FIN 3321-002 Financial Statement Analysis Texas Tech ...

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Business Valuation of Steel Dynamics, Inc. NASDAQ – STLD

Submitted April 28, 2009

FIN 3321-002 Financial Statement Analysis

Texas Tech University: Spring 2009

Mark Moore, Instructor

Eric Callahan [email protected]

Adam Dunlap [email protected]

Margaret Fisher [email protected]

Lydia Herschap [email protected]

Jacob Lewis [email protected]

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Table of Contents:

Executive Summary 7

Company and Industry Overview 16

Company Overview 16

Industry Overview 17

Five Forces Model 18

1. Rivalry of Existing Firms 20

Industry Growth Rate 20

Concentration of Competitors 22

Differentiation 24

Switching Costs 25

Economies of Scale 25

Learning Economies 27

Excess Capacity 28

Exit Barriers 30

Conclusion 31

2. Threat of New Entrants 31


First Mover Advantage 33

Access to Channels of Distribution and Relationships 33

Legal Barriers 34

Conclusion 35

3. Threat of Substitute Products 35

Relative Price and Performance 35

Customers’ Willingness to Switch 36

Conclusion 36

4. Bargaining Power of Customers 37

Switching Cost 39

Differentiation 40

2

Importance of Product for Cost 41

Importance of Product for Quality 41

Number of Customers 42

Volume per Customers 43

Conclusion 44

5. Bargaining Power of Suppliers 44

Switching Cost 46

Differentiation 46

Importance of Product for Cost 47

Importance of Product for Quality 47

Number of Suppliers 47

Volume of Suppliers 48

Conclusion 49

Analysis of Industry Value Creation Key Success Factors 49

Classification 50

Cost Leadership 50


Efficient Production 51

Simpler Product Designs 53

Lower Input Costs 54

Low-Cost Distribution 55

Research and Development 56

Brand Advertising 56

Differentiation 56

Conclusion 57

Firm Competitive Advantage Analysis 57


Experience 59

Culture 59

Product Variety 60

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Distribution 60

Conclusion 61

Formal Accounting Analysis 61

Key Accounting Policies 63

Type One Key Accounting Policies 63



Low Input Costs 65


Type Two Key Accounting Policies 67

Goodwill 67

Currency Risk 68

Benefit Plans 69

Operating and Capital Leases 70

Credit Risk 71

Accounting Flexibility 72

Goodwill 73

Operating Leases 74

Credit Risk 76

Accounting Strategy Evaluation 78

Goodwill 79

Currency Risk 81

Credit Risk 83

Qualitative Analysis of Disclosure Quality 85

Type One Key Accounting Policies 85



Low Input Costs 87


Type Two Key Accounting Policies 89

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Goodwill 89

Credit Risk 90

Quantitative Analysis 91

Quantitative Analysis – Expense Manipulation Diagnostics 91

Asset Turnover 91

Cash flow from Operations/Income from Operations 93

Cash flow from Operations/Net Operating Assets 94

Total Accruals/Net Sales 96

Conclusion 98

Quantitative Analysis-Sales Manipulation Diagnostics 98

Net Sales/Cash Flows from Sales 99

Net Sales/Accounts Receivable 101

Net Sales/Inventory 102

Conclusion 104

Potential Red Flags 104

Accounting Distortions 105

Goodwill 106

Financial Analysis, Financial Statement Forecasts, and

Estimating the Cost of Capital 112

Financial Analysis 113

Liquidity Analysis 113

Current Ratio 114

Quick Asset Ratio 115

Inventory Turnover 116

Days Supply Inventory 118

Receivables Turnover 119

Days Sales Outstanding 120

Working Capital Turnover 121

Cash-to-Cash Cycle 122

Conclusion 123

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Profitability Analysis 124

Gross Profit Margin 126

Operating Profit Margin 127

Net Profit Margin 128

Asset Turnover 129

Return on Assets (ROA) 130

Return on Equity (ROE) 131

Conclusion 132

Growth Rate Analysis 132

Internal Growth Rate 132

Sustainable Growth Rate 134

Capital Structure Analysis 135

Debt to Equity 135

Times Interest Earned 137

Debt Service Margin 138

Altman’s Z-Score 141

Conclusion 143

Financial Statement Forecasting 144

Income Statement 145

Balance Sheet 152

Statement of Cash Flows 158

Conclusion 164

Estimating Cost of Capital 164

Cost of Equity 165

Alternative Cost of Equity 167

Cost of Debt 168

Weighted Average Cost of Debt 170

Weighted Average Cost of Capital 171

Conclusion 172

Valuation Ratios and Methods 173

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Multiples Based Valuations 173

P/E (Trailing) 174

P/E (Forward) 175

P/B 176

D/P 177

Price Earnings Growth 178

P/EBITDA 179

P/FCF (Per Share) 180

EV/EBITDA 181

Conclusion 182

Intrinsic Valuation Models 182

Discounted Dividends 182

Discounted Free Cash Flows 184

Residual Income 187

Abnormal Earnings Growth 189

Long Run Residual Income 191

Analyst Recommendation 194

Appendix 1 197

Appendix 2 200

Appendix 3 205

Appendix 4 222

Works Cited 225

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Executive Summary

Analyst Recommendation: Undervalued, Buy*

STLD ‐ NASDAQ (4‐1‐2009) $8.98 Alman's Z‐Scores

52 week Range 5.18‐40.92 2004 2005 2006 2007 2008Revenue 8.08 BillionMarket Capitalization 2.0 Billion Initial Score 2.95 2.95 3.43 2.13 2.73Shares Outstanding 181.99 Million Revised Score 2.95 2.93 3.44 2.18 3.01

Restated

Book Value per Share $8.93 $8.98

Return on Equity 29.39% 43.15% Financial Based Valuations

Return on Assets 10.34% 13.13%As Stated Restated

Trailing P/E 10.00 N/A

Cost of Capital Forward P/E 16.65 14.64

Divs to Price 7.80 N/AEstimated R‐Squared Beta Ke Price to Book 0.03 0.01

PEG Ratio 3.65 N/A3 ‐ month 19.81 1.76 14.97 Price to EBITDA 1.70 2.871 ‐ year 32.22 1.66 14.16 EV/EBITDA 1.63 1.902 ‐ year 32.32 1.86 16.67 Price to FCF 4.07 N/A5 ‐ year 28.10 2.37 17.1510 ‐ year 32.15 1.9 14.84

Upper Lower Intrinsic Valuations

Ke 14.17 19.94 8.48

Size adjusted Ke 15.86 21.64 10.18Valuation Price

Upper Bound

Lower Bound

Backdoor Ke 22.69 Discounted Dividends $5.63 $27.24 $3.15Cost of Debt 6.52 Free Cash flows $0 $65.49 $0WACC Before Taxes 9.22 11.26 7.21 Risidual Income $14.38 $27.63 $9.68Size adjusted WACC 8.34 11.86 7.81 Long Run Risidial Income $10.49 $12.77 $6.48

AEG $9.35 $37.72 $7.50

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Main Competitors Steel Industry Past 5 Years:

Source: Yahoo Finance

Steel Dynamics past Year’s Performance”

Source: Yahoo Finance

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Industry Analysis

Steel Dynamics is a steel and steel product manufacturer located in Indiana and

was founded in 1993. The founders took the small scale, underfunded operation and

turned it into a highly profitable player in the North American Steel Industry. A proper

industry analysis involved the use of Porter’s Five Forces Model to determine the

industry profitability. The main competitors were found to be United States Steel, AK

Steel, and Nucor Corporation.

The steel industry currently presents a growing trend, however is expected to

decrease with respect to the current recession. A highly concentrated, commodity

driven industry presents little differentiation. High switching costs occur in the industry

because of the amount of money tied up in production equipment. Since the industry

has high price competition, it is crucial to note that controlling excess capacity is a

primary concern for all firms. Firms find a way to increase their infrastructure by

acquiring components of other similar firms. The chart below summarizes our analytical

findings for the five forces model:

After completing this step, we could then classify the industry in terms of its

strategy for creating competitive advantage. Steel firms are cost leadership driven

focusing primarily on economies of scale, efficient production, low-cost distribution, and

low input costs as the key success factors. Steel Dynamics and its competitors focus on

raw material costs, key items being energy and steel scrap and scrap substitute. By

instituting recycling programs within their own operations and mini-mills, steel firms

have created a sustainable competitive advantage.

Competitive Force Degree of Competition Rivalry Amongst Existing Firms High

Threat of New Entrants Low Threat of Substitute Products Moderate

Bargaining Power of Customers Moderate Bargaining Power of Suppliers Moderate

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Lastly, we determined whether or not the firm currently has the resources and

capabilities to deal with the said key success factors. In the competitive advantage

analysis we found that Steel Dynamics continually makes efforts to improve their

current core competencies. Doing so is always a positive aspect because it adds value

to the entire industry. Therefore, the firm has “matched their core competencies with

their value driving key success factors” (Palepu and Healy).

Accounting Analysis

All corporations are required to present financial statements. On these

statements are the man-made figures that have been prepared for financial uses.

Following all prescriptions of the Generally Accepted Accounting Principles only partially

ensures usefulness of the annual reports. Further scrutiny of the key accounting

policies is an important part of the valuation process.

When attempting to discover potentially distortive information, this valuation

team found it best to identify the key accounting policies for the industry. Then we

followed up with a complete formal accounting analysis, which involves determining

accounting flexibility, strategy, and level of quality disclosure. Doing so allowed us to

determine which areas, industry wide and firm specific, could possibly lead to “red

flags”. The largest red flag was raised by the lack of Goodwill impairment. The

staggering jump from 2.7% to 30.9% of Plant, Property &Equipment led us to believe

that the firm may be overstating their assets.

Sales and expense manipulation diagnostics were also used in order to determine

the credibility of reported figures. We studied the rate of change for the diagnostics.

Doing so, we made sense of the proper business context. Overall, we found it be that

all four steel firms present credible numbers.

The key accounting policies for Steel Dynamics revolved around Goodwill, Credit

Risk, and a host of policies that relate directly to the firm’s key success factors. Such

key success factors include economies of scale, low-cost production and distribution,

and efficient production. Disclosure levels were found to be moderately high for all

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stated areas for Steel Dynamics. Nucor, US Steel and AK Steel stacked up well, all

providing a transparent view of their firm through the financial statements. The most

significant accounting policy and the only one that required restatement of financial

data was Goodwill. Significant disclosure related to acquisitions allowed for a basic

analysis of the key accounting policy. We determined that since Goodwill represented

at least 20% of Plant, Property and & Equipment, we would need to restate our

financials for the present and past 5 years.

Financial Analysis, Forecasts, and Cost of Capital

A proper financial analysis employs three basic categories of ratios. The first

type deals with the firm’s liquidity, referring to how well a firm can covert assets into

cash. Profitability ratios where then used to determine the relationship between

revenues and the costs that are incurred to earn them. Using information from the

balance sheets and income statements, we were able to draw conclusions on how well

firms are turning profits. Lastly, capital structure ratios were used to determine the

economic and financial viability of the firms. By calculating these ratios, we were able

to determine the trends of the industry and the impacts of said trends. The most

significant and note worthy ratio for Steel Dynamics is the debt to equity ratio. It is

clear that the firm has greatly increased its leverage, taking on a considerable amount

of debt. This fact creates a concern of whether or not the firm can pay back its debt,

which is noted as the only serious drawback from the apparent undervalued firm.

The ratio analysis pointed to industry similarity in some areas, and clear market

segmentation in others. Nucor was the typical outperformer and AK Steel leaned

towards underperformance, when such an observation was made. Steel Dynamics

presented dissimilar results from the industry in the current ratio, gross profit margin,

and debt service margin. We also studied the internal and sustainable growth rates for

the last five years for all firms. These growth rates help set industry-wide benchmarks.

Steel Dynamics has demonstrated either matching such rates or outperforming them all

together.

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After we conducted the financial ratio analysis, we were able to complete the

next step in a valuation, forecasting the financial statements. Focusing on critical line

items and ignoring items that could not reasonably be forecasted, we predicted the next

ten years worth of figures. The balance sheet, income statement, and statement of

cash flow forecasts all provided the inputs that would later be used to intrinsically value

the firm. The most important aspect of forecasting is predicting future sales growth

because it built the foundation for our forward-looking analysis. We have come to the

following conclusions as to what rate the sales for Steel Dynamics should grow, taking

into consideration our current recession.

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-10% 5% 10% 15% 15% 15% 15% 15% 15% 15%

Discount rates were found by estimating the appropriate cost of capital. Using

regression data, we were able to apply the most appropriate beta and the stated risk

free interest rate to the Capital Asset Pricing Model. Once we computed the cost of

equity using this method, we performed a size-adjustment which gave us 15.86%. This

cost of equity was compared to an alternative method. However we choose to stay with

our CAPM results. A weighted average for the cost of debt was the next rate to be

determined. Using provided interest rates from annual reports as well as applicable

short term rates we found it to be 6.52%. Then we found our Weighted Average Cost

of Capital (WACC) before and after tax to be 8.34% and 9.82%, respectively. These

estimated and calculated discount rates served an important role in our intrinsic

valuation models, as they were used to successfully discount year by year and terminal

values.

Valuation Analysis

When determining the value of a company, many models can be utilized in

order to see how a firm is performing relative to an observed share price. These models

vary from financial ratio valuations to intrinsic valuation models. From these valuations,

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an analysis was performed in order to determine the correct price per share at April 1,

2009.

The method of comparables approach was used to simply enhance our overall

equity valuation. This ratio-based valuation lacks theory and has no consistent set of

rules governing it. Using publicly available information and the annual reports of Steel

Dynamics, we computed ratio-based prices for a string of different metrics. The price

to earnings ratio was the starting point and all outliers were left out of the industry

average calculations. Also, negative values for any denominator were left out and

considered useless.

By using intrinsic valuation models, a more reliable analysis can be performed

than the method of comparables. This has to do with relatively strong forecasted

numbers that are used within each of the models. Not only are these models based on

stronger numbers, but they also have a higher explanatory power. The five intrinsic

valuation models consist of: discounted dividends, discounted free cash flows, residual

income, abnormal earnings growth, and long-run residual income.

The first intrinsic valuation model utilized was the discounted dividends method.

This method shows how the present value of dividends and the terminal perpetuity

adjusted for time consistency gives a fair pricing of Steel Dynamics. This model ended

up being too sensitive to growth rates and having a very low explanatory power. This

model had the company being mostly overvalued and very few of the estimated share

prices as fairly valued. With a cost of equity of 15.86% and a growth rate of 5%, the

share price is $5.63, which shows Steel Dynamics as overvalued. From the model for

Steel Dynamics, more than half of the explanatory power lies within the terminal value

perpetuity and that makes the model unreliable.

The second model, discounted free cash flows, is a valuation method that uses

future free cash flow projections and discounts them to arrive at the present value. The

present value, found using WACC BT, assists our analysis of the potential profitability of

the investment. This model’s results were greater than 110% of the observed share

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price, which indicates that this is a good investment opportunity. Although this model

indicated a good opportunity for investment, it is still sensitive to growth rates and for

the most part is unreliable due to its low explanatory power.

The next model is the most reliable out of the five that were utilized. With the

residual income method, there is a high explanatory power and majority of the weight

is placed on the book value of equity of the visible items, not the “wishful” items. Also,

this model is not as sensitive to growth rates as the ones before it have shown. An

example of this is shown within the analysis performed. With a cost of equity of 19.94%

and a growth rate range of -10% to a -50% the calculated share price went from $9.77

to only $9.88. This is a very small price change in relation to the large growth rate

adjustment showing how reliable this method is compared to others. Overall, this model

shows Steel Dynamics as undervalued and therefore a good investment opportunity.

The Abnormal Earnings Growth Model is the next model that helps us determine

the equity value of Steel Dynamics. AEG is similar to the Residual Income Model in that

is has theory, has high explanatory power, is insensitive to changes in growth rates,

and has more weight in near-future earnings. For Steel Dynamic’s the reliability of this

model is seen in the insensitive changes of price and the closeness to the residual

income valuation results. For instance, the time consistent price when held at a .1586

cost of equity, and adjusted growth rates between -.1 and -.5, only changed by $.44.

Within a reasonable cost of equity, AEG’s time consistent price is insensitive to changes

in growth rates. The AEG Model presented Steel Dynamic’s share price as undervalued.

The final intrinsic valuation model utilized was the Long Run Residual Income

model. This method has three inputs that factor into its analysis. These are the cost of

equity, the growth rate and return on equity. Because dividends are harder to forecast,

the return on equity is utilized instead. After finding a growth rate convergence, three

separate charts are used to tie the three main drivers (Ke, g, ROE) of the model

together. This is done by keeping one of the three inputs constant and changing the

other two in the equations used. For Steel Dynamics, the long run residual income

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model yielded favorable results by showing the company as undervalued. Overall, this

model supports the original residual income model in respects to the favorable results.

By utilizing the method of comparables and intrinsic valuations, one can

determine if a company is worth more, less or equal to its reported value. This is very

important to potential shareholders when they make decisions about investing in a firm.

Upon review of the intrinsic valuations and the method of comparables, our valuation

team has concluded that Steel Dynamics is overall an undervalued firm and a sound

choice to invest in.

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Company and Industry Overview

Having a strong foundation of basic knowledge of the Steel Industry and the

companies that it is composed of is of great importance if one wishes to understand to

more intricate facets of the industry. After reading the information contained in both the

company and industry overview, one should have a basic understanding of the history

behind Steel Dynamics Inc, the sales volume and growth of Steel Dynamics’ as well as

the company’s main competitors, and the overall state of the steel industry.

Company Overview

Steel Dynamics was founded in 1993, when three men (Keith Busse, Mark Millet,

and Richard Teets Jr.) set out to not only found a new steel company but to do so

without corporate backing. Using their professional reputations as their only collateral,

the three began seeking independent funding from various investors that had

knowledge of the industry and saw promise in the new venture. By late 1993, the three

had raised over 270 million dollars, and by 1996, Steel Dynamics was in full operation.

Today, Steel Dynamics Inc. (STLD) is one of the largest steel producers and scrap

processors in the United States with 5,940 full time employees, most recent annual net

sales of 8.1 billion dollars and a market capitalization of 2.14 billion dollars. Steel

Dynamics Inc. manufactures a variety of steel products and through acquisitions of

companies such as the OmniSource Corp., is now one of the largest scrap metal

processors in the United States.

All though Steel Dynamics scrap processing operations are a vital part of the

overall company, the steel operations element of the company accounts for over 81%

of Steel Dynamics net sales. The steel operations division is divided into four separate

entities; the flat roll division, structural and rail division, bar division, and the steel of

West Virginia division. Over the past five years, Steel dynamics has enjoyed record

growth and a steadily increasing market share. In 2004 alone the company more than

doubled its net sales from 987 million to 2.1 billion.

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(10-K: STLD)

This rapid growth is mostly due to Steel Dynamics’ aggressive expansion of mini-mill

operations throughout the upper Midwest and Southeastern United States. The main

operations headquarters and largest steel production facility of Steel Dynamics is

located out of Jefferson, Indiana. This location and its close proximity to the Ohio River

allows Steel Dynamics to gain access to markets in the southern US.

In 2007, Steel Dynamics made several key acquisitions that greatly expanded the

overall diversity of its products. One such acquisition was the July. 2007 purchase of

The Techs. The newly acquired company now allows Steel Dynamics to gain access to

markets that require specific widths or gauges that existing facilities could not currently

produce. As mentioned before, the one billion dollar purchase of the OmniSource

Corporation affords Steel Dynamics control of a large market share of the North

American scrap recycling and processing industry.

Industry Overview

Steel Dynamics main competitors in the “Steel and Iron: Basic Materials” market

are US Steel Corp. (X), Nucor Corp. (NUE), and AK steel holding Corp. (AKS). Steel

Dynamics and its competitors are very comparable in respects to products offered and

technology. The firms that operate within Steel industry: basic Materials all rely on their

flat roll steel operations for a large portion of their earnings. US Steel and Nucor

currently control the largest market shares in the industry, but Steel Dynamics is rapidly

catching up due to a high rate of growth over the past five years. Despite the slowing

economy, the steel industry has done comparatively well. Steel Dynamics, as well as

the company’s main competitors, has seen (in most cases) steady growth over the last

five years. While Steel Dynamics and Nucor operate domestically in North America, AK

*in millions* 2004 2005 2006 2007 2008

Total Assets 1,730 1,760 2,250 4,520 5,230

Net Sales 2100 2184 3238 4387 8100Growth (Net Sales) 112.80% 4.00% 48.26% 35.48% 84.64%

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Steel and US Steel are multinational firms with entities in South America (AK Steel) and

Europe (US Steel).

