Jason Stipp: I'm Jason Stipp for Morningstar. Our research team recently uncovered an interesting bond opportunity in the steel sector. I'm joined today by Min Tang-Varner, she's a securities analyst; and Bridget Freas, she's an equity analyst covering the steel sector. They are going to tell me a little bit about what they found that maybe the market is missing.
Thanks for joining me.
Bridget Freas: Thank you.
Min Tang-Varner: Thank you for having us.
Stipp: First question for you, Bridget. You cover the stock, it's called Steel Dynamics. Steel industry, I think, is one that a lot of folks have some preset ideas about. Is this company, you know, it fits the mold of the steel industry or is it sort of a new generation of the steel company?
Freas: It definitely is a new generation steel player. It is one of the smaller of the major U.S.-focused steel companies and when we think of steel, a lot of times we just think construction markets. They are a lot more diversified, big presence in automotive, and appliance and machinery.
But I think the big thing to know about Steel Dynamics is they really are a low-cost player in the industry. They are very efficient steel making plants, very flexible way of operating, which is very important in sort of a volatile market as it is now, and they also source a lot of their raw material internally. So it gives them a lot of control over their input costs, and it enables better margins then you typically see in steel.
Stipp: So, definitely because they've adapted somewhat to what the environment is in their industry. Still though, I think steel is very highly cyclical and sensitive to the economy. We haven't kind of going through a bumpy recovery recently. What is Steel Dynamics' results looked like and what does that sort of tell us about what the operating environment today has been for the company?
Freas: Right, very volatile, highly cyclical, definitely and the whole steel market in general is coming off of just a disastrous 2009. For the company, their sales fell 50% and they reported just a very small loss for the year, but that was actually a lot better than a lot of firms out there did. But we've kind of turned the corner. They've reported positive results in the first two quarters of the year. So, I think we're past the bottom, but it's definitely been a rough time in the past couple of years.
Stipp: So if we're going to be talking about, just coming to these bonds obviously we want to get a sense of its balance sheet. Can you tell us a little bit about what it looks like and what is – compared to recent history, where they were and where they are now?
Freas: Sure. Well, they had a couple of major acquisitions that they've funded through debt back in 2007 and 2008. So they added about $1.5 billion to their debt and given the drop in earnings in 2009, they haven't been able to pay that down. So they are pretty highly leveraged right now, and their current debt to EBITDA on a trailing basis is about five times.Read Full Transcript
Stipp: So it seems like for a company in the steel industry that seems like a lot of leverage. How do they manage it? I mean, do you think this is a problem for the company?
Freas: Yeah. It's definitely high, higher than we'd like to see, but you have to remember that the company is well managed. They haven't had the same degree of earnings volatility and much better margins than a lot of their competitors. So, we would definitely like to see the leverage ratios improve. But we think that they well. We think that this level of debt is sustainable just based on their earnings recovery that we expect in the next few years, but at the same time, we think that they will generate ample cash flow and would be able to pay that down if they wanted to.
Stipp: So when you were examining the company's debt and given the amount of leverage that they have and also the rough patch that they've been through, what's your take looking at it from a credit perspective?
Tang-Varner: Well the unique thing that we're looking at the credit ratings for companies is we incorporate our moat analysis. So Steel Dynamics, consider its very flexible cost structure as well as its low-cost position, we do assign it a narrow moat. Although this operating profile is obviously tempered with the high leverage ratio they usually have, and we also consider their large capital expenditure plans in terms of their capacity expansions as well as their Mesabi iron ore mines.
So, combined with these to size, we do assign a BB rating for the company in general. We like the company. I think it's a very well-run company, and you know, the credit ratio we talked about, we consider it's going to be significantly improved from their trough that they had reached in 2009. So the outlook is very promising.
Stipp: So given how you are sizing up the company versus how the market is sizing up the company, do you think that it's trading where it should be or is there some room for opportunity there?
Tang-Varner: Well to give you some perspectives, we are rated the Alcoa and U.S. Steel, both as BB plus rating, both of them one notch higher rated. The Alcoa has a 2017 bond that are trading at -- are T-spread of 250 and U.S. Steel has 2017 bond, that is trading at 345.
So for Steel Dynamics, there are four 2015 and 2016 bonds, are quoted on the high side of 500 and 600. We consider that one notch differential really does not warrant a 250 bps of difference and we consider that's a very appealing bond.
Stipp: So, if you're going to be looking at this company situation, and obviously, if this was an opportunity that you took advantage of, what might you expect in the short-term or the near-term for their performance? And then we'll talk a moment about what we think longer term?
Freas: Right. Well the company has kind of had a rough summer. We've seen steel prices drop off, shipping volumes declined, some seasonal weakness. So the third quarter is not looking as bright as the first half of the year, but we really think that this is sort of temporary blip.
As we are entering the fourth quarter, steel prices have rebounded. We are expecting stronger order rates. So, the near term isn't too bright, but we think the long-term fundamentals are there. The market is definitely in recovery. Sometimes it's just a little bit of two steps forward, one step back, and the third quarter is going to be one step back.
Stipp: Did you expect that maybe this is going to take a little bit of time to play out? How might you say your expectations for the longer term and where do you think it's going to end up after there is some time for the market to sort of realize the underlying strengths of this company?
Tang-Varner: Well considering the 2016 bonds right now is actually traded at 598 T-spread, which we consider is probably a very weak BB type of bonds are traded. The recovery there we are foreseeing and its operations as its credit metrics move back to the 2.5 time range, we consider this bond should probably be trading at a high BB range.
We do caution that the company, the management team has a very clear intention of using leverage. I mean, on one hand it increases the financial risk the company is undertaking, but on the other hand it certainly improves the return on investment capital.
So at this underlying, we do not think that it's actually one of the major hurdle for us to assign an investment grade rating for them, but at the same time, we think a 2016 bond yielding 5.78% on the yield to maturity basis is a very appealing opportunity.
Stipp: Well, certainly it sounds like an interesting opportunity. Thanks so much for joining me and for the insight and the background on the company and its credit.
Tang-Varner: Thank you.
Freas: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.