The wait for the turnaround in the steel industry has been a challenging one for shareholders. While some companies, including U.S. minimill operators Steel Dynamics (Nasdaq:STLD) and Nucor (NYSE:NUE) and foreign producers like Ternium (NYSE:TX) have seen their shares turn around, other steelmakers like ArcelorMittal (NYSE:MT), U.S. Steel (NYSE:X), and Gerdau (NYSE:GGB) have had a rougher go of it.
Sentiment seems to be turning around for Brazil-based Gerdau. Steel companies there are having more success in pushing through higher prices and demand has been pretty solid from customers in autos, aviation, and other types of heavy industry. What's interesting, though, is that sell-side enthusiasm isn't really reflected in their estimates, and Gerdau doesn't look all that cheap on a near-term numbers basis. While improving conditions in Brazil and a pick-up in the U.S. could definitely lead to upward estimate revisions, the bull case does require investors to look out beyond just the next 12 to 18 months of EBITDA.
A Sizable, but Largely Unheralded, Player in Steel
Many investors know that Nucor is the largest U.S. steelmaker, and many would likely guess that ArcelorMittal and U.S. Steel figure prominently in the top three. It may surprise some that Gerdau is fourth-largest, with more than 11 million tons of production capacity (including its specialty steel operations). Gerdau is also the largest producer in Brazil, with similar production capacity.
Gerdau is largely focused on long products – bars, rods, wires, and so on – and specialty steel. With that, Gerdau serves the infrastructure and non-residential construction markets, as well as industrial end markets like autos, aviation, and marine.
Like Nucor and Steel Dynamics, Gerdau uses electric arc furnaces to produce its steel at so-called minimills. Also like Nucor and Steel Dynamics, Gerdau has invested considerable resources to develop iron ore assets – while electric arc furnaces use scrap steel as the primary input, additional iron is typically needed to produce steel with the desired level of quality and performance characteristics.
Waiting For the U.S. to Turn
As the U.S. business contributes close to one-third of the company's revenue and one-quarter of its profits, it's a major component of the Gerdau story. Unfortunately, the company is facing many of the same challenges as Nucor and Steel Dynamics – namely, low activity in infrastructure and non-residential construction and weak demand for long steel products.
This in turn is leading to weak financial performance. For the most recent quarter, Gerdau reported U.S. volumes fell 3% year over year, leading to a large decline in adjusted EBITDA (down 52%) and an adjusted margin only about one-third of the Brazilian business.
Potential Improvement from Top to Bottom
All things considered, Gerdau has a relatively attractive collection of end markets. Gerdau is not only exposed to the fast-growing Brazilian construction market, but also the growing heavy industry operations in the country (including autos, heavy machinery, aviation, and so on). What's more, while the U.S. market is not helping the company today, U.S. construction activity should pick up at some point. At the same time, the company is benefiting from a “bottom up” improvement in product mix and better returns from its iron ore operations.
The Bottom Line
While Gerdau should be a good play on Brazilian growth and a U.S. recovery, not to mention the fact that it's generally a well-run steel company, valuation doesn't make it an obvious buy now. Steel stocks like Gerdau typically trade at 6.5 times to 7 times forward EBITDA. Based on current sell-side numbers, that only works out to a fair value of about $6.50 today, even though the sell-side average target price is closer to $8.50.
I certainly don't rule out the possibility that Gerdau could outperform expectations and/or that improving industry conditions will lead to higher estimates. Even so, I think you have to go to some length to make Gerdau shares look cheap, while stocks like Steel Dynamics and ArcelorMittal may represent better values today.
Disclosure: As of this writing, the author has no financial positions in any companies mentioned.