Reliance, Inc. (RS) Earnings Call Transcript & Summary

Good morning, everyone. Kicking us up this morning is Reliance Steel and Aluminum. Reliance is the largest metal service center and processor in North America. It operates more than 300 locations in 40 states in the U.S. and has presence in 12 countries. The company has a very diversified portfolio and specializes in small orders with quick turnaround and increasing levels of value-added processing. Reliance is also well known for being a relatively high margin, consistent free cash flow generator. With us today are Reliance's CEO, Karla Lewis; and CFO, Arthur Ajemyan. Thank you both for being with us today.

And for the members of the audience, we're going to do this as a fireside chat. So if you do have questions, please send them in through the BMO app. But to kick it off, Karla, you recently took over the CEO role and you have been with Reliance for quite some time. So can you give us a bit of an overview of what differentiates Reliance relative to peers? In other words, what makes you so successful?

Yes. Well, first off, thank you, Katja and David, for inviting us here today. And being from the West Coast, we really appreciate having the 8 a.m. slot to be up here for our presentation. But -- so hopefully, we'll stay awake and get through the presentation. But -- and thanks to all of you in the audience to coming in to learn about Reliance. And yes, I've been with Reliance for 30 years, started out as a pretty small company. We went public in 1994. We've grown the company quite a bit since then. We've completed 71 acquisitions since 1994. I think we were about $300 million in sales when we went public. Last year, we were $17 billion in sales. So we've bought various sized companies, but we really look for well-run companies with good management teams and then run a very decentralized operation. I think that's one of the things that sets Reliance apart is that decentralized structure. We're also very customer focused, and that's part of the reason for the decentralization. Typically, our customers are within about 150 to 200-mile radius of our operations. And that allows us to be able to service 40% of our orders. Customer calls us today, we deliver tomorrow. Our average order size last year was about $3,700 in order, which is up significantly mainly because of pricing, but we're delivering a lot of small orders, and you get paid for that. So we're really there about being reliable, getting the -- getting our customers what they need when they need it. We really try to embed ourselves into our customers' operations so they rely on us. And we've also, over the last, I would say, 7 to 8 years, we've also really stepped up our investments in value-added processing equipment. We saw better equipment with more capability being made by the equipment manufacturers. And so we've invested quite a bit in that. And with that equipment, we're able to provide our customers, we believe, with a better product. We're typically -- we're not manufacturing end products. We're just changing the size and shape of the product, typically for our customers so that it fits into their production stream. And with the more capable equipment, we can take some steps out of what our customers do, which we then had to train our salespeople to charge for that because we're providing more value. So at Reliance, we used to process about 40% of the orders we shipped. We've increased that steadily over the last few years to about 50%. And along with that, our gross profit margin has increased about 400 basis points over that time period. So that -- to us, that demonstrates that our folks are getting the return on the investments we're making in them for capital expenditures. So I think the amount of value-added processing, the focus on next-day delivery, small orders. We think we have a very strong workforce as well. We also own our own fleet of trucks. There are a lot of companies in our industry where they want to only sell like a full truckload quantity. So it's bigger orders, typically lower margin and they're generally just sending those to one customer. We have 1,700 trucks. We have our own truck drivers. We look at them as an extension of our sales team, and they may go out and make 10 to 15 stops instead of one stop. So that's -- so those are, I think, are the main things that, I would say, differentiate us. Plus a very strong balance sheet and a very balanced capital allocation philosophy.

Okay. I will take next one from the app. Please discuss end market demand trends.

