Is Steel Dynamics a Growth Trap?

Chart 1: Recap of Investment Thesis

Recap

In Jan 2021, I had concluded that STLD was not cheap. There was long-term value but you had to be patient if you wanted a better buying opportunity.

The investment thesis was that:

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

The main investment risk was that the margin of safety was not enough at the current price then. There was only a 7 % discount to the intrinsic value based on STLD growing at the long-run US GDP nominal growth rate.

But I believed that STLD 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.

In short, STLD was a good company but a poor investment.

Is the current performance outstanding?

For the first quarter ended 2021, the Group had a YTD revenue of USD 3.5 billion and a YTD PAT of USD 435 million. These were better than the revenue and PAT of USD 2.5 billion and USD 191 million for Q1 2020.

There were improvements across the 3 business segments – Steel, Metal Recycling, and Steel Fabrication.

For the Steel segment with accounted for 71 % of the Group’s external sales, growth was driven by price increases.

• While the total tonnage shipped in Q1 2021 was 3 % lower than that for Q1 2021, external sales increased by 29%. The average selling price this year was about 34 % higher than last year
• At the same time, raw material prices did not increase as much so that the metal spread increased by 32% compared to that last year. This increase in spread drove the increase in operating income

The Metal Recycling segment which accounted for 13 % of the Group’s external sales benefited from the strong metal demand.

• Ferrous scrap external shipment in tonnage increased by 11 % compared to last year
• The recycling spread for both ferrous and non-ferrous scrap also increased compared to Q 1 last year. These drove the increase in operating income

The Metal Fabrication segment benefitted from the robust non-residential construction market.  There were increases in tonnage and selling prices.

With all 3 cylinders firing, you should not be surprised by the first-quarter results.  But as you can see, the growth is more price-driven than volume-driven. For a cyclical commodity, this is not a sign of sustainable growth.

At the same time, from a long-term perspective, I do not see any change to the key metric – gross profitability (Refer to Note 1) as illustrated in the chart below.

Chart 2: Performance Index

If you dig deeper into the performance of the various business segments, you will see that there were no significant changes in 2020. As the chart below shows, you do not see some long-term uptrend.

Chart 3: Segment operating margins

In the context of competitive position, the 2020 performance of STLD relative to its competitors has not changed much.  As can be seen from the chart below, all parties suffered a declining business in 2020.

Chart 4: Peer Revenue Index

Note: AK Steel was acquired by Cleveland Cliff in 2020 and hence there are no data for 2020

Is there any change in the business direction?

The Group has a total capital employed (TCE) comprising shareholders’ funds, minority interest, and loan of USD 7.83 billion million as of 31 Mac 2020. 

In my previous analysis, it was based on the financials that ended in Sep 2020. The chart below showed the changes in the capital structure and its deployment for these 2 periods. 

You will note that the Group has more assets now with these funded by both an increase in SHF and Debt. This was to be expected given the new Southwest-Sinton Texas plant under construction.

Chart 5: Comparing Sources and Uses of Funds

While there is an increase in the TCE, there is nothing in the 2020 Annual Report to or show a change in the business direction.  The fact that STLD will have the same members of the Board and Named Executives in 2021 supports this “status quo”. 

Along this line, the new Texas plant will adhere to the same sustainable model as the Group’s other steel-making facilities.

Furthermore, an analysis of the performance of the 3 segments showed similar conclusions as those in Jan 2021. Refer to the chart and table below.

• The Metal recycling segment has not contributed to the Group’s bottom line. But the segment has ensured the supply of low-cost high-quality material to the Steel segment
• The Steel segment is the main profit generator for the Group in terms of the dollar amount
• The low return of 7% for the Group is because a significant part (17 %) of the TCE is tied up in cash.

Table 1: Segment Performance

 Notes

a) Ave revenue and Operating income based on 2010 to 2020

b) Return on Assets = Ave Operating Income / Total Assets

c) The majority of the Interco sales relate to the Metal recycling segment

d) The majority of the Total Assets under Others is cash

Was shareholders’ value created?