Annual Growth (Net Sales)

*in millions* STLD X AKS NUE

2004 112.80% 33.20% 28.64% 44.90%

2005 4.00% 0.82% 8.65% 11.60%

2006 48.26% 11.54% 7.26% 16.14%

2007 35.48% 7.37% 15.51% 12.47%

2008 84.64% 41.15% 9.14% 42.62% (10-K: STLD, X, AKS, NUE)

There are still problems facing the domestic industry, such as China’s increased

exportation of steel to the US due to slowing demand in the country. Another looming

problem is the recent disagreements between iron ore suppliers and the steel makers

the supply. “The world’s steelmakers want at least a 10% reduction in iron ore prices,

but miners want to keep prices level as the two sides begin secretive contract

negotiations in what looks to be a bust year for commodities.” (Matthews, 2009)

Five Forces Model:

To understand an industry, one must first identify it, and then understand how

and why certain forces affect it. This is exactly the purpose of the five forces model.

According to the model, the profitability of an industry, and the firms that compose it, is

influenced by five forces. These five forces include rivalry among existing firms, threat

of new entrants, threat of substitute producers, bargaining power of buyers, and

bargaining power of suppliers. A better understanding of these five forces is a better

understanding of business itself. The chart below provides a synopsis of our analytical

findings:

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Competitive Force Degree of Competition

Rivalry Amongst Existing Firms High

Threat of New Entrants Low

Threat of Substitute Products Moderate

Bargaining Power of Customers Moderate

Bargaining Power of Suppliers Moderate

The nature of competition among similar can vary greatly throughout different

industries. “In most industries the average level of profitability is primarily influenced by

the nature of rivalry among existing firms in the industry” (Palepu, 2008). How many

competing firms, and the size of those firms, makes a large difference in how

competitive pricing in the industry is. Other factors that contribute to the intensity of

the rivalry among firms are: concentration and balance of competitors, degree of

differentiation and switching costs, scale/learning economies and the ration of fixed to

variable costs, and the excess capacity and exit barriers factor.

Threat of new entrants is another key factor in an industry. The easier it is to

enter into an industry; chances are that more firms will in fact enter. Many factors such

as the existence of legal barriers affect the how likely the threat of new entrants will be

a factor in an industry. In industries such as the steel industry, one of the most

important barriers is the economies of scale barrier due to the fact that the startup

costs can, and most likely will, be enormous.

The threat of substitute products is the chance that customers will switch to

products that perform the same function or provide the same benefit. This factor can

greatly affect the way firms price their products. In other words, the threat of substitute

products can be a very complex problem that a firm faces. “In some cases, threat of

substitution comes not from customers switching to another product but from utilizing

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technologies that allow them to do without, or use less of, the existing products”

(Palepu, 2008).

How well a buyer can manipulate the seller that supplies him with products

(bargaining power of buyers) can be a extremely important factor in deciding how a

company conducts its’ self. The price sensitivity of a certain product and the relative

bargaining power of the buyer usually decide to what extent a buyer can exert influence

over the price. Companies such as Wal-Mart have a very large power over their

suppliers simply because of their immense size and buying power. Buyers are most

powerful when there are many companies that sell easily substitutable products to the

ones that their suppliers offer.

The bargaining power of suppliers is on the other spectrum of that of the buyer.

If the supplier offers a good that cannot be easily replicated or substituted, when it

come to bargaining, it is now the supplier that hold the upper hand. If a company

needs a certain good to operate their business, they are very dependent in a way on

their suppliers.

Rivalry Among Existing Firms

As a main source of competition in the steel processing industry, a understanding

of the rivalry among existing firms helps to define the competition, and aids companies

in their formation of successful and insightful business strategies. The average level of

profitability is mainly affected by the competition amongst the existing firms in the

industry, as outlined in the following sections (Palepu).

Industry Growth

The industry growth rate is measures how fast the overall industry is expanding

or contracting and at what speed. For instance: when the industry is growing, there is a

greater supply of the product than the demand for it, which results in less competition

between the firms. To help visualize the growth rates of the steel processing industry,

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the following graph shows the percent change in net sales from the previous year of

Steel Dynamics and three of its close competitors over the past six years (in

thousands):

(10-K and 8-K: SDI, Nucor, USSC, AK Steel)

While these numbers do not show the entire steel industry, they accurately reflect the

arena that Steel Dynamics and its closest competitors compete in. Despite being the

smallest competitor in net sales for this section of the industry, according to the chart

the industry has been growing steadily for the past six years, moving up from having

net sales of $28.2 billion in 2003, to $63.2 billion in 2008.

Steel and Iron: Basic Materials ( Net Sales, in thousands) Steel Dynamics Nucor USSC AK Steel Industry Total Industry mean

2003 987,248 6,265,823 16,873,000 4,041,700 28,167,771 13,837,0742004 2,144,913 11,376,828 15,715,000 5,217,300 34,454,041 16,690,7922005 2,184,866 12,700,999 14,039,000 5,647,400 34,572,265 16,739,9162006 3,238,787 14,751,270 13,975,000 6,069,000 38,034,057 18,207,3322007 4,384,844 16,592,976 16,893,000 7,003,000 44,873,820 21,340,6992008 8,080,521 23,663,324 23,817,000 7,644,300 63,205,145 29,582,442


Knowing if the industry is growing or contracting is vital but when many

companies are competing, a firm’s market share also becomes very important. For

0.00%

50.00%

100.00%

150.00%

200.00%

250.00%

2004 2005 2006 2007 2008

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example, a company does not need to acquire more market share if the industry is

growing at fast rate. But if there are many participants in the industry, the only method

of growth is to acquire the market share of others. Expansions of a firm’s market share

come in the form of mergers and acquisitions of other firms.

Lately the industry has been slowing quite drastically with the country going into

a recession. When this happens, firms are forced to cut costs in order to lure business

away from competitors and retain current customers.

Currently, talks about the stimulus plan which could inject “about $30 billion into

roads and bridges and $32 billion into energy transmission” are almost the only thing

inspiring hope in the steel industry for this upcoming year (Opdyke). According to the

Wall Street Journal, this money would potentially come from “a massive effort repairing,

rebuilding and improving everything from roads and bridges to the nation’s electrical

grid,” assuming the increase in demand for steel pushes the overall price up (Opdyke).

Overall, steel processing industry has been growing in recent years. This has

somewhat helped decrease competition between firms since there is a greater supply of

than demand for the product, but this may all change in the upcoming year as an effect

of the current recession.

Concentration of Competitors

For the Steel Processing industry, the understanding the concentration of

competitors is vital and the most important aspect when looking at the rivalry among

existing firms. According to the World Steel Association, there are over 80 companies

with at least 3.8 million metric tons of crude steel output, with Steel Dynamics coming

in at a low 63rd place as of 2007 (worldsteel.org). Also to be noted, the largest steel

company in the world, Arcelor Mittal, only accounts for around 10% of the steel output

in the total industry (arcelormittal.com). These two facts help illustrate how many

companies there are competing with one another in this industry. Since there is no real

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dominate company in the steel industry, no one firm sets the rules of the industry and

all are vulnerable to destructive price competitions.

Steel Dynamics has a relatively small percentage of the industry’s market share.

As shown in the following pie chart of the total net sales (from 2003-2008) of the

industry, Steel Dynamics accounts for about 13% of the industry.

Firms’ Percent of Total Assets of Industry: 2003 2004 2005 2006 2007 2008

Steel Dynamics 7.67% 7.11% 7.26% 8.56% 12.86% 13.16%

Nucor 23.89% 25.18% 29.52% 30.08% 27.96% 34.74%

USSC 41.82% 45.36% 40.56% 40.34% 44.48% 40.39%

AK steel 26.61% 22.36% 22.66% 21.02% 14.70% 11.71% (10-K: SDI, Nucor, USSC, AK Steel)

It is interesting to note that over the past six years, Steel Dynamics’ has almost doubled

their market share. While AK Steel has lost over 45% of their share of the industry, this

does not necessarily mean that they have decreased in size, just that they have not

matched their direct competitors’ growth rates. If this downward trend continues, they

may no longer be considered a direct competitor of Steel Dynamics in the upcoming

decade.

It is extremely difficult to find perfect direct competitors in this industry due to

the various different operations each firm conducts. Steel dynamics has three main

operations: Steel, Fabrication, and Steel Scrap and Scrap Substitute Operations. Each of

these operations produces many different products, from flat rolled and structural steel

to fabrication of girders and steel joints. While Steel Dynamics has these three main

operations, its “direct competitors” such as AK Steel, may have different operation

sections like steel tubing for the automotive industry (10-K: SDI, AK Steel). This is

24

important to understand when looking at graphs and directly comparing the firm’s

existing competitors.

Due to the slight and few differences in the companies, most are highly

competitive in pricing. Steel Dynamics’ 2007 10-K states: “competition for sales… is

based primarily on the price, quality, and location of the [steel], as well as the level of

service provided in terms of reliability and timing of delivery.” Steel Dynamics Inc. has a

slight advantage in the structural and rail division since there are “currently no other

structural mills located in the Midwest, one of the largest structural steel consuming

regions in the United States” (SDI 10-K).

The steel industry has to compete with firms in other industries as well: Steel

competes with other materials such as aluminum and plastic (particularly in the

automobile industry), cement, composites, glass and wood (SDI 10-K).

In conclusion, due to the high number of firms that are formidable competitors,

there is increased fighting for lower prices; thus, placing the steel processing industry

into the cost leadership category.

Differentiation

In order to deal with direct competition, many companies rely heavily on their

ability to differentiate their goods and services. If there is high differentiation, a firm is

able to set or charge a higher premium with little to no fear of a price war. However,

the steel processing industry has low differentiation in general and is therefore forced

to compete on price.

As previously explained, Steel Dynamics produces many different types of steel.

This firm believes that this “diversified mix of products enables [Steel Dynamics] to

access a broader range of end-user markets, serve a broader customer base and

mitigate [their] exposure to cyclical downturns… in any one product or end-user

market” (SDI 10-K). Although the industry in general has very low diversification, Steel

25

Dynamics’ many different specific sections help them compete on many different levels

with multiple different competitors.

As stated before, the competition between steel firms is largely based on price

because of the overall similarities between their products. For this reason, all firms in

the steel processing industry, including Steel Dynamics, competes by controlling their

costs in order to reduce the cost of the finished product.

Switching Costs

When analyzing a firm’s switching costs, one determines if the said firm can

effectively take their resources and successfully enter into another industry and to what

degree of difficulty. If the switching costs are relatively low, the company can easily

switch into another market if its benefits are greater and there are more incentives to

engage in a price war.

Since the steel processing industry’s resources are very specific and serve a

single purpose, the switching costs are very high. The extremely expensive plant,

property and equipment of the industry make switching industries a costly. The strong

exit barriers of this industry also add to the switching costs of the firms. However, the

switching costs of producing different types and grades of steel to another are low. In

the steel processing industry, if a firm chose to start producing a different grade of

steel, they could do so with minimal switching costs. But overall, if a steel producing

firm wanted to switch to producing a completely different metal or product, the

switching costs would be staggering.

Economies of Scale

In scale economies, firms must increasingly mass produce their goods to drive

down the average cost per unit, offsetting the cost of fixed overhead. If an industry,

such as the steel processing industry, has economies of scale, the companies will turn

to more expansion and acquisitions of other companies in order to become key players

in the competition.

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To make a profit in this industry, a firm must produce large enough quantities to

cover their costs. When this is the case, it affects competition because fewer firms can

obtain market share. The high cost of fixed overhead automatically decreases the

competition, but this leads to increases in rivalries between existing firms, which

sometimes gives way to price wars.


As stated earlier, if there are many participants in the industry, the main method

of growth is to acquire the market share of others. It is important to note that while the

above graphs show increase in market share in reference to revenues, they do not

illustrate investment in PPE. Referring to the above pie charts, Steel Dynamics has

greatly increased their market share relative to the other firms in the industry.

This was mainly due to the firm’s acquisitions in 2007 of two companies:

OmniSource Corporation and The Techs (SDI 10-K) .Through the acquisition of

OmniSource Corporation, Steel Dynamics increased their market share and became one

of the largest scrap processors in the United States. According to the SDI 10-K, they

“purchased The Techs to expand [their] market-share in the value-added steel coating

business.” The purchase of The Techs allows this firm to success markets that required

things that Steel dynamics’ existing facilities could not formerly supply. Both of these

situations are perfect examples of Steel Dynamics increasing their market share to

Steel dynamics

4% Nucor22%

USSC60%

AK steel14%

Industry Sales Revenue 2003

Steel dynamics

13%

Nucor37%

USSC38%

AK steel12%

Industry Sales Revenue 2008

27

become a key player in the industry, while simultaneously decreasing their overall

production cost per unit.

To illustrate this point, we divided each firm’s cost of goods sold by its plant,

property and equipment, and looked at how they grew or shrunk per year:

Steel Dynamics, Inc.: CGS/PPE (in thousands)

2003 2004 2005 2006 2007 2008

% Change,

6 yr:

SDI CGS 841,920 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262

PPE 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857

CGS/PPE 84.10% 150.52% 169.98% 211.91% 209.97% 330.43% 292.91%

AKsteel CGS 3,886,900 4,553,600 4,996,800 5,452,700 5,919,000 6,491,100

PPE 2,433,900 2,324,500 2,257,500 2,133,400 2,065,900 2,061,300

CGS/PPE 159.70% 195.90% 221.34% 255.59% 286.51% 314.90% 97.19%

USSC CGS 974,000 1,039,000 931,000 963,000 1,172,000 1,288,000

PPE 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000

CGS/PPE 28.53% 28.65% 22.68% 21.74% 17.52% 19.27% -32.46%

Nucor CGS 5,996,547 9,174,611 10,108,805 11,284,606 13,462,927 19,612,283

PPE 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861

CGS/PPE 212.86% 325.54% 353.98% 395.06% 416.42% 474.66% 122.99%

The above graph shows that we can expect that most firms in this industry increased by

at least 100%. Steel Dynamics increased by over 300%, which allots to about a 50%

increase per year, proving that the firm has been able to acquire or merge with

companies and grow at a faster rate than its direct competitors. However, this

expansion is due more to mergers and acquisitions, rather than more efficient

machinery.

Learning Economies

In learning economies, the longer a firm has been in the industry the more

efficient it is believed to be due to its assumed wealth of knowledge and by learning

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through doing. The steel processing industry is not exactly a learning economy, but it

shares many of characteristics of one.

In the Steel processing industry, the ratio of fixed to variable costs is very high

due to the extreme amounts of capital the companies have to invest in their plant,

property and equipment required to process steel. There is a noticeable need for new

technology in the steel processing industry. This new technology would result in lower

production costs, therefore decreasing the ratio of fixed to variable costs. For example,

SDI can successfully produce rail from the traditional lengths of 39 feet all the way up

to a staggering 240 feet, and eventually plan on increasing this length to 320 feet (SDI

10-K). While other companies in the United States are limited to 80 foot lengths, SDI

competes effectively because of their superior existing plant layout. The research and

development departments of SDI are constantly working to improve the overall steel

process by looking into alternative iron-making technologies (SDI 10-K). Overall, this

introduction of new technology would potentially give the firm an advantage over the

other firms existing in or entering into the steel processing industry, so this is a

moderate factor in the rivalry among existing firms for the steel processing industry.

Excess Capacity

If capacity in an industry is larger than consumer demand, there is a strong

incentive for firms to cut prices to fill capacity (Palepu). For the steel processing

industry, the strong presence of exit barriers causes this to be an issue. A firm will cut

its selling price per unit in order to sell more units, thus bringing down the overall

production price per unit and assigned fixed overhead.

Unfortunately for the steel processing industry, they are also forced to compete

with other countries’ excess capacities as importation continues to grow. When other

foreign firms over produce, their steel products are frequently offered at a lower price

and flood the US markets. If steel importing starts to increase rapidly, American steel

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processing firms will not be able to both compete in foreign price wars and still see

profits, since the production costs in these countries are typically drastically lower. In

the current recession, there has been a severe decrease in the demand for steel which

has also contributed to excess capacity in the industry. There is much more excess

capacity as firms across the world are trying to adapt to and deal with the recent

decrease in the housing and construction markets (Chen). In a Wall Street Journal

article, Robert Matthews quoted that “in the past few weeks, several steelmakers,

including Arcelor Mittal and AK Steel Holding Corp., have announced production

curtailments and layoffs to better match falling demand for automobiles, appliances and

construction” (WSJ-U.S. Steel to Lay Off). With demand down this transfers some of the

bargaining power from the steel industry back to the customers.

A firm constantly growing at a fast rate is another factor that contributes to

excess capacity in the industry. To see if the firms in the steel processing industry are

growing too quickly and consequently overproducing steel, we took Sales divided by

plant, property and equipment over the past six years:


2003 2004 2005 2006 2007 2008

% Change, 5 yr:

SDI Sales 987,248 2,144,913 2,184,866 3,238,787 4,384,844 8,080,521

PPE 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857

Sales/PPE 98.61% 209.46% 218.49% 284.93% 265.41% 389.83% 295.30%

AKsteel Sales 4,041,700 5,217,300 5,647,400 6,069,000 7,003,000 7,644,300

PPE 2,433,900 2,324,500 2,257,500 2,133,400 2,065,900 2,061,300

Sales/PPE 166.06% 224.45% 250.16% 284.48% 338.98% 370.85% 123.32%

USSC Sales 16,873,000 15,715,000 14,039,000 13,975,000 16,873,000 23,817,000

PPE 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000

Sales/PPE 494.23% 433.28% 342.00% 315.53% 252.29% 356.33% -27.90%

Nucor Sales 6,265,823 11,376,828 12,700,999 14,751,270 16,592,976 23,663,324

PPE 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861

Sales/PPE 222.42% 403.68% 444.76% 516.43% 513.24% 572.70% 157.49% (Companies’ 10-K)

30

The above graphs illustrates that over the past few years, Steel Dynamics’ production

has increased by almost 300%, about 50% per year. Across the industry, most firms,

like AK Steel and Nucor, have increased production by around 140%, about 20% per

year. This proves that excess capacity as a result of overproduction is a much larger

issue for Steel Dynamics than it is for other firms in the industry. Since the steel

processing industry already has high price competition, excess capacity is a huge

component in the rivalry among existing firms on a world-wide basis.

Exit barriers

If leaving an industry is difficult, then strong exit barriers exist. In such

situations, companies are less likely to leave the industry and are instead forced to

solve their dilemmas or face shutting down production completely. According to Palepu,

“the competitive dynamics of the steel industry demonstrate these forces at play.”

The cost to start up steel processing firms is in the millions: according to the

Steel Dynamics 10-K, the founders had to raise $270 million in 1993 to start up the

company. Because of this it is very difficult for new entrants to start up a firm in this

industry.

PPE, net (in thousands)

2003 2004 2005 2006 2007 2008 5 year avg.:

Steel

Dynamics 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857 1,314,464

Nucor 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861 3,118,739

USSC 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000 4,824,500

AK steel 243,390 232,450 225,750 213,340 206,590 2,061,300 530,470

Total PPE:

Industry 7,475,641 7,701,801 8,186,436 8,635,458 11,779,685 14,950,018 2,447,043


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As shown in the above graph, the machinery is expensive, costing around $2.5

billion per firm in the over the past five years. Since the assets of the industry are very

costly, product and industry-specific, and according to the graph overall getting more

expensive each year, shutting down operations would result in a huge fiscal loss.

Because of this, competition is much more intense. Equipment in the steel processing

industry is extremely specialized, meaning that the plant property and equipment could

not be used for anything else in other industries, which poses as a huge exit barrier.

The assets of the industry are very costly and therefore shutting down would

result in a huge fiscal loss. Because of this, competition is much more intense.

Conclusion

The steel processing industry’s rivalry among existing firms is very complex and

competitive. Steel processing has high cost competition resulting in a cost leadership,

commodity-based industry with characteristics of both economies of scale and learning

economies. Overall, there is a high level of competition between the firms and a high

growth rate in the past six years, despite the current markets. Very strong exit barriers

and switching costs exist, and it is hard for new firms to enter the industry due to the

high costs of plant, property, and equipment.

Threat of New Entrants

The threat of new entrants is the fear of new companies taking over sections of

the market share. More competitors can split market share and thus decrease overall

profitability. This danger of new entrants is occurring in the steel industry as well.

Unlike some other industries, the threat of new companies is low. This is due to the size

of competition in the steel industry. There are over 70 companies in the world that

manufacture steel. This proves to be a huge barrier for incoming companies. Also, there

are many factors that a company must overcome when they want to start in this

industry. These include economies of scale, first mover advantage, access to channels

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of distribution and relationships, and legal barriers. With so much competition and

factors to overcome, the steel industry is one of the toughest to gain entry into.

Economies of Scale

A company’s size and the amount it allocates towards its resources is a

considerable obstacle when entering the steel industry. Of the top 70 steel

manufacturers in the world, the smallest company produces 3.4 million metric tons or

mmt (World Steel Association). Each metric ton is roughly 2200 pounds. This equates to

7.7 billion pounds of steel manufactured in the smallest steel company. Steel Dynamics

manufactured 21.6 million tons or 19.6 million metric tons from 2008 to 2004 (SDI 10-

K) while US Steel and Nucor Steel companies produced 103.4 and 98.3 mmt

respectively over the same five year period (Companies 10-K’s). The size of the smallest

company is a formidable barrier for any new company trying to enter the steel industry.

