Danieli & C Officine Meccaniche SPA, steel or
steal?
Danieli S.p.A. -
Officine Meccaniche Danieli & C. (Dan) is an Italian firm located in the
north east of the country. It manufactures machinery to produce iron and
steel. The Company manufactures pellet
plants, blast furnaces, continuous casting equipment, rolling mills, forging
presses, extrusion presses, longitudinal and transverse cutting equipment, and
plant automation systems. Dan ranks among the three largest suppliers of plant
and equipment to the metal industry. Moreover Dan is leader in minimills, in
long product casting and rolling plants, and among the front runners in the
flat product and iron ore sectors. The Danieli’s two biggest competitors are
SMS (private company) and Siemens VAE (a diversified giant). These three
companies dominate the market even if they face some competition from other
smaller firms located in China, Turkey and Spain (Bascotecnica). The market
share of these smaller companies can be considered insignificant compared to
the big three and they are highly specialized just in some product lines. Of
the big three the less profitable is Siemens and maybe it could live the
market, giving an opportunity to the other two to increase their market share.
At the moment, China, India and Brazil are the most important markets for these
products.
Danieli has a
long history. It was founded in 1914 by the Danieli brothers and was located in
Brescia (a town in northern Italy). It was one of the first Italian companies
to use Electric Arc Furnaces in steelmaking. In 1929, part of the firm was
transferred to Buttrio (300 km east from Brescia), where now are located the
headquarters. In 1964 the first minimill was installed in Germany and the first
continuous casting plant was installed in Italy with the Riva Group. The
success of the minimill concept spread to Spain, the USA and the Far East. The
advantage of this method is its flexibility in times of overproduction and
market crisis. Through the years Danieli became one of the most important
players in the steel plant making sector introducing a lot of innovations. For
a detailed history of Dan go to: http://www.danieli.com/at-a-glance/history.
Company Overview
The main business
area of Danieli is the construction of plants and machines to produce iron and
steel (74%). The other 26% of revenues comes from steel production itself. The
steel production area has lower margins (4,04% EBIT margin) compared to plant
making (11,39%), therefore we expect Dan to focus on plant making and not
increase its investments in steel production (or even disinvest in this area).
However, the exact opposite is happening. More than 50% of its Capex is devoted
to the steel production, even if more than 80% of the assets are used in the
plant-making sector. Therefore, Danieli is increasing (and this is not a new
trend) its investments in the lower margin sector and this could hamper the
company’s margin as a whole. The good news is that the steel production segment
is only 26% of total revenues and its impact is not that big on the overall
profitability of the firm. Moreover, its steelmaking segment is almost totally composed
by ABS (Acciaierie Bertoli Safau), a well managed business that is focused on
special steel and therefore has better margins than other steel producers.
From a geographic
point of view, the firm is well diversified. 33% of revenues comes from the
Middle East, 33% from Europe and Russia, 22% from the Far East and 12% from
Americas. It is somewhat worrying that 33% of the revenues comes from an
unstable area like Middle East. Actually, after the Arabian Spring and all the
social and political unrest, Dan had to shut down some construction projects in
Egypt and Libya. However, given the broad diversification of revenues, Dan
looks safe form a geographic point of view.
The advantage of
Danieli, compared to its competitors, is that its products are more tailor-made.
Other firms offer standardized products while Danieli has the flexibility to
adapt to the demands of customers and customize its products to fulfill all
their needs.
Segment analysis
Dan can be
divided in four different areas: Plantmaking, Steelmaking, Finance companies
and Services and other activities. The two most important areas are Plantmaking
(73,76% of revenues) and Steelmaking (23,24%). In the early 90s Dan became shareholder of an
Italian specialty steelmaking company called Acciaierie Bertoli Safau or ABS
and in the second part of the decade Dan bought the rest of ABS (100%) and entered
fully in the steelmaking business. In 2011 ABS had revenues for 822,4 millions
(an increase of 87% from 438,7 millions in 2010) and Net Profit of 19,1 (the
year before the loss was of 6,1 millions) for a 2,3% Profit Margin. This
steelmaking segment is quite cyclical and from a NI of 52 millions in 2008 it
passed to 20 millions of losses in 2009. However the Plantmaking segment, by
far the most important, has higher net margins (7,45% in 2011) and is not as
much cyclical as the steelmaking one.
