Danieli & C Officine Meccaniche SpA DANR:IM
November 28, 2012 - 1:05pm EST by
flubber926
2012 2013
Price: 12.20 EPS $2.60 $2.50
Shares Out. (in M): 74 P/E 4.6x 4.7x
Market Cap (in $M): 1,413 P/FCF 4.9x 5.2x
Net Debt (in $M): -569 EBIT 224 205
TEV ($): 782 TEV/EBIT 3.4x 3.8x

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  • Steel
  • Manufacturer
  • Industrial
  • Italy
  • Buybacks

Description

Although an Italian company, Danieli is one of the global leaders in the design and manufacturing of steel plants. Through its wholly owned subsidiary (ABS), it is also a specialty steel producer. (75% EBIT plant manufacturing and 25% ABS).

We are recommending a long position on Danieli Savings shares, which trade at a 45% discount to the ordinary shares even though both classes have the same economic rights. The savings shares actually yield close to double the dividend yield of the ords (3.5 pct vs 1.8%), and both have similar liquidity.
Admittedly, the savings have historically traded at a discount to the ords.. Ranging between 10 and 52%.
 
We believe this to be a great company, operating in a good industry at a very attractive valuation.

 

The Company

Danieli is the combination of a very good business (plant making), which is roughly 75% of the company's EBIT and revenues and a moderate to good cyclical business which is specialty steel production.

Danieli produces 1mm tonn/yr of steel and is due to expand its capacity to 1.5mm tonn/yr in 2013. (additional capacity located in Eastern Europe). The company produces high quality steel for among others, the automobile industry in Italy (60% sales), o/w roughly half the sales are ultimately destined for the Italian export market. The remaining 40% are customers in Western and Eastern Europe. Needless to say, eventhough ABS is widely regarded as a highly speacialized, quality steel producer, this business (roughly 25% of consolidated sales), is highly cyclical and commoditized to some extent. We tend to agree with the consensus view that 2013 will be a tough year for steel producers given the global supply/demand dynamics only to be worsened within the European block due to well known economic conditions and at best, a slow recovery of demand. It is important to mention that our case for Danieli center's on its main business, which is plant building. In our proyections we model flat EBIT at ABS for the next 24 months even as capacity is increased by 50%. You can throw in your own numbers but as you'll see any upside from that number further increases our margin of safety. 

Why is Danieli such a great business if 1/4 of its sales are cyclical and commoditized? The answer is simple. Up to know, and that could change (we'll address that when we discuss risks), the plant manufacturing industry is an oligopoly in which three players (who've maintained very stable market shares amongst each other in the past), enjoy a 60%+ share of the global market.

 

Some history on Danieli

The company was founded in 1914 by the Danieli family and in its 98 years of existence has established itself as an undisputed technological leader in the design & assembly of electronic arc furnaces and steel plants which are based upon the DRI (direct reduced iron) technology.

Contracting a new mini mill is a big decision for most steel manufacturers since the average cost to build one ranges between €350 and €400 million. Because of the latter technology, know-how and reputation are decisive factors when choosing a plant manufacturer. These traits ultimately constitute a large barrier of entry to deter potential competitors (it takes a long time to build that reputation and huge investments to garner the techonology), and in our opinion also cast a wide moat for the company itself.

When conducting our checks with competitors and former clients, we came to realize that the average Danieli executive (managers and up), have been with the company for an average 25 years. People start working at Danieli and expect to retire while working at Danieli, so to say. The company has a very strong corporate culture.

The best example of this is the CEO itself. Mr. Benedetti (current CEO), first joined Danieli in the early 1970's, was appointed Group Sales Director in 1977, Director of Engineering in 1980 and has been CEO since the early 1990's.

This company which is based in Buttrio, Italy became a global force within its industry under Mr. Benedetti's stewarship. 

Danieli today has 8 production plants spread across the globe (two in Italy, two in Germany, two in mainland China, one in Thailand and one in Austria) and 16 design and engineering departments which are geographically diversified as well (Ukrania, Poland, Romania, Spain, UK, Germany, Switzerland, Japan, Brazil, France, Sweden, Vietnam and the US), a necessary condition in order to compete in their niche and again, we'd consider another point which only strengthens their competitive moat.

Technological innovation is engrained in the company's corporate culture. Research and Development has always been a priority for Danieli. The company spent €282 million in R&D at the height of the financial crisis, 9% of sales.

Their order backlog is widely diversified as well, only 26% of their backlog are clients in Europe and Russia. The Far East and Australia are the largest geographical exposure with 40% of the orders, followed by Europe and Russia, Africa and The Middle East (20%) and The Americas with 14% of total backlog.

