Description

In June 2021 I pitched a short Nucor (NUE) thesis on the basis of steel prices being temporarily high and steel stocks projecting that transitory strength into the future. 18 months later, US steel prices (HRC) have dropped from $1,600 to $640/ton. However, steel minimill equities have kept climbing, and NUE specifically is up around 50% from our entry point.

While we certainly have taken a healthy dose of humble pie and remain short NUE, we think at these levels a short position in Steel Dynamics (STLD) is even more compelling. At the core of the thesis is the unsustainable surge in fabrication margins for STLD. Steel Fabrication has always been a minor business for STLD, where it accounted for typically no more than 10% of total EBITDA. Due to factors I will explain, Fabrication earnings in 2022 will be 18x the amount posted in 2018-19, accounting for now 38% of total company EBITDA. This is a business currently that used to make $200/ton of EBITDA, and it’s currently making over $3,000/ton!

Against the company’s promotional mantra “this time is different”, we expect fabrication earnings to compress significantly, and the stock to follow.

Company description

• While steel is generally a bad industry to be in over the cycle, STLD is arguably the best house in this bad neighborhood. The company was founded in the 90s by Mark Millett (current CEO) and Keith Busse, who both learnt the trade at Nucor (NUE). The company has 3 segments: Steel operations, Metals recycling, and Steel fabrication.
• Steel Operations: Like NUE, STLD has focused on building and acquiring Electric Arc Furnace (EAF or “minimill”) steel mills in the United States, which have a lower and more flexible cost base than traditional Blast Oxigen Furnace mills like X, CLF or MT would operate. Steel Operations has traditionally accounted for 80-90% of STLD’s earnings. The company has 13.9mm tons/yr of steelmaking capacity, making it the 4^th largest steel manufacturer in the US. The company has been in the (bumpy) process of ramping up its greenfield new mill in Sinton, TX (3mm tons/yr capacity) through 2022 and into 1H23.
• Metals Recycling: over the years and particularly through the Omnisource in 2007, STLD has built a scrap recycling operation that largely sources scrap inputs for the company’s steel mills (66% of ferrous scrap went to STLD mills). This is a small segment that generally makes under 10% of corporate earnings.
• Steel Fabrication: is a downstream operation that mostly produces joist and deck steel products, which are mostly used for construction end-markets. This segment historically has been a sideshow, contributing under 10% of total earnings.
• STLD is in all fairness a well-managed company. Mark Millett is a shrewd guy and for the most part a savvy capital allocator. Most major M&A deals have been smart and accretive to the company. Recent greenfield initiatives have been mixed.. The market initially hated the Sinton mill project as it was perceived as adding unnecessary flat-rolled capacity to the US market. The new aluminum rolling mill project is still a question mark.

Thesis

• The crux of our thesis is around normalizing Fabrication earnings over the next couple of years. As stated above, this used to be a small, sleepy segment that most people didn’t pay too much attention to. However, Fabrication segment earnings creeped up in 2021 and then exploded in 2022, as pricing and margins decoupled vs steel prices and surged above $5,000/ton, which is more than triple pre-COVID levels. This is  pricing and margins story, as no significant capacity has been added. As said, 2H22 segment margins of $3,100/ton compare to $200/ton both in 2019 and 2020.

Fabrication for STLD is essentially joist and deck, two steel products that involve some shaping and welding but that are far from rocket-science. Their main end-market is construction, and particularly non-residential.

When asked about the drivers behind this surge in fabrication margins, STLD talks about joist and deck supply having been rationalized and consolidated over the years, resulting in improved pricing power.. The company also talks about a new psychological paradigm where all of the sudden they can “price for value” vs the old mentality of “cost plus” approach to pricing. Joist and deck account for 2-3% of construction costs, which allegedly makes buyers price insensitive. The suggested implication, says STLD, is that structurally high prices are here to stay.

We find it hard to agree with the above arguments, as industry consolidation took place over 10 years ago, when NUE (#1 player in joist and deck) and STLD (#2) acquired smaller players.

The more likely driver behind these unprecedented joist and deck prices is the inelastic demand coming from datacenter, e-commerce warehouses and such that exploded in 2021. STLD saw an opportunity to fleece this desperate buyers, and executed it well. Joist and deck projects are typically 6-9 months out, so during 2022 STLD has been delivering on all these projects booked in late 21-early 2022, when demand was booming and steel prices with HRC at near $2,000/ton provided an argument for higher downstream prices.

With this background, players like AMZN are already walking back from warehouse construction plans (AMZN is largely a NUE customer, but it still has the effect of loosening the overall market), while we’ve also heard anecdotal evidence of school and similar non-res projects being pushed out while they way for lower construction costs.

Street consensus has Fabrication EBITDA peaking at $2.4bn in 2022 (up from $131mm in both 2019 and 2020), declining progressively to $1.7bn in 2023 and settling around $300mm in 2025-2027. Assuming HRC prices remaining in the $700-800/ton range, STLD’s corporate EBITDA should decline from $5.8bn in 2022 to the mid/low $2bns in 2024-2025. For reference, EBITDA was $1.3bn in 2019. At a 6x EBITDA historical multiple and after accounting for 2H22-2023 FCF, we believe a target price in the $75-80/share is fair, for 30% downside.

• We also believe stock buybacks have been a major source of support under STLD’s stock price, as the company has been aggressively deploying $500mm/qtr on repurchases so far this year. We believe buybacks will diminish going forward, given the normalization in Steel operations and Fabrication earnings, and importantly, the capex needs from the newly announced $2.2bn aluminum mill ($800mm to be spent in each 2023 and 2024). This should see FCF decline from $3.5bn in 2022 to $1.1-1.3bn in 2024-25.

Risks

• The biggest risk to our thesis is that it is largely already in consensus estimates. Sell-side numbers already call for a normalizing in Fabrication prices and margins, and for a material decline in STLD’s earnings. If you believe that the market is efficient and only moves in response to earnings surprises, this idea is not for you. We generally buy into that line of thinking, but in this case think otherwise, as the stock has been rallying to all-time-highs even as a correction in earnings is around the corner. Our thinking is the multiple will hold steady as EBITDA gets cut in more than half over the next couple of years.
• Timing of Fab normalization: Fabrication is largely a backlog/project business where the backlog is converted into sales generally within 6-9 months of being booked.. Therefore there is a lag in trends normalizing. STLD has showed confidence its backlog is strong and at high prices (not as high as $5,000/ton, but still favorable) through at least 1H23. Because we don’t have a lot of transparency, the shape of the decline might be off by a few quarters. We think it’s fair to expect that as fabrication margins start to show compression,

Catalyst

• Fabrication pricing and margins fade