Gerdau (GGB, Financial), the $5.1 billion Brazilian steel manufacturer, reported a 16% drop in sales to 8.5 billion Brazilian reals ($2.6 billion) and an incredible 5,705% profit growth to 823.5 million reals in the first quarter (9.7% margin vs. 0.1% in the year-earlier period).
Gerdau, nonetheless, reported net loss when it also reported its adjusted net income figures for the period. According to the company, its adjusted net income is a nonaccounting indicator reconciled with the financial statements and consists of net income (loss) adjusted by extraordinary events that influenced the net income (loss) without cash effect.
The industrial company deducted 930 million reals in reversal of contingent liabilities and 370 million reals in reversal monetary update of the liabilities, along with a some positive adjustment regarding these reversals.
As a result, Gerdau’s adjusted income came at a loss of 34 million reals compared to 14.2 million reals in profits the same period of last year.
Total return
In the past five years, Gerdau ADR shares failed to generate any positive returns but total losses of 16.7% to its shareholders compared to Standard & Poor's 500’s 15.3% total gains (Morningstar).
Valuations
Despite no trailing earnings, Gerdau still traded at good discount compared to its book value with 0.7 times multiple while industry median multiple trades at book value (GuruFocus). The steel manufacturer also had price-sales (P/S) ratio of 0.46 times vs. the industry median of 0.54 times.
The company also had trailing dividend yield of 0.52%.
Average 2017 sales and earnings-per-share expectations indicated forward multiples of 0.44 times and 12.2 times.
Gerdau
According to filings, Gerdau S.A. (Sociedade AnĂ´nima) is a Brazilian corporation that was incorporated on Nov. 20, 1961 under the laws of Brazil. The steel manufacturer is the product of a number of corporate acquisitions, mergers and other transactions dating back to 1901.
Gerdau is mainly dedicated to the production and commercialization of steel products in general, through its mills located in Argentina, Brazil, Canada, Chile, Colombia, the U.S., India, Mexico, Peru, the Dominican Republic, Uruguay and Venezuela.
In addition, Gerdau is the leading manufacturer of long steel in North and South America.
According to information from the Brazilian Steel Institute (Instituto Aço Brasil), Gerdau is Brazil’s producer of long steel. Gerdau holds significant market share in the steel industries of almost all countries where it operates and was classified by the World Steel Association as the world’s 17th-largest steel producer based on its consolidated crude steel production in 2015, the year for which the last information is available.
Also, Gerdau offers a wide array of steel products, which can be manufactured according to the customer’s specifications.
The company’s product mix includes crude steel (slabs, blooms and billets) sold to rolling mills, finished products for the construction industry such as rebars, wire rods, structural, hot rolled coils and heavy plates; finished products for the consumer goods industry such as commercial bars, light shapes and mesh wire and products for farming and agriculture such as poles, smooth wire and barbed wire.
Gerdau also produces special steel products, normally with a certain degree of customization, utilizing advanced technology, for the manufacture of tools and machinery, chains, locks and springs, mainly for the automotive and mechanical industries.
In fiscal 2016, Gerdau generated 47.6% of its sales in North America, 32.5% in Brazil, 15.5% in Latin America and 4.5% in Europe/Asia.
In addition, Gerdau’s segments are as follows: Brazil Operations, North America Operations, South America Operations and Special Steel Operations.
Brazil Operations
The segment includes operations of steel and iron ore in Brazil except Special Steel. In the first quarter, sales in Brazil grew by 3% to 2.78 billion reals – 32% of total unadjusted Gerdau sales –Â and delivered an EBITDA margin of 14% vs. 9% the year prior.
According to the company, overall shipments to both domestic and export customers fell reflecting weaker demand, but sales improved due to higher net sales per tonne sold in Brazil (domestic market). Further, the segment’s profitability (EBITDA) improved secondary to lower selling, general and administrative expenses.
North America Operations
This division includes all operations in North America, including the jointly controlled entity in Mexico, with the exception of Special Steels.
