Got nerves of steel? Try Gerdau

This exporter's stock responds with great volatility to changes in macro-economic sentiment.

By Jim J. Jubak May 9, 2012 9:26AM
Gerdau (GGB) offered pretty much what you'd expect in first-quarter earnings from a steel exporter in the current global economy, but after a 20% gain in 2012 -- more than twice the 9.6% pickup in Brazil's Bovespa index -- what you'd expect wasn't good enough. 

Shares of Brazil's Gerdau fell 2.3% on May 3 after the company reported earnings. The New York-traded ADRs (American Depositary Receipts) then traded down another 4.4% on Friday May 4 as the U.S. market sold off on a disappointing April jobs report. And Tuesday, Gerdau fell another 4% on the selloff prompted by another turn of the Greek and Spanish debt crisis. (Gerdau is a member of my Jubak's Picks portfolio.)

All this hasn't taken Gerdau quite back to where it was on Dec. 30 ($7.78), but, closing at $8.30 Tuesday, it isn't all that far away.

Let me begin with the company's first-quarter earnings report as the foundation for my suggestions of what to do with this stock. (Now, now, nothing quite that impolite.)

Gerdau reported first-quarter net income of $370 million reais ($192 million.) That was even with the fourth quarter of 2011 but down 5.4% from first quarter of 2011 net income of 391 million reais. Analysts had expected that net income would climb to 436 million reais. Revenue rose 10% from the first quarter of 2011.

In the short-term, the problem this quarter was the result of heavy rains in Brazil that hindered production. Exports dropped 21% in the quarter.

Longer term, the problems are rising costs and weaker global demand. The company's EBITDA margin (earnings before interest, taxes, depreciation, and amortization) came in at 11% -- even with the fourth quarter of 2011 but below the 13% level in the first quarter of 2011. The company's average selling price for it steel products climbed slightly but only because the U.S. economic recovery offset weakness in Europe.

In its conference call, Gerdau said that it intends to tackle rising costs with a $5.4 billion investment over the next five years in new production capacity and in expanding the company's iron ore mining operation. The goal in the iron ore unit is to bring capacity to 11.5 million metric tons by 2014, up from 6.5 million tons currently. That would make the company self-sufficient in iron ore -- enabling Gerdau to better control its raw materials costs -- and also give it significant export capacity.

The company said it expects demand and pricing to improve in the second half of 2012. That seems likely if the U.S. economy stays roughly on course and if demand in Brazil picks up thanks to infrastructure projects before the 2014 World Cup and 2016 Olympics. GDP growth in Brazil fell to 2.7% in 2011 from 7.5% in 2010, but is projected to improve to 3.3% in 2012, according to the central bank's most recent survey of economists.

The second half also promises another catalyst for the stock: That's when the company is expected to provide more details on how it plans to monetize the value of its iron ore operations either through a spin off and a public listing or some other strategy.

As of May 8, in recognition of the continued softness of the global economy I'm cutting my
target price for Gerdau's ADRs to $12 (that's roughly 45% above the $8.275 hit Tuesday) by the end of 2012 from my current $14.80 target. The ADRs pay a 1.4% dividend.

Don't expect anything like a straight line from Gerdau, however. The stock responds with great volatility to any change in the market's macro-economic sentiment. It rallied strongly at the beginning of the year when sentiment was positive on U.S. economic growth. It has been crushed recently when fears about U.S. growth have resurfaced -- along with a revival of fears focused on the euro debt crisis.

I think this leaves you with two alternatives. If you're a disciplined long-term investor with nerves of steel, you can use bottoms like the one that we're approaching again at $7.50 to $8 to build cheap positions in Gerdau. (You can then trim that position to take profits when it rallies or just hold on for the long-term since the fundamentals are sound.) If you're a decent trader, I think Gerdau has set up a pretty clear trading range that you should be able to navigate profitably over and over again until fundamentals assert themselves in the long run. (Jubak's Picks isn't set up as a trading portfolio, but that doesn't mean you can't use a Pick as a trading vehicle on your own.)

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. The fund did own shares of Gerdau as of the end of December. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here. 
Tags: GGB
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