Investment View
BlueScope is Australia’s largest steel producer, holding a leading position in metallic-coated and painted steel building products with facilities in Australia, the US, and East Asia. The business is in a formidable position with limited competition in key markets, limited CAPEX requirements, and a net cash balance sheet. Movements in steel margins can significantly impact earnings and the share price. Earnings in FY22 were almost 3x higher than what we regard as a mid-cycle level of earnings.
Business mix improving. Over the last five years, BSL has expanded its offering within high-end, consumer-facing products which has allowed it to enjoy industry-leading capacity utilisation rates, making it more resilient to market downturns. The business is currently undergoing a 40% capacity expansion of its North Star business in the US, which has enjoyed ~100% utilisation rates for the last 15 years, to meet increasing demand. Production expands from FY24e.
Steel margins are the key driver of cash generation. Steel margins (iron ore/scrap steel + processing costs minus the steel price) are the key driver of BSL’s earnings sentiment and the share price. Steel margins are inherently volatile and difficult to forecast. BSL’s 1H23 earnings guidance is for steel margins of US$375/t, compared with US$775/t in 2H22 and spot steel margins of ~US$530/t. Both steel prices and margins are currently trading around the long-term average.
Expansion of US factory. BSL is currently expanding its North Star production facility by +40% over the coming years for a cost of $US700m. We believe that given the historically strong performance of this facility (~100% utilisation for the last 15 years), it will also be a significant driver of earnings going forward.
Cash is King. BSL has a strong track record of generating significant free cash flow (FY23E A$1.5bn). The balance sheet is net cash at A$370m. BSL is currently undertaking the US expansion and undertaking a A$500m buyback (6% of issued shares, ~65% completed). Over the last 5 years >20% of shares on issue have been bought back.
Valuation. BSL currently trades at ~5x EV/EBITDA, well below the long-term average of 9x, and below US steel peers at 6-7x (which is also low relative to history). On a price-to-book measure, BSL is trading at 0.8x vs the long-term average of 0.95x. These multiples appear to low given our expectations for improved steel prices across both Asia and the US through 2023. Longer-term, increased volumes from the North Star asset, along with the potential for additional capital management has the potential to re-rate the share price. We rate BSL a Buy.
Figure 1: Geographic earnings breakdown FY22
Figure 2: Volume lift from North Star (US) expansion
Key Investment Considerations
1. Significant Leverage to Steel Margins
BSL earnings have significant leverage to steel margins. FY22 was the most profitable year for BSL in its history. Earnings were almost 3x higher than normal, as the industry benefited from supernormal steel margins. Movements in steel margins has a significant influence over the BSL share price.
Asian (proxy for BSL Australian steel business) and US steel prices have fallen ~40% and ~60% respectively, from all-time highs in 4Q 2021. Margins in Asia have proved more resilient, with falls of 30%. US steel margins have collapsed by 80% to ~$US200/t which is around the long-term average. Both steel prices and margins in Asia and the US are now trading at 2019 levels or around the long-term average. The BSL share price, has fallen by one third since its peak in 4Q2021.
We estimate for the Australian steel business, BSL requires a steel price of just over $A200/t to breakeven. The current Asian Hot Rolled Coil (HRC) steel price is ~$A900/t.
Figure 3: US steel margins have returned to the long-term average
Figure 4: Australian steel margins have returned to the long-term average
2. Buybacks to keep EPS growth greater than NPAT growth
BSL has a strong balance sheet with a net cash position of A$370m and FCF in FY23E anticipated to be ~A$1.5bn. This is a material improvement on the pre-GFC BSL, which had a net debt position of A$1.5-2.0bn. This now provides BSL with significant financial flexibility.
Figure 5: BSL net debt position has significantly improved. BSL remains in a strong position to continue to return cash to shareholders.
BSL is currently engaged in a A$500m buyback which implies ~30m shares may be retired in the next 12 months, representing ~6% of shares on issue. BSL is two-thirds of the way through this buyback. We expect this to be an on-going process (since FY17 the group has retired over 115m shares or ~20% of shares on issue) if steel margins continue to hold. Over the medium term, BSL should be able to deliver EPS growth that outpaces earnings growth.
