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Event
We offer a year-end update on the North American steel sector and the key trends that influence the stocks within ourInfrastructure and Construction (I&C) coverage universe that are levered to the industry.
Action
Our ‘top pick’ in the sector remains Russel Metals mainly because: (i) we expect the growth of unconventional oil and gasresources and the advancements in hydraulic fracturing techniques to power the Energy Tubular Products division’s earnings in4Q11 and 1Q12; (ii) the Metals Service Centers and Steel Distributors units have successfully adjusted to the post-2008 reality oflower steel industry shipments and weaker demand for small construction projects, and today can churn out steady, adequatereturns, and (iii) the firm boasts industry-leading inventory turns and ROEs (despite its low debt leverage). We are alsoconstructive on ADF Group because the small-cap firm has remained profitable through the bottom of the U.S. commercial construction cycle and its shares look deeply undervalued to us. We believe Canam Group is similarly undervalued on a P/Bbasis, but the company carries too much debt to our liking and the outlook for commercial construction in the U.S. remains subdued at best. Accordingly, we maintain our neutral stance on Canam.
Analysis
Our research and channel checks suggest a disconnect between the dampened enthusiasm for the North American steel sectorat present and its underlying fundamentals. In the past weeks, many North American steel producers have issued press releasescautioning that their 4Q11 results would fall short of analyst expectations. This decline reflects lower steel prices and metalmargins for sheet products, which are the direct result of some new domestic supply coming to market. In addition to theincreased competition, the market volatility early in the fourth quarter contributed to buyer uncertainty and negativelyimpacted buying patterns. We believe this drop in sheet metal prices has caused some undue pressure on the stock prices of thesteel distributors (which have actually continued marching to a different beat than the producers) and provided investors withan excellent opportunity to buy quality names like Russel Metals at a discount.
Valuation
Our $29.00 target price on Russel Metals is predicated on an EV/EBITDA multiple of 7.6x our 2012 estimates, which representsthe North American service center operators’ ten-year average. Our $5.50 target for Canam Group is derived using a multiple of0.7x our estimated book value at Dec-30-11. Our target multiple represents the low end of the stocks 10-year P/B multiplerange, which we feel is warranted given the absence of catalyst we see for the firm in the short to medium term. We value ADFGroup similarly to Canam, at 0.7x estimated book value, notwithstanding its smaller capitalization and more concentratedcustomer base, because the steel fabricator has a stronger financial position and healthier operating performance of late.
