Is Steel Dynamics a reverse value trap? (Part 1 of 2)

Case 08-1:  This is my first case study of a US-listed company.  It is intended to demonstrate that the approach is also applicable to companies listed in other parts of the world. 

Is there such a thing as a reverse value trap?

A value trap is a stock that appears cheap relative to historical prices but is really overpriced. It is a value trap because the business is facing some insurmountable issue.

What is a reverse value trap then?  

It is a stock that appears expensive relative to historical price or historical multiples.  But the fundamentals show that the business is actually flourishing. While appearing expensive it is really a bargain.

Nasdaq listed Steel Dynamics Inc (SDI or the Group) is an iron and steel Group with a market price of USD 36.87 per share (as of 31 Dec 2020).

It is trading at a Price to Book value of 1.8 compared to the US steel industry average Price to Book value of 1.4 (Source: Damodaran Jan 2020).

In the Malaysian context, any “brick and mortar” business trading at such Price to Book multiple would have been considered overpriced. (refer to Note 1)

Is SDI overpriced or is it a reverse value trap?

Join me in a 2-part series as I argue why there is still a buying opportunity with SDI.

Part 1 is presented here while Part 2 was published on 17 Jan 2021.


Contents

  • Is there anything Special about the Group’s Expertise?
  • Is there Concern about how it Uses its Funds?
  • Is the Current Performance Outstanding?
  • Tracing the Group’s Rich and Unique History
  • Is there a Great Future?
  • Pulling it all together

Is Steel Dynamics a reverse value trap?

Is there anything Special about the Group’s Expertise?

SDI was founded in 1993 by three former executives of Nucor and began production at its Indiana, USA flat roll mill in 1996.

The Group has grown both organically as well as through acquisitions and today has 3 main operating segments:
  • Steel.  With 6 electric arc furnace steel mills, the products include hot roll, cold roll and coated steel, long products, and steel finishing.
  • Metal recycling. Operating under OmniSource LLC this includes both ferrous and non-ferrous scrap processing.
  • Steel fabrication. This includes the New Millennium Building Systems LLC joists and deck plants whose products are used within the non-residential construction industry. 

With the current annual production capacity of 13 million tons, SDI is one of the largest producers of carbon steel products in the United States. 

SDI is essentially a US market-based Group with only 4% of the 2019 revenue from exports.

According to the Group, its competitive advantages are
  • Financial strengths and flexibility
  • Low, highly variable cost structure
  • Diversified value-added product mix
  • Secured supply of recycled ferrous metals
  • Entrepreneurial culture

The Group has a vertically connected business platform as illustrated in the chart below. 

According to SDI,

“...this results in higher utilization and lower costs, providing strong cash flow generation…”

Essentially SDI is a steelmaking group with the Metal recycling segment being an important part of the process. 
  • Without the Metal recycling segment, SDI would have to set-up an in-house scrap operation to supply the steel mills.
  • But the Steel fabrication segment is not part of the conventional steelmaking sector. 


SDI Business platform
Chart 1: SDI Business Platform
Note: 
a) The external purchase was derived based on 100% material balance ie ignores production losses. It is intended to illustrate the scale of the in-house vs external supply situation and is not intended to represent the actual purchases.
b) The inflow for Steel is greater than the outflow due to increases in inventory. 



Case Notes

The company analysis and valuation is only one component of the investment process.

Your investment process must cover the following
  • How to allocate your net worth to several asset classes
  • Within each asset class eg stocks, how to construct and manage the portfolio
  • In the context of stocks, how to identify the stocks to buy, determining how much to buy, and when to buy and sell
  • what is the overall risk mitigation plan

I have tried to provide several blog posts to answer the various issues and you should go through all of them if you are a beginner.

In the context of risk mitigation, investing in the stock market must only be part of your investment plan.

I have shown in other posts in the blog that in the Malaysian context, there are times when you should also consider investing in properties.

As part of the risk mitigation plan, you may consider investing outside of your home country. This post is about looking at a US-listed company. 





Is there Concern about how it Uses its Funds?

As of the end of Sep 2020, the Group had a Total Capital Employed (TCE) of USD 6.9 billion. Shareholder’s fund accounted for 61 % of the TCE with the balance from debt.

This is equivalent to a book debt to TCE ratio of 42 % compared to the US steel industry average of 39 % (Industry source: Damodaran Jan 2020). 

Items

Ref

USD million

Shareholders’ Equity

SHF

4,201

Minority Interests

MI

(158)

Total Debt and Lease     

Debt

2,874

TCE

 

6,918


Items

Ref

USD million

Net Operating Assets

Net OA

5,650

Net Financial Assets

Net FA

1,268

Non-Operating Assets

Non-OA

0

Total

 

6,918

Table 1: Sources and Uses of Funds (3rd Quarter Sep 2020)


About 82% of the TCE has been deployed for the operations with the balance tied up mainly in cash.

