Steel Dynamics Is One To Watch With A Contrarian Eye As Fatigue Shows In Steel End-Markets

The steel market has definitely gotten more interesting of late. While Steel Dynamics (NASDAQ:STLD) management said all of the right things after first quarter earnings, including referencing a strong order backlog and evidence of strength in multiple end-markets, spot prices have continued to shrink and the outlook for many important steel-consuming industries has weakened. Most recently, Nucor (NUE) surprised the Street with weaker than expected mid-quarter guidance (EPS almost 30% below the sell-side at the midpoint) on weaker pricing and shipments.

Now the Street awaits Steel Dynamics’ mid-quarter update. No two steel companies have exactly the same mixes or contract/spot exposures, so it’s not inconceivable to me that STLD’s outlook could hold up better in the short term, especially as about half of the business should lag spot trends by roughly a quarter. Still, I see weakening end-market demand as a key risk for the remainder of the year.

It has been a while since I’ve written on Steel Dynamics, and while I was bullish the last time, I didn’t expect quite such a surge in non-residential construction demand (driven by warehouses) and the blowout profits in the fabrication business. I’m less bullish now, as it’s tougher to make the valuation numbers work, but this is a name to keep on a watch list as management has shown over and over again that they know how to make money in this volatile industry.

Is There A Storm Coming, Or Just Some Light Showers?

One of the dominant themes with steel companies over the past few years has been the expectation that capacity additions in the U.S. would eventually outstrip demand and drive weaker prices. While that could still happen, growth from end-markets like construction has been stronger than expected, giving companies unexpected pricing power.

Steel prices are already well off their highs, with the most recent spot quotes somewhere in the $700’s (getting accurate spot prices is getting harder and harder) and down more than half from the 2021 peak. Prices were strong at the start of the year (around $1,100), but have weakened pretty steady since then, despite very low import spreads that should be beneficial for pricing.

Looking around the space, I can see warning signs for demand. Auto production hasn’t been all that strong this year and is expected to soften as the year goes on. Oil and gas capex is starting to soften, and we’re starting to see companies leveraged to short-cycle manufacturing and heavy machinery revising their guidance lower (including calls for revenue contraction in 2024).

Non-residential construction, too, has softened. Non-residential starts are contracting now, and particularly warehouses. Warehouses were over 40% of non-residential starts in 2022 and over 30% in 2023, with build rates well above long-term averages as companies looked to refurbish buildings and expand in response to e-commerce and reshoring demand growth. In the first quarter, though, warehouse starts were down 26% year over year and another 11% quarter over quarter, while manufacturing starts were down 34% yoy and 15% qoq.

Warehouse construction activity is still almost double the long-term average, but it seems likely to me that new starts are going to continue to soften here in 2024. I’m more bullish on a future rebound in manufacturing activity, particularly with multiple government stimulus offerings boosting the reshoring trend, but I do see a risk to what has been a highly profitable business for Steel Dynamics and Nucor in recent years (that is, long steel products and fabricated steel products like decks and joists).

Flattening Growth And Ongoing Reinvestment

The good news is that Steel Dynamics is one of the best operators in the business. Even if steel prices decline into the $700’s, STLD should still be able to produce mid-teens EBITDA margins and high single-digit to low double-digit free cash flows. The company is underway with some large capex projects, including an expansion into aluminum, but there should still be cash left over to fund capital returns to shareholders, and I’d note that the company has been good about returning cash to shareholders, with the sharecount down about 30% since 2018.

The bad news is that while good operators hold up better during downturns, they still largely go unloved when they’re not growing. EBITDA declined last year, and I expect it will decline this year and the next (2025) before rebounding in 2026. Multiple years of declining revenue, EBITDA, and EPS is a tough set up for any stock, and I expect that at least a few bearish analysts will fret over the company’s spending on new value-added steel lines (painting, galvanizing and the like), the aluminum project, and additional ESG projects (like renewable energy for its plants and “bio-carbon” to reduce its anthracite needs).

Beyond this multiyear reset period, though, I do think there are healthy drivers for the business.

For starters, there seems to be no political appetite for easing up on tariffs on Chinese steel (or aluminum). There is, however, more appetite for ongoing stimulus for manufacturing reshoring (including the CHIPS Act), as well as infrastructure projects. Infrastructure activity is likely already helping to offset some of the weakness from non-residential construction, and I do expect more activity in 2025 and 2026.

I also like Steel Dynamics’ leverage to reshoring and nearshoring – not just on the construction side (literally building new factories and warehouses), but also on the product supply side. The plant that the company built recently in Texas is well-placed to supply sheet steel to Mexico, and while I think Ternium (TX) is likely a better play on nearshoring-driven steel demand in Mexico’s manufacturing sector (for autos in particular), I think Steel Dynamics has good leverage here too.

It’s also worth mentioning that the (relatively) recent decision to invest in aluminum production isn’t as big of a change for Steel Dynamics as it may seem. While there are of course risks here, management isn’t exactly wrong about its view that there is a dearth of modern low-cost manufacturing capacity for sheet aluminum used in markets like packaging (beverage cans) and autos, and with auto OEMs still focused on lightweighting wherever possible (particularly for EVs), this can be a credible demand driver.

The Outlook

My modeling assumptions for Steel Dynamics are based on the idea that hot rolled steel prices will slide toward the mid-$700’s over the next few years and that demand may surprise to the worse for 2H’24 and 2025. Of course, in a business like steel the best you can do is take your best shot at forecasting and see what happens (nobody modeled the 2022 surge in STLD’s fabrication profits a year or two before).

I’m expecting a nearly 25% peak-to-trough move in STLD’s revenue, with 2025 as the trough year. I expect that EBITDA margins will likely bottom somewhere in the 13%’s, although I can see a “perfect storm” of weaker non-residential and industrial demand and persistently higher operating costs creating some risk in a worse-case scenario (EBITDA margins have troughed in the single digits before).

Longer term, I expect Steel Dynamics to continue to outgrow the industry, and I believe long-term revenue growth in low-to-mid single-digits is still possible. I do expect healthy mid-teens EBITDA margins during the recovery, though I’m not forecasting a repeat of the 25%-plus boom years (modeling peak/trough results is challenging, to say the least), and I’m expecting health free cash flow margins in the high single-digits to low double-digits, with controllable capex requirements allowing for meaningful capital returns to investors.

Valuation is mixed. The shares don’t seem unreasonably priced on discounted cash flow (including a best-efforts attempt at modeling future peaks and troughs). Using my preferred blend of full-cycle and next-year EBITDA multiples, though, I don’t come up with such an attractive valuation. At 6.5x full-cycle and 7.5x 12-month EBITDA, I think Steel Dynamics is close to fair value.

The Bottom Line

Given weakening conditions and weaker guidance across a wide range of Steel Dynamics’ markets, not to mention the weaker intra-quarter update from Nucor, I’m inclined to be cautious about Steel Dynamics now. The shares are already down about 20% from their high, but corrections of a third haven’t been that rare in the past. I like the idea of being aggressive when others are fearful, and the Street is definitely getting more fearful about steel, but I do think it may yet be a little early to get fully contrarian on these shares.