2023-07-21 14:07:01 ET
Summary
- Steel Dynamics is a leading US-based steel producer facing headwinds due to poor economic conditions, but continues to invest in its business for future growth.
- Despite a year-on-year decline, STLD reported strong Q2 2023 results and is expanding into aluminum, with a new facility expected to start operations by mid-2025.
- STLD's strong balance sheet, consistent dividend growth, and shareholder-friendly approach make it a compelling long-term investment, although waiting for a bigger correction might be prudent.
Introduction
It's time to discuss Steel Dynamics ( STLD ) , one of the most fascinating US-based steel producers, as it has products that go far up the value chain, allowing STLD to maintain a terrific track record of consistent dividend growth and capital gains.
Unfortunately, the stock has run into headwinds. While STLD shares are still up 5% year-to-date and 55% above their 52-week low, they are also 25% below their 52-week high, which also happens to be its all-time high.
Poor economic conditions are the main reason why investors are dumping this stock.
The good news is that STLD continues to invest in its business, paving the way for higher margins and volumes down the road. While this stock price decline isn't fun for investors, I believe weakness needs to be embraced, as STLD is a terrific long-term steel bet at the right valuation.
Now, let's dive into the details!
A Quick Look Back
Before we dive into the numbers, I want to very briefly summarize what I wrote in my last article in May , when I covered what makes STLD such a special company.
- STLD is the second-largest steel company in America, with a market cap of around $17 billion.
- It consistently outperforms during economic upswings, making it one of the best steel stocks globally.
- STLD focuses on value-added steel products, with roughly two-thirds of its portfolio in this category, providing it with pricing power and high margins.
- The company is a market leader in categories like coated steel, used in the construction industry and automotive sectors.
- STLD has a healthy balance sheet, protecting its investors against elevated rates.
- The company maintains a strong dividend track record, making it a reliable choice for investors.
What 2Q23 Results Tell Us About The Company
In the second quarter of 2023, STLD reported a more than decent financial performance, with net income of $812 million ($4.81 per diluted share) and EBITDA of $1.1 billion. Note that the EPS result came in $0.07 higher than expected.
The company's revenues reached $5.1 billion. While this is an improvement from the previous quarter, primarily driven by higher realized steel selling prices, it is down 18.2% on a year-on-year basis.
Operating income in the second quarter was $1.1 billion, which is a 27% increase compared to the first quarter, mainly due to a significant expansion in the steel metal spread.
Unfortunately, year-on-year operating income took a big hit, as it was down 34%.
Looking at steel prices, we see significant price declines. The average external sales price dropped by 18% year-on-year but rose by 16% compared to the first quarter.
Meanwhile, shipments of steel remained strong. We see that total shipments were up 3%, as flat-rolled shipments offset weakness in long products steel.
Sequentially, steel shipments are down, which makes sense because steel prices tend to be leading while steel shipments are lagging.
The chart below compares COMEX hot rolled coil prices to the ISM manufacturing index.
Furthermore, in terms of steel operations, the company achieved higher utilization rates, which stand at 93% (excluding Sinton), outperforming the domestic industry average of 76%.
This higher through-cycle utilization rate was attributed to the company's value-added diversified product offerings, competitive supply chain solutions, and internal pull-through manufacturing volume.
Having said that, STLD's metals recycling operations reported an operating income of $40 million during the second quarter, which was consistent with the previous quarter. Unfortunately, increased shipments were offset by lower metal spreads.
During its 1Q23 call, the company noted that it benefits from its circular manufacturing model, which provides high-quality, lower-cost scrap, improving furnace efficiency and reducing overall working capital.
Furthermore, STLD's Mexico recycling operations offer a competitive advantage in terms of reliable supply and future increased scrap aluminum collection.
On top of that, the company is currently the largest North American metals recycler, processing and utilizing ferrous scrap and non-ferrous aluminum, copper, and other metals.
Regarding steel fabrication operations, STLD achieved an operating income of $462 million in the second quarter, showing significant strength despite a 13% decrease in average pricing. Volumes remained steady.
Furthermore, a sign of strength is that the steel joist and deck order backlog extends into the first quarter of 2024.
Although it has contracted from the record highs experienced in 2022, the forward backlog pricing remains robust, and spot pricing is resilient.
Looking ahead to the second half of 2023, STLD expects steel fabrication earnings to remain strong, although slightly lower than the first half, due to a number of factors like the Infrastructure Inflation Reduction Act, Department of Labor initiatives, decarbonization support, and manufacturing onshoring, all of which are expected to support steel consumption and demand in the coming years.
Looking at the chart above, it's fair to say that Steel Dynamics is right when it notes a much better environment for steel demand.
With that in mind, Steel Dynamics is expanding its business.
Taking Things To The Next Level
When I just mentioned the utilization rates, they were adjusted for issues at the company's Sinton project.
