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Business Valuation of Steel Dynamics, Inc. NASDAQ – STLD
manufacturers, mining companies, off-highway construction equipment, steel producing
mini-mills, copper refineries, secondary smelters and more.
In 2008 however, the recession has put more bargaining power in the hands of
the customers, because demand for steel has fallen. In Nucor’s 10-K, they directly
addressed the issue, stating: “Due to the global liquidity crisis, capital spending and the
related demand for our steel products remains depressed.” U.S. Steel’s flat roll division
sells mainly to automotive, appliance, and construction-related industries and thus
because of the global recession has suffered lower demands.
30%
21%11%
10%
14%14%
Total Tons Sold to Outside Customers in 2008 for Nucor
Corp. Sheet
Bar
Structural
Plate
Raw Materials
Downstream Products
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Steel suppliers typically diversify their risk of losing customers by selling to many
different industries and by doing so also increase their bargaining power. Nucor’s many
different customers are represented in the pie chart above. U.S. Steels attempt at
diversification is witnessed through them having “no single customer account for more
than 10% of gross revenues (U.S. Steel 10-K).” This ultimately creates more
negotiating power for the steel industry.
Volume per Costumer
The quantity purchased by each customer is important for a company to better
position themselves in an industry. For example, since service centers make up the
largest portion of steel sales then SDI and other steel processors target their production
toward the service center’s uses. Volume per customer is also important in that a
customer who buys in large bulk or makes up the majority of a company’s sales is going
to have a lot more bargaining power then a customer who purchases a small amount of
steel products. In this section we are trying to determine if the customers monopolize
the steel industry’s sales enough to influence their bargaining power over the steel
suppliers.
The volume per costumer is determined in a “negotiated spot sales contract
which establishes the quantity purchased for the month (STLD 10-K).” Listed below is
Steel Dynamics break down of their Flat Roll Division’s costumers:
Customers: 2006 2007
Service Center (including end-user intermediaries) 82% 80%
Pipe and Tube 4% 6%
Original equipment manufacturer 14% 14%
Total: 100% 100%
The push relationship between customers and steel producers is apparent in the volume
per customer as well. Steel firms attempt to diversify through the number of customers
they sell to and the amount they sell. Customers do not have much bargaining power in
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this aspect because the volume bought per customer only totals a small portion of the
producer’s overall net sales. AK Steel and U.S. Steel have additional bargaining power
because they sell domestically and internationally. This allows them to find customers
anywhere, taking away part of the customer’s ability to negotiate steel prices. The
percent of AK Steel’s customers internationally and in the United States are represented
in the following table.
Geographic Areas 2008 2007
Net Sales % Net
Sales % United States 6376.4 83 6077.9 87 Foreign Countries 1267.9 17 925.1 13
Total 7644.3 100 7003 100 The table shows that of AK Steel’s sales 17% (an increase of 4%) were sold to foreign
countries. On the other hand with the market down and steel stock prices down, the
demand for steel has decreased and the price increased (Wall Street Journal).
Conclusion
The bargaining power of customers is stronger because of their low switching
cost, similarities of steel quality, importance to price and cost leadership and the state
of the current global economy. This strength influences ore and steel prices to
decrease, which they have been since July 2008. The bargaining power of the
customers is weak in the areas of the number of customers and the volume per
customer. Bargaining power is determined by one’s negotiating abilities to affect prices.
Thus the steel prices can be raised by the suppliers here. These factors lead us to
conclude the costumer has a medium bargaining power.
Bargaining Power of Suppliers
The bargaining power of suppliers shows who “wears the pants” in a supplier’s
relationships with their customers in reference to price. Again, bargaining power can
either be high, low or moderate. The extent to which either the supplier or customer
can control prices and how is determined through the six sectors that we look at to help
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analyze an industry. Depending on who has the power we can further categorize an
industry. We will use bargaining power of suppliers as a tool to discover who has
control of prices in the steel industry.
The bargaining power of suppliers is the extent to which a supplier can dictate
costs. The suppliers provide the steel producers with steel scrap and scrap substitutes.
These include ferrous, nonferrous, processed and unprocessed scrap metals. Other
inputs into a steel factory are electricity and gas. Steel Dynamics, AK Steel, U.S. Steel,
and Nucor purchase their raw materials to produce the steel from scrap and scrap-
substitutes suppliers. In short, the suppliers are steel scrap or substitute factories. The
price of scrap depends mainly on the quantity demanded in the market. Currently, the
market and economy are suffering. The economy has really taken a toll on the steel
companies, Nucor Corporation, for example, reported a 71% drop in earnings, and the
decreased demand is affecting customers, firms and suppliers (U.S. Steel Warns-WSJ).
Also, On January 30th, 2009 the Wall Street Journal reported 2008’s 4th quarter earnings
for many industries, including the Iron and Steel Industry. The steel industry reported a
net loss of $89.846 billion, (Industry-to-Industry). With demand low the suppliers have
more power to charge a higher price. The iron ore prices (c/dmtu) went from $80.47 in
2007 to $140.6 in 2008 (Steel on the Net). This follows the Law of Demand, as demand
decreases, prices are inversely affected and will rise. Since the Steel firms are now
paying more for their raw materials and inputs from their scrap suppliers, then earnings
will continue to decrease.
Normally suppliers have the most bargaining power in highly competitive
industries, however, with the recession the scrap suppliers are suffering as well as the
producers. If the suppliers are suffering then the steel industry gains the ability to
negotiate prices. Furthermore suppliers fear the threat of forward integration, which
does exist with Steel Dynamics, AK Steel and several others. To evaluate the bargaining
power of suppliers further we will examine their switching costs, differentiation,
importance of product for costs and quality, number of suppliers and volume per
supplier.
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Switching Costs
The cost for a supplier to switch customers (steel producers) is high. Even
though there are fewer suppliers than customers, the customers purchase in large bulks
and generally have lasting contracts with the suppliers. This gives the power to the
customers to choose what price they will pay. This also strengthens supplier-buyer
relationships, which additionally increases the power of the customer. The suppliers do
have some negotiating power in small customized market segments. In the steel
industry the “least costly method of making steel uses scrap metal as its base;” so steel
scrap suppliers have more power than other scrap substitute suppliers, like iron (STLD
10-K). Having a demanded commodity gives the steel scrap suppliers the most power,
which is still limited. The suppliers also have bargaining power because there are not
many alternative raw materials for steel manufacturers to use. Nucor commented on
the lack of substitutes, stating “if our suppliers increase the prices of our critical raw
materials, we may not have alternative sources of supply (Nucor 10-K).” Overall, for
switching costs the suppliers have the bargaining power.
Differentiation
Steel scrap is steel scrap. It is a major input that is just melted down and then
molded. It is difficult for suppliers to differentiate themselves through quality or
customization so instead they focus on price and contracts with customers. If there is
little differentiation between suppliers then buyers have control over prices. The prices
reached a high of $865 per ton in 2008, indicating the suppliers’ power (SDI 10-K).
Another way buyers are differentiating themselves is forward integration and
acquisitions of suppliers. U.S. Steel for example acquired 50% of ApoloTubulars, a
Brazilian supplier of welded casing, tubing, and line pipes (USSC 10-K). Another
example of steel firms gaining control of suppliers through acquisitions is when Steel
Dynamics bought OmniSource, one of North America’s largest scrap recycling
companies, who in 2007 “supplied [Steel Dynamics’] steel mills with 15% of their
ferrous raw material requirements (STLD 10-K).” Forward integration threatens the
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power of suppliers and grants the buyers more bargaining power. A supplier can
however, differentiate themselves through geographic location. Suppliers try to be near
their customers so shipping costs are cheaper. Good geographic location allow suppliers
to form better relationships with buyers in the area, thus giving the suppliers more
power to charge a higher price.
Importance of product for cost
The cost of the product is extremely important. The customer’s goal is to get the
greatest amount of steel at the lowest price. If the price is too high the customers have
the power to switch suppliers. The ore prices are determined by the composition of the
scraps, the quality, size, weight and location of the materials. Customers of recycling
companies are looking for these listed factors at an affordable price. This does give
some power to suppliers, but unfortunately the quality, size and weight of materials are
relatively the same between suppliers. Cost does have a greater importance when
purchasing specialty goods, allowing the supplier some bargaining powers.
Importance of product for quality
Customers are looking for a certain amount of quality in their steel scraps. The
value and price of the supplier’s product is “determined by specific needs and
requirements of the consumer (AKS 10-K).” This is representative of the customers,
such as steel processors, having more influence in their contracts than suppliers. The
customers set the requirements of a contract and the suppliers strive to meet the
agreement. The quality of the scraps for most steel companies is not nearly as
important as price, which explains why most companies use scrap metal as its base.
Customers focus on cost efficiency and not so much the quality on the inputted scraps.
It is the final product that has more emphasis on quality.
Number of Suppliers
There are more customers than suppliers. They form contracts illustrating the
customers are able to drive down price because of the number of suppliers they buy
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from. In these contracts some steel firms will not “purchase a material amount of scrap
metal from a single source” in order to protect their assets (STLD 10K). They do buy in
bulk but from multiple suppliers so as to eliminate unsystematic risks. Since competition
is so high, often firms in the industry spread out their purchases similarly. Not
purchasing a material amount from one supplier emphasizes the bargaining power of
the buyers. Inputs into steel facilities besides scrap include electricity and gas. Nucor
speaks for the entire industry when they said “steel mills are also large consumers of
electricity and natural gas (Nucor 10-K)”. Many contracts are formed with utilities
companies for a discounted price. Even in these relationships the buyers have power
over price because they require such a large amount of electricity and gas that the
supplier corporate health is affected by their partnerships. It is common in the steel
industry to enter into fixed supply agreements with electricity companies.
Volume per Suppliers
“No single scrap metals recycler has a significant market share in the domestic
market (STLD 10-K).” This indicates the competitiveness of the suppliers. Suppliers
want to sell in economies of scale and at great volumes to increase revenue and their
bargaining power. Due to forward integration, suppliers continue to lose power and the
volume they supply is decreasing. This is witnessed through SDI’s acquisition of Iron
Dynamics, who “during 2007 supplied 252,000 tons of direct reduced iron” to SDI. It is
also witnessed through Nucor’s raw material strategy of upstream goal to controlling
approximately 6,000,000 to 7,000,000 tons per year of high quality scrap substitutes for
consumption by the steel mills” (Nucor 10-K). Customers are creating their own
methods of getting raw materials and need to import less and less from scrap suppliers.
This places the bargaining power further into the hands of the customer.
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Conclusion
After analyzing the bargaining power of suppliers we conclude that the steel
industry has a medium level of power. The moderate level is because of the “push”
relationship between the suppliers and the steel processors. They are continuously
fighting for control over price. Especially with the economy hurting the steel industry
the power has more recently moved towards the suppliers.
Analysis of Industry Value Creation and Key Success Factors
Classifying an industry and identifying key success factors is crucial in order to
understand how firms create value and use competitive strategies to gain critical
advantages. There are two basic competitive strategies that firms focus on in an
attempt to form competitive advantages. The first strategy, cost leadership, focuses on
supplying the same basic product as its competitors at a lower cost. Often, firms try to
lower input costs while finding ways to decrease the cost of distribution, both in and
out. Also, limiting the amount of investment into research and development, realizing
economies of scale, and instituting tight cost control systems are forms of cost
leadership. Differentiation, the second strategy, focuses primarily on “providing a
product that is distinct in some important respect valued by the customer” (Palepu and
Healy 2-9). In order to do this, the industry must have some type of qualitative
characteristic that customers can use to distinguish between the products of multiple
suppliers. Firms that use this strategy often attempt to provide superior product quality
and variety. They also focus on better customer service and make investments in
brand image as well as research and development. When a firm chooses to focus on
one of these routes, they enable themselves to possibly gain a higher profitability in
their industry.
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Classification
The Five Forces model provides a method to determine an industry classification.
Using the information discussed in the previous sections, we can infer the following.
Steel manufacturers face a high degree of uncertainty in their industry, which translates
to a significant amount of risk involved with decision-making. Differentiation is a
difficult strategy for steel producers to rely on because steel is a highly competitive,
commodity industry. Commodities are things that are not easy to differentiate along
lines of quality. With little threat of substitute products in key customer industries, such
as the appliance or automobile industry, steel manufacturers can operate at virtually full
capacity. For most of the primary customers, a certain gauge of rolled steel is basically
the same wherever it is purchased. Therefore, the steel industry can be classified as
primarily geared towards effective use of the cost leadership strategy. However, the
selection of one of the two strategies does not always lead to a sustainable competitive
advantage. For this reason, we will explore how the steel industry adds value by
primarily using cost leadership and a minimal amount of differentiation tactics.
Cost Leadership
The primary source of raw materials for the steel industry is ferrous scrap
material. The sources of scrap are extremely varied, ranging from scrap derived from
in-house operations to obsolete automobiles, appliances and even railroad materials.
Therefore, the suppliers of such materials add basically no value to the chain. It is up
to the producers of steel products to transform these raw materials into products that
intermediate and end users desire. In order to add value using a cost leadership
strategy, firms in the industry must focus on a laundry list of tactics, and by doing so
can ultimately add significant value to the entire chain. The following subsections will
explain in detail the meaning, significance, and proper use of said laundry list.
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Economies of scale
In an industry such as steel, it is no great mystery that size matters. For
example, in the past two years US Steel has acquired numerous facilities, including
numerous sites previously owned by Lone Star Technologies Inc., and Stelco Inc., and
they have done so for a very specific reason. Just as Steel Dynamics acquired
Omnisource, US Steel is attempting to increase the size of their infrastructure. Cost
leadership focused industries are constantly looking for ways to increase their firms’
size. Economies of scale are defined as “the cost advantages that a business obtains
due to expansion” (Wikipedia.org). Therefore, by acquiring other segments of industry,
steel producers can gain a critical advantage over firms that are simply “making do”.
The ultimate production of a steel firm must be a function of its size. Thus, when a
firm in the industry can use economies of scale to their benefit, they can generally
expect to see increases in profitability. Nucor Corp. attributed their success of being
“North America’s most diversified producer of steel and steel products” (Nucor 10-K)
almost directly to their recent acquisitions. The evidence is undeniable in the steel
industry; by using economies of scale as a part of a cost leadership strategy, any one
firm can dramatically increase their profitability.
Efficient Production
For a firm to add value to the supply chain, they must be able to take something
of little worth and transform it into something else that has great worth or usefulness.
In very simple terms, the steel industry takes materials that would serve no purpose
other than land-fill, grinds them up, melts them down, and uses the molten metal to
create value adding products for numerous industries. Whether the firms are producing
high or low gauges of hot or cold rolled steel or specialty products that involve more
complicated steps, production processes must be efficient in order to possibly gain a
competitive advantage.
