12 September 2019

SSAB, high strength stock

SSAB, the leading Nordic steel manufacturer, has long decided to focus on specific areas (high strength and special steels) with a view to addressing the higher value-added market segments and protecting itself from the intense competition in carbon steel at large. The last few years have confirmed the group was on the right track to achieve industry-leading profitability, but it is still far from immune to macro headwinds.

Job done

Last time we had a closer look at the group about a year ago (“SSAB again macro-driven”, September 2018), we wrote its share price had outperformed that of peers in the past two years or so. This is still the case and the positive gap has remained more or less the same (c.+15%). This was not enough to match the index though (see chart):

The group’s efforts (and success) to restore margins certainly explain this achievement, even if the absolute performance remained poor as for the sector at large. As far as Steel is concerned, SSAB’s overperformance probably validates the idea that some of the group’s segments are more profitable than the industry average. What happened in the past few years is pretty simple: after an initial underperformance margin-wise in 2012-13 due, among others, to the strong krona and a weak Mining/Construction business (over-represented at SSAB), the group has progressively returned to an industry profitability level and even surpassed it as of late, with efforts on the cost side as well as the increase in the mix of special products:

SSAB succeeded in keeping margins at a double-digit level EBITDAR-wise since FY16. This is all the more remarkable since it had to integrate lower-margin Ruukki (Finland) bought in FY14 (for too much by the way). Our sample also includes stainless steel players, the margins of which are higher than at carbon steel players, which makes SSAB’s achievement rather convincing. That said, it does not mean all is rosy for the Swedish group.

Two main issues have been and are still ongoing: first, similar to what happens to all carbon steel makers, iron-prices remain an issue. SSAB needs a good 7mt of iron-ore yearly to produce roughly 5mt of steel. This is a quarter of their SEK30bn input materials costs (together with coal, scrap, alloys…), sourced in Sweden and Russia. It is not rocket science to assert a US$10 per ton increase in iron-ore prices costs the group US$70m (or c.€63m), that is c.8% of EBITDA (FY19e).

Obviously, the situation gets worse considering that prices have gone up much more than that as of late (c.+25% since year-end 18 or c. US$30/ton), and this is despite some cooling down since mid-July (to c.US$90). The current strength of the US$ does not help either. To make things worse in the short term, the terms of supply contracts imply a lead time between prices and P&L impacts (long-term index-based contracts), meaning the Q3 results should be substantially burdened, while the cost of iron-ore was already sequentially up 15% in SEK terms in Q1 and another 18% in Q2.

On the more positive side, scrap and coal prices have gone down but, although partly compensating for higher iron-ore prices, this is not as positive as it seems: this is obviously the signal of a slowing down world economy, which does little to support demand and prices for Swedish steel and just underlines the “madness” surrounding iron-ore's recent pricing.

More work ahead

Despite its success in rebuilding margins, SSAB has (so far at least) failed on one point, which happens to be key in its communication to investors: demonstrate that its niche strategy should differentiate it from the sector at large. The 5-year performance actually shows a very strong correlation between SSAB, peers and the steel price index, and this is despite its higher specialisation

Similarly, the stock price has been slashed in the past weeks and months on the back of weaker prices and no one has apparently been ready to make a difference between SSAB and its peers. This could be interpreted in two ways: a sign that the market was turning bearish and not caring a lot for company-specific features or, and this would be more embarrassing, that it does not believe in the “high-strength story” any longer.

The ambitions of the group to reach a c.40-50% share of high-strength/special products in its mix are still claimed, but a few key segments (Automotive, Construction Machinery, Heavy Transport) that happen to be key customers for these products are not exactly in their best shape ever.

This has undoubtedly raised doubts about the group’s prospects. Also, the group does not communicate much on the real profitability gap between basic commoditised carbon steel and higher value-added segments, making analysts’ and investors’ jobs uneasy. Lastly, the pollution of input costs (again, iron-ore up, scrap and coal down) has recently made it even harder to forecast earnings (not to speak of the weakening demand weighing on prices).

Accordingly, the stock performance has blindly followed the sector’s, which could be seen as an opportunity for those who (still) believe in the group’s higher specialisation. The commitment to maintain a low debt level through the cycle also helps believe an overpaid acquisition of the likes of Ruukki (thank God in paper) will not happen again. Fingers crossed, but this seems a given listening to management. Such a move would kill their credibility anyway and be a form of suicide for top management.

Valuation: it’s all about timing

Our valuation certainly shows a significant 22% upside for the stock price

The DCF or NAV leave ample room for the stock to perform, but it is certainly due to the sharp share price correction as of late, and a reminder that we see no fundamental/long-term reasons why steel markets should not rebound at some stage. The dividend yield is also very supportive, a direct consequence of SSAB’s clean balance sheet which makes a 30-50% pay-out possible without putting the group at risk (in absolute or credit rating terms).

All in all, there seems to be an opportunity, even if improved macro conditions are a prerequisite for a re-rating of the stock. This certainly leaves some time for investors to make up their minds in the current shaky environment, but the stock should be looked at cold-bloodedly, we think.