We expect BSL’s North Star division to be a key driver of market earnings upgrades over the medium term. BSL US steel margins are typically higher than what is received in Australia.
North Star has operated at full capacity for 15 years, including through the GFC, producing high quality Hot Rolled Coil (HRC) product that is predominantly used in US autos. The timing of this expansion coupled with expected improvement in US auto volumes (industry volumes have fallen ~20% since FY19) bodes well for improved earnings over the medium term.
3. Valuation Considerations
Investors typically use multiple based valuation measures to assess valuation, given the inherent volatility in steel earnings across the cycle. BSL currently trades at ~5x EV/EBITDA, well below the long-term average of 9x, and in-line with US steel peers (which are also low relative to history). Earnings forecasts for FY23e currently assume steel margins hold at current levels (which are around the long-term average).
US steel peers provide the strongest valuation reference point, which the BSL share price typically tracks closely. Historically, BSL has traded at a small valuation premium to US peers given superior end market exposure (US automotive and Australia).
At 0.8x price to book, BSL is currently trading below its long-term average of 0.95x. The market is concerned that steel margins will continue to weaken, whilst the potential for slowing demand in Asia and Australia potentially exposes BSL to an excess industry position.
Longer-term, increased volumes from the North Star asset, along with the potential for additional capital management has the potential to re-rate the share price.
Figure 6: BSL vs US steel peer valuations. sector prices don’t look stretched, particularly if we avoid a global economic recession.
Figure 7: EV/EBITDA BSL vs US peers highlights a large valuation gap
Figure 8: Attractive free cash flow yield >15%
4. Share price assumes steel margins 20% below long-term average over FY23E
BSL’s earnings can be volatile as steel prices respond to demand and supply drivers. FY23E consensus forecasts reflect recently provided management guidance which is based on US steel margins of ~US375/t across 1H23E. The market is currently assuming this level of margin holds into 2H23E. At current prices, margins are currently ~20% below the long-term average reflecting higher input costs and expectations of slowing steel demand in the US as the economy slows.
We expect the BSL North Star division to be a key driver of upgrades over the medium term as new capacity comes online (this segment has operated at full capacity for 15 years – including during GFC). The timing of this expansion coupled with higher US auto manufacturing bodes well for improved volumes from 2024E.
Bluescope's US Steel Market Peers
BSL’s North Star assets have proven to be highly profitable through the cycle. A $US750m expansion currently underway should lift production volumes by >40%.
The US steel market has seen net capacity reductions over the last decade help underpin margins for North Star. BSL’s key peers in the US include Nucor (NUE.US), Steel Dynamics (STLD.US) and United States Steel (X.US).
Over 2021-22, the US steel industry benefited from the record high steel prices and margins. Cash generation soared, and companies have used the windfall gains to repay debt, increase dividends and share buy-backs.
Share prices over 2022 rallied strongly despite the deterioration in the market environment. Strong cash generation, rational industry supply growth (i.e. limited) and ongoing strength in order volumes and order backlogs was behind the performance.
Valuations were (very) cheap on an earnings and price-to-book measures at the start of 2022.
Against this backdrop, BSL’s underperformance vs US peers stands out. In our view the de-rate of BSL relative to US peers is unsustainable. BSL screens well vs US peers on both valuation metrics, and opportunities for growth.
Figure 9: US steel companies have significantly outperformed BSL over 2022.
- Nucor (largest US steel maker): 3Q EPS topped analyst forecasts, with EPS of $6.50. This was down from $7.28 earned in the prior quarter driven by lower steel prices/margins. Nucor’s December guidance for 4Q22 was below Street at $4.25-35 reflecting the continued fall in US steel prices. NUE's returns profile has improved in recent years thanks to a doubling of market share, and strong cash generation, which has been used to lower leverage and reduce shares on issue by 20% since 2017.
