Steel Dynamics Is A Value Trap At 4.5x P/E (NASDAQ:STLD)

Investment Thesis

Steel Dynamics (NASDAQ:STLD) is a leading domestic steel producer and metal recycler in the United States. The stock has a staggering performance in 2022, up around 65% YTD. Despite the surge in stock price, its P/E ratio is still well below its 5-year average. A value investor using P/E ratio may deem it a great opportunity to buy the stock. However, I believe it is a value trap, as one may have neglected the stock being cyclical in nature. And on the contrary, it is an opportunity to sell short STLD as steel price has retreated to the regular price zone, but the market is still in the hype surrounding the stock.

A Staggering Performance In 2022

The company operates in three segments: steel operations segment, metals recycling operations segment and steel fabrication operations segment. The steel operations segment primarily consists of steelmaking and numerous coating operations, and is accountable for 72% of net sales in 2021. Half of the products in this segment, like reinforcement bars, steel beams and steel piles, are consumed by construction-related activities.

The financial performance of STLD has been impressive in recent years. Its revenue has doubled, and earnings have four-folded in a five-year span. Its free cash flow also surged from $1,240 million in 2017 to $5,398 million in 2022 TTM. Such excellent performance is highly dependent on two crucial factors: high steel price and high utilization rate.

The Covid-19 pandemic caused steel production activities to be put on a halt. But the steel demand had far exceeded the industry’s expectations, leading to a spike in steel prices. Hot-rolled coil steel prices surged from around $450/ton in April 2020 to about $1950/ton in September 2021. The diagram below shows steel prices since 2018. The soaring steel prices have benefited companies like STLD as their margins expanded. Both gross margin and operating margin doubled from 2020 to 2021.

Although the steel price has retreated about half from its high in the first two quarters of 2022, it was still trading outside the normal range ($350/ton-$950/ton). With the fabrication backlog at a record level, the company can still deliver outstanding earnings results.

STLD also benefited from its higher-than-industry average utilization rate. In the previous quarter (Q3 2022), the company’s production utilization rate was approximately 93%, a significantly higher-than-industry average of 75.7%, and its competitor Nucor’s (NUE) of 77%. This shows STLD’s efficiency and resilience throughout various stages of the cycle, and its ability to deliver excellent performance when tailwinds come.

What to Expect in 2023?

The performance of STLD is highly dependent on steel price. When steel prices rocketed, the company enjoyed higher margins and thus led to amazing returns. But in contrast, when the price decreases, it may suffer a decline in earnings.

Last time we saw a huge decline in steel prices was from 2018 to 2020. Hot-rolled coil steel prices declined from $900 to $450 within that period. Even though STLD has a great management team and sufficient diversification, its top-line and bottom-line dropped. Please refer to the table below for financial data in 2014 – 2015 and 2018 – 2020, where steel prices declined significantly.

	2014	2015	2018	2019	2020
STLD High or Low Price	“High” $25.5	“Low” $16.2	“High” $52.1	“Low” $25.1	“Low” $15
Hot-rolled Coil Steel Price	“High” $685	“Low” $364	“High” $942	“Low” $491	“Low” $447

Click to enlarge

(Source: Author, with data from Trading View)

Steel Price

Hot-rolled coil steel traded between $350/ton to $950/ton range from 2008 to 2020. At the time of writing, the steel price had fallen back to the zone from its historic high at $1950, representing a 65% drop. In the latest earnings conference call, CEO Mark Millet reflected that non-residential construction activities remain solid, but new residential construction has softened a little. As mentioned earlier, half of the steel shipments are construction-related. Thus, construction activities will have a prominent impact on the demand for their products.

For the residential housing market, single-family homebuilding starts and permits for future construction have dropped to the lowest level since June 2020. Sentiment for home purchasing is also gloomy as housing is unaffordable, and the 30-year mortgage rate is still clinging at 6.5%. Bank of America (BAC) economists said the cooldown in the housing market has spread to the manufacturing sector. The U.S. ISM Manufacturing PMI, released on 1 Dec 2022, decreased to below 50 for the first time since June 2020.

The non-residential market is, on the contrary, more positive. In the U.S., total spending for new construction is still solid. Certain building types, like warehouses, are in high demand.

Warehouse construction utilizes many steel components, like steel beams and columns, steel angles and sections, steel sheets, etc. Warehouses were in huge demand during the pandemic and thus led to a warehouse construction boom. In 2022, although vacancy rates have started to tick upward slightly, demand is still well above the long-term average.

But recent layoffs in tech companies reduced the demand for office spaces. And banks are tightening standards for commercial real estate’s loan for construction and land development purposes, which sets higher barriers for commercial developers to construct new developments.

Meanwhile, consumer demand for autos is also mixed. Automakers expected slightly higher demand in the coming year as the supply chain improves, but weaker economic conditions will limit its recovery. General Motors (GM) is relatively conservative for auto demand in 2023. The company’s Executive Vice President said they have plans to deal with economic tightness next year. Automotive is accountable for 12% of sales (by weight) in STLD’s Steel Operation Segment.

On the supply side, a study from the CME group found the inventory level of steel is high and estimated to escalate further, which pushes steel prices further downward. For instance, NUC and CLF’s inventory levels are historically high.

Overall, the steel price is unlikely to return to a high level in the coming year. Futures prices also indicated that Wall Street expects the steel price to hover around the $700/ton to $800/ton zone in 2023. Dreadful economic backdrop may exert further downward pressure on the price as demand continues to shrink.

