Steel Your Portfolio With CMC

CMC (CMC: $52/share), formerly known as the Commercial Metals Company, has a history of profitable growth, thanks to its competitive advantages, the alignment of shareholder and management interests and a focus on value creation. The stock earns an attractive rating based on my stock rating methodology and is my stock of the week. Do read this article along with the accompanying spreadsheet.

A History of Profitable Growth

Since fiscal 2019 (FYE 8/31), CMC has compounded revenue by 6.9% per year, and compounded net operating profit after tax (NOPAT) by 23.3% a year. In that propitious time, NOPAT margins have more than doubled, from 3.85% to 7.86% in the last twelve months (LTM) ending Q3 2024, as its invested capital turns have declined from 1.58 to 1.27. The net impact of this has been to improve returns on invested capital (ROIC) from 6.99% to 9.99% in the aforementioned period.

Vertical Integration is a Competitive Advantage

In 1915, when the Russian immigrant, Jacob Feldman, founded the company in Dallas, Texas, as the American Iron & Metal Company, CMC was a recycling company, in fact, just as a single scrap yard, yet, when in their 2023 letter to stockholders then executive chairman, Barbara R. Smith, (now succeeded by Robert S. Wetherbee), and president and chief executive officer, Peter R. Matt explained the firm’s rebranding from the Commercial Metals Company to CMC, they remarked that this reflected CMC’s evolution into “a leading construction solutions provider with a growing commercial portfolio spanning multiple platforms.” Today, CMC is a vertically integrated network of recycling facilities, steel mills and fabrication operations providing ferrous and nonferrous scrap metals (“raw materials”), finished long steel products such as rebar, merchant bar, and semi-finished billets for rerolling and forging applications ("steel products"), fabrication and post-tension cable offerings (“downstream products”), and construction-related solutions, such as Tensar geogrids and Geopier foundation systems from its operating segments in North America, its most important segment, and Europe, which consists largely of a vertically integrated network of recycling facilities, an electric arc furnace (EAF) mini mill and fabrication operation in Poland. 

Vertical integration allows CMC 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 long steel products, fabricate them into custom shapes and lengths, and reclaim end-of-life steel material as feedstock for new steel products. This five-stage process is sustainable: 98% of its raw materials are made from recycled material and 89% of its co-products and waste streams are recycled or converted into other products. 

In his seminal paper, The Nature of the Firm, Ronald Coase observed that, 

When we are considering how large a firm will be the principle of marginalism works smoothly. The question always is, will it pay to bring an extra exchange transaction under the organising authority? At the margin, the costs of organising within the firm will be equal either to the costs of organising in another firm or to the costs involved in leaving the transaction to be “organised” by the price mechanism.

Vertical integration is not only a question of whether it is both more manageable and cheaper to organise economic activities within a firm as opposed to without, but, as Clayton Christensen found in the The Innovator’s Solution, it touches upon the question of innovation:

…when there is a performance gap — when product functionality and reliability are not yet good enough to address the needs of customers in a given tier of the market — companies must compete by making the best possible products. In the race to do this, firms that build their products around proprietary, interdependent architectures enjoy an important competitive advantage against competitors whose product architectures are modular, because the standardisation inherent in modularity takes too many degrees of design freedom away from engineers, and they cannot not optimise performance.

To close the performance gap with each new product generation, competitive forces compel engineers to fit the pieces of their systems together in ever-more-efficient ways in order to wring the most performance possible out of the technology that is available. When firms must compete by making the best possible products, they cannot simply assemble standardised components, because from an engineering point of view, standardisation of interfaces (meaning fewer degrees of design freedom) would force them to hack away from the frontier of what is technologically possible. When the product is not good enough, backing off from the best that can be done means that you’ll fall behind.

Companies that compete with proprietary, interdependent architectures must be integrated: They must control the design and manufacture of every critical component of the system in order to make any piece of the system. As an illustration, during the early days of the mainframe computer industry, when functionality and reliability were not yet good enough to satisfy the needs of mainstream customers, you could not have existed as an independent contract manufacturer of mainframe computers because the way the machines were designed depended on the art that would be used in manufacturing, and vice versa. There was no clean interface between design and manufacturing. Similarly, you could not have existed as an independent supplier of operating systems, core memory, or logic circuitry to the mainframe industry because these key subsystems had to be interdependently and iteratively designed, too.

