Why Steel Dynamics is a Strong Buy

Arthur is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The World Trade Organization’s decision to oppose China’s attempts to limit exports of raw materials required by the global steel industry has a positive effect on North American manufacturers. Previously enforced restrictions forced high input prices across various industries onto international market, while Chinese firms enjoyed low input costs. A ban on restrictions introduces a fairer industrial playing field.

Macroeconomic Indicators

Macroeconomic indicators have been slowly improving, suggesting that the U.S economy is back on track to boost output. The Industrial Production report, released by the Federal Reserve Board indicates that production of consumer durable goods including automobiles and home appliances has been steadily growing. Likewise, production of primary and fabricated metal products has shown 9.0% and 8.2% year-over-year growth. According to the Business Outlook Survey, complied by the Federal Reserve Bank of Philadelphia, which serves as a leading indicator of business activity, the data reinforces that managers are optimistic about current prospects; between December 2011 and January 2012, the diffusion index jumped from 6.8 to 7.3.

Slowing China

2011 steel production soared 6.8% to 1,527 million tonnes, largely driven by growing demand from China. 2012 production, however, is expected to fall by a slight 2%, according to World Steel Dynamics, despite overall North American market growth and optimism. Naturally, the cause for the decline is the forecasted slowdown in China, a nations which consumes approximately 45.5% of global steel production. A slight drawback in global steel production would undoubtedly hinder the performance of major steel producers such as ArcelorMittal (NYSE: MT) which produces around 100 million tonnes of the metal and has a strong reliance on the Chinese markets. South Korea’s Posco (NYSE: PKX), the world’s third largest steelmaker, after ArcelorMittal and China’s Baosteel, also has a large dependence on this market. Although rapid expansion through China has made Posco one of the top performing steel operators in the last decade, the company stands to be among those hardest hit if the Chinese bubble bursts. Easing demand in Europe and a possible slowing in the world’s most populous nation will hit large cap corporation with the most force as they will lose sales in a vital market.

But...

A smaller company which I think is well positioned to be somewhat shielded from a potential fallback in China, although not fully, while continuing to take advantage of a growing U.S. market is Steel Dynamics (NASDAQ: STLD). Steel Dynamics is the fifth largest American producer of carbon steel products and mainly serves the domestic market. The corporation, which was founded by 3 entrepreneurs, is also diversifying its core business away from solely basic steel products through acquisitions to enter the recycling and iron resource business. Metal Recycling and Ferrous Resources account for approximately a third of net sales, with steel fabrication operations contributing a modest 4%.

Strong Operations

Despite its relatively small size, Steel Dynamics is the most efficient operator in the U.S. Its operating income per ton of steel shipped is around $129. In contrast, domestic competitors such as Nucor (NYSE: NUE) and United States Steel Corp. (NYSE: X) generate approximately $75 and $20 in operating income per shipped ton, respectively. Looking at their respective EBITDA margins, once again reveals Steel Dynamics strong levels of profitability despite its significantly smaller market cap. Steel Dynamics operates with an industry leading EBITDA margin of 11%, compared to 10% and 5% for Nucor and U.S. Steel. Strong operations greatly benefited the company as full year net income increased by 98% as the average per ton selling price soared by $123 to $897.

I am extremely bearish on China and feel that investors should minimize any exposure to the country either directly or indirectly. A Chinese drop in steel demand may actually have a small positive impact on Steel Dynamics, especially since the company is not heavily exposed to the Asian economy – since China typically buys raw materials in the spot market, declining demand will force input prices to fall, thus improving Steel Dynamics margins. In addition to the WTO decision, the impacts might be sizeable.

Conclusion

Steel Dynamics also has a strong management team lead by Mark Millet who is a seasoned veteran of the steel industry through his extensive professional experiences and at the academic level as well. With $1.94 billion in debt, the company is not overly leveraged and easily has a strong enough balance sheet and cash flow stream to satisfy its debt as payments come due.


Motley Fool newsletter services recommend Nucor. The Motley Fool owns shares of ArcelorMittal. apinkasovitch has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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