Given that its debt to TCE is about the industry level, the Group’s cash position looks high as it has cash to firm value of 12 % compared to the steel industry average of 7 % (Source: Damodaran Jan 2020).

I suspect that a significant part of the USD 1.3 billion cash would be deployed in the coming years as SDI has USD 1.4 billion fixed asset investment under construction. 

SDI Sources and Uses of Funds
Chart 2: Sources and Uses of Funds

The Group did not provide any breakdown of how its funds have been deployed by segments.  

However, you can get a picture by looking at how the total assets have been deployed.
  • The Steel segment accounted for about 62 % of the total assets.
  • The Other segment which included cash accounted for 22 % of the total assets.
  • The other 2 operating segments together accounted for the balance of 16 %.

SDI assets
Chart 3: SDI Assets

Is the Current Performance Outstanding?

For the 9 months ended Sep 2020, the Group achieved USD 7 billion of revenue with USD 374 million net income.

In comparison with the same period last year, the current period revenue is 14 % lower while the net income is 33 % lower.

Not surprisingly, the Group attributed the performance to the economic impact of Covid-19.

The current year performance is in contrast to the long-term improvement in the business as can be seen from the Performance Index below
  • Revenue, net income, and gross profitability have improved since 2010. 
  • The jump in profits in 2017 and 2018 is due to the twin effect of zero impairment in these 2 years c/w 2016 as well as the twenty-odd % annual revenue increase. 
 
SDI Performance Index
Chart 4: Performance Index

An analysis of the performance of the 3 segments showed
  • The Metal recycling segment has not contributed to the Group's bottom line. However, the segment has ensured a supply of low-cost high-quality material to the Steel segment. In 2019, the Metal recycling segment supplied about 1/3 of the Steel segment’s scrap requirements. 
  • The Steel segment is the main profit generator for the Group in terms of dollar amount as well as % returns.
  • The majority of the Total Assets under Others is cash. 

SDI segment performance
Table 2: SDI segment performance
Notes
a) Ave revenue and operating income based on 2010 to 2019
b) Return on Assets = Ave operating income/Total assets
c) The majority of the inter-co sales relates to the Metal recycling segment

Tracing the Group’s Rich and Unique History

Over the past 10 years, the revenue of the Group has grown from USD 6.3 billion in 2010 to 10.5 billion in 2019 equivalent to a CAGR of 5.8 %. 

However, not all the segments were growing at the same rate
  • The Steel segment accounted for about 54% of the Group revenue in 2010 but in 2019 it has grown to 68 % of the Group revenue.  
  • The Metal recycling segment has shrunk from 43 % of the Group revenue in 2010 to about 21 % in 2019. It actually had a compounded annual reduction in revenue of 2.7 %

The chart below shows how the profile of how the Group revenue has changed over the 10 years period. 

SDI Revenue profile
Chart 5: SDI Revenue profile

The Steel fabrication segment is not really a significant revenue contributor. 

SDI operating margins
Chart 6: SDI operating margins by segments

Chart 6 shows the historical operating margins:
  • The Metal recycling segment losses in 2013 to 2015 were due to substantial asset impairments.  Even without this impairment, it is a very low margin business and all the more worrisome given the declining revenue.
  • The Metal Fabrication segment has improved its operating margin from a loss a decade ago to an average of 10% over the past 3 years. 

How did the growth come about?  Through a combination of organic growth and acquisitions

Steel segment

This segment has 2 main product groups - sheet steel and long products with 13 million tons of annual capacity in 2019 compared to the 2010 capacity of 6.4 million tons. (Refer to Note 2)
  • It currently has 8.4 million tons of flat roll steel shipping capacity compared to 4.0 million tons in 2010 (Refer to Note 2).
  • SDI currently has 4.6 million tons of long products shipping capacity compared to 3.4 million tons in 2010.

The majority of the flat roll capacity increases were achieved through acquisitions.
  • In 2014, SDI acquired Severstal Columbus, one of the newest and most technologically advanced mini-mills in North America increasing the capacity by about 3.2 million tons.
  • In 2018, the Group acquired the former Kentucky Electric Steel plant adding 0.25 million tons capacity.
  • The Heartland flat roll division with 1.0 million tons of cold rolling capacity was acquired in 2018.

Under construction is the next generation Southwest-Sinton electric arc furnace flat roll steel mill with a 3 million tons annual production capacity that is targeted to open in mid-2021.

