BlueScope upside wired to further cost-cutting & rising Chinese production

Having gone from ‘no-hoper’ status to market darling within the last 12 months, on the back of higher steel and iron ore prices – which dipped as low as US$38 a tonne late in 2015 – Australia’s largest steelmaker, BlueScope Steel Limited’s (ASX: BSL) share price witnessed another welcomed 12% kicker mid-May to $6.26 following upgrades to the steel producer’s earnings guidance.

After range-trading for well over a year, the share price took off in early-February following the revelation by management that underlying EBIT (earnings before interest and taxes) for the six-months ending 30 June 2016 would be around $209 million.

Four months later, management now expects underlying EBIT to be around $270 million due largely to an earlier than expected delivery of targeted cost reductions, higher steel and iron ore prices – now back over $50/tonne – better than anticipated Australian domestic dispatches, plus better than expected margins in the international businesses.

There’s growing expectation that iron ore prices can remain above $50/tonne, but it’s important to note that following cost-cutting initiatives, BlueScope Steel is also better positioned to survive any future lower price environment.

The magnitude of BlueScope Steel’s turnaround since it racked up $2.2 billion worth of losses between 2011 and 2014 hasn’t been lost on the market, with the share price virtually double what it was in early-July 2015.

Meanwhile, continued job cutting at BlueScope’s 90-year-old Port Kembla operation remains an open sore for the business. Strikes have re-emerged with workers fully aware that around half of its $60 million earnings upgrade can be attributed to staff cuts.

What’s adding to ill-will amongst employees who survived the cuts, are revelations there’ll be greater use of contract labour to drive further savings.

Unlike its competitor, Arrium (ASX: ARI) which is now in the hands of administrators, BlueScope Steel’s balance sheet is in much better shape than it was a year ago, with strong long-term cash flow relative to reported profit.

Despite having a funding gap of $1.7 billion, net-debt to equity is expected to decrease from 30.59% in 2016.

Similarly, after very poor earnings per share (EPS) growth over the last five years, the stock is expected to deliver exceptional EPS growth; with EPS forecast to grow from (F16) $0.43, to $0.57 and $0.63 in 2017 and 2018 respectively.

What’s given analysts renewed interest in the stock is a greater sense of earnings sustainability, assuming there’s another step up in Chinese production.

The promise of what could be another 30% step up in steel prices bodes well for BlueScope’s  2017 earnings outlook, and could be strong enough to warrant further upgrades from here; with some analysts’ forecasts pointing to excess cash flow of around $250 million pouring out of the company  by the end of the 2017 financial year.

The drive to push down costs is still far from over, but further increases in gross profitability make it easier for BlueScope management to justify keeping Port Kembla open.

While BlueScope Steel trades on a 73% premium to its intrinsic value (IV), and a price to earnings (P/E) of 32.60x, it still trades at a 30% discount to an upper-end 12 month target of $8.10.

Assuming BlueScope Steel can squeeze further cost reductions and benefit from any additional step up in steel prices, buying on dips should be rewarding, with upgrades to earnings likely to follow.