I used the following 3 metrics to answer this question.

• Comparing the after-tax return on Total Capital Employed (TCE) with the WACC
• Comparing the return assuming no dividend or share buyback ie CAGR in SHF with the cost of equity
• Looking at total shareholders’ gain from investing in the shares of STLD

As can be seen from the table below, the returns were all greater than the respective cost of funds.  In other words, STLD has managed to create shareholders’ value.

Table 2: Shareholders’ value creation metrics

 Notes

1. Based on average EBIT/TCE from FYE 2010 to FYE 2020 and assuming a 27 % tax rate
2. From FYE 2010 to FYE 2020. This looked at how the SHF would have grown over this period assuming that no dividends were paid
3. These are the returns that a shareholder would have obtained if he had bought a share in STLD at the beginning of 2010 and held it on until 31 Dec 2020

The other positive thing is the share repurchase price. I had previously noted that the 2016 to 2019 share repurchases were undertaken at prices that did not seem to add value to shareholders.

Well for 2020, the share buybacks were carried out at much lower prices and closer to book value ie they added value to shareholders.

Is there still an awesome buying opportunity?

In my previous post, I valued STLD based on the financials from 2010 to 2019. Here I will look at the valuation based on the financials from 2010 to 2020.

Chart 6: Comparative valuation

The chart and table compared the valuation for the 2 different valuation periods.  I looked at several valuation metrics – Asset or Book Value, Earning Power Value and Earning Value with growth.

For the valuation with growth, I considered 2 scenarios:

• Conservative Earning with growth at 2.3 % CAGR. This is the historical steel consumption growth from 2010 to 2019
• Optimistic Earning with 4.0 % growth based on the long-term US GDP growth rate

Note that these were the same growth rates I assumed in my Dec 2020 valuation.

`Table 3: Comparative valuation metrics

Looking at the chart and table, you could be forgiven to think that there is now a buying opportunity. Don’t jump the gun.

All valuations are based on assumptions and it is worth revisiting these assumptions.  For the valuation model, I have used a single-stage Free Cash Flow to the Firm (FCFF) model as per Damodaran.

FCFF = EBIT X (1-tax rate) X (1-Reinvestment rate)

Value = [ FCFF X (1+growth rate) ] / [ WACC – growth rate ]

I derived the EBIT and WACC based on the following:

• EBIT = [ Latest annual revenue X normalized gross profit margins ] less SGA. For STLD, I considered the Executive incentive payments as part of the SGA
• The WACC was derived based on the Capital Asset Pricing Model. The Beta used was based on the steel sector Beta obtained from Damodaran

The key inputs and assumptions used in the valuation are shown below. You can see that the latest WACC is lower than that the last time. This explains why the current values with growth are very much higher than the previous ones.

The analysis showed that the increase in valuation in Apr 2021 is not due to an increase in the “normalized free cash flow” or growth rates. Rather it was due to a reduction in the discount rate.

This is not a characteristic of a growth stock.

Table 4: Valuation data

Notes

1. For the Dec 2020 valuation, the normalized GP was based on 2010 to 2019 average gross profit margins. For the Apr 2021 valuation, the normalized GP was based on 2010 to 2020 average gross profit margins.
2. I adopted the Damoradan method for estimating the market cost of debt
3. The Beta for the Dec 2020 valuation was based on Damodaran Jan 2020 datasets. For the Apr 2021 valuation, I used the Jan 2021 datasets

WACC anomaly

The main culprit for the low WACC for the April 2021 valuation is the Beta. You should not be surprised as 2020 was a Covid-19 pandemic year.

I do not want to get into the debate on how best to derive Betas.  However, we should look at the WACC and understand what it stands for.  It reflects the time value of money and the risk of the cash flow.

