Steel Dynamics Has Strong Pipeline of Growth Projects and Superior Margins

Steel Dynamics (NASDAQ:STLDSTLD), a Fort Wayne, Indiana-based steel producer and metals recycler, after investing significantly in value-added capacity over the past few years, is now entering a capex harvesting period. The mini-mill producer of steel products plans to begin shipping head-hardened rail before the end of 2014, a new, higher-margin product for the company. Following the rail addition, the company expects to start up its 325,000-ton SBQ expansion in the fall. Both of these new product additions are expected to improve STLD’s margins.

Steel Dynamics is also well positioned to benefit from the continued recovery of non-residential construction demand. With higher order rates and growth in STLD’s fabrication division, the company is seeing increased momentum in non-residential demand. The company currently has 1.1 million tons of dormant steel capacity that has not been utilized due to market conditions. Moreover, STLD also has 150,000 tons of latent fabrication capacity that is directly tied to construction. While the non-residential recovery has been relatively slow, incremental improvements in demand will likely support the company’s capacity utilization, which would positively benefit volumes and margins due to improved fixed cost leverage.

The company reported adjusted fourth-quarter 2013 earnings per share of 24 cents, in line with the consensus estimates of 25 cents. The results came in at the higher end of company’s guidance range of earnings of 21 cents to 25 cents per share. Strong steel operating results were offset by weaker-than-anticipated scrap results. The company provided limited forward guidance but remains optimistic on the non-residential market. STLD will assess next steps for the loss-making Minnesota operations after trials are completed in first-quarter 2014.

Strong cash flow generation potential

The Fort Wayne-based steelmaker continues to generate impressive free cash. In addition, the company has a potential to generate $350 million to $400 million in free cash flow in each of the next three years, or nearly 20 percent of STLD’s total current enterprise value. With the company’s organic capacity utilization rates already near 90 percent, it is increasingly likely the company will 1) raise dividend and/or repurchase stock or 2) reinvest a portion of the excess cash into future growth and/or expansion projects.

As mentioned earlier, STLD also has significant capacity utilization opportunities. Based on 2013 production, the company has about 1.1 million tons of un-utilized production capacity throughout its operations and excess fabrication capacity of 150,000 tons, all largely tied to construction markets. The company remains optimistic on gradual non-residential construction growth in 2014, citing a growing beam order book and strong seasonal joist demand.

Mesabi remains an overhang

STLD’s Minnesota operations remain a drag on earnings. Despite confirming production capabilities of 30,000 tons per month, achieving iron concentrate production costs under $50 per ton and 87 percent plant availability, fourth-quarter Mesabi Nugget shipments of 59,000 tons registered a sequential increase of only 7,000 tons. Due to poor production yields and higher costs, the Mesabi operation reported a net loss of $8.1 million, or 3 cents per share.

The company is conducting a number of test trials aimed to reduce fines output and replace coal with lower-cost carbon reductants. We expect some resolution by the end of first-quarter 2014. STLD is implementing solutions to improve yield and costs in first-quarter 2014 and if notable progress is not achieved, STLD will assess the commercial viability of the facility. In the meantime, losses are guided to remain similar quarter over quarter in first-quarter 2014.

Conclusion

We have a buy rating on STLD. The company is well positioned to benefit from being a vertically integrated steel producer in the U.S. The company will eventually benefit from the combination of improvements in end markets, some resolution of the ongoing Mesabi Nugget challenges, and its ongoing SBQ and rail expansions. Driven by expected recovery in non-residential construction, Steel Dynamics is expected to register strong growth in 2014. STLD has a 45 percent end market construction exposure and should benefit from the expected positive growth in domestic steel production for construction end markets in 2014 and 2015.

Moreover, the company’s long product’s low capacity utilization signals there could be significant upside if meaningful end market demand materializes. Finally, for income investors, the company also has an attractive dividend yield of 2.6 percent.

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