Description

Investment Summary

Worthington Steel (WS) represents the steel processor spinoff of Worthington Industries (WOR) which occurred in December 2023.  The spin created two separately traded entities WS and WOR (now renamed to Worthington Enterprises).  The reason for the spin was to unlock the value of the higher margin Worthington Enterprises by spinning off the lower margin more volatile WS.  The spin was a success as the value of both entities are higher. 

WS in this case is the “cigar butt” spinoff due to its perceived steel/auto commodity-like volatility, but I believe that WS is mispriced/misunderstood, and actually has a few secular trends in its favor including products going into EVs and electric infrastructure.

In the near term, there will be earnings headwinds from steel price declines however in the long run electrical steel laminations will drive secular growth with a shift towards EVs/hybrids and electrification of the country.

With its current valuation of just 8.8X Earnings and 7.7 Price/Free cash flow, we think that this is a solid risk reward for a WS that may be overlooked. 

Our target is $41/share.

End Markets

WS serves a number of end markets with auto being the primary one.  A significant driver of revenues is new car production. It also has exposure to the general economy in construction, energy, electrical grid, agriculture, trucking and various equipment end markets.

Business Description

The WS is one of North America’s premier value-added steel processors with the ability to provide a diversified range of products and services that span a variety of end markets. The WS maintains market leading positions in the North American carbon flat-rolled steel and tailor welded blank industries and is one of the largest global producers of electrical steel laminations. For nearly 70 years, the WS has been delivering high quality steel processing capabilities across a variety of end-markets including automotive, heavy truck, agriculture, construction, and energy. The WS serves its customers primarily by processing flat-rolled steel coils, which are sourced primarily from various North American steel mills, into the precise type, thickness, length, width, shape, and surface quality required by customer specifications. The WS sells steel on a direct basis, whereby it is exposed to the risk and rewards of ownership of the material while in its possession. Additionally, the WS toll processes steel under a fee for service arrangement whereby it processes customer-owned material. The WS’s manufacturing facilities further benefit from the flexibility to scale between direct and tolling services based on demand dynamics throughout the year.

WS has 3 basic product lines: Flat Rolled Steel Procession, Electrical Steel Laminations and Tailor Welded Blanks/Lightweighting - Custom designed products for Auto Industry geared towards making cars lightweight, auto frames

Deeper Dive into end markets

WS is exposed to auto production as a steel processor but also is benefitting from secular trends:  Electric Vehicles, Renewable Energy, and Electrical Infrastructure.

WS will also benefit from government spending on infrastructure nationwide

Operational Footprint

WS has operations primarily in the US.  The company has deep ties to the rust belt manufacturing industry for its traditional Hot Roll Conversion productions.

However, WS has a broader reach when it comes to their electrical steel products which are delivered all over the world.  

We view the electrical steel products as the secular growth side of the business.  While the company doesn’t break out the size of this product segment nor its margins we view these value added products as likely to have higher margins than the traditional products sold.

Earnings Model and Modeling Considerations.

As mentioned above the strongest driver of revenue and earnings volatility are steel prices.  We are in the process of steel prices declining which will have a negative impact on revenues and near term earnings.  

Offsetting this will be the growth in electrical steel and other end markets which offer secular growth.  

The fiscal year is end is May, and we are forecasting a stable steel price environment moving forward.  The company is targeting a 10+% EBITDA margin and we have them modeled at a 9% rate in fiscal year 2026 which we view is conservative.

Maintenance capex runs in the $35-40mm range however the company has identified numerous growth opportunities surrounding electrical steel processes that we anticipate growth capex in these areas to be about $50 million.

Consolidated Subsidiaries and Investment in Unconsolidated Affiliate

The consolidated and combined financial statements include the accounts of Worthington Steel and its consolidated subsidiaries. Investments in unconsolidated affiliates are accounted for using the equity method. Material interWS accounts and transactions are eliminated.

The WS owns controlling interests in the following three operating joint ventures: Spartan Steel Coating, L.L.C. (“Spartan”) (52%); TWB WS, L.L.C. (“TWB”) (55%); and Worthington Samuel Coil Processing, L.L.C. (“WSCP”) (63%). The WS also owned a controlling interest (51%) in Worthington Specialty Processing (“WSP”), which became a non-operating joint venture on October 31, 2022, when its remaining net assets were sold. These joint ventures are consolidated with the equity owned by the other joint venture members shown as noncontrolling interests in the WS’s consolidated and combined balance sheets, and their portions of net earnings and other comprehensive income (loss) (“OCI”) shown as net earnings or comprehensive income attributable to noncontrolling interests in the WS’s consolidated and combined statements of earnings and comprehensive income, respectively.

The WS owns a noncontrolling interest (50%) in one unconsolidated joint venture: Serviacero Planos, S. de R.L. de C.V. (“Serviacero Worthington”). The investment in the WS’s unconsolidated affiliate is accounted for using the equity method. 

Balance Sheet

The balance sheet is conservative at just about $90 million of net debt, and a 1.4x current ratio.  

Valuation

The closest company is probably Reliance Steel (RS) which is a much larger company with better margins and valuation.  RS is is 4X the size of WS with EBITDA margins at around 12% vs. 7% for WS.  Currently RS trades at about 16X PE and 12X EV/EBITDA.

While WS trades at 11X PE and 6.7X EV/EBITDA, it is cheap on its own with just a 7% EBITDA margin.  

If WS can achieve its 10%+ EBITDA margin goal it can significantly close the valuation multiple gap.

Our target for WS is 9X EBITDA or approximately $41 share or a 37% return from current levels.

Risks

Steel Prices

The primary risk for WS is steel price movements which is the strongest driver of earnings.  When steel prices are going up, the WS benefits from inventory gains that result in higher margins. On the flip side, margins tend to decline when prices are falling.  

Global Demand

Steel prices are affected by global factors beyond the control of the WS.  If there is a global slow down, while steel prices may decline so may demand for WS products.   

Secular Trends

Long-term secular shifts in steel consumption can pose risks and opportunities. The indirect downstream steel trade is a notable long-term risk for the WS and sector. Additionally, as an economy enters its developed stage following growth, there tends to be a lower need for steel and metals per capita. All these factors have weighed on steel consumption over the long term and will continue to in the coming decades.

Trade Policy: 

Trade policies such as tariffs are risks. The US and other countries have been particularly aggressive on the trade policy front for decades, aiming to protect the domestic industry from overcapacity issues in different regions and/or dumped products.

Big 3:

Approximately 50% of net sales are to automotive-related customers. Although we do sell to the domestic operations of foreign automakers and their suppliers, a significant portion of our automotive sales are to Ford, General Motors, and Stellantis North America (the “Detroit Three automakers”) and their suppliers.

Unions:

The United Auto Workers (“UAW”) strikes against the Detroit Three automakers could have material adverse effects on our business, financial position, results of operations and cash flows. The automotive industry is one of the largest consumers of flat-rolled steel, and the largest end market for our Steel Processing operating segment.

Catalyst

A few more quarters of being a public stand alone company.

Cycling through a near term steel price decline

Demonstration of higher margins