When I last wrote about Steel Dynamics (STLD), I found it a little strange that the shares had been left behind in the short-cycle industrial recovery. Although I wasn’t, and still am not, all that bullish on pricing given considerable under-utilized capacity in the industry and more capacity coming online in the near future, I thought upturns in steel-consuming markets like autos and heavy machinery and ongoing near-term strength in non-resi construction would support a better demand outlook.

Since then, Steel Dynamics raised guidance for the third quarter on stronger shipments to the auto and non-resi construction end-markets, and the shares have risen about 17% since then, outpacing industrial stocks and closing that gap I had seen before. With that two-month move, I see the shares now more as “fairly-valued” rather than particularly cheap and while I wouldn’t be in a rush to sell on this momentum, I do think the risk of weaker non-resi markets in 2021-2022 remains a meaningful consideration.

Better Volumes Drive Better Numbers

Mini-mill operators Nucor (NUE) and Steel Dynamics make a regular practice of providing mid-quarter (or, really, “late quarter”) updates, and this round was positive with both companies boosting guidance.

Steel Dynamics is now looking for EPS of $0.42 to $0.46 in the third quarter, or $0.46 to $0.50 on an adjusted basis. Those numbers compare to a prior average sell-side estimate of $0.41, but it’s not entirely clear to me if all of the published sell-estimates were “adjusted” or not. Either way, it’s a positive update.

The strength in the quarter is coming from volumes, with management noting increased shipments on recovering demand in the auto sector and ongoing strength in the non-resi sector. Non-residential construction has been strong pretty much all year, while autos are now recovering from the sharp COVID-19 downturn in the second quarter. As a reminder, volumes were strong in the second quarter as well, with Steel Dynamics running its mills at well above industry averages (89% for flat-roll versus mid-50%’s) and gaining share.

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Pricing remains weak. Management expects a sequential decrease in realized prices as indexed contracts have a lagging impact on pricing in the quarter. Still, overall pricing is still not that strong, as the industry has considerable under-utilized capacity and you don’t typically see much pricing strength until industry utilization rates go into the mid-70%’s or higher. Management commented that industry pricing has stabilized and improved in the second half of the quarter on this stronger demand, and that’s true, but benchmark prices are still likely to be down about 10% yoy on average for hot-rolled steel.

Nucor’s update reflects a lot of these dynamics as well. Nucor expects a flat sequential performance in its mills business, with most of the improvement coming from fabricated products (where non-residential demand is a significant driver).

A Mixed Recovery So Far

As far as I’m concerned, the demand outlook still remains mixed. Demand volume is definitely improving, with almost every auto-related company reporting better than expected improvement in the third quarter. Likewise, a range of heavy industry participants have suggested that business is showing signs of improvement off the bottom – volumes are still going to be down year over year, but they’re improving sequentially and the recovery story in autos, heavy machinery, and other steel-consuming end-markets still has legs.

There are still areas of weakness and/or concern, though. Oil/gas demand is weak and likely to remain so for a while. Likewise, process industries are going through their own downturn, and the recovery is likely to lag short-cycle industrials by at least six months. Non-residential is my biggest source of concern, as it’s such a large steel-consuming industry. Various indicators (including the Dodge Momentum Index, bank lending trends, etc) continue to show a thinning pipeline of projects for 2021, and I believe we’ll see definite weakness in areas like office, industrial, and consumer leisure new-builds.

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Given all of that, I believe this is going to be a mixed recovery setting for steel companies. Volumes will improve, and that will help some aspects of operating leverage, but I don’t see pricing strength. There’s still a lot of under-used capacity out there and I still believe pricing can decline in 2021 ahead of greenfield capacity additions that will add further to the pricing pressures.

The Outlook

This is pretty much what I expected from Steel Dynamics, so I’m not really making meaningful modeling changes. A few tweaks here and there add about $1/share to my fair value (both in DCF and EV/EBITDA), but I don’t consider that particularly material. I continue to value Steel Dynamics on the basis of a long-term cash flow model, with revenue growing at around 3% and FCF growing slightly better, as well as a blended EV/EBITDA approach that uses near-term EBITDA as well as “full cycle” EBITDA.

The Bottom Line

Steel Dynamics shares have done well since my last update, handily outperforming the S&P, but performing more or less in line with Nucor. ArcelorMittal (MT) and Cleveland Cliffs (CLF) have done even better; lower-quality companies typically do better in recoveries, but I’m still a little surprised that investors were comfortable enough to bid up those two names to the extent they did. In any case, I don’t see STLD as particularly undervalued now, but there seems to finally be some momentum in steel, and I wouldn’t be in a rush to cash in, though I might consider some protective stops.

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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