During the recent quarter, sales in North America fell by 16% to 3.6 billion reals – 41% (largest) of all segments – and delivered an EBITDA margin of 4% vs. 8% in the same period last year.
According to Gerdau, shipments to North America actually improved by 2.5%, due to the improvement in the nonresidential construction and manufacturing industries. Further, sales figures dropped drastically because of 19.4% appreciation in the average price of the Brazilian real against the U.S. dollar.
Meanwhile, higher costs of raw materials reduced the division’s profitability by half in the recent quarter.
South America Operations
This segment includes all operations in South America except Brazil and includes the Jointly Controlled entity in the Dominican Republic.
In the first quarter sales in South America fell by 19% to 1 billion reals – 11% of total unadjusted sales – and reported an EBITDA margin of 12% vs. 17% in first-quarter 2016.
According to Gerdau, shipments to Peru (South America) declined by 3.2% secondary to heavy rains. In addition, profitability was affected by exchange rate movements among other reasons.
Special Steel Operations
This division includes special steel operations in Brazil, U.S. and India. Special Steel sales fell the worst among the segments with 37% sales decline to 1.36 billion reals – 15% of total unadjusted sales – and reported an EBITDA margin of 14% vs. 8% the year-prior period.
According to Gerdau, shipments in the special division experienced a marked 30% shipment reduction mainly due to the divestment of Gerdau’s units in Spain.
Sales and profits
On average, Gerdau experienced 1.9% sales decline in the past three years, negligible profits (losses logged since fiscal 2015).
Cash, debt and book value
In March Gerdau had 4.5 billion reals in cash and cash equivalents, and 19.7 billion reals in debt resulting in a debt-equity ratio of 0.8 times vs. 0.86 times the year-prior quarter. As observed, the company was able to reduced its overall debt by 882 million reals and also improved its equity as a result of 812.6 million reals addition to retained earnings.
Of Gerdau’s 53.6 billion reals assets 19.4%Â were identified as goodwill and intangibles. The company also had a book value of 24.9 billion reals compared to 24.3 billion reals.
Cash flow
In the first quarter, Gerdau reported a 96% drop in cash flow from operations as a result of much higher cash outflow in inventories, receivables and purchase of trading securities ending up with 36.4 million reals.
Capital expenditures including additions to other intangibles were 244.8 million reals leaving Gerdau with 208.4 million reals in free cash outflow. Nonetheless, the company provided 2 million reals in dividends. On average, Gerdau provided 99% of its free cash flow in provided dividends and share repurchases.
In addition, the steel manufacturer also allocated 455 million reals in loan repayments, net any proceeds.
Conclusion
Gerdau’s recent quarter operations revealed conflicting indicators whether Brazil’s largest steel producer is heading back to profitability. Sure enough, company-reported EBITDA figures were a little impressive, but profit/loss figures would further strengthen any conviction prior to buying the company’s shares.
The company has several moving parts. Its Brazil operations – second largest of revenue sources – seemed to have turned positive, but a closer look revealed that Gerdau reported an actual decline in shipments instead secondary to weaker demand.
Meanwhile, its largest revenue source –Â North America –Â would have shown some positivity instead if not for the fluctuation in the currency markets, which is inevitable and should be expected instead. Only Special Steel (18% of revenue) exhibited some stability having excluded Gerdau’s divestment in its Spain operations.
Despite a good amount of blue sky elements –Â goodwill and intangibles –Â the company has guarded its balance sheet pretty well despite the downturn in the industry it operates in. In addition, the steelmaker was able to carefully allocate its cash flow for shareholder payouts during recent years.
Four analysts have an average price target of $3.81 per ADR share of Gerdau. This would indicate a 32.3% upside from the share price of $2.88 (at the time of writing).
Meanwhile, applying a 30% discount to Gerdau’s current book value would indicate 17.4 billion reals – 6.6% upside from the market valuation of 16.4 billion reals in the Brazil exchange – and $3 per ADR share – 4.4% upside.
In summary, Gerdau ADR shares are a speculative buy with $3.5 per share target price.
Disclosure: I do not have shares in any the company mentioned.
