The word is out: Brazilian steel manufacturers are the industry's next global powerhouses. At present, out of total global crude steel production of 1.3 billion tons a year, the Brazilian share works out to be 3%.
Of particular interest for international steel producers is the new Chinese export tax to be implemented as of January 2009, which will restrict Chinese steel exports. Of the two major indigenous steel manufacturers in Brazil, Gerdau
(GGB)
and Companhia Siderurgica Nacional
(SID)
, Gerdau has the more interesting strategic orientation.
Gerdau manufactures a wide variety of steel products, ranging from rolled steel to slabs, wires and galvanized products. But its strategic focus in its main markets to date - namely, Brazil, North America and to some extent elsewhere in Latin America -- is to set up shop close to customers so it can source raw products more cheaply.
In particular, it is the largest producer of long steel in the Americas, for which it uses its decentralized production process, adjusting the size of plants to meet customer demands, thereby sourcing raw materials locally. Long steel is used for such diverse applications as railroad tracks, wires and structural steel used in buildings. Gerdau's major markets are construction, manufacturing and the ag business.
Additionally, compared with its primarily Brazilian rival, its valuations are more attractive. GGB's and SID's respective P/E ratios are 17.92 and 79.86, compared with sector norms of 21.38. Market caps are equivalent for the two companies, with SID's value at $36.3 billion, slightly higher than GGB's $28.8 billion. The following graph shows that five-year and two-year returns for the company are 94% and 75% respectively, making Gerdau's lower valuations even more impressive.
Gerdau is the largest long-steel producer in Brazil, with 47% market share, followed by Belgo Mineira, a subsidiary of Arcelor Mittal
(MT)
. Crucial to any steel company's operations these days is how well the company manages its input costs. Because Gerdau operates in a decentralized manner in its North American and Brazilian markets, it has managed to control its expense growth relative to revenue growth. As a result, its operating margins were reported at 17%, compared with MT's 14%.
Given the size difference between Gerdau and Arcelor Mittal (which quotes a market cap of $135 billion), Gerdau's capex, which amounted to $1.54 billion over 2007, compares favorably with MT's $5.4 billion. Furthermore, Gerdau anticipates increasing its capex by 36% until 2010, with especially strong growth in such markets as North America (44% capex growth) and Latin America ex Brazil (113% capex growth).
Beyond Latin and North America, the company faces stiff competition, but I believe that at least over the medium term, Gerdau is positioned to be a strong presence in the Americas, especially since its stated policy is that the delivery expense for the customer is limited to freight charges from the nearest competitive mill, with Gerdau absorbing any incremental freight charges.
First Out of the Gate
For a variety of reasons, Gerdau dominates its closest Brazilian competitor. In particular, although SID mines the iron ore that it uses in its mills (about 3.3 million tons last quarter), Gerdau's advantage is that most of its mills operate as electric arc furnace, or EAF, mini-mills, which produce crude steel from raw materials such as scrap steel or pig iron, sourced locally .
And while Gerdau is stepping up its international presence (i.e., principally Latin and North America), SID is retrenching, with its export shipments declining by 41% over the first quarter of 2008 from last year's value, while the company's domestic shipments increased by 55%.
Because of these considerations, and despite SID's higher ROE, I believe the future looks brighter for Gerdau, according to the following table. (GGB's figures are based on the 2007 report, while those of SID are based on the first quarter of 2008, annualized when appropriate.)
Income growth
ROE
Ebitda margin
Capex
Net debt/Ebitda
Current ratio
GGB
22%
26%
20%
$1.5 billion
0.6
2.3
SID
2%
37%
45%
$892 million
0.93
1.2
Given Gerdau's high capex relative to its market size, high current ratio, strong income growth and relatively high ROE, I believe it has the potential to become your friendly neighborhood steel supplier.
At the time of publication, Vijayraghavan was long GBB.
Vasu Vijayraghavan was an academic finance professor at the University of Paris who has now turned to a new career as a financial consultant. As an academic, she wrote on corporate governance issues, especially in the European context, and she believes in a long-run and balance sheet approach to stock picking.
Currently, Vasu is working as a consultant for lawyers, doing business valuation. She is a Level II CFA candidate and enjoys writing long/short and earnings calls pieces for TheStreet.Com.
Vasu holds a Ph.D. from the University of Michigan and a B.A. from Harvard University.