- United States Steel (second largest US steel maker): in December, the company commented that commercial steel demand in the US is better and scrap prices have begun to increase. Flat-rolled customer inquiries are accelerating, and spot steel selling prices are improving. 2022 is expected to be the second-best year from an earnings perspective. The company is also planning to buy back $150m of common stock. Market earnings estimates for 2023 which halved from March to October 2022 as steel prices fell have now stabilised.
- Steel Dynamics (third largest US steel maker): in December the company provided FY22 earnings guidance of $4.10-$4.14 which was ahead of market estimates of $3.84 per share. Steel Dynamics has returned 50% of net income to shareholders over the last 5 years (dividends + share buybacks) with the balance sheet approaching a net cash position. Steel Dynamics sees steel consumption remaining steady, whilst its fabricated steel order backlog remains historically high.
Potential Impact of Australian Carbon Tax
The Australian Government has released (January 2023) a design proposal for the “Safeguard Mechanism”, which is effectively a carbon tax by another name. The proposal calls for high-emitting industrial facilities to cut or offset greenhouse emissions from FY24. The Government has a target of reducing national emissions by 43% in 2030 versus 2005 levels. This is an interim target towards the government's net zero by 2050 ambition.
For high-emitting companies like BSL (11m tonnes p.a. or around 2% of national emissions), reducing or offsetting carbon emissions will come at a cost. Just over two-thirds of BSL steel volumes are produced in Australia, which will be exposed to the proposed policy.
We expect BSL will need to purchase carbon offsets to meet the requirements of the new policy.
It is difficult for a steel mill (specifically a coal-fired blast furnace) to have a step change in carbon efficiency. BSL talks to an anticipated 11% improvement in carbon emissions between 2018-2030, which implies a less than 1% carbon efficiency improvement per year.
At present, BSL generates around 1.8t of C02 per tonne of steel produced. Under the Safeguard Mechanism, the unabated cost at the maximum price cap of $75 per tonne, equates to $A135 per tonne of steel produced. This compares to the spot Asian HRC steel price of ~$A870 per tonne in January 2023, representing a 15% cost impact at current steel prices.
If the proposed reforms are legislated, we expect the overall impact to be a net negative for BSL.
The government has proposed a $A600m compensation package available for trade-exposed industries (like BSL) which could help cushion the impact in the early years.
Whilst difficult to quantify the financial impact of the proposal given several features are still being worked out with the industry, we assess that the reforms as they stand today would have a low-mid single-digit impact on BSL’s valuation. We would expect BSL would be able to pass on more than two-thirds of the cost to consumers in the early years.
Investment View
BSL is a well-run business with a strong management team. Over the last five years the Group has expanded its offering within high-end, consumer facing products which has allowed it to enjoy industry leading capacity utilisation rates, making it more resilient to market downturns.
Surplus cash has been directed to selected acquisitions and capacity expansions, whilst share-buybacks have reduced the share count by >20% since 2017. We expect further share buy-backs over coming years.
We rate BSL a Buy. Whilst steel prices and steel margins are currently around long-term levels, the market is more bearish. Both BSL and US steel peers are trading at 25-30% discount to long-term earnings multiples.
The market is pricing in recession in steel mill profitability. In our view, that is unlikely given the outlook for steel demand in key markets. Additionally, the potential for China COVID reopening to have a positive impact on Asian steel prices over 2023/24 remains in place. In the US, an economic soft-landing and peaking of the US interest rate cycle is likely to be a clear positive for industrial cyclical stocks like BSL.
Longer-term, increased volumes from the North Star asset, along with the potential for additional capital management has the potential to re-rate the share price. We rate BSL a Buy.
Risks to Investment View
Figure 10: BSL PER well below its long-term average
Figure 11: BSL PER relative to market continues to screen cheap
Figure 12: BSL price to book. A discount to book value is overly pessimistic in our view
Figure 13: Dividend yield. Only part of the story, with ongoing share buyback adding to returns
