Gerdau

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Gerdau S.A. is a leading Brazilian steel producer that operates globally, with a significant presence in Latin America, North America and India.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Gerdau is a manufacturer and seller of long steel (including billets, blooms and slabs), common long steel (rods, bars, light profiles), special steel (tool steel and heavy plates) and pig iron. The company is also engaged in industrial operations and processing, in addition to the trading of products with its distribution channel.

Gerdau’s operations are organized geographically into business segments: Brazil, North America, Latin America and Special Steel.

  • Brazil: This segment is engaged in the production and commercialization of steel in Brazil.
  • North America: Operations encompass the production and commercialization of steel in North America, including the United States and Canada.
  • Latin America: This segment covers the production and sale of steel across Argentina, Colombia, Peru and other parts of South America.
  • Special Steel: Activities are involved in the production of special steel.

The steel industry is cyclical, sensitive to macro-economic conditions and global trade dynamics. The demand for steel is influenced by several factors including industrial production, infrastructure spending, and construction activity, particularly in emerging markets like China, India, and Brazil. This is a mature industry with slow growth but with a fairly consistent global demand as countries continue to construct and build.

  • Increased consolidation: The steel industry has been consolidating, which tends to be beneficial for the remaining players by creating higher bargaining power.
  • Trade protections: The protectionist trade policies that have emerged in the past few years have caused tariffs and quotas that affect the steel industry
  • Focus on Sustainability: The steel industry is under increasing scrutiny regarding its environmental footprint and is having to meet ever-stricter regulatory requirements.
  • Technological advances: New technologies, such as electric arc furnaces (EAFs), are changing how steel is produced, increasing energy efficiency while being less pollutive. These are also disrupting the supply chain in the steel market.

Competitive Landscape

The steel industry is highly competitive, with many global and local players. Gerdau competes with major global steel companies such as ArcelorMittal, and Nucor, and Chinese producers. Competition comes from both domestic and foreign competitors. There are limited ways to differentiate yourself from competitors, besides from scale of operations and lower transportation costs.

What Makes Gerdau Different

Gerdau has a large and diverse geographic footprint, with a strong presence in both developed and emerging economies, particularly in Brazil, and South America. The company’s focus on specific types of steel production, like long steel, makes them a major player in their specific market segments and allows them to have some pricing power. Gerdau has historically relied more on large, integrated mills than electric-arc furnaces but has been transitioning their operations to EAFs in recent years.

Financial Analysis

Revenue Distribution

Gerdau’s revenue streams are diverse, based on geography and type of steel. A significant part of the revenue is generated from their North American and Brazilian operations. Sales of long steel products make up the majority of revenues, but there is still an important part that is composed of special steel sales. The revenues also vary by the steel price, raw material and economic situation.

Over the past few years, there has been a shift of the company’s revenues more towards Brazilian and North American operations.

  • 2021-2023 trends: revenues of Brazilian operations have increased by 47% while North America revenues have only increased by 13%. Revenues in both segments are growing, but the Brazilian segment shows more dynamism and growth.
  • The revenues of special steel operations, on the other hand, have declined by 14% in the last three years, which may signal that this segment is under pressure.
  • The total sales revenues have increased by 31% in the last three years, from R$70.1 billion to R$92.1 billion.
  • Geographic Segments:
    • In 2022, Brazil accounted for R$44.1 Billion in net sales, North America for R$27.3 billion, Latin America for R$15.9 billion and Special steel for R$3.2 billion.
    • In 2023, Brazil’s net sales increased to R$50.7 Billion, North America to R$31.0 billion, Latin America R$17.5 billion and Special steel decreased to R$2.9 billion.
    • A major point to note is the decline in revenues from Special steel, which is likely a result of weakening prices in that particular industry.
  • Sales By Product:
    • Finished steel products are the main drivers of total revenues. This is followed by common long steel and special steel.
    • The growth of revenues by finished steel products is much higher than other steel products, with their revenues increasing more than 30% in the past 3 years.

Margins

Gerdau’s operating margins are very sensitive to the overall steel prices. Since steel prices are generally dictated by global market dynamics, the business has very limited control over what prices are. Their cost structure, on the other hand, is pretty predictable, consisting mainly of raw materials and energy, where the company does have some leverage by operating efficient mills and processes.

  • Margins saw a significant decrease in 2022 and are expected to be lower in 2023
  • The net profit margin in 2021 was about 16%, but it fell significantly in 2022 to about 8% and it’s expected to be near to 7% in 2023.
  • The EBITDA margin also followed the net profit margins in their trajectory.
  • Gross margins: They have remained between 15% and 20% over the last 4 years, with slight dips and increases reflecting the rise of prices and costs. This could also be a result of contracts that lock prices for some periods of time.

