Reliance Steel Going For New Highs And Record Profits

Key Points

• The supply of steel is vital to most of the industries that support the modern economy as we know it, and a high capacity utilization reading across all of these downstream spaces pose quite a high-demand environment for the raw material.
• Reliance Steel is a provider of choice for most of the key sectors relying on steel, and a bump in the fundamentals of the firm speak to the pent-up demand it is currently experiencing.
• Record-breaking year for sales and free cash flow place the stock at a five year low valuation with regards to earnings and free cash flow, nonetheless upcoming earnings announcements may point to disappointing outlooks; however, this may bring the stock back down to more attractive dividend yields and a key support level. 

There are a few foundational materials that make our world go round, money is not one of them, but it sure does buy them all. Vaclav Smil, a renounced Czech scientist, wrote in his book "How the world really works" that the four pillar basic materials of civilization are Cement, Steel, Plastics, and Ammonia. These four foundational ingredients give birth to the infrastructure developed and emerging countries enjoy, the sustainability of the global food supply chain, the building block of transportation and energy, and many more applications. 

Steel is necessary for industries ranging from construction in its most apparent form, usage for buildings and foundational infrastructure, to the transportation spectrum in manufacturing ships, airplanes, and automobiles. Steel also plays a vital role in the agricultural ecosystem, making implementing plows, cultivators, and farming equipment possible.

The aftermath of the COVID-19 pandemic came in the form of cheap money as interest rates in the United States hovered near zero, incentivizing and stimulating capital expenditure and durable goods orders from several industries, many having to do with steel in one way or another.

As traveling opened its doors again, companies like Boeing NYSE: BA opened their factories for aircraft production (where steel is needed). Many others in myriad spaces upped their new orders to fulfill returning demand in their respective areas of the economy.

High Utilization Across Industries 

Among the many industries that rely on steel for their operations, a select few have been showcasing several months of high capacity utilization data, translating to upped demand for their products or services, directly translating to increased demand for the raw material that makes these exchanges possible; steel.

According to the FED capacity utilization readings by industry, spaces like primary metals and computer electronics saw readings below 70% (typically readings between 75-80% imply the upper end of utilization, and thus concerns for inflation or the need to expand capacity).

On the other hand, other industries, such as machinery and fabricated metals, saw readings above 78%, each signaling high activity and sustained demand for their products and services. By the nature of these industries and their underlying capacity utilizations, investors can deduce that those firms in the value chain closer to the raw material (steel) are seeing the bulk of economic activities.

Other indicators like the United States building permits survey and housing starts point to increased activity as of the first quarter of 2023. Construction is one of the pillars of demand sustaining necessary steel production, whether for demolition, renovations, or entirely new structure.

Reliance Steel, a Crowd Pleaser

Reliance Steel & Aluminum NYSE: RS performs and serves in various markets, all of which are, as aforementioned, highly dependent on steel and currently facing the upper end of the demand cycle. As of the fourth quarter of 2022, Reliance Steel derived 35-45% of its revenue from the "General Manufacturing" segments, which include customers operating in the energy, industrial machinery, and semiconductor industries, all of which have seen disruption within their respective supply chains sparking the need for increased capacity and supply of finished metal products born from steel.

Reliance's second most significant segment is the transportation industry, serving aerospace and automotive customers. Supply chain disruptions in the automotive sector, along with travel restrictions, have caused bottlenecks and quick pivots in new orders for the underlying operators, all for the benefit of Reliance Steel. Finally, ending the remaining 30-40% of the revenue pie is the construction segment, which, as evidenced by the pivoting expansion in activity within permits and starts, is becoming a tailwind for future segment earnings.

Reliance's product composition is almost made for the current economic climate. Much of its product line is dedicated to carbon steel and its derivatives, with a secondary focus on stainless steel and aluminum alloy. It seems that no matter what the cycle is within one industry (affected by discretionary spending cycles), another segment will be ready to support the firm as a whole through the other extreme of economic sentiment.

Record Year for Deep Value

The year 2022 was a record-breaking one for Reliance Steel, reaching total revenue of USD 17 billion and passing down all the benefits to stakeholders as a byproduct of record-breaking operating and net income margins of 14.7% and 10.8%, respectively. However, despite a tremendous year for the fundamentals of the firm and industry, some market participants and analysts seem to be afraid to push for more upside as inflation and rising interest rates pose a risk to declining steel market prices and compressed new orders and production of underlying customers. 

The stock is still trading at an attractive 8.3x price-to-earnings ratio as of year-end 2022 financials and a similar 8.6x price to free cash flow. This similarity speaks to a healthy balance sheet with low debt and high liquidity, allowing the firm to keep making acquisitions to consolidate the industry and Reliance's pricing power.

 A coming first quarter 2023 announcement may bring a bit of disappointing guidance as the possible economic slowdowns may cause management to provide more conservative outlooks. Nonetheless, investors could start watching the stock on a decline to its proximate support level of $195-$215, where the dividend yield would then equal closer to 2% compared to its current yield of 1.6%. 

Whatever the case may be, investors can find comfort in knowing that at least a third of the customers Reliance serves in non-cyclical industries, and any sufficient cash flow will surely make its way to share buybacks as the firm has retired over ten million shares from the open market in the past five years.