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Efficient production in the steel industry focuses on eliminating waste and
reducing scrap. Granted, the scrap can possibly be recycled and used again, but this
ignores the concept of getting the most out of your labor. Firms in the steel industry
want to be as efficient as possible because of the high energy costs associated with
their production processes. Because domestic steel producers face stringent
regulations regarding environmental concerns, firms in the industry typically invest in
projects the will improve efficiency while eliminating legal concerns. For example, AK
Steel spent one million dollars in 2008 rebuilding one of their “clarifying cooling towers”
(AK Steel 10 K). This investment allows one of the main ingredients, carbon, to be
used more efficiently which can dramatically increase financial results and ultimately
creates value in the long run. US Steel also creates value by using “recoverable” tons
(meaning that they obtain materials internally) to increase iron ore production by nearly
one million tons from 2007 to 2008. This method of increasing efficiency plays a large
role in the future profitability of steel firms.
Also, the steel making process produces numerous spillover costs to the
environment and even the employees themselves. Dangerous work environments and
toxic pollutants are of great concern among all firms in the industry. For this reason,
strict standards and procedures are enforced throughout operations and any other
business activities. For example, by making significant improvements in safety, US
Steel has reported a 62% improvement from 2003 to 2007 in terms of injuries per three
hundred thousand man hours worked.
Another instance where firms in the industry are creating value and keeping
costs low is “in-house” operations with regards to specialty items. Steel Dynamics
exemplifies this very well with their on-site paint line. This segment of their business
“receives material directly from [their] other processing lines and is capable of painting”
(SDI 10-K) hot and cold rolled galvanized coils as well as regular cold rolled coils. Steel
Dynamics Inc. considers itself to be the only mill in North America that can offer such
services on-site and they use it to “realize substantial savings” (SDI 10-K) in a variety of
costs.
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The steel industry attempts to monitor and allocate resources in order to
maximize profit potential and increase the amount of value added into the supply chain.
Firms watch the job sheets in the facilities very closely to ensure employee accuracy.
Monitoring the amount of overhead is also very important to the steel industry. By
keeping a constant eye on operations in all mini-mills, from the arc furnaces to the
incoming scrap yard, firms in the steel industry successfully use cost control devices as
part of a cost leadership strategy.
Therefore, with the combined forces of using high tech production components,
minimizing waste, reducing scrap, and getting the most out of their labor forces
through the use of safety regulations, firms in the steel industry demonstrate how
efficient production as a cost leadership tactic can lead to a competitive advantage.
Simpler Product Designs
For the most part, steel producers in the United States focus on providing basic
need items for various customers. US Steel states that it is their focus to provide value-
added steel products. Since rolled steel sheets and beams are basically the same
anywhere you choose to purchase them, there is little that the firms can do to increase
their profitability in terms of product differentiation. Even though Nucor prides itself on
producing to customers orders, with regards to specifications, the very same tactics are
being used across the industry. One example of a firm in the steel industry branching
out from the typical simple product designs is AK Steel’s move towards meeting new
found product demand. Despite typical industry norms, AK Steel is expanding its
product design to meet demands for “high-end, energy efficient grain-oriented electrical
steels” (AK Steel 10 K). However, it is only a matter of time until all domestic firms in
the industry follow suit.
Therefore, using the cost leadership strategy of using simple product designs,
the steel industry gains a significant competitive advantage over industries attempting
to “build a better mousetrap”. It makes little to no sense for a steel firm to try to
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compete on any other ground than cost control. With that said, we will move on to the
next item on the list, which is lowering input costs.
Lower Input Costs
Historically, the prices and availability of the two main inputs in the steel industry
have been relatively solid. However, in the past few years, the cost of energy and raw
materials has been volatile. Therefore, it is clear that in order to be a cost leader in the
industry, firms must find ways to cope with the changing situations. With regards to
energy costs, this can be easily remedied by signing a “fixed price interruptible
electricity supply agreement” (SDI 10-K). When such a contract is signed, price levels
will decrease, however the supplier of electricity will gain the ability to interrupt the
service in the event of some unforeseen emergency “or in response to various market
conditions”. This type of agreement might allow firms to realize lower costs in terms of
electricity. Another large portion of energy costs that steel firms encounter is natural
gas. Nucor has been able to cut costs on gas by entering into long term contracts. In
order to minimize price volatility in this market, some firms have attempted “entering
into hedging transactions on the futures markets” (SDI 10-K), which in basic terms
means they are investing money in firms that provide the energy, hoping to increase
stability down the road. According to multiple Form 10Ks, firms are paying for energy
at current market prices. With that said, it seems to be perfectly clear that firms in the
steel industry have trouble controlling these types of costs. Therefore, it is nearly
impossible for these firms to lower energy costs while increasing the amount of added
value.
The availability of raw materials and their related prices is a great concern for all
steel manufactures. For instance, AK Steel’s operating costs in 2008, nearly $780
million, were primarily due to increasing raw material costs. Despite the fact that the
amount of input varies per ton of steel depending on numerous factors, that amount is
still relatively gigantic. Scrap prices are well known for their unpredictability. Since steel
producers require enormous amounts of raw materials, the only was to cut costs is find
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a way to be your own source of materials. However, this tactic will never be viable all
by itself. Steel producers have been able to lower their input costs by acquiring other
scrap processing firms, but they still rely heavily on outside suppliers. Firms in the
industry have also tried to control costs of raw materials, but the end result in all cases
appears to be that this source of adding value is very difficult to perfect.
Low-cost Distribution
Firms in the steel industry have positioned themselves in such a way that
shipping to customers is at maximum efficiency. By increasing the number of mini-mill
locations, and by setting up shop typically along major access points for various forms
of transportation, firms in the steel industry have maximized cost control to the best of
their ability. To gain a better understanding of exactly how many locations steel firms
might have, we can list the states in which Nucor Corp. has operations: Arkansas, South
Carolina, Indiana, Alabama, Texas, Utah, North Carolina, Washington, Illinois,
Connecticut, Mississippi, New York, Ohio, and Nebraska. Nucor has steel mills in all of
these states, which can dramatically reduce shipping costs because of the large web of
locations. AK Steel only has facilities in Ohio, Indiana, Kentucky, and Pennsylvania.
Having fewer locations to ship from reduces their ability to keep distribution costs low,
and may negatively affect their cost leadership strategy.
Freight charges will vary for different modes of transport, and the ever-
unpredictable oil industry has gas prices constantly fluctuating. With situations as
volatile as they are, the only real way for firms in the industry to add significant value is
to set a flat rate for their customers. The industry uses trucks and railways to get their
products where they need to be, and for the most part, the shipments are delivered
promptly. By expecting variations in transport costs and adjusting business activities to
deal with such variances, steel producers maintain a tight control on distribution costs.
Also, having access to vital waterways such as the Ohio River has provided numerous
firms with a competitive advantage. Therefore, strategic geography plays a large role
in firms’ desire to be a cost leader using low-cost distribution.
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Research and Development
There are two basic types of research and development. The first type results in
new product lines. This form of R&D makes very little sense to the steel industry.
Therefore, adding value in the industry revolves around researching and developing
new methods for reducing steps in processes. This form of industrial engineering is very
common for steel producers, as they are constantly looking for new ways to improve
their operating activities. These firms might also invest in finding alternative iron-
making technologies. Most of this research is done “in-house”, and it comprises very
little on net spending. In fact, US Steel employs only 115 individuals in their research
division, which is roughly 0.2% of total employees. However, when a break through
does occur, the firms can pass along savings to their customers thereby increasing the
amount of value added.
Brand Advertising
Advertising is a selling expense for basically all firms across the country. Since
the steel industry focuses on cost control as a main source of achieving competitive
advantages, it does not typically spend a great deal on brand image or advertising.
Commodity items such as steel products are hard to differentiate simply by placing ads
in publicly distributed releases. For this reason, more personal selling is used by firms
than advertising. By giving customers personal attention, rather than hoping to reach
all customers across the nation, firms can possibly gain an advantage over another.
Therefore, it is obvious that using cost leadership as a business strategy implies very
little use of brand advertising.
Differentiation
The strategy of differentiation is not totally irrelevant for the steel industry;
however its use is very limited. The two basic ways firms attempt to differentiate are
by providing product variety and flexible delivery. With numerous mills and facilities
located across the nation, Nucor and the others offer customers fast delivery at a basic
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market price. Also, the firms in the industry do not simply make one type of steel. For
instance, US Steel provides products for the appliance, automotive, and construction
industries. By allowing themselves to sell to numerous customers, they are able to
increase their profit potential and perhaps realize significant gains. Therefore, while the
industry mainly focuses on a tight cost control system, there is evidence that
differentiation strategies are being used.
Conclusion
When analyzing an industry, it is crucial to identify the critical success factors in
that industry. The two basic competitive strategies, cost leadership and differentiation,
are sources of advantage. We classified the steel industry as a picture perfect example
of who would use cost leadership. Firms can offer a basic scope of steel products in a
low concentrated industry and compete with each other for customers. Using tactics
like realizing economies of scale, use of efficient production methods, little investment
in research and development or branding, simplifying product designs, and attempting
to lower input costs, firms will surely be effective users of cost leadership. We will now
look deeper into Steel Dynamics Incorporated, and evaluate their competitive
advantages
Firm Competitive Advantage Analysis
While there are more than a few ways to characterize firm’s strategic business
activities, there are two commonly referred to competitive strategies that allow for easy
comparison and evaluation. The two strategies are generally accepted as mutually
exclusive, meaning that a firm traditionally chooses a path of cost leadership or of
differentiation. In the highly competitive commodity market that steel represents, it is
very common for a firm to focus on cost control. Steel Dynamics attempts to lead the
way in cost control as well as offer their customers a variety of quality products for
various uses. Core competencies for the firm include state-of-the-art low cost facilities,
an experienced management team, a unique corporate culture, a diversified product
mix, and strategically located shipping and manufacturing facilities. We will elaborate
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on how Steel Dynamics utilizes these competitive strengths to gain an advantage in all
aspects of their business.
Economies of Scale
As one of the largest steel producers and scrap processors in the United States,
Steel Dynamics definitely has size on their side. According to their 10K, the firm
estimates an annual steelmaking capability of approximately 5.3 million tons and an
estimated scrap processing capacity of 6.0 million tons for ferrous and 800 million
pounds of nonferrous metallics. With such enormous numbers in terms of capacity,
cost control must stem from the very foundation of the business. Steel Dynamics
attributes their low operating costs “primarily to efficient plant design, high productivity
rate, low ongoing maintenance cost requirements and strategic locations near sources
of [their] primary raw material, scrap steel, and [their] customers” (SDI 10-K). Steel
Dynamics also believes itself to be one of the lowest cost producers in the United States
due to their “state-of-the-art facilities”. Using high efficiency electric arc furnaces, they
have reported one of the lowest operating costs per ton.
The ability to produce cannot stand alone. It must be accompanied by the
knowledge and skills that are necessary to complete every day activities. The
“productivity rate of approximately 0.3 man hours per hot band ton produced” (SDI 10-
K) at their Flat Roll Division demonstrates precisely how efficient their facilities must be.
The less labor cost they incur relative to production dramatically increases gains and
allows for more expenditure on employee training and improvement. In summation,
Steel Dynamics attempts to use their low cost facilities to earn above-average profits
and force competitors to either charge less, thus gaining less, or simply exit the
industry all together.
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Experience
Steel Dynamics values experience and considers employee improvement one of
their main goals. They also have a senior management staff with a “proven track
record in the steel industry” (SDI 10-K). Forward thinking by top management in terms
of acquiring various mini-mills and other such facilities has led the firm to expansion in
total return for the past six years, excluding a small dip in 2005. The firm’s mission
statement clearly demonstrates the level of maturity and overall experience that the
managers at Steel Dynamics possess. It is there goal to “meet or exceed customer
expectations with regard to quality, service, and price; to be a world-class supplier by
continually improving their processes, equipment, and systems; to provide a safe
working environment for all employees; and to continue to enhance the skills of
employees through ongoing training and education”(SteelDynamics.com). Having such
a talented group of individuals at the helm allows Steel Dynamics to make critical
business decisions that improve the quality not only for the external users but also the
stakeholders of the firm.
Culture
A corporation’s culture refers to the set of assumptions about the organization
those members of the company share. It provides a type of framework that can direct
and organize people’s behaviors while on the job. A culture must be strong in order for
it to have an impact on the way people think and act. However, it is critical that the
strong culture encourage appropriate behaviors. Steel dynamics considers their culture
unique in contrast to others in the steel industry. They “emphasize decentralized
decision making” (SDI 10-K), which empowers employees and ultimately adds to their
competitive advantage. They have also established numerous incentive programs
designed to reward teams for their effort “towards enhancing productivity, improving
profitability, and controlling costs” (SDI 10-K). Steel Dynamics uses a culture that is
closely aligned with the competitive environment of their industry, and they continue to
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adapt to the constantly changing global economy, thus adding to their list of core
competencies.
Product Variety
Steel Dynamics offers a wide variety of products. Their “current products on a
company-wide basis include hot rolled, cold rolled, galvanized, Galvalume® and painted
sheet steel; various structural steel beams and rails; special bar quality steel; various
merchant steel products, including beams, angles, flats and channel; and steel joists
and deck materials” (SDI 10-K). This competitive strength is not to be confused with
the competitive strategy of diversification. Steel Dynamics’ focus is on cost control,
therefore they attempt to produce and distribute this wide variety of quality products at
the lowest possible cost. Having a “diversified mix of products enables [them] to
access a broader range of end-user markets, serve a broader customer base” (SDI 10-
K), and cope with downturns in the markets for their products. During 2007, the firm
extended their diversification by acquiring Omnisource, increasing their scrap
processing and management, transportation, and brokerage services. Therefore, it is
apparent that while focusing on low cost, Steel Dynamics has also been able to
maintain a condition for constant improvement and diversification across numerous
business activities.
Distribution
As in any industry that must produce and subsequently ship what they have
produced, strategic geographic locations can be a significant source of competitive
advantage. Steel Dynamics has steel making facilities located near sources of raw
materials as well as near their customers. Close proximity to such factors allow the firm
to save on freight for inbound and outbound products. Their mills in Indiana, located
along the Ohio River, “provides [them] with an expanded geographic reach to Southern
markets” (SDI 10-K). Having facilities located in multiple states across the Midwest and
South Atlantic allow for a large scope of potential profitability. Therefore, it is clear that
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strategically locating their facilities plays a significant role in the success of Steel
Dynamics.
Conclusion
A cost leadership strategy focuses on providing basically the same product or
service at a lower cost. In order to do this, the firm must design and implement tight
control systems. Efficient production and facilities, low-cost distribution, and effective
managerial tactics are just a few of the competitive advantages Steel Dynamics
capitalizes on in their industry. These economic assets that the firm possesses are
critical to success and sustaining them is a long term goal. Steel Dynamics continues to
make efforts to improving the current and obtaining new competencies, and doing so is
in any firm’s best interest. By focusing on the value adding activities of their business,
Steel Dynamics as a whole has done a fine job of demonstrating how a firm should go
about the entire competitive strategy process. The firm has “matched their core
competencies with their value driving key success factors” (Palepu and Healy), and has
ultimately proven the sustainability of their competitive advantages.
