Is Steel Dynamics still a buying opportunity? (Part 2 of 2)

Value Investing Case Study 08-2:  I drafted my Seeking Alpha article Steel Dynamics: Wait for the coming price decline in Dec 2020 based on the information in Part 1 and 2 of this case study. The valuation was based on the 2020 data set from Damodaran that was updated on 8 Jan 2021.  However, to ensure consistency between this case study and the Seeking Alpha article, I have maintained the 2020 valuation data for this case study.  Since the publication of this post on 17 Jan 2021, the company has released its 2020 financial statements. An updated article incorporating this info has been published as Case Study 08-3.  Revision date: 12 May 2021.

Is SDI a buying opportunity


Steel Dynamics Inc (SDI or the Group) is a Nasdaq listed Group in the iron and steel industry that is trading at USD 36.87 per share (as of 31 Dec 2020) ie Price to Book value of 1.8.

The US steel industry had an average Price to Book value of 1.4 (Source: Damodaran Jan 2020).

Is SDI expensive? As a value investor, there are two key scenarios:

  • The stock price is currently below the historical high or that it is cheap relative to the historical multiple.  The question then is whether this is a value trap or a bargain.  
  • The stock currently looks expensive as its current multiple is higher than the past or industry multiple. The question then is whether this is an overpriced stock or a growth stock. There may be a buying opportunity if this is a growth stock.

SDI is definitely not in the former category.  It is not a question of being a value trap. It belongs to the second category.

The challenge is determining the actual situation ie is SDI overpriced or is there still a buying opportunity?

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

Part 2 is presented here while Part 1 was published on 10 Jan 2021.

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Contents

  • Did Top Management Seize Opportunities?
  • Is there an Awesome Buying Opportunity?
  • Will there be Spectacular Growth in Shareholders’ Value?
  • How to Secure Your Investment by Minimizing Risk
  • Pulling it all together


Case Notes

I chose SDI to see whether the approach I used in analyzing and valuing Malaysian and Singaporean listed companies is applicable in the US context.

My approach is to look at companies from a 10 to 12 years perspective to smooth the performance over a business cycle.  I am not too concerned with quarterly results.

I look at the big picture. It is a helicopter view looking at the forest rather than the trees.

US companies provide much more detailed information about the operations compared to those listed on Bursa Malaysia or SGX.

Does the additional information provided by the US companies translate into more trees or does it provide a clearer picture of the forest?

I found that the US Annual Reports and SEC filings provided:
  • A lot more information on the operations so there is a tendency to be distracted from the goal of seeing the “forest from the trees”.
  • A more comprehensive risk assessment. 

When it comes to assessing management, I look for whether management interests are aligned with those of the shareholders, its operating and capital allocation performance, and whether management is honest and transparent.

In the Malaysian context where many of the companies are controlled and managed by the major shareholders, there is little issue about management alignment.  

In the US context where there is a greater separation of management and ownership, I have not found an effective way to assess this.  

In the context of SDI, I have taken the management assertion of this alignment as correct.

The other advantage with the US companies is that there are many financial sites that tabulate the historical financials. This enabled me to focus on the qualitative aspects as the readers would be able to access the quantitative comparisons easily. 

Some of these sites also provide analyses and valuation of companies for their members. If you don't have the time or skill to undertake your own analysis and valuation, you should consider subscribing to such services. Those who do this well include people like Seeking Alpha.*. Click the link for some free stock advice.




Did Top Management Seize Opportunities?

Management

In 2019, the directors and executives of SDI as a group held 4.9 % shares of the company. 

2 institutions (Blackrock and Vanguard) collectively held 20.2%.  I would not classify SDI as an owner-managed group given the low ownership by the directors and executives. 

In 2019, SDI reported 8 members on the senior leadership team with an average age of 55 years and 21 years average tenure with the Group.  In fact, 4 of them were from the pioneering team. 

According to SDI, its leadership team objectives are closely aligned with its shareholders.

