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BlueScope’s North Star Expansion Compelling

Australia | Aug 20 2019

An unfavourable earnings impact dents the first half outlook for BlueScope Steel, although most of the negatives should reverse and brokers welcome the approval of the North Star expansion.

-Soft outlook overshadows approval of North Star expansion
-Will steel spreads improve sufficiently to buoy the stock?
-North Star expansion viewed favourably

 

By Eva Brocklehurst

Disappointing guidance is the hallmark for the first half of FY20 for BlueScope Steel ((BSL)), although improved sentiment has been noted amid demand stemming from infrastructure projects. A modest overall pick-up in volumes is expected, helped by re-stocking.

Nevertheless, earnings are likely to be softer in the first half because of an unfavourable impact from export pricing, lower coke export earnings and blast furnace instability in the the Australian Steel Products business.

First half guidance is for a -45% decline in earnings, half on half, implying around $275m in EBIT. Citi expects most of the negative factors should reverse and forecasts second half earnings of $396m while Ord Minnett also suspects guidance errs on the conservative side.

Credit Suisse acknowledges the pain in being wrong-footed by guidance. In the case of BlueScope Steel, the broker points out, minor exposures within segments can cause a major variance to earnings when there are extreme price moves that are not obvious.

For example, BlueScope Steel consistently exports around 150,000t per half year to the US. The collapse in US steel prices from one half to the other could mean a -US$180/t reduction in average pricing on 150,000t, creating a -$35-40m impact on earnings for an exposure that is not closely watched by the market.

In addition, UBS notes the share of value-added production sold domestically declined in the June half by -7%, in line with the slump in detached housing, while the shift to exports contributed to a lower earnings margin of 7% versus 11% in the first half.

Housing approvals may have troughed, but the broker suspects it will take 6-12 months before activity bottoms, which adds downside risk to margins outside of steel spreads – the difference between the raw material price and finished product.

The results mark the peak earnings in this cycle, Citi agrees while noting the balance sheet is strong and there is growth from the North Star expansion. North American operations were affected by the fall in steel prices, and customers de-stocked as a result. Re-stocking has now commenced in the US, the broker points out, and should emerge in Australia.

The soft outlook overshadowed the announcement the board had approved the North Star expansion. The project offers medium-term growth and, given a share buyback is due to re-start, Citi recommends buying the dip in the stock price.

Morgan Stanley agrees that the focus is now on cash flow and further capital management, although further upside in steel spreads may be required to reach its $14 price target, and the softer guidance does diminish the upside potential.

In contrast, Credit Suisse does not envisage sufficient improvement in steel spreads, volumes or coke prices to motivate new buyers of the stock.

North Star

Ord Minnett suggests investors should look at the expansion of North Star favourably, noting that around 70% of the costs of the project is already sitting in the bank. The broker does not envisage risks to the ability to fund the required $1bn over three years for the expansion, despite weakness in steel margins and the softer outlook.

The company has approved the US$700m expansion of the mini mill which should lift capacity by 43% to 3.0mt. Completion is expected by mid FY22. A further potential increase to 3.5mtpa was reaffirmed, subject to de-bottlenecking of the hot strip mill. If this incremental expansion were to progress, Citi assesses overall expenditure per tonne would improve significantly.

Supply and demand is expected to be balanced in North Star's region and the company is targeting a minimum 15% return on invested capital based on long-term historical spreads of US$250-300/t.

The close proximity to both scrap suppliers and customers provides a freight advantage at North Star, Citi asserts, and the ability to continuously run the facility at full capacity ensures operations are maximised. Citi reiterates a Buy rating and includes the North Star expansion in its forecasts. At the 15% return target, operating earnings (EBITDA) improve by around $180m per annum from FY24. in the broker's calculation.

The company has written down a -$64m impairment related to the business in Thailand and remains focused on cutting costs. BlueScope Steel has conceded a mistake in assessing the Thai home appliance market. This appears more likely to be 100,000tpa as opposed to the prior expectations for 400,000tpa, largely because of heavy imports from China. This miscalculation has resulted in the idling of the older plant.

Higher raw material costs from coal, scrap and alloys as well as electricity and freight prices drove a material decline in profitability in the NZ and Pacific steel business in FY19. Credit Suisse remains concerned about the NZ business and its seeming dependence on elevated vanadium credits to generate an acceptable return.

There are four Buy ratings, one Hold (UBS) and one Sell (Macquarie, yet to update on the results) on FNArena's database. The consensus target is $13.61, suggesting 13.9% upside to the last share price. Targets range from $11.15 (Macquarie) to $15.30 (Credit Suisse).

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