Formal Accounting Analysis:
Financial statements are prepared for every corporation. They use statements to
tell a story of what the firm is involved in. The problem with the accounting numbers
that are used to create these statements is that they are potentially distorted by the
level of man-made estimate errors and manipulations. For this reason, companies are
required to conform to Generally Accepted Accounting Principles (GAAP) in order to
ensure that managers are using standardized and regulated methods of estimation.
The Financial Accounting Standards Board (FASB) establishes these regulations and the
Security Exchange Commission (SEC) has the legal authority to enforce them. Post
Sarbanes-Oxley, all parties including the executives are responsible for the accounting
choices of the firm. In accordance with external auditing rules, companies must have
their financials audited by some third party. These auditors provide their opinions on
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whether a firm has generally complied with GAAP. By doing so, the quality and
credibility of financial statement data can be ensured, however auditors are not always
able to catch fraud.
There are some limitations to GAAP that enable managers to gain flexibility in the
reporting of certain items. Management can use the requirement of “best practice”
accounting to its benefit and can potentially provide misleading financial information.
Many incentives push managers to distort reality using legal GAAP methods in order to
obtain desired objectives. For example, a firm may lower its income temporarily in
order to keep unions from using profits as a basis for wage increase demands.
Companies may also be inclined to limit segment disclosure in order to keep
competitors from using the information to improve their business decisions. Other
reasons for distortion include tax considerations and covenant violation avoidance. The
legality of these actions presents a major flaw in GAAP, and is perhaps why there has
been a steady move towards International GAAP.
Accounting analysis uses six formal steps to identify and evaluate the key
accounting policies chosen by a firm. The process leads to eventual “undoing” of any
distortions that were found material, and allows for an improved picture of what the
firm is doing financially. The steps in performing a proper accounting analysis are as
follows:
1. Identify key accounting policies. 2. Assess the degree of actual accounting flexibility in policy selection and
estimation. 3. Evaluate the accounting strategy related to the norms in the industry. 4. Evaluate the quality of disclosure methods using qualitative and quantitative
data. 5. Identify potential “Red Flags” that signal questionable accounting. 6. If the analysis points to misleading information, “Undo” or “restate the reported
numbers to reduce the distortion to the extent possible” (Palepu and Healy).
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When these steps are carefully followed, an analyst should be able to gain a better
understanding of what a firm’s financial position really looks like, rather than observing
potentially misleading accounting numbers. We will now define and discuss the key
accounting policies related to the previously mentioned key success factors.
Key Accounting Policies
Firms accounting choices and policies have an enormous effect on the credibility
and reliability of the information they provide for analysts and interested investors.
There are two basic types of key accounting policies to be concerned with. The first
type links directly to the key success factors previously mentioned. For instance, we
identified Steel Dynamics and its industry competitors as typically cost leadership
focused firms. When such a business strategy is utilized, one would expect to see a
variety of common business activities. Firms attempt to gain economies of scale,
efficient production, simple product designs, and low cost distribution to gain
competitive advantages. These firms also expend minimal amounts of resources in
research and development as well as brand image. These mentioned are the business
activities that we find important for the steel industry, and they link directly to the key
accounting policies we will soon elaborate on.
Type One Key Accounting Policies:
As stated, the first type of key accounting policies that are significant in their
relation to a valuation are those that directly link to the identified key success factors of
a firm. The steel industry faces many challenges when trying to sustain their
competitive advantages. This is due to the commodity type product that is produced
and sold. Steel makers, especially those that mainly produce standard issue flat rolled
steel, must carefully consider their treatment of key success factors. Disclosure related
to such items is important for an analyst to examine because it allows for a better
perspective on the industry as a whole. Using an absolute and relative basis, we will
define type one key accounting policies, discuss their flexibility, and analyze the level of
disclosure related to each.
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Economies of Scale
Size matters in the world of steel manufacturing. In such case, acquisitions are
made on a regular basis to enhance firms’ infrastructure. Steel firms purchase a variety
of asset from other firms, including whole plants or individual components such as an
electric arc furnace. Defined previously as the cost advantages a firm gains when
increasing their size, economies of scale allow for increased competitiveness and leads
to increasing efficiency. Firms are almost guaranteed to include information regarding
acquisitions in their annual reports. These transactions could be extremely expensive
and therefore require accurate accounting treatment.
GAAP does not require that a firm provide information regarding the acquisition
on intangibles such as customer relationships. However, Steel Dynamics has included
such a figure in their notes to the financial statements and they assign a large weight to
the asset itself. They have also set up amortization using a straight line method,
therefore including it in selling and administrative expenses. US Steel does the same
when it comes to purchased assets, as would Nucor and AK Steel if they were
presented with material figures like Steel Dynamics. It would make little sense for a
large corporation to leave off, for example, $353 million dollars in intangible assets.
Therefore, it can be said with reasonable certainty that firms have a good amount of
flexibility when reporting their acquisitions. However, it is more than expected for a firm
in the steel industry to heavily outline the details regarding their purchases and
exchanges. This is primarily due to the face that leaving such information out of the
annual reports would skew the reported figures to an overwhelming extent. With that
said we will now analyze the quality of disclosure and provide a conclusion as to what
the significance is of our findings.
Efficient Production
In order for a firm in the steel industry to create value in the chain, it must
attempt to achieve a reliable and efficient set of production processes. Production
process disclosure is not as easy to obtain as economies of scale, however using
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intuition about the industry we can come to a reasonable conclusion about the key
accounting policy of efficient production. Steel firms primarily focus on eliminating
waste and reducing scrap. High energy and transactions costs also relate to firms
efficiency in production. By keeping a constant watch on the expenditures related to
producing the steel, these firms are able to create a significant accounting policy out of
one of their key success factors.
There is a very low level of disclosure for firms with regards to how they present
information about their production processes. They basically provide a stereotypical
description of production techniques in their annual reports, and nothing more. Firms
are not going to disclose information that could lead to their competitors using it
against them. If Nucor were to provide a step by step set of instructions explaining
how they have achieved the lowest amount of selling, general and administrative
expenses relative to their very high level of sales, it would most likely lead to other
firms attempting to duplicate such processes. For this reason, managers in the steel
industry use their flexibility in the disclosure of this account policy to prevent other
firms from “stealing” ideas.
Low Input Costs
The steel industry relies heavily on its ability to locate and utilize the most cost
effective raw materials. With steel scrap prices being volatile, monitoring the
expenditures for such items can become a job in itself. What is more, steel firms face
changing energy costs on a regular basis. Therefore, the two main inputs for the steel
making process, raw materials and energy, make up another type one key accounting
policy that we will call low input costs. Firms will either heavily disclose the sources of
their materials and their energy contracts, or they will only slightly disclose. Very
seldom will an analyst find zero disclosure related to input costs in a firm’s annual
reports. US Steel includes information as to how lowering input costs can drive up
margins and ultimately increase profitability. Nucor even holds exclusive rights to “Strip
casting” in the United States and Brazil. This advantage allows for lower energy
consumption, and ultimately lower input costs.
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We can observe the relative disclosures among firms in the industry as they
relate to the actual accounting strategy. Nucor, AK Steel, US Steel and Steel Dynamics
all provide information regarding raw materials costs and energy costs. The
determining factor as to quality of disclosure is rather simple to understand. Firms are
not forced to show their hedged energy contracts, for example. By choosing to do so,
they increase the value to the users of the annual reports. All steel firms that were
researched included pages of information outlining their sources of steel scrap and
scrap substitute. Therefore, it can be concluded that steel firms choose to disclose
input costs to a high degree.
Low-Cost Distribution
There is no doubt that keeping distribution costs low is a significant factor for
steel firms. Logically, this is defended by the fact that one unit of rolled steel can weigh
more than a ton. Therefore, shipping costs can comprise a very large expenditure.
Low-cost distribution is therefore a type one key accounting policy, linking directly to
the key success factor similarly named. Steel firms have positioned their facilities in
such ways as to create a “web” of distribution points. They discuss their locations in
their annual reports which provide us with a sense of how they are disclosing relevant
distribution information. Our main discussion will encompass whether or not Steel
Dynamics and its competitors provide high or low quality disclosure and what level of
transparency is related to the disclosure.
Steel firms can choose how much in to include with regard to their distributing
expenditures. All firms list locations of mini-mills and other production facilities. They
also list the cities and states that each facility is located in and any main distribution
center nearby like the Ohio River. By locating near such a river, firms like Nucor and AK
Steel have increased their ability to distribute and sustain competitive advantages.
Finally, we can conclusively say all four steel firms have high disclosure and they use it
to better their financial information.
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Type Two Key Accounting Policies:
The second type of key accounting policies are relative to the key success factors
in that they provide a glimpse of potentially distortive, discretionary uses of legal GAAP
provisions. These policies involve judgment and are therefore open to “noise” and
“bias” that can create deviations from the truth. It is for this reason that we will define,
discuss, and analyze the most significant key accounting policies, and following the
steps of a formal accounting analysis, we will be able to undo any distortions that make
themselves apparent. For the steel industry, the policies we will analyze are Goodwill,
Currency risk, Benefit Plans, Operating Leases, and Credit Risk. These accounting
policies can materially affect the users’ view of the company. Using a broad perspective
while focusing on industry, we can gain a better view on what these policies really are
and how they are significant.
Goodwill
The figure “Goodwill” is present on the majority of firms that often acquire
assets. The steel industry is a perfect example, what with its history of plant
acquisitions. It is an accounting number that generally is a result from firms increasing
their infrastructure, vis-à-vis acquisitions. Therefore, it directly links to the key success
factor of obtaining economies of scale. Goodwill represents the excess of cost over the
fair value that is paid for an acquisition of assets and liabilities. For the most part,
companies consider this extra amount of payment necessary but basically lacking
tangible value.
Firms must regularly test their Goodwill for impairment, according to FASB.
However, it is not required that firms write off or amortize a certain amount per year.
When the carrying value of the asset begins to exceed the fair value, it might be a clear
signal to a firm that the asset needs to be amortized and marked to market.
Firms will either show a significant amount of Goodwill, and will therefore require
adjustments in order to get a clear picture. Yet others will show an amount that is not
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material. For our purposes, we conclude that if a company’s balance sheet shows
Goodwill as twenty percent or more of their long term physical assets, then restatement
will be needed. If this situation does not present itself, then it can be concluded that
Goodwill is not a source of potentially distortive accounting. Industry analysis has led
us to believe that the normal amount of Goodwill for steel firms represents a material
amount. The exception was AK Steel, who has recently not been involved with any
mergers or acquisitions. For this reason, we will impair the amount for Steel Dynamics
and eventually restate the financial statements in order to gain a better perspective.
We have found that all five of the companies we have studied have not impaired
their Goodwill for the last five years. This could be a sign of an existing problem for the
firms. Since the acquisition has been made, it basically represents a sunk cost that
might result in an earnings overstatement. Lack of disclosure for impairment appears
to be the only issue at hand for the industry. However, disclosure of relevant
information is still relatively high. It simply means that the industry is not trying to
deceive users of financial statements with discretionary accounting, but rather have
used their flexibility to simply omit certain items from their documents.
Currency Risk
Foreign currency risk is typically reserved for firms competing in the global
economy. It is typically thought to be the risk involved from changes in prices of
money in currency against another. Hedging is a proper tool that firms use to do away
with some of this risk. If not properly hedged, firms that have assets operating in
foreign countries might face serious currency risk. Even relatively small changes in
exchange rates can create million dollar swings for firms that have a lot of foreign
currency interaction. For example, US Steel not only operates in the continental U.S.,
but in Europe as well. The “Euro” is the main form of currency, if discussing a country
within the European Union. So if the price of a euro goes up relative to the dollar,
currency risk is exposed.
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With regards to the steel industry, foreign currency risk for most firms is
immaterial. The reason for this seems to be that most firms operate exclusively in the
United States. An exception is ironically U.S. Steel, who has operations in Europe. They
highly disclose the information that investors would need to see in order to understand
the probability of serious loses due to exchange rate fluctuations. By keeping currency
risk to a minimum, the steel industry is demonstrating serious cost leadership strategy.
They achieve this minimum risk by keeping their operations local, as much as possible.
However, as far as being the most significant key accounting policy, currency risk falls
near the end of the spectrum.
Benefit Plans
Pensions and other post-retirement benefit plans can comprise one of the largest
and most complex long term obligations that a company can face. There are two basic
types of pensions. “Defined Contribution Plans”, for example a 401K, is a retirement
plan that sets aside some amount each year for the firms employees. Restrictions do
apply in terms of withdrawal, but for the most part this type of plan is preferred.
According to Investopedia, there is no real way to know exactly how much a retiree will
receive. This is due to market movements and the flexible nature of the benefit.
Employers make a deposit into an account in your name for a certain percentage of
your gross income. There is also a “matching clause” that can be included in this type
of plan, which involves an employer matching everything you put in up to some
percentage (pre-tax). For example, Steel Dynamics has a 10% matching clause. The
second type is referred to as “Defined Benefit Plan”. This type of plan is basically a
promise of a lifestyle after retirement. The employer promises to pay an employee
some “percent equal to their last year’s salary multiplied by the number of years
worked” (Mark Moore). The accounting for this form of pension is much simpler, and
as we know, when things seem simple, they usually provide potential for distortive
information.
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For Steel Dynamics, we find that a contribution plan is used, whereas for the
three main competitors, a benefit plan is used. When a firm uses a benefit plan, they
have discretion in terms of establishing appropriate discount rates. As we have
mentioned, when discretion is sizeable and flexibility is as well, a firm can potentially
provide users of financial statements with distortive information. As is relates to the
key success factor of keeping costs low, Steel Dynamics has a better opportunity to
manage a competitive advantage. Once they have established a percentage, they can
expense it in the accounting period. On the other hand, all three competitors must face
the challenges of over or understating their liabilities. For example, if too large a
discount rate is used, the following will occur:
Assets Liabilities Owners
Equity
Revenues Expenses Net Income
No effect Understated Overstated No effect Understated Overstated
By understating the present value of their obligations, they have essentially presented
financial statements with misleading information. This example demonstrates how easy
it is for a firm to distort their accounting numbers.
For the sake of simplicity, we can conclude that because Steel Dynamics does
not use the defined benefit plan, we will not need to assess the reliability of their
figures. Therefore, it is the opinion of this valuation team that the information provided
Steel Dynamics Inc. does not present problems in the context of pension liabilities.
With that said, we can look at another key accounting policy that will basically present
the same result.
Operating and Capital Leases
Companies exercise a fair amount of flexibility, provided by GAAP provisions,
with regard to the manner in which leases are treated in the financial statements.
Companies can either purchase or lease assets. Depending on what route they choose,
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they will either treat it like a capital lease, reporting the asset on the books, or they will
expense it regularly as an operating lease.
Operating lease commitments are thought to be significant if they represent an
amount exceeding 10% of long term debt. In the case of the steel industry we have
found the following to be true of their operating leases as a percent of long term debt:
Steel Dynamics US Steel Nucor AK Steel
% of LT Debt 1.5% 4.8% 6.8% 1.8%
It is clear that as a key accounting policy for these four firms, operating leases do not
present an opportunity to potentially distort accounting numbers. Disclosure quality for
this segment of key accounting policy is above average, and points to an unbiased
presentation of financial statements, industry wide. Therefore, we can conclude that
with regards to Steel Dynamics, a restatement of the Income Statement or Balance
Sheet in the context of leasing activities will not be needed.