According to Palepu and Healy, “new entrants will at least initially suffer from a cost

disadvantage in competing with existing firms.” This cost disadvantage will come

whether a company chooses to start out large or it starts small and has to expand.

Established corporations will have a stronghold on the suppliers and customers, and

make it very difficult for any new entrant to try and take portion of the market.

*Total Assets of U.S. Industry (in thousands)

2003 2004 2005 2006 2007

Steel Dynamics 1,448,439 1,733,619 1,757,687 2,247,017 4,519,453

Nucor 4,511,577 6,140,391 7,148,845 7,893,018 9,826,122

USSC 7,897,000 11,064,000 9,822,000 10,586,000 15,632,000

AK Steel 5,025,600 5,452,700 5,487,900 5,517,600 5,167,400

Total Assets

Industry

18,882,616 24,390,710 24,216,432 26,243,635 34,144,975

*Statistics provided by companies 10-K’s

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First Mover Advantage

A new company must overcome the first mover advantage that the established

steel companies have already placed on the industry. This can range from setting

industry standards to being the first to gain exclusive access to the suppliers needed.

The latter of the two options holds true in the steel industry. Many of the suppliers of

scrap metals have already made agreements with established steel manufacturers and

are less likely to enter into a contract with a new corporation. With suppliers already

having ties with companies, this can be a tough problem for any new business to

overcome.

Another example of a first mover advantage is the ability to gain use and exploit

new technologies. Nucor is a prime example of this situation. They were the first ones

to utilize the mini-mill, a smaller more efficient mill to effectively produce a narrower

range of products. After this was formulated by Nucor, all the other steel companies fell

in line and began to operate the same way, but for the longest time, Nucor had a cost

and production advantage over other firms.

Access to Channels of Distribution and Relationships

Like the first mover advantage, access to channels of distribution and

relationships is an important problem that new entrants to an industry must overcome.

These are agreements that established companies have made with suppliers and

customers that go back for years at a time. These relationships are usually long lasting

and at times can be stronger than any amount of money thrown at a company. This

can be demonstrated by Steel Dynamics and its customer Knapheide Manufacturing, a

utility and truck body manufacturer. According to Peggy Magliari, Knapheide’s director

of materials,” Knapheide has sought to reduce the number of suppliers it deals with,

favoring deeper, long-lasting vendor relationships that bring continuity of supply and

service–and considerable growth potential” (steeldynamics.com). This association is an

example of how having a strong relationship can benefit suppliers as well as buyers for

future profitability.

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Having the ability to distribute steel where needed is an important quality any

company needs in order to survive. As the demand of steel is shifting towards foreign

suppliers, many US steel manufacturers are starting to feel the effects. The outsourcing

of steel is placing a downward affect on steel prices in the United States which in return

is hurting the nations company’s sales, profit margin and ultimately profitability. With

profitability being a corporation’s definitive goal, this problem of outsourcing steel is a

great disservice to any company trying to enter the market.

Having a strong customer base is very important in this industry. With so much

competition, many of the buyers are already taken by established steel manufacturers.

“Historically, approximately 50 percent of the U.S. Steel’s flat-rolled product sales in the

United States have been based on sales contracts with durations of at least one year”

(US Steel 10-K). This shows that a major steel manufacturer, like U.S. Steel, feels that

long term customers are important to its success. Having a strong buyer base provides

security for both suppliers and purchasers when it comes to purchasing a product.

Legal Barriers

Many new entrants must face financial barriers other than start up costs. These

costs usual deal with legal costs such as patents or licenses to provide the service or

materials they would like to offer. In the steel industry, the legal barriers a new entrant

must face will deal more with environmental regulations. Steel producers in the United

States are subject to numerous federal, state and local laws and regulations relating to

the protection of the environment. These laws continue to evolve and are becoming

increasingly stringent. Environmental laws and regulations, particularly the Clean Air

Act, could result in substantially increased capital, operating and compliance costs (US

Steel 10-K). These regulations are ever changing at international, federal, state and

local levels. This presents large expenses each year to meet the regulations. Any new

entrant would be discouraged by these extra costs.

35

Conclusion

The threat of new entrants is low in the steel industry. This is due to many

factors such as: the economies of scale, first mover advantage, access to channels of

distribution and relationships, and legal barriers. The possibility of a company making it

in this industry is relatively low due to these factors and large start up costs. These

difficulties and complications eventually deter new entrants from trying to enter the

steel industry.

Threat of Substitute Products

The threat of replacing a product with another is a strong fear in every industry.

The steel industry is no different. In many applications, steel competes with other

materials, such as aluminum, cement, composites, glass, plastic and wood. Increased

use of these materials in substitutions for steel products could materially adversely

affect prices and demands for our steel products (Nucor 10-K). This threat of

substitutes is based on relative price and performance of the alternate products, as well

as the customer’s willingness to switch.

Relative Price and Performance

The relative price and performance of a product are important factors when it

comes to deciding on a substitute product. Steel is a product that has many uses but it

can be replaced by other commodities. For instance, in the automobile industry there

are strong enough plastics that can do the same job as steel. A great example of this

threat is also in Nucor’s 10-K which states, “Congress has recently raised the Corporate

Average Fuel Economy (“CAFE”) mileage requirements for new cars and light trucks

produced beginning in 2011. Automobile producers may reduce the steel content of

cars and trucks to achieve the new CAFE fuel economy standards, reducing demand for

steel and resulting in an over-supply in North America.” The change in standards will

call for a substitute as strong as steel but not as heavy which proves to be a tough

problem for steel manufacturers.

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The economy and its cycles cause many consumers to look at different products

to get the job done. In a slow economy, consumers look to replacements for the sake

of price. Usually plastics are cheaper and are just as effective in certain products. Like

price, performance plays a strong role in substituting a product. If a product cannot

perform the same way steel does then a company will not want to use that in their

merchandise. But if an alternate product is just as effective as and cheaper than steel, a

corporation will be quite a bit more willing to switch products.

Customers Willingness to Switch

Some companies, no matter how good of a replacement, are not willing to switch

away from steel. They either produce a product that is primarily based on steel or there

is not an adequate substitute. At the moment, steel is the leading commodity for

construction, automobiles and construction equipment. These industries require a

strong substance and steel is that option.

Not only does a customer’s willingness to switch involve different products, but it

also entails changing companies. This is where a certain degree of specialization is

important. The ability of a company to differentiate the products and stand out versus

its competitors will enable it to grab a larger portion of the market share and increase

its profitability. For instance, converting straight bars into angles that are needed for

further construction is a great way to set oneself apart from other companies. Also,

taking the extra step and painting the steel before shipping it will only make a

company’s business more profitable. This next step of adding value to the steel after it

has been manufactured will keep customers longer and might even add new ones.

Conclusion

In this tough economy, steel manufacturers must do what they can to separate

themselves from other companies. This will allow then to keep customers and possibly

receive new ones. Whether it is by providing cheaper products or making them

specialized, a steel company has to be ahead of everyone else to keep its business. A

37

customer’s willingness to switch can be swayed, but it takes time and effort to do so.

The threat of switching products is medium compared to other industries. There are

some products where alternate commodities will work but overall the threat of

substitutes is not a large factor.

Bargaining Power of Customers

The bargaining power of customers is important in determining whether the

supplier or the customer has the ability to drive down prices in their business

relationships. It also helps to pinpoint the industry segment a company is in. Bargaining

power for customers can be high, where the customer has the ability to easily switch

suppliers and can control the costs they pay. Bargaining power can be low too for

customers, where they need the business of the suppliers and will meet their cost

demands.

The relationship could also be a “push” between the suppliers and customers

where they are fighting for control over price. We call that a “medium” or “moderate”

level of bargaining power. Bargaining power can dictate the success of both the supplier

and the customer.

Steel is a prominent component of many buildings, cars, factories, railroads, so

steel processors have a wide range of customers as well. Steel companies who focus on

flat-rolled steel supply the following customer types: service centers, pipe and tube

companies, and original equipment manufacturers. SDI’s largest flat-rolled steel

customer is Heidtman Steel Products, Inc, making up almost 10% of its consolidated

net sales (SDI 10-K). Steel firms who produce structural and rail steel parts sell their

products to customers such as, steel service centers, steel fabricators, construction

companies, automobile manufactures, and various other manufacturers. Most all United

States steel companies who sell railroad beams will do business with one of these

railroad purchasers: Burlington Northern/Santa Fe, Union Pacific, Canadian Pacific

Railway, CSX Transportation and others. We will examine six sectors to determine if the

38

steel processors or the customers have bargaining power within the steel and iron

industry.

The Iron and Steel Industry consists of low concentration and thus high

competition. Steel Dynamics and its competitors compete to be cost leaders. One

method of dictating price depends on the bargaining power of customers. The

customers have power in negotiating prices because of the large number of steel

producers in the world. With the economy in a recession the price of steel has naturally

decreased and many of the large steel companies are reporting losses, giving customers

even more tools for negotiation. The negative effect of the economy is shown below

through the Wall Street Journal’s stock prices of steel companies for the last two years.

Another example of the steel industry being negatively affected by the recession is seen

through the following Wall Street Journal statement made on December 3rd 2008 in

regard to steel companies:

“The latest round of job cuts stems from the sudden slowdown in the world economy. Car makers,

equipment manufacturers and construction companies, all big purchasers of steel, have pulled back on

orders. That has caused steelmakers to slam the brakes on output in order to keep prices from falling as

demand is drying up. Prices for steel hovered around $1,100 a metric ton earlier this year but have since

fallen to about $690 a metric ton. Many steel plants aren't able to produce steel at a profit once the price

drops to about $650 a metric ton.” –Robert Guy Matthews

39

All of these downturns are greatly affecting the steel industry and the bargaining

power of customers and suppliers. Typically, the steel industry is a customer’s market.

In a customer’s market the customer can negotiate the prices in their contracts down

with suppliers. However, customers are not the only ones with power in the steel and

iron industries, specifically noted with Steel Dynamics Inc, and their competitors. In the

steel industry there is a push relationship between customers and steel suppliers.

Although there is a global wide base of suppliers, in 2005 steel producers supplied

United States customers with over “30.2 million metric tons of steel”, indicating a large

customer base as well (Global Steel Industry).

The customer base consists of end-user intermediaries, automakers,

construction, packaging manufacturers, railroad industries, and pipeline and rig

companies. Switching costs, differentiation, importance of product for costs and quality,

number of customers, and volume per customer are examined to further determine the

bargaining powers of customers in relation to Steel Dynamics and other steel

manufacturers.

Switching Costs

Switching costs refer to the price of switching suppliers or substitute materials.

In other words, switching costs represent how easy and inexpensive it is for a customer

to switch their business to a different supplier. Switching costs are low because there

are many steel suppliers, many alternatives, and little product differentiation between

suppliers. The more suppliers the more bargaining power a customer has to control

price and “lock-in” a supplier. In 2007 there were 80 steel producers supplying more

than 3.4 million metric tons of steel (World Steel). This illustrates only a portion of the

amount of steel producers. There are over 20 other prominent countries producing

steel, including China, Japan, Italy, and Brazil. “The share of Chinese steel in 2007

reached 36.4% of the world population” (World Steel). The threat of foreign

competition is even more evident with United States Steel Corp’s assessment: “Steel

imports to the United States accounted for an estimated 26 percent of the U.S. steel

market in 2007. Increases in future levels of imported steel could reduce future market

40

prices and demand levels for steel produced in our North American facilities (10K).”

After all that being said, having foreign competition further gives the customers

bargaining power over price. They can easily threaten to move companies or move over

seas.

Switching to an alternative product also has few costs. Alternative commodities

and basic materials that customer’s could substitute out steel for include: iron, pig iron,

concrete, aluminum, plastic, cement, composites, glass or wood (STLD 10-K). Just as

the entrance barriers to the steel industry indicate, steel producers do not compete on

innovation but on price. For example, U.S. Steel encouraged the idea of the steel

industry being a cost leadership industry when they stated that one of their business

strategies was to “improve reliability and cost competitiveness (U.S. Steel 10-K).” All of

these factors contribute to the customers’ power.

On the other hand, even though the costs are few, the time and effort of

switching suppliers does create some collateral for the suppliers. Contracts are typically

made many months or even years in advance, so switching producers would be a

hassle. Steel Dynamics utilizes this information and focuses on their relationships with

customers to create a more balanced relationship.

In conclusion, the customers hold more bargaining power in relation to switching

costs because steel processors compete on cost leadership, there is a mass amount of

steel suppliers, and because there are numerous substitute materials for steel.

Differentiation

Differentiation under bargaining power of customers is the extent to which

suppliers can be different or unique in the customer’s eyes. Here customers also gain

bargaining power from the steel industry’s lack of innovation. Customers control their

suppliers and prices because there is little product differentiation between individual

steel producers. There is little differentiation of steel because there is a limited variety

between products and technologies. AK Steel, US Steel, Nucor Corporation, and Steel

Dynamics ultimately all produce flat rolled and galvanized steel. Since there is little

differentiation of products, a customer can find the most bulk of steel for the most

41

efficient cost. Steel technologies, like the electric arc furnaces, are fairly constant across

the industry, contributing to the lack of differentiation and thus the bargaining strength

of customers. It is very difficult to distinguish yourself as a steel company. Most try to

reduce operating costs or add value in specific areas. Given that differentiation is

generally weak a customer can easily switch suppliers at a low cost.

Importance of Product for Cost

“Historically, the price of steel scrap, as a commodity, has tended to be volatile,

rising and falling with supply and demand (STLD 10-K).” Because steel is a commodity,

the cost of the product is very important. As previously stated, steel producers fight for

cost leadership because customers have the power to switch suppliers easily depending

on their prices. Although there are a variety of steels the quality of steel is pretty

consistent across producers, also explaining why cost is more important. Customers are

looking for the best quality at the lowest price, so there is a trade off between the two

aspects. As quoted in Nucor Corporation’s 10-K “the principal competitive factors are

price and service.” In such a competitive industry the price of the product is extremely

important. Since so much emphasis is placed on the price of the product, the

customer’s have the flexibility of comparing prices and finding the lowest priced

supplier.

Importance of Product for Quality

Quality of steel is important because of the functions it serves, for instance a

steel beam in construction. Steel companies fight for market share mostly based on

price and customer/supplier relationships, but also on quality. The quality of steel is

influenced by the scrap material, the melting methods and the finishing processes. All in

all the quality of steel is difficult to influence so the price of the product has more

influence in steel and iron industries.

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Number of Customers

The number of customers aspect of analysis is where a push relationship

between customers and a supplier becomes apparent. The steel industry sees that

there is not a shortage of customers when in 2008 “the global consumption exceeded 1

billion tons of steel products (World Steel).” Because steel companies provide to such a

broad group of customers they had some breathing room in negotiating prices before

the current economic condition. For example, “during 2007 [Steel Dynamics] sold their

flat roll products to approximately 200 customers” (STLD 10-K). These 200 customers

included service centers, pipe and tube companies, original equipment manufacturers,

steel fabricators, cold finishers, forgers, OEM manufacturers, other steel mills, ingot

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

43

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.


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.

Steel Dynamics:

Nucor:

‘04 ‘05 ‘06 ‘07 ‘08 Long-Term Debt 923,550 923,550 922,300 2,250,300 3,266,600 Lease Commitments 4,048 13,402 11,990 40,532 151,558 Percentage .4% 1.5% 1.3% 1.8% 4.6%

‘04 ‘05 ‘06 ‘07 ‘08 Long-Term Debt 441,232 435,116 435,106 2,029,845 2,650,384 Lease Commitments N/A N/A N/A 29,628 50,499 Percentage N/A N/A N/A 1.5% 1.9%

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U.S. Steel:

‘04 ‘05 ‘06 ‘07 ‘08 Long-Term Debt 1,373,000 1,613,000 1,371,000 5,184,000 4,630,000 Lease Commitments 460,000 376,000 270,000 251,000 186,000 Percentage 33.5% 23.3% 19.7% 4.8% 4.0%

AK Steel:

‘04 ‘05 ‘06 ‘07 ‘08 Long-Term Debt 2,222,800 2,232,800 2,232,800 666,400 634,100 Lease Commitments 15,800 13,200 10,000 28,700 43,200 Percentage .7% .6% .4% 4.3% 6.8%

* Statistics provided by companies 10-K’s

If any of these companies were to change from operating lease to capital leases, it

would not significantly change their financial statements because of the small

percentage.

Credit Risk

In reporting credit risk in the notes of financial statements and annual reports

there is limited flexibility. The limited flexibility is due to restricted covenants and

contracts created to protect firms from credit exposure. However, there is flexibility for

steel companies and other suppliers when estimating loan defaults and the allowance

for doubtful accounts. The allowance for doubtful accounts represents the expected

amount of accounts receivables to go uncollected. Credit risk helps analysts determine

the ability of a firm to repay their debts. If a company has a high bond rating and a low

credit risk they are more valuable to investors. Credit risk helps in our analysis of

determining if SDI’s financial statements are credible because we can determine if their

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interest rates, debt and allowance for doubtful accounts are accurately reported.

Companies can misrepresent their credit exposure in order to receive loans, to avoid

being forced into bankruptcy or liquidation, and to protect their abilities to finance

future operations.

Credit risk applies to Steel Dynamics both when it lends to its customers and

when it issue long-term debt, making credit risk a material key accounting principle.

Steel Dynamics and its competitors all similarly stated that they are “exposed to credit

risk in the event of nonpayment by our customers (SDI 10-K).” The credit crisis hit the

automotive, construction and appliance industries hard, causing an increased risk of

insolvency for the connected steel firms. For AK Steel “approximately 28% and 24% of

trade receivables outstanding at December 31, 2008 and 2007, respectively, are due

from businesses associated with the U.S. automotive industry (AK Steel 10-K).”

Due to the current economic conditions there are incentives to distort the

amount expected to be collected from customers to either receive lower interest rates

when issuing credit or to better appeal to shareholders by overstating current assets. A

reduction in the interest rates has the ability to improve the company’s credit rating

could increase their fair value of debt. AK Steel, U.S. Steel, Nucor and SDI all have debt

of more than $500 million (10-Ks). Credit risk can materially alter a company’s

financials, as seen in the example AK Steel provided in their 10-K: “a decrease of 1% in

interest rates would result in an increase in the total fair value of the long-term debt by

approximately $26.3 million (AK Steel 10-K).” The effects of distorting the allowance for

doubtful account estimates are shown below:

In 2008 AK Steel reported an allowance for doubtful account of 1.8 million, down from

1.9 million in 2007. As the table shows this would overstate its assets, by about

$100,000. Relevant to their sales this is an immaterial amount, but the potential for

distortion does exist.

Assets Liabilities Owner’s Equity Revenues Expenses Net Income Overstated Not affected Overstated Not affected Understated Overstated

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GAAP has instilled some regulations to help prevent the flexibility of credit

related issues by creating a “full disclosure principle.” This requires that Financial

Statements disclose credit related information in the footnotes, this can be misleading.

In an article titled “Disclosing Credit Issues on your 10-K” the author further sums up

the reasons for potential financial distortions with regards to credit issues: “Disclose too

much, and you’re possibly exposed to harmful moves by your competition,

retrenchment by customers and suppliers, and reduction of credit. In short, the

allowances for doubtful accounts are estimated to be larger today in the steel world,

especially because there is slacking demand for steel, customers are having difficulty

obtaining credit, and a reduction in purchases is increasing total credit exposure (U.S.

Steel 10-K). Steel Dynamics and their industry competitors’ financial statements

conform to GAAP standards.

On the other side of lending credit out, when a company issues credit from a

bank or supplier there is almost no wiggle room to recording the interest expense or the

long-term debt. The interest rate and principle are fixed numbers written in the notes

payable contract and thus are required to be disclosed. Nucor’s net interest expense in

2008 was $90,483,000, up from $5,469,000 because of an increase in the average debt

outstanding and its accompanied interest rates (Nucor 10-K). This is a large increase in

interest expense which could be detrimental to Nucor’s value. The steel industry is not

vague in their descriptions of matching interest rates and amounts borrowed.

Besides having the potential to distort the people made numbers of estimating

the amount that will be uncollected, steel companies have stringent guidelines to

discussing credit risks. Ultimately the flexibility related to credit issues, long term-debt

and accounts receivable, are limited.

Accounting Strategy Evaluation

The accounting strategy a firm uses is made up of a combination of policies and

practices that they employ. This part of the formal analysis highlights exactly what

areas in the accounting process that provides management with the ability to manage

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their earnings. The Securities Exchange Commission has attempted to reduce

managerial manipulation through numerous regulations. These regulations, at best,

quiet the noise from biased accounting practices; however they still leave many

loopholes for firms to distort the image of their activities. For this reason, it is vital that

analysts determine the quality of the disclosure a firm uses. High quality financial data

is a result of high disclosure, and it generally signifies that a company is not trying to

mislead any users of the data. Low disclosure points to a poor accounting strategy and

requires a significant amount of research just to understand the economic results of the

firms’ business activities. Once an analyst or any other interested individual has

determined what type of disclosure a firm has, and exactly what accounting policies are

used, they can then truly gain a transparent picture of the firm.

