Russel Metals Stock: A Steel Coil Spring? (TSX:RUS:CA)

Russell Metals Inc. (TSX:RUS:CA) operates as a metal processing and distribution company in Canada and the US. It operates in three segments: Metals Service Centers, Energy Field Shops and Steel Distribution.

The Metal Service Centers segment operates a network of metal service centers supplying metal products in a range of sizes, shapes and specifications, including hot rolled and cold finished carbon steel, pipe and tube, stainless steel, aluminum and other non-ferrous specialty metal products .

The Energy Field Stores segment offers specialized products such as flanges, valves, fittings and other products for the energy industry.

The Steel Distributors segment sells steel products to other steel service centers and equipment manufacturers, which include carbon steel plates, flat rolled products, beams, channels and pipes.

Russell Metals Inc. was established in 1929 and is headquartered in Mississauga, Canada.

Russel was a solid performance in this cyclical industry, exceeding target return on capital of 15%.

The company has an impeccable balance sheet with low debt and a large cash surplus. It has deployed capital in several incremental acquisitions, the most recent of which closed in August 2024.

Management has proven to be shareholder friendly, with a good track record of dividend increases and share buybacks.

Current performance reflects the current low point in the steel supply and demand cycle, which has reduced margins from post-Covid highs.

I think Russel is in a very strong position to take advantage of the near-term cycle to continue to acquire competitors at increased valuations. However, the cycle is not over yet.

I’ll take a look at the business and stock price performance and outlook and tell how I’ll play the current setup.

Company performance

Russel provided a shareholder update with its Q2 earnings release. The figures clearly demonstrate the cyclical nature of the steel distribution business, with pressure on margins driven by steel price and demand.

The slide below has a lot of information that tells the story pretty succinctly.

The good news is that earnings have held up quite well in difficult circumstances, with 2024 coming out close to 2023. In addition, the company has shown great financial discipline, using excess profits from the post-covid peak to clean up the balance sheet. aggressively paying down debt to be in a positive net debt position. Already in 2024, some of this excess cash has been used in a mix of buybacks and share buybacks (more on that later.)

However, EBITDA margins have been reduced over the period, from a high of 16% in 2021 to a current level of 8%. However, this margin compression appears to have flattened out at this 8% level, which has been sustained in recent quarters.

The financial results summary shows that the revenue profile is starting to flatten, with net income stabilizing at $50 million over the past two quarters. Capex is growing modestly, thanks to investments in upgrading processing facilities.

As mentioned above, Russel has been buying shares since 2022 and has reduced the number of shares by 8% year to date, with a new buyback authorization approved after Q2 2024 results.

However, EPS has declined over the past three years, appearing to have bottomed out in Q4 2023, with slight increases over the past 2 quarters.

With a capital allocation strategy balanced between investments, buybacks and dividends and the cyclical nature of the business, dividend growth has been significant but not consistent, around 2% per year over the past decade, but has recently accelerated. The current yield is 4.4%.

Book value per share also shows a cyclical profile, with clear ups and downs over the last decade, but a shift in gear in 2022-2024.

Stock price performance

Russel has performed reasonably well for shareholders over the past 5 years, charting the TSX benchmark over the period. I also show the performance of Labrador Iron Ore Royalty, as a proxy for steel as a commodity.

Year-to-date performance paints a different picture, as margin compression through results showed. Russel generated a negative 14% return against the TSX’s positive 15% and also underperformed Labrador Royalty.

The elephant in the room

The jumbo-sized question for Russel is, of course, “Where are steel prices headed and what impact will that have on Russel’s earnings?”

The chart below from this study by Steelonthenet.com highlights just how cyclical steel prices are. Drawing on data from multiple sources, including Fitch, the OECD and the World Steel Association, the report concludes that steel prices will not peak until mid-2025.

Key factors in the outlook are the impact of a prolonged slowdown in Chinese steel demand and increased production capacity.

Russel would argue that their own market does not fully reflect global steel prices as they only have exposure to Canada and the US and have also increased their processing capabilities to capture more of the value chain.

However, they admit that Q3 and beyond will continue to show the impact of the down cycle, particularly in the steel distribution side of the business, where margins map to the global steel price. The Service Center business segment is expected to show a decline in margins in Q3 and a rebound in Q4, while the Energy segment is considered stable in margins.

The figure below shows the compression of the price cycle on margins. While Russel’s focus is on managing working capital down as margins compress, the profitability profile has fallen faster than capital employed.

Over the past two quarters, working capital has started to rise, while yields continue to fall. While the bottom of the margin cycle should remain above the lows of the Covid era, I think it would be reasonable to expect the bottom and recovery to be similarly shaped – the catalysts for a V-shaped margin recovery seem thin .

Overall, I would expect to see Q3 results under continued pressure on margins. There is also the open question of the revenue impact of the looming recessions in both Canada and the US.

Further on the macro front, we have now seen the Bank of Canada cut interest rates by 0.75% from their peak, with a cut at each meeting. As the Canadian economy remains under clear pressure, the BOC can be expected to continue its tapering cycle, especially as the US Fed begins its own easing program. While over the long term this should provide a boost for stocks, the short-term impact of rate cuts may not be so positive for Russell. With limited interest expense and a large cash balance, Russel’s cash flow will benefit from recent high rates. This tailwind will lessen somewhat in the future.

Offsetting these depreciation effects, Russel will see revenue from recent acquisitions flow through. The recent deal with Samuel is one of four recent acquisitions that will contribute in Q3 and beyond. The value created by increased Capex is not likely to contribute until 2025.

Putting all this together, I would expect to see continued pressure on Russel’s earnings through the first half of 2025. I expect quarterly net income to remain around $50 million or $3.2 annualized (including seasonality) before to increase in the second semester of 2025.

This appears to be in line with analyst estimates, as shown by Seeking Alpha.

The consensus forward P/E ratio for 2024 is 11.9x, falling below 10x for 2025.

Analysts covering the stock are evenly split between BUY and HOLD ratings.

With an average price target of $46 or a 23% upside from current levels.

Risks to Outlook

I think with steel prices chasing a cyclical low, this earnings optimism is warranted. However, risks abound. Here are the main ones:

• Global economy lags recovery in steel demand.
• Deeper than anticipated recessions in Canada or the US.
• China is calling for the suppression of steel prices further and lower.
• Integration risk of recent acquisitions (I see this as low due to size.)

Conclusion – How I will play Russel

There’s a lot to like about Russel’s management and execution.

• Solid balance sheet with good cash and liquidity.
• Rational acquisition strategy.
• Shareholder-friendly capital management.
• Good positioning for a cyclical uptrend.

However, I think margin pressure could be sustained longer than anticipated and I see a downside risk to the share price heading into the end of the year.

• Worse than expected Q3 results.
• Market volatility around macro outlook and US election.
• Some tax loss sold towards the end of the year.
• Market multiple falls below 11x actual 2024 earnings.

As such, I believe that the 2024 share price lows around $34 could be revised in the coming months. This is about 10% below the price at the time of writing and about 10.75x expected earnings for 2024. I rate Russell a HOLD.

I’m currently short December guaranteed cash of $34 to target a $34 entry point. I will continue to sell OTM puts and buy direct on dips below $34.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.