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Nucor Corporation (NUE), Harsco Corporation (HSC): Misunderstood Services Provider Riding on Increase In Steel Production

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TMS International Corp. (NYSE:TMS) is a typical case of industry bias, where investors avoid certain stocks categorically because they are classified in an unattractive industry. Firstly, TMS International is not as dependent on steel prices as perceived by investors. Secondly, TMS International is free cash flow positive, if one adjusts for growth capital expenditures to reflect the nature of its business. Furthermore, TMS International is attractively valued relative to peers.
Harsco Corporation (NYSE:HSC)

Started in 1926, TMS International is the largest provider of outsourced industrial services to steel mills in North America as measured by revenue and has a substantial and growing international presence. It provides mill services at 81 customer sites in 11 countries and operates 35 brokerage offices from which it buys and sells raw materials across five continents.

Correcting misconceptions

Contrary to what most investors will think, steel production volumes of TMS’ customers are a more important driver of TMS’ earnings than steel prices, as customers typically pay TMS on a fee-per-ton basis tied to production volumes.TMS has also built in certain elements into its contracts to shield itself from the effects of increased operating costs and reduction in steel production volume. These include tiered pricing structures with unit prices increasing to offset any decline in volumes, minimum monthly fees, and price adjustments based on published price indices.

Also, most investors will associate high capital expenditure requirements with the steel industry and might penalize TMS International unfairly. To understand the nature of TMS International’s capital expenditure, there is a need to differentiate between maintenance capital expenditures and growth capital expenditures. Maintenance capital expenditures are tied to equipment utilization and customers’ production volumes and are therefore highly variable. On the other hand, growth capital expenditures are only incurred after TMS International has won new contracts which meet its internal rate of return. Based on management’s definition of discretionary cash, calculated as Adjusted EBITDA net of maintenance capital expenditures, TMS International has doubled discretionary cash production from $54 million in 2007 to $102 million in 2012.

Growth drivers

At its 2012 Fourth Quarter Earnings Call, TMS International estimated that the outsource services market will grow from $2.6 billion in 2012 to $3.8 billion in 2017, driven by increasing demand for operational efficiency and the consolidation of the steel industry. Like their peers in other industries, steel producers are increasingly realizing the need for outsourcing essential non-core services such as the provision of industrial services to reduce costs in light of competition from other steel producers. In addition, consolidation has created bigger and more sophisticated multi-national players in the industry, who are more likely to adopt outsourced industrial services. This is validated by the fact that steel producers in developed markets such as North America and Europe have historically outsourced more industrial services than steel producers in developing markets.

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