This investment thesis first appeared on SumZero on 27 December 2024.
Steel Dynamics, Inc. (STLD: $117/share) proves a simple and compelling thesis: first, its alignment of shareholder and management interests have ensured that the firm has created shareholder value, and, given that these incentives remain in place, the firm can be trusted to act in the best interests of its shareholders; secondly, free cash flows (FCF) generation has been such that the firm should be viewed as a source of safe, growing dividends; lastly, the risk-reward profile of the firm, as expressed by its earnings quality and valuation, make it an attractive investment in terms of my stock rating methodology. The reader is encouraged to look through the accompanying spreadsheet in which I calculate the metrics used in this thesis, as well as deploy my reverse discounted cash flow (DCF) model.
Vertical Integration is a Competitive Advantage
Steel Dynamics was founded in 1993 as a steel company operating one electric arc furnace (EAF) steel mill in Indiana, and has since evolved into what it describes as a “lower-carbon emissions metals solutions company, providing diversified high-quality products and enhanced supply-chain solutions”, operating seven EAF steel mills shipping, 15 flat roll steel coating lines, a copper rod and wire operation, 70+ metals recycling operations, and 9 steel processing operations, with a 16 million tonnes steel shipping capacity. It is the fifth largest steel company in the world, in terms of market capitalisation, and the fifth largest steel producer in North America.
The company has a vertical manufacturing model connecting its metals recycling platform, and steel mills and fabrication operations, which helps it hedge against steel price volatility. Vertical integration allows Steel Dynamics to locally source scrap material; melt the recycled scrap metal into steel in its EAFs, which are more energy efficient and produce less greenhouse gas emissions than traditional blast furnace technology; roll that steel into finished steel products, fabricate them, and reclaim end-of-life steel material as feedstock for new steel products. Consequently, in periods of low steel demand, the company can source its needs internally, whereas in periods of high steel demand, it can purchase what it needs. Not only is its metals recycling platform its largest supplier of recycled ferrous scrap, it is also expected to be its largest source of recycled aluminum scrap in its planned aluminum operations. As the reader will see in the chart on Steel Dynamics’ capital allocation, a consequence of that is that there has been negative net working in three of the last five years, with a net investment in working capital of $1.3 billion between 2019 and the LTM. This vertically integrated model permits Steel Dynamics to have a higher through-cycle steel production than other steel producers, and to enjoy low, highly variable costs, industry-leading profitability.
Peer-Group Leading Profitability
Revenue has compounded by 11.3% a year from 2019 to the last twelve months (LTM) ending in 3Q 2024, from approximately $10.5 billion to $17.9 billion. By way of reference, according to Credit Suisse’s “The Base Rate Book”, the 5-year mean and median sales compound annual growth rates (CAGR) for the 1950 to 2015 period were 6.9% and 5.2% respectively. Steel Dynamics combines exceptional growth with profitability. Net operating profit after tax (NOPAT) has shot up from $720.4 million in 2019 to $1.73 billion in the LTM, compounding at 19.2% a year. In parallel, Steel Dynamics’ NOPAT margin has enlarged from 6.9% to 9.7%, while its invested capital turns declined from 1.53 to 1.38. The result of this is that, as will be further discussed further in the section, “Alignment of Shareholder and Management Interests”, that returns on invested capital (ROIC)1 have grown from 10.6% to 13.3%.
Steel Dynamics’ profitability compares favourably to peers such as Nucor Corp. (NUE) and CMC (CMC).
Alignment of Shareholder and Management Interests
Steel Dynamics’ long-term incentive plan (LTIP) performance awards seem geared toward achieving the firm’s financial, operational and strategic goals. In order to ameliorate the principal-agent problems that are so rife in business, 25% of the long-term incentive plan (LTIP) performance awards are tied to annual after-tax ROIC relative to a “steel selector comparator group”, composed of companies such as Nucor and the Commercial Metals Company. The rest of the awards are equally tied to revenue growth, operating margin, and cash flow from operations as a percentage of revenue.
In its 2024 Proxy Statement, management remarked that it believes after-tax ROIC “provides an indication of the effectiveness of the company’s invested capital” explaining that it calculates after-tax ROIC as: Net Income Attributable to Steel Dynamics, Inc / (Quarterly Average Current Maturities of Long-term Debt + Long-term Debt + Total Equity). There are flaws to this measurement, one of which is that the numerator, total net income, includes non-core, non-recurring items, and another of which is that its measure of invested capital does not account for items such as after-tax accumulated asset write downs, so that management is not being properly judged for its stewardship of invested capital. Nevertheless, in 2023, the firm earned an after-tax ROIC of 32%, the highest of the S&P 500’s materials companies. According to my calculations, Steel Dynamics has grown ROIC from around 10.6% in 2019 to nearly 13.3% in the LTM. This compares favourably with peers Nucor and CMC, whose ROIC rose from 9% to 11% and 6% to 9.3% respectively.
We can assess management's performance in terms of growing shareholder value through an analysis of its economic profit2. Since 2019, Steel Dynamics has compounded economic profits by 14.2% a year, from $234 million to $466.3 million3.
Tying executive compensation has a further benefit to the firm and its shareholders: in an industry whose capital cycle is historically defined by wild ebbs and flows, having leading firms such as Steel Dynamics, Nucor, CMC, and U.S. Steel tying some portion of executive compensation to either ROIC or return on capital employed (ROCE), strengthens the industry’s sense of value and helps to spread more rational industry behaviour. Firms are less prone to aggressively expand capacity in response to rising prices, aware of the dangers of industry-wide overcapacity and that growth can be value-destroying. For those firms whose executive compensation is already tied to ROIC or ROCE, the odds of their benefitting from value-destroying behaviour on the part of rivals, are higher.
