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Morningstar | BlueScope’s Share Price Decline Reflects Falling but Still Buoyant Steel Prices

At its annual general meeting, BlueScope reiterated first-half fiscal 2019 guidance for underlying EBIT approximately 10% higher than the half just gone. Guidance in August looked conservative at the time, given strong steel prices, but subsequently declines means BlueScope left its guidance unchanged. Global economic growth appears to have peaked in the near term. Also, there are some concerns around the potential for a more material decline in economic activity given growing trade barriers, rising interest rates and the maturity of the current cycle. Despite the recent decline in steel prices, they are still high relative to history. So too are steel making spreads, which have benefited from artificial trade barriers in the U.S. and government supply intervention in China.

We maintain our AUD 8.70 per share fair value estimate and our AUD 1.59 per-share earnings forecast for fiscal 2019, a 17% increase on last year. BlueScope shares have fallen by about one third from the July 2018 peak of close to AUD 19. The decline reflects some moderation in steel spreads, to still historically favourable levels, and potential broader market concerns. Despite the decline, BlueScope shares remain overvalued. Shares look cheap based on fiscal 2019 valuation metrics such as the P/E and EV/EBITDA, however, it’s our contention that current earnings are unlikely to be sustained.

Key to our overvaluation call is the expected moderation in margins from current elevated levels. We forecast an operating margin in fiscal 2019 of 10.8% but have this declining to 6.3% in fiscal 2023. This compares historical margins of 4.9% and 2.5% for the five- and 10-years ended fiscal 2018 respectively. Our midcycle earnings forecast is AUD 0.88 per share in fiscal 2023, a 45% decline from forecast fiscal 2019 levels.

We think it’s likely margin support from strong domestic demand in Australia will moderate over time. It’s also likely there will be a supply response globally, and particularly in the U.S., given the improving financial position of the competing firms, the low barriers for would-be new entrants and attractive current steel spreads. BlueScope is likely to expand production in the U.S. by 0.6 to 0.9 million tonnes a year, equivalent to about 1% of total production in the U.S. Some other U.S. producers have agreed to restart mothballed facilities or build new capacity.

The steel makers are overearning in the current favourable environment. BlueScope says its key markets in the U.S., Australia, and New Zealand remain buoyant and that steel making spreads remain well above levels of the last few years, supporting our view. Commodity steel lines, and higher-value building materials, have underpinned the strong improvement in margins for BlueScope. Our operating margin forecast for fiscal 2019 of 10.9% is at decade highs, only surpassed in the pre-GFC boom. Strong spreads in the U.S. are partly thanks to the Trump tariffs, but also Chinese production curtailments, which impacts global prices. Australia is similarly benefiting from high steel spreads but also a positive mix shift due to demand for building products, which is likely near a cyclical high.

The potential expansion of the North Star BlueScope mill in the U.S. does raise the question if BlueScope’s past pro-cyclical investment mistakes are likely to recur. But at an estimated cost of just USD 500 to USD 700 million and with the balance sheet having no net debt, the expansion is manageable. We don’t see a material risk of dilution to returns on invested capital from the proposal. The investment would only represent about 10% of BlueScope’s total adjusted invested capital, and it is arguably the firm’s highest quality asset, due to the relatively low-cost position. Expenditure can be financed from current cash holdings of nearly AUD 1.0 billion, 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. If the company proceeds, the relatively conservative shareholder return policy of 30% to 50% of free cash flow may be retained for a few more years so the balance sheet can remain healthy through the build.