This has been achieved through "...meaningful stock ownership positions and performance-based incentive compensation programmes that are correlated to SDI profitability and operational performance in relation to its steel manufacturing peers..." (Source: SDI)

With such an alignment and long tenure, how did senior management perform from an operational and capital allocation perspective?

Operations

SDI management contends that SDI has one of the most diversified, high margin product offerings of any domestic steel producer.

In its 2019 Annual Report, SDI had reported that it achieved best-in-class industry performance for a number of key measures. 

Management viewed its peers as AK Steel, Commercial Metal, Nucor, and US Steel. The chart below showed that SDI outperformed its peers in terms of revenue and gross profit margins.  

SDI Peer Revenue
Chart 1: Peer Revenue


Company

Average gross profit margin - 2017 to 2019

SDI

17 %

AK Steel

13 %

Commercial

13 %

Nucor

14 %

US Steel

10 %

Table 1: Peer gross profit margins

For another perspective of the leadership team performance, I compared SDI results with those of the iron and steel sector (I&S sector). 

The I&S sector comprises 17 companies listed on all the US stock exchanges with a market cap > USD 100 million and includes the largest cap companies such as POSCO, ArcelorMittal, and Nucor.  (Refer to Note 1)

In 2019, the I&S sector revenue is at the same level as that for 2010. The I&S sector revenue actually dropped to below the 2010 levels from 2015 to 2017.

In contrast, SDI 2019 revenue was 66 % higher than the 2010 revenue.

US Iron and Steel sector revenue
Chart 2: USA Iron and Steel sector revenue

In terms of average return on shareholders’ funds (with the latter defined as total equity + non-controlling interests) over the past 10 years, SDI had an average of 12 %.  

The Iron & Steel sector return averaged 2 % and ranged from - 30 % to 15 %.

Capital allocation

Over the 10 years period, SDI generated about USD 7.487 billion of cash from operations.  Of these
  • USD 1.992 billion was spent on CAPEX.
  • USD 2.375 billion was for acquisitions.
  • USD 1.124 billion was paid out as dividends.
  • USD 1.148 was used for share repurchases.
  • There was a balance of USD 1.109 billion for other uses.

SDI deployment of cash from ops
Chart 3: Deployment of cash from operations

Over the 10 years period, the Group generated USD 3.923 billion of net income.  Effectively 
  • The dividends represented a 29 % payout ratio.
  • About half of the net income was re-invested as CAPEX.
  • If you assumed both the CAPEX and acquisitions as re-investments, these exceeded the net income.  However, you should not be surprised given its historical debt to equity ratio of 0.9

About 58 % of the cash from operations was reinvested back into the business that generated an average of 13 % EBIT/TCE.

It has been an effective use of funds. 

There has also been a history of taking advantage of its good rating to replace its existing debt with lower-cost ones. 
  • In 2019, it issued 2 Notes at 2.8% and 3.45 % respectively and used the proceeds to repay a 5.125 %  one. 
  • In 2016, it issued USD 400 million 5 % Notes and used the proceeds to purchase the 6.125 % Note.
  • In 2013, it issued USD 400 million 5 ¼  Notes to repay an outstanding USD 500 million 6 ¾ % one. 

Were there management missteps?

The iron making venture is one.  Around 2008 SDI viewed 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 incurring about USD 260 million impairment in 2014. 

You could argue that the price for the acquisition of OmniSource in 2007 was another one as it resulted in USD 410 million goodwill and trade name impairment in 2015.  
  • SDI spend USD 1.1 billion on OmniSource which reported an average net income of USD 428 million for 2006 and 2007.
  • While SDI did not provide any data on OmniSource performance after 2007, the Metal recycling segment in 2008 had USD 105 million operating income.  
  • The segment operating income went downhill thereafter and from 2009 to 2019, before impairment charges, the segment cumulative operating income amounted to about USD 70 odd million. 

But considering that these impairment charges have been incorporated into the net income, I would conclude that the leadership team had a good operation and capital allocation track record. 