Yes. So we just had our earnings call a couple of weeks ago. Not a lot has changed there. We think things still look good for 2023. I know if you read some of the headlines and watch some of the macroeconomic indicators, you can come up with arguments why demand should not be as strong this year. But with the markets we serve, we're very upbeat. Our largest end market is nonresidential construction and infrastructure and that continues to be strong. We continue to see new jobs coming along. And at Reliance and most service centers, we're not selling large amounts of metal to the big projects, the big sky scrapers. We're typically 4 to 5 stories and below. So we're -- when residential construction has been strong the last few years, certainly that has fallen off. But once they build new communities, they need schools and hospitals and gas stations and strip malls. And those are the types of projects that Reliance typically participates in. And we do get fill in on the big jobs, a lot of that metal goes direct from the mill. But then they forgot to order something, they need different sizes. So we'll participate in that. And then with infrastructure, we haven't really seen the infrastructure bill kick in yet. We think that probably happens later this year. But we're staying busy with water projects, bridges, et cetera, on the infrastructure side. So our nonres business remains healthy. Automotive, we do not sell metal, for the most part, directly to automotive. We do what's called toll processing where we don't own the metal, but typically on behalf of the steel or aluminum mill, we inspect the metal, we edge trim it, do other processing to it, and then we ship and deliver it to the automaker, but our customer is the producer, and we just charge a fee for the services we do on the metal. And that keeps us from having to deal with the metal price volatility on the volume going direct to the automakers who are usually pretty good negotiators on the price of the metal. So that's the way we participate in auto. That is continuing to pick up for us, and we expect it to continue to pick up a little more. And a big growth area for us in the automotive side has been processing aluminum. We've added greenfields over the last few years and have been supporting that kind of general manufacturing, a lot goes into that. That's a large end market for us as well. Industrial machinery remains strong. A lot of the heavy equipment, ag and construction equipment, we continue to operate at steady levels from that demand standpoint. Moving a little more away from some of the carbon products, aerospace is a strong market. That's been improving throughout 2022, and we expect that to continue through 2023. So we're very positive on aerospace. Semiconductor is another market we participate in, and that had been at record levels the last few years. Long term, we are still very positive on semiconductor. We do see a little downturn, fourth quarter and the beginning of this year. And semiconductor, we kind of participate in two parts of that market. One is selling metal to the equipment makers of semiconductor chips, and that's where we're seeing a little more of the falloff on demand. The other part of the business we do is more project based, where we sell ultra-high purity electropolished stainless steel tubing and fittings, which is a very high-value product for us. And that's really what the semiconductor chip manufacturers use when they're building new chip plants and it pipes the gases into the clean rooms. So that, we think, has some long-term upside for us right now, especially here in the U.S. That business, we -- most of our growth has been in South Korea and China over the last decade or so. But now with all the announced builds in the U.S., we're expanding our operations. We have a first phase of an expansion coming online. It's a smaller part of the expansion next quarter. And then in first half of 2024, we've got a larger facility going into Texas to really help us support the -- to increase our capacity and support that demand. And energy, we participate -- at energy, we're going to say oil and gas, it's a pretty small part of our business now. And that was pretty good in 2022. I think it's leveling off a little bit right now. But another good part of the business. We do sell into the renewable energy markets, but we kind of dump that into our nonres infrastructure bucket because with who we're selling to, which are typically like job shops and subcontractors, we don't always know where our metal is going. So we have to make our best estimates of the end market usage.

Can you remind us how much of your sales are exposed to the semiconductor market right now?

Well, if we knew, we would tell you, but probably 5% or less.

That's a good guess. That's a good estimate.

Yes. And but I would say with the high-value products and we do a significant amount of processing on those products, the contribution to pretax income is greater than the sales percentage.

And certainly, on a tonnes basis, it's much less than 5%.

Okay. Now beyond the semiconductor expansion project, are there any specific markets that you want to expand further into?

Well, we always want to expand further into all markets with all the different products. So we -- at Reliance, from a growth standpoint, as I mentioned in the opening comment, we have grown quite a bit through acquisitions over the years. But as we've expanded our footprint -- and again, each of our service centers, for the most part, they're usually specialized. We have some that are focused on aerospace. Some are focused on semiconductor, energy, non-res, et cetera. We don't carry all products in every location. We think we do a better job of servicing our customers and knowing how to charge appropriately by having that kind of more specialized knowledge. And so we might -- like in Los Angeles, Houston, Chicago, we might have 10 or so different of our companies operating there. But they're each servicing different parts of the market. And so as we've grown Reliance, I think we've -- and as I mentioned earlier, we see more capabilities in the equipment that's out there. We now look at, do we want to take a known commodity, right, one of our management teams and let them grow their business or open a greenfield site? Or do we want to pay a premium to buy a location in a new market? So a lot of times now, we prefer lower risk and lower cost to open a greenfield operation. We will still look at acquisitions. But over the last few years, they've typically been a little more nichey where they're doing something that we're not currently doing in our existing operations. But we see -- so we look at greenfield growth, for instance, the Texas semiconductor operation I'm talking about. We've done greenfield with -- in a number of toll processing facilities, both in the U.S. and in Mexico. We just put together our 2023 CapEx budget, which is a record at $500 million. About half of that is value-added processing equipment. Our customers keep asking us to do more for them. We saw that trend happening even pre-pandemic, but I think with difficulty in labor now and our customers just trying to be smarter about where they're investing their capital dollars. They continue to ask us to do more for them. And so we're able to support them in that. But we don't have any specific geographic or product markets. I mean, we're going after things where we've got a bit more of energy around growth right now. So we expect to be a little more aggressive on growth while still maintaining our margins this year.

