We recently researched BlueScope Steel (ASX:BSL) in The Dynamic Investor following the AGM on 22 November. What are the risks with investing in BSL, and can the share price head higher from here?
About BlueScope Steel
BlueScope Steel is a flat steel producer for the domestic Australian, NZ and US markets. It is a leading international supplier of steel products and solutions. They are principally focused on the global building and construction industry. The Company is structured into five divisions, with the main contributors to revenue and earnings being the Australian Steel Products (ASP) and Building Products Asia and North America divisions, as well as the North Star operation in Ohio (US).
The North Star mill in Ohio (US) is a single-site electric arc furnace producer of low-cost HRC. The mill operates at industry leading utilisation rates and is strategically located near its customers and in one of the largest scrap markets of North America.
The Australian Steel Products (ASP) division produces and markets a range of high value coated and painted flat steel products for Australian building and construction customers, as well as commodity flat steel products. Products are sold mainly to the Australian domestic markets, with some volume exported. Key brands include zinc/aluminium alloy-coated Zincalume steel and galvanised and zinc/aluminium alloy-coated pre-painted Colorbond steel.
Key Fundamental Drivers
Lag in HRC Spreads to Impact Group Earnings
While the Company maintained group guidance for EBIT of A$800-900m in the first six months of financial year 2023 (1H23), earnings for 2H23 are expected to be the weakest since the June 2020 half year. This is due to the lag effect from lower Hot Rolled Coil (HRC) prices. North Star’s current lagged HRC spread (US$410/t) is well below a high of ~US$1500/t a year ago, but above long-term levels.
Uncertain Earnings Outlook for ASP Division Facing Earnings Pressure from Other Factors
Aside from East Asian HRC spreads, we note the presence of several earnings headwinds for the ASP division. Monetary conditions in Australia (i.e. rising RBA cash rates and changes in the A$) are a 12-month lead for domestic steel consumption. This is significant especially in light of market forecast for housing prices to decline by 15-20% over the next 12 months. Housing is important for BSL’s Australian operations as it accounts for ~one-third of its domestic steel demand – which is broadly evenly split between new builds (predominately detached housing) and Alterations & Additions.
Residential housing approvals in September were 13% lower (on the prior corresponding period) and 5.8% lower than August. Alterations & Additions spend in value terms was down 9.2% in September on the prior corresponding period and 2.9% lower than August.
These factors point to a more challenging earnings outlook for ASP beyond 1H23. In particular:
• Domestic dispatches for FY23 are likely to be ~7-8% lower than FY22, with the decline in FY24 likely to be more moderate (~1-2%). Domestic dispatches are expected to be flat, as a resumption of migration supports detached housing volumes.
• The average realised selling price for all ASP products (domestic and export) are expected to contract by ~10-15% in each year for FY23 and FY24.
• Unit cash operating costs across FY23 and FY24 are expected to reduce, due to lower iron ore, scrap and metallurgical coal prices.
Strong Balance Sheet and Capital Management Potential
BSL has sufficient balance sheet capacity and adequate liquidity to pursue further Merger & Acquisition (M&A) opportunities. In particular, the net cash position of $367m as at 30 June 2022 is well below the net debt target of $400m. The Company intends to pursue M&A opportunities over the short-to-medium term, in light of the decline in steel prices leading to more attractive valuations for potential targets.
In addition to the potential for further M&A activity, capital management is set to continue. After buying back $638m in shares in FY22, the Company has extended the share buyback program by a further $500m over the next 12 months. Further, with Australian tax losses utilised in early 2H22, BSL anticipates future franking of dividends. To this end, it is expected that the 1H23 interim dividend will be ~40% franked.
Fundamental View
While current valuation metrics still appear attractive (on an EV/EBITDA basis, BSL trades at a discount to its peer group of ~4-5%), we consider that there are several risk to earnings in FY23/24 that investors need to be aware of. They are namely: i) Declining global steel production and demand, ii) A further reduction in US and East Asian spreads, iii) The risk of a faster-than-expected slowing in end markets (and destocking event given elevated inventories in certain commodity products) and iv) More challenging conditions for end markets in Australia (i.e. residential housing approvals; Alterations & Additions) on the back of tightening monetary policy.
Charting View
During the past several months, there had been strong resistance near $17.50 (horizontal blue line). BSL finally broke higher at the start of December, triggering a buy signal. It is currently easing back in a flag formation to “re-test” this breakout. With a tight stop under $17.50, current levels remain a buying opportunity. The next line of resistance from here is near $19.
Michael Gable is managing director of Fairmont Equities.
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