Steel Dynamics: A Mixed Bag Of Opportunities And Risks

Investment Thesis

Steel Dynamics, Inc., (NASDAQ:STLD) a prominent player in the U.S. steel industry, offers a mixed bag for prospective investors. While the company has promising diversification, effective cost management, and a strong order backlog, the immediate future suggests caution. Decreasing profitability, price instability, and worsening cash conversion cycles present challenges that cannot be ignored.

Given these conditions and following the evidence, the investment recommendation would be to adopt a "Hold" stance on Steel Dynamics for the time being. It's crucial to observe how the company navigates the concerning trends in the next few quarters before making any long-term investment decisions.

Investors must watch key financial metrics like steel prices, operating income in the Steel Operations Segment and the Cash Conversion Cycle closely. If you are already invested, stay put but monitor diligently. If you are considering investing, it might be wise to wait for clearer signs of stability and growth.

Overview

Steel Dynamics, Inc., one of the largest steel producers and metal recyclers in the U.S., reported its second quarter of 2023 results. With a diversified portfolio of steel products, the company managed to achieve 3.2 million tons of steel shipments, mainly driven by strong demand in the automotive, construction, energy, and industrial sectors. Despite this, the company witnessed a decrease in consolidated operating income by 34% to $1.1 billion, compared to the second quarter of 2022. Furthermore, the net income attributable to Steel Dynamics decreased by 33% to $812.1 million.

The steel operations segment saw a 5% increase in shipments but a 15% decrease in net sales compared to 2022, largely due to falling steel prices. The company's primary cost in steel manufacturing, metallic raw materials, decreased by 18% per net ton. The metals recycling operations, which contribute to 12% of the net sales, also experienced a decrease in net sales by 14%, even though shipment volumes were up. About 62% of the ferrous scrap from these operations was consumed in their own steel mills. Lastly, the steel fabrication operations, accounting for around 15% of the net sales, saw a 28% decrease in net sales, again due to falling prices.

For future guidance, Steel Dynamics expects third-quarter 2023 profitability to be lower, with earnings per share projected to be between $3.46 to $3.50, which is down from the second quarter’s $4.81 per share. As of August 31, 2023, the company has purchased $920 million of its common stock and paid $202 million in cash dividends to shareholders.

When it comes to long-term investment in Steel Dynamics, there are several key factors to consider. First, the company has diversified its revenue streams by serving multiple industries, which is generally good for reducing investment risk. Next, the company has been effective in cost management, reducing its primary manufacturing costs—metallic raw materials—by 18% per net ton, creating potentially more room for profit if selling prices stabilize or increase. Adding to investor confidence, the company has executed a stock buyback of $920 million and paid out $202 million in dividends, showing a strong belief in its own financial health and a commitment to its shareholders.

However, there are red flags; Steel Dynamics expects lower profitability in the upcoming third quarter, signaling that despite strong fundamentals, market conditions are affecting short-term performance. There's also concern about falling average selling prices across all segments, leading to decreased net sales and operating income. Another red flag is that despite an increase in shipment volumes, the net sales have gone down, meaning the company is selling more but earning less—a worrying sign for long-term profitability. On the positive side, the company has a strong order backlog extending into 2024, particularly in its steel fabrication operations, which could indicate sustained demand.

In summary, Steel Dynamics shows promise as a diversified company with good cost management and shareholder-friendly activities. However, the immediate future suggests lower profitability and challenges in price stabilization. Long-term investors should weigh these factors carefully.

Revenue Analysis

Looking at the company's financial data, the picture that emerges is one of contraction and declining profitability. For the three-month period ending in June 2023, the Steel Operations Segment experienced a 15% drop in net sales compared to 2022, and a 17% drop for the six-month period. The Metals Recycling Operations Segment saw a 14% and 7% drop for the same periods, respectively. Even worse, the Steel Fabrication Operations Segment reported a 28% fall for the three months and an 18% decline for the six months.

The Gross Profit has significantly declined, another red flag. The operating income paints a concern. In the Steel Operations Segment, which is a major part of the business, there was a 36% decrease for three months and a 54% decrease for six months. Metals Recycling dropped by 39% and 27%, and Steel Fabrication dropped by 23% and 5%.

