Downgrade: Underperform on GGB

We recently downgraded our recommendation on Gerdau S.A. (GGB - Analyst Report), one of the leading steel producing companies in the world, from Neutral to Underperform.

The steel maker recently reported its second quarter financial results with earnings per share of 18 cents, down 38% year over year and much below the Zacks Consensus Estimate of 32 cents. The company’s performance received a setback due to rising cost of sales.

In the first two quarters of 2011 the company’s cost of sales increased by 26.3% and 17%, respectively, driven primarily by higher raw material costs. Steel production is largely dependent on two chief raw materials, iron ore and coking coal; so any unprecedented hike in prices/or disruption in supply will prove to be a major hindrance to the company’s business.  

To add to the peril, Gerdau’s growth momentum faces headwinds arising from foreign currency fluctuation, cyclicality of the industry and stiff competition from its peers including other major steel majors like Companhia Siderurgica Nacional (SID">SID) and Arcelor Mittal (MT">MT).

However, Gerdau’s effort to satisfy almost 100% of its iron ore needs internally by 2012 is appreciable. The company intends to reach an annual iron ore production capacity of 6.6 million metric tons by 2012. Also, the company acquired some mineral assets in the last five years, and more acquisitions are expected in the future.

Moreover, with the gradual revival of the global economy, capital spending in manufacturing and construction industry is on the rise, thereby boosting the outlook for the steel industry. According to the World Steel Association, global consumption of steel is likely to increase by 6% in both 2011 and 2012 to 1.36 and 1.44 billion tonnes, respectively, while steel demand in China, the United States and India continues to soar.

In order to cope with the rising demand, Gerdau plans to invest roughly R$10.8 billion between 2011 and 2015. The Brazilian steel industry will also get a boost as the country is hosting the 2014 World Cup and 2016 Olympic Games.

The current Zacks Consensus Estimate for the third quarter is $0.08, representing a year- over-year decline of 63.64%. Estimates for fiscal years 2011 and 2012 are $0.81 and $1.07, respectively.

Read the full analyst report on SID

Read the full analyst report on MT

Read the full analyst report on GGB