Credit Risk
All firms in the steel industry are exposed to some form of credit risk. The main
concern found for almost all firms tended to be the difficulty in drawing upon existing
financial agreements. The key accounting policy of recognizing credit risk is incredibly
relevant in said industry. Despite the lack of flexibility due to various restrictions, firms
are able to squeeze as much wiggle room out of GAAP as possible. The figures for
credit risk must be present in a devoted section of a firm’s 10-K. The exposure to such
risk arises due to the expectation of uncollectible sales on account. There are two basic
concerns with respect to credit risk; long term debt issuance and customer transactions.
Both of these reported figures are man made numbers, and therefore provide firms
with a chance to potentially distort the reality of their business.
GAAP has recently provided that firms must fully disclose any issues related to
credit risk. Because this form of risk can possibly represent a large sum of money in
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terms of cash that will not be coming in, it can be directly linked to the strategy of cost
leadership. For instance, all four steel firms are currently operating under a “revolving
credit facility” worth over $500 million. AK Steel even boasts an $850 million asset
based credit facility. Such a large number poses a large credit risk concern. Nucor,
perhaps the least credit risk stricken firm, prides themselves on an industry-high credit
rating. However, like all firms in the industry, the current credit crisis could temporarily
restrict borrowing ability, at least on acceptable terms. The crisis is also making it
difficult for steel customers to obtain the credit they need to fund their purchases. Both
examples of credit risk prove to be significant for all four firms. In fact, Steel Dynamics
states that non-payment ability of customers is their primary source of credit risk.
The overall disclosure related to credit risk is classified as very high quality. All
of the information that the firms present is necessary for investors to gain a clear
picture of the company. Knowing that a firm is exposed to a great deal of risk is
valuable to investors who face a tough decision whether to invest or not. For Steel
Dynamics, US Steel, and AK Steel, the exposure is very high. Nucor faces a smaller
amount of risk, however given the current crisis, no firm can hide. It is the opinion of
this analysis team that US Steel, AK Steel, Nucor, and Steel Dynamics all provide a
transparent view of their business by providing full disclosure of credit risk. For that
reason, it can be said that the value added by this key accounting policy is nothing to
take lightly.
Accounting Flexibility
The manner in which a firm uses policies and estimates demonstrates the
concept of accounting flexibility. The type of policies and choices that are implemented
by the firm determine how much flex they will have when applying GAAP. The overall
flexibility of the firms accounting measures is a function of how strict they are in
following the rules and regulations set forth by the accounting standards board.
Because GAAP cannot outline every last detail to the letter, firms are provided with
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opportunities to make their own managerial choices. With such an opportunity, comes
the possibility of potentially distortive or misleading practices. For example, there is no
exact amount of Goodwill that firms must impair; they must make a judgment call.
With any judgment decision, bias looms nearby, and is a direct result of accounting
flexibility. If it is clear that the numbers presented are biased, the firm may be overly
aggressive, reducing the overall quality of the accounting numbers. Therefore, in order
for investors to gain a true understanding of the underlying economic significance of
business activities, they must know have knowledge of the flexibility that a company
holds.
Goodwill
During business mergers, a corporation records material amounts of intangible
assets while purchasing intangible assets. Essentially, Goodwill symbolizes this by the
excess of cost over the fair value that is paid in an acquisition of assets and liabilities,
thus making it an intangible asset.
Since it is an intangible asset and requires a great deal of estimation to value,
many firms find it extremely relative and difficult to predict Goodwill’s actual useful life
and its amortization. As required by GAAP’s FASB Statement No. 142, companies are
required to “perform an annual impairment test” where the firm compares the fair value
of the reporting unit to its corresponding carrying amount (SDI 10-K). If there is a
difference, the company is required to impair, or mark-down, the Goodwill to the lower
value.
Over the past five years, Steel Dynamics has not impaired their goodwill at all.
The flexibility of the firm’s senior level mangers is very great for this situation. GAAP
allows companies to test in-house for impairment, which means have complete control
of the estimates and numbers they choose to use. Due to the high level of flexibility
available and the absence of impairment, we suspect that most of the companies in the
industry are manipulating their Goodwill figures, which in turn will affect the valuation
of their assets, net income and retained earnings.
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As for Steel Dynamics, up until 2005 there was no Goodwill on the books, as
shown by the graph below:
Steel Dynamics' Goodwill as a Percent of Total Assets, PPE (in thousands)* :
Total Assets Goodwill % of Total Assets PPE % of PPE 2008 6,054,879 781,555 12.9% 1,997,495 39.1% 2007 4,519,453 510,983 11.3% 1,652,097 30.9% 2006 2,247,017 30,966 1.4% 1,136,703 2.7% 2005 1,757,687 1,925 0.1% 999,969 0.2% 2004 1,733,619 0 0.0% 1,024,044 0.0% 2003 1,448,439 0 0.0% 1,001,116 0.0%
*(SDI 10-K)
This graph illustrates that goodwill is a significant percentage of PPE and that it is
increasingly becoming a larger percentage of total assets. The sudden and rapid growth
of Goodwill is a potential red flag for dishonesty and manipulation in the upcoming
years.
Although GAAP requires them to perform testing annually, Steel Dynamics has a
high level of flexibility for the impairment of Goodwill. With estimated numbers,
companies are able to manipulate Goodwill and show their version in the books.
Operating Leases
Many corporations have flexibility when it comes to showing leases on their
financial statements. According to U.S. GAAP, this can be shown in two ways and they
both have dramatic effects on the final financial report. The flexibility a company has
allows it to either show liabilities on a balance sheet or deny placing them in its books.
Knowing which path a company chooses is important when it comes to finding an
accurate measurement of the financial records.
The first option a company has is using capital leases. This choice would show
liabilities and assets on the balance sheet. This portrays a more correct financial
statement, and shows investors the corporation’s commitments and risks more
accurately as well. The way this is explained on the balance sheet is by debiting the
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lease as an asset and crediting it as a liability. At the same time, the company can then
continue and depreciate the lease, and will therefore show an even more accurate
report of the numbers.
The second alternative, which is the most common in the steel industry, is
operating leases. Here, the company can choose to not show any assets or liabilities.
They will instead show the lease as an operating expense. By choosing this method,
firms will overstate expense, which in return, understates net income. This becomes a
benefit for tax payments. A lower income allows for lower tax expenses. As stated
earlier, operating lease is more commonly used in the steel industry. For most steel
companies, choosing to record capital or operating leases does not change their
balance sheets in a significant way. This is because their lease commitments are a
minute portion of the long-term debt. The following table shows the percentage of
lease commitments to long-term debt in Steel Dynamics and its major competitors.
By amortizing the goodwill we have effectively decreased goodwill’s value in
2008 from $781.5 million to $516.5 million. This is yielded a difference over five years
of $265 million, and considering Steel Dynamics’ net income in 2007 was merely $285.8
million, this is obviously a significant number to the firm. The deduction of this
intangible asset affected the following: total assets, liabilities, net income and retained
earnings.
Since goodwill is classified as a non-current asset on the balance sheet, we had
to add “goodwill impairment” onto the statement. The overstated total assets decreased
by the amortization amounts for each year in the above table.
As a result of overstating goodwill, Steel Dynamics’ total expenses were
understated by the missing amounts of goodwill expense. Therefore, added “goodwill
expense” to underneath “selling, general and administrative expense,” which increased
the expenses by the amortization amounts year to year.
By doing this, we also consequently decreased the amount of net income on the
income statement by the impairment amounts in the above graph. Since net income is
closed into the balance sheet, retained earnings were also decreased by the change in
net income.
These changes are shown in the following pages. First are the statements in
their original forms from Steel Dynamics’ 10-Ks, followed by our restated income
statement and balance sheet which have been adjusted for the impairment of goodwill.
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STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Years Ended December 31
2004 2005 2006 2007 2008Assets
Current assets: Cash and equivalents 16,334 65,518 29,373 28,486 16,233 Accounts receivable, net 209,742 197,527 348,148 662,285 424,003 Accounts receivable-related parties 38,981 38,830 53,365 44,103 49,921 Inventories 381,488 398,684 569,317 904,398 1,023,235 Deferred income taxes 6,856 6,516 13,964 10,427 23,562 Other current assets 18,980 13,307 15,167 38,795 143,953 Total current assets 677,519 725,733 1,036,197 1,696,229 1,709,915 Property, plant and equipment, net 1,024,044 999,969 1,136,703 1,652,097 2,072,857 Restricted cash 989 1,588 5,702 11,945 18,515 Intangible assets — — 12,226 514,547 614,786 Goodwill — 19,250 30,966 510,983 770,438 Other assets 31,067 30,397 25,223 133,652 67,066 Total Non-current Assets: 1,056,100 1,031,954 1,210,820 2,823,224 3,543,662 Total assets 1,733,619 1,757,687 2,247,017 4,519,453 5,253,577
Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 136,517 111,067 145,938 358,921 259,742 Accounts payable-related parties 5,371 4,475 2,004 19,928 3,651 Income taxes payable 30,497 25,870 4,107 Accrued expenses 75,750 80,527 91,527 150,687 209,697 Accrued interest 8,796 8,952 Accrued profit sharing — — 46,341 53,958 62,561 Senior secured revolver — — 80,000 239,000 36,600 Current maturities of long-term debt 6,774 2,156 686 56,162 65,223 Total current liabilities 233,208 207,177 396,993 904,526 970,981 Long-term debt: Other long-term debt 19,458 17,960 16,920 16,183 2,219,161 Unamortized bond premium 7,147 5,459 3,772 — — Total long-term debt: 441,605 438,419 358,192 1,734,683 2,219,161 Deferred income taxes 209,215 231,105 256,803 301,470 365,494 Minority interest 2,469 1,118 1,424 11,038 8,427 Other long term liabilities — — 2,497 38,540 65,626 total non-current liabilities 653,289 670,642 618,916 2,085,731 2,658,710 Total Liabilities 886,497 877,819 1,015,909 2,990,257 3,629,691
Commitments and contingencies Stockholders’ equity: Common stock 523 529 537 542 542 Treasury stock, at cost -84,141 -270,905 -230,472 -457,368 -737,319 Additional paid-in capital 390,505 405,900 367,772 553,805 541,686 Other accumulated comprehensive income — — — 21 -1,411 Retained earnings 540,235 744,344 1,093,271 1,432,196 1,820,385 Total stockholders’ equity 847,122 879,868 1,231,108 1,529,196 1,623,886 Total liabilities and stockholders’ equity 1,733,619 1,757,687 2,247,017 4,519,453 5,253,577
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STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Years Ended December 31 *Adjusted for the impairment of goodwill
ACTUAL 2004 2005 2006 2007 2008
Assets Current assets: Cash and equivalents 16,334 65,518 29,373 28,486 16,233 Accounts receivable 209,742 197,527 348,148 662,285 424,003 Accounts receivable-related parties 38,981 38,830 53,365 44,103 49,921 Inventories 381,488 398,684 569,317 904,398 1,023,235 Deferred income taxes 6,856 6,516 13,964 10,427 23,562 Other current assets 18,980 13,307 15,167 38,795 57,632 Total current assets 677,519 725,733 1,036,197 1,696,229 1,709,915 Property, plant and equipment, net 1,024,044 999,969 1,136,703 1,652,097 2,072,857 Restricted cash 989 1,588 5,702 11,945 18,515 Intangible assets — — 12,226 514,547 614,786 Goodwill — 19,250 30,966 510,983 770,438 Goodwill impairment — 385 6,578 108,771 516,473 Other assets 31,067 30,397 25,223 133,652 67,066 Total non-current assets 1,056,100 1,031,569 1,204,242 2,714,453 3,027,189 Total assets 1,733,619 1,757,302 2,240,439 4,410,682 4,737,104
Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 136,517 111,067 145,938 358,921 259,742 Accounts payable-related parties 5,371 4,475 2,004 19,928 3,651 Income taxes payable 30,497 25,870 4,107Accrued expenses 75,750 80,527 91,527 150,687 209,697 Accrued interest 8,796 8,952 Accrued profit sharing — — 46,341 53,958 62,561 Senior secured revolver — — 80,000 239,000 36,600 Current maturities of long-term debt 6,774 2,156 686 56,162 65,223 Total current liabilities 233,208 206,792 390,415 795,755 454,508 Long-term debt: Other long-term debt 19,458 17,960 16,920 16,183 2,219,161 Unamortized bond premium 7,147 5,459 3,772 — — Total long-term debt: 441,605 438,419 358,192 1,734,683 2,219,161 Deferred income taxes 209,215 231,105 256,803 301,470 365,494 Minority interest 2,469 1,118 1,424 11,038 8,427 Other long term liabilities — — 2,497 38,540 65,626 Total liabilities 886,497 877,434 1,009,331 2,881,486 3,113,218
Commitments and contingencies Stockholders’ equity: Common stock 523 529 537 542 542 Treasury stock, at cost (84,141) (270,905) (230,472) (457,368) -737,319 Additional paid-in capital 390,505 405,900 367,772 553,805 541,686 Other accumulated comprehensive income — — — 21 -1,411 Retained earnings 540,235 743,959 1,086,693 1,323,425 1,303,912 Total stockholders’ equity 847,122 879,868 1,231,108 1,529,196 1,623,886 Total liabilities and stockholders’ equity 1,733,619 1,757,302 2,240,439 4,410,682 4,737,104
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STEEL DYNAMICS, INC.: CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Years Ended December 31,
Actual 2004 2005 2006 2007 2008
Net sales Unrelated parties $1,885,387 $1,959,428 $2,995,952 $4,158,844 7,743,251 Related parties 259,526 225,438 242,835 225,705 337,270 Total net sales 2,144,913 2,184,866 3,238,787 4,384,549 8,080,521Costs of goods sold 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262 Gross profit 603,490 485,149 829,992 915,694 1,231,259Selling, general and administrative expenses 96,581 91,974 170,878 224,540 267,688 Profit Sharing — — — — 66,997 Amortization — — — — 41,334 Operating income 506,909 393,175 659,114 691,154 855,240Interest expense 38,907 34,341 32,104 55,416 144,574 Gain from debt extinguishment Other expense (income), net -7,031 -1,792 -4,545 5,500 -33,147 Income before income taxes 475,033 360,626 631,555 630,238 743,813 Income taxes 179,719 138,841 234,848 235,672 280,427 Net income $295,314 $221,785 $396,707 $394,566 463,386Basic earnings per share $5.99 $4.97 $4.22 $4.24 $2.45
0.582578 0.564087 0.601879 0.570880 0.541820 Weighted average common shares outstanding 49,287 89,242 93,931 93,161 189,140 Diluted earnings per share, (including the effect of assumed conversions for 2005-2007) $5.27 $4.35 $3.77 $4.02 $2.38 Weighted average common shares and share equivalents outstanding 56,527 103,284 105,774 98,402 194,586 Dividends declared per share $0.25 $0.20 $0.50 $0.60 $0.40
111
STEEL DYNAMICS, INC.: CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Years Ended December 31, *Adjusted for the impairment of goodwill
Actual 2004 2005 2006 2007 2008
Net sales Unrelated parties $1,885,387 $1,959,428 $2,995,952 $4,158,844 7,743,251 Related parties 259,526 225,438 242,835 225,705 337,270 Total net sales 2,144,913 2,184,866 3,238,787 4,384,549 8,080,521 Costs of goods sold 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262 Gross profit 603,490 485,149 829,992 915,694 1,231,259 Selling, general and administrative expenses 96,581 91,974 110,808 150,865 267,688 Profit Sharing — — — — 66,997 Amortization — — — — 41,334 Goodwill expense — 385 6,578 108,771 516,472 Operating income 506,909 658,729 652,536 550,343 142,642 Interest expense 38,907 34,341 32,104 55,416 144,574 Gain from debt extinguishment Other expense (income), net -7,031 -1,792 -4,545 5,500 -33,147 Income before income taxes 475,033 360,241 624,977 521,467 743,813 Income taxes 179,719 138,841 234,848 235,672 280,427 Net income $295,314 $221,400 $390,129 $285,795 -53,086 Basic earnings per share $5.99 $4.97 $4.22 $4.24 2
Weighted average common shares outstanding 49,287 89,242 93,931 93,161 189,140 Diluted earnings per share, (including the effect of assumed conversions for 2005-2007) $5.27 $4.35 $3.77 $4.02 $2.38 Weighted average common shares and share equivalents outstanding 56,527 103,284 105,774 98,402 194,586 Dividends declared per share $0.25 $0.20 $0.50 $0.60 $0.40
112
Financial Analysis, Financial Statement Forecasts, and Estimating the Cost of Capital
When valuing a firm, one must not overlook the critical nature of the financial
statements. Not only must we evaluate the statements of an individual firm, but it
must also closely study the statements of the industry, which includes the main
competitors. In order to properly value a firm, a careful financial analysis using a
variety of ratios must take place. Liquidity, profitability, and capital structure issues are
all addressed using a host of easy to use ratios. Once these have been calculated, an
analyst can offer fact based opinions and inferences in order to paint a clear picture of
what the firm is doing with a financial frame of reference. Using these ratios the
analyst can then move on to actual financial statement forecasting for future years
performance.
