Summary

• Steel Dynamics had a respectable performance in a quarter marked by significant steel spot price weakness and growing import competition.

• Fabrication is providing a nice offset and the demand outlook for non-residential construction has management relatively upbeat; closing Mesabi Nugget for a couple of years will also improve margins.

• I believe Steel Dynamics shares could trade closer to $23 even without a significant reversal in steel prices.

As Chinese steel mills continue to throw steel into the export market, producers like Steel Dynamics (NASDAQ:STLD), Nucor (NYSE:NUE), andArcelorMittal (NYSE:MT) are finding it difficult to make much headway with their own operations. I liked Steel Dynamics on a relative and absolute basisback in February, and I'm happy to say that the shares have risen more than 10% since then - beating out other producers' stocks by a pretty healthy margin (Nucor down about 4%, ArcelorMittal down about 7%, and Gerdau(NYSE:GGB) down more than 40%).

I believe Steel Dynamics is faring better due to its better free cash flow generation profile, its stronger EBITDA/ton, its decision to curtail Mesabi Nugget, and its leverage to opportunities in fabrication and higher-value products like rail. I do still believe the shares are undervalued, but there's no shortage of cheap-looking steel stocks and it is hard to see how steel prices will improve when low coal and iron ore prices, not to mention government subsidies, continue to encourage Chinese mills to export more and more steel.

Okay Results In A Tough Environment

Like many other steel companies, Steel Dynamics provides interim updates that largely reduce the surprise factor around actual earnings reports. To that end, while the numbers reported Monday evening essentially matched the average estimates going into the report, they were lower than the expectations at the start of the quarter (by about $0.02/share).

Steel Dynamics saw a single-digit decline in revenue on both an annual and sequential basis, with all of the units showing a modest sequential decline. Steel shipments were up 15% but counterbalanced by a double-digit decline in realized prices. Fabrication saw modest declines in both shipments and price, while recycling saw price declines offset a modest increase in volume.

The increase in steel shipments is interesting to me. The utilization rate jumped to 87% in the quarter, against an industry average that looks to have been in the low 70%'s. That would seem to mark share gains for Steel Dynamics, and it will be interesting to see which companies are the "donors".

Adjusted operating income did fall about 9% from last year's level, but rose 20% sequentially with much-improved results in fabrication and recycling driving the improvement. The metal margin in the steel operations fell by double-digits over both yoy and qoq comparisons, as there's just only so much the company can do in a weak pricing environment.

The company is strongly to the good with respect to free cash flow generation so far this year, and I think over $700 million for the full year is plausible. This company has an enviable record of free cash flow generation through good years and bad, and I wouldn't ignore that detail as a strong mark in the company's favor.

Biting The Iron Bullet

I think many investors were pleased to see the announcement in late May that Steel Dynamics will be idling its Mesabi Nugget direct reduced iron plant for at least two years. This has been a long-term effort on the part of Steel Dynamics (and JV partner Kobe Steel) to produce pig iron from iron fines, but it has never really worked out as hoped. That's disappointing relative to Nucor's progress with its direct reduced iron operations, but I don't think it can be argued that Steel Dynamics hasn't worked hard to make this viable.

Recent production costs at Mesabi Nugget were reportedly running around $340/ton, which just makes no sense to continue when pig iron can be imported for less than $100/ton and when voestalpine (OTCPK:VLPNY) reportedly has ample excess capacity at its new hot briquetted iron facility in Texas. With Mesabi Nugget closed (but not off the table entirely), Steel Dynamics should see less earnings leakage without totally surrendering this potential long-term input cost hedge.

Self-Improvement Under A Macro Cloud

Steel Dynamics sounded relatively bullish on demand trends for the second half of the year, with non-residential construction and OEM auto activity both looking good. Management also noted that it expects scrap prices to continue declining in the second half of the year; a positive for input costs, but not so good for the recycling operations.

Steel Dynamics does still have some self-help opportunities. The Columbus plant that it acquired from Severstal is still running less efficiently than Steel Dynamics other plants, but the company has already made progress here and should be able to drive further improvements (there's nothing fundamentally wrong with the plant, it's more a function of retraining workers and changing operating processes). I'd also note that this plant gives Steel Dynamics more leverage to the auto industry and particularly so in Mexico.

There are also still product-driven opportunities. I've talked before about the company's opportunity to increase its presence in premium rail and I wouldn't ignore the company's strong leverage to non-residential construction in its fabrication business, where it holds about one-third of the market for joists and decks.

All of that is nice, but the overall environment is not. There is excess blast furnace capacity around the world and that's not going to shut down so long as coal and iron prices are so long (and so long as China wants to keep workers on the job and is willing to offer tax breaks and subsidies to metal producers). To that end, I'd note that hot-rolled prices have fallen about 30% over the past year (shredded scrap steel has fallen a similar amount) and is near the lowest point of the last six years. Taking up trade cases with the FTC can help, but what the industry really needs is to see iron, coal, and steel capacity taken offline to support higher prices.

Estimating The Value

Valuing steel companies (or any commodity company, for that matter) is always tricky because of the intense cyclicality and the significant operating and financial leverage at play. On a cash flow basis, I can say with reasonable confidence that Steel Dynamics needs to generate mid-single digit FCF margins to hold long-term appeal; the company has done it before and the company's capital spending should be relatively lower in the next few years.

On an EV/EBITDA basis, a 7x to 7.5x multiple on my 12-month EBTIDA estimate will support a fair value of $21 to $23, but clearly there is a vulnerability here to lower near-term profits. Last and not least, a low double-digit forward ROE assumption supports a fair value around $20, while a forward ROE similar to the past (in the mid-teens) would bump the target to $23.

The Bottom Line

All told, then, I still believe that Steel Dynamics shares should trade above $20. This is a very efficient mini-mill operator, and one that I believe does have some worthwhile self-driven catalysts like the move into rail, the improvement of the Columbus plant, and the expansion of the fabrication business. I'd remind investors, though, that there have been a lot of times in the past few years where that same argument could have been made and the shares didn't respond - I think there is value in the steel space, but investors have to be willing to take the risk that these are value traps and that steel will remain weak for a longer period due to low input costs and high levels of import competition.