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Improving Markets Drive Commercial Metals, Higher Debt Ail

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On Jun 26, we issued an updated research report on Commercial Metals Company (CMC - Free Report) . Improvement in key end markets, rising scrap prices and favorable macroeconomic and market conditions in both the United States and Poland bode well for the company. However, expected losses in the Americas Fabrication segment, recent surge in imports in Poland and higher debt levels remain concerns.
Upbeat Q3 Results
Commercial Metals reported adjusted net income of $49 million or 41 cents per share in the third quarter of fiscal 2018 (ended May 31, 2018) compared with $31.6 million or 27 cents recorded in the prior-year quarter. It was aided by strong demand across all of the company’s segments. Net sales of $1,204 million for the quarter rose 15% year over year but fell short of the Zacks Consensus Estimate of $1,272 million.
In the quarter, ferrous and non-ferrous prices have gone up approximately 19% and 12%, respectively, on a year-over-year basis.
Favorable End Markets to Drive Growth
There have been improvement in farm equipment manufacturing activity, construction machinery and energy related spending. Additionally, non-residential construction activity in the United States is growing at approximately 3% per year and now approaching spending levels witnessed prior to the financial crisis. Strong bid activity has led to significant growth in the company’s backlog.
Leading indicators of macroeconomic and market conditions in both the United States and Poland suggest continued economic growth and should translate into improved long product steel demand. The imposition of tariff under Section 232 for additional import duties for steel mill and aluminum products should level the field for Commercial Metals against imported rebar and merchant bar products. The company can now effectively compete on a global basis.
Acquisition of Certain Assets of Gerdau Positive, Debt Levels a Concern
On Jan 2, the company entered into a definitive purchase agreement to acquire certain U.S. rebar steel mill and fabrication assets from Gerdau S.A., a producer of long and specialty steel products in the Americas, for a cash purchase price of $600 million. The closing of the transaction is anticipated before calendar year-end 2018. On completion of the transaction, the company’s global melt capacity will go up to approximately 7.2 million tons. The company will also have an expanded geographic presence in the largest construction region in the United States. The buyout is expected to be accretive to earnings and cash flow within the first year of transaction closure.
However, the company’s debt to equity ratio has gone up to 78% as of May 31 to fund the acquisition. Higher debt levels and interest expense remain concerns.
All Segments Poised for Growth Except Americas Fabrication
The company’s top-line is benefiting from the increase in global investment in infrastructure, spurred by improvement in the construction and energy sectors, which has led to an environment of increased pricing of raw materials, including scrap prices. This increase in scrap prices has favorably impacted quarter-over-quarter and year-over-year average selling prices in the company’s Americas Recycling, Americas Mills, and International Mill segments.
The Americas Mill segment will continue to benefit from improving construction activity as well as lower imports. Notably, in the third quarter, the Americas Recycling segment reported its highest quarterly profit in seven years on the back of strong demand for ferrous scrap and an increasing price environment for both ferrous and non-ferrous material. The segment is poised well on the back of rising scrap prices.
At the International Mill segment, strong market conditions will continue in Poland which will aid results. In Poland, steel consumption was a record 13.5 million metric tons in 2017, increasing for the fourth year in a row. The construction sector, which accounts for 43% of national steel consumption, showed an increase of 12% in production supported by infrastructure projects co-financed by EU funds. This rising inflow of EU investment and upbeat business confidence has led an expected GDP growth rate of 3.7% for 2018. Conducive markets in Poland and the company’s recent investment in the country poises it well for improved results in the future.
However, increase in scrap prices has adversely impacted the Americas Fabrication segment (that generated 25% of third quarter revenues), as projects that were included in the backlog are carrying lower selling prices and consequently were unable to offset rising rebar substrate and production costs. The segment is anticipated to incur losses in the balance of 2018 due the lower priced backlog.
Other Headwinds
The company’s volumes in the International Mills segment were affected due to higher rebar imports into Poland putting its market share under pressure.  Strong demand fundamentals in Poland have led to a recent surge in imports.
Shares of Commercial Metals rose 2.9% against the industry’s drop of 1.5% in the past six months.
Commercial Metals currently carries a Zacks Rank #3 (Hold).
Some better-ranked stocks in the sector include KMG Chemicals, Inc. , Veritiv Corporation (VRTV - Free Report) and Ingevity Corporation (NGVT - Free Report) . While KMG Chemicals sports a Zacks Rank #1 (Strong Buy), Domtar and Ingevity carry a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
KMG Chemicals has expected long-term growth rate of 28.5%. Its shares have appreciated 12% over the past six months.
Veritiv has an expected long-term growth rate of 6%. Its shares have gained 34% over the past six months.
Ingevity has expected long-term growth rate of 12%. Its shares have appreciated 14% in the past six months.
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