You mentioned investing in value-added processing, and you have been doing this for many years. But it seems that many or most of your peers now are talking about investing in value-added processing. If this trend continues, is there a risk that there will be oversupply of the value-added processing capabilities, which could over time impact margins?

Well, I mean, I think it depends what you're talking about doing in value-added processing. And certainly, we've heard other competitors talk about that. I think we've had a strong balance sheet for quite some time. I think some of the others in our industry have the balance sheets now that allow them to start to invest a little more. And whether we're distributing metal, processing metal, we always have competition. So we just really focus on servicing our customers. And if we continue to do that well and provide superior service, we're not that concerned. We always have people competing against us. And a lot of the growth we've had in value-added processing over the years hasn't been as much taking share from other service centers, even though some of that happens, it's been more, like I just mentioned, our customers outsourcing what they were doing in-house to us.

Is there an optimum level of value-added processing that you can reach? Or how do you think about that?

Yes. I mean, as I mentioned, we've kind of steadily gone from about 40% of our orders to 50%. We expect that with the investments we're making. We expect that to continue to increase. But we don't have a set number. It's really what's the customer demand. And as long as we see profitable value-add business, we will continue to invest in equipment and hopefully drive our margins higher. And I think Arthur always points out to me, too, the number we track that we tell you about, the 50%, is based on number of orders. But maybe on the same order that we were processing before with our new equipment, we have better capability. So it doesn't take the 50% up, but it does take our profitability up because we're doing more for our customer.

Okay. We have a question from the app. What is the typical margin difference between spot and contract business? What is the valuation uplift in value-add products?

Well, I'll take a stab, and then I'll let Arthur answer the tough part of it. But we do very little contract business. Where we have long-term contracts is in our aerospace business, but we think that's probably 3% of our total revenues. And when we -- the reason we're willing to lock into those long-term contracts on the aerospace side is because we can also lock in with our suppliers, so we protect our margin for the life of that contract. I mentioned earlier, we don't participate a lot with directly selling metal to automotive. Same is true with appliance. We toll process that. And that's really because there -- a lot of times, you have to lock into a fixed sale price without having your buy side locked in, and we don't want to take on that risk. So we do have some quarterly programs that are index based, and contractual business is usually a little less than -- at least on the contracts we'll take. It's a little less than our spot business, but that varies significantly in our spot business depending on lead times, depending on the product availability, how much processing we're doing. Arthur, do you want to address?

The short answer is margins on orders with processing are higher in aggregate, and it could be by a number of percentage points. But it is a bit nuanced because if it's commoditized processing versus a niche product that you're not processing, you could have actually a margin profile on one end that's higher than on a commoditized product that's processed. But another thing that value-added processing does, it provides a fair amount of stability to our margin profile. Take case in point, second half of 2022, as prices were declining across pretty much all product groups, our margins on orders with value-added processing were much more stable than any -- than sort of the typical stock pool order that you're doing without processing. So that helps our overall margin profile from a stability perspective. And another way to really kind of see the cumulative effect of the years of investments we've made in value-added processing, I would say looking at year 2020 and kind of comparing that to maybe another normal year pre-pandemic, going back to 2017 where before you had any Section 232 price run-up, et cetera, we made as much money EBITDA dollars in 2020 on $900 million less in sales than we did in 2017, right? So where does that come from? Those are some of the structural improvements in the business that Karla talked about, the investments in value-added processing that over time has started to contribute to much more stable margin profile -- and higher and stable margin profile.