The numbers in
the table above show that the PM business is much less cyclical than the SM
one, even during the present economic crisis. Moreover the SM segment has worse
margins, as can be seen in the next table:
Despite net
margins are higher in the PM segment, Dan is increasing its capex in the lower
profitable SM segment and this can be a worrying trend:
The table shows
that despite 80% of the assets are employed in the PM business, only 34% of
capex is spent in this segment in 2011. The last two lines clearly show an
increase in the capex deployed in the lower margin SM segment. This indicates
that Dan is increasing this segment and it can lead to a decrease in the
overall company’s margins. We hope that Dan can increase SM margins or that
decides to decrease the pace of investment in this segment.
However the SM
business gives a little diversification to Dan, even if the sector of both
segments is the steel one. In fact, the amount of the order book for 2011 was
3.387 millions, a decrease of 8% in comparison to 2010 (3.682). However, this decrease
was partly offset by an increase in the special steel market from 219 to 380
millions.
Financials
Given that the
balance sheet is quite stable and that Dan’s liquidity and solvency positions are
of no concern, we will give a closer look to the income statement:
The income statement shows some interesting things. In the last 6 years sales’ compounded growth rate was 13%, while EBIT and NI growth were respectively 24% and 33%. Therefore Dan has been able to increase revenues while containing costs. NI has always been positive even if, during the financial crisis it decreased 7% in 2009 and 4% in 2011. In 2010 revenue decreased by more than 19% but Dan had been able to cut costs and increase profits by an astonishing 49%, especially reducing cost of materials. This indicates that even if a huge operating leverage is expected in a firm of these characteristics, managers have been able to cut costs and not incur in heavy losses. In conclusion, even if Dan operates in the steel market, its income statement does not look like the IS of a cyclical company. It has less operating and financial leverage and its operating income is more stable, constantly positive and often growing even in tough years.
Below we take a
brief look to the solvency and liquidity positions of the firm:
Solvency and
liquidity are improving and of no concern. The interest coverage ratios also
reflect a strong balance sheet and a strong capacity to pay interests and repay
debt maturities. The only ratio that deserves a closer look and study is cash
form operations / interests. In fact, this ratio is constantly decreasing due
to a decrease in the numerator (CFO). However, the decrease in CFO is linked to
working capital accounts and is not concerning even if its evolution should be
followed closely.
The share
In the last 5
years the A share price have been quite volatile, ranging form a high of 25 to
a low of 5. At the moment, share price is around 15 euros even if it could get
lower given the Italian sovereign debt crisis and the downward pressure that
the Italian market is facing.
If we compare Dan
common share price graph to the Ftsemib index (Italian stock market index)
graph, we can see that it was hit much less than the index during the present
crisis.
In fact, the
Index lost almost 70% of its value in the last five years, led by the crisis
faced by banks and other financial institutions.