Goodwill

Goodwill is often identified on the balance sheet as the excess of cost over the

fair market value of the net assets required. Also, this information is subject to

manipulation because of the use of estimated numbers. As stated before, this intangible

asset is required to be annually tested for impairment, and subsequently marked down

if the Goodwill’s book value is greater than its fair value.

Overall, the industry has high disclosure when it comes to Goodwill. All of the

firms, except for Steel Dynamics, have Goodwill listed directly on their consolidated

balance sheets. Also, the companies showed how they acquired the current year’s

goodwill and broke it down by each of their acquisitions.

As shown by the following graph, Goodwill is typically around 25% of plant

property and equipment for the industry.

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2007 Goodwill as a Percent of Plant, Property and Equipment:

(2007, in thousands)* Goodwill PPE % of PPE

Steel Dynamics 510983 1652097 30.93% USSC 1712000 6688000 25.60%

AK Steel 371000 20659000 1.80% Nucor 847887 3232998 26.23%

*Company’s 10-K

Since AK Steel has had very few mergers and acquisitions, their percentage is

much lower than the industry norm. After looking through five 10-Ks of firms in the

steel industry, we noticed that none of the companies impaired their Goodwill. All of the

firms stated that they annually compare the fair value of the Goodwill unit to its

carrying amount. After viewing the steel industry, we discovered that none of the firms

had impaired their Goodwill in the past five years. This leads us to believe that the

industry has been overstating its assets and net income through the manipulation of

Goodwill. While Goodwill may have been impaired in the mergers and acquisitions,

these companies need to do a better job disclosing their practices. This immediately

raises a red flag since the Goodwill percentages of Plant, Property and Equipment are

typically over 20%.

As for Steel Dynamics, up until 2005, Goodwill was not stated in its financial

records. The graph below shows the percentage of Goodwill to Plant, Property and

Equipment, or PP&E.

Steel Dynamics' Goodwill as a Percent of Total Assets, PP&E (in thousands)* :

Total Assets Goodwill % of Total Assets PP&E % of PP&E 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)

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This graph illustrates that goodwill is a significant percentage of PP&E 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 potential dishonesty and manipulation in the

upcoming years.

We believe that the impairment of Goodwill is necessary, since it is currently over

30% of the firm’s plant, property and equipment. Because of this, we amortized Steel

Dynamics’ goodwill by 20% over five years, which produced the following results:

Impairment of Goodwill (in thousands)* 2003 2004 2005 2006 2007 2008

Goodwill Before: 0.0 0.0 1,925.0 30,966.0 510,966.0 781,555.0 Goodwill After: 0.0 0.0 1,540.0 24,387.8 402,194.6 516,472.6

Difference: 0.0 0.0 385.0 6,578.2 108,771.4 265,082.4 *(SDI 10-k)

As shown by the table above, the amortization of goodwill in 2008 resulted in the assets

being overvalued at a staggering $265,082,400 which negatively affects the firm by

overstating owner’s equity and net income. One can also conclude from the table that

Steel Dynamics’ flexibility with goodwill amortization leads directly to aggressive

accounting policies.

In conclusion, while both the industry and Steel Dynamics have high disclosure

of their goodwill, there is a lot of room for flexibility. This gives way to the practice

aggressive accounting policies, resulting in higher reported earnings and giving a

distorted view of the company all together.

Currency Risk

Steel Dynamics does not expose itself to any form of currency risk, according to

its annual reports. They present their lack of risk very well. Therefore, they are a high

disclosure firm. The rest of the Steel Processing industry mirrors Steel Dynamics’

tendencies in the field of currency risk, also presented with high disclosure. With the

exception of USSC and Arcelor Mittal, a global firm based in Europe who is not a close

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competitor of SDI, the Steel Processing industry has a moderately low level of

involvement in foreign affairs and therefore little foreign currency risk.

USSC has by far the most currency risk, with different branches located in

Slovakia, Serbia and Canada, along with a $1.2 billion dollar-based loan to a European

affiliate (USSC 10-K). USSC goes into great detail about the scope of their involvement

in foreign markets, which in turn allows one to come to conclusions about what effect

the foreign affairs will have on the firm. The firm uses commodity-based and foreign

currency derivative instruments to limit their exposure to currency risk. As a whole, it

seems that USSC uses conservative accounting policies, while its foreign counterparts

practice moderate ones.

Nucor has the second most currency risk out of the industry, with operations in

Canada, “joint ventures in Brazil and Australia and the direct reduced iron facility in

Trinidad” (Nucor 10-k). Nucor recognizes this risk, stating in their 2007 10-k that since

some of their steel subsidiaries work in abroad markets, and their results are translated

into U.S. dollars based on average exchange rates prevailing during a reporting period,

that “during times of a strengthening U.S. dollar, our reported net revenues and

operating income will be reduced because the local currency will translate into fewer

U.S. dollars.” Recognizing their great exposure to foreign currency risk, Nucor entered

into foreign currency contracts to negate the effects of currency fluctuation and

continued to hedge this risk through the use of derivative financial instruments. This

firm practices conservative accounting policies.

In conclusion, both Steel Dynamics and the steel processing industry are overall

only slightly exposed to foreign currency risk, except for Nucor and USSC who are

moderately exposed. The use of foreign exchange contracts and derivatives, and an

industry-wide trend of not participating in price speculation was found in every single

10-k of the industry. This, combined with the publicity of the exchange rate information

and minimal GAAP flexibility, illustrated that the industry as a whole also practices

conservative accounting policies in this field.

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Credit Risk

Steel Dynamics Inc. exercises their accounting flexibility of reporting credit risks

by being a high disclosure and moderately conservative company. Compared to their

competitors, SDI’s 10-K offers the most information on credit risk and the most

information on their compensating interest rates. Having transparent financial

statements allows SDI to have lower interest rates and higher credit quality. In the steel

industry there is not much information found on credit risk, which is a great indicator

that credit risk is not being used to distort financials. There is also relatively high

disclosure regarding credit risks across the steel processing industry. However,

comparatively SDI is above average.

SDI, AK Steel, Nucor Corporations and United States Steel do not offer a lot of

information regarding credit risk and interest rates because it is not of value to their

economic growth. SDI does disclose credit risk conservatively, but this is not all

positive. Conservative numbers can also be misleading, but again with the level of

information offered from the industry any mention of credit risk boosts investor

confidences. AK Steel proves that credit is an immaterial amount by making sure “no

customer accounted for more than 10% of net sales of the Company during 2008, 2007

or 2006 (AK Steel 10-K).” Although this is specific to AK Steel, SDI supports a similar

structuring of their loans and accounts receivables. By dividing SDI’s allowance for

doubtful accounts by its net sales we can see that it’s expected loss of receivables, and

thus credit exposure, is not material in altering Steel Dynamic’s reported financials.

2008 2007

Allowance for Doubtful

Accounts

29,008,000

7,735,000

Net Sales 8,080,521,000

Percent .359% .176%

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Steel companies across the board do not present much information on credit

risks because they are insignificant to their success, but with the information that is

presented they conservatively offer high disclosure. With the information that is offered,

it is very useful in determining the stability of the company. For example, both Nucor

Corporations and Steel Dynamics, pinpoint their interest expense rates to the

appropriate borrowed amounts of their long-term debt. An example is displayed in the

graphs below.

Steel Dynamic’s borrowings consisted of the following at December 31 (in thousands):

2007 2006

Senior secured revolver . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 239,000 $ 80,000 Senior secured term A loan . . . . . . . . . . . . . . . . . . . . . . . . 536,250 — 63⁄4% senior notes, due 2015. . . . . . . . . . . . . . . . . . . . . . . . 500,000 — 73⁄8% senior notes, due 2012 . . . . . . . . . . . . . . . . . . . . . . . 700,000 — 91⁄2% senior notes, due March 2009 . . . . . . . . . . . . . . . . . . — 300,000 4.0% convertible subordinated notes, due December 2012 37,250 37,500 Other secured obligations . . . . . . . . . . . . . . . . . . . . . . . . . . 17,345 17,606 Unamortized bond premium . . . . . . . . . . . . . . . . . . . . . . . . — 3,772

Total debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,029,845 438,878 Less current maturities . . . . . . . . . . . . . . 295,162 80,686

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,734,683 $ 358,192

This represents the relationship between a lender and SDI (the customer). By

specifically showing this information we conclude that steel processing companies are

not attempting to distort any financial numbers and are being conservative in what they

do provide. Strong evidence of this is simply that the “gross interest expense decreased

$1.3 million” from 2005 to 2006 (SDI 10-K).

Another reason credit risk is disclosed lightly is because steel processors are

highly liquid companies. Nucor didn’t even mention credit risk at all in their entire 2008

10-K because of their liquidity and credit risks insignificance to the steel industry. Steel

Dynamics, AK Steel and U.S. Steel discuss their protective measures and disclosing

techniques for ensuring they collect their receivables. Many steel companies referenced

that they “mitigate our exposure to credit risk by performing ongoing credit evaluations

and taking further action when necessary, such as requiring letters of credit or other

security interests to support the receivable from our customer (US Steel 10-K).” AK

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Steel extended this accounting strategy and implemented “constraints with respect to

credit quality” on their customers. This shows us how conservative steel processors are

in terms of their long-term debt and the uncollected amounts loaned to customers.

Nucor stated that since the fourth quarter in 2007 they have $2.3 million in notes

outstanding (Nucor 10-K), further indicating the high amount of disclosure offered by

steel processors. This allows shareholders to be confident in their investments in the

steel industry. The steel industry really works towards transparency in regards to credit

issues.

With the little flexibility given to evaluate credit risk, SDI and their competitors’

financial statements are relatively conservative and of high disclosure. In the steel

industry credit risk does not pose a threat for distortion or affecting the overall value of

a company.

Qualitative Analysis of Disclosure Quality

The quality of the accounting information presented by a firm is important to

evaluate. GAAP is not an exact science, and because it allows for flexibility, certain

critical factors can be hidden from those who would most benefit from their disclosure.

There is a good amount of discretion for managers with regard to the amount and type

of information they choose to disclose. Since the information provided is eventually

going to be used by investors to make investing decisions, it is critical that one discerns

fact from fairy tale. Not providing the information that is needed reduces accounting

quality. When the information matches up with reality, the quality can be classified as

high. Therefore, by evaluating the accounting treatment a firm uses, and using this

evaluation to classify the company as high or low quality, we can with relative certainty

identify any potential “red flags”.

Type One Key Accounting Policies:

Economies of Scale

Segment related disclosure is very common for the steel industry. Firms all

provide ample evidence of product divisions and segments that each contribute a

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certain amount of profitability. All of the firms we studied included sections resembling

the following: Steel Operations, Fabrication Operations, and Steel Scarp and Scrap

Substitute Operations. There is some variation in the segments of the businesses,

however for our purposes, this is irrelevant. The F.A.S.B. requires that firms provide

disclosure about enterprise segments. We are concerned with how often managers use

their accounting discretion and how their disclosure is tied to the value of the key

accounting policy evaluation.

Steel Dynamics is a very high disclosure company, providing pages of detailed

information regarding their acquisitions. US Steel is very similar in the manner in which

they present said information. Providing detailed information of the sort leads a

business analyst to believe that the firm is trying to tell a story about their business.

They answer questions like; is the firm growing? Or in what way is the firm attempting

to obtain economies of scale? Nucor, along with Steel Dynamics, provides the following

figures related to each segment of their business: Net sales, Operating Income, Income

before Taxes, Depreciation and Amortization, assets, liabilities, and capital

expenditures. They report segment results because it allows users of the annual

reports to understand exactly what the industry is involved in.

It is not uncommon to see very similar trends in the steel industry regarding the

treatment of the key accounting policy, economies of scale. Firms can use their

flexibility to determine what they include and what they will leave out. It was ultimately

found that the steel industry as a whole highly discloses significant information about

their segments and acquisitions. The quality of this information is also determined to

be high. The firms do not attempt to distort relevant information and therefore present

a transparent view of their financial stance. Segment information is critical because it

allows for a true picture of what each aspect of the business is accomplishing on its

own. Most commodity producing firms are similar; however the steel industry really

sets the bar high in their treatment of this type one key accounting policy.

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As mentioned, the steel industry has a lot of flexibility in their choices of

reporting production efficiency information. They choose to provide relevant

information regarding their new production capabilities. AK Steel discusses the

installation and use of a new clarifying cooling tower that dramatically increases the

efficiency of their carbon utilization. Also, US Steel provides information regarding their

use of “recoverable” steel within their own facilities. By using this form of recycling,

they can reduce the amount of time spent collecting materials. Reducing waste and

minimizing unused scrap is the essence of efficient production in the steel industry. It

is therefore reasonable to say that for the most part, steel firms provide analysts with a

good amount of production information.

The level of disclosure may not be as high as it is for other key accounting

policies however the quality of efficient production information is far from what one

might call poor. Each firm provides specific figures for items related to production. Key

accounting policies that directly link to key success factors are significant because they

provide an analyst with an opportunity to gain a proper perspective on business

activities. They may not indicate whether or not the numbers are misleading or

potentially distortive, but they do outline how the industry creates value. The steel

industry can be categorized as a high quality, yet typically low disclosure industry from

an efficient production stand point. Steel Dynamics is the same but it is this valuation

team’s opinion that they might even “out-disclose” other firms in the area of scrap

reduction. For the rest of the issues, all firms are basically identical, with small

variations in their choices of what to disclose.

Low Input Cost

With any key accounting policy, the main issue is the overall transparency and

usefulness of the reported financial information. With the policy of low input costs, it

can be said that the reports are almost as transparent as it gets. The markets for scrap

are highly competitive, and thus firms must attempt to gain some form of edge over

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their rivals. US Steel as well as Nucor provides a section that informs analysts of the

sources and uses of raw materials. US Steel purchases all of their required limestone for

flat-rolled needs from outside sources. They do this because they feel that competitive

market prices are acceptable. The fact that they could be leaving out certain

information is irrelevant because it is impossible to know what the firm should be

saying; all we can use is what is given.

Steel Dynamics, as benchmarked against the industry norms, stacks up well.

They not only disclose their sources of materials but the possible risk factors that play

into the issue. They discuss availability and cost as well as what certain types of scrap

might be used for. For example, the principle raw material for the firm is scrap-metal

derived from various sources, such as self-contained facilities or worn out vehicles. The

same can be said, as shown in the annual reports, for the three main competitors.

The quality of disclosure for low input costs is very high. All firms, without

exception, provide detailed information regarding the primary costs associated with

manufacturing. An important distinction to make between firms like Steel Dynamics

and companies like US Steel and Nucor might be the products that are produced. Nucor

produces an alloy line as well as fasteners. US Steel, with its most recent acquisition, is

involved in producing oil tubing. Steel Dynamics does not produce either of these

products, yet they do discuss every segment of their company and what each produces.

High segment disclosure in relation to input costs creates a highly transparent and

extremely useful annual report. With the great deal of information provided, an analyst

would most certainly find their needs satisfied, for this key accounting policy.

Low-Cost Distribution

Disclosure related to this item is not difficult to find. Within the first dozen pages

of all firms’ annual reports, an analyst would find a list of facilities and their locations.

Segments are also disclosed within these facility disclosures, which further increases the

usefulness of the information. The greatest amount of information related to low cost

distribution is presented in the acquisitions sections of the reports. Steel Dynamics

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outlines their most recent purchases, highlighting how their location adds to the overall

value of the firm. US Steel was the least informative in terms of listing all locations and

facilities. Because Nucor has the greatest sized infrastructure, it can be reasoned that

they should have the upper hand in achieving low cost distribution.

Most of the facilities that distribute steel products from all of the studied firms

are located in the east north central Midwest portion of the country. Raw materials

flow most effectively to this area and hence products flow most effectively out of this

area. Transparency of information is high for this accounting policy. A user of annual

reports would find it rather simple to locate information regarding distribution locations.

For this reason, we have found that there is considerable usefulness of the financial

reporting information. Another important point is that despite a section entitled

“distribution costs”, firms in the industry do a decent job of disclosing how much they

spend on freight in their reports. However, because of the use of consolidated financial

statements, we are unable to provide exact figures. With that said, it can be concluded

that Steel Dynamics and its main competitors are high disclosure firms. Each provides

ample information in their annual reports that is of high quality to financial statement

users. Providing a transparent set of reports that are useful in decision making

therefore increases the value added by the steel industry.

Type Two Key Accounting Policies:

Goodwill

The steel processing industry has a high level of transparency for goodwill. The

majority of the firms went into great depth explaining their annual tests for impairment,

listed goodwill on their balance sheets and discussed how they arrived at the listed

numbers for goodwill.

While the transparency was high, there was a severe lack of usefulness across

the industry. We discovered that no firms amortized their goodwill in the past five

years, which led us to believe that as an industry there is a prominent trend of

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overstating goodwill in order to manipulate the earnings in favor of the firm. This was

especially true for Nucor and USSC, as they both had goodwill percentages of PPE over

25% in 2007 (Nucor, US Steel, 10-K).

Steel Dynamics’ disclosure of goodwill has a moderate level of transparency.

While they merely state the goodwill numbers on their balance sheets, Steel Dynamics

goes into depth when explaining their annual impairment test and further into their 10-

k the firm briefly explains the origins of that year’s goodwill. This is helpful to readers,

but only to a point: Steel Dynamics does not discuss goodwill from previous periods.

Steel Dynamics ultimately falls short of providing a sufficient level of useful

information for decision making by failing to impair goodwill over the past four years.

Subsequently net income appears to be overstated by $265 million in 2008. This not

only affects the value of assets and net income, but also overstates retained earnings

and understates expenses. We believe that this was done on purpose by management

in order to alter effected ratios in the firm’s favor, which provides less useful

information for investors.

Overall, while the industry has high disclosure of goodwill and Steel Dynamics

only had a moderate level, both the industry and SDI failed at providing useful goodwill

information by never impairing goodwill, thus greatly overstating their numbers.

Credit Risk

The annual reports and financial statements of SDI, AK Steel, Nucor and U.S.

Steel reflected high quality information on credit risks. The main credit issue for the

steel industry is their difficult in drawing upon existing financial agreements because of

the credit crisis. Steel Dynamics especially went beyond disclosing relative information

of credit risks when they reported their long-term debt and effective interest rates. The

information presented was unbiased and the steel processors as a whole provided all

the data necessary to evaluate their financial reality regarding credits in the footnotes

of the financials. In summary, credit risks were discussed fully and transparently,

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increasing their overall quality of the firm. The primary concern presented to our

valuation with respect to credit risk is the firm’s ability to survive its leverage.

Quantitative Analysis

The quality of a firm’s quantitative disclosure is of paramount importance if one

wishes to accurately evaluate the overall value of the firm. The performance of sales

diagnostics and expense diagnostics should result in valuable information about how

flexible the disclosures of a firm are, compared to the accuracy of those disclosures. If a

diagnostic does not reflect the information that is provided by the company this is what

is called a “red flag” or known discrepancy. Our valuation team will use these

diagnostics to not only asses the accuracy and transparency of a firms disclosures, but

also to comparatively assess the overall value of the firm and its competitors.

Expense Manipulation Diagnostic:

The expense diagnostic diagnostics are used to examine the correlation of the

values of certain line items that a firm is obligated to disclose. These figures provide

valuable information that could uncover any discrepancies in a firms reporting. Graphs

containing the raw and change values of the diagnostic ratios are the tools used to

assess the viability of the reported numbers of a firm. Upon review of calculated graphs

our team analyzed any irregular movement and/or major “outliers” within the industry.

Used in the expense manipulation are line items from the balance sheet (total assets

and operating assets), income statement (net sales), and statement of cash flows (cash

flow from operations).

Asset Turnover (Net Sales/Total Assets)

Core expense diagnostics are used to determine the reliability of reported

figures. This measure of accounting credibility is calculated by dividing net sales by total

assets. This can potentially illustrate if a firms assets are overstated, understated, or

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accurately stated. A denominator effect occurs in this diagnostic if assets are being

overstated, perhaps thorough the acquisition of goodwill without proper impairment or

expensing. Therefore, if assets have increased or decreased materially, the resulting

effect will be illustrated in the following graph.

Upon review of the above graph we see an increase in assets across the board in

the industry, except for AK Steel. Firms that merge and acquire often report Goodwill as

a line item. Goodwill is an indefinite life asset that should be expensed when

impairment losses occur. When firms make acquisitions, which Nucor, US Steel, and

Steel Dynamics have done on a large scale recently, the line item Goodwill will

ultimately increase total assets. This accounting number can be easily overstated, and if

goodwill is not expensed, net income might also prove to be overstated. In the situation

of a dramatic decrease for three of four firms, we can successfully argue the point that

there is potential concern with regards to the reported figure.