The first question that comes to mind is why is the WACC (aka the risk) lower in a pandemic period? Shouldn’t 2020 be riskier? 

There are many studies and discussions about this anomaly.   They attribute this to the low interest-rate environment and the economic stimulus. Valuation experts such as Duff and Phelps have suggested adjusting the computed rates to account for these anomalies.

The other question is the valuation model. My model assumes the same WACC for all periods in the future.  Does this make sense?  We know that 2020 is a Covid-19 year and at best, it will represent the risk for the next few years.

Wouldn’t it be more realistic to then have 2 discount rates?

• One for the next 2 to 3 years to reflect the pandemic situations
• Another to represent the non-pandemic periods

Rather than turn the whole valuation exercise into a number-crunching one, I would rather take a simple approach.  This is to say that a more realistic intrinsic value lies somewhere between the Dec 2020 and the Apr 2021 values.

You may think that this is a wishy-washy answer. Given the many assumptions used, I am not sure whether there is any benefit in adjusting the WACC for 2021 and using two discount rates.

Furthermore, the valuation number is only one piece of the fundamental analysis puzzle. You should devote equal time to getting all the pieces of the puzzle.

There are also strategic insights from comparing the Asset Value with the EPV. This method is attributable to Prof Bruce Greenwald of Columbia Business School.  You will note that for STLD, the Asset Values are less than the EVPs.

According to Greenwald, this means that the returns are greater than the cost of funds.  Recall that in the earlier section, I have provided the evidence for this. For such a situation to be sustained, STLD must have a strong moat. 

However, I have a separate analysis that for STLD, this is Asset Value < EPV is not the true picture.  This is because the Asset Value has been “depleted” by its share repurchase programme.  If we factor in this share repurchase programme, the difference between the Asset Values and EPV narrows. Refer to “Steel Dynamics: How To Flesh Out The Real Valuation Insights.”

I had concluded in that article that STLD did not have a strong barrier to entry. Its current strong performance could be chipped away and was boosted by financial engineering means. From a long-term investment horizon, I would treat any valuation incorporating growth with a pinch of salt.

Conclusion

For a company to be a growth stock, it must have a growth runway and be in a growth industry. In my Jan 2020 article, I had shown that STLD did not have both these characteristics.

• Steel consumption in the US grew at 2.3 % CAGR for the past 10 years
• STLD physical steel shipment grew at a 7.4 % CAGR during the same period. But it came on the back of a USD 1.7 billion acquisition in 2014

The 2020 and the Q2 2021 performance did not or show a different picture. If there are no secular drivers of growth, the conclusion is that STLD is a growth trap.

But the market price has run away. This is the market looking at the Q1 2021 results. As the analysis has shown, the strong first-quarter performance for the steel operations is the result of price increases.  The steel shipment tonnage did not show any growth.

If nothing else, the shipment tonnage validates my thesis.  This is not a growth sector and STLD will have to grow by taking market share from its competitors and/or importers.

If you follow this to the logical conclusion it must mean that

• The current steel price increase is not sustainable as the US steel industry is still under-utilized. Globally there is still excess capacity. I would expect the supply of steel to ramp up in the coming one or two quarters
• The Q1 2021 performance is not reflective of the long-term performance. From a valuation perspective, I would still value STLD based on its “normalized” earnings

Process vs results

In my Jan analysis, I had concluded that STLD was financially sound with a strong management team.  It had a business strategy that was aligned with the Group being in a commoditized cyclical sector. In other words, it was a good company. I continue to hold this view taking into account the 2020 results.

But I always differentiate between a good company and a good investment. A good investment is one that enables you to make money. In Jan 2021, I had concluded that there is not enough margin of safety when you value STLD on a long-term basis.

The Jan 2021 investment thesis was the result of my value investing process. I was not trying to judge the next quarter’s market price, but rather to estimate the intrinsic value of the business.