Regarding the Sinton project, the team achieved positive EBITDA during the second quarter, although production rates were lower than planned due to equipment issues. Repairs are in progress, and they expect to progressively ramp up production to an 80% run rate by the end of the year.
The company is also moving ahead with its expansion into aluminum, intending to build a 650,000 metric-ton aluminum flat roll facility in Columbus, Mississippi.
This facility will serve the sustainable beverage and packaging markets, targeting 300,000 tons of cans, 200,000 tons of auto-related products, and 150,000 tons of industrial products.
The on-site melt capacity will be supported by two satellite recycled aluminum slab casting centers in Mexico and the Southwest US.
The company expects to start up the rolling mill around mid-2025, with the Mexico slab center operational on January 1, 2025, and the Southwest US slab center in the first quarter of 2025. This also means that the company will encounter lower CapEx down the road, which is beneficial for free cash flow growth.
Steel Dynamics also provided us with some numbers, as it is confident in the growth prospects of its aluminum expansion, expecting to add $650-$700 million of through-cycle annual EBITDA and an additional $40-$50 million of earnings from the Omni recycling platform.
Lastly, it needs to be said that the company has a fantastic position, as it can service prime markets in Texas, the West Coast, and Mexico.
Not only does this come with great connections to railroads, but it also means the company benefits from economic re-shoring and faster growth in Mexico, which I highlighted in a recent article about railroad giant Canadian Pacific Kansas City ( CP ).
Shareholder Returns
Despite the poor year-on-year performance, STLD's cash generation and balance sheet remained strong. As of June 30, its liquidity stands at $3.5 billion, including a recently renewed unsecured $1.2 billion revolver.
The company refinanced its revolver, which will likely have a positive impact on its financial position going forward.
Note that the company is expected to become net cash positive in 2024, meaning it could end up with more cash than gross debt. The company enjoys a BBB credit rating. I would not be surprised if the company were to end up with a BBB+ rating within 24 months.
That said, during the second quarter of 2023, STLD generated an operating cash flow of $808 million, and the first-half cash flow from operations totaled $1.5 billion.
For the second half of the year, the company expects capital investments close to $1 billion, primarily allocated to the aforementioned aluminum flat-rolled investments and the completion of four flat-rolled steel coating lines by the end of 2023.
Essentially, STLD has implemented a capital allocation strategy that prioritizes high-return growth while also focusing on shareholder distributions.
The company increased its dividend by 25% in February and repurchased $734 million (3.9% of outstanding shares) in 2023.
Currently, STLD yields 1.7%. It has a payout ratio of less than 10% and a 17.4% 5-year dividend CAGR, which is impressive.
Note that dividend growth has accelerated since the pandemic, which is based on re-shoring benefits, better pricing, and the company's own business improvements.
Since the pandemic, the company has bought back 20% of its shares, which is impressive.
As a result, of high-value products, strategic expansion, a top-tier balance sheet, and consistent shareholder distributions, the company has outperformed its peers, as I showed at the start of this article.
Valuation
I'm not a huge fan of giving commodity-focused stocks a price target. The main reason is the massive influence of commodity prices. If steel prices rebound, expectations will soar.
With that in mind, the company is expected to generate close to $1.1 billion in free cash flow after 2023. That is based on normalization in steel prices and lower CapEx.
That would imply a current free cash flow multiple of 15x. I believe that's a good deal, as it supports aggressive dividend growth and buybacks.
Additionally, I believe that if economic growth rebounds, we'll see much higher free cash flow, allowing the company to accelerate shareholder distributions.
That said, the current valuation is fair. The company is trading at less than 5x NTM EBITDA. While there is a risk that EBITDA comes down in the short term due to the economic trend, I am not as pessimistic about steel as I would usually be at this stage of the cycle: secular growth is simply too strong.
The current consensus price forecast is $110, which is 8% above the current price.
I agree with that.
However, I'm not buying at these levels. As much as I like cyclical dividend growth stocks like STLD, I have close to 50% industrial exposure, 17% energy exposure, and related cyclical investments.
If I were to invest in STLD, I would wait for a bigger correction.
My bullish rating reflects the company's longer-term potential.
Takeaway
I have to say that Steel Dynamics is a captivating steel producer with remarkable earnings potential. While facing headwinds due to poor economic conditions, STLD remains a superior steel stock. Its value-added steel products provide pricing power and high margins, making it a market leader in categories like coated steel.
Not only that, but STLD continues to invest in its business, paving the way for higher margins and volumes in the future.
STLD's expansion into aluminum and strategic growth plans bode well for long-term earnings.
Additionally, its strong balance sheet, consistent dividend growth, and shareholder-friendly approach make it a compelling long-term steel investment.
Although the current valuation is fair, considering the potential for higher free cash flow and economic growth, waiting for a bigger correction might be a prudent move.
Nonetheless, STLD's longer-term potential remains bullish.
For further details see:
Steel Dynamics - Simply One Of The Best