Today’s CMC has grown larger and more vertically integrated because the transaction costs of modularization have increased and because the firm has found that vertical integration is key to their ability to innovate: by way of example, Smith and Matt pointed out that “CMC was the first company in the world to successfully construct and operate a micro mill and the first company to introduce spooled rebar to the North American market.” The company’s strategic acquisitions also reflect this growing vertical integration: in 2023, the firm acquired Tensar, a designer and developer of proprietary solutions for soil stabilisation; EDSCO Fasteners, a provider of anchoring solutions for the electrical transmission market, and Tendon Systems, a supplier of post-tension cabling systems used in concrete construction. So, for instance, with vertical integration, CMC can ensure a steady-supply of low-cost raw materials from its recycling operations to its nearby steel mills and its fabrication facilities give it a large and consistent source of demand, while giving it forward insight into end customer demand. These operations are located in the highest demand locations in North America and Europe, maximising their value for CMC. 

It can be argued that the costs of modularization are high not just for CMC, but for customers: it is cheaper to deal with one firm across the many stages of construction, a company whose scale allows it to offers its products at competitive prices, than to bear the transaction costs of looking for different partners, negotiating multiple contracts, and monitoring many arrangements.

Executive Compensation Aligns Shareholder and Management Interests

The stock market allocates capital to where it may be most productively used, which is to say, where it can earn the highest ROIC. There is abundant evidence that a management that focuses on ROIC delivers value for shareholders:

Under CMC’s executive compensation plan, detailed in the 2023 Proxy Statement, 50% of the annual cash bonus incentive is tied to a target ROIC, and 75% of the performance share units (PSUs) are tied to the attainment of a positive ROIC over a three-year period. CMC's inclusion of ROIC in its executive compensation is key to its creation of shareholder value, as evidenced by rising ROIC and economic profits. Not only has ROIC risen from 6.99% to 9.99% in our analysis period, but the firm has grown economic profits from -$17.1 million to $67.04 million in that time.

CMC's Price Leaves Room for Further Upside

At the current price, CMC has a price-to-economic-book-value (PEBV) of 1.06, which means that the stock market expects that CMC will never grow its NOPAT by  more than 6% above its current level, even though it has compounded NOPAT by 23.3% a year in the last five years. I used my reverse discounted cash flow (DCF) model to analyse the implied value of the stock based on conservative assumptions about CMC’s future growth in cash flows.

In the first scenario, I quantified the expectations baked into the current price. I assume,

  • CMC maintains its current NOPAT margin of 7.86%, and
  • revenue grows 2.24% in 2024 and 6.07% thereafter, equal to consensus estimates

In this scenario, NOPAT compounds by just 3% compounded through 2026, and the stock is worth ~$51/share today, roughly equal to the current price, for an implied competitive advantage period (CAP) of two years. 

If one assumes that:

  • CMC's NOPAT margin rises to 9.26%, its 3-year average and
  • revenue grows revenue by 6.9%, its 5-year revenue CAGR, between 2025 and 2026

CMC compounds its NOPAT by about 3% for the next two years, and the stock is worth $67.35 today, a 28% upside to the current price. 

If, however, one assumes that

  • CMC's NOPAT margin is 9.26%, and
  • revenue grows revenue by 3.88%, its 3-year revenue CAGR

CMC compounds its NOPAT by about 2% for the next two years, and the stock is worth $61.59 today, a 17% upside to the current price. 

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to CMC's quarterly reports for the LTM period:

Income Statement: I made $73.8 million in adjustments to calculate NOPAT, adjustments that are equal to 13% of CMC's GAAP net income.

Balance Sheet: I made $1.7 billion in adjustments to calculate invested capital with a net decrease of $268 million. CMC's $566 million in cumulative asset write-downs, were among the largest adjustments, equal to 8.4% of CMC's reported assets.

Valuation: I made $2 billion in adjustments with a net effect of decreasing shareholder value by $1.4 billion. Aside from total debt, the largest adjustment to shareholder value was $286 million in deferred tax liabilities, representing nearly 5% of CMC’s market cap.

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