The long products capacity increase appeared to be due to organic growth
  • A new caster for rail making at Columbia City started production in 2010.
  • In 2016, the company acquired Vulcan Threaded Products for USD 126 million adding 125,000 tons to the Group’s capacity.
  • In 2017, SDI began a $28 million expansion of its Roanoke Bar Division and a $75 million expansion of its Structural and Rail Division.

Around 2008 SDI had the view that due to the volatile nature of the ferrous scrap industry, it would be beneficial to develop a cost-effective iron source for a portion of the mill’s melt mix.

Accordingly, SDI invested in the Minnesota iron making operations. It would appear that due to technical and mining rights issues, these facilities were discontinued in 2014/2015. 

Today only the liquid pig iron part of the operations that supplied solely to one of the SDI mills is still in operations.  This supply has grown from 180,000 tons in 2010 to 249,000 tons in 2019. 

Metal recycling 

As part of its steel operations, SDI purchased scrap from numerous scrap suppliers in addition to its own scrap operations. 

In 2007 the Group acquired one of its suppliers, OmniSource for about USD 1.1 billion. The total transaction value included the assumption by SDI of certain liabilities, including USD 220 million of debt.

SDI existing scrap operations were then rolled into OmniSource.

“This acquisition creates a significant new business platform for SDI and represents a quantum leap... this acquisition opens the door for further profitable growth in a sector of increasing relevance on a global scale…These initiatives are expected to play a significant role in SDI’s future steelmaking growth.”

This new business platform did not materialize.  
  • In 2010 the Metal recycling segment shipped 5.2 million gross tons of ferrous materials but this declined to 4.6 million gross tons in 2019.
  • However, in terms of in-house usage, the shipment has increased.  In 2019 the Metal recycling segment shipped 3.1 million tons to the Steel segment compared to 2.1 million tons in 2010. 

Steel fabrication

New Millennium was started in 1999 to produce produces joists, girders, trusses, and steel roof and floor decking for the non-residential building sector.
  • In 2003 SDI bought out the other shareholders to a fully owned subsidiary. 
  • A second plant began production in 2005 in Lake City, Florida. 
  • A merger with John W. Hancock, Jr., LLC and Socar Inc was undertaken in 2006.  
  • New Millennium purchased 3 joist plants from Commercial Metal Company in 2010 making New Millennium the 2nd largest joint and deck provider in the country.

The business has grown substantially from 164 tons shipped in 2010 to 644 tons in 2019.

Is there a Great Future?

Steel is one of the most common manmade materials in the world.

SDI is in a sector characterized as follows
  • Steel products are commodities.
  • The industry is cyclical.
  • Its profitability is very dependent on government trade policies

Refer to the CSC Steel case study for some perspective of the industry.

Steel consumption in the US increased from 79.9 million tons in 2010 to 97.7 million tons in 2019 equivalent to a CAGR of 2.3 %

In contrast, SDI external shipment increased from 5.0 million tons in 2010 to 9.4 million tons in 2019 resulting in a CAGR of 7.4 %. 

SDI grew by increasing its market share. I estimated that SDI had about 6 % of the USA steel market in 2010 and this increased to about 10 % by 2019. 

USA steel consumption
Chart 7: Steel consumption in the USA


Growth prospects

Short of further acquisitions the Steel segment revenue growth has to come from either
  • Increased consumption in the US.
  • Reduced imports.

The positive news is that the current level of steel consumption in the US is below the long-term average as can be seen from the chart below.  

If the Biden administration focuses on infrastructure development, the prospects of increased steel demand would be there.

USA apparent steel consumption
Chart 8: Apparent steel consumption in the USA  Source: ArcelorMittal USA

In terms of imports, there has been a decline in the imports due to the various trade barriers instituted as can be seen from the chart below.

Again, if the Biden administration continues with the trade protection measure and/or impose additional ones, it would be positive for SDI.

USA steel imports
Chart 9: Imports of steel into the USA  Source: ArcelorMittal USA

Cyclical nature 

Over the past 10 years, SDI's physical external shipment of steel grew at a CAGR of 7.4 %.  However, in terms of revenue growth, it was only 5.8 %.

The only way to reconcile this is if the unit selling price declined from the 2010 level.  This is partly due to changes in the product mix as well as the general movements in the product prices.

The chart below illustrates such movement

SDI steel segment unit price
Chart 10: SDI Steel segment unit selling price

The unit price changes are not surprising given the cyclical nature of the industry and the global over-capacity situation.

Capacity Utilization

The combination of imports and low consumption growth has meant that industry capacity utilization has been below 80 % for the past 10 years in contrast with those in the 2000s as can be seen from the chart below.

While I am not familiar with the US steel cost structure, in Malaysia you will need utilization to be above 80 % to be profitable.