Financial Statements

Looking at the financials, we can discern that Gerdau is a highly cyclical business that greatly reflects the global economic conditions. As mentioned earlier, they are heavily affected by the price fluctuations that are largely out of the company’s control. The company generates a lot of revenues on paper but they have little control over the profitability of the company as prices fluctuate. However, the company has good capital discipline and low debt, which allows it to weather difficult economic times without jeopardizing the balance sheet.

  • Income Statement: Revenues grew substantially, and they reached their highest point in 2022. But margins have contracted sharply in 2022 and are expected to be lower in 2023.
    • The high levels of revenues and margins before 2022 made their net income skyrocket from about R$6 billion in 2017 to a high of R$11 billion in 2021. After the fall in profitability in 2022 and the projected drop in 2023, their income seems to be settling at the R$6 to R$7 billion a year level.
  • Balance Sheet: A good mix of short term assets, long term assets and low debt.
  • The debt to total capitalization has been reduced to approximately 0.29, which is great considering that previously it was over 0.45.
  • Cash balances remain stable despite all the buybacks and dividends. They had $2.9 billion in cash in 2022 and $3.5 billion in 2023.
  • Cash Flow Statement: As most companies, the cash flow is subject to changes due to varying profit and capital expenditures.
    • Operating cash flows have been trending up for the past years but are expected to decrease in 2023 given the drop in profitability.
    • The company also engages in share repurchases to return value to its shareholders.

Recent Concerns and Management Outlook

Gerdau is facing some challenges from recent changes in industry dynamics. The company has been hit with low prices, high input costs, and declining margins in the last year. A large part of this is attributed to increased imports into the U.S and Europe, especially from China, and slowing demand from higher interest rates. Also, the steel industry is facing increased regulations that are negatively impacting their bottom line.

  • Response: The management is aware of the problem and is focused on reducing costs, by re-negotiating contracts, and using cheaper inputs in the production process. They have been implementing the use of artificial intelligence for optimization of production and logistics.
  • Future: The management is optimistic about the future growth of operations, particularly in Brazil, as they foresee more growth in infrastructure and construction, which will in turn create a greater demand for their products.

Moat Rating

3 / 5.

Gerdau has created some advantages that create a narrow moat around their business, and the company is susceptible to various factors that could challenge or eliminate their competitive advantage.

  • Scale and Cost Advantage: Gerdau is one of the major steel producers in Latin America, having access to a low cost region with a large market. Their mills are not the most efficient in the world, but their ability to control distribution allows them to have an advantage over smaller local players.
  • Intangible Assets: Gerdau has a brand name, particularly in South America, that gives them a competitive advantage. They are able to maintain this through constant advertising.
  • Switching Costs: Some of their contracts have high switching costs, especially with government entities.

Risks to the Moat

Gerdau is very susceptible to a number of risks:

  1. Cyclicality of the Industry: The most significant risk to Gerdau’s business is that of the cyclic nature of the steel industry. Their profitability and valuations are extremely reliant on the ups and downs of the economy. This is difficult to forecast, and when the cycle turns around for the worse, the stock is severely punished.
  2. Global Competition and Overcapacity: As an international commodity business, they are at the mercy of trade and global supply imbalances. This makes their performance susceptible to any trade policy change.
  3. Raw Material Prices: Gerdau is exposed to fluctuations in the cost of raw materials, particularly Iron ore.
  4. Technological Disruption: They may be at a disadvantage if they don’t rapidly adapt to new technologies like EAF and digital systems.
  5. Environmental Regulation: They may face difficulties in the future by the new standards implemented to reduce pollution. Their old methods of production may become less sustainable.

Business Resilience

Gerdau has a diverse geographic portfolio with strong market positions in its different areas of operation. Given that the company has little long-term debt, their ability to withstand the economic cycles is better than a lot of its competitors. However, even with all of those advantages, their profitability and sales are tied to global macroeconomic events and the overall health of the steel industry. The company has not shown the ability to grow and increase its profits consistently and seems to be tied to its existing markets.

Understandability Rating

2 / 5.

While the business is pretty simple to conceptualize as a manufacturing company, the global steel industry is far from being simple and straightforward. The company has large operations in South America, North America, and Europe, making it more difficult to accurately predict its earnings because they are influenced by various different external factors. The financial statements may also prove difficult, because their method of reporting financials is affected by foreign exchange rates. A good understanding of the steel business and global economic forces is required to understand Gerdau.

Balance Sheet Health Rating

4 / 5

Gerdau has made strides in reducing their debt, and now their debt to capitalization ratios are very low. They have good liquidity and a considerable amount of cash, which gives them flexibility to deal with volatile market situations. The management has also been implementing policies to strengthen their balance sheet for the long term, like investing in more efficient mills and more profitable projects. Their strong balance sheet helps the company endure the ups and downs of the cyclical steel industry and manage through periods of low margins and low sales.