00.20.40.60.81

1.21.41.61.82

2003 2004 2005 2006 2007 2008

Asset Turnover

AK Steel

Nucor

SDI

USSC

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Cash flow from operations/Operating Income

This measure of accounting credibility is calculated by dividing a firm’s cash flow

from operations by the net operating assets that the firm possesses. If the numbers are

declining, then operating income is growing faster than the firm’s cash flow from

operations. This would lead a valuation team to question the credibility of a firms

reported numbers due to the fact that a firm might be underreporting expenses

involved in reconciling income, such as amortization expense, to improve its financial

picture.

Upon reviewing the information contained in the above graph it is obvious that

AK steel’s numbers are showing some major fluctuations. While Steel Dynamics, Nucor,

and U.S. Steel maintain a very stable trend, AK steel fluctuates very dramatically from

down to (-3) all the way up to (1). Due to the fact that the fluctuations move in an

erratic manner on an annual basis this is cause for concern. Upon review of AK Steel’s

financial disclosures, it is clear that AK Steel reports very different adjustments to its

CFFO year to year. For example, between the years of 2005 and 2007, adjustments to

CFFO were reported as 282.3, (-23.8), and 495.4.

‐4

‐3

‐2

‐1

0

1

2

2003 2004 2005 2006 2007 2008

CFFO/OI (Raw)

AK Steel

Nucor

SDI

USSC

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When reviewing the change in CFFO/OI, the industry displays a much more

volatile trend with Steel dynamics being the exception (due to the firms’ fairly

consistent activity). The information above is calculated using the “first derivative”

which translates to the rate of change. Any value that is greater than zero suggests that

a firm is experiencing positive changes on the annual basis.

Cash Flow from Operations/ Net Operating Assets

This diagnostic is calculated by dividing a firm’s cash flow from operations by the

net operating assets that the firm possesses. If the values are increasing at an

unreasonable rate, this might mean that a firm is not depreciating their property, plant,

and equipment assets. Though an increasing value does not always mean a firm is

distorting its statements by understating depreciation expense, this would lead a

valuation team to question the credibility of a firms reported numbers. Understating

depreciation expenses would lead to an overstated net income.

‐4

‐2

0

2

4

6

8

2003 2004 2005 2006 2007 2008

CFFO/OI (Change)

AK Steel

Nucor

SDI

USSC

95

Three out of four firms show a trend of staying in the vicinity between (-.05) and

(.12) on the graph. Once again the exception is AK Steel which proved to be very

volatile ranging far below the industry average at (-12.54) to above it at (3.59). Due to

the volatility and unpredictable nature of AK steel’s movement along the graph, red

flags need to be raised. The sharp declines in AK Steel’s numbers lead our valuation

team to believe that this is cause for a red flag. These declines could have been caused

by AK Steel reporting an understated depreciation expense from 2004 to 2006, only to

have misreported numbers catch up to them in 2007 when they correctly stated the

depreciation expense.

‐3.5

‐3

‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

2003 2004 2005 2006 2007 2008

CFFO/NOA (Raw)

AK Steel

Nucor

SDI

USSC

‐100

0

100

200

300

400

500

2003 2004 2005 2006 2007 2008

CFFO/NOA(Change)

Steel Dynamics

Ak Steel

Nucor Corp.

U.S. Steel

96

Upon analyzing the change form of CFFO/ NOA once again shows the majority of

firms following the same trend. This time it is Nucor that is the exception. In 2004,

Nucor jumped a staggering 434 points only to return to normal levels in 2005. Since

Nucor experienced such a large jump relative to the market norm in 2004 this is cause

for concern. Because any value above zero points towards a healthy change, but a

jump as great as 434 does not inspire much confidence in the viability of the reported

numbers.

Total Accruals/ Net Sales

This measure of the viability of a firm’s financial disclosure is calculated by

dividing a firm’s total accruals by its net sales. Due to the very nature of accruals,

uncollectable accounts will lead to bad debt expense which a firm must forecast.

Because it is up to the firm to forecast a reasonable amount of capital to be set aside

for uncollectable accounts, it is also possible for firms to manipulate these numbers to

improve the financial picture of the firm.

‐2

‐1

0

1

2

3

4

5

6

7

2003 2004 2005 2006 2007 2008

Total Accruals/Net Sales (Raw)

Steel Dynamics

Ak Steel

Nucor Corp.

U.S. Steel

97

Upon review of the data in the above graph, our analyst team comes to the

conclusion that there is no real trend in the data. The unpredictable nature of

forecasting the capital needed to be set aside for uncollectable accounts leads to the

large fluctuations in the above graph. Though Steel Dynamics experienced a large peak

in 2005, it became relatively stable for the years 2006-2008. Industry wide, the firms do

not follow a specific trend from year to year which leads our valuation team to the

conclusion that due to the nature of accruals, no outliers exist despite the fluctuations.

It is possible that firms underestimated the allowance for doubtful accounts to improve

their financial image, but our valuation team does not find it necessary to raise any red

flags after reviewing the above diagnostic.

Upon reviewing the change form of total accruals/sales, it is clear that all but one

of the firms in the industry (Nucor) enjoyed a healthy change in their total

accruals/sales for the last 6 years. For the most part Steel Dynamics trended upwards

to peak above one for the years 2006-2008. This leads our valuation team to the

conclusion that Steel Dynamics exhibits a propensity to accurately forecast projected

expenses associated with accruals.

‐45

‐40

‐35

‐30

‐25

‐20

‐15

‐10

‐5

0

5

10

2003 2004 2005 2006 2007 2008

Total Accruals/Sales (Change)

Steel Dynamics

Ak Steel

Nucor Corp.

U.S. Steel

98

Conclusion

After reviewing the expense diagnostics, it is clear that, for the most part, Steel

Dynamics, Nucor, and US Steel have viable and credible reported numbers. AK Steel is

the only firm that we found to raise major red flags in almost every diagnostic. Since AK

Steel is a good match as a competitor to the rest of the industry, different market

segmentation is not the reason for the observed discrepancies. Overall, the expense

diagnostics that were performed lead this valuation team to the conclusion that Steel

Dynamics, along with most of its competitors, have credible reported numbers.

Sales Manipulation Diagnostics:

Sales manipulation diagnostics are used to analyze the credibility of firms

reported revenues. To do our quantitative analysis we examined three of five possible

diagnostics:

1. Net Sales/Cash Collections from Sales

2. Net Sales/Net Accounts Receivable

3. Net Sales/Inventory

These diagnostics allow us to do a cross-sectional comparison of Steel Dynamics to the

industry over the past five years. There are two ways to compute the diagnostics; in a

raw form pertaining to individual years, or in a change form between a specific year

and the previous year (t –t-1). The raw form compares the results on a time series basis

to discern the relationship year to year. This allows us to establish expectations for

what SDI’s normal reported earnings are and to discern if there is any abnormal or

questionable behavior, like unexplained spikes, in its reported revenues. The change

form is used to do a cross-sectional evaluation between SDI and its main competitors.

This allows us to compare SDI’s reported revenues to the industry’s to understand the

normal industry behaviors, so we can recognize questionable ratios, and thus determine

the overall credibility of SDI’s earnings.

99

Net Sales/Cash Flow from Sales

The net sales divided by cash flow from sales (CFFS) manipulation diagnostic is

used to help determine the validity of the steel industry’s reported revenues. The

amount of Cash Flow from Sales is computed by taking Net Sales and adding

(subtracting) the decrease (increase) in the change of Account Receivables from year to

year. When the ratio equals one, a firm’s sales are supported by cash. Firms can

misrepresent this diagnostic by manipulating the liabilities, owner’s equity and revenue

accounts.

In the raw form, Sales over CFFS is stable across the steel industry. There is

strong evidence of stability with the results ranging from .99 to 1.4 (SDI, AK, Nucor,

and X’s 10-Ks). Steel Dynamics represents the highest level with the 1.4 ratio in 2007

because in 2007 its net sales increased considerably from $3,238,787,000 to

$4,384,549,000 (SDI 10-K). If SDI’s multiple acquisitions in 2007 hadn’t caused their

net sales to sky rocket, we would be skeptical of their reported earnings. Apart from

this, the steel industry keeps a tight range very close to the desired ratio of 1. Other

steel processors, such as Worthington Industries, Rockwell and Olympics’ sales are also

comprised highly of cash (Worthington Industries). Concluding, the steel industry is

stable around a 1:1 ratio. SDI’s results are consistent with its competitors implying

0.9

1

1.1

1.2

1.3

1.4

2003 2004 2005 2006 2007 2008

Net Sales/Cash Flow from Sales (Raw)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

100

credible reported revenues. For our purposes the steel industry broke down the

information we needed to conduct a more thorough valuing of Steel Dynamics.

The change form takes the first derivative, or the rate of change, for each year

between 2003 and 2008. The first derivative tells us at what rate SDI and its

competitors are collecting cash for their sales. A desirable rate of change is an

increasing positive number, or greater than zero, indicating that a company’s revenues

are supported by cash. An increasing growth rate because as a steel company sells

more steel we expect to see more cash flows from sales year to year

The first derivative should be positive, but since the diagnostic is negative for

U.S. Steel in 2005 and AK Steel in 2003, we assume that as their sales increased, their

cash was not increasing enough to cover their sales. Apart from 2007 when SDI had a

low increase of accounts receivables causing a “denominator effect” and a spike to

39.14, the industry maintains a ratio around 1. Across the steel industry there was a

low ratio indicates that their sales are being supported by cash, which further leads us

to believe the validity of their earnings.

‐149141924293439

2003 2004 2005 2006 2007 2008

Net Sales/Cash Flow from Sales (Change)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

101

Net Sales/Accounts Receivable

Net Sales divided by Accounts Receivable is another sales diagnostic we use to

determine if SDI and its competitors are falsely stating earnings.

The high industry results seen in the graph above are viable because most steel

companies prefer to have their sales supported by cash than receivables. However, in

2008 when Steel Dynamics ratio sharply increases to 17.84 its sales are not being

supported by its receivables, which raised a “red flag” if AK Steel and Nucor’s results

didn’t also jump in 2008. The 2008 spikes are explained by the steel companies’ huge

increases in revenues. Nucor’s earnings went up from $16,592,976,000 in 2007 to

$23,663,324,000 in 2008, despite the economy (Nucor 10-K). Due to the explained

spikes and a stable industry we are further lead to believe Steel Dynamic’s and the steel

industry’s reported revenues.

5

7

9

11

13

15

17

19

2003 2004 2005 2006 2007 2008

Net Sales/Accounts Receivable (Raw)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

102

This change form diagnostic is measured by: (Salest – Salest-1)/(A/Rt – A/Rt-1).

It is measured to evaluate the rate of change and the sign of the ratio. This ratio should

be greater than zero and a positive relationship between sales and accounts receivable

should exist. As clearly seen in the graph, the results for the industry were sporadic,

especially for SDI. Steel Dynamics ranges from -190 to 10.16. SDI, AK Steel and Nucor

all had negative growth rates throughout the six years evaluated, which means that the

firm’s accounts receivables were decreasing year to year while its sales were increasing.

A negative number and inverse relationship lead us to question the credibility of their

reported revenues.

Net Sales/Inventory

The Sales to Inventory ratio is used to see if the amount of inventory sold is

proportional to the amount of revenues per year. Referring back to the “Money Merry-

Go-Round,” we expect to see an increase in sales with an increase in inventory. If the

ratio has a positive ratio then the reported revenues are feasible, if not they are

questionable.

‐250

‐200

‐150

‐100

‐50

0

50

2003 2004 2005 2006 2007 2008

Net Sales/Accounts Receivable (Change)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

103

All competitors have fairly stable proportions of sales to inventory from 2003-

2008. On an industry and firm level the stable trend paths seen in the graph above

support accurate reported revenues. For example, AK Steel’s results from 2004-2006

were consistently around seven, at 7.65, 6.99 and 7.08.

There is some reason for “red flags” when the lines slope upward, because this

indicates that sales are increasing while their inventory accounts are decreasing. For

0

2

4

6

8

10

12

14

16

2003 2004 2005 2006 2007 2008

Net Sales/Inventory (Raw)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

‐60

‐50

‐40

‐30

‐20

‐10

0

10

20

30

40

2003 2004 2005 2006 2007 2008

Net Sales/Inventory (Change)

Steel Dynamics

AK Steel

Nucor Corp.

U.S. Steel Corp.

104

instance, when U.S. Steel’s sales between 2003 and 2004 increased by approximately

$4.67 billion while its inventories decrease by $.09 billion. The change form is also

indicating questionable earnings because there are many negative growth rates. Nucor,

AK Steel, U.S. Steel, and SDI all experience negative growth rates; AK Steel four out of

the six years evaluated. Firms could be inflating their sales by reported unearned

revenues prematurely. This means they are not maintaining a constant positive

relationship between sales and inventories. The results lead us to be skeptical of SDI

and its competitors stated earnings.

Conclusion

Overall SDI’s sales reported are credible because of the diagnostic results. The

change form of Sales divided by Inventory was the only diagnostic that had

questionable results because of the negative growth rates. The rest of the ratios

presented little evidence of manipulation. This is backed by the fact that in the first

derivative there were positive growth rates.

Potential Red Flags

Within every industry, there are potential red flags, or problematic concerns that

arise in the financials of a certain company. These questionable signs may include large

write-offs in the financial statements, abnormal profits within a short period of time, or

unexplained accounting adjustments that could affect the company’s books. From these

problems, investors and analysts can see if there is anything that warrants further

investigation. Once the red flag is found and shown to be an important part of the

books, the analyst must undo the accounting distortion so that the numbers better

represent the firm’s actual performance. After the distortions have been undone, the

financial records will be portraying the actual state of the firm much better.

A large red flag that was raised within Steel Dynamics’ financial statements was

their lack of impairment of goodwill. This was shown by a dramatic jump in goodwill

105

from 2006 to 2007. After looking further into the company’s financial statements, it was

found the Steel Dynamics did not impair goodwill in 2006 or 2007. During this time, SDI

had three major acquisitions; The Techs, OmniSource Corporation, and Elizabethton

Herb and Metal. The additions of these three companies were all in the fiscal year of

2007, which was the reason why goodwill jumped from 2.7% of plant, property and

equipment to a staggering 30.9% (SDI 10-K). This 28.2% increase in goodwill shows

that Steel Dynamics is overstating their assets which understates their expenses and

therefore overstates the net income of the entire company. By overstating the net

income, Steel Dynamics is showing better earnings than they are really obtaining.

These misleading figures give analysts a distorted view of the company. In order for

the analysis to be accurate, the goodwill must be impaired and restated correctly.

Potential red flags are important problems within a company’s financial

statements where flexibility allows managers to distort numbers. This usually allows for

abnormal profits and an incorrect view of the company’s overall performance. Other

than goodwill, Steel Dynamics’ financials do not raise red flags. This shows that the

corporation has very good disclosure for its other operations. This is important because

when these problems are found, a restatement of the financial statements is needed in

order to undo the accounting distortion. If the firm discloses its books truthfully, then

analysts do not have to go back and restate the income statement and balance sheet

which will be shown in the next section.

Accounting Distortions

Accounting distortions are usually caused by managers’ intentional

misrepresentation of certain assets which cause their statements to reflect their firms

more favorably. In order to more accurately value Steel Dynamics, we felt it was

necessary to restate goodwill, and consequently restate the affected balance sheets and

income statements. By doing this we hope to undo the accounting distortions and

provide more useful information to both common readers and investors.

106

Goodwill

After carefully studying Steel Dynamics’ 10-K, we noticed that goodwill had never

been impaired. After an analysis, we also discovered that goodwill has become an

increasingly larger percentage of the firms’ long term assets, as restated in 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%

There was no goodwill on the books until 2005, and in three years it has jumped from

.2% of plant property and equipment, up to 39.1% in 2008. The approximate $780

million growth of goodwill over three years immediately caught our attention. We

realized that we needed to restate Steel Dynamics’ income statements and balance

sheets in order to undo these blatant accounting distortions and to present more useful

information to readers. With regards to amortization, we wrote off goodwill at 20% over

five years, which is shown in the following graph:

Impairment of Goodwill (in thousands) (SDI 10-K)

2003 2004 2005 2006 2007 2008

Goodwill Before: 0.0 0.0 1,925.0 30,966.0 510,966.0 781,555.0

Goodwill After: 0.0 0.0 1,540.0 24,387.8 402,194.6 516,472.6

Amortization

amount: 0.0 0.0 385.0 6,578.2 108,771.4 265,082.4

107

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.

108

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

109

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

110

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.

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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



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



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




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




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




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




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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

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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



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


WORKING CAPITAL TURNOVER


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

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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

Sustainable Growth Rate Negative Negative Stable Trend

126

Gross Profit Margin

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


Steel Dynamics Steel Dynamics Restated

AK Steel Nucor


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


AK Steel Nucor


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



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


AK Steel Nucor


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


AK Steel Nucor


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

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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



AK Steel Nucor


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



AK Steel Nucor


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




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



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

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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


AK Steel Nucor


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

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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

statement we found the following numbers:

Sales Growth Percentage:

2002 2003 2004 2005 2006 2007 2008raw avg.: adj. avg.:

42.4% 14.2% 117.3% 1.9% 48.2% 35.4% 84.3% 49.1% 42.0%

(SDI 10-K).

As shown above, the percentages greatly vary from year to year, yielding the raw

average useless. After selecting data from the most consistent years, the sales growth

rates adjusted average provided a growth rate of 42%. Upon reviewing the forecasted

numbers that resulted from such an extremely high rate and researching other analysts’

predictions for Steel Dynamics we decided that while this rate may be sustainable, it

was ultimately unreasonable. According to Palepu and Healy, even when a firm is

growing rapidly at present, it is generally unrealistic to assume that the current high

growth rate will persist indefinitely. Therefore, we came up with the following numbers:

Predicted Sales Growth Rates: 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-10.0% 5.0% 10.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%

We predicted that the current recession will only last through 2009 and that the steel

processing industry will begin to recover in 2010 and maintain a solid growth rate of

15% starting in 2012. Throughout our research, we found that the majority of analysts

predict the current recession to be over by December 2009 and begin to steadily

recover in 2010 (Wall Street Journal). For these reasons, we chose a 10% decline for

2009 and grew the firm back at 5% increments thereafter. We chose a 15% growth

rate because, as stated earlier, our research showed more optimistic numbers around

20% but the analyst quotes were around 10%, so we took the average of the two

146

forecasts. Using these percentages we were able to forecast net sales for the next nine

years. Since sales were not affected by the amortization of goodwill, in both the as-

stated and restated income statements we found that net sales grew to be 3.07 times

larger over the next 10 years.

Cost of goods sold was forecasted next. Using the common sized income

statement we found that this item was consistently staying at around 75% of net sales.

We assumed it would continue to hold true for the next nine years, except for 2009

where we predicted it would be around 80% due to the recession’s demand for lower

prices. As sales increase, the cost of goods sold per unit decreased. Now, since net

sales and cost of goods sold were now forecasted, we were able to simply subtract

COGS from net sales to plug in our gross profit figures. Gross profit grows at a higher

rate, because we expect to sell more in the upcoming years which consequently

lowered the COGS expenses.

Selling, general and administrative (SGA) expenses were also forecasted using

the common size income statement. We found the percentage SGA expenses

percentage of net sales to be consistently around 4.81%. We took this rate and held it

consistent in forecasting SGA expenses throughout the years. The same was done in

regards to forecasting interest expense: we identified stability in this expense as 1.61%

of net sales and times that by the forecasted sales over the next nine years.

Now that both gross profit and selling, general and administrative expenses were

forecasted, we were able to forecast operating income using the following formula for

the common size income statement: operating income rate= gross profit – SGA

expenses. We grew operating income by multiplying the corresponding rates times the

predicted net sales. This resulted in around $4.5 billion of operating income in 2018 on

the stated income statement, and $4.7 on the restated income statement. Had we not

adjusted the statement for the amortization of goodwill, there would have been a $200

million forecasting error.

Net income was consistently around 30% of operating income. We chose to

predict net income as increasing by 30% of operating income on the common size

income statement for the as-stated statements, and 25% of the restated statements to

147

compensate for the future amortization of goodwill. We then took that rate and

multiplied it by the projected net sales, causing operating income to quadruple in the

following nine years on both income statements. There is about a $176 million

difference between the as-stated and restated predictions for net income in 2018. This

is the effect of future goodwill amortization.

Dividends declared per share were forecasted last. Currently, Steel Dynamics is

paying $.40 dividends per share so we carried that rate out for the next nine years. It is

important to note that SDI has had two stock splits in the recent years and while it is

likely they will do this again in the near future, we are unable to predict when this will

be.

