Ryerson Made Hay While The Sun Shone. But Is The Sun Still Shining? (NYSE:RYI)

Investment thesis

From 2014 to 2022, Ryerson Holding Corporation’s (NYSE:RYI) revenue grew at 7.1 % CAGR. But this was due more to changes in the selling price as there was hardly any tonnage growth despite its acquisitions.

The price growth, especially the price spike in the past 2 years, enabled it to generate strong earnings. But RYI is a cyclical company. This is despite its efforts to mitigate the cyclical effect by distributing a variety of metals and serving customers in diverse sectors.

As such it is more appropriate to analyse and value its performance over the cycle. Over the cycle, it has been able to improve its operating efficiencies. There is a sufficient margin of safety based on its performance over the cycle. As such I would consider RYI an investment opportunity.

Company background

RYI is a leading value-added processor and distributor of industrial metals with operations in the United States. The company IPOed in 2014 and as such I will base my analysis from 2014 to 2022.

While RYI also has operations in Canada, Mexico, and China, the US accounted for about 91 % of the revenue in 2022. The company is a key intermediary between metal producers and end users of metal products.

• Metal producers prefer large order quantities, longer lead times, and limited inventory to maximize capacity utilization.
• End users seek to purchase metals with customized specifications, including value-added processing.

RYI acts as a “one-stop” supplier that offers processing services along with lower order volumes, shorter lead times, and more reliable deliveries.

This is a relatively stable business in terms of products and customer profile as can be seen from Chart 1.

• Carbon steel accounted for about half of the metals distributed. Stainless steel and aluminum accounted for about ¼ each.
• RYI has about 40,000 customers across a wide range of manufacturing end-markets. You can see that there was some shifts in the fabricators and transportation end-customer profile from 2014 to 2022.

The metal sector is cyclical and many of RYI’s customers and many of the industries in which its customers compete are cyclical. But the company believes that:

“…our various and diverse offerings, ways-to-markets, and end markets reduce the volatility of our business in the aggregate, thus somewhat reducing earnings volatility.”

RYI’s business strategy includes:

“…providing a superior level of customer service…inventory management solutions while maintaining low operating costs…Our growth strategy is based on increasing our operating results through organic growth activities and strategic acquisitions…”

Its operating strategy is aptly captured by the following statement from its 2014 inaugural Annual Report as a listed company.

“…encompasses a three-part plan to enhance operational efficiency, expand margins, and achieve profitable growth.”

The thrust of my analysis is to see how well the company has delivered on these goals and to value it on this basis.

Performance

I looked at 3 metrics to get an overview of the past 9 years’ performances – revenue, PAT, and gross profitability (gross profits/total assets). Chart 2 summarizes the trends.

You can see that despite the company’s efforts, revenue and earnings have been cyclical and volatile. Over the past 9 years, the company went through 2 cycles.

You can see uptrends in the 3 metrics, notwithstanding the losses in the first 2 years of its listed life. 2020 was also a bad year due to Covid-19.

The more significant one is the uptrend in gross profitability. It points to improvements in operating efficiency. According to Professor Novy-Marx, gross profitability has the same power as PBV in predicting cross-section returns. This augurs well for RYI.

Notes to Chart 2:

a) To plot the 3 metrics on one chart, I converted them into indices. I used the respective 2014 value as the base of 1.00

b) RYI incurred a loss in 2014. Thus, the PAT base is negative 1.00.

1H 2023 performance

For the first 6 months ended Jun3 2023, RYI revenue declined by 21.3 % compared to the same period in 2022. The company attributed this to 18.4 % lower average selling price and 3.5 % lower shipment tonnage.

Its gross margin also decreased to 19.1% compared to 25.1% for the first six months of 2022. The result is that its PAT decreased to USD 85 million compared to USD 360 million for the first six months of 2022.

You may be discouraged by this performance. But I am a long-term value investor and especially for cyclical companies, I consider quarterly results “noisy”. Rather I look at the performance over the cycle.

Financial position

I would rate RYI as financially sound based on the following:

• It has USD 39 million cash as of the end of Dec 2022. This is about 2 % of its total assets. To be fair, RYI spent about USD 81 million over the past 2 years on dividends and share buybacks.
• It has a 0.38 debt capital ratio as of the end of Dec 2022. On a positive note, this had reduced from 1.1 in 2014. The steel sector debt capital ratio was 0.22 as per the Damodaran Jan 2023 dataset.
• It has improved the cash conversion cycle from 101 days in 2014/15 to 59 days by 2021/22.
• Over the past 9 years, there were only 2 years with negative cash flow from operations. During this period, it generated a total of USD 1.27 billion of cash flow from operations compared to its net profit of USD 0.82 billion. This is a good cash conversion ratio.

Looking at the past 6 months results, the company seems to be heading into the downtrend leg of the cycle. According to the company:

“The metals service center industry typically experiences cash flow trends that are counter-cyclical to the revenue and volume growth of the industry. During an industry downturn, companies generally reduce working capital assets and generate cash as inventory and accounts receivable balances decline, and as a result, operating cash flow and liquidity tend to increase during a downturn.”

As such I would not worry too much about the financial standing of RYI.

Cyclical sector

Steel and aluminum are cyclical commodities as illustrated in Chart 3.

You can see that the peak-to-trough prices for the past 2 years (especially for carbon steel) have been larger than those before 2020.

Prices for the past 2 years were outliers when you look at both metal prices over the past 40 years. You should not be surprised that metal prices today are lower than those in 2021/22.

While prices were cyclical, there were underlying long-term price growths. From 1982 to 2022:

• Cold roll steel sheet and strip Producer Price Index grew at 4.1 % CAGR.
• Aluminum sheet, plate, and foil Producer Price Index grew at 1.9 % CAGR.

Valuation of cyclical companies

Damodaran opined that cyclical companies’ performance depends on where they are in the cycle. Extrapolating the performance based on the current earnings and cash flows can lead to misleading valuations.

To overcome the cyclical issue, we have to normalize the performance over the cycle. To reflect the current size of the business, Damodaran suggested that we should take the current revenue and determine the earnings by multiplying it with the normalized margins.

I will develop my financial model of RYI based on this approach.

Drivers of growth

From 2014 to 2022, RYI revenue grew at a 7.1 % CAGR. When I broke down this revenue uptrend into selling price and shipment tonnage as per Chart 4, I found that from 2014 to 2022,

• There was hardly any growth in shipment tonnage.
• Price growth accounted for the bulk of the revenue growth. There was a 0.97 correlation between revenue and average selling price during this period.
• The bulk of the revenue growth occurred from 2020 to 2022. The average selling price in 2022 was 81 % higher than that in 2020 while shipment tonnage was about the same.

From 2014 to 2022, the total assets increased from USD 1.87 billion to USD 2.33 billion. During this period RYI spent USD 367 million on CAPEX and USD 321 million on acquisitions.

The company did not provide a breakdown of the revenue growth due to acquisitions. As such, I could not estimate the portion due to organic growth.

But using the amount spent on CAPEX vs acquisitions, I would say that a bit more than half of the growth could be attributed to organic growth.

The sad part is that despite the growth of total assets by about ¼ comparing 2022 with 2014, there was hardly any increase in shipment tonnage.

But RYI took advantage of the price uptrends to drive revenue and profits. But did it improve its operating efficiencies?

Operating parameters

To get a sense of these, I carried out a DuPont analysis as well as looked at the gross profit and SGA (Selling, General, and Administration) expenses. Refer to Charts 5 and 6.

You can see that ROE was very volatile. There was not clear sign of any ROE growth.

The DuPont analysis showed that changes in leverage explained a large part of the volatility of the ROE. While there was growth in the asset turnover from 2014 to 2018, it was not sufficient to offset the impact of leverage. Net margin was comparatively “stable”.

I also looked at the margins from a % of revenue and on a dollar per ton basis as per Chart 6.

• There were growths in % gross profit margins as well as dollar gross profits per ton. This was evident even if you ignore the past 2 years’ outlier situation.
• There was hardly any improvement in the SGA. If you ignore the past 2 years’ performance, the % SGA margin and dollar SGA per ton increased. These are not signs of better cost controls.

The positive sign is that the % net margin (gross profit margins minus SGA margin) and dollar profit per ton (dollar gross profit per ton minus SGA per ton) showed uptrends from 2014 to 2019. I have ignored the outlier years as these had extraordinarily high growths.

The thrust of my analysis was to answer the following questions:

• Did the company improve its operating results through organic growth activities and strategic acquisitions?
• Did it enhance its operational efficiency, expand margins, and achieve profitable growth?

I am not sure the answer to the first question is a strong “Yes”. Sure revenue and profits grew, but the picture was not so clear for ROE. The company would have benefitted from the past 2 years’ price tailwinds even if there was no acquisition.

To be fair I could not answer whether the CAPEX and acquisition changed its product mix so that it could benefit from the price spike. However looking at the product profile in Chart 1, the product mix may not be a big factor.

As for the second question, the answer is a “Yes”. The improvements in the gross profitability, asset turnover, and gross margins more than offset the higher SGA expenses. There was also a significant improvement in the cash conversion cycle.

From a financial modeling perspective, I assumed that there was no change in the normalized gross profit margin and SGA margin as the base case.

Valuation

I valued RYI based on the single-stage Free Cash Flow to the Firm model. The key parameters in the model were shipment tonnage, average selling price, gross profit (GP) margin, and SGA margin.

I assumed that there is a long-term growth of 4% pegging this to the long-term growth in the steel Producer Price Index.

I considered 3 Scenarios:

Scenario 1. This is assuming there is no outlier price spike. I used the values from 2014 to 2020 to represent the normalized values.

Scenario 2. This was based on the 2021 to 2022 average values. I consider this an outlier Scenario and does not represent the long-term performance.

Scenario 3. This is a weighted average value based on a 95 % probability for Scenario 1 and a 5 % probability for Scenario 2. The probability was based on the past 2 years price spike compared to the price trends over the past 40 years.

I assumed that there were no improvements in the normalized margins for all the 3 Scenarios.

The results and assumptions are summarized in Table 1. You can see that there is almost no margin of safety under Scenario 1 while there is an exceptional margin of safety under Scenario 2.

I think Scenario 3 is the most likely Scenario. The is a 26 % margin of safety here.

Notes to Table 1:

a) 2014 to 2020 average.

b) 2021 to 2022 average.

c) Weighted average with 95% probability of Scenario 1 and 5 % probability of Scenario 2.

Sensitivity analysis

There is a margin of safety under Scenario 3 as shown in Table 1. But the value under Scenario 3 will of course depend on the probability or weight used for Scenario 2.

• A 1% probability for Scenario 2 would reduce the margin of safety under Scenario 3 to 6%.
• A higher than 5 % probability for Scenario 2 would increase the margin of safety under Scenario 3.

So the challenge is determining the probability of the next outlier price.

At the same time, while I have shown a 1% margin of safety for Scenario 1, it is not as bleak. This was because I assumed no improvements in the normalized margins.

Under Scenario 1, we have a net margin = GP margin – SGA margin = 4%.

If the net margin was increased to 5 %, the margin of safety under Scenario 1 would be 48%. You can see the value of RYI is very sensitive to the changes in the net margin.

Are there opportunities for RYI to improve the net margins? Looking at my analysis, I would think so.

The advantage of just relying on Scenario 1 for the margin of safety is that we do not have to depend on another price outlier situation. But to generate the additional 1% net margin, RYI would have to continue to focus on operational improvements.

Valuation model

My valuation is based on the single-stage Free Cash Flow to the Firm model as illustrated in Table 2.

The critical parameters are the Revenue, Gross profits, and SGA. These are derived as per the assumptions in Table 1.

I assumed that the tax rate, Reinvestment, and WACC are the same under all the Scenarios.

FCFF = EBIT(1-t) X (1- Reinvestment rate).

The tax rate was based on the past 2 years’ average tax rate to account for the international operations.

Reinvestment = CAPEX – Depreciation & Amortization + Net Working Capital. I estimated that this is equal to the average 2014 to 2022 Reinvestments.

The WACC was based on a Google search for the term “Ryerson Holding WACC” as shown in Table 3.

The value of Equity = Value of the Firm + Cash equivalents + Investments – Debt – Minority Interests.

The Cash, Debt, and Minority Interests were based on the Dec 2022 values.

Risks and limitations

The crux of my analysis is that RYI is a cyclical company. As such, I considered its normalized margins over the cycle.

The challenge is determining the pattern of the cycle. In this context, I have assumed that the future cycle comprises 2 components:

• A 95 % probability of the 2014 to 2020 pattern.
• A 5 % probability of the 2021 to 2022 outlier pattern.

The challenge is estimating the probabilities. I have assumed that the outlier probability was 5% based on the past 40 years price record.

I have shown that the sufficient margin of safety is not enough if the probability of the 2021 to 2022 pattern was reduced to 1%. I am not sure whether anyone can provide a better basis for estimating the probabilities. An investment in RYI is essentially a bet on another future price spike.

The mitigating factor is that there is a sufficient margin of safety if you just rely only on the 2014 to 2022 pattern. But this is provided RYI can continue to improve its operating efficiencies. This seems more likely and does not depend on a price spike.

But there is nothing to suggest that we cannot bet on both a price spike and improving margins. I would like to think that an investment in RYI is a bet on two horses.

Conclusion

RYI operates in cyclical sectors. The company attempted to dampen the effects of the cycle by offering different metals and serving customers in different sectors. However, my analysis has shown that both the topline and bottom line are still cyclical.

As such I have analyzed and valued RYI as a cyclical company. This meant looking at the normalized performance over the cycle. There were 2 challenges in doing this.

• Over the past 2 years, there was an extraordinary price spike.
• There were signs of improving operating efficiencies.

To address the first concern, I used a probability-weighted average approach to value RYI.

To address the second concern, I assumed that there was no improvement in the margins as the base case. I then use sensitive analyses to determine the margin of safety assuming there is a 1 % improvement in net margin.

The positive news is that there are margins of safety under the probability weighted scenario as well as in assuming 1 % improvement in the net margins.

Based on this I would consider investing in RYI.

The question is when to pull the trigger. You will note that investors headed for the exit in August following the release of RYI’s second quarter results.

I think steel prices are still coming down and the performance of RYI will continue to deteriorate (relative to 2022) in the coming months. As such there is a strong possibility that the market price will continue to decline in the short term. You might want to wait for more bad news first.

But I am not a technical analyst and I will leave it up to you to decide when to enter.

I am a long-term fundamental investor. As such, I try to look at how the business will perform over the next decade or so. My valuation is also from this perspective. This is not an analysis or valuation for those looking for gains over the next few months.