2023-07-28 13:08:59 ET
Summary
- Steel Dynamics shares remain high due to the profitable Steel Fabrication segment, but declining prices and a potential recession may impact earnings.
- Global steel production has returned to negative growth, with a 5% decrease in May, driven by restrictions in Europe and China.
- Operating income is poised to drop following the turnaround in prices for special steel products, which will weigh on the company’s valuation in the future, despite the stabilization of STLD’s.
Investment Thesis
Steel Dynamics ( STLD ) shares still remain near their historical highs. Shares have been supported by the ultra-marginal Steel Fabrication segment, that contributed 20% of revenue and an extreme 60% of operating income.
However, prices for special steel products, following the reversal in the cost of steel, began to decline driven by the low-digit rate of construction and reconstruction of infrastructure projects. With the looming USA recession, we can see further compression of hot-rolled steel prices and steel fabrication prices. That will compress EBIT dramatically. Rating for the shares is SELL.
The Steel Market
According to the World Steel Association , the trend of global steel production has returned to the negative zone after a period of rapid growth on the back of the reopening of the Chinese economy. In May, steel production decreased by 5% y/y due to sharp restrictions on production in European countries and China. The only countries where the trend was positive were in Africa, as they increased production by 18% y/y to 1.3 mln tons, and in the CIS region, where production jumped by 11.5% y/y due to increased production in Russia.
The reopening of the Chinese economy did not meet expectations. The manufacturing PMI for the past 3 months stayed below 50 (49.2 for April, 48.8 for May and 49.0 for June), while the market had expected higher numbers. Amid the slowdown of China's economy, prices for industrial metals continued to decline, and production followed suit. China's production cuts in May were some of the biggest compared with the rest of the top 10 market players.
We expect that, as U.S. manufacturing activity fades (capacity utilization in June fell again, to 78.9%), the demand for steel in the country will decline, which will put pressure on prices and production. U.S. steel production already slipped by 5% y/y over the first 5 months of this year.
Financial Results Outlook
The average price of hot-rolled steel in the U.S. reached $1055 per ton in 2Q 2023. Global steel prices rose in response to the Chinese economy's reopening after lockdowns and increased domestic consumption, which also affected U.S. prices. However, we still expect steel demand to decline with the onset of recession, causing prices to fall.
Realized prices of STLD steel are set to continue to decline, even as spot prices are fluctuating. We expect the trend to continue following global prices.
The cost of special steel products has finally started the long-awaited turnaround in response to the slowdown in the construction/reconstruction of non-residential and infrastructure projects. In the first five months of 2023, the total volume of non-residential buildings fell by 1% y/y to 156.7 bln on the back of headwinds in office property and a slowdown in school construction, which was partially offset by the start of construction of industrial facilities. Construction unrelated to buildings increased by 25% y/y to $110 bln in the first five months of 2023 due to ongoing reconstruction of gas pipelines and bridges. Residential construction fell by 25% y/y to $141.5 bln.
We are lowering our EBITDA forecast from $4164 mln (-24% y/y) to $4149 mln (-24% y/y) for 2023, and from $3561 mln (-14% y/y) to $3213 mln (-30% y/y) for 2024, given the reduced forecast for realized prices in the segment of special steel products.
As a reminder, operating income is poised to drop following the turnaround in prices for special steel products, which will weigh on the company's valuation in the future, despite the stabilization of STLD's core steelmaking business.
Valuation
We are maintaining a SELL rating for shares of STLD. Our target price for the stock is $82.
Our baseline valuation accounts for a future decline of prices in 2023-2024 by averaging the fundamental estimates for 1 1/2 years ahead, from 3Q 2023 - 2Q 2024 for the period from 1Q 2024 - 4Q 2024.
Conclusion
We believe it's too early to invest in STLD stock just yet. First of all, that's because during a recession, U.S. steel prices, as well as prices for special steel products, could fall faster than we expect. That would have an adverse impact on the company's financial results and share prices.
For further details see:
Steel Dynamics: Prepare For Recession