EUR 850.00 For Business Accounts Only

Morningstar | BlueScope Is Still Enjoying a Favourable Price Tailwind for Now

BlueScope’s underlying fiscal 2018 EBIT of AUD 1.24 billion was in line with our forecast and 14% ahead of fiscal 2017. The result was primarily driven by improvement in the Australian steel products business, where underlying EBIT increased 28% to AUD 587 million. EBIT at the New Zealand operations, though small, also rose 83% to AUD 112 million. Underlying EBIT at the remaining divisions--building products, buildings, and North Star BlueScope--in aggregate was close to flat on a year ago. Australian steel products benefited primarily from higher steel prices and, to a lesser extent, a more favourable mix of products. The demand environment remained favourable, underpinned by the continued boom in housing construction and infrastructure. New Zealand similarly benefited from higher prices but also from cost improvement.

However, we still view BlueScope’s shares as meaningfully overvalued. We retain our AUD 8.70 per share fair value estimate, with the benefit of the time value of money and slightly higher near-term earnings offset by the plan to repurchase an additional AUD 250 million of expensive shares. First-half fiscal 2019 guidance is for EBIT to increase by 10% from second-half 2018. As a result, we’ve increased our underlying earnings forecast to AUD 1.60 per share from AUD 1.53.

Still, our midcycle earnings forecast is unchanged at AUD 0.75 per share in fiscal 2023, based on an expected normalisation of margins. Profits are at highs not seen for a decade. Current margins are elevated and unlikely to persist. BlueScope recorded 10.7% underlying EBIT margin in fiscal 2018 compared with five- and 10-year averages of 5.7% and 2.8%, respectively. We think it’s likely that margin support from strong domestic demand will moderate over time. It’s also likely there will be a supply response from the steel industry more broadly, given the improving financial position of the competing firms, the low barriers to entry, and attractive current steel spreads.

Free cash flow was strong at AUD 731 million, though down slightly on last year’s AUD 749 million, mainly due to increased working capital from higher volumes and prices. This free cash flow has funded a continued strengthening of the balance sheet. BlueScope is now on a very firm financial footing with net cash of AUD 64 million versus AUD 262 million of net debt at end June 2017. Management maintains guidance to pay 30%-50% of free cash flow to shareholders in the form of dividends and on-market buybacks; however, in the longer term, we expect this ratio will probably rise, given the strengthening balance sheet. The company is targeting to hold AUD 200 million-AUD 400 million of net cash, which we think is commendable and appropriate, given the cyclical and capital-intensive nature of the business.

The final AUD 0.08 per share unfranked dividend was modest but close to our expected AUD 0.10 per share forecast. BlueScope is favouring shareholder returns through ongoing on-market share buybacks due to a lack of franking credits. The company set aside a further AUD 250 million for share repurchases. We commend the firm’s desire not to engage in merger and acquisition activity at this point in the cycle, with the CEO frankly describing the prevailing target asset prices as akin to purchasing straw hats in summer. However, we think the same logic should be applied to share repurchases, given that BlueScope’s profit is at decade highs and reflected in an elevated share price.

BlueScope has flagged the potential to expand its NorthStar BlueScope electric arc furnace in the U.S. by 600,000-900,000 tonnes of steel a year. This would be a 29%-43% increase on fiscal 2018 sales of 2.1 million tonnes of steel. Based on our expectation for lower steel spreads in future, we estimate the project to be value-neutral. The project is at an early stage and we do not yet include it in our base-case financial forecasts. If steel spreads stay elevated for longer than we expect, BlueScope may proceed with the expansion at an estimated cost of USD 500 million-USD 700 million. We think the expansion can be financed from current cash holdings of AUD 944 million, plus forecast free cash flow, without the need to increase debt. BlueScope will update the market on the project in the second half of fiscal 2019, and if the company decides to proceed, it may just see the shareholder return policy of 30%-50% of free cash flow retained for a few more years.

Our interpretation of underlying EBIT differs slightly from BlueScope’s, as we have excluded only net asset impairments and asset sales from the result. Gains and losses from discontinued businesses, business development, restructure, and redundancy costs occur fairly regularly for BlueScope, and we consider these normal operating expenses, given the nature of the steel industry.