Is there an Awesome Buying Opportunity?

I generally use two approaches in assessing the intrinsic value ie Asset-based and Earnings-based.
  • Asset Value (AV) is broken down into several components - NTA and Book value.  
  • Earning Value is broken down into the Non-Operating Asset component, Earning Power Value (EPV), and the Earning Value with growth.
  • For the Earning Value with growth, I have a Conservative one with growth a 2.3 % CAGR and an Optimistic one with 4.0 % CAGR

As can be seen from the chart:
  • The Earning Value is greater than the Asset Value.
  • Over the past 5 years, the highest market price has gone above the Earning Value with growth.

In a normal competitive environment, I would expect the EPV to be about the same as the Asset Value.

SDI Valuation
Chart 4: SDI valuation

EPV > AV

For SDI, its EPV is 1.4 times its Asset Value.  This can only be sustained if SDI has some competitive advantages.

While the Group has listed its competitive advantages, I believe that the most relevant ones for a being in a commoditized and cycled sector are:
  • Lowest cost producer.
  • Strong financials to withstand the down part of the cycle.

SDI would be able to maintain its lowest cost advantage as this is the result of:

“…efficient plant design and operations, our high productivity rate, low ongoing maintenance cost requirements, and strategic locations near our customers, and high sources of our primary raw material, ferrous scrap.”  (Source: SDI)

SDI's ability to maintain an average Steel segment capacity utilization of 80 % over the past 10 years will also help to keep its cost low.

Secondly, SDI has a good capital allocation track record as well as good liquidity and/or financial management.

Accordingly, the scenario of EPV > Asset Value is justified in the case of SDI.

Earning Value with growth

The current price of USD 36.87 (as of 31 Dec 2020) is above the Book Value and EPV.

Thus, the margin of safety would have to come from a valuation assuming growth.  In this context, I have assumed the following:
  • Conservative scenario: 2.3 % CAGR based on the historical growth rate of USA Steel consumption in tonnage.
  • Optimistic scenario: 4.0 % CAGR based on the long-term USA GDP growth rate (2 % for real potential GDP and 2 % for inflation).

My valuation shows that there is only a 7 % margin of safety under the Optimistic scenario.

SDI valuation metrics
Table 2: SDI valuation

The other key assumptions used in the above valuation are
  • The base revenue is set to the 2019 revenue.
  • The gross profit margin is based on the past 10 years average given the cyclical nature of the business.


Further details on the valuation methodology and assumptions are listed in Note 2.

Can its growth be justified?

The above analysis showed that SDI is a buying opportunity only if growth can be sustained.

The 4 % growth assumption is based on the 2 % long term US potential GDP growth and 2% inflation. 

Over the past decade, the US nominal GDP has grown by slightly more than 4 % CAGR. 

The positive view is that the growth assumptions I have used are lower than the historical growth achieved by SDI over the past 10 years:
  • 5.8 % CAGR in revenue ie nominal growth rate.
  • 7.4 % CAGR based on tons of external steel shipment from both organic and acquisitions.
  • 5.6 % CAGR based on tons of external steel shipped based on organic growth.
SDI growth assumptions
Chart 5: SDI growth assumptions

What are the drivers of growth?
  • The current US steel consumption is about 10% below the past 20 years' historical average. As shown in Part 1, over the past 10 years, the annual steel consumption has been moving towards the 20 years average level.
  • Any Biden administration infrastructure expenditure plans will provide additional impetus.
  • Imports of steel have been declining as shown in Part 1. 
  • The new Southwest-Sinton plant may have the potential to export to Mexico.  However, SDI will have to compete with other existing Mexican steel importers.

The challenge for a cyclical sector is whether the price levels in the future cycles would be higher than those in the past.  

The past 2 decades of hot roll steel sheet and strip prices as shown in the chart below does not paint a positive picture. 

If you take this view that future steel prices would be at the 2019 levels, then you should use the physical consumption growth rate rather than the revenue growth rate. 