A More Diversified Business

In order to reduce the impact of the steel price cycle, STLD is proactively engaging in value-added flat-rolled sheet coating lines and investing in recycled aluminium flat-rolled mills to diversify its businesses.

The four new lines, including two paint lines and two galvanizing lines, are targeted for start-up in the second half of 2023. They will increase the annual coating capacity by 1.1 million tons, cementing the company’s position as the largest domestic non-automotive coater of flat-rolled steel.

For the recycled aluminium mills, STLD invested $2.2 billion over four years for a 650,000-tonne aluminium flat-rolled mill with two satellite recycled aluminium slab centers in Mexico and U.S. The sites are planned to start up in 2024 to mid-2025.

Some may have concerns about the escalating capital expenditure due to these two projects. The company, in the previous quarter, held over $1.4 billion in cash (or equivalent). It allows their management team to fund the recycled aluminium mills project fully in cash without the need to raise additional capital. Meanwhile, they anticipated the CapEx in 2023 would be around $1.2 billion to $1.3 billion, which is at a similar level in 2020 and 2021.

Potential Risks

The investment thesis is developed with two significant factors: declining steel prices and lower profitability.

Steel prices are unlikely to return to the previous high level in 2021, but unexpected global events like Covid and Ukraine war will have a major impact on the demand and supply of steel. Besides, the following two scenarios may also lead to more bullish steel prices in 2023.

Steel prices may avoid a hit if a recession in 2023 does not come. Some optimists believe that the risk of recession next year is low as consumer confidence and real household disposable income is improving. But most Wall Street analysts expected an economic downturn in 2023, which will likely drive the steel demand and prices down.

China is the world’s largest steel consumer, consuming around 1 billion tons yearly. Following the country’s relaxation of Covid restriction rules, it is expected to pick up its demand gradually to support the revitalizing economy. However, China has an annual production capacity of 1.2 billion tons of steel, most of which is consumed domestically. It is not expected to impact U.S. steel prices significantly.

For STLD’s profitability, the earnings of STLD are anticipated to be cut in half next year due to weakening steel prices and narrowing margins. However, the company may surprise us as backlog cases have been piling up. In the latest conference call, the company mentioned a strong and diversified order backlog that extends well through the first half of 2023 with strong pricing dynamics.

A P/E Value Trap

Despite STLD surging 65% YTD, the P/E ratio of the stock looks incredibly attractive. It is trading at 4.53x of its earnings, about half its 5-year average. Its EV/EBITDA is also 40% below its 5-year average. However, I believe the stock is a value trap and is likely to underperform the broader market based on the following two reasons.

First, steel prices have declined two-thirds from its high, but the stock price has not reflected it. As mentioned above, the stock is likely to fall when steel prices plummet. Steel price has returned to the normal trading zone. However, the market is still giving STLD a huge premium. The disconnection between its price and fundamentals will likely be reflected in 2023.

Second, STLD is a cyclical stock. It has earnings history chiefly following the steel price cycle. As Ben Graham mentioned:

Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years.

This is particularly true when we refer to STLD’s past 5-year earnings and P/E ratio. If an investor bought STLD in December 2018, when the stock had already declined over 40% from its recent high, and P/E ratio is at an attractive level of 5.61. He would suffer another 50% drop before STLD reached the bottom. The P/E ratio is likely to drop if the stock retreats in Q1 2023, but please recall that it is a value trap.

	2017	2018	2019	2020	2021
EPS	3.36	5.35	3.04	2.59	15.56
P/E Ratio	12.84	5.61	11.2	14.24	3.99

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(Source: Author, with data from Gurufocus)

Valuation

As the P/E ratio of the company is cyclical, it is not appropriate to compare its historic P/E ratio to the current P/E ratio. On the contrary, the equity value of STLD has been steadily improving and is non-cyclical. Thus, I will utilize the P/B ratio as a valuation tool.

The current company’s equity is $7,935 million, and the book value per share is $45.15. If you compare the five-year P/B ratio of 1.89 average with the current P/B ratio of 2.27, you won’t find STLD’s current valuation attractive. The stock is trading at a 20% premium. Combined with the gloomy macro environment, the already plummeted steel prices and unfavourable historical price data, it will not be surprising that the stock will decline well over 20%.

Analysts estimated the revenue and EPS to plummet 20% and 51% respectively next year. What goes up must come down. I see a huge disconnection between the stock’s future profitability and current stock price. Thus, I am short-selling the stock despite its underlying excellent management team and diversified business.

Risk of Shorting

The drop of a steel stock can be divided into two stages. First, the stock will decline with the steel prices, and the P/E ratio will drop accordingly. Then, as there is a time lag between the steel prices and earnings, the P/E ratio will climb in the second stage as earnings decrease.

Thus, investing in the first stage of the downturn cycle would be wiser. I believe it is more likely to happen in the first half of 2023, and earnings of STLD will decline in the second half of 2023 as backlogs fall and pricing declines.

The current high interest rate environment makes short selling less favourable. According to Interactive Brokers, current margin loan rates range from 5.17% to 13.25%. If the stock returns to its fair value (about 20% lower than its current level) in six months, the return will be 13.38% to 17.42%.

In a recessionary environment, a 13% return in six-month is quite attractive. However, investors should be reminded that short selling has the potential for unlimited losses. Thus, it is of utmost importance to stop loss when things go the other way around.