148

STEEL DYNAMICS, INC.: CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Years Ended December 31,

Actual Predicted 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

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 7,272,469 7,636,092 8,399,702 9,659,657 11,108,605 12,774,896 14,691,131 16,894,800 19,429,020 22343373 Costs of goods sold 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262 5,817,975 5,803,430 6,383,773 7,244,743 8,331,454 9,581,172 11,018,348 12,671,100 14,571,765 16,757,530 Gross profit 603,490 485,149 829,992 915,694 1,231,259 1,454,494 1,832,662 2,015,928 2,414,914 2,777,151 3,193,724 3,672,783 4,223,700 4,857,255 5,585,843 Selling, general and administrative expenses 96,581 91,974 170,878 224,540 267,688 349,727 367,213 403,934 464,525 534,203 614,334 706,484 812,456 934,325 1,074,474 Profit Sharing — — — — 66,997 Amortization — — — — 41,334 Operating income 506,909 393,175 659,114 691,154 855,240 1,104,767 1,465,449 1,611,994 1,950,390 2,242,948 2,579,390 2,966,299 3,411,244 3,922,930 4,511,370 Interest expense 38,907 34,341 32,104 55,416 144,574 117,087 122,941 135,235 155,520 178,849 205,676 236,527 272,006 312,807 359,728 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 $394,566 463,386 331,430 439,635 483,598 585,117 672,884 773,817 889,890 1,023,373 1,176,879 1,353,411 Basic 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 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4

149

Common Size Income Statement Actual Predicted

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 (1 year recession)

Sales Growth Percent 117.26% 1.86% 48.24% 35.38% 84.30% -10.00% 5.00% 10.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Net sales Unrelated parties 87.90% 89.68% 92.50% 94.85% 95.83% Related parties 12.10% 10.32% 7.50% 5.15% 4.17% Total net sales 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% Costs of goods sold 71.86% 77.80% 74.37% 79.12% 84.76% 80.00% 76.00% 76.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% Gross profit 28.14% 22.20% 25.63% 20.88% 15.24% 20.00% 24.00% 24.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% Selling, general and administrative expenses 4.50% 4.21% 5.28% 5.12% 3.31% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% 4.81% Profit Sharing — — — — 0.83% Amortization — — — — 0.51% Operating income 23.63% 18.00% 20.35% 15.76% 10.58% 15.19% 19.19% 19.19% 20.19% 20.19% 20.19% 20.19% 20.19% 20.19% 20.19% Interest expense 1.81% 1.57% 0.99% 1.26% 1.79% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% Gain from debt extinguishment 0.00% 0.00% 0.00% 0.00% 0.00% Other expense (income), net -0.33% -0.08% -0.14% 0.13% -0.41% Income before income taxes 22.15% 16.51% 19.50% 14.37% 9.21% Income taxes 8.38% 6.35% 7.25% 5.38% 3.47%Net income 13.77% 10.15% 12.25% 9.00% 5.73% 4.56% 5.76% 5.76% 6.06% 6.06% 6.06% 6.06% 6.06% 6.06% 6.06%Basic earnings per share 0.00% 0.00% 0.00% 0.00% 0.00%

150

STEEL DYNAMICS, INC.: CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share data) Years Ended December 31, *Adjusted for the impairment of goodwill

Actual Forecasted 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

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 7,272,469 7,636,092 8,399,702 9,659,657 11,108,605 12,774,896 14,691,131 16,894,800 19,429,020 22,343,373 Costs of goods sold 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262 5,817,975 5,727,069 6,299,776 7,244,743 8,331,454 9,581,172 11,018,348 12,671,100 14,571,765 16,757,530 Gross profit 603,490 485,149 829,992 915,694 1,231,259 1,454,494 1,909,023 2,099,925 2,414,914 2,777,151 3,193,724 3,672,783 4,223,700 4,857,255 5,585,843 Selling, general and administrative expenses 96,581 91,974 110,808 150,865 267,688 288,717 303,153 333,468 383,488 441,012 507,163 583,238 670,724 771,332 887,032 Profit Sharing — — — — 66,997 Amoritization — — — — 41,334 Goodwill expense — 385 6,578 108,771 516,472 Operating income 506,909 393,175 659,114 691,154 855,240 1,165,777 1,605,870 1,766,457 2,031,426 2,336,140 2,686,561 3,089,545 3,552,976 4,085,923 4,698,811Interest expense 38,907 34,341 32,104 55,416 144,574 117,087 122,941 135,235 155,520 178,849 205,676 236,527 272,006 312,807 359,728 Gain from debt extinguishment Other expense (income), net -7,031 -1,792 -4,545 5,500 -33,147Income 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 -53,086 291,444 401,468 441,614 507,856 584,035 671,640 772,386 888,244 1,021,481 1,174,703 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 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4

151

Common Size Income Statement Actual Forecasted 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Sales Growth Percent 117.26% 1.86% 48.24% 35.38% 84.30% -10.00% 5.00% 10.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Net sales Unrelated parties 87.90% 89.68% 92.50% 94.85% 95.83% Related parties 12.10% 10.32% 7.50% 5.15% 4.17% Total net sales 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% Costs of goods sold 71.86% 77.80% 74.37% 79.12% 84.76% 80.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00% 75.00%Gross profit 28.14% 22.20% 25.63% 20.88% 15.24% 20.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00% 25.00%Selling, general and administrative expenses 4.50% 4.21% 3.42% 3.44% 3.31% 3.97% 3.97% 3.97% 3.97% 3.97% 3.97% 3.97% 3.97% 3.97% 3.97% Profit Sharing — — — — 0.83%Amoritization — — — — 0.51%Goodwill expense — 0.02% 0.20% 2.48% 6.39%Operating income 23.63% 18.00% 20.35% 15.76% 10.58% 16.03% 21.03% 21.03% 21.03% 21.03% 21.03% 21.03% 21.03% 21.03% 21.03% Interest expense 1.81% 1.57% 0.99% 1.26% 1.79% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61% 1.61%Gain from debt extinguishment 0.00% 0.00% 0.00% 0.00% 0.00%Other expense (income), net -0.33% -0.08% -0.14% 0.13% -0.41%Income before income taxes 22.15% 16.49% 19.30% 11.89% 9.21%Income taxes 8.38% 6.35% 7.25% 5.38% 3.47% Net income 13.77% 10.13% 12.05% 6.52% -0.66% 4.01% 5.26% 5.26% 5.26% 5.26% 5.26% 5.26% 5.26% 5.26% 5.26%Basic earnings per share 0.00% 0.00% 0.00% 0.00% 0.00%

152

Balance Sheet

We forecasted the balance sheet next because it also is mainly affected by the

net sales predicted. Since the ratio that connects the balance sheet to the income

statement is the asset turnover ratio, we started off with forecasting total assets first.

The asset turnover ratio is a lagged ratio because the formula for ATO is salest divided

by total assetst-1. We use total assets from the prior year because they are the assets

that affected the sales in the current year. We found that Steel Dynamics has an

adjusted average of ATO rate of 1.79 for the as-stated statements, and 1.88 for the

adjusted statements. This difference is caused by the decrease in total assets as a

result of the amortization of goodwill. We then took the corresponding rates for each

statement and multiplied them times the net sales on the corresponding income

statements to get our total assets. Because we do not have the net sales forecasted for

2019 as required, we had to plug the forecast for 2018. After reviewing the progression

of the increase in the forecast of other previous years, we saw a constant growth rate

of 15%. We then multiplied the as-stated 2017’s forecast of $12,496,697 by 1.15 to get

2018’s total assets of $14,371,202. For the restated balance sheet we did the same,

using 2017’s total assets of $12,195,936 to get 2018’s $14,025,326.

Next we forecasted accounts receivable using the accounts receivable turn-over

(ARTO) ratios. The ARTO is found by dividing total net sales by accounts receivable. We

found the ARTO ratio was 9.89, and to forecast accounts receivable we took the

forecasted net sales and divided it by the ARTO ratio.

We used a similar process for forecasting inventory, using the inventory turn-

over (ITO) rate. The ITO is found by COGS/inventory. We found the ITO ratio had an

adjusted average of 4.35 for the as-stated and restated statements. To forecast

inventory we took the forecasted cost of good sold from the corresponding income

statement and divided it by the corresponding ITO rates.

Using the common size balance sheet, we saw that total current assets was

consistently at about 41% of total assets. Because of this, we forecasted total current

assets as 41% of total assets for the next ten years. Now that we had total current

153

assets forecasted, we simply subtracted the numbers from total assets to get Steel

Dynamics’ total non-current assets.

To forecast total current liabilities, we used the current ratio of 2.52 for the

stated statements and 2.59 for the adjusted statements. The current ratio is found by

dividing total current assets by total current liabilities. To forecast, we divided total

current assets by 2.52 and 2.59 for the corresponding statements. The result was that

the restated balance sheet was $285,000 less of current liabilities than that of the as-

stated balance sheet.

Total Equity was very difficult to forecast. To compute these projected figures we

first had to predict total retained earnings. In doing this we used the following formula:

Retained Earnings t = Retained Earnings t-1 +Net Income t – Dividends Paid t

Due to the amortization of goodwill, the 2018 forecast of retained earnings was about

$140 million less on the adjusted balance sheet than the forecast on the as stated

sheet. Total Stockholder’s Equity was then calculated as the difference between

retained earnings t and retained earnings t-1. The stock holders’ equity on the restated

balance sheet increased 4% from the as-stated balance sheet, actually increasing the

value of the firm.

In the valuation process, there is more importance placed on forecasting equity

accurately than there is in forecasting for liabilities. Because of this and in order to

make our balance sheet balance, we found total liabilities using a plug rate of total

assets minus total equity.

154

STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Years Ended December 31 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Assets Current assets: Cash and equivalents 16,334 65,518 29,373 28,486 16,233 Accounts receivable, net 209,742 197,527 348,148 662,285 424,003 735,336 772,102 849,313 976,709 1,123,216 1,291,698 1,485,453 1,708,271 1,964,512 2,259,188 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 1,337,466 1,334,122 1,467,534 1,665,458 1,915,277 2,202,568 2,532,954 2,912,897 3,349,831 3,852,306 Deferred income taxes 6,856 6,516 13,964 10,427 23,562 Other current assets 18,980 13,307 15,167 38,795 143,953Total current assets 677,519 725,733 1,036,197 1,696,229 1,709,915 1,751,062 1,926,168 2,215,094 2,547,358 2,929,461 3,368,880 3,874,212 4,455,344 5,123,646 5,892,193 Property, plant and equipment, net 1,024,044 999,969 1,136,703 1,652,097 2,072,857Restricted cash 989 1,588 5,702 11,945 18,515 Intangible assets — — 12,226 514,547 614,786Goodwill — 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 2,519,821 2,771,803 3,187,574 3,665,710 4,215,566 4,847,901 5,575,086 6,411,349 7,373,051 8,479,009 Total assets 1,733,619 1,757,687 2,247,017 4,519,453 5,253,577 4,270,883 4,697,971 5,402,667 6,213,067 7,145,027 8,216,781 9,449,299 10,866,693 12,496,697 14,371,202

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 36,600Current maturities of long-term debt 6,774 2,156 686 56,162 65,223 Total current liabilities 233,208 207,177 396,993 904,526 970,981 694,866 764,352 879,005 1,010,856 1,162,485 1,336,857 1,537,386 1,767,994 2,033,193 2,338,172Long-term debt: Other long-term debt 19,458 17,960 16,920 16,183 2,219,161Unamortized 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 65,626total 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 2,379,726 2,434,547 2,729,748 3,040,251 3,397,329 3,807,969 4,280,205 4,823,276 5,447,807 13,214,909

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 2,087,656 2,459,923 2,869,418 3,369,315 3,944,197 4,605,312 5,365,593 6,239,917 7,245,389 8,401,682 Total stockholders’ equity 847,122 879,868 1,231,108 1,529,196 1,623,886 1,891,157 2,263,424 2,672,919 3,172,816 3,747,698 4,408,813 5,169,094 6,043,418 7,048,890 1,156,293 Total liabilities and stockholders’ equity 1,733,619 1,757,687 2,247,017 4,519,453 5,253,577 4,270,883 4,697,971 5,402,667 6,213,067 7,145,027 8,216,781 9,449,299 10,866,693 12,496,697 14,371,202

155

BALANCE SHEET: Common size ACTUAL Forecasted 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Assets Current assets: Cash and equivalents 0.94% 3.73% 1.31% 0.63% 0.31% Accounts receivable, net 12.10% 11.24% 15.49% 14.65% 8.07% Accounts receivable-related parties 2.25% 2.21% 2.37% 0.98% 0.95% Inventories 22.01% 22.68% 25.34% 20.01% 19.48%Deferred income taxes 0.40% 0.37% 0.62% 0.23% 0.45% Other current assets 1.09% 0.76% 0.67% 0.86% 2.74% Total current assets 39.08% 41.29% 46.11% 37.53% 32.55% 41.00% 41.00% 41.00% 41.00% 41.00% 41.00% 41.00% 41.00% 41.00% 41.00% Property, plant and equipment, net 59.07% 56.89% 50.59% 36.56% 39.46% Restricted cash 0.06% 0.09% 0.25% 0.26% 0.35% Intangible assets — — 0.54% 11.39% 11.70%Goodwill — 1.10% 1.38% 11.31% 14.67% Other assets 1.79% 1.73% 1.12% 2.96% 1.28% Total non-current assets 60.92% 58.71% 53.89% 62.47% 67.45%

change in NCA -15.20% -3.62% -8.22% 15.93% 7.98% Total assets 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 7.87% 6.32% 6.49% 7.94% 4.94% Accounts payable-related parties 0.31% 0.25% 0.09% 0.44% 0.07% Income taxes payable 0.00% 0.00% 1.36% 0.57% 0.08% Accrued expenses 4.37% 4.58% 4.07% 3.33% 3.99%Accrued interest 0.51% 0.51% 0.00% 0.00% 0.00% Accrued profit sharing — — 2.06% 1.19% 1.19%Senior secured revolver — — 3.56% 5.29% 0.70% Current maturities of long-term debt 0.39% 0.12% 0.03% 1.24% 1.24% Total current liabilities 13.45% 11.79% 17.67% 20.01% 18.48% 16.27% 16.27% 16.27% 16.27% 16.27% 16.27% 16.27% 16.27% 16.27% 16.27% Long-term debt: Other long-term debt 1.12% 1.02% 0.75% 0.36% 42.24% Unamortized bond premium 0.41% 0.31% 0.17% — —Total long-term debt: 25.47% 24.94% 15.94% 38.38% 42.24% Deferred income taxes 12.07% 13.15% 11.43% 6.67% 6.96% Minority interest 0.14% 0.06% 0.06% 0.24% 0.16% Other long term liabilities — — 0.11% 0.85% 1.25% Total Liabilities 51.14% 49.94% 45.21% 66.16% 69.09% 55.72% 51.82% 50.53% 48.93% 47.55% 46.34% 45.30% 44.39% 43.59% 91.95%

Commitments and contingencies Stockholders’ equity: Common stock 0.03% 0.03% 0.02% 0.01% 0.01% Treasury stock, at cost -4.85% -15.41% -10.26% -10.12% -14.03% Additional paid-in capital 22.53% 23.09% 16.37% 12.25% 10.31% Other accumulated comprehensive income — — — 0.00% -0.03% Retained earnings 31.16% 42.35% 48.65% 31.69% 34.65% 48.88% 52.36% 53.11% 54.23% 55.20% 56.05% 56.78% 57.42% 57.98% 58.46%Total stockholders’ equity 48.86% 50.06% 54.79% 33.84% 30.91% 44.28% 48.18% 49.47% 51.07% 52.45% 53.66% 54.70% 55.61% 56.41% 8.05% Total liabilities and stockholders’ equity 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%

156

(adjusted for the impairment of goodwill) STEEL DYNAMICS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share data) Years Ended December 31 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Assets Current assets: Cash and equivalents 16,334 65,518 29,373 28,486 16,233 Accounts receivable 209,742 197,527 348,148 662,285 424,003 735,076 771,830 849,013 976,365 1,122,820 1,291,243 1,484,929 1,707,669 1,963,819 2,258,392 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 1,336,677 1,315,792 1,447,371 1,664,477 1,914,148 2,201,270 2,531,461 2,911,180 3,347,857 3,850,035Deferred income taxes 6,856 6,516 13,964 10,427 23,562Other 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 1,578,874 1,736,762 1,997,276 2,296,867 2,641,397 3,037,607 3,493,248 4,017,235 4,619,820 5,312,793 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 18,515Intangible 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 2,589,220 2,848,142 3,275,364 3,766,668 4,331,668 4,981,419 5,728,632 6,587,926 7,576,115 8,712,532Total assets 1,733,619 1,757,302 2,240,439 4,410,682 4,737,104 4,168,094 4,584,904 5,272,640 6,063,535 6,973,066 8,019,026 9,221,879 10,605,161 12,195,936 14,025,326

Liabilities & 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 3,651Income 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 36,600Current maturities of long-term debt 6,774 2,156 686 56,162 65,223 Total current liabilities 233,208 206,792 390,415 795,755 454,508 610,084 671,092 771,756 887,519 1,020,647 1,173,744 1,349,805 1,552,276 1,785,118 2,052,885 Long-term debt: Other long-term debt 19,458 17,960 16,920 16,183 2,219,161Unamortized 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 65,626Total liabilities 886,497 877,434 1,009,331 2,881,486 3,113,218 2,316,923 2,399,633 2,719,858 3,088,117 3,511,614 3,998,637 4,558,713 5,202,800 5,943,500 6,795,305

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 390,505 405,900 367,772 553,805 541,686Other accumulated comprehensive income — — — 21 -1,411 Retained earnings 540,235 743,959 1,086,693 1,323,425 1,303,912 1,531,197 1,865,298 2,232,808 2,655,445 3,141,478 3,700,415 4,343,193 5,082,388 5,932,462 6,910,047 Total stockholders’ equity 847,122 879,868 1,231,108 1,529,196 1,623,886 1,851,171 2,185,271 2,552,782 2,975,419 3,461,451 4,020,389 4,663,167 5,402,362 6,252,436 7,230,021 Total liabilities and stockholders’ equity 1,733,619 1,757,302 2,240,439 4,410,682 4,737,104 4,168,094 4,584,904 5,272,640 6,063,535 6,973,066 8,019,026 9,221,879 10,605,161 12,195,936 14,025,326

157

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

Assets Current assets: Cash and equivalents 0.94% 3.73% 1.31% 0.65% 0.34% Accounts receivable 12.10% 11.24% 15.54% 15.02% 8.95% 17.64% 16.83% 16.10% 16.10% 16.10% 16.10% 16.10% 16.10% 16.10% 16.10%Accounts receivable-related parties 2.25% 2.21% 2.38% 1.00% 1.05% Inventories 22.01% 22.69% 25.41% 20.50% 21.60% 32.07% 28.70% 27.45% 27.45% 27.45% 27.45% 27.45% 27.45% 27.45% 27.45% Deferred income taxes 0.40% 0.37% 0.62% 0.24% 0.50%Other current assets 1.09% 0.76% 0.68% 0.88% 1.22% Total current assets 39.08% 41.30% 46.25% 38.46% 36.10% 37.88% 37.88% 37.88% 37.88% 37.88% 37.88% 37.88% 37.88% 37.88% 37.88% Property, plant and equipment, net 59.07% 56.90% 50.74% 37.46% 43.76%Restricted cash 0.06% 0.09% 0.25% 0.27% 0.39% Intangible assets — — 0.55% 11.67% 12.98% Goodwill — 1.10% 1.38% 11.59% 16.26% Goodwill impairment — 0.02% 0.29% 2.47% 10.90% Other assets 1.79% 1.73% 1.13% 3.03% 1.42% Total non-current assets 60.92% 58.70% 53.75% 61.54% 63.90% 62.12% 62.12% 62.12% 62.12% 62.12% 62.12% 62.12% 62.12% 62.12% 62.12%

change in NCA -15.20% -3.64% -8.44% 14.50% 3.84%Total assets 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%

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 7.87% 6.32% 6.51% 8.14% 5.48% Accounts payable-related parties 0.31% 0.25% 0.09% 0.45% 0.08%Income taxes payable 0.00% 0.00% 1.36% 0.59% 0.09% Accrued expenses 4.37% 4.58% 4.09% 3.42% 4.43% Accrued interest 0.51% 0.51% 0.00% 0.00% 0.00% Accrued profit sharing — — 2.07% 1.22% 1.32%Senior secured revolver — — 3.57% 5.42% 0.77% Current maturities of long-term debt 0.39% 0.12% 0.03% 1.27% 1.38% Total current liabilities 13.45% 11.77% 17.43% 18.04% 9.59% 14.64% 14.64% 14.64% 14.64% 14.64% 14.64% 14.64% 14.64% 14.64% 14.64% Long-term debt: Other long-term debt 1.12% 1.02% 0.76% 0.37% 46.85% Unamortized bond premium 0.41% 0.31% 0.17% — —Total long-term debt: 25.47% 24.95% 15.99% 39.33% 46.85% Deferred income taxes 12.07% 13.15% 11.46% 6.83% 7.72% Minority interest 0.14% 0.06% 0.06% 0.25% 0.18% Other long-term liabilities — — 0.11% 0.87% 1.39%Total Liabilities 51.14% 49.93% 45.05% 65.33% 65.72% 55.59% 52.34% 51.58% 50.93% 50.36% 49.86% 49.43% 49.06% 48.73% 48.45%

Commitments and contingencies Stockholders’ equity: Common stock 0.03% 0.03% 0.02% 0.01% 0.01% Treasury stock, at cost -4.85% -15.42% -10.29% -10.37% -15.56% Additional paid-in capital 22.53% 23.10% 16.42% 12.56% 11.43%Other accumulated comprehensive income — — — 0.00% -0.03%Retained earnings 31.16% 42.34% 48.50% 30.00% 27.53% 36.74% 40.68% 42.35% 43.79% 45.05% 46.15% 47.10% 47.92% 48.64% 49.27%Total stockholders’ equity 48.86% 50.07% 54.95% 34.67% 34.28% 44.41% 47.66% 48.42% 49.07% 49.64% 50.14% 50.57% 50.94% 51.27% 51.55% Total liabilities and stockholders’ equity 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%

158

Statement of Cash flows

We forecasted the statement of cash flows last because it is extremely difficult to

predict from year to year. Although the statement is very volatile, we forecasted out

dividends paid, cash flows from operations (CFFO), cash flows from investing (CFFI),

and cash flows from financing activities (CFFF).

