Steel Maker Hits the Long Ball

09/22/2010 3:49 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Brazilian steel maker Gerdau (NYSE: GGB) is on the march in the US steel market and back home in Brazil.

In August, the company acquired the remainder of the shares of its 66%-owned US subsidiary Gerdau Ameristeel. That gives Gerdau a wholly owned platform for expanding in the US market. (The acquisition of the remainder of Gerdau Ameristeel will also reduce that company’s cost of capital, since parent Gerdau pays only half as much as the subsidiary in the capital markets.)

The company didn’t let much moss grow on that deal: On September 15, Gerdau announced that it would acquire TAMCO, a California mini-mill that is a producer of long-steel products, such as rebar, used in construction.

In Brazil, the company is pursuing an expansion of capacity that will add a new mill producing flat-rolled steel, beginning production in 2012, and diversifying it away from long-steel products. In the long-steel market, Gerdau is the second largest producer in the world.

Long steel has been a depressed market, because of the slowdown in construction in the US and in other economies.

I actually like that. It means that Gerdau has good upside leverage with the recovery of that market. And the tough times in that segment have left the company with very little competition in some markets. For example, TAMCO is the only producer of long-steel products in California.

The long-steel market in Brazil should also get a big boost from the government’s efforts to increase investment in infrastructure and construction as Brazil prepares to host the 2014 World Cup and the 2016 summer Olympics. Gerdau has about 20% of Brazil’s steel market.

The expansion into the flat-rolled market in Brazil will increase Gerdau’s margins (since margins in flat-rolled steel are higher than in long steel) and will also position Gerdau to sell into such fast-growing industries in Brazil as automobiles and consumer white goods.

At its current price just above $14, Gerdau trades for about 12x projected 2010 earnings and 11x  projected 2011 earnings per share. Morningstar projects revenue will climb 16% in 2010 and that operating margins, currently at 13.4%, will climb back to historical levels of 15% to 20% through 2014. The company has never had a losing year in its history, by the way.

I think the stock is likely to experience weakness in the near term, due to what I’ve called the Petrobras (NYSE: PBR) effect (see this post) and to rising prices for scrap steel, an essential raw material for mini-mill producers such as Gerdau. The company is close to self-sufficient for its Latin American operations, but needs to buy scrap for about 60% of its US mills.

I’d use the weakness as a buying opportunity. I’m adding this ADR to Jubak’s Picks with a target price of $20 by June 2011.

Full disclosure: I don’t own shares of any company mentioned in this post in my personal portfolio.

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