Danieli, steel or steal?

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.