Key ratios like the Asset Turnover ratio can be used to link the statements in
order to use actual numbers to derive logical future performance. Properly forecasted
numbers are crucial to the success of an equity valuation. Finally, once ratios are
computed and statements are forecasted, we can then estimate the cost of capital for a
firm. Standard procedures call for regression data, looking for maximum amounts of
explanatory power and stability. Using the Capital Asset Pricing Model (CAPM) and an
alternative method as well, we estimated the cost of equity. Then, using a weighted
average approach, a cost of debt was estimated. With these figures determined, the
WACC (Weighted Average Cost of Capital), before and after tax, could be computed.
All of the presented and calculated data is the next step for determining the actual
value of a firm, and will be used in the final process of equity valuation.
113
Financial Analysis:
A proper evaluation of financial statements, typically referred to as a financial
analysis using ratios, is the first step in the process. Conclusions drawn from using
ratio analysis are improved when bench-marking is used against the industry. By
observing the changes and stabilities of certain key ratios, logical arguments can be
backed by industry benchmarked results. The benefits of ratio analysis include
observable trends in the industry that can be used to make insightful conclusions. We
will discover and discuss three types of ratios; liquidity, profitability, and capital
structure.
Liquidity Analysis
The critical starting point for any appropriate financial analysis of an industry and
a specific firm is to perform a thorough ratio analysis. By using very familiar ratios to
analyze numbers found on financial statements, a valuation team can build a base for
further scrutiny of the true value of a firm. This section will focus on evaluating
liquidity ratios. Such ratios indicate the specific ability to maintain sufficient resources
to meet obligations that are coming due. Basically, the main focus is on firms in the
steel industry and their ability to cover debts. A few operating efficiency measures will
also be included in this analysis, as they also add to the firm’s liquidity factor. Using a
time series and cross sectional approach, we present the figures that are easy to read
and clearly communicate the general trends and their implications. By doing such an
analysis, we are able to assess the financial condition of the company and the ultimate
results from its ongoing operations.
114
Current Ratio
To begin the liquidity analysis, we computed a six year horizon of what is known
as the Current Ratio. This ratio is determined by dividing the total current assets of a
firm by their total current liabilities. These numbers are found on the balance sheets of
all firms, and when plugged into this ratio, can give a view of a firm’s liquidity. All other
things equal, one would hope to see a relatively stable relationship. Also, a larger
number for the current ratio is desirable for most firms because it equates to more
financial coverage. If a number is below 1, it would indicate that a firm cannot pay off
its short term liabilities with its short term assets. As the graph indicates, all firms in
this valuation have current ratios of basically above 1.5 for the last six years. For the
last four years, however, Steel Dynamics has shown a steady decline in coverage. This
is a negative for a firm and could either be explained by an increase in liabilities or a
decrease in assets. In the case of Steel Dynamics, the resulting decline in current ratio
is most definitely a product of rapidly increasing total current liabilities. From 2006 to
2007 alone, there was a six million dollar increase. The steel industry however paints a
much more pleasant picture with regards to the ratio. The industry average is basically
stable, around 2.5, which means good coverage for upcoming obligations. The spread
is very typical for a commodity industry like steel, with a maximum around 3.5 and a
minimum of 1.5, for the time period analyzed. Nucor outperforms the other firms,
especially US Steel, in terms of coverage, and we will see this same basic trend in a few
other ratios as well. Steel Dynamics’ trends are the most volatile, having the highest
highs and the lowest lows. There is hardly any observable market segmentation since
all firms present basically the same results. It is important for firms to maintain a
relatively good current ratio because bankers would prefer firms to maintain high
current assets to ensure repayments.
The impact of this ratio on Steel Dynamics is concluded to be negative, primarily
due to the steady decrease in coverage for the last few years. However, they are still
very able to meet their obligations. On the other hand the impact on the industry as a
115
whole is considered to be a favorable change, relying on the observable increase in
coverage over the last year.
Quick Asset Ratio
The next ratio that is useful in determining a relevant conclusion of an industry
and a firm’s overall liquidity is the Quick Asset Ratio, sometimes referred to as the Acid-
Test ratio. The denominator for this ratio is composed of the most liquid three
components of current assets. It includes cash and cash equivalents, marketable
securities, and accounts receivables. The sum of these figures is then divided by the
total current liabilities. The ease of converting these assets into cash in order to meet
current obligations is a significant factor for basically all firms in any field. Inventory is
left out of the equation in order to fully observe a more narrow view of liquidity. A
higher ratio is preferred by firms because it implies that they are able to convert their
current assets into cash relatively quickly.
The graph presented shows the acid-test numbers for the last six years. Clear
market segmentation has occurred throughout this time series, with Nucor topping all
others for every single year. Steel Dynamics is almost constantly the lowest. This is
00.51
1.52
2.53
3.54
2003 2004 2005 2006 2007 2008
Current Ratio
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
116
clearly due to the lack of marketable securities, which would decrease the denominator
making the final computation lower than is would be with a large amount of securities.
On average, the industry is stable with respect to the quick asset ratio. This implies
relative ease of conversion for all competing firms. US Steel presents the only real
increase in from 2007 to 2008. Steel Dynamics is below the industry average for the
last five years which allows for the conclusion that the change on liquidity for the
individual firm is actually a negative impact. As for the industry, the same can be said
for all competitors minus US Steel. However, the competitors do not show as
considerable a change, so we will not label the impact as negative, rather simply as
essentially no change.
Inventory Turnover
Inventories can represent a sizeable share of total assets. Holding inventory for
an exceptionally long period is never considered favorable. For firms in the commodity
steel industry, inventory turnover does not have to be high. The flat rolled steel is not
going to spoil. The ITO (Inventory Turnover Ratio) measures, within a considerable
degree of accuracy, how efficient a firm is or has been with regards to controlling such
an expensive investment as inventory. Intuitively, it can be said that a favorable ratio
0
0.5
1
1.5
2
2.5
2003 2004 2005 2006 2007 2008
Quick Asset Ratio
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
117
result would be high, meaning that total inventory will be turned over numerous times
within a given year. More turns means more revolutions of the “cash wheel”.
By dividing the cost of revenue by inventory at cost for a given year, we
computed this turnover ratio. Immediate attention is drawn to the lowest line on the
graph, Steel Dynamics. Having less turns indicates perhaps a negative aspect of
operating efficiency taking place at the company. However, the stability of said firm
might outweigh the high turn, high uncertainty downsides that apparently face all
competitors. It is clear that all companies in the mix have dramatically increased from
their lows in 2007. This increase in operating efficiency ultimately increases liquidity
and viability of a company. Another ratio that is considerably linked to this is the days
supply of inventory calculation. It points to the same general conclusions only in a
mirroring manner, using a more familiar concept of “days” rather than “turns”.
0
2
4
6
8
10
12
14
2003 2004 2005 2006 2007 2008
Inventory Turnover
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
118
Days Supply Inventory
As just suggested we see just the opposite, in a sense, of the inventory turnover
illustration. Take the number of days in a year, 365, and divided it by the ITO to arrive
at the number of days that a dollar spends in inventory. Production improvements,
especially the key success factor of increasing efficient production which is common in
the industry, will improve this figure. This metric is favored when performing a financial
analysis because of the relevant unit.
Despite the obvious segmenting that has been found, the industry average is
well over a month. One could even estimate that for this situation it should be thought
of as two months, or 60 days. A commodity that can sit longer in inventory is not
always a negative effect for firms that manufacture it. As stated, Steel Dynamics
produces primarily rolled steel with a shelf life much like any other durable item. Firms
like Nucor and US Steel are involved in projects that require them to produce goods on
demand, to be utilized by the purchaser as soon as possible. This specialization and
quick selling tactic, in some respect, lowers the amount of time inventory hangs around.
Industry average is shown as very stable, with a minor shift towards increasing
operating efficiency. Overall, the impact on our results for all companies is a favorable
change.
0
20
40
60
80
100
120
2003 2004 2005 2006 2007 2008
Days Supply Inventory
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
119
Receivables Turnover
A reliable ratio for determining whether or not a firm is efficient in the manner in
which is makes and collects sales on credit. By dividing sales by the net accounts
receivables, we arrived at a pretty consistent conclusion for this aspect of financial
analysis. When a company sells a product and accounts for that sale on credit, it
creates an account to be received. The more a company makes this type of sale, the
greater the figure on the balance sheet. Accounts receivables are very important for
accounting numbers, especially since they can be sold or even pledged in a transaction.
The graph below portrays consistent industry averages and individual numbers.
Nucor sells more products, and therefore is expected to have a higher amount of
receivables. However, all firms have demonstrated similar selling and collecting
processes. For the most part, the turnover ratio averaged around 10 turns; however in
2008 the numbers literally doubled. To account for this drastic increase, we observe
the fact that sales increased industry wide. With a larger number in the denominator,
we see the mathematical illustration of an increase across the board. Essentially, there
was a positive impact in the last year for steel firms, all increasing their receivables
turnover. All previous years, 2003-2007 demonstrated no significant changes.
0
5
10
15
20
25
2003 2004 2005 2006 2007 2008
Receivables Turnover
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
120
Days Sales Outstanding
An even more precise measure that involves the proceeding ratio is called Days
Sales Outstanding. It is found by dividing the number of days in a year, 365, by the
Accounts Receivables Turnover Ratio. This measure demonstrates on average how
long it takes to collect on an account. Of course one would want to be paid sooner
rather than later, a principle of finance. If we were to see a trend of rapid increases in
length of time, it might cause some concern from an outsider’s point of view. Also, a
high number of days might indicate inefficiency with regards to collection processes.
We see the same obvious market segmentation that occurred in the previous
ratio. Nucor takes considerably less time to collect on their sales. Beyond this point,
we come to the conclusion that the most recent information points to an actual
convergence of all firms. Therefore, it is difficult to speak wisely on the reason for the
shape of this graph. Steel Dynamics represents the most significant positive impact in
the last year. This effect can be rationally argued as a result of altering the terms of
their short term receivables. Despite being the industry out-performer, Nucor
demonstrates the only actual increase in days sales outstanding. The information
shown here is a direct result of the receivables turnover ratio calculations. When the
turns are high, days will be low, and vice versa.
0
10
20
30
40
50
60
2003 2004 2005 2006 2007 2008
Days Sales Outstanding
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
121
Working Capital Turnover
A ratio called Working Capital Turnover is a good measure for evaluating the
entire collection of processes previously mentioned. Therefore, a favorable result for
this ratio would be relatively high. The formula for this ratio is total net sales divided by
the amount of working capital. Working capital is of course the current assets minus
the current liabilities. The relevant information provided by this ratio is whether the
firm is doing a decent job of using the money from its sales to efficiently fund its
operations. Because working capital is related to operating efficiency and liquidity, it is
a significant ratio that attention need be paid to. Managing the level of working capital
is a job in and of itself for most industries.
The chart that portrays the last six years of ratio data presents little
segmentation. The most impressive move shown is from 2007 to 2008 as Steel
Dynamics drastically improves. A stable relationship between industry average and
individual firm figures clearly demonstrates similar operating activities. Nucor, which
leads the way in many ratios, does not for working capital turnover. US Steel is said to
be getting the most “bang for buck”, as it out performs all other firms in the time trend
analysis. This ratio allows us to believe that even though certain preceding ratio figures
for Steel Dynamics are not often extremely favorable, the measurement used to analyze
the entire process shows significant improvement most recently.
0
2
4
6
8
10
12
2003 2004 2005 2006 2007 2008
Working Capital Turnover
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
122
Cash-to-Cash Cycle
The figure below is a artistic representation of what many financial analysts refer
to as the Cash to Cash Cycle, or the “money merry go round” unprofessionally
speaking. It represents the process of investing money into a cycle of inventory, sales,
receivables, and collections. The summation of the Days Sales Outstanding and the
Days Supply of Inventory numbers will provide an analyst with a figure known as the
“Cash to Cash Cycle”. The final results indicate how long it takes a firm, in days, to
turn money invested into inputs into final revenues.
Intuitively, the lower the figure that is found for firms in the industry, the more
liquid that industry tends to be. This is due to the fact that both components of this
ratio are more favorable if they are smaller. Fewer days means more liquidity, and
overall better viability.
The graph points out Steel Dynamics’ underperformance against industry norms.
However, all firms taken into consideration did improve over the last year. Consistency
123
would indicate proper procedures taking place, and improvements only mean good
things for a firm. Because steel making is a relatively long process, one would expect
to see a relatively lengthy cash to cash cycle. AK Steel, US Steel, and Nucor have had
better figures for this ratio than Steel Dynamics for the last six years. However,
because of the most recent data shown, we can conclude that the overall impact is
favorable for the steel industry as a whole.
