Brazil Bounce Not Enough for Gerdau

06/30/2011 4:09 pm EST


Jim Jubak

Founder and Editor,

Brazilian-US steelmaker Gerdau (GGB) was up 3.6% yesterday, and another 1.3% today (as of 3 p.m. New York time).

The spike follows calls from Goldman Sachs and Deutsche Bank for a possible third-quarter surprise in demand for steel, and for rising prices, with current levels forming a floor. (Gerdau is a member of my Jubak’s Picks portfolio.

Shares of other steelmakers were up as well. Nucor (NUE), for example, gained 4% yesterday and today.

I think it’s the positive change in sentiment toward emerging stock markets that has led to the relative outperformance by Gerdau as compared with the steel group.

Brazil’s major market index, the Bovespa, is up 1.6% from June 24 through 3 p.m. today. That’s quite a contrast to the 4.1% loss recorded by the index from June 9 through June 16.

And during that period, Gerdau has substantially underperformed the market index. In fact, for 2011 to date, shares of Gerdau are down 20.63%—versus a drop of just 2.81% for the iShares MSCI Brazil Index (EWZ).

So you can see why Gerdau might be bouncing higher than its peers today.

On the fundamentals, Gerdau isn’t out of the woods yet, but the forest is thinning. The big problem has been an appreciating Brazilian real that has made steel imports into Brazil cheaper, and steel exports from Brazil more expensive. (Gerdau exports about 35% to 40% of its Brazilian production.)

It doesn’t look like the real is about to get significantly cheaper very soon, but I’d expect the rate of appreciation to moderate as the government’s program of interest-rate increases to fight inflation draws to a close this year.

Gerdau has had some protection from an appreciating real, since the company is also the second-largest steel-mini mill operator in North America, and gets about one-third of its sales from the United States.

Disruptions in the global auto industry after the Japanese earthquake and tsunami have cut into demand and prices in North America—and the recession in the commercial construction industry hasn’t helped—but trends in both areas look better in the near to medium-term future.

Margins have already started to pick up. First quarter EBITDA (earnings before interest, taxes, depreciation, and amortization) margins climbed to 13.2%, from 10.4% in the fourth quarter of 2010. That was still below the 19.7% margin in the first quarter of 2010.

One wild card in Gerdau’s valuation is the likelihood that the company will sell off some part of its iron-ore business. Production from its 2.9 billion-ton iron ore resource exceeds the future needs of its Acominas mill, and the company has scheduled the completion of a study for the end of year on how it could monetize this resources.

Credit Suisse estimates that the net present value of Gerdau’s iron ore business is $3.2 billion to $4.2 billion. Gerdau’s total market capitalization is $29 billion.

The battle against inflation in Brazil will continue to operate as a drag on Brazil’s economy and stock market. The central bank just raised its projections on inflation for the end of 2011 to 5.8%, up from 5.6%. The Banco Central do Brasil also raised its projection for 2012 to 4.8%, from 4.6%.

Inflation as of mid-June was running at a 6.55% annual rate. That’s above the top end of the bank’s inflation target of 4.5% plus or minus two percentage points.

I think that means the central bank will continue to raise interest rates to fight inflation well into the fourth quarter of 2011. That will slow the speed with which Brazilian shares reach their target prices.

I had calculated that Gerdau would reach $20 a share by the end of 2011. As of June 29, I’m cutting my year-end target to $16 a share.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Gerdau as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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