Gerdau grew from a small nail factory that was founded in 1901 in Porto Alegre, Brazil. As the nail business grew, so steelmaking was added in the 1940s and 1950s and diversification into wire drawing then followed. Expansion based on a number of foreign ventures across North and South America took place during the 1980s and 1990s, with creation of Gerdau Ameristeel in 2003 [together with Canada's Co-Steel] representing an important milestone, and the $1.5 billion acquisition of Quanex in 2007 and $4.2 billion 2007 acquisition of Chaparral Steel especially noteworthy also.
Gerdau S.A. (GGB) is a leading steel producer in Brazil with operations in South America, North America and Europe. The company is also the largest producer of long steel in the Americas. Gerdau produces steel, mostly through mini-mills and distributes steel products through its own network of 68 commercial Gerdau branches in Brazil. The company operates 26 steel mills and plants in Argentina, Brazil, Chile, Colombia and Uruguay. During 2006, the group produced 15.6 million metric tons of slabs, blooms and billets, the output of rolled products reached 12.7 million metric tons.
In the North American market, the company operates through its subsidiary, Gerdau Ameristeel. Its North American facilities are based in both the U.S. and Canada. Gerdau's business strategy is focused on the decentralized production of long steel with electric arc furnace (EAF) mini-mills employing continuous casting technology. Additionally, Gerdau has three integrated mills. Plants are sized and located to meet the needs of local markets and to access customers efficiently. This plan is a response to the geographical dimensions of Brazil and the U.S. as it relates to transportation and high freight costs. As a result, Gerdau is able to supply its customers and purchase raw materials locally. During he first three quarter 2007, the Brazilian business accounted for approximately 47% of total revenue, North American business represented 32.8%, Europe represented 9.6% and other South American countries represented 10.6%.
Gerdau has been benefiting from rising steel prices, despite the more challenging international economic environment in recent months. Nevertheless there has been some volatility in prices. Steel prices have declined during the end of 2006 however, there was a price recovery in the first quarter 2007 and during the second quarter 2007 steel prices were stable in a very high level. In the third quarter 2007 steel prices reached the top again and kept on rising in the end of 2007. The rebound in price was due to the continued growing demand for steel in Asia, particularly China and the consolidation of this industry in recent years. The graph below shows the Global Steel Price index, published by the London-based CRU international.
The consolidation of the steel sector that has been taking place in the last three years is also responsible for the continued high price levels in the international steel market. During 2007, there was an important consolidation round when the Indian steel maker Tata Steel Group decided to make a US$8 billion bid for the Anglo-Dutch steel maker Corus. We believe there is still room for more mergers in the followings quarters and the Brazilian companies are targets. Gerdau in particular is not an obvious target since the company is very traditional and geographically diversified, nevertheless all Brazilian companies could be considered as targets for mergers and acquisitions.
While steel prices are still high, the threat of Chinese production increases remains. China recently became a Steel exporter, and this development will certainly have a huge impact on international steel prices in the medium-term. Increasing production in China coupled with lower economic growth in the U.S. increases the chances that steel prices might be reaching a cyclical peak. The continued difficult situation in the U.S. housing sector as a result of the subprime mortgage problem is a concern, mainly considering the huge exposure of Gerdau to the North American market through its subsidiary Ameristeel. The U.S. market has been facing continued problems in the housing sector and the short-term outlook remains highly uncertain, particularly in the construction sector that is directly affected by mortgage crisis. After all the recent problems in the subprime system and some concerns over the financial sector in the U.S., we understand the risk of a recession in the U.S. in the following quarters has increased considerably.
In the last few weeks, Brazilian newspapers have been reporting that negotiations between CVRD (RIO the biggest iron steel producer in the world) and Baosteel (the biggest Chinese steel producer) have been fierce and that price increase for iron for 2008 should be between 30% and 50%, a huge increase, mainly considering the current business environment and widespread fear of a U.S. recession in the very short-term. We are concerned that higher steel prices coupled with a more challenging economic environment in the U.S. could undermine GGB s operating margins. Also concerning is the less benign monetary policy in Brazil. In fact, Brazilian Central Bank decided to stop to cut basic interest rates in the very short-term. After the August Bank meeting an official report was released with strong comments on domestic inflation pressures and in October it was decided to leave rates unchanged for the first time in 2 years. In December 2007 and January 2008, rates were left unchanged again.
Third quarter results were very positive. However, it is worth noting that the company's debt has been growing quarter-after-quarter due to the continued expansion/acquisitions. We understand that GGB is more exposed to the risk of falling prices of steel in the very short-term as a result of its continued expansion program based on higher debt. In fact, during the third quarter 2007 net debt increased 179% year-over-year due to the payment for the acquisition of Chaparral Steel Company. Considering the risks of the current business environment, we believe it is time for a cautious approach on GGB.
Gerdau has been expanding internationally in order to reach new markets. On July 10, 2007, the North American arm of Gerdau, Gerdau Ameristeel (GNA) announced it signed a definite merger agreement to acquire Chaparral Steel Company for US$4.2 billion. Also on July Gerdau acquired D & R Steel LLC in Arizona and Trefusa in Spain. On June 22, 2007, Gerdau announced the formation of a joint venture with Kalyani Group from India in order to establish an Indian company called SJK steel plant limited. The new facility will be a mini mill with capacity of 275 thousands of metric tons of liquid steel per year. During the second quarter 2007 there was other less important acquisitions, like Siderurguca Sizuca in Venezuela, Valley Placers Inc in the U.S., Industrias Nacionales in the Dominican Republic and Siderurgica Tultitlan in Mexico. On October 2007, Gerdau announced that it signed a letter of intent for the acquisition of a 49% stake in the capital stock of the holding Mexican company Corsa Controladora, S.A. de C.V., which holds 100% of the capital stock of Aceros Corsa, S.A. de C.V. and of their distributors, paying US$100 million. On November 2007 Gerdau has signed a definitive agreement to acquire Quanex Corporation, for US$ 39.20 per share in cash. Quanex Corporation, through its MacSteel division, is the second largest producer of specialty steel in the U.S. We are afraid that the continued expansion of Gerdau and its high debt will make the stock more exposed to the risk of a recession in the U.S. market in the very short-term.
Finally, we remain concerned over the continued strength of the Brazilian real. Even though the difficult international economic environment, the Brazilian currency remains close to its highest point in more than seven years. Particularly concerning was the recent decision of the Brazilian Central Bank to stop cutting interest rates coupled with falling rates in the U.S.. The real remains strong and should stay strong for some time. The continued strength of the real is undermining Gerdau's competitiveness. While Gerdau has found some ways to benefit from the currency strength like increasing the amount of debt denominated in U.S. dollars, the net result is definitely a negative for the company.
The economic outlook of Latin America remains positive. However, at this point, it seems that steel prices will soon be affected by the more challenging international economic scenario. Also important to mention is the continued increase in costs for some important inputs like iron ore. The slower economic growth in the U.S. points out to the steel price reaching a cyclical peak in the short term. All things considered, we are changing our current recommendation on GGB from Hold to Sell.