Description

Kloeckner & Co. (“KCO”) is a leading global steel and metal products distributor serving the construction, machinery, automotive, and consumer end markets. KCO is listed in Germany but generates roughly half of its earnings in the US. Despite significant exposure to the US market, KCO is covered exclusively by European analysts, primarily those who specialize in industrials and not steel distribution, which is poised to generate record margins on the back of record steel prices. This disconnect between KCO and its analyst coverage has resulted in unreasonably low expectations for 2021 earnings and a substantial valuation discount.

Against this backdrop of low expectations, the fundamental earnings power of KCO has reached an inflection point for several reasons. First, steel prices have increased to historic levels, up 170% year over year, with no signs of stopping due to strong demand and supply constraints. The price of steel, which has averaged roughly $600/ton over the last decade, rose to roughly $1,200/ton in Q1 2021, and is approaching $1,400/ton so far in Q2. Like most distribution businesses, KCO benefits from inflation by charging its customers a percent margin on top of the cost of materials, so as steel prices rise, KCO is able to generate a higher dollar gross profit on the same volume of shipments.

Following a robust Q1 2021 with implied gross profits in the €260-270/ton range, consensus expectations naively assume a swift decline back to KCO’s historical average of €205/ton for the back half of 2021.  Historically, Q1 typically accounts for ~20% of annual EBITDA, yet analysts assume Q1 will account for an outsized 40% of annual EBITDA in 2021, implying that steel price benefits will be short lived and limited to Q1 before declining for the rest of the year.  Our view is different: while Q1 levels of profitability are not sustainable in the long-term, current steel prices should still enable KCO to earn outsized levels of profitability for the remainder of the year. Even if steel prices fall 50% from current levels, they will still be ~20% higher than the 2020 and long-term average.

Second, following organic volume declines in eight of the last nine years management has finally consolidated its footprint and right-sized the business, exiting 50% of its distribution and service locations, leading to massive cost savings from lower overhead. Third, KCO’s digitalization initiatives and automation of traditionally laborious quoting and processing procedures has allowed the company to decrease its labor force by 15%. Management estimates the combined savings from the recent footprint and workforce optimization, collectively known as the “Surtsey” program, will lead to annual cost savings of at least €100 million from KCO’s already reduced 2020 operating expenses.

Taking these datapoints into account, we have been able to underwrite a forecast for 2021 EBITDA that is materially higher than the consensus estimate of €318 million. Based on record steel prices that will increase gross profit, massive cost savings from the “Surtsey” program, and conservative volume growth estimates from easy COVID-comparables, we believe 2021 EBITDA could be above €400 million.

At a 6x EV/EBITDA multiple, this would imply a valuation of €18.00 per share, or roughly 50% upside. If KCO rerates to a multiple in line with its American peers of 8x, this would imply a valuation of €26.00 per share, or roughly 120% upside. KCO will report its Q1 earnings and provide guidance for Q2 on April 29, and we believe that this will be a catalyst for the stock as the current consensus estimate for Q2 EBITDA, which is 33% lower than Q1 guidance, is unreasonably low given that Q2 will benefit from both higher steel prices and higher shipment volumes as the global economy continues to recover.  Our view is corroborated by recent updates by others in the steel/distribution value chain such as Reliance Steel & Aluminum, Steel Dynamics, and Nucor which all expect Q2 2021 earnings to either approach or surpass their record Q1 earnings.

Catalyst

• KCO will report earnings on April 29 and they will provide guidance for Q2