Value-Creating Capital Allocation
Steel Dynamics’ capital is allocated to eight major areas: mergers & acquisitions (M&A), sporadic purchases of short-term investments, capital expenditures, dividends, debt repayment, gross buybacks and changes in net working capital.
Of these, I will discuss three elements to show management’s skill at value-creating capital allocation: dividends, gross buybacks and capital expenditures.
Dividends are Supported by FCF
Steel Dynamics has expanded its regular cash dividends from $0.24 per share in Q1 2019 to $0.46 per share in 1Q 2024, compounding annual dividends by 13.9% a year. In 2024, the firm is paying a dividend of $1.84 per share, with a yield of 1.57%. Moreover, although in that period FCF has declined from $233.4 million in 2019 to $509 million in the LTM, for a cumulative $5.7 billion, it has only paid out $1.4 billion in dividends. This gulf between FCF generation and dividend payments is an expression of the quality of the dividends and the scope which the firm has to grow them.
Gross Buybacks Reward Continuing Shareholders
According to my calculations, Steel Dynamics has traded below its economic book value (EBV) throughout the 2019-2023 period, only trading at a price-to-EBV (PEBV) ratio above 1.0 in the LTM, so it is hard to assess management’s ability to resist the temptations of buying its stock at elevated prices, especially given that the LTM PEBV of 1.22 is attractive.
What can be said is that gross buybacks have rewarded continuing shareholders, building their long-term value per share. Buybacks have also reduced Steel Dynamics’ share count from 214.5 million to 153 million. With $1.3 billion in buybacks in the LTM, the firm has a buyback yield of 7.22%, for a total shareholder yield of 8.79%.
Steel Dynamics’ Hidden Growth Capex
Investors typically use depreciation and amortisation as a proxy for a firm’s maintenance capex, however, as Venkat Ramana R. Peddireddy’s work reveals, this often leads to the costs of inflation and technological obsolescence being ignored. Calculating Steel Dynamics’ maintenance capex using Peddireddy’s method shows that in the LTM, depreciation and amortization exceed maintenance capex is $57.5 million greater than decoration & amortisation, suggesting that the firm’s growth capex is larger than investors may conclude.
Investments into Working Capital
As aforementioned, Diamond Hill’s net working capital as I calculate it is equal to its operating current assets (operating cash, which I estimate to be 5% of total revenue, operating investments -investments less Deferred Compensation Plan Investments in the Funds-, accounts receivable, and other current assets), net of its non-interest bearing current liabilities (NIBCL) (accounts payable and accrued expenses and accrued incentive compensation). Net working capital has burgeoned from $100.5 million in 2019 to $125.7 million in the LTM, or 92% of the firm’s total assets. Importantly, revenue is equal to 116% of net working capital, revealing an asset light business model. Net working capital has compounded at 4.6% per year, showing the modest incremental investments needed to grow the business. Operating investments compose 91.4% of total assets and are the largest component of net working capital. This is because, while operating current assets have risen from $135.8 million to $154.7 million in that time, the value of non-interest bearing current liabilities (NIBCL) has declined from $35.3 million to $29 million. In 2019, 2020, and 2022, net working capital has declined, making it a source of cash. This is important given that research by Robert L. Kieschnick, Mark Laplante, and Rabih Moussawi reveal that, “the incremental dollar invested in net operating working capital is worth less than the incremental dollar held in cash for the average firm”.
Steel Dynamics Has Room to Run
With a share price of $117 per share, Steel Dynamics has a price-to-EBV (PEBV) ratio of 1.22, which indicates that the market expects its NOPAT to grow NOPAT by 22% from its present levels, despite a history of compounding NOPAT by 19.2% a year. I used my reverse discounted cash flow (DCF) model to analyse the implied value of the stock based on conservative assumptions about Steel Dynamics’ future growth in cash flows.
In the first scenario, I quantify the expectations baked into the current price, and assume that,
- Steel Dynamics maintains its current NOPAT margin of 9.67%,
- revenue declines 3.4% in 2024, then grows 2.27% in 2025 and 7.51% in 2026, in line with consensus estimates, before growing 4.9% thereafter.
Under this scenario, the company has a market-implied competitive advantage period (MICAP) of less than a year.
If one assumes that:
- Steel Dynamics’ NOPAT margin rises to 13.3, its 3-year average, and,
- revenue grows by 11.3%, its 5-year CAGR
Then the stock is worth $155, an upside of 32% from the current price.
If, however,
- NOPAT margin is 12.65%, its 5-year average, and,
- revenue grows by -0.56%, its 3-year CAGR
Steel Dynamics’ stock is worth $148, an upside of 26.5% from the current price.
Impact of Footnotes Adjustments and Forensic Accounting
Here below are details of adjustments made to Steel Dynamics’s quarterly reports for the LTM period:
Income Statement: I made $203 million in adjustments to calculate NOPAT, with the net effect of reversing the impact of $23.9 million in non-operating income. The adjustments are equal to 1.4% of Steel Dynamics' GAAP net income.
Balance Sheet: I made $3.1 billion in adjustments to calculate invested capital with a net decrease of $2.1 billion. The largest of these adjustments was $1.8 billion in excess cash, equal to 11.6% of Steel Dynamics' reported assets.
Valuation: I made $4.6 billion in adjustments with a net effect of decreasing shareholder value by $3.1 billion. Aside from total debt, the largest adjustment to shareholder value was $943 million in estimated deferred tax liabilities, representing nearly 5.3% of Steel Dynamics’ market cap.
- NOPAT/Average Invested Capital ↩︎
- Economic profit margin*invested capital, where economic profit margin refers to ROIC - weighted average cost of capital (WACC). ↩︎
- DataWrapper does not recognise LTM as a valid date format, so "2024" in the charts really means "LTM". ↩︎