Note that in my valuation, I have assumed that growth came from an increase in tonnage shipment assuming that there is no increase in price. This is a conservative approach. 

Hot roll prices
Chart 6: Hot roll prices   Source: FRED

Valuation under various growth scenarios

The Earning value with growth based on several scenarios is shown below. 

SDI margin of safety
Table 3: SDI valuation under various growth scenarios
Notes
a) Based on historical growth in US steel consumption in tonnage. This will mean that SDI maintains its current market share in tonnage terms.
b) To match, the current market price, we will have to assume a 3.41 % growth.
c) Based on 2% real GDP and 2 % inflation rate.
d) With a 2-stage growth model. Based on SDI actual external shipment growth rate of 7.4 % for the high growth stage and 4 % long term US GDP rate for the terminal growth.  SDI market share will increase from 10% to 16%.
e) Based on the past 5 years highest average Price to Book ratio of 2.96.  Growth will have to be 6.09 %


From a historical perspective, as shown below, SDI had a Price to Book ratio that ranged from 0.8 to 3.0 with a 10 years average of about 1.6.
  • The Optimistic scenario places it above the historical average Price to Book ratio.
  • Its Price to Book ratio based on the current price is even above the historical average Price to Book ratio.
  • As a reference, the Severstal Columbus plant was acquired in 2014 at about book value. 
SDI Price to Book history
Chart 7: SDI Price to Book    Source: Macrotrends

Catalysts

I have a contrarian catalyst approach.

I believe that the coming year or two will provide a buying opportunity for the patient investor as I expect that the profits would be affected by the coming on stream of the Southwest-Sinton plant.

This will affect the Price to Earnings multiple that many investors monitor. 

There may be investors who are more quarterly-results focussed cashing out.  If this happens and causes the market price to decline lower than the current level, it should be a buying opportunity.

Will there be Spectacular Growth in Shareholders’ Value?

With an average after-tax return on total capital employed of 9.6 % compared to its WACC of 8.3 %, any growth will create value for the shareholders.

Secondly, assuming no dividend was paid, the net income from 2011 to 2019 would have grown the 2010 shareholders’ funds at 12.2 % CAGR.

Thirdly, if a retail investor had bought a share in SDI at the beginning of 2010 and held it on until 31 Dec 2020, he would have gained USD 30.92 per share.

His investment today including dividend would have increased at a CAGR of 12.1 %

I would have considered this a reasonable return.

 

USD per share

Current price

36.87

Purchase price

12.35

Capital gain

24.52

Dividend declared

6.40   (a)

Total gain

30.92

Table 4: SDI shareholders' gain
Note:
(a) Assumed 2020 dividend to be the same as that for 2019 of USD 0.96 


What are the negatives?

Despite the growing dividend payments, SDI is not a dividend stock as the current dividend yield is about 2.6 % 

Secondly, it might be challenging for an investor to achieve a similar level of total return if he buys SDI at the current market price.
  • An investor at the beginning of 2010 would have bought the share in SDI at a Price to Book value of 1.4 (based on 2009 end financials) compared to the steel industry average of 1.3 (Source:  Damodaran Jan 2010). 
  • If the investor buys at the current market price, it would be at a Price to Book multiple of 1.8 compared to the industry average of 1.4 (Source: Damodaran Jan 2020). 

Share purchase

From the beginning of 2016 onwards, when there was strong cash flow from operations, SDI began to repurchase its shares.

Any share repurchase will create shareholders value if it is carried out at prices below its intrinsic value. 

Assuming that the historical Earnings Value would be doubled that of the Asset value, I would conclude that:
  • The 2019 share purchase would have resulted in adding value for the shareholders.
  • The other share purchased were unlikely to have added shareholders’ value.
SDI Share buyback
Table 5: SDI Share buyback


How to Secure Your Investment by Minimizing Risk

Risk

In its 2019 Form 10K, SDI listed 20 principal risk factors that could affect the Group. There were 2 factors that were not covered in its 2010 Form 10K - cybersecurity and impairment.  