And if anyone from Reliance is listening to this, you should get at least 15% more gross profit margin on processed orders.

Discuss the difference in your processing and what the upstream steel producers call fabrication. Would you get more into their version of fabrication?

So I would say at Reliance, we try to not compete with our customers, and we're appreciative of our suppliers who take on that same philosophy. However, they need to run their own businesses and they're making investments in some processing that's getting a little closer to us. But for the most part, the processing that they're doing, while there's a little overlap, they're kind of staying in their lane and just doing kind of downstream for some of the metal they're producing. So we don't see a big overlap at this point. And well, we’re just appreciative if we swim in our lane and they swim in theirs.

Discuss your current inventory levels versus historical average.

Yes. So at Reliance -- and a lot of times, we hear the investment world and analysts talking about destocking and restocking and I think some companies do that. But at Reliance, we've always really focused on inventory management and on our inventory turn. For each of our businesses, we have a different expectation of what their inventory turn goal should be. It’s really based upon their shipment levels to their customers. We buy on the spot. We sell on the spot. We buy probably 95% plus at least of carbon steel from domestic suppliers. We think we can manage our inventory better by buying from the domestic mills who work with us to help us with shorter lead times, more frequent deliveries. So that helps us turn our inventory. We don't buy much offshore because then you're buying bigger quantities. We think that negatively impacts our turn. And having the right turns for the products you sell helps mitigate the pricing volatility. We still deal with that, but it helps mitigate that. So I think we were at 4.5 turns company-wide last year. Our goal is 4.7 turns. We did get a little heavy at the beginning -- like March, April last year, we saw a lot of panic buying after the war in the Ukraine started. And so some people, us included, I think, got a little heavy at that time, but we've been working down our inventory levels, and we feel really good with where we are currently.

We have another question on the value add. What's your return on capital on value-add equipment investments?

Well, it depends on the type of investments you're making. If it's a small piece of equipment, the payback could be relatively short. If you're adding a major processing line or you're doing a greenfield, then obviously, the payback is going to be much different. But also in our business, if you have a plant that's got 20 different saws, you're not necessarily running a P&L at each saw level. So in a way, it becomes a bit of an art, how you measure returns if you're replacing an old saw with a new one, how much of that is incremental value. So it's not -- our CapEx, $500 million that Karla mentioned, is a couple of thousand line items. I mean this is -- the biggest projects could be a greenfield, right? But for the most part, things are a few hundred thousand dollars per line item. So this is not a situation where you're putting $100 million into one project and you're measuring returns. And the best way to really point to the returns that we've received over time is the expansion in our gross profit margins over the last 4, 5 years. So I know that's not necessarily a specific answer to the question, but that's just the nature of the business.

Maybe shifting gears quickly to your capital allocation strategy and how do shareholder returns fit into that.

Yes. So at Reliance, we think we've executed a very balanced strategy. I would say our preference on capital allocation is to grow our business, whether that's through our organic growth with capital expenditures that we've talked about or through acquisitions. But we're only going to do it if we find the right investments, both organically and with acquisition. So the timing, we never set targets of we're going to buy X number of companies or X amount because we think that we might do a bad deal. And so we want to make sure we're buying good companies with returns and growth prospects for those businesses. But we also want to respect our shareholders and return value. So we've had a dividend for -- quarterly dividend for 67 years now. We just increased it 14% in the first quarter of this year. We've never not paid a dividend, and we've never decreased our dividend. So our strategy there is to pay it at a sustainable level. And then we've also been pretty active in repurchasing our stock recently. And Arthur, if you want to give the 5-year?

Yes, sure. I mean we think capital allocation makes sense for us. When you do a 5-year look back, don't look at an individual quarter or a year. It's just not going to tell the full story. On a 5-year look back, our returns are slightly below 50% of our net income that's combined -- dividends and repurchases combined. So -- and when you look at overall kind of capital allocation, roughly 50% of it goes towards growth, CapEx and acquisitions and the other half goes towards returns, dividends and buybacks.

Okay. Well, thank you so much for being with us today. And we ran out of the time, unfortunately.

All right. Thanks, everyone.

Thank you.