Investment Thesis
It is true that
Danieli’s future depends on steel but it is important to understand that Dan is
not a steel making company. The firm is increasing its steel making operations
but more than 70% of revenue comes from plant making. Therefore, margins and
returns are much better. Moreover, the Italian stock market suffered a lot from
the problems that the country is facing with its huge public debt and the
difficult choice between the threat of default on its obligations and the exit
from the monetary union and the return to the inflationary lira. These problems
can be really challenging, especially the possible hard lending in China and
the consequent shock that could hit other emerging markets like India and
Brazil, two important markets for Danieli’s products. However, we think that
Dan can cope with this problems, especially because of its market share and its
strong balance sheet. Lets look at some financials:
11/07/2012
Price = 16,41
Market Cap =
1,022 billions
EV = 21,6
millions
EV/EBITDA = 0,07
P/E = 5,3 (2011
net income)
P/FCF = 22
P/B = 0,86
P/S = 0,33
Cash per share =
20
Dan looks really
cheap. Actually it looked even cheaper when its price per share plummeted below
6 euros per share in 2009. However, it still looks cheap from different points
of views. Probably the most surprising is that cash is 124% of stock price
(however, it should be taken into consideration that in the cash account the
firms puts also advances form clients). Market Cap is more than 1 billion and
EV is only 21 millions given that cash and short-term investments are more than
1,3 billion and total financial debt is around 376 millions. Therefore the firm
is well capitalized and its margins are good. The average gross margin in the
last three years was higher than 40% (around 45%). Operating margin increased
from 4% in 2009 to 9,5% in 2011 and Net margin in 2011 was 6,15%. Moreover, ROE
in 2011 was higher than 17% and the average ROE in the last 5 years was 18,3%
(with a peak of more than 22% in 2008). Shareholders equity in the last 8 years
has increased at a rate higher than 13%, not bad. There are some indications of
a possible competitive advantage: gross margins are constantly above 40% and in
2010 reached 50%; the firm has a net cash position and generates a lot of cash;
the financial debt is only 30% of equity and net debt is negative because of
more than 1,3 billions in cash; last but not least, Dan is one of the three big
players in the market and its market share is another indication of a possible
competitive advantage. A firm with these characteristics with an EV/EBITDA of
0,05, an EV/EBIT of 0,07 and a P/E of 5,3 looks like a steal. As we said, there
can be some reasons why Dan looks so cheap, like a probable overcapacity in
steal markets and problems that are arising in key markets such as China, India
and Brazil. However, we think that Dan is paying also its belonging to the Italian
stock market and the fact that the firm is seeing as a steel maker, while more
than 70% of its revenues comes from the plant making business, a business with
better margins.
Discounted Cash Flow Valuation
In the next table
we realize a proforma analysis forecasting Dan’s IS for the next 5 years. Our
estimations are really conservative and we assume an annual increase in income
much lower than the past 7 years’ one. We want to be extremely conservative
because the steel market can be hit hard by the ongoing financial crisis and
because we think that demand from middle and far east, especially China and
India, could slow down as a consequence of the burst of the housing and construction
bubble. The burst of these economies should drag down also other economies that
supply raw materials to them: countries such as Brazil, Australia and Canada.
Following the
last Dan’s interim report we forecast an increase of 2% in sales. However Dan
will not be able to decrease costs enough and we expect a decrease in NI of around
30% for the next year, followed by an increase in the subsequent years. In our
calculation NI will not recover to 2011 levels till 2016. Therefore, this is a
quite conservative forecast that takes into account a decrease in fixed
investments in emerging economies. We must consider that even in a crisis
scenario, the capacity of Dan in providing tailor made and efficient products
can be a positive aspect in a situation in which energy costs can increase and
clients search more efficient methods of production.
Considering that
the Dan is forecasting a Capex of around 90 millions in the next years, we used
this estimation in our proforma analysis and assumed that D&A and Capex
will be around 100 millions. With this assumption, we can consider our proforma
NI as the owners’ cash flow and perform a discounted cash flow valuation:
The result of the
DCF valuation is a market capitalization of 1,9 billions, with an upside potential
of 86%. In order to test our result we perform a sensitivity analysis. We shock
the discount rate, that in our base case scenario is 10%, and the multiple we
used in our terminal value calculation (12):
In the table we
highlighted in bold black our calculation of market cap, that is 1,9 billions
resulting form applying a 10% discount rate and a 12 NI multiple. Two
interesting data come out from the sensitivity analysis (highlighted in red):
if we apply a P/E multiple of 15, not that exceptional for a good business like
Dan, we get a market cap of 2,2 billions (an increase of 18% in our valuation);
the second point concerns the lowest valuation. If we discount at the highest
rate (15%) and apply a P/E multiple of 8 in order to calculate de terminal
value, we get a market cap 18% higher than the present MCap. Using these
assumptions and a DCF valuation, Dan looks very cheap. However, we need to
consider that Dan has two types of shares and that the B share usually has a
50% discount from the A share. In our opinion this high discount is not
justified because the nominal amount of both shares is the same and both are
entitled to the same amount of dividends and retained earnings. Even if we
consider unjustified this discount, it has not disappeared in the past and we
cannot assume that it will disappear in the future, even if it could and maybe
it should. Taking this discount into consideration, we get a market cap of 1,2
billions a 17% upside potential.