The quality of earnings, represented by Net Income, reveals a significant downturn, diminishing from $1,214,652K in 2022 to $816,177K for the three-month period in 2023. Given the Net Income of $816,177 on Net Sales of $5,081,630, the Profit Margin is approximately 16% for the three months ending June 2023, down from 19.5% in the same period last year. These metrics raise several red flags, primarily in the Steel Operations Segment, which seems to drive the company's value with $3,608,233 in sales. Given the declining numbers, the sustainability of this value driver is highly questionable. As such, the most critical financial metric to watch closely is the Operating Income, especially in the Steel Operations Segment. It's worrying to see it decline from $1,102,725 to $702,646 in just three months this year.

Interestingly, dividends have risen from $0.34 to $0.425 per share, possibly as a tactic to maintain shareholder confidence, but that could place additional financial strain on the company given its overall dismal performance.

Given these conditions, it's reasonable to expect challenging times ahead for the company in the future unless something changes. Declining sales and profitability across almost all segments, coupled with the alarming dip in operating income, raise several red flags. On a slightly optimistic note, the marginal decrease in the Cost of Goods Sold could suggest some efficiency gains, but this is far from enough to offset the negative trends in revenue and profits. In summary, both the short-term and long-term financial health of the company appear to be on shaky ground, making its future sustainability and profitability seem questionable.

Balance Sheet Analysis

Taking a closer look at the company's Balance Sheet, the financial position is a bit of a mixed bag. On the asset side, the total current assets have dipped slightly to $7,396,055K from $7,638,018K at the end of last year. However, accounts receivable has seen a little bump, up to $2,079,949K in 2023 from $1,976,282K in 2022. When it comes to long-term assets like property, plant, and equipment, they've increased to $5,783,622K in 2023 from $5,373,665K in 2022, signaling that the company might be investing more in its operations.

Shifting gears to liabilities, current liabilities have actually decreased to $1,759,035K from $2,032,296K, which is positive for the company's short-term financial standing. In particular, accounts payable has slightly increased to $1,039,149K from $1,007,304K, while income taxes payable have jumped to $39,177K from a low $6,520K. Long-term debt is fairly stable, standing at $3,010,829K, almost the same as last year.

Taking stock of equity, the number of common stock shares has remained fairly constant, while retained earnings have seen a nice bump up to $12,681,894K from $11,375,765K. This makes me believe we could be looking at retained earnings of around $14,000,000 next year. This growth in retained earnings actually marks it as the most important financial variable to watch. But it's worth mentioning that the quality of those earnings might be in question given that operating income has decreased, as indicated in the income statement.

A current ratio of around 4.2, calculated by dividing the total current assets of $7,396,055K by the total current liabilities of $1,759,035K is a healthy number, signaling that the company shouldn't have any issues covering short-term debts. When it comes to red flags, there's a noticeable dip in 'Cash and equivalents,' which went from $1,628,417K to $1,475,356K. Now, if this trend continues, we could be looking at cash reserves shrinking to about $1,322,295K next year.

In summary, the company appears to be in a stable, if slightly declining, financial state with some red flags like a decrease in operating income and a slight dip in current assets. But on the flip side, lower current liabilities and a significant uptick in retained earnings do indicate strong short-term financial health and profitability.

Free Cash Flow Analysis

The company's cash from operations has been increasing consistently, moving up from $1,139 million in 2021 to $4,181 million in 2023, signaling that the core business is quite robust. On the flip side, capital expenditures dipped to $743 million in 2022 from $1,258 million in 2021, before climbing back to $1,170 million in 2023, suggesting a cautious approach to investment in 2022. The current portion of long-term debt declined from $94 million in 2021 to $37 million in 2022 but increased slightly to $57 million in 2023, hinting at prudent debt management.

Net Working Capital has increased from $2,393 million in 2021 to $4,233 million in 2022, though it did dip a bit to $3,607 million in 2023. This indicates that short-term debts aren't a huge worry right now.