 

The Plant Engineering & Construction Industry

The total market value for the E&C market in 2013 is expected to be around €10-12 billion.  35% for equipment and plants for flat products, 35% for long products and the balance for other sectors (tube plants, DRI, etc).

A full 70% of the market is shares by four big players: SMS Siemag, Siemens VAI, Danieli and a Japanese JV.

The remaining 30% is fragmented within a number of small and medium sized companies in different geographies. These companies only have ability to compete on particular technologies and have mostly been active in the revamping projects.

Global steel consumption stands today at around 1,450 M/tons.

We've read various reports which argue that by 2020, as a consequence of economic fundamentals in EM and developing makets, urbanization and industrialization trends and growing GDP per capita among other factors, global steel consumption will hover around 2,000 M/tons.

A little over 80% of the global increase in steel consumption during the last 10 years (around 400 M/tons), have come from China. Going forward, Chinese demand should moderate while other regions such as India, Brazil, North Saharan Africa and The Middle East should not only compensate but drive production. 

Plenty reports have been written on this subject and are easily accesible thus I will not bother you further with economic trends or projections to which we in actuality give little weight given the undervaluation of this company.  

 

 

Danieli's business model - the cash cycle

 

As we've previously tried to explain, customers choose Danieli for its reputation (time delivery, quality), technology (technological solutions, reduced energy consumption, environmental friendliness), and financial strength which is an important factor when you consider that it takes two to three years to complete a plant.

The business relationship between Danieli and its customer begins with a one to three month consultation in which the company builds it technical proposal, equipment list and cost estimation among other things to determine a project price.

The next step is normally a three to five month period of time in which negotiations take place, financial, legal and commercial conditions are set and ultimately end with a final contract between the two parties. In this stage Danieli, recieves its first down payment and the financial package is commited.

Once the contract is in place, the whole process of Engineering, planning and logistics begins, Danieli manufactures and sources components, conducts site improvements and necessary buildings and ultimately installs and supervises the plant. The process concludes this phase with testing, commissioning and startup.

Plant startup is normally an 8 month process which commences oncethe plant has been commissioned.. Danieli engineers remain on site for technical support and training.

As said once the contract is signed this is a two to three year process.

The nice part is that Danieli is paid progressively through these stages but will generally have been paid 100% by the end of the second year.

Thus, as you'll next see it really has no capital requirements. The entire operation is financed by its clients. Negative working capital and infinite returns on invested capital. In our opinion a very attractive business proposition to say the least.

 
Valuation
 
The following table is really self-explanatory. We derive the market cap by multiplying the ordinary shares outstanding by its market price and adding that to the savings shares outstanding by its market price.
 
As said before, both share classes have the same economic rights (although savings shares have a guaranteed higher dividend), the only difference between the classes are voting rights.
 
We substact customer advances and provisions (pension obligations are fully covered), from the company's net cash as if this were a run-off operation.
 
 
Danieli 2012 2013
Saving shares 35,7 35,7
Ordinary shares 38,1 38,1
Price savings 12,2 12,2
price ordinaries 22,5 22,5
Market Cap 1.294 1.294
Net debt -1.351 -1.339
Customer Advance 713 709
Provisions 258 258
E Value 782 789
     
Sales 3.081 3.000
EBITDA 313 296
EBIT 224 205
FCF 165 143
     
EV/Sales 0,3 0,3
EV/EBITDA 2,5 2,7
P/FCF 7,8 5,5
     
     
WC levels -713 -709
Delta 40 -5
     
NOPAT 150 150
Adj C.E. -33 121
ROCE  -454% 124%
     
FCF yield/ EV 19,7% 17,8%
 
 
As seen, at current market prices you are able to buy this company for 2.5x FV/EBITDA with a 18-20% free cash flow yield.
 
The market is valuing Danieli as if it were to cease to exist within the next five years or so in our opinion.
 
Management apparently believes that it's shares are undervalued as well.
 
The company completed an 8%+ share buy back (cancelling the shares) in early October. Important to note that management bought back double the number of savings shares than the ordinaries repurchased.

 

Risks

We see one important risk: that is that Chinese companies have only built plants for local steel makers up to now. (The Chinese companies are accounted for in the 30% market share that we discussed). It is only a matter of time when local demand tempers and they start building outside of China.

These companies are price disruptors. Up to now, technological know how and quality have been the main competitive advantage of Danieli and the other three niche players. Chinese companies are quick to copy and adapt technology and can afford to discount pricing in order to gain into such a lucrative market.

The question is how much time will Danieli's (and for that matter SMS Siemag and Siemens VAI), moat will last.

Our take is that it will be tested, perhaps diluted to some extent but it'll take longer than what the current valuation affords.

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1. Continued share repurchases
2. New backlog being contracted
 
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