Conclusion
The processes involved in a financial analysis use ratios as a starting point. From
there one can forecast numbers and make estimations of the cost of capital. When
comparing the liquidity measures we came to a set of conclusions that can be
summarized in the following table. For the most part, the steel industry is liquid,
meaning they are capable of meeting their obligations and converting items into cash
quickly. The impacts observed are backed by actual results from using the said list of
ratios. Now that we have analyzed the liquidity of the steel industry, we will move on
to determine the level of profitability the firms demonstrate.
020406080
100120140160
2003 2004 2005 2006 2007 2008
Cash‐to‐Cash Cycle
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
124
RATIO IMPACT ON SDI
IMPACT ON INDSUTRY
TREND
CURRENT RATIO Negative Favorable Positive QUICK RATIO Negative No Significant
Change Stable
INVENTORY TURNOVER
Favorable Favorable Positive
RECEIVABLES TURNOVER
Favorable Favorable Positive
WORKING CAPITAL TURNOVER
Favorable Favorable Positive
Profitability Analysis
Profitability ratios effectively illustrate the relationship between revenues and the
cost that are incurred to earn them. Therefore information from both the balance sheet
and income statement is used. Profitability analysis ratios provide investors with the
information necessary to evaluate several key factors related to profits which include:
1) Operating Efficiency
a. Gross Profit margin
b. Operating Expense
c. Operating profit
d. Net profit Margin
2) Asset Productivity
a. Asset turnover
3) Rate of Return on Assets
a. ROA
4) Rate of return on Equity
a. ROE
The operating efficiency ratios compare expense items found on the income
statement to sales. This is important because one of the main goals for any firm is to
125
achieve a target volume of sales while incurring the minimum amount of expense while
doing so. Asset productivity measures the productivity (in terms of revenue) of
resources owned by company. Return on assets is a comprehensive measure of profits
because both operating efficiency and asset productivity are considered. Return on
equity is a measure of how profitable the owner’s interest in the firm’s total assets is.
Several factors influence ROE, including profit margin, assets turnover, and how ROA
and ROE relate to each other. By evaluating these four critical factors with financial
ratios, investors gain the critical ability to set industry benchmarks to evaluate a firm.
As illustrated by the above table, Steel Dynamics has experienced a decrease in
profitability in virtually every measure in 2008. The industry has fared somewhat better,
experiencing an increase in the industry average of asset productivity.
RATIO IMPACT ON SDI IMPACT ON INDSUTRY TREND
Gross Profit Margin Negative No significant Change Positive
Operating profit Negative Negative Negative
Net Profit Margin Negative No significant Change Stable Trend
Asset Turnover Negative Favorable Positive
ROA Negative Negative Stable Trend
ROE Negative Negative Stable Trend
Internal Growth Rate Negative No Significant Change Stable Trend
Gross profit margin is a percentage measure of the relationship between gross
profits (Total Revenues less cost of goods sold) and sales in the current period. In other
words, gross profit margin is a ratio that measures basic product profitability. The
higher the gross profit margin is, the more efficient the firm is at turning their inventory
into profits. Steel Dynamics Gross profit margin is currently performing at the industry
average of 15%. 2008 is the first time in the last six years that Steel dynamics has not
significantly outperformed the industry average. This is due to an increasing cost of
goods sold over the past two years. Like Steel Dynamics, the other firms in the industry
have all moved towards the industry average of 15% with exception of US Steel which
is still underperforming with a gross profit margin of 12%. The nature of the Steel
Industry (basic materials) leads firms to have low gross profit margins due to the fact
that basic material manufactures rely on selling large quantities of product in contrast
to a specialty steel manufacturer who relies on superior product specialization and
quality.
‐0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
2003 2004 2005 2006 2007 2008
Gross Profit Margin
Steel Dynamics AK Steel Nucor U.S. Steel Industry Average
127
Operating Profit Margin
The operating profit margin ratio is a measure of day to day business profit. The
operating profit margin allows an analyst to gauge how efficient a firm is at managing
costs associated with the production process. The higher the ratio, the more efficient
the firms operations are. This is very important due to the critical nature of the
utilization of everyday operating activities to produce profit. This ratio is calculated by
dividing operating income (gross profit less operating expense) by total revenue. As
seen in the graph above Steel Dynamics (in terms of operating profit margin) is
operating close to the industry average of 9% with an operating profit margin of
10.5%. The only firm that perennially underperforms compared to its competitors is AK
Steel which has fluctuated around 1%. Steel Dynamics’s restated operating profit
margin is basically the same as the original number due to the fact that the only line
item that affects the restated numbers is a small impairment of goodwill. The change in
the restated numbers is so slight that it is not an important issue.
‐0.2
‐0.15
‐0.1
‐0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
2003 2004 2005 2006 2007 2008
Operating Profit Margin
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
128
Net Profit Margin
Net Profit margin is a very good measure of a firms well being due to the fact
that it serves not only as a measure of profitability, but as a measure of how well a firm
is able to control its cost as well. Net profit margin is calculated by dividing a firm’s net
income over sales which then yields the ratio in percentage form. A high net profit
margin ratio would mean that a firm has high net income and is able to control costs
associated with selling the product. Steel Dynamics has steadily increased their net
profit margin since 2003 to a 2008 ratio of .06 which is on par with the industry
average. This was mainly achieved by extremely large increase in sales (180%) over
the past 6 years. Once again, AK Steel is the underachiever in the industry with a net
profit margin that for the most part stays around .04. Once again, Steel Dynamics’s
restated numbers for this ratio are insignificant.
‐0.20
‐0.10
0.00
0.10
0.20
2003 2004 2005 2006 2007 2008
Net Profit Margin
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
129
Asset Turnover
Asset turnover is one of the most important profitability measures available to a
financial analyst because it effectively measures how effectively a firm is utilizing the
assets that it employs. This ratio is calculated by taking total revenue and dividing it by
total assets. It is important to note that this particular ratio is calculated with lagged
total asset numbers. This basically means that to find the correct ratio for 2008, total
revenue from 2008 and total assets from 2007 would be used. The reason a lag is used,
is to ensure that the assets that actually produced the profits for the current year are
used in the calculation, not the assets for the current term. This ratio effectively links
arguably the two most important line items from the balance sheet (Total Assets) and
the income statement (Total Revenue). Though initially falling short, Steel Dynamics
has been keeping up to par with the industry average for the past three years. Nucor
has the best asset turnover ratio by far with a ratio of 2.45 in 2008, while AK steel falls
below the industry average once again.
0
0.5
1
1.5
2
2.5
3
2003 2004 2005 2006 2007 2008
Asset Turnover
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
130
Return on Assets (ROA)
Return on Assets is a percentage measure of how efficient a firm is at generating
profit from its operating assets. To calculate this ratio you divide the current period’s
net income by the previous period’s total assets. Like asset turnover a lag is utilized so
that to assets that produced the capital are used in the calculation. A high ROA ratio is
favorable because the high ratio would lead an analyst or investor to the conclusion
that management is making sound decisions when investing in assets. The Industry as
a whole stayed around a ROA ratio of .15 with exception of AK steel once again. US
steel enjoyed a sharp increase of ROA in 2004, due to US Steel’s liquidation of a large
portion of their assets that same year. The restated ROA for Steel Dynamics was once
again so similar to the original numbers that it is not an important issue.
‐0.20
0.20.40.60.81
1.2
2003 2004 2005 2006 2007 2008
Return on Assets
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
131
Return on Equity (ROE)
Return on Equity is a ratio that provides information on how well a firm is
generating income from shareholders equity. Once again, this is a ratio calculated using
lagged numbers. Therefore, the current year’s net income is divided by the previous
year’s share holder’s equity to provide accurate information on how well income was
generated from the equity. A higher ratio is preferred because this is a good indication
to investors if the firm is utilizing funds shareholders equity, or “plowback” funds, to
produce income and growth for the firm. Steel dynamics 2008 restated ROE ratio is
below the industry average at -.03. This was due to the large amount of shareholders
equity that was lost from the impairment of goodwill on the restated financial
disclosures.
‐5
‐4
‐3
‐2
‐1
0
1
2
2003 2004 2005 2006 2007 2008
Return on Equity
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
132
Conclusion
After performing the applicable profitability analysis’s, it was determined that
Steel Dynamics has either matched or outperformed the industry average over the last
6 years. This is a good indication that Steel Dynamics is not only controlling their costs
effectively, but is also experiencing high profits. Though Steel Dynamics has kept up
with the competitors in the industry, they have experienced declines in their profitability
ratios over the last year. For the majority of Steel Dynamics’s restated ratios were not
causes for concern. This is due to the fact that the changes were so minute that in
most cases the change in the restated numbers is not visibly evident in the graphs.
The operating efficiency, asset, and equity productivity strategies that Steel Dynamics
has implemented seem to be working. This is evident upon review of the overall trend
of the industry which has been generally positive over the last six years.
Growth Rate Analysis
Analyzing firms past internal growth rates and sustainable growth rates affords
and analyst or investor information that can be used to set industry wide benchmarks.
The internal growth rate and sustainable growth rate represent an “upper bound” or
maximum amount that a firm can grow without outside funding or a restructuring of its
capital structure. For any decision that hinges on future profitability, taking growth rate
analyses into account is critical if one wishes to make an educated and calculated
decision.
Internal Growth Rate
The internal growth rate is the largest amount of growth that a firm can achieve
with assets found within the company. In other words, IGR is how much a firm can
grow without any outside assistance in the form of loans. Due to this, the internal
growth rate that a firm can achieve is directly correlated with the amount of retained
earnings that are available for “plowback” purposes. A high internal growth rate is good
133
because this would show that a firm is self sufficient at utilizing retained earnings and
has ability to finance itself with capital created from its operations. The internal growth
rate is calculated by multiplying the firms return on assets ratio by 1 minus the dividend
payout ratio. Steel dynamics internal growth rate fluctuated between 11% and 19%
between the years of 2003 and 2008 and never dipped below the industry average.
This is a good indication that steal dynamics is putting its retained earnings to work by
expanding the company. The industry (including steel dynamics) had a comparatively
poor year in 2003 but regained ground over the past 5 years. The only firm that
consistently had internal growth rates far below the industry average is AK Steel. The
last six years have shown that AK steel has little to no ability to expand itself through
the use of residual earnings. After 2005, Steel Dynamics restated numbers change due
the impairment of its goodwill. Steel Dynamics restated numbers do not change enough
to raise any alarm.
‐0.1
0
0.1
0.2
0.3
2003 2004 2005 2006 2007 2008
Internal Growth Rate
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
134
Sustainable Growth Rate
The sustainable growth rate is the highest growth rate that a firm can sustain
without increasing their leverage. As soon as a firm decides to exceed this rate, it must
gain its needed capital from outside sources. Since leverage is kept constant new equity
requires new debt. The sustainable growth rate is calculated by multiplying the firms
return on equity by 1 minus dividends over net income (payout ratio). The sustainable
growth rate for Steel Dynamics has exceeded the industry aver over the last 6 years,
even growing as large as 39% in 2004 and a most recent SGR of 33%. Steel dynamics
has paid dividends since 2004 which in turn reduces the amount of plowback capital
available for the firm to put towards growing the company. Once again all of Steel
Dynamics’ competitors enjoy a healthy growth rate with the exception of AK Steel which
enjoys a very meager 2008 SGR of .093%. Once again Steel Dynamics restated
numbers change after 2005 due to impairment of its goodwill. Comparison of the
original numbers and the restated numbers, we came to the conclusion that the original
SGR would not be realistically sustainable. Once Steel Dynamics’s SGR was restated, the
firm still slightly outperforms the industry average.
‐0.60
‐0.40
‐0.20
0.00
0.20
0.40
0.60
2003 2004 2005 2006 2007 2008
Sustainable Growth Rate
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
135
Capital Structure Analysis
The capital structure of a company refers to the financing of any acquired assets.
Assets are financed by a combination of liabilities and equity. There are three capital
structure ratios we use to measure Steel Dynamics’ ability to repay its interest and
principle on debt. In assessing their debt payment abilities we are also able to analyze
their credit exposure. These ratios include: Debt to Equity, Times Interest Earned, and
Debt Service Margin. To accurately analyze the results of the capital structure ratios we
created a table of Steel Dynamics and its three main steel and iron competitors to
determine the industry debt structures. This is visible below, we will now discuss the
trends and structure present in the steel industry, and Steel Dynamics specifically.
Debt to Equity
The Debt to Equity Ratio is simply a company’s leverage. It helps determine the
amount of credit risk a company is exposed to and how they are financed. The amount
of Debt to Equity is computed by dividing a company’s total liabilities by their total
owner’s equity. Both numbers are found on the Balance Sheet. A low debt to equity
ratio, between .4 and 1.25, is preferable because it indicates that a company’s structure
is primarily financed with equity, and so the company has less risk of not repaying the
interest and principle on their debt, with their current cash flows. If a Debt to Equity
ratio is above a 1.5, this indicates that for everyone $1.00 of equity there is $1.5 of
debt, which should alert concern for high credit risk.
As the graph indicates, the steel processing industry’s debt to equity average
was around 1.53 for the past six years. All of the competitors follow a similar trend
pattern, increasing and decreasing in the same years. Having such high ratio means
that Nucor, U.S. Steel and Steel Dynamics are financed more with debt than equity. For
investors and issuing credit this is seen as a “red flag.” However, if you just look at the
firm’s leverages from 2004-2006 it was lower. This coincides with the economic growth
of the time. Once the recession of October 2007 hit, the debt to equity logically reflects
a higher amount of debt being used to finance the steel and iron industries because
cash flows slowed. Nucor Corporation has the lowest D/E, which is highly favorable for
136
investors and lenders. And then on the other side, U.S. Steel was on the higher end
with a 6.17 ratio in 2003.
*Note AK Steel was removed from the analysis and graph because of their high negative equities which drastically skewed the graph so that the other ratios were not comparable.
Steel Dynamics’ amount of debt compared to equity is stable throughout the six
years. Generally, you want a consistent financing ratio because it shows the company
has a set leverage level they try to maintain. The debt to equity ratio can be lowered by
either increasing the amount of equity, like stocks, or decreasing the amount of
liabilities incurred. For SDI both debt and equity were growing from 2003-2006 but the
equity was increasing at a faster rate than debt was, dropping the Debt to Equity Ratio.
Having both debt and equity increasing is a good sign because it shows the company is
acquiring more assets every year. The increase in percent change of equity and the
decrease in the percent change of debt until 2006 are displayed below:
2003 2004 2005 2006 2007 2008
Total Liabilities 59.45% 51.14% 49.91% 45.21% 66.16% 69.09%
Total Owner’s Equity 40.54 48.86 50.06 54.79 33.84% 30.91%
Total Sources of Assets 100% 100% 100% 100% 100% 100%
00.51
1.52
2.53
3.54
4.55
5.56
6.5
2003 2004 2005 2006 2007 2008
Debt to Equity Ratio
Steel Dynamics
Steel Dynamics Restated
Nucor
U.S. Steel
Industry Average (with out AK Steel)
137
As a whole, the industry is consistent. Steel Dynamics’ restated balance sheets
didn’t make much of a difference with the debt-to-equity structure. In fact, the Debt to
Equity ratio between restated and stated was the same until 2007. Even then the ratio
still remained within a .32 range. This is quantitatively shown in the chart below.