I would be interested to see whether there are other value investors who would have estimated a higher intrinsic value for STLD in Jan 2020.  Please let me know as I want to see how our analysis differs.

On the other hand, if you are a trend follower, it is likely that you would have forecast a continuation of the trend as illustrated in the chart below and bought STLD.

Chart 7: STLD trendline. Source: Yahoo Finance

However, I do not believe that you should mix investing styles. Each investing style has its own behavioral and mindset requirements. While I have learned both fundamental analysis and technical analysis, I have not been successful in using technical analysis.  I keep seeing patterns that were not there. 

If you want to be a momentum or trend follower, be an expert in this area and stick to this style. But if you want to be a value investor, stick to value investing and don’t be mesmerized by backward-looking results.

Was I an idiot not to buy STLD?  Yes. It is like not buying the winning lottery. Who would not feel so?

But the point about investing is to stick to the process. For the past 15 years of value investing, I knew that my success is a combination of skill and luck.  While there were a few occasions that I have lost money, I have a CAGR that was more than the index. This was because following a process minimizes bad luck.

By sticking to my investment process, I

• Minimized the various behavioral biases
• Do not overlook issues
• Have a consistent approach. This will enable more objective comparisons between different stocks

Moral of the story? As a value investor, you will never get the glamour that is associated with the momentum investor or the speculator. I am sure the momentum guys would be gloating over STLD. But hopefully, the value investors make more money in the long run.

Is there still a margin of safety?

We all have different our own approaches in the margin of safety. I look at the margin of safety from 2 perspectives:

• 20 % to 30 % discount from the intrinsic value. Unless the stock is a “compounder” (ie one with a strong moat), I used the EPV as the reference intrinsic value
• An Acquirer’s Multiple of less than 6. (Refer to Note 2)

As you can see, STLD did not meet these criteria.

From a technical valuation angle, I would ignore the Apr 2021 Earning Value with 4 % growth as this number is very close to the WACC of 5.5 %. This meant that the value using the single-stage model would be “skewed”.

I still believe that when STLD opens the new plant, the Group will experience lower capacity utilization. I still hoped that the market will interpret this negatively and provide a buying opportunity.

Of course, if you are a momentum investor or trend follower, it is likely that you would currently still buy. Unfortunately for you, I am not analyzing STLD on these bases.

END

Notes

1) Gross profitability is an indicator introduced by Professor Robert Novy-Marx, University of Rochester. It is computed by dividing sales minus the cost of goods sold by total assets…Gross profitability has roughly the same power as book-to-market predicting the cross-section of average returns…Controlling for gross profitability explains most earning-related anomalies and a wide range of seemingly unrelated profitable trading strategies.  “The Other Side of Value: The Gross Profitability Premium” – Robert Novy-Marx

 2) This defined as TEV/EBITDA.  Popularized by Tobias Carlisle, this is a valuation framework that aims to assess the true cost a third party would pay to acquire the company’s cash flow or operating profits.  Carlisle analyzed the returns from different valuation multiples and found that the Acquirers’ multiple had the most success identifying undervalued stocks.

“The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market” – Tobias Carlisle.

3) Unless specifically mentioned otherwise, all charts and tables are produced by the author from readily available SEC filings.

Editor’s Note: The article is from H.C. Eu who blogs at Investing for Value. He is a self-taught value investor and has been investing in Bursa Malaysia and SGX companies for more than 15 years. His value investment experience has been enhanced by both his Board experiences and his contacts with controlling shareholders of many Bursa-listed companies. These have given him a unique opportunity to be able to analyze and value companies differently from other research houses.  If you enjoyed this piece, you can find similar pieces and other value investing tips in his blog.

H.C. Eu is 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 company.   Investments or strategies mentioned may not be suitable for you and you should have your own independent decision regarding them. The opinions expressed here are based on information he considers reliable but he does not warrant its completeness or accuracy and should not be relied on as such. He does not have any equity interests in the company featured.