Normal Earnings Valuation
Our second
approach, is to estimate normal earnings and then applying a reasonable
multiple, without taking into account future growth (considering it a plus). We
will think in market capitalization and not price per share because Dan has two
different types of shares: ordinary shares (A) and saving shares (B) (azioni di
risparmio). While A shares have voting rights and B shares not, B shares are
entitled to the same amount of dividends and net income (and actually a little
more), the par amount of both shares is 1 and the book value per share is the
same. However, B shares trade at an average discount of 50% and sometimes at a
wider one and this fact is a little inexplicable. In fact, Dan is owned by the
Danieli family who, with another shareholder (Benedetti) owns more than 65% of
Dan through the holding company Sind International SPA and therefore voting
rights are not that important in a family business. Despite this fact, B shares
are less liquid and trade at a permanent discount. Given this strange
organization we will perform our evaluation on a Net Income basis and not on an
EPS basis. Considering last 8 years average ROE, we estimate that a ROE of
13,8% is sustainable and this ROE supposes a 5,2% Net Margin over 2011 Revenue.
If we assume a 20% decrease in earnings this ROE would result in 6,5% Net
Margin, that is a margin that the company demonstrated in the past that can
reach. Therefore, we estimate a normal NI of 164 millions and if we apply a
conservative P/E ratio of 12 we get a Market Cap of 1,96 billions. This is an
upside of 92,17% relative to the actual market capitalization. If we apply a
margin of safety of 40% we get a conservative buy price of 1,18 billions still
15% higher than todays Market Cap. As we told before in the DCF valuation, we
should take into account that the B shares trade at an average discount of 50%
in comparison to A shares and therefore we should take into account this fact
in our market cap calculation (even if we consider this undervaluation of B
shares as unjustified and probably correcting in case of a buyout transaction).
Risks
We already
outlined the risks inherent in Dan business. It operates in a cyclical sector
(steel) and the demand for its products can be hit by the difficulties that
emerging markets such as China, Brazil and India are facing and Dan’s business
can be hit if the social situation in Middle East remains unstable. Moreover,
the Italian difficult situation can scare international investors that do not
want to face currency risks (depreciation) in the possible scenario in which
Italy has to leave the euro and go back to the inflationary lira. Finally,
there is a risk that the enormous amount of cash can be spent in a
diworsefication by management, i.e. spent in unrelated businesses or businesses
with lower margins. However, this risk is low given the historical record of
management that invested always in a conservative manner and always in
businesses related to the steel industry.
These risks are
real and possible. Nevertheless, Dan at the moment is so cheap that the price more
than discounts these risks.
Conclusion
Danieli is not a
common steel making company. Its main business (70% of revenues) is the
Plantmaking one: construction of machinery and entire plants to produce steel.
This business has higher profitability and margins than the Steelmaking one and
is less cyclical. The main risk in this business is the probable overcapacity
in the steel market and the difficulties that demand can show in the next
future given the decrease in China and other emerging market demand for steel.
However, the capacity of Dan to adapt to customers’ requests and produce tailor
maid machinery that exactly matches the needs of these customers can be an
advantage even in an adverse market. At the moment Dan is trading at very low
multiples, and there is a potential upside of around 90%, not taking into
account possible future growth when the market recovers from the crisis levels.
In addition to the difficulties in the steel market and sovereign debt crisis
that hit Italy (Dan should not be affected by the sovereign debt crisis because
it exports more than 90% of production and is geographically very diversified),
another problem that probably does not permit the disclosure of its value is
its complicated shares’ distinction. In fact, B shares have the same economic
benefits and trade at a discount of more than 50%. It looks like a great
arbitrage opportunity (buying the B shares instead of the A shares and waiting
for the gap to narrow) but the gap between the two prices never narrowed much
more. However, in a hypothetical acquisition of the whole firm or in an
hypothetical liquidation, both shares should have the same value. Even if in
the recent past the gap between these to shares never closed up, from a long
term point of view it could be an even better bargain buying the less liquid B
shares and wait for this gap to narrow.
Disclosure: I do
not hold a position in any issue mentioned in this post.