I suspect that SDI probably faced these 2 issues over the past 10 years

It is also positive to note that there were some risk factors that were covered in the 2010 Form 10K that was not specifically listed in 2019.  I believe that these may no longer be critical.
  • Technology and start-up risks. SDI experienced this with the shutdown of the Minnesota ironmaking operations in 2014/15.
  • Significant risk of injury or death.
  • Stock price fluctuation.
  • Payment of dividends.

The factors listed are operational and business risks all of which SDI faced over the past 10 years.  The most impactful risk remains the global excess capacity. 

From an investor’s perspective, the critical risk at the current market price is valuation risk. 
  • This is because, in order for a margin of safety, there is a need to make assumptions about growth.
  • This in turn is affected by economic and political risks that are not within the control of management.

The analyses have shown that the management team has a good operation and capital allocation track record. So, it is a question of external forces influencing how well SDI will perform.
  • If the next decade turns out to be similar to the previous decade, I am confident that the Optimistic scenario will prevail.  SDI will continue to gain market share.
  • If it is worse, given its strong management, SDI will be able to deliver the Earning Power value. 
  • If the next decade turns out to be better, the Aggressive scenario will be relevant.

If you are a conservative investor, you should wait for a price pullback when the market overreacts to the drop in profits when the Southwest-Sinton mill comes online.


Pulling it all together

At the current market price, it is obvious that SDI is not a value trap as it is not cheap from the perspective of the past 12 months prices.

What is the investment thesis then?
  • This is Group with a strong growth track record and a leadership team that is a good operator and capital allocator.
  • It is financially strong with a good credit rating that has enabled the Group to replace existing debts with lower interest paying ones.
  • The Biden administration will unfold an economic stimulus plan that will spur the demand for steel. I expect the trade protection measures to continue to provide import replacement opportunities. 
  • SDI strategy of being a low-cost producer with strong financials is aligned with being in a commoditized cyclical industry

The main investment risk at the current price is that even for a 7% margin of safety, you have to assume that SDI can grow according to the long-run US GDP nominal growth rate.

However, I believe that SDI will report a declining profit in 2021/22 with the opening of the new mill.  I do expect the market to have a knee-jerk reaction that will provide you with a better buying opportunity.

The long-term value of SDI is there. You have to be patient if you want a better buying opportunity. 


End of Part 2 of 2

The Update was published on 12 May 2021

Coming Next on 7 Feb 2021 - SGX listed New Toyo International



Notes
1) List of companies in the Sector was based on Investing.com screen for “All Equity type” under the “Iron & Steel” industry with market cap > USD 100 million as of 8 Dec 2020.
  • ArcelorMittal
  • Aperam
  • Carpenter
  • Ferroglobe
  • Gerdau
  • Grupo
  • Haynes
  • Nucor
  • POSCO
  • Ryerson
  • SIM
  • S Dynamics
  • Ternium
  • TimKen
  • US Steel
  • Worthington

2) Valuation methodology
  • The valuation is based on Free cash flow to the firm model as per Damodaran.
  • Valuation with growth is based on a perpetual stable growth model.
  • Free cash flow = EBIT X (1 - tax rate) X Reinvestment rate.
  • Reinvestment rate = Growth rate / Return.
  • Selling, General & Admin expenses based on USD 46 per ton.
  • Interest rate based on 2019 average.
  • Profit-sharing based on past 3 years average 8.6 % of PBT where the PBT is before the profit-sharing component.
  • The 2-stage growth model is based on 10 yrs of high growth with a reinvestment rate of 33% as per the historical rate. SDI market share will increase from 10% currently to 16 % in the 10th year. 
  • Cost of capital data from Damodaran Jan 2020 data set.

Items

Value

Risk-free rate

1.9 %

Risk premium

5.2 %

Cash adjusted unlevered Beta

1.29

Cost of equity

10.4 %

WACC

8.3 %

Tax rate

27 %




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 & Disclosure
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.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.






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