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Outperform on Reliance Steel

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We maintain our Outperform recommendation on Reliance Steel & Aluminum Co. (RS - Free Report) which is a leading metals service center for value-added materials management and metals processing services. During the third quarter of 2011, Reliance Steel completed the acquisition of Continental Alloys & Services, Inc. for $415 million.

The company has plenty of capital to grow its existing operations and fund acquisitions. Reliance Steel continues to evaluate and execute additional growth projects as appropriate, given the economic conditions and outlook at the time.

Reliance Steel reported strong net income of $1.13 per share in the third quarter of 2011 versus $0.65 in the prior-year quarter, exceeding the Zacks Consensus Estimate of $1.11.

Quarterly sales were $2.14 billion, up 29% year over year. In the third quarter of 2011, the company sold 1.08 million tons of metal, up 13% year over year and the average price per ton sold was up 16% compared with the prior-year quarter. In the quarter, carbon steel sales were 53% of net sales; aluminum sales were 15%; stainless steel sales were 15%; alloy sales were 11%; toll processing sales were 2%; and other sales were 4%.

In August 2011, Reliance Steel acquired Continental Alloys & Services Inc. (“Continental”), headquartered in Houston, Texas, and certain affiliate companies. Continental is a leading global materials management company focused on high-end steel and alloy pipe, tube and bar products and precision manufacturing of various tools designed for well completion programs of global energy service companies. It has 12 locations in the United States, Canada, United Kingdom, Singapore, Malaysia, U.A.E. and Mexico.

Continental and its affiliates had combined net sales of $88.4 million for the two months ended September 30, 2011. Due to this acquisition Reliance’s alloy tons sold increased 33% year over year in the third quarter of 2011.

The company’s net debt-to-total capital was 31.0% as of September 30, 2011. Even after borrowing to fund the acquisition of Continental in 2011, the company had a substantial remaining borrowing capacity with only $790 million of outstanding borrowings on its $1.5 billion credit facility as of September 30, 2011. This provides ample funds for the company to continue its growth initiatives through acquisitions as well as internal activities.

Capital expenditure for the nine months ended September 30, 2011 was $112.7 million. For 2011, management expects capital expenditure to be approximately $200 million primarily driven by internal growth activities comprising expansions of existing facilities, purchases of equipment as well as establishing presence in new geographic markets.

The company also plans to exit various leased facilities and move into newly built and/or purchased ones. Reliance Steel continues to evaluate and execute additional growth projects as appropriate, given the economic conditions and outlook during the period.

However, Reliance Steel’s operating results depend primarily on prices and availability of metals. In late 2010 and early 2011, suppliers announced significant price increases for carbon steel products. Most of the price increases have been raw material cost driven rather than demand driven.

With no corresponding improvement in demand, these price increases may not be sustainable and there could be significant decreases in carbon steel product prices from current levels, which could have an adverse impact on the company’s gross profit margins and profitability.

The company’s non-residential construction market is its largest end market and continues to be the weakest. Some customers in the construction industry are in a seasonal business. For a few months they experience lower revenue due to a reduced number of working days for shipments of products, resulting from vacation and holiday closures at some of its customers.

Reliance Steel competes with Metals USA Holdings Corp. (MUSA - Free Report) . Currently, Reliance has a short-term (1 to 3 months) Zacks #1 Rank (Strong Buy) and a long- term Outperform recommendation.

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