Steel production in the USA
Chart 11: Steel capacity and production in the USA  Source: ArcelorMittal USA

Over the past 10 years, SDI had an average capacity utilization of 80 % and it dipped below 80% in 2014 and 2015 (Refer to Note 3). This was the result of a jump in 3.6 million tons of additional capacity following the Columbus mini mill acquisition. 

SDI capacity had grown by an equivalent CAGR of 6.5 % over the past 10 years.  I estimated that a big part of this growth came from acquisitions with some “acquired sales”. As such there may not be a significant impact on the overall plant utilization. 

Given that it has an additional 3 million tons of new capacity coming on stream in 2021, would SDI be able to increase its sales quick enough since this has to come from organic growth?

SDI Steel segment utilization was 84 % in 2019. When the new plant comes on stream, I expect the capacity utilization to drop in the next 1 to 2 years to below 70 %. (Refer to Note 4)

I would not be surprised to see a corresponding drop in profits for the next year or two given the projected lower capacity utilization. 

Pulling it all together

We have to differentiate between a good company and a good stock investment.
  • A good investment is one that can enable you to make money. From a value investor perspective, this requires that the stock to be available at a price that is below its intrinsic value.  Until we carry out a valuation of SDI, we cannot draw any conclusion on this.
  • A good company is one with has strong fundamentals and SDI seems to fit this.

SDI is a good company because:
  • It is financially strong.  The Group has the industry average debt to capital ratio while having a higher than industry cash position.
  • Revenue, profits, and gross profitability are trending up.
  • Both the Steel and Steel Fabrication segments are generating returns that appear to be higher than the cost of funds.  While the Metal recycling segment has not performed, it may have contributed to the Steel segment performance.
  • SDI physical steel external shipment has grown at a CAGR of 7.4 % over the past 10 years compared to the USA steel consumption CAGR of 2.3 %.
  • SDI has increased its market share of the USA market. A bigger part of this increase has been due to acquisitions.  However, I estimated organic growth at 5.6 % (Refer to Note 4) which is higher than the USA steel consumption growth rate. 

Whether SDI would be a buying opportunity would depend on a detailed assessment of the intrinsic value.

If you want to know whether SDI is a good stock to invest in, join me in Part 2 of this series. 


End of Part 1 of 2


Part 2 of 2 was published on 17 Jan 2021



Notes

1) Histogram - Price to Book of Bursa Malaysian companies as of end 2016

Malaysian 2016 Price to Book multiples
Chart 12: Malaysian Price to Book multiples

a) I did present the current distribution as it could be skewed by the Covid-19 pandemic.  I chose 2016 as this represented the time before the property and construction sector got soft.
b) According to Damodaran, the US Steel industry as of 5 Jan 2017 had an average Price Book ratio of 2.5.  This is much higher than for Malaysia. 

2) SDI reported a capacity of 6.4 million tons for 2010 excluding the Techs capacity of 1.0 million tons.  However, from 2016 onwards SDI included the Techs capacity when reporting the steel capacity. For consistency, I have added back the Techs capacity to those years' capacities which did not include the Techs.

As such my computation of SDI utilization resulted in a different set of figures compared to what SDI presented in its Annual Reports and 10Ks. 

3) I ignored the 2010 utilization.  Based on SDI reported 5.4 million tons of production and 6.4 million tons of capacity in 2010, the utilization would be 84 %.  However, after adjusting for the Techs capacity of 1 million tons, the revised utilization would be 73 %.  

4) Estimate of organic growth and capacity utilization
  • To estimate the growth in shipments excluding those that are due to acquisitions, I first estimate the annual increase in shipments excluding those resulting from acquisitions.
  • With the individual growth rates for each year, I created an index of annual shipment with 2010 as the base of 100.
  • The CAGR was then estimated by comparing the index for 2019 with that for 2010 to get a CAGR of 5.6 %.
  • SDI capacity with the Southwest-Sinton plant will be 16 million tons in 2022.
  • The 2020 shipment was estimated to be 9.3 million tons based on the Q3 YTD shipment of 6.958 million tons. 
  • Conservative estimates: Based on 9.3 million tons in 2020 and organic growth at 5.6 % per annum, the shipment will be 10.4 million tons for 2022.
  • Optimistic estimates: Based on 2019 SDI external shipment of 9.4 million tons and organic growth at 5.6 %, the shipment will be 11.1 million tons for 2020. 
  • Capacity utilization in 2022 was deduced to range from 65 % to 69 %



Reading guide
If you are a first-time visitor to this blog, you may not be familiar with some of the concepts that I have used in my analysis and valuation.  I suggest that you check up the Foundations series - Fundamentals 01,  Fundamentals 02, and Fundamentals 03.   I also have a Definitions page in case you are not familiar with the terms I have used. 




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Disclaimer
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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