag to an EBITDA producer in the next three years, we should see a healthy free cash flow inflection even if steel activity continues to moderate.
Importantly, while steel is seen as a very cyclical industry, I see strong secular tailwinds that should dampen this and help keep cash flow elevated. First, the Trump Administration imposed tariffs on foreign steel, and the Biden Administration has largely continued this policy . This has helped to restrict supply of steel in the US and support domestic prices and manufacturers, like STLD. Given one of Biden or Trump is likely to be elected President in 2024, this policy appears poised to continue for the foreseeable future, a positive for STLD.
Next, it is important to emphasize how much of a bright spot nonresidential construction has been for the US economy. As you can see below, activity has increased dramatically. A significant portion of this is due to government policy: the bipartisan infrastructure bill, the CHIPs Act, and the Inflation Reduction Act have increased direct government construction spending and incentives for private nonresidential construction. While this rate of growth is highly unlikely to persist, these programs run for several years, and so I expect this elevated level of spending to persist.
Importantly, these programs, like incentivize for semiconductor factories, run independent of economic activity. They also support construction that takes years to complete, and given a company will not want to lose its subsidy, construction will likely be completed. In fact, manufacturing construction has nearly doubled over the past two years. Factories require steel. Equally important, after completion, much of the machinery that is used to make products, and end products themselves, use steel. A larger US manufacturing base is a long-term positive for steel demand and for STLD.
Of course, other aspects of steel demand are cyclical. Importantly, I would note that indicators of the manufacturing's sector health, like the ISM index, have begun to move a little higher in recent months. This has coincided with increased hopes for a "soft landing" in the economy. A recession is a risk for shares, but the probability of one appears to be lessening. Additionally, given government policy, STLD should see demand hold up better during a recession than one would ordinarily expect.
Institute for Supply Management
As such, I believe we should see prices and volumes begin to hold around current levels, pointing to about $14 in run-rate earnings power or about $2.2 billion in free cash flow. Important as 2025 approaches, we should see a ~$500 million swing in FCF from its aluminum plant. This provides meaningful upside. Additionally, STLD can continue to reduce its share count by 8-10% per year, meaning EPS may be closer to $15 in a stabilizing steel price environment.
At 7-8x earnings, shares are attractive, particularly as this multiple seems to focus on near-term economic risks, rather than the long-term growth offered by its cap-ex program and the support of government policy. As cash flow proves resilient and the aluminum plant comes more closely onto the market's radar, I expect shares can trade up closer to 10x earnings or $130-$140. Steel Dynamics is an attractive buy. Strong cash generation and growth prospects more than offset near-term economic risks.
For further details see:
Steel Dynamics: A Strong Company At An Attractive Multiple