Earnings Before Interest and Taxes jumped from $1,984 million in 2021 to $5,864 million in 2022 but slipped to $3,878 million in 2023. The Net Operating Profit After Taxes, followed a similar path, climbing from $1,547 million in 2021 to $4,574 million in 2022, then down to $3,025 million in 2023. These fluctuations hint at some volatility, so if I were to make forecast for next year, based on the trend, I'd say a moderate 5% decrease in EBIT and NOPAT wouldn't be surprising.

The management seems to be doing its job effectively, given the growth in NOPAT and strategic reduction in debt. In terms of investment guidance, I’d suggest a 'Hold' stance on this company, primarily because while the operational cash flow is strong, the EBIT and NOPAT have been a mixed bag.

Cash Conversion Cycle

Starting with Days Inventory Outstanding, we notice it increased from 75.31 days to 78.09 days. This means the company's inventory isn't moving as quickly as it used to, which could potentially tie up funds. Simultaneously, the Days Sales Outstanding jumped from 32.57 to 42.86, meaning the company's taking more time to get payments in from customers. This could be a liquidity issue waiting to happen. On the flip side, the company seems to be taking its time to pay off its suppliers, as evidenced by the Days Payables Outstanding going up from 25.98 days to 28.35 days.

One crucial metric to monitor is the Cash Conversion Cycle, which worsened from 81.90 days to 92.60 days. That means it's taking the company longer to convert its inventory into cash. Given these upward trends in "Days Outstanding" metrics, I'd cautiously forecast more of the same in the future unless significant operational changes are implemented.

The total revenue dipped from $22,260.77 million to $20,452.83 million, which obviously affects its valuation. From an external risks perspective, the numbers hint at operational risks, keeping into account inflation and rising interest rates. As for investing in this company, It's more of a "Hold" situation until these metrics show some improvement.

Shareholder Yield

The Dividend Yield of 1.41% means that if you own shares in this business, you're getting a modest 1.41% return through dividends. Now, the Buyback Yield is 9.08%, which is pretty aggressive. This suggests the company is buying back its shares, probably because it thinks they're undervalued. When we combine these two, we get a Net Payout Yield of 10.50%, indicating that the company is committed to giving value back to its shareholders through dividends or share buybacks.

The company has also slightly cut down its debt, with a Debt Paydown Yield of -0.11%. It's a small but positive step that indicates the company is not drowning in debt. The overall Shareholder Yield, which includes dividends, buybacks, and debt reduction is at 10.39%. However, one potential red flag could be the high Buyback Yield compared to the Dividend Yield. Some investors prefer a dividend-heavy approach, and this company seems to be focusing more on buybacks.

If we were to make a forecast about next year, the trends suggest that we might see a continuation of the share buyback strategy and similar dividend yields. The Buyback Yield, at 9.08%, emerges as the most crucial variable to watch, given it contributes significantly to the overall shareholder yield.

As for the company's strategy, it looks like management is intent on improving shareholder value, particularly through share buybacks. This either means that the company believes it has better uses for its cash or that its stock is undervalued.

Investment Recommendation

Based on the thorough analysis of Steel Dynamics' financials, it's a mixed bag. While the company has shown some robustness in operational cash flow, it's experiencing declining sales and profitability across almost all segments. The operating income, particularly in the Steel Operations Segment, has seen significant decreases. Other metrics like Net Income and Profit Margin are also declining. Although the company's Balance Sheet suggests a stable short-term financial standing, there are red flags like a decrease in current assets and operating income. The Free Cash Flow analysis does show prudent debt management and increasing cash from operations, which is a good sign.

From an external risks perspective, the company seems to be facing operational risks, considering factors like inflation and rising interest rates. Shareholder Yield analysis indicates that the company is focusing more on share buybacks than dividends, which could be a strategy to improve shareholder value or an indication that the stock is undervalued.

Considering all these points, my recommendation to a financial investor interested in Steel Dynamics would be to "Hold". The company has both strengths and weaknesses in its financials. While there are signs of solid short-term financial health and effective debt management, the declining profitability and various red flags in revenue and operations make it challenging to confidently suggest buying more of the stock. A "Hold" stance would be appropriate until these metrics show some notable improvement.