Liabilities Owner's Equity
Debt to Equity
Restated Liabilities
Restated Owner's Equity
Restated Debt to Equity
2004 886497 847122 1.05 886,497
847,122 1.05
2005 877819 879868 1.00 877,434
879,868 1.00
2006 1015909 1231108 0.83 1,009,331
1,231,108 0.82
2007 2990257 1529196 1.96 2,881,486
1,529,196 1.88
2008 3629691 1623886 2.24 3,113,218
1,623,886 1.92
SDI’s restated and stated numbers remained around 1.4. Comparatively, this is
lower then the industry average. SDI finances their assets with an average $1.40 of
equity for every $1.00 of debt. Although this is not as low as other industries, this is
favorable for SDI’s growth and it shows a lower default risk than their competitors. SDI
appears to have a set amount of leverage they try to maintain. The steel industry has
room for improvement in how they finance their assets.
Times Interest Earned
We continue our capital structure analysis with determining the ability of firms to
cover their interest expenses with their operating income. The ratio we use to do this is
called the “Times Interest Earned” ratio. It is computed by dividing a firm’s income from
operations by their interest expense of the same period. Times Interest Earned
specifically is critical to shareholders, because shareholders can not earn a profit unless
the company is able to adequately cover all of its interest charges. A larger number is
desired because this indicates that a company’s operating income completely covers the
interest amounts. In fact, banks prefer a number between 4 and 7 because this ensures
138
the interest they charge on bank loans will be recovered. The results for Steel Dynamics
and their competitors are shown below.
The steel industry has high numbers and is very volatile. AK Steel and Nucor
have no trend or pattern, with Nucor having extreme volatility. This could indicate that
Nucor is in a different segment. Steel Dynamics has a high times interest earned ratio.
In 2006, SDI had a ratio of 20.53. This number means that SDI could pay their interest
charges 20.53 times with their income from operations. Having such high numbers is
usually due to either an increase in earnings, or not financing their assets with large
amounts of debt, so their interest expenses are really low. After impairing goodwill,
SDI’s restated operating income decreased, causing the times interest earned ratio to
decrease as well. As illustrated above in the sporadic graph, there is no synchronization
or regularity seen in the Times Interest Earned Ratio for the steel processing industry,
which could be a potential financial problem. To alleviate banker’s concerns, SDI and
the steel industry should better target the amount of operating income that adequately
finances the interest expense.
Debt Service Margin As times interest earned covers the interest payments of debt, the debt service
margin measures the ability of a company to cover their principle amount owed with
their cash flow from operations. The Debt Service Margin (DSM) ratio requires a lag
‐80
20
120
220
320
420
520
2003 2004 2005 2006 2007 2008
Times Interest Earned
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
139
effect to take place, meaning that we will use the current portion of long-term debt of
the previous year to calculate this years DSM. This is reflected in the equation below:
Debt Service Margin= Cash Flow from Operations
Current Portion of Long-term debtt-1
DSM is lagged because a company uses the CFFO of this period to cover the
installments due on long-term debt that were incurred in the previous period.
Cash flow from operations is generally used to retire long-term debt. Naturally, the
higher the debt service margin, the better, because then the cash flow from operations
is completely covering the current portion of long-term debt. Banks especially pay
attention to DSM, to see if the company’s they lend to will be able to meet the required
principle payments. The graph further illustrates SDI and its competitor’s capital
structure:
Again, the steel processing industry has an irregular pattern regarding the debt
service margin. Times interest earned, which relates to the interest, and now debt
service margin, which relates to the principle, both are indicating no structure or trend,
numerically seen in Appendix 3. If a company does target their coverage of interest and
principles they are considered to have less credit risk and often receive lower interest
rates when borrowing money. Each competitor seems to be independent of each other,
regarding DSM. AK Steel didn’t report any current liabilities of LT debt for three years.
‐100
0
100
200
300
400
500
600
700
2003 2004 2005 2006 2007 2008
Debt Service Margin
Steel Dynamics AK Steel Nucor
U.S. Steel Industry Average
140
U.S. Steel had very low coverage, averaging under a 1:1 ratio. Having a ratio below 1
concludes that the majority of a company’s cash flow from operations is used to cover
their debt, this is not desirable. Nucor has some structuring, maintaining a range
between 1.5 and 4.68. The industry average can be thrown out here, because of such
volatility regarding payments.
The only trend Steel Dynamics follows is having an extremely high ratio. Higher
is better, but again this could reflect SDI having low financing with debt, and thus low
payments of long-term liabilities. Having a high ratio, could also be the product of
having a large amount of cash flow from operating activities. SDI’s large CFFO usually
means the more steel is being produced and sold, so having a high ratio may very well
be because SDI is generating enough revenue where they don’t have to incur as much
debt. The debt service margin for Steel Dynamics drastically increases, going from
10.17 in 2003 to 642.2 in 2007. This is relieving the pressure of CFFO to cover debts.
In conclusion of the capital structure ratios, the steel industry needs to target
both their times interest earned and their debt service margin ratios to increase stability
and decrease credit exposure. The trends indicate volatility and randomness. Although
debt to equity is high, there is consistency and structure. U.S. Steel demonstrated
consistent capital structure through out all three ratios; where as the rest of the steel
industry did not have much structure. Steel Dynamics has favorable results for their
leverage ratio and unfavorable results on their structuring choices to pay their interest
and debt principles. This is summarized in the table that follows.
CAPITAL STRUCTURE
RATIOS
IMPACT ON
SDI
IMPACT ON
INDUSTRY
TREND
Debt to Equity Favorable Negative Positive
Times Interest Earned Negative Negative Irregular
Debt Service Margin Negative Negative Irregular
Altman’s Z-score Favorable Favorable Positive
141
Altman’s Z-Score
In 1968 Edward Altman created a model called, z-score, which forecasts the
probability of a firm entering bankruptcy. Altman’s multilevel model has 5 independent
layers which ultimately combined, lead to credit ratings. The ratios are basically put into
a “blender” and are not related. Z-scores 72% of the time accurately measure the credit
exposure of a firm, and are widely used for decisions about bank loans (Altman’s Z-
Score). A probability of below 1.81 signifies high probability of bankruptcy. A z-score
between 1.81 and 2.67 is a grey are, but is considered in range of bankruptcy. A higher
z-score is most definitely preferred, and a score above 2.67 recognizes that the firm is
healthy, and not close to defaulting. “Generally speaking, the lower the ratio the higher
the odds of bankruptcy (Investopedia).” The five layers that make up the z-score
equation are broken down below:
1.2
1.4
3.3
.6
1.0
Layer One: The first layer is 1.2 weight, or level of importance, and is used to
determine if a firm’s working capital is large enough to pay off their debt. Like
mentioned in the liquidity analysis, working capital runs into a contradiction. The
bankers want high current assets to ensure being repaid, and managers want low
amounts of ending inventory to avoid storage and loss costs.
Layer Two: The second layer has a 1.4 thickness and evaluates factors of the asset
equation. It basically explains how much profits are from net income.
Layer Three: Is the most heavily weighted layer and establishes the profitability of
assets. A higher ratio shows that the company has more profitable assets, which leads
to overall more cash. More cash is preferred by the business, investors, and bankers.
142
Layer Four: The fourth explains the relationship between the actual market value and
the original reported book value of equity. This layer has the smallest thickness.
Layer Five: The fifth layer shows the asset turnover ratio. Again, a higher ratio is better
because it indicates that you are selling your assets quicker, which implies more
customers, which implies that the firm can cover their liabilities.
The Z-Scores for the steel processing industry are graphically depicted as follows:
As a whole the steel industry average is in the safe zone (>2.67). This is
indicates that firms in the steel processing industry have a low chance of declaring
bankruptcy. The industry average also states that their credit ratings are good. Nucor
has a very high Z-Score, and thus a very low probability of defaulting on their loans. AK
Steel according to the model should be at great risk of bankruptcy. Its low Z-score
alerts banks and lenders that they potentially will default and thus is even harder for AK
Steel to issue credit or borrow money.
Steel Dynamics’ Z-Score is above the industry average for every year in the past
six years, except for 2005 and 2007, where it is hovering a little below. All of SDI’s Z-
‐1.5
‐0.5
0.5
1.5
2.5
3.5
4.5
2003 2004 2005 2006 2007 2008
Z‐Score
Steel Dynamics Steel Dynamics Restated
AK Steel Nucor
U.S. Steel Industry Average
143
Scores are in the healthy zone, implying a very low chance of bankruptcy. Their credit
risk is low due to their high Z-Score. Since Altman’s Z-Score has become the rule of
thumb, SDI should be able to get lower interest rates on bank loans, and also be able
to receive more loans and funding in general.
In summary, the steel industry has a lower probability of defaulting on their
loans, and high credit rating. The Z-Scores specifically indicate the credit risk of the
industry as being positive, although the Debt Service Margin and Times Interest Earned
ratios indicate potential financial problems. Steel Dynamics follow the industry averages
almost exactly in the evaluation of credit risk ratios. Steel Dynamics and U.S. Steel are
the most consistent and solid competitors in how they structure their firm’s capital to
cover their debts. In short, SDI could improve their consistency in covering the interest
and principle debt payments, but has good leverage and Z-scores.
Conclusion
Overall, the capital structure for the steel industry lacks consistency, including
Steel Dynamics. With Times Interest Earned and Debt Service Margin there is an
irregular trend. However, in Debt to Equity SDI has a high ratio, and its credit risk
based on its Altman’s Z-Score was reported favorable. Steel Dynamics does not exhibit
stable trends in their capital structure ratios.
CAPITAL STRUCTURE
RATIOS
IMPACT ON
SDI
IMPACT ON
INDUSTRY
TREND
Debt to Equity Favorable Negative Positive
Times Interest Earned Negative Negative Unstable
Debt Service Margin Negative Negative Unstable
Altman’s Z-score Favorable Favorable Positive
144
Financial Statement Forecasting:
Forecasting is the most important and hardest step in valuing a firm. Forecasting
provides performance targets for managers, information to bankers asses the likelihood
of loan repayments, and helps analysts communicate their views of the firm’s prospects
to investors (Palepu). In order to do this, one must be have a deep understanding and
knowledge of the industry and firm’s recent financial statements and ratios, industry
trends, and other analysts’ expectations for future. In an attempt to predict the future
of Steel Dynamics, we forecasted the firm’s both stated and re-stated income
statements, balance sheets, and statements of cash flows.
When forecasting we chose to only forecast those line items that were on the
‘condensed’ statements. We did this for a number of reasons: not only would an
extremely detailed line-item forecast be tedious and our chosen assumptions would not
give us a solid basis to make all the assumptions required for such a detailed forecast
(Palepu). Therefore, the condensed statements provided sufficient information required
for analysis and decision making.
We created common size financial statements to help more accurately forecast
each statement. The common size financial statement “displays all items as percentages
of a common base figure” (Investopedia). This provides a different and useful
perspective of the financial statements, showing for example, “what percentage of sales
is actually cost of goods sold and how the percentages have changed over time”
(Investopedia).
145
Income Statement
We first began forecasting the income statement with sales, using the past five
years’ sales growth percentages as reference points. From the common size income
STEEL DYNAMICS, INC.: CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Years Ended December 31, *Adjusted for the impairment of goodwill
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 (adjusted for the impairment of goodwill) Common Size - STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Years Ended December 31
Investing activities Purchases of property, plant and equipment
-102,046 -63,386 -128,618 -395,198 -412,497
Acquisition of business, net of cash acquired — — -89,106 -848,071 -271,159 Purchase of securities — — -14,075 -3,584 -20,373 Maturities of securities — — 14,075 — 32,758 Other investing activities 55 1,345 311 224 2,037 Net cash used in investing activities
Increase (decrease) in cash and equivalents -49,096 49,184 -36,145 -887 -12,253 Cash and equivalents at beginning of year 65,430 16,334 65,518 29,373 28,486 Cash and equivalents at end of year 16,334 65,518 29,373 28,486 16,233
161
Common Size Statement of Cash Flows ACTUAL Forecasted 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization . 34.18% 29.56% 28.35% 32.26% 26.93% Unamortized bond premium — — — -0.78% — Equity-based compensation — — 2.19% 1.89% 1.84% Deferred income taxes 43.32% 7.15% -0.12% 2.95% 3.23% Gain from debt extinguishment — — — — — Loss on disposal of property, plant and equipment 0.33% 0.17% 0.00% 0.13% 0.07% Minority interest 0.75% -0.43% 0.08% -0.09% -0.34% Changes in certain assets and liabilities 0.00% 0.00% 0.00% 0.00% 0.00% Accounts receivable -51.56% 3.91% -17.85% 13.46% 40.11% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Inventories -79.46% -5.53% -16.36% -27.93% -2.41% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Other assets -3.34% 0.50% -0.83% -1.03% -19.45% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Accounts payable 23.27% -10.39% -2.42% -11.40% -11.41% Income taxes payable 0.00% 2.11% 3.45% -2.50% -2.81% Accrued expenses . 13.40% 1.59% 5.54% 0.89% 4.46% Net cash provided by operating activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
(% of net income) 83.95% 140.12% 102.08% 108.53% 171.00% Investing activities Purchases of property, plant and equipment 100.05% 102.17% 59.16% 31.70% 61.64% Acquisition of business, net of cash acquired — — 40.98% 68.03% 40.52% Purchase of securities — — 6.47% 0.29% 3.04% Maturities of securities — — -6.47% — -4.89% Other investing activities -0.05% -2.17% -0.14% -0.02% -0.30% Net cash used in investing activities 100.00% 100.00% 100.00% 100.00% 100.00%
(% of net income) -34.54% -27.97% -54.80% -
315.95% -147.61% Financing activities
Issuance of current and long-term debt -96.55% -
134.67% -
147.53% 386.17% -2405.26%
Repayments of current and long-term debt 178.18% 138.58% 132.88% -
215.50% 2030.12% Issuance of common stock (net of expenses) and proceeds from exercise of stock options, including related tax effect -14.31% -7.72% -12.74% 3.60% -15.57% Purchase of treasury stock 28.29% 93.60% 110.61% -65.28% 424.08% Dividends paid 3.82% 9.16% 16.78% -6.81% 60.25% Debt issuance costs 0.56% 1.05% — -2.18% 6.38% Net cash provided by (used in) financing activities 100.00% 100.00% 100.00% 100.00% 100.00%
(% of net income) -66.04% -89.97% -56.39% 207.20% -26.10%
Increase (decrease) in cash and equivalents -16.63% 22.18% -9.11% -0.22% -2.70% Cash and equivalents at beginning of year 22.16% 7.36% 16.52% 7.44% 6.28% Cash and equivalents at end of year 5.53% 29.54% 7.40% 7.22% 3.58%
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STEEL DYNAMICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS *adjusted for the amortization of goodwill 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Operating activities Net income 295,314 221,785 396,707 394,566 453,386 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization . 84,749 91,865 114,812 138,136 208,752 Unamortized bond premium — — — -3,350 — Equity-based compensation — — 8,862 8,073 14,278Deferred income taxes 107,404 22,230 -478 12,642 25,045 Gain from debt extinguishment — — — — — Loss on disposal of property, plant and equipment 815 532 12 551 557Minority interest 1,856 -1,351 306 -386 -2,611 Changes in certain assets and liabilities
Increase (decrease) in cash and equivalents -49,096 49,184 -36,145 -887 -12,253 Cash and equivalents at beginning of year 65,430 16,334 65,518 29,373 28,486 Cash and equivalents at end of year 16,334 65,518 29,373 28,486 16,233 Increase (decrease) in cash and equivalents
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Common Size Statement of Cash Flows ACTUAL Forecasted *adjusted for the amortization of goodwill 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization . 34.18% 29.56% 28.35% 32.26% 26.93%Unamortized bond premium — — — -0.78% — Equity-based compensation — — 2.19% 1.89% 1.84% Deferred income taxes 43.32% 7.15% -0.12% 2.95% 3.23%Gain from debt extinguishment — — — — —Loss on disposal of property, plant and equipment 0.33% 0.17% 0.00% 0.13% 0.07%Minority interest 0.75% -0.43% 0.08% -0.09% -0.34%Changes in certain assets and liabilities 0.00% 0.00% 0.00% 0.00% 0.00% Accounts receivable -51.56% 3.91% -17.85% 13.46% 40.11% Inventories -79.46% -5.53% -16.36% -27.93% -2.41% Other assets -3.34% 0.50% -0.83% -1.03% -19.45% Accounts payable 23.27% -10.39% -2.42% -11.40% -11.41%Income taxes payable 0.00% 2.11% 3.45% -2.50% -2.81%Accrued expenses . 13.40% 1.59% 5.54% 0.89% 4.46% Net cash provided by operating activities 100.00% 100.00% 100.00% 100.00% 100.00%
Investing activities Purchases of property, plant and equipment 100.05% 102.17% 59.16% 31.70% 61.64%Acquisition of business, net of cash acquired — — 40.98% 68.03% 40.52% Purchase of securities — — 6.47% 0.29% 3.04% Maturities of securities — — -6.47% — -4.89%Other investing activities -0.05% -2.17% -0.14% -0.02% -0.30% Net cash used in investing activities 100.00% 100.00% 100.00% 100.00% 100.00%
Financing activities
Issuance of current and long-term debt -96.55% -
134.67% -
147.53% 386.17% -
2405.26%
Repayments of current and long-term debt 178.18% 138.58% 132.88% -
215.50% 2030.12% Issuance of common stock (net of expenses) and proceeds from exercise of stock options, including related tax effect -14.31% -7.72% -12.74% 3.60% -15.57%Purchase of treasury stock 28.29% 93.60% 110.61% -65.28% 424.08%Dividends paid 3.82% 9.16% 16.78% -6.81% 60.25% Debt issuance costs 0.56% 1.05% — -2.18% 6.38% Net cash provided by (used in) financing activities 100.00% 100.00% 100.00% 100.00% 100.00%
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Conclusion
It is easy to see why forecasting the basic three financial statements is a critical
step in any equity valuation of a firm. Throughout the process, we used different
methods of forecasting; including plugging rates, analyzing trends and utilizing the
common size statements. Finding structure in previous years formed a basis of what we
chose to forecast in both the stated and adjusted statements. The use of structure
prevents analysts from forecasting unnecessary line items.
