Steel Dynamics Can Benefit From Demand Bottoming (NASDAQ:STLD)

Shares of Steel Dynamics (NASDAQ:STLD) have been a solid performer over the past year, rising about 25%. However, shares have pulled back over 10% from their high as investors have been concerned about a potential slowing in the economy. I last covered STLD in April, reiterating shares as a “buy.” Since that recommendation, performance has been disappointing with shares down 13% even as the market has rallied 5%. With solid Q2 results and long-term tailwinds, I believe this is a dip that should be bought.

Steel Demand May be Bottoming

In the company’s second quarter reported on July 17^th, Steel Dynamics earned $2.72, which beat consensus by $0.05, though revenue declined by 9% from last year to $4.6 billion as the steel market has moderated. Earnings were down 43% from last year, given lower margins as steel prices have fallen. It is worth remembering that through six months, STLD has earned $1 billion, dramatically above full year 2019 earnings of $671 million.

In the last quarter, the company said underlying steel demand was “stable.” However, customers are working down inventories in case prices keeping falling. Essentially if you expect commodity prices to fall in the future, you are incentivized to work down existing inventories before buying more product.

Because of this behavior, customer inventories are very low. Given how low channel inventories are, if we see demand prove to be resilient, that can create positive momentum for pricing. In fact, Steel Dynamics management sees prices at the “bottom” with “positive moves in the future.” Indeed, it is already seeing improved order entry and expects a solid H2 given this improvement.

The Secular Backdrop is encouraging

From a macro perspective, I agree that demand should remain solid, which should support pricing. As I have discussed in the past, the secular outlook for steel demand is solid in my view. As you can see below, nonresidential construction is running at a very elevated level, though it is no longer growing quickly. A series of government programs, like the Inflation Reduction Act, CHIPs act, and bipartisan infrastructure bill all are enabling more construction, which is leading to elevated steel demand.

Given this funding has already passed Congress and is multiyear in nature, this demand should persist even if the economy slows down. More cyclically, we likely are on the precipice of a Federal Reserve rate-cutting cycle, which I expect to commence this September. Lower rates may boost demand in rate-sensitive sectors like auto and construction, which are significant consumers of steel.

This cyclical swing alongside secular support from the government is likely in my view to keep steel demand stable to slightly higher over the next 12-18 months. Additionally, steel supply is somewhat constrained because the Biden Administration has maintained the Trump Administration’s tariffs. As such, I would expect these tariffs to remain in place whether Donald Trump or Kamala Harris win the Presidential Election. Reshoring manufacturing is also an ongoing bipartisan push, which is why we have seen government incentives for nonresidential construction increase. That should continue to support steel demand.

In other words, we have secular government support for steel demand, a government limitation on supply, and if rates begin to fall, we may begin to see a cyclical swing in private sector steel-related activity. Combine that with low channel inventories, and it is likely Q2 represents a bottom for the business—a bottom which as noted above is quite strong relative to pre-COVID norms. While the focus on H1 sogginess has weighed on shares over the past quarter, this potential upswing can lift shares back past their highs in my view.

Q2 results showed lessening pressures

Importantly while Q2 results were down, there were some signs a bottom could be nearing, particularly in its higher value-add fabricated steel unit. External steel was sold at $1,138 a ton, down 5% from Q1 and 9% from a year ago, and shipments were down 2% to 3.2 million tons. As a result, Steel operating income declined by 27% to $442 million.

While steel fabrication profits fell 61% to $181 million, they did rise by 1% sequentially, an encouraging sign we are near the bottom. Fabricated steel was sold for $2,978/ton, down 32% from last year and 5% from Q1. Fabricated shipments were down 11% to 159k tons, though they rose 11% sequentially. The increase in shipments was a positive.

Again to be clear, the market has shown softness during the first half of the year, a bit more than I expected, but the pace of decline is moderating, a key step before we begin to see increases. Additionally with customers reducing their own inventories, the demand STLD is seeing is likely lower than end-market consumption, which may already have bottomed (barring a recession). If we see cyclical end-market demand recover and consumers even normalize inventory levels, that creates a constructive backdrop for the latter part of the year and into 2025.

While steel production has meaningful fixed cost, STLD has made its cost structure as variable as possible to preserve margins, in particular using profit sharing to compensate employees. Given the more muted steel environment, profit-sharing expenses fell $43 million to $48 million, helping to stabilize results. Now, SG&A was up $19 million to $160 million. This is misleading as to its cost efforts at existing operations because non-capitalized expenses associated with its new aluminum plant flow through into SG&A. Excluding this, SG&A would have been flattish.

Its aluminum plant will swing free cash flow

STLD continues to plan for a mid-year 2025 start for its $2.7 billion plant and get it to 75% utilization by the end of next year. Bringing this plant online should over time lead to at least $1.25 of incremental earnings power. Moreover as it goes from spending to build the plant to having the plant produce aluminum, STLD is positioned to see a significant swing in free cash flow as cap-ex goes down meaningful and revenue rises.

Even with this large project and the market softness, Steel Dynamics is a very cash generative business in my view. In the second quarter, it had a free cash flow burn of $37 million, but there was a $186 million usage in working capital for pro forma free cash flow of $149 million. It has generated $482 million of adjusted free cash flow year to date. In H1, it spent about $800 million on cap-ex, and I expect H2 spending to be closer to $1.2 billion as it progress on its aluminum plant. This year, I expect $800 million-$1 billion of normalized free cash flow, but even holding steel market conditions flat, this should move past $1.6-$1.8 billion once the aluminum plant is up and running.

STLD also maintains a pristine balance sheet with $1.5 billion of cash. Against this, it has $3.1 billion of debt for 1x debt/EBITDA leverage and just 0.5x net leverage. It has a well-staggered maturity profile, and in July, it issued debt to manage its 2024 maturity.

With such low financial leverage, STLD can use all free cash flow to return capital to shareholders, and that is what management is doing. In Q2, there were $309 million in share repurchases, reducing the count by 1.5%, and its share count is down 6.7% from last year. On top of this, it offers a 1.4% dividend yield.

Conclusion

Back in early April, I was targeting $13.50-14 in 2024 EPS, and I expected over $15 in 2025 given a decreasing share count and the opening of its aluminum plant, which should add at least $1.25 in EPS. Now, it generated $6.39 in H1 earnings. With its share count continuing to decline and with the steel market likely bottoming, I expect H2 earnings to exceed H1 results. However, it may take a bit longer for customers to rebuild inventories and accordingly I am widening my EPS range to $13.00-$14.00, depending on the magnitude of customer inventory building. This assumes modest economic growth. Any tailwind from Fed rate cuts would be more likely to be felt in 2025 as it takes time for projects to break ground.

Shares are about 9.5x 2024 earnings, which I view as attractive given we are near a cyclical swing. Additionally, STLD’s free cash flow profile is likely at an inflection point as the aluminum plant nears completion meaning free cash flow should inflect even if the market stays softer for longer. That should enable it to continue to grow its dividend and reduce its share count by 7-10%.

Given the commodity nature of the business, I view an 8% normalized free cash flow valuation as appropriate. With $1.7 billion of free cash flow in this environment (adjusting for one-time aluminum expansion spending) and a share count likely to be ~145 million within a year, shares can trade up to $151. If we see a cyclical recover as I expect, free cash flow could move closer to $2 billion, and I see shares moving past $160.

As a consequence, I would be a buyer of STLD. After a disappointing few months, shares are positioned to recover as free cash flow begins to ramp, interest rate-sensitive demand recovers, and its share count continues to fall.