We first forecasted dividends paid by applying the same percentages from the

sales growth rates as our applied dividends growth rates. We used these rates instead

of a single rate in hopes of making our predicted statements more accurate and

applicable to the long-term effects of the current recession. These applied dividends

growth rates are as follows:

Predicted Dividends Paid 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

dividends paid: 64,159 67,367 74,104 85,219 98,002 112,703 129,608 149,049 171,407 197,118growth rate: -10% 5% 10% 15% 15% 15% 15% 15% 15% 15%

When forecasting cash flows from operations (CFFO), we chose to use the

CFFO/sales ratio. Other ratio options were CFFO/operating income and CFFO/net sales,

but the CFFO/sales ratio was the most consistent from year to year and not affected by

the amortization of goodwill. We then took the average of the ratio over the past years

and came up with the rate of .31. We then multiplied that rate times the predicted sales

of the year to come up with our forecast for CFFO.

Next, we forecasted cash flows from investing activities (CFFI) using the growth

rate of non-current assets. The growth rate of non-current assets on average was

5.23% for the as-stated statements, and 3.30% for the adjusted statements. We then

took 1 + the corresponding rates, and multiplied that times the previous year’s CFFI,

except for 2009 where we used a -5.23 and -3.30% to account for the current

recession.

Lastly we forecasted the cash flows from financing activities (CFFF), which we

saved for the end due to its extreme volatility. To forecast, we referenced the percent

159

increase in the dividends paid to stockholders (as seen above). We used those growth

rates to grow the CFFF section.

160

CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Net income 295,314 221,785 396,707 394,566 453,386 357,208 518,955 622,746 818,995 1,064,693 1,437,336 2,012,270 2,817,178 3,944,049 5,521,669 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 14,278 Deferred 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 12 551 557 Minority interest 1,856 -1,351 306 -386 -2,611 Changes in certain assets and liabilities

Accounts receivable -

127,838 12,153 -72,277 57,653 310,985

Inventories -

196,992 -17,196 -66,240 -119,577 -18,667 Other assets -8,282 1,551 -3,373 -4,393 -150,810 Accounts payable 57,680 -32,299 -9,787 -48,835 -88,451 Income taxes payable 6,553 13,974 -10,684 -21,765 Accrued expenses . 33,213 4,933 22,434 3,807 34,602 Net cash provided by operating activities 247,919 310,756 404,952 428,203 775,301 2,254,465 2,367,189 2,603,907 2,994,494 3,443,668 3,960,218 4,554,250 5,237,388 6,022,996 6,926,446

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

-101,991 -62,041 -217,413

-1,246,629 -669,234 -634,239 -667,404 -702,303 -739,028 -777,673 -818,338 -861,130 -906,160 -953,544

-1,003,406

Financing activities Issuance of current and long-term debt 188,292 268,706 330,000 3,157,053 2,845,900 Repayments of current and long-term debt

-347,487 -276,510 -297,231

-1,761,807

-2,402,033

Issuance of common stock (net of expenses) and proceeds from exercise of stock options, including related tax effect 27,899 15,401 28,503 29,446 18,422 Purchase of treasury stock -55,179 -186,764 -247,411 -533,654 -501,777 Dividends paid -7,452 -18,276 -37,545 -55,642 -71,288 -64,159 -67,367 -74,104 -85,219 -98,002 -112,703 -129,608 -149,049 -171,407 -197,118

145.25% 105.43% 48.20% 28.12% -10.00% 5.00% 10.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Debt issuance costs -1,097 -2,088 — -17,857 -7,544 Net cash provided by (used in) financing activities

-195,024 -199,531 -223,684 817,539 -118,320 -106,488 -111,812 -122,994 -141,443 -162,659 -187,058 -215,117 -247,384 -284,492 -327,166

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

Accounts receivable -

127,838 12,153 -72,277 57,653 310,985

Inventories -

196,992 -17,196 -66,240 -119,577 -18,667 Other assets -8,282 1,551 -3,373 -4,393 -150,810 Accounts payable 57,680 -32,299 -9,787 -48,835 -88,451Income taxes payable 6,553 13,974 -10,684 -21,765 Accrued expenses . 33,213 4,933 22,434 3,807 34,602 Net cash provided by operating activities 247,919 310,756 404,952 428,203 775,301 2,254,465 2,367,189 2,603,907 2,994,494 3,443,668 3,960,218 4,554,250 5,237,388 6,022,996 6,926,446 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 -

101,991 -62,041 -217,413 -

1,246,629 -669,234 -647,149 -668,505 -690,566 -713,355 -736,895 -761,213 -786,333 -812,282 -839,087 -866,777

Financing activities Issuance of current and long-term debt 188,292 268,706 330,000 3,157,053 2,845,900 Repayments of current and long-term debt

-347,487 -276,510 -297,231

-1,761,807

-2,402,033

Issuance of common stock (net of expenses) and proceeds from exercise of stock options, including related tax effect 27,899 15,401 28,503 29,446 18,422 Purchase of treasury stock -55,179 -186,764 -247,411 -533,654 -501,777 Dividends paid -7,452 -18,276 -37,545 -55,642 -71,288 -64,159 -67,367 -74,104 -85,219 -98,002 -112,703 -129,608 -149,049 -171,407 -197,118 % change in dividends paid 145.25% 105.43% 48.20% 28.12% -10.00% 5.00% 10.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% Debt issuance costs -1,097 -2,088 — -17,857 -7,544 Net cash provided by (used in) financing activities

-195,024 -199,531 -223,684 817,539 -118,320 -106,488 -111,812 -122,994 -141,443 -162,659 -187,058 -215,117 -247,384 -284,492 -327,166

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

Dynamics.

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Weighted Average Cost of Debt

CURRENT LIABILITIES Amount Rate Weight Weighted RateAccounts Payable 259,742 0.0048 0.0834 0.0004005Accounts Payable-Related Parties 3,651 0.0048 0.0012 0.0000056Income Taxes Payable 4,107 0.0048 0.0013 0.0000063Accrued Expenses 209,697 0.0048 0.0674 0.0003233Accrued Interest — — — — Accrued Profit Sharing 62,561 0.0048 0.0201 0.0000965Senior Secured Revolver 36,600 0.0048 0.0118 0.0000564Current Maturities of Long-Term Debt 65,223 0.0668 0.0210 0.0013995TOTAL 0.0022881

Long-Term Liabilities Amount Rate Weight Weighted RateSenior Secured Term A loan 503,800 0.0650 0.1618 0.01092336 3⁄4% Senior Notes 500,000 0.0675 0.1606 0.01185277 3⁄8% Senior Notes 700,000 0.0738 0.2248 0.01742577 3/4% Senior Notes, Due 2016 500,000 0.0775 0.1606 0.01204549 1⁄2% Senior Notes 500,000 0.0750 0.1606 0.00642424.0% Convertible Subordinated Notes — — — — Other Long-Term Debt 15,361 0.0287 0.0049 0.0001416Unamortized Bond Premium — — — — Deferred Income Taxes 365,494 0.0287 0.1174 0.0033694Minority Interest 8,427 0.0287 0.0027 0.0000777Other Long Term Liabilities 65,626 0.0287 0.0211 0.0006050TOTAL 0.0652190

Kd6.52%

Weighted Average Cost of Capital

As the general formula for a company goes, Assets = Liabilities + Equity, every

company is financed by debt and equity. In order to find a correct Weighted Average

Cost of Capital, WACC, the formula is used. Once this

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is calculated, the firm will know its required return and can thus value future projects

for a correct Net Present Value.

Because we already have cost of debt, 6.52%, and cost of equity, 15.86%, from

the equations before, the only numbers needed are the total values of the assets, the

book value of liabilities and the market value of equity. From http://finance.yahoo.com

the market capitalization is found at roughly $1.70 billion and there is about $3.11

billion on the books for Steel Dynamics’ liabilities (SDI 10-K). In order to find the value

of the assets, the addition of the market value of equity and book value of liabilities is

needed, and this number is roughly $4.81 billion. After inputting the numbers into the

formula above, the WACC for Steel Dynamics is 9.82%. The size adjustment is already

factored in with the cost of equity so there is no need to add it again into the final

number.

The WACC found above is before tax and an after tax is needed as well. This is

done by taking the tax rate of 35% and subtracting one from it. Then, the .65 number

is multiplied in to the weighted average of debt section of the WACC formula and the

WACC after tax is calculated. Once this is done, the Weighted Average Cost of Capital is

found to be 8.34%. This is a credible number because it falls within the guidelines of Rf

< Kd < WACCAT < Ke.

Weighted Average Cost of Capital

Tax Rate

$3.11 B 6.52% 35% $1.70 B 15.86% $4.81 B

WACC Before Tax = 8.34%

WACC After Tax = 9.82%

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Conclusion

In conclusion, estimating the cost of capital takes multiple steps and equations to

solve. The first is determining the cost of equity and this was done by both Capital

Asset Pricing Model and the alternative cost of equity. This is required rate of return an

investors needs to compensate them for possible risk associated with investing in the

firm. A correct beta is needed and this is found using the risk free rate of treasuries

from the St. Louis Federal Reserve website, the S&P 500 returns and the returns of the

firm. The next step is calculating the cost of debt where weighted averages of liabilities

are needed. The interest paid on debt is needed to find the cost of capital. Once these

are all found, the cost of capital can be calculated. The numbers are as follows:

Upper Lower

CAPM = 14.16% 19.94% 8.48%

Size Adjusted CAPM = 15.86% 21.64% 10.18%

Backdoor Ke = 22.69%

Cost of Debt = 6.52%

WACCBT = 9.22% 11.26% 7.21%

WACCAT = 7.74% 9.79% 5.74%

Size Adjusted WACCBT = 8.34% 11.86% 7.81%

Size Adjusted WACCAT = 9.82% 10.39% 6.34%

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Valuation Ratios and Models

With the accumulation of the previous research, we are now able to move on to

the last few steps in our valuation. Our ultimate goal throughout the process has been

to analyze the value of a firm’s equity. Using a multiples based valuation, we can begin

to see a picture of whether or not the firm is over or under valued. This method lacks

theory and therefore will not weigh heavily on our valuation determination. A more

precise string of valuation methods will be further used to determine “intrinsic values”

for various metrics. These methods do not use averages to compute a model based

price, rather they use specific values for certain key items. The five intrinsic methods

we will use will each provide a different outlook, however one should expect to see a

pattern develop. Using company figures and our forecasted figures, we can assign

value to the equity of a firm and provide an analysts recommendation.

Multiples Based Valuations:

The starting point chosen for the valuation process is the use of multiples based

valuations. Also referred to as the “method of comparables”, this string of results is

basically ratio based. There is no accepted theory for this process and it is generally as

mechanical as it gets. We also run into trouble with this method because there is not a

consistent set of rules when using the method. For the stated reasons, we will not

heavily weight the results in our overall final valuation decision.

Each multiple gives insight as to the financial position of the firm. Using

publically available information from Yahoo Finance and the individual firms’ annual

reports, we have arrived at a method based price for each multiple. Crucial to the

success of this method is compute relevant industry averages; being sure to omit

negative values as they are useless to this method as well as excluding potential

outliers. We have used eight measures, each of which will be defined and discussed in

order to determine which might be appropriate. However as we know, there is no

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theory stating which valuation multiple is best. All of the following information is based

on 4/1/2009 prices.

P/E (trailing)

The price to earnings ratio, trailing twelve months, is the first measure we came

across. It is defined as the price per share divided by the last four quarters of earnings

per share. Using Yahoo Finance and the annual reports of Steel Dynamics, we have

found the following information.

Company EPS P/E US Steel 1.25 AK Steel 211 Nucor 6.6

SDI 2.55SDI restated ‐0.29

Average 3.93 Ratio Based Price 10.01 Ratio Based Price (Restate) N/A

From the presented figures, we can conclude two key points. First, the restated

earnings per share for Steel Dynamics could not be used because it is negative.

Second, AK Steel was left out of the industry average because it is a significant outlier.

The process of finding a ratio based price is simple. Multiply the industry average by

the firm’s earnings per share to arrive at $10.01 per share. Compared to the closing

price on April 1, 2009 which was $8.98, we can conclude that this measure provides

that the firm is overvalued. We defend this with the fact that as 10% analysts, the

model based price does not fall into our lower and upper bounds of $8.08 and $9.88,

respectively.

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P/E (forward)

The forward price to earnings ratio is similar to the previous; however it uses the

next four quarters that we forecasted as the earnings per share portion. Using Yahoo

Finance and our forecasted earnings, we have compiled the following information. It is

important to note that if growth is expected in the future, the trailing model price

should be lower than the forward. Despite our anticipation of the recession, we

observe just that.

As shown above, we are able to use all inputs because none of them are

negative. We have chosen to exclude Nucor in the industry average citing it as an

outlier. Steel Dynamics can be shown on an as stated and restated ratio based price.

By multiplying the average by the forward earnings per share, we come to $14.93 as

stated and $13.13 on a restated basis. With that said, we can conclude that both prices

indicate an overvalued firm.

Company EPS fore P/E fore US Steel 8.99AK Steel 7.42Nucor 11.04

SDI 1.82SDI restated 1.60

Average 8.21Ratio Based Price 14.93 Ratio Based Price (Restate) 13.13

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P/B

The next measure used in the method of comparable was the price to book ratio.

This ratio is found by dividing the firm’s current price per share by its book value of

equity per share. The price to book ratio gives insight as to whether the firm is growth

or value oriented and lets us compare the market value of the firm to the book value.

The following information was derived using Yahoo Finance and annual reports.

Company BPS P/B US Steel 0.5 AK Steel 0.81 Nucor 1.51


Average 0.94 Ratio Based Price 0.03 Ratio Based Price (Restate) 0.01

As we can see from the information above, there were not any significant outliers

present nor were there any negative (unusable) figures. As we expect to see, Nucor

has a high P/B ratio, indicating growth. US Steel lower and could be considered a value

firm. We multiplied the industry average P/B by Steel Dynamics’ stated and restated

BPS to arrive at very low figures for price per share, method based. The incredible

amount of variance from the share price of $8.98 can best be explained by

outperformance by others, namely Nucor, in the industry. Based on the ratio price, we

can conclude that the firm is severely overvalued. However because of the large

difference, we will not place a large amount of importance on this comparable.

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D/P

The next ratio is different from the previous ratios in that it uses price per share

as the denominator and dividends per share as the numerator. Despite the

arrangement, we can use the same process as before with a slight adjustment. The

following information was derived using Yahoo Finance and annual reports.

Company DPS D/P US Steel 0.05 AK Steel 0.03 Nucor 0.05


Average 0.05 Ratio Based Price 7.80 Ratio Based Price (Restate) 7.80

As we have done previously, outliers were excluded in the average. This time it was AK

Steel whose D/P was much lower than the others. To get the price, we divided SDI’s

dividends per share by the industry average dividends to price ratio. Despite the close

proximity to the actual price, this method based price leads us to the same conclusion

that the firm is slightly overvalued.

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Price Earnings Growth

Known informally as the PEG ratio, the price to earnings growth ratio compares a

firms P/E to its expected growth. We used the one year ahead earnings growth rate in

our calculations. One must be careful not to use the forward P/E ratios because this

would basically double count for the growth of earnings. A higher growth rate is

expected for firms with high P/E ratios. By dividing the P/E ratio by growth, we can

arrive at a more appropriate metric for determining the relative price of stock. The

following information lacks a PEG ratio for both US Steel and AK Steel; therefore Nucor

will be the only firm in the industry average.

Company g P.E.G US Steel N/A AK Steel N/A Nucor 9.54


Average 9.54 Ratio Based Price 3.65 Ratio Based Price (Restated) N/A

Finally, we have arrived at a method that demonstrates a fairly valued result. However,

it is difficult to be precise using this comparable due to the lack of PEG numbers for two

of three main competitors.

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P/EBITDA

EBITDA is a well known figure in finance. It stands for earnings before interest,

taxes, depreciation and amortization. Like the other methods that use the market cap

for the numerator, we will derive a model based price by multiplying Steel Dynamics’

EBITDA by the industry average P/EBITDA. Nucor was selected for exclusion on the

grounds that it is a significant outlier. The following information was derived using

Yahoo Finance and annual reports.

Company EBITDA P/EBITDA US Steel 0.72 AK Steel 0.84 Nucor 3.11

SDI 1.09 SDI restated 1.84

Average 0.78 Ratio Based Price 0.85 Ratio Based Price (Restated) 1.44

This comparable reflects an obvious conclusion of the firm being overvalued. The ratio

based price is far lower than the observed share price, which verifies the previous

statement as correct. With that said, we will move on to the next possible measure.

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P/FCF (per share)

Measuring the free cash flow to the firm’s assets is a critical step in the valuation

of said firm. By adding the CFFO and the CFFI, we arrive at the FCF. Then, we divide

the free cash flows by the outstanding shares to arrive at the denominator for this ratio.

A large ratio indicates a relatively more expensive investment from an investor’s point

of view. AK Steel’s figures for this method will be left out due to their negative ratio.

Company FCF per P/FCF US Steel 4.98 AK Steel ‐7.34 Nucor 9.04



Given the ratio based price, we come to the conclusion that the firm is overvalued.

Following intuition, we can also state that the free cash flows to the assets are not as

valuable as they appear.

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EV/EBITDA

The last method that we used in our multiples based valuations is enterprise

value over earnings before interest, taxes, depreciation and amortization. This method

is often used because its components ignore the concept of a firm’s capital structure. In

other words, there is less confusion for investors because they need not worry about

the debt or equity financing that a corporation uses. In order to correctly run this

method, an analyst must compute the enterprise value of a firm. This is calculated as

the market value of equity plus the book value of liabilities minus cash and financial

investments. This figure represents the market core of the business, or what investors

are actually investing in.

Due to the fact that we restated our financials, we came to two separate

enterprise values for Steel Dynamics. The following information was compiled using

Yahoo Finance and annual reports.

Company EV EV/EBITDA US Steel 1.43

AK Steel 0.91

Nucor 3.37



As shown, the ratio based prices indicate that the share price for SDI is well overvalued.

By multiplying the EV by the industry average, we came to the presented figures.

Therefore, we can intuitively note that the greater the enterprise value, the higher the

ratio based price. Also, we must not forget that Nucor was left out as an outlier in this

method.

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Conclusion

We have demonstrated the fact that the “method of comparables” is basically

piracy. Using publicly available information, an analyst could determine a ratio based

price per share for any firm. Valuing the firm is the main objective of this method,

however it clearly lacks theory. This team has found that most of the method based

prices indicate Steel Dynamics as overvalued. However, when we begin to use more

reliable valuation methods, we might find ourselves in a completely different ballpark.

For this reason, we will not place a heavy weight on the significance of these findings.

Intrinsic Valuation Models:

Unlike the method of comparables, intrinsic valuation models are based on

theory. These models will, each in their own way, provide a value for the equity of a

firm. The market value of equity as it changes through alterations in variables will be

shown in box format. The provided boxes allow for easy observation as to the results

of the valuation model. Color coding indicates whether the model based, time

consistent price in under or overvalued with respect to the observed share price on April

1, 2009.

Discounted Dividends

The discounted dividends model is a theory that cash payoffs a claimholder

receives or dividends are discounted back using a present value rate in order to find the

correct equity value at a per share basis or price per share. This is a very simple way to

value the equity of a firm, and with that it is not a very reliable method. There are two

necessary parts within in this model, the cost of equity and the expected dividends. The

cost of equity was found earlier within the Capital Asset Pricing Model and the expected

dividends are found from future payout ratios and growth rates of earnings.

This model is viewed as very unreliable and a limited way to find the correct

equity of a firm by many financial analysts. An important limitation of the process is its

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focus on the company’s growth rate. With the sensitivity of this method, any change in

the growth rate could cause a large change in the price per share. An accurate growth

rate and cost of equity is needed in order to find the correct equity required. This is

hard to find because quite a bit of those numbers are opinions and not based on strong

known figures.

