Our view: We expect Stelco to report another record quarter on steady volumes, and higher steel prices and view the recent pull back as an opportunity to build a position at a more attractive share price. We continue to like Stelco for its highly fixed, low cost operations and despite our expectations of a moderating steel price the shares continue to look attractive. We maintain our Outperform rating and revise our Price Target to $61 from $62 as we incorporate a DCF valuation into our target methodology.
Key points:
• Q3 preview: We expect sequentially stronger earnings in Q3 driven by flat sales volumes, inline with management's guidance, and improving steel prices (avg. HRC price +23% q/q), partially offset by slightly higher operating costs due to increased energy costs and other inputs. Our realized price estimate for shipped tons increased ~30% q/q compared with the prior quarter increase of ~35% as we saw HRC price increases decelerating, however given the 7-8 week lag we estimate on deliveries throughout Q3, we expect prices continued to increase through the end of the quarter and be up qtd in Q4.
• Further capital returns expected: We estimate Stelco will generate $708M in FCF in H2/21 (net of the $398M share repurchase of Lindsay Goldberg shares in August), $734M in FCF in 2022 (26% yield) and look to return capital to shareholders. With no major capital projects planned and the completion significant investment in the company's assets over the past several years we could see an increase in the regular $0.20/ sh quarterly dividend and/or share repurchases. We could see Stelco execute another share repurchase with Lindsay Goldberg, buying back the remaining 7.7M shares they own within the next 6 to 12-months.
• Higher steel prices flowing through to earnings: We have revised our modeled steel prices (see pg 2), marking-to-market near-term prices and moving the medium and longer term prices up slightly with consensus. We've also updated our Q4 realized prices as lead times remain extended at ~7 weeks and sales are currently booking into late November. We continue to expect prices to moderate as new domestic supply ramps up and imports increase. Market participants have also noted inventory levels have improved which we expect has contributed to the deceleration in steel prices.
• Valuation continues to look attractive: We have updated our valuation methodology and now derive our target using a 50/50 blended DCF and EV/EBITDA multiple on 2022E earnings. Our near term earnings estimates increased on higher expected steel prices, however this was offset by the inclusion of the DCF valuation which resulted in our target moving to $61 from $62. Stelco shares continue to look attractive trading at a discount to our estimate future cash flows and its peers. We estimate Stelco shares are trading at 3.5x 2022E EBITDA compared to peers at 4.3x & 1.7x 2021 earnings compared to peers at 3.2x (appendix 2).