Forecasting the income statement using sales provided a basis for the entire
forecasting process. These results should yield figures very similar to what should occur
in the future. The balance sheet is mainly affected by the forecasted sales; however,
the results of forecasting are less reliable than those of the income statement. Harder
to predict, the statement of cash flows demonstrates a lower confidence level due to its
uncertainty. If goodwill continues to grow at a rapid rate and Steel Dynamics does not
amortize it, we can expect to see the net income, assets, retained earnings and
stockholder’s equity to be vastly overstated and liabilities to be understated. This will
result in larger differences between the actual and restated statements. There was a
significant difference in the actual and adjusted statements. If goodwill continues in its
trend we feel that the information presented above provides an accurate view of Steel
Dynamics’ future financial positioning.
Estimating Cost of Capital:
The return an investor expects to earn on their investment is known as the cost
of capital. This is an important rate that a potential shareholder must know before they
begin to invest in a company or project. In order to calculate the cost of capital, the
cost of equity and cost of debt must be found first. Within the cost of equity, there are
multiple ways to compute it. One of these is through the Capital Asset Pricing Model
and the other is by the alternative cost of equity or backdoor method. For the cost of
debt, a weighted average must be found for the liabilities of the company. After these
two inputs have been calculated, the cost of capital can be computed from a weighted
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average. Once this is discovered, the investor will have a good idea as to how much
they can expect to receive in return for their investment.
Cost of Equity
The cost of equity is the minimum rate of return a shareholder receives from a
firm to compensate for the risk associated with the investment. This usually leads to a
higher return than the market provides because there is quite a bit more risk involved
with investing in a single company. As the risk either increases or decreases, the return
follows in a positive correlation. For example, if a company is risky in their investment
decisions, this will lead to a higher cost of equity. Therefore, this company has a certain
level of risk that it is taking and the shareholders who are investing in these risks must
be compensated. This is a basic fundamental principle of classical finance. There are
many ways to calculate an estimated cost of equity, but the one that was used to find
Steel Dynamics’ cost of equity was Capital Asset Pricing Model, or CAPM.
The Capital Asset Pricing Model or the equation is a
technique to compensate investors in two ways; for the time value of money and for
risk (Investopedia.com). The time value of money is expressed by the risk free rate or
and it offsets the investor leaving money in an investment over a period of time.
Within the formula above, is the cost of equity, β or beta is the coefficient that
relates the systematic risk of the market to risk of an individual firm, is the return
on the market, and is the market risk premium.
For Steel Dynamics, a risk free rate of 2.87% was used, and this was found from
the St. Louis Federal Reserve 10 year treasury yield curve. For the market risk
premium, 6.8% was the most logical percentage to use. According to Palepu & Healy,
“Over the 1926 – 2005 period, returns to the S&P 500 index have exceeded the rate on
intermediate-term treasury bonds by 6.8 percent.” Beta was found through multiple
regressions that involved information from seven years of both Steel Dynamics’ monthly
returns and the S&P 500 monthly returns, treasury rates from the St. Louis Federal
Reserve on a 3 month, 1 year, 2 year, 5 year and 10 year basis. Once this information
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was brought together, the various regressions were completed and a beta was found
on a 24, 36, 48, 60, and 72 month time span. The time horizons were utilized in order
to find the most effective beta for the equation.
The beta of a firm is defined as the systematic risk of a company compared to
the market as a whole. This undiversifiable risk that the company and market share also
explains the volatility of the firm compared to the market. If a company has a beta of
one, then the risk of the corporation coincides with the market. On the other hand, if
the firm has a beta above or below one, then the riskiness of the business will be more
or less volatile than the market, respectively.
Because multiple regression analyses were completed, a different factor had to
be assessed in order to find the beta that was the most significant. This is where the r-
squared or r^2 came in to effect. R^2 is the explanatory power of the beta coefficient,
so the highest r^2 is used to determine which beta will be utilized in the calculation of
the cost of equity. The table below shows the regressions completed and their r^2 as
well. Although there were a total of 25 regressions completed, the following are the
most significant of the individual time horizons. Within the 1 year time horizon, the 36
month regression analysis showed the highest r-squared of .3023 and from that the
estimated beta came out to 1.66. Although this is a low explanatory power and shows
little significance, it is the highest r^2 for Steel Dynamics and therefore is the best beta
to use within the CAPM formula. According to Yahoo Finance, the beta for Steel
Dynamics should be 1.74 which is relatively close to the beta found within the
regression analysis.
Time Horizon Months Est β Adj r^2 Lower β Upper β MRP Rf Ke Lower Ke Upper Ke3 month 72 1.78 0.1863 0.9273 2.64 0.068 0.0287 0.1497 0.0918 0.20821 year 36 1.66 0.3023 0.8244 2.51 0.068 0.0287 0.1416 0.0848 0.19942 year 72 2.03 0.2160 1.13 2.94 0.068 0.0287 0.1667 0.1055 0.22685 year 72 2.10 0.2269 1.92 3.02 0.068 0.0287 0.1715 0.1593 0.234110 year 72 1.76 0.2266 1.01 2.51 0.068 0.0287 0.1484 0.0974 0.1994
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Once the most correct beta is determined, the final Ke can be calculated. From
these numbers, the most accurate cost of equity for Steel Dynamics is 14.16%. Along
with a final Ke, upper and lower betas were found using a 95% confidence interval.
After recalculating CAPM with these adjusted betas, an upper beta of 19.94% and a
lower beta of 8.48% were found. Also, over the course of 3 month, 1 year, 2 years, 5
years and 10 years, Steel Dynamics’ beta is relatively stable which explains that the
company’s capital structure has been pretty constant throughout those times.
Cost of Equity
14.16% = .0287 + 1.66 (.068)
Cost of Equity with Upper and Lower 95% CI
Upper Ke: 19.94% = .0287 + 2.51 (.068)
Lower Ke: 8.48% = .0287 + .8244 (.068)
After the final Ke is found, a size adjustment must be factored in as well. This is a
premium that is added for the size of the firm which is measured by the market
capitalization of the company. Smaller firms are usually riskier, so a larger size premium
is added to compensate for the risk of investing in the firm. According to
http://finance.yahoo.com the market capitalization of Steel Dynamics is $1.70 billion
which places the firm in the fourth size decile. This gives the cost of equity an additional
1.7% on its final percentage. After adding in this premium, the final Ke with size
premium comes to 15.86%. This is the number that is used in the alternative cost of
equity and the weighted average cost of capital.
Alternative Cost of Equity
The alternative cost of equity, also known as the backdoor method, is a different
method to find the cost of equity and can be utilized to verify the Capital Asset Pricing
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Model. The formula of ⁄ 1
is the calculation needed to find the
alternate Ke. The price to book value, ⁄ , uses the price per share times shares
outstanding, and the book value of Steel Dynamics and it comes out to 1.30. ROE or
return on equity is 25% over our forecasted period and the growth percent of Steel
Dynamics came out to 15%. After the formula above was manipulated, the alternative
Ke came out to 22.69% which is quite a bit more than the size adjusted CAPM of
15.86%. Because the alternative cost of equity is so much larger than the Capital Asset
Pricing Model, we feel that 15.86% is a more accurate cost of equity for Steel
Dynamics.
⁄ ROE Growth Rate (g) ⁄ 1 Cost of Equity (Ke)
1.30 25% 15% .30 22.69%
Cost of Debt
According to Investopedia.com, the cost of debt is defined as the effective rate a
company pays on its current debt. This is usually lower than cost of equity because
debt holders receive assets before shareholders in the case of a default by the
company. The cost of debt is computed differently for each of the current and long-
term liabilities. This is because there are multiple interest rates depending on maturity
and risk. Because the Weighted Average Cost of Capital, WACC, requires one rate for
cost of debt, a weighted average of short-term and long-term debt must be computed.
The first part of finding this average is to put the individual liabilities into a percentage
of total debt. The next step is to find the rate of interest for each of those liabilities. For
Steel Dynamics, because the current liabilities interest rates were not disclosed in the
10-K, the rates were found using the St. Louis Federal Reserve’s numbers for their 1
month AA financial commercial paper rate. This came out to .45% and the estimated
number is .48% which is a reasonable change. For the long term liabilities, the Steel
Dynamics’ 10-K was utilized. The senior notes all used interest rate numbers found from
the 10-K for each liability. For the remaining long term liabilities, the risk free rate of
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2.97% was used because those numbers were not disclosed in the 10-K as well. Finally,
the next action is to multiply the percentage of total debt by the rate to get the
weighted average of debt for the individual liabilities. Then by adding these numbers
together, a final weighted average cost of debt is found for the company.
The following table shows the individual amount of liabilities, the rate of interest
for each, the weight and finally the weighted rate of liabilities. Then, by adding up the
weighted rate of the current liabilities and long-term liabilities, the total cost of debt is
calculated at 6.52%. This is a reasonable number because it falls within the guidelines
of being higher than the risk free rate of 2.87%. The next step is to utilize this number
within the Weighted Average Cost of Capital equation and calculate it for Steel
CURRENT LIABILITIES Amount Rate Weight ResourcesAccounts Payable 259,742 0.48% 0.0834 1 mo AA financial commercial paper rateAccounts Payable-Related Parties 3,651 0.48% 0.0012 1 mo AA financial commercial paper rateIncome Taxes Payable 4,107 0.48% 0.0013 1 mo AA financial commercial paper rateAccrued Expenses 209,697 0.48% 0.0674 1 mo AA financial commercial paper rateAccrued Profit Sharing 62,561 0.48% 0.0201 1 mo AA financial commercial paper rateSenior Secured Revolver 36,600 0.48% 0.0118 1 mo AA financial commercial paper rateCurrent Maturities of L-T Debt 65,223 6.68% 0.0210 SDI 10-K
% valuePV of year by year dividends 2.6234 48.31%Pv of the terminal value perp 2.81 51.69% 11.28Model Price 5.43 100.00%Time consistent model price 5.63Observed Share Price (4/1/2009) 8.98Initial Cost of Equity (You Derive) 0.1586Perpetuity Growth Rate (g) 0.05
Annual Normal Income (Benchmark) 257,548 299,937 358,979 423,925 503,209 594,385 699,238 819,818 958,486 1,117,954 1,301,342 Annual Residual Income (maintains value 73,882 139,697 124,619 161,192 169,676 179,432 190,652 203,555 218,393 235,457 250,815pv factor 0.86 0.74 0.64 0.55 0.48 0.41 0.36 0.31 0.27 0.23 0.20YBY PV RI 63,768 104,069 80,128 89,456 81,274 74,182 68,031 62,692 58,055 54,023 49,669 Percent change in RI 89.1% ‐10.8% 29.3% 5.3% 5.8% 6.3% 6.8% 7.3% 7.8% 6.5%
% Value avg % ch RI: 6.52%Book Value Equity (Thousands) 1,623,886 59.6% 9,512,285Total PV of YBY RI 735,677 27.0%Terminal Value Perpetuity 362,840 13.3% 1581433.4Market Value of Equity 12/31/08 2,722,404 100%divide by shares 181,820 Model Price on 12/31/08 14.97$ growth ratetime consistent Price 15.53$ -0.10 -0.20 -0.30 -0.40 -0.50
WACC(AT) 0.0982 Kd 0.0652 Ke 0.1516 Shares: 181820change in AEG = annual change in net income 65,815 (15,078) 36,573 8,484 9,756 11,220 12,903 14,838 17,064 Perp:
Core Net Income 331,430.09 Total PV of YBY AEG (84,000.76) PV of Terminal Value 17,410.60 75883.79Total Average Net Income Perp (t+1) 264,839.93 Shares Outstanding 181820Divide by shares to Get Average EPS Perp 1.46Capitalization Rate (perpetuity) 0.1586
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