Description

The recent bloodbath in the global financial markets has resulted in all sorts of business being offered at irrational valuations.  Steel companies, like other commodity producers, have been among the hardest hit. Despite four years of consolidation and record profits, many steel companies sell below book value, below replacement cost, and below what strategic buyers have been paying for assets. There is no question that slowing global growth will impact the industry negatively in the short-term, but for long-term value investors, this is a great time to pick up steel producers at bargain prices.  

One such company is Commercial Metals Company (NYSE:CMC). CMC is conservatively managed, with a variable cost structure, a strong balance sheet, and an attractive dividend yield. It also happens to be a well-positioned acquisition target in an industry going through a long-term consolidation process.

CMC is a steel production, fabrication, and trading company. The company has four steel mills (mini-mills) in the US, located in AL, AR, TX, and SC, with a fifth under construction in AZ. As a result of recent global acquisitions, the company also has steel mini-mills in Poland and Croatia. In addition to being a steel producer CMC is backward integrated into scrap generation and processing, and is forward integrated into the fabrication of steel products, principally rebar, structural steel, joists and deck  for use in various types of construction projects. CMC also has a global steel trading business, which provides the company with valuable insight into global market trends and helps identify global acquisition opportunities, like the mills in Poland and Croatia.

At the current stock price of $11 (down from a high of close to $40 earlier this year) CMC’s enterprise value is $2.7 billion - $1.3 billion of market cap (114.5 million fully diluted shares) plus $1.4 billion of net debt. (Net debt includes long term debt, notes payable and documentary letters of credit).   

For a number of reasons, I believe that $2.7 billion of EV represents a significant discount to CMC’s true value.  First, consider that as of November 2008 CMC had close to $1.4 billion of net working capital on its balance sheet. That is, net working capital accounts for 50% of the company’s enterprise value. Not surprisingly, on the company’s most recent conference call management suggested that inventory liquidation will free up “hundreds of millions” in cash over the next quarter or two.    

CMC has been consistently profitable, even in difficult market environments due to its variable cost structure and its integration along the steel product value chain.  In the last four years, through the company’s most recent FY ending 8/31/2008, EBITDA has averaged $600 million per year, with a low of $530 million and a high of $670 million. In the most recent quarter (which ended November 31, 2008) EBITDA was $155 million. Thus, on a current run rate or based on the most recent 4 years, CMC is valued at 4.5 times EBITDA.

Now I know what you’re thinking. “Yea, wait ‘til the next few quarters when the economic slowdown pummels steel demand and steel companies start bleeding like stuck pigs”. I’ll concede that the near term prospects for steel demand and steel prices are bleak, but this doesn’t mean that all steel companies are going to bleed cash.  In fact, CMC may continue generating cash throughout the downturn, and be poised for a strong rebound when global growth resumes. Why?

First, CMC is a mini-mill, which means it buys steel scrap and recycles the scrap into finished steel products. Scrap is bought on a spot basis and the price rises and falls with the strength of the market. In the last few months scrap prices have fallen much faster than finished steel prices, so CMC’s (and other mini-mill’s) metal margin per ton has expanded.  On the most recent quarterly conference call management indicated that the metal margin per ton (i.e., the spread between scrap cost and finished steel selling price) set an all-time record.  

These margins will certainly decline in the near-term but the industry has reacted quickly and aggressively to protect margins in the face of weak demand. US steel industry capacity utilization has fallen from 90% this summer to less than 50% in December.  Since final demand is not off by 45% (more like 25%) the implication is falling inventory levels throughout the steel industry supply chain. When the economy turns, the steel producers will not only have to meet rising demand levels, but will also have to replenish inventories. This bodes well for prices and margins on the other side of this recession.    Moreover, as a long-term investor you have to appreciate the industry’s discipline in the face of weak demand.

  

Second, CMC is fully integrated along the value chain, which has the effect of smoothing earnings. For example, management has indicated that while falling steel prices are bad for the steel mills, the company’s fabrication business benefits.  Fixed-price fabrication contracts are now being delivered with steel products that are much cheaper than when the contracts were originally bid. On the latest conference call management alluded to rising margins in fabrication.

Third, CMC is not exposed to the market for consumer durables, like cars and washing machines.  CMC produces rebar and various types of structural steels that are used in a variety of construction applications.  In fact, the company’s most important market is infrastructure projects which are likely to get a boost sometime in 2009.

In short, CMC’s business model has allowed the company to generate earnings and pay dividends even in difficult market conditions.  In the last major economic downturn (2001 to 2003), which was very severe for the US steel industry (close to 50% of US capacity went through bankruptcy), CMC remained solidly profitable. Average annual EBITDA fell only 17% from its peak prior to the downturn, not a disaster by any measure.  And the company continued to pay dividends, which it has done for 177 consecutive quarters. Last month CMC confirmed its quarterly dividend of $.12 per share. At $11, this translates into a 4.4% annual yield. 

Finally, the steel industry has embarked on a process of consolidation and globalization since the downturn which ended in 2003. Most executives and analysts who follow the industry closely expect this process to continue. CMC is a very attractive takeover target for US and global steel companies looking to expand market share.   CMC’s plants are located in markets with good long-term prospects, the southern US and central Europe. The plants are non-union and well run, with competitive cost structures in their home markets. Finally, the company is publicly traded with no blocking shareholder, making it ripe for a takeover.

Over the last six years, the EV per ton of capacity which strategic buyers have paid for mini-mill steel assets has risen as the number of takeover targets has declined and the long-term prospects for the industry have improved.  In 2007, two mini-mill businesses were acquired in the US by Gerdau, one of the global consolidators in the industry. On average, Gerdau paid about $1,300 per ton of capacity for these businesses.

CMC’s mills are not as profitable as Chaparral or MACSTEEL were at the time of the acquisitions (due to product mix differences) but CMC is much more vertically integrated than either of them. Vertical integration is increasingly a strategic priority for most global consolidators and is clearly adds value to CMC as an acquisition target. 

At $800 per ton of capacity (a 40% discount to what Gerdau paid for Chaparral and MACSTEEL) CMC would be worth $3.2 billion and its shares would be worth close to $16, 45% above the current price.  

Catalyst

The next quarter or two are likely to be difficult, but there are several potential catalysts to get CMC’s share price moving. One is a stimulus bill aimed at infrastructure. CMC’s steel and fabricated products are used extensively in infrastructure projects and the company will benefit from a stimulus plan focused on infrastructure spending.

Another potential catalyst is an uptick in sales volumes and steel prices. Inventories at steel companies, distributors, and end users have dropped significantly and are 40% below their last peak, as steel companies have cut production more severely than final demand has fallen. When the market does turn, maybe ever before it turns, distributors and final users will begin buying. When they do, most industry participants expect steel prices and margins will expand fairly quickly. Once investors see expanding margins and operating rates, steel company valuations will react quickly.

A third potential catalyst is a takeover. This is a long shot in the next quarter or two because strategic buyers are being very cautious with cash in this environment. However, once the bigger mills have some comfort that the world as we know it is not coming to an end, the consolidation process is likely to be reignited and CMC has to be on the short list of a number of global consolidators.