In order to calculate the discounted dividends model, there are many inputs that

must be factored into the equation. First, the expected dividends must be forecasted

out eleven years. Next, a present value factor must be found on a year by year basis.

This will be the item that we multiply the dividends by in order to find the present value

of the dividends. Once this is found, the indefinite dividend growth rate must be

calculated in order to find the correct model price. This is computed by taking the

future expected dividend and dividing it by the cost of equity minus the expected

growth rate. For Steel Dynamics, this came out to 1.23 ÷ (.1586 - .05) and the total

was 11.28. After this was found, the total of 11.28 was multiplied by the present value

factor for year ten which came out to .2487. This allowed the present value of the

perpetuity to equal 2.81, and once this is added up with summation of the first ten

year’s dividends present values or 2.62, the total came out to 5.43. After this is found,

the model price must be changed to be time consistent with the current price per share.

The current price of Steel Dynamic’s price per share was $8.98 as of April 1st, 2009 so

the model price had to be multiplied by the cost of equity taken to three months ahead

in order to find a time consistent price. After this is calculated, the time consistent

model price for Steel Dynamics came out to $5.63 which means the firm’s price per

share is overvalued according to the model.

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Discounted Dividends Model

0.02 0.03 0.04 0.05 0.06 0.07 0.080.1018 9.87 10.75 11.91 13.52 15.91 19.79 27.240.1207 7.58 8.06 8.66 9.43 10.45 11.87 13.99

Ke 0.1397 6.49 6.82 7.22 7.72 8.35 9.18 10.330.1586 5.00 5.18 5.39 5.63 5.93 6.29 6.750.1779 4.21 4.32 4.46 4.61 4.79 5.00 5.250.1975 3.60 3.68 3.77 3.86 3.98 4.11 4.260.2164 3.15 3.20 3.26 3.33 3.40 3.49 3.59

Growth Rate

White = Fairly Valued9.88 < 8.98 < 8.08

YellowOvervalued

GreenUndervalued

The model above shows the final calculations for Steel Dynamics. As shown, the

table explains how sensitive this model is overall. With a change in the growth rate

from 2% to 8% there is about a $17.00 increase within the price per share. With this

sensitivity, there is a very slight comparability to the actual price per share. Overall, the

discounted dividends model shows that Steel Dynamics is overvalued.

Discounted Free Cash Flow

The discounted free cash flows analysis uses the previously forecasted statement

of cash flows that are “then discounted at the firm’s estimated cost of capital to arrive

at the estimated value” (Palepu). This evaluation model is the easiest to compute, but

typically has the worst explanatory power.

The formula for the discounted free cash flows is as follows:

MVEE FCF

1 WACCBT,

∞

LiabilitiesMV,

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To fix this, we need to state the present value of the terminal value perpetuity in time

zero dollars. In order to do this, we change the equation to:

MVEE FCF

1 WACCBT,

E FCF1 W BVL

Now, the perpetuity is no longer stated in the year ten dollars, and is brought back to

the same year as the year-by-year model.

This valuation model’s initial conditions are extremely sensitive to error, since

they are based off of the most volatile and difficult statement to forecast, the statement

of cash flows. The discounted free cash flows model is also very sensitive to the

discount and terminal value growth rates. The model is inherently flawed because the

growth rates of free cash flows blows up to infinity, therefore making the model a poor

measure with relatively low explanatory power.

First we found Steel Dynamics’ free cash flows for the forecasted years 2009-

2018 by adding the forecasted cash flows from operations with the forecasted cash

flows from investing activities. Earlier we discovered that the firm’s weighted average

cost of capital before tax was 9.82%. Using this, we found the present value factor by

taking 1/(1+WACCBT)^year forecasted. For example, for forecasting two years after

2008, we would take 1/(1+0.0982)2. Next we multiplied the free cash flows times the

corresponding PV factor to get the present value year by year future cash flows (PV

YBY FCF). After that, we added up all of the results to get the total PV YBY FCF.

Next we found the present value of the perpetuity in year 11 (2019). To do this,

we first found the free cash flow of the firm’s assets for 2019 by multiplying the FCF of

2018 by 113%, after observing a constant trend of at 13% increase from year to year.

We then took this number and divided it by WACCBT minus the perpetuity growth rate.

After that we found took the PV of the perpetuity and multiplied it by the PV factor from

year 10 (2018).

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To find the Market value of the assets, valued at December 31, 2008, we added

the total PV YBY FCF and the FCF perpetuity. Then we subtracted book value of debt

and preferred stock from the MV of assets to get the market value of equity (MVE).

From Steel Dynamics’ 2008 10-K, we found that there were 181,820 shares outstanding

at the end of the year. Using this information, we divided the MV of equity by the

number of shares outstanding to get the price per share at December 31, 2008.

However, our observed price was at April 1, 2009. In order to change the PPS to

the time consistent price, we multiplied the PPS by (1+ WACCBT)3/12 to account for the

three month lapse. Because of the linked formulas, as we changed the growth and

WACCBT rates, the time consistent price would change, as reflected in the graph below.

The results from these steps are as follows:

0.02 0.03 0.04 0.05 0.06 0.07 0.08

0.0781 0.00 0.00 0.00 0.00 7.09 35.44 0.00

0.0848 0.00 0.00 0.00 0.00 0.00 10.40 65.49

0.0915 0.00 0.00 0.00 0.00 0.00 0.94 15.84

0.0982 0.00 0.00 0.00 0.00 0.00 3.44 24.74

0.1050 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.1118 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.1186 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Here, any cells that were fairly valued would have fallen within a 10% range of the our

observed share price of $8.98, but none of the results fell in this range The green cells

are greater than 110% of the observed share price, and therefore considered to be

undervalued. On the other hand, the yellow cells are less than 90% of the observed

share price, and considered to be overvalued. The red cells were originally negative

numbers, however since a negative stock price is impossible, we replaced them with the

lowest possible stock price of $0.00. This model was extremely volatile to any changes,

which also reduced the reliability and explanatory power of the model. While the

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discounted free cash flows model’s yielded a majority of useless results, we chose the

perpetuity growth rate of .07 and the WACCBT of .0848 to get the time consistent share

price of $10.40. Since this result is greater than 110% of the observed share price, this

valuation model states the stock is undervalued.

In conclusion, the discounted free cash flows model is simple to compute, but

does a poor job explaining what is going on with the firm. Even after it has been

adjusted to include the discounted terminal value perpetuity, the evaluation model is

inherently flawed as it is based on an unrealistic growth rate and very unreliable

forecasting of from the statement of cash flows. This model yielded results higher than

the current stock price, indicating that investment in the firm would be wise.

Residual Income

The residual income model has the highest explanatory power out of all the

intrinsic valuation models with an un-equaled 40-70 percent for a single firm, and up to

90 percent for an industry, which in-turn makes it the most reliable intrinsic valuations

used by our valuation team. This is due to the fact that it puts very little weight in

“wishful thinking”, unlike models such as the dividend growth model which relies heavily

on forecasted future earnings and payout ratios. This adds some validity to the model

due to the fact that forecast errors tend to magnify with time. Because the outputs of

the residual income model are based little on speculation, it is not at all sensitive to

growth rates. After the calculation of this model an analyst will be able to tell if the

company has destroyed value, maintained value, or created value.

The calculation of the Residual Income model is easiest explained if broken down

step by step. After finding the values for net income, total dividends, and book value of

equity the next step is to calculate the annual normal income. The annual normal

income, also known as the benchmark (NI*), will serve as the income that will support

the shareholders required rate of return. To calculate the annual normal income, the

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initial cost of equity (.1568 for Steel Dynamics) is multiplied by the previous year’s book

value of equity (BVE). This is calculated on an annual basis for ten years into the future

(2009 through 2019). After the annual normal income is calculated the next step is the

find the annual residual income by subtracting the benchmark form net income for the

same period. The third step is the calculation of the year by year present value of

residual income. This is simply done by multiplying the annual residual income by the

present value factor (which was calculated in the same fashion as seen in the dividend

discount model). After adding up the time zero book value of equity, the total PV of YBY

residual income, and the terminal value of perpetuity we were left with the market

value of equity valued at 12/31/2008. The final step before the sensitivity analysis is to

divide the market value of equity by the number of shares outstanding to get the model

price of a share at 12/31/2008. The table below illustrates the values of the inputs that

go into the calculation of market value of equity:

MVE

*in thousands except for percentages Value %

Book Value of Equity 1623886 59.6

Total PV of YBY RI 735677 27

Terminal Value of Perpetuity 362840 13.3

The next step is to compare the model price at 12/31/2008 to the time

consistent price. The time consistent price takes growth rate and initial cost of equity

into account in the same manner as the previous intrinsic valuations. The growth rate is

kept negative so that the rates will approach the cost of capital and therefore will

approach equilibrium. This is done to keep valuation models realistic in respects that a

positive perpetual growth rate would send the model into infinity. As follows is the

Residual Income analysis valued at April first, 2009 for Steel Dynamics:

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0.00 -0.10 -0.20 -0.30 -0.40 -0.50 0.0848 49.38 35.80 31.76 29.82 28.68 27.93 0.1094 31.75 26.06 24.04 23.01 22.39 21.97 0.1340 21.72 19.40 18.46 17.96 17.65 17.43 0.1586 15.53 14.73 14.38 14.18 14.05 13.96 0.1722 13.12 12.76 12.60 12.50 12.44 12.40 0.1748 12.70 12.41 12.28 12.20 12.15 12.12 0.1994 9.68 9.77 9.82 9.85 9.87 9.88

Yellow‐Overvalued White‐Fairly Valued Green‐ Undervalued

9.88<8.98<8.08

Upon review of the results, it is clear that Steel Dynamics is undervalued

according to this model. Since we are a 10% valuation team, anything model priced

below 8.08 would be considered overvalued and any model price above 9.88 would be

considered undervalued. If the model price falls between 8.08 and 9.88, it is considered

to be fairly valued. A value highlighted in green means the time consistent price of a

share of Steel Dynamics stock is undervalued, a box with no color is a price that is fairly

valued, and a value highlighted in yellow is a share that is overvalued. Since the

residual income started positive, the values get smaller as the growth rate gets smaller.

Since there are no prices highlighted in yellow and only six out of 42 in white, our

valuation team came to the conclusion that Steel Dynamics is a very undervalued and

healthy firm according to this model and our analysis.

Abnormal Earnings Growth

The Abnormal Earnings Growth (AEG) Model is an intrinsic valuation model that

calculates a firm’s equity value, similar to the Residual Income Model. In fact, AEG is

the annual change in residual income. The results of the AEG Model will help our

valuation team determine if Steel Dynamic’s has destroyed, added, or maintained value.

The equation to determine prices, and thus the equity value, is shown below:

P0 = Core Net Income + Present Value Year-by-Year AEG + Present Value AEG Terminal Value Perpetuity

Ke

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Although the AEG Model is not intuitive, it is a reliable model because it has high

explanatory power, is not sensitive to changes in growth rates and places more weight

on earnings in the near future. It is critical for the AEG Model to use negative growth

rates so the market moves back towards equilibrium. A more negative growth rate will

bring the model back to equilibrium faster.

The calculation of Steel Dynamic’s abnormal earnings growth is also best

explained in steps. After finding the values for net income and total dividends, the first

step is to find the Abnormal Earnings Growth components. These include cumulative

dividend income, and the normal income benchmark. The cumulative dividend income

(CDI) has a direct and indirect part. The direct part is net income earned, and the

indirect wealth is found from the dividend reinvested program, or DRIP. DRIP is

calculated by multiplying the previous year’s total dividends by the cost of capital. The

normal income benchmark is the previous year’s net income times (1 + Ke). After these

values are found, subtract the benchmark from CDI to arrive at AEG. Then discount

AEG back to time-one dollars by multiplying it by the Present Value Factor. The sum of

PV AEGs from 2010 to 2018 equals the total present values of year-by-year. For Steel

Dynamic’s the adjustment added value because of being a large positive number at

$96,819.37. Next the PV of terminal value is computed by first, dividing the year ten

AEG perpetuity by the difference between the cost of capital and the growth rate, and

second multiplying that by the PV Factor of the ninth year forecasted. This concludes

the numerator components of the equation for the total average net income perpetuity

(t+1). We found it on a per share basis and then discounted the EPS perpetuity by the

cost of capital to find the intrinsic value per share price as of December 31st, 2008. To

get the time consistent price you multiply the intrinsic value price by (1+ke) ^ (3/12).

After making adjustments in cost of capital and growth rates to alter the time consistent

prices we recorded them in the intrinsic valuation box that follows.

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-0.10 -0.20 -0.30 -0.40 -0.50

0.1018 44.22 40.98 39.35 38.37 37.72

0.1207 30.47 28.96 28.17 27.69 27.360.1397 21.80 21.16 20.81 20.59 20.440.1586 16.13 15.93 15.82 15.74 15.690.1779 12.20 12.22 12.23 12.24 12.240.1975 9.42 9.54 9.62 9.66 9.700.2164 7.50 7.66 7.76 7.83 7.88

Yellow‐Overvalued

White‐Fairly Valued

9.88<8.98<8.08 Green‐ Undervalued

The Abnormal Earnings Growth Model indicates that Steel Dynamics is

undervalued. Being 10% analysts, there were only six overvalued prices and six fairly

valued prices. This implies that if SDI can cover its liabilities then SDI is a good buy.

SDI valued their firm at a price of $8.98 and according to the majority of the AEG Model

the price should range anywhere from $12.20 to $44.22. Our model was found to be

accurate because our change in AEG matched our residual income check figure from

the Residual Income Model. AEG from 2014 and on consistently got 15% more positive.

Further reliability in the AEG Model is shown through the similarities between the

Residual Income valuation box and the AEG box show above. SDI beat its cost of

capital of 15.86 which continued to add value to the firm. Because SDI started out with

a positive perpetuity this influences the values to get smaller as we move to a more

negative growth rate. The only differences stem from a small error in the perpetuity

values. In conclusion, within a reasonable cost of capital Steel Dynamics is undervalued

based on the Abnormal Earnings Growth Model.

Long Run Residual Income

Though the long run residual income model is similar to the residual income

model, it uses Return on Equity (ROE) instead of forecasted dividends to calculate the

market value of equity. Because of their volatile nature, dividends are hard to forecast

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in the long run, and would therefore make the long run RI Model unreliable if dividends

were used instead of ROE. In turn this model is based off of an entirely new formula as

seen below:

MVE=BVE [1+ ((ROE-Ke) / (Ke-g))]

As stated before, the change in the equation is that the long run ROE and

growth are taken into account instead of dividends. The first step in the process of

calculating long run residual income is to calculate ROE. This was done by taking all of

the forecasted ROE numbers, eliminating the outliers, and taking the average of the

remaining values. The ROE that our valuation team converged on is 19%. We then

found that the applicable growth rate is 8% because it was the “convergence” or

centered rate. Using a growth rate of 8% and a ROE of 19% we were able to calculate

a model price of $12.31. The Ke is once again is .1586. Three different variations of the

long run RI Model were calculated using a different combination of the three variables

(Ke, G, and ROE) each time. The first of the models (as seen below) uses Ke with a

centered value of .1586 and g with a centered value of .08. The second model uses a

combination of Ke and ROE, while the third incorporates ROE and the growth rate, and

holds the third variable constant. Critical to the valuation model is the determination of

whether the models numerators or the denominators are negative or positive. A

negative numerator or denominator would yield a negative value and would in turn

render the model unrealistic. If the value of the denominator (Ke – g) is too small, the

output will be unrealistically large due to the denominator effect, again rendering the

results unrealistic.

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g -0.03 -0.04 -0.08 -0.38 0.13

0.1018 15.27 14.84 13.59 10.83 0.00

0.1302 12.65 12.44 11.83 10.29 2,762.64

Ke 0.1586 10.81 10.73 10.49 9.81 19.44

0.1875 9.43 9.43 9.41 9.36 9.73

0.2164 8.37 8.41 8.54 8.96 6.51

Yellow‐Overvalued



Ke

0.1018 0.1302 0.1586 0.1875 0.2164

0.15 0.00 0.00 0.00 0.00 0.00

0.17 0.00 0.00 0.00 0.00 0.00

ROE 0.19 -0.03 -0.04 -0.08 -0.38 0.13

0.21 0.00 0.00 0.00 0.00 0.00

0.23 0.00 0.00 0.00 0.00 0.00

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For the above model, we used an upper bound of 9.88 and a lower bound of 8.08 to

decide if a model price is overvalued, undervalued, or fairly valued. If a value is

highlighted in green, the price is undervalued. If a price is highlighted in yellow it is

overvalued and if it is not highlighted at all then the prices is fairly valued. According to

basic financial theory, the growth rate should never exceed the cost of capital because

this would produce a negative stock value. Upon review of the results of this model, our

valuation team has once again come to the conclusion that Steel Dynamics is an

undervalued firm.

Analyst Recommendation

The purpose of our research and analysis has been to ultimately determine the

value of Steel Dynamics’ equity. After a significant amount of effort, it is our opinion

that the firm is undervalued. We have arrived at this conclusion through a series of

analytical steps which together have enabled us to defend our proposition. An industry

analysis focusing on key success factors built our knowledge base for the steel

ROE

0.15 0.17 0.19 0.21 0.23

-0.03 8.84 9.83 10.81 11.79 12.77

-0.04 8.86 9.80 10.73 11.66 12.60

g -0.08 8.93 9.71 10.49 11.26 12.04

-0.38 9.12 9.46 9.81 10.15 10.49

0.13 6.48 12.96 19.44 25.92 32.40

Yellow‐Overvalued



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processing industry. Using this base we were able to determine which accounting areas

might be potentially distortive. Then, after restating the last five years worth of

financial statement data, we could begin a process of forecasting the next ten years.

Appropriate forecasts and discount rate estimations provided the inputs to our intrinsic

valuation models. Focusing on the most reliable models while taking into consideration

the increased leverage of the firm, we have determined the market value of Steel

Dynamics’ equity to be undervalued.

It was important to this valuation team to expose the accurate economic value of

the intrinsically undervalued firm. In order to this, we had to begin by observing the

industry environment. We discovered an industry with high price competition and a

considerable amount of rivalry amongst existing firms. This type of competition is

healthy because it allows for firms to constantly attempt to add value in any way

possible. Success for steel manufacturers revolves around a cost leadership position.

The firms sell products to all sorts of customers; however, being linked to key industries

like the automotive industry might spell doom for some unhealthy steel firms. We do

not feel that the current economic slow-down will be able to stifle the growth of Steel

Dynamics following the recession. Therefore, the economic ramifications of our current

situation does not affect our opinion of the firm’s value.

After analyzing the key accounting policies for the individual firm and the main

competitors, we could state with considerable certainty how clearly the firms were

presenting themselves. High disclosure was found to be very common with respect to

key accounting areas. A lack of information regarding a specific topic was not found to

be troublesome because it simply meant there was nothing to discuss, for example

currency risk. The lack of impairment for Goodwill was the only situation where we

found potentially misleading information. For this reason, we tested for impairment and

made the appropriate adjustment to the balance sheets and income statements.

Financial analysis put us one step closer to determining how well the firm is

operating in its industry. We used benchmark analysis to evaluate the trends in various

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ratios. Despite our extensive findings, we have concluded that the most important

observation that was made involved the Debt to Equity ratio for the industry. We see

Steel Dynamics’ figures drastically increase in the last year. A vast increase in leverage

is the primary concern for this valuation team because it presents the only issue with

our valuation opinion. We feel that if the firm can satisfy all of its debt holders, then it

would most certainly be a wise investment.

The most valuable research and analysis that we have performed is the intrinsic

valuation process. We utilized a set of different models, all of which offer a different

view of the firm’s value. The results that followed the method of comparables also

proved to be unreliable and therefore were not heavily weighted in our decision. The

least reliable of the models provided us with results that might lead inferior analysts to

infer overvalued prices. However, focusing on the most reliable of the models, the

Residual Income Model, we have been able to defend our opinion. We have found that

the observed share price of $8.98 is well below our model based prices. Model based

prices for the original cost of equity ranged from $15.53 to $13.96, which all fall outside

of our 10% analyst bounds. The fact that the model price is nearly double the

observed price leads us to infer that the firm’s equity is clearly undervalued. Therefore,

after meticulous research and analysis, we recommend investing in Steel Dynamics.

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Appendix 1:

Total Assets of Industry (in thousands) 2003 2004 2005 2006 2007 2008SDI: 1,448,439 1,733,619 1,757,687 2,247,017 4,519,453 5,253,577Nucor 4,511,577 6,140,391 7,148,845 7,893,018 9,826,122 13,874,443USSC 7,897,000 11,064,000 9,822,000 10,586,000 15,632,000 16,130,000AK steel 5,025,600 5,452,700 5,487,900 5,517,600 5,167,400 4,677,400Total assets: Industry 18,882,616 24,390,710 24,216,432 26,243,635 35,144,975 39,935,420

Firms' Percent of Total Assets of Industry: 2003 2004 2005 2006 2007 2008

Steