Companhia Siderúrgica Nacional: Competition, Low Margins And High Leverage (NYSE:SID)

Investment Thesis

I recommend selling the shares of Companhia Siderúrgica Nacional (NYSE:SID). The Brazilian steel industry is suffering from the large supply of Chinese steel in the domestic market. Additionally, there is no Government action to protect the national industry, this is due to the importance of China as Brazil’s trading partner.

Domestic market demand remains weak, making it difficult to pass on the price. Result? Low margins, and by the way the company has the lowest margin among its Brazilian competitors. This is due to the priority of capital allocation in the growth of operations.

Additionally, given the capital-intensive nature of the sector, SID trades at the highest P/B among its competitors, meaning it has a stretched valuation.

Introduction

Based in São Paulo, SID is one of the largest steel companies in Brazil, in addition to occupying an important position in the world market. The company it also has operations in the mining, logistics and energy segments, which support its verticalized production chain.

The company is present in 17 states in Brazil and also operates in two countries, Germany and Portugal. Now, let’s get to know its history and business model in more depth.

History And Business Model

SID was founded by former president Getúlio Vargas in 1941, the company was the first integrated producer of flat steel in Brazil. And after its privatization in 1993, the company has been adopting an aggressive investment strategy with the aim of diversifying its business. SID is a holding company that has several businesses, let’s talk a little more about them:

Steel

In the steel segment, with vertically integrated and cost-competitive operations, SID produces flat-rolled steel, including slabs, hot-rolled and cold-rolled, and a wide range of value-added steel products, such as galvanized sheet and tinplate. Its products are used in the automotive, capital goods, packaging, construction and home appliance industries.

The company has an annual capacity of 5.6 million tons of crude steel, whose production is concentrated at the Volta Redonda plant (RJ), also having cold rolling and galvanizing operation.

Mining

In the mining segment, the Company is also an important producer of iron ore in Brazil, through its main subsidiary, SID Mineração. SID Mineração operates two own mines, Casa de Pedra and Engenho, both in the state of Minas Gerais.

Part of the ore production, which has a high iron content, is sold to supply the company’s steelmaking activities. The company has an annual production capacity of 30 million tons of iron ore per year. As a reference, Vale, the Brazilian mining giant, has a capacity of around 315 million tons of iron ore per year. According to Fitch, the company is the 2nd largest iron ore exporter in Brazil.

The majority of its production is exported to various countries, mainly in Asia. Currently, SID holds 79.75% of CSN Mineração’s shares, with 11.5% held by a consortium of Asian companies and 8.7% in free float.

Cement, Energy and Logistics

The company has 3 other businesses that have less representation in revenue. In logistics, it operated the TECAR port terminal, in the Port of Itaguaí (RJ) and holds an 18.63% stake in MRS Logística.

SID has also been operating in the cement segment since 2009, and with the acquisition of LafargeHolcim’s assets in Brazil, completed in September 2022, SID Cement became the second-largest company in the sector in the country, with seven integrated plants and installed capacity of around 17 million tons per year (compared to 6 million previously).

Finally, in the energy segment, the company has an installed capacity of 2,025 MW, through participation in 27 hydro assets, which make up the majority of this capacity (1,743 MW), three wind assets and three cogeneration thermal assets, in addition to three wind projects and a solar project.

Below, we have the revenue breakdown by segment:

We can see that, although the company is still heavily exposed to steel and iron ore sales, it has been seeking to diversify its business in recent years.

This diversification strategy has been aggressive, consuming a lot of capex and increasing the company’s leverage, as we will see throughout the report, and this is due to the competitive scenario.

We will first talk about the domestic competitive scenario, and then talk about the impact of Chinese imports on the company’s business.

Competitive Landscape

The Brazilian steel market is dominated by 3 companies: Companhia Siderúrgica Nacional (SID), Usiminas (OTCPK:USNZY), and Gerdau (GGB). According to Fitch, SID’s corporate profile is similar to that of Usiminas, as it is more integrated and diversified in assets. Let’s look at the crude steel production capacity of competitors.

Both are highly exposed to the domestic steel industry. And both have weaker competitive advantages than the steelmaker Gerdau, which has a diversified presence of operations with a large part of its operating cash flow generated from its operations abroad, mainly in the USA, which allows it to better resist economic cycles.

Also according to Fitch, among the three steel producers, Gerdau has consistently maintained the strongest balance sheet, the most diluted debt amortization schedule and has made efforts to improve its capital structure through divestment.

SID’s gross debt levels remain high in relation to Gerdau and Usiminas. SID also has a more challenging debt repayment schedule than Usiminas or Gerdau. All these aspects observed corroborate my sell thesis for the shares. Now let’s analyze the financial indicators of SID and its competitors.

SID Fundamentals

In the following, I will use Koyfin to compare SID with its peers in Brazil, like Usiminas and Gerdau.

Click to enlarge

Source: Koyfin

Well, in the financial analysis it is clear that despite SID having the best EBITDA margin, the company has the lowest growth in the last 3 years, has the lowest net margin, the lowest ROE, and is the most leveraged, which corroborates my sell thesis for the shares.

In my view, an aggressive growth strategy with high leverage can be dangerous, mainly due to the cyclical nature of the steel industry, but mainly due to the oversupply of Chinese steel in Brazil, which we will talk about below.

Oversupply of Chinese Steel in Brazil

Brazilian steelmakers have a big problem to solve, the oversupply of Chinese steel in the Brazilian domestic scenario. Why does this occur?

The first point is that the Chinese economy is slowing down. According to data from Statista, the Asian country’s growth has been below 7% since 2015 (except for 2021, when the basis for comparison was low, as 2020 was the year the Covid-19 pandemic began). In previous years, the country grew above 10%. Therefore, there is a surplus of steel in China and the country needs to export this surplus, selling it cheaper.

For China to sell steel at a much lower price to other countries, the local government provides subsidies to Chinese producers. The Chinese Government is the controller of most of the country’s steel mills and ordered the sale of steel under these conditions, in a countercyclical effort to keep the economy strong.

The fact is that China is the largest producer and consumer of steel in the world, and government stimulus has not yet been enough to revive demand. However, China has not reduced its steel production, and what is the result?

There is an oversupply of steel around the world, coupled with taxation imposed by other countries and economic blocs, such as the United States, the European Union and Mexico, which has meant that imports from China are being directed to Latin America, especially the Brazil, as we can see in the graph below.

We can see that from 2021 onwards, imports begin a significant upward trajectory, and what has been the behavior of shares at the end of 2021 until today?

Only Gerdau, which has a more diversified business model and with a lot of revenue from the USA managed to have its prices stabilized in the period, while SID and Usiminas, more exposed to the domestic scenario that was impacted by the oversupply of Chinese steel, had a strong drop in prices.

However, when we talk about investments we need to look at the future, not the past. In this sense, Brazilian steel companies are putting pressure on the Government to increase taxes on Chinese steel and make Brazilian industry more competitive. But why do I think that this pressure will not produce results and the scenario will remain difficult for SID and Usiminas?

According to S&P, bilateral trade between the countries grew 10% year-on-year in 2022 and reached a record US$ 150 billion. And the new agreements signed indicate that Lula’s government must give priority to deepening ties with China.

China considers Brazil to be the most important “strategic partner” in Latin America, and is likely to continue deepening economic and political ties with Lula’s government during President Xi Jinping’s third term.

It is important to remember that Lula has already been questioned as an anti-American, and China’s growth between 2002 and 2010 was one of the main reasons why Lula had a good Government during the period.

That said, I do not believe in any move by the Brazilian Government to strain relations with China. This illustrates my pessimism with SID shares, but we need to check the valuation for more precise conclusions.

Valuation Seems Stretched

We will use the price/book value indicator to evaluate SID. The justification is that the indicator reflects well the large net worth of steel companies, characterized by having many fixed assets. Let’s see:

Despite the concentration of its operations and sales in Brazil, the company still has a price/equity value higher than the average of its competitors of 0.8x. However, the valuation of Brazilian companies is cheap, as I explain in this report on EWZ, so it is fair to say that the company should trade at 1.0x p/b, which implies a downside of 9% and a price fair share price of US$ 2.67, so my recommendation is to sell the shares of Companhia Siderúrgica Nacional.

Latest Results

The results released by SID for 4Q23 revealed a modest recovery, but still require caution. The EBITDA margin increased to 29.1%, with EBITDA reaching US$725 million.

This improvement, although significant, does not change the fact that, when put into historical perspective, it still falls far short of the historical record. And despite Brazil being in an interest rate cut process (Brazil began its interest rate cut process in August 2023, its interest rate was 13.75% and is currently 11.25%), interest rates are still very high and business confidence in the industrial sector is still far from the highest levels as we can see below.

Potential Threats To The Bullish Thesis

Recent data from the Chinese economy indicate reacceleration. Therefore, one of the risks to my thesis is a demand for steel from China. With this, China would not export record levels of steel to the world, and would solve the problem of Brazilian companies with Chinese competition.

It is possible that the Brazilian Government will respond to the request of national steel companies and increase tariffs on Chinese steel, reaching levels of 25%. Although the Brazilian Government has a good relationship with China, there is a goal of closing the fiscal deficit in 2024, and an increase in steel import tariffs could help meet the goal.

The revenue diversification strategy in businesses such as cement can be successful in the long term. Despite the company’s greater leverage at the moment, the strategy can reduce SID’s exposure to the cyclicality characteristic of the steel sector, and consequently bring better results. The risks to the bearish thesis are diverse, it is important that the investor analyzes them carefully.

The Bottom Line

Valuation by price/book, used for companies with many fixed assets, indicates that the company is overpriced compared to its competitors. Furthermore, the company has the highest leverage and lowest net margin.

Additionally, the competitive scenario is very difficult, with the company having to compete against the oversupply of Chinese steel, which is largely subsidized by the Chinese Government. It is also necessary to mention that the interest rate in Brazil is still 2 digits, and does little to accelerate businesses that may demand the steel produced by SID.

Based on this analysis, my recommendation is to sell SID shares, in my opinion the share is overpriced given the business risks.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.