In the days before COVID-19, I liked Commercial Metals (CMC) as a mispriced steel asset leveraged to better underlying pricing power, a still-healthy non-residential construction market, and ongoing self-help potential as the company continued to leverage production and distribution optimization opportunities. While the stock outperformed its steel peers for most of 2020, it underperformed the S&P 500, and recently, Steel Dynamics (STLD) and Cleveland-Cliffs (CLF) have pulled ahead in terms of returns since that prior article.

Although the valuation still looks out of whack, it’s harder to recommend Commercial Metals when the outlook for non-residential construction is deteriorating. A federal infrastructure stimulus bill would be a big help, but that is most likely a 2021 event (if then…), and I’m concerned that pricing could be weaker on softer demand. I do see this as one of the more interesting price/value opportunities, but those macro worries do hold back some of my enthusiasm.

A Solid End To The Fiscal Year

Commercial Metals’ fiscal fourth quarter (calendar August quarter) was fine relative to expectations. Revenue beat by about 2%, while EBITDA was a 16% beat on a “reported adjusted” basis and still nearly a 9% beat adjusting out a carbon credit in the European business.

Revenue declined 9% yoy but rebounded 5% qoq, helped by healthy ongoing demand in non-residential construction as projects complete. North American revenue fell 8% yoy and rose 5% qoq, with strong steel product shipments (up almost 9%). Pricing wasn’t too bad, with steel product pricing falling 4% qoq and downstream product pricing up modestly. The European operations reported a 12% yoy revenue decline and better than 3% qoq improvement, with shipments up a little less than 2%.

Adjusted EBITDA (including the credit) rose 11% yoy and 14% qoq, with North American EBITDA up 14% yoy and 9%. On a per-ton basis, core EBITDA on finished shipped steel rose almost 9% qoq to $114. EBITDA in Europe fell 14% qoq excluding the credit.

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The Market Outlook Is The Big Question Now

Although acknowledging uncertainty in the outlook, Commercial Metals management sounded relatively bullish on the outlook, including a strong construction outlook. I don’t have the same confidence or bullishness in the outlook for non-residential construction in the U.S. going into 2021.

After a strong multiyear run, I believe we’re going to see a correction in non-residential construction activity, probably lasting for around two years. In addition to fairly typical election uncertainty and the uncertainty created by the recession, the underlying cause of that recession (the COVID-19 pandemic) adds new uncertainties as to what the long-term demand for offices, retail spaces, and hospitality may look like, to say nothing of lender hesitancy to underwrite CRE loans in those areas.

Non-residential activity has stayed strong in 2020 as building owners and project managers have worked hard to keep projects on track, and there could still be some tailwind from this, but I am concerned about the thinning pipeline. The chief economist at the Associated General Contractors of America has noted increasing delays and project cancellations, ABI readings have been unimpressive, and ConstructConnect reported a 40% decline in September starts. The Dodge Momentum Index, too, reflects the pressures. While the September numbers were better than the August numbers, the September numbers saw a 12.8-point decline from the year-ago period, with commercial down 18.3 points and institutional down 5.9 points after an overall 11.7-point yoy decline in August (commercial down 9.7 points, institutional down 14 points).

At this point, I think it’s too late to avoid at a brief correction in non-residential construction, even if there’s a vaccine available relatively early in 2021. With that, I think CMC and Nucor (NUE) (which together control about 80% of the U.S. rebar market) are going to face a weaker demand environment, with pressures likely on both volume and pricing.

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The big unknown is the outlook for infrastructure spending (roads, bridges, et al). This accounts for more than a third of CMC’s end-market demand. In the near term, I’m pretty concerned that the economic pressures from COVID-19 will hit municipal spending on such projects. The unknown is whether the federal government will step up with a stimulus package. Both sides of the aisle have put forth various pledges, promises, and plans, but it seems unlikely that anything big will happen until after the election, and quite likely not until after the inauguration, unless there’s some newfound spirit of bonhomie and cooperation in Congress.

Self-Help Still In Play

Commercial Metals management deserves a lot of praise for the efforts taken in recent years to improve the business. The acquisition of the Gerdau (GGB) rebar assets has gone better than expected, and CMC has taken steps beyond that to optimize sales, manufacturing, and distribution/logistics, including better planning and sales forecasting to limit inventory builds without compromising the company’s ability to serve customers (that tough balance between tying up working capital in inventory and risking out-of-stocks).

The construction of a new micro-mill in Arizona is part of that ongoing self-help story. This mill will produce 500ktpa of merchant bar quality steel (a type of long steel), and it will be the first MBQ facility to use a “continuous-continuous” production process – a process that improves mill productivity, lowers costs, and creates a more standardized product.

Outlook

The biggest source of upside for Commercial Metals relative to my expectations would be stronger demand from the U.S. non-residential construction market (about one-third of overall demand), and federally stimulated infrastructure spending would be only just a bit behind in terms of significance.

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As is, I expect EBITDA to dip a bit in 2021 and 2022 relative to 2020. I continue to value Commercial Metals on the basis of my old full-cycle EBITDA estimate, a number that is about 7% below management’s long-term target. With my estimates, I still see fair value around $26 to $27, while hitting management’s goal would push the fair value close to $30. Commercial Metals also looks undervalued on a discounted cash flow basis; while DCF is a tough way to value cyclical commodity companies (you’ll never get the ups and downs exactly right), buying below DCF fair value in weaker periods has historically worked for me.

Bottom Line

I do worry that estimates are still too high for CMC in 2021 and 2022, and that there’s downside risk from weaker non-residential and infrastructure demand. I don’t see CMC reaching my full-cycle average figure until FY’23, with some years of over-earning after that. I’m hesitant to recommend CMC into a tough macro backdrop with downward revision risk, but the value is interesting, and this is definitely a name to consider if you’re more bullish on non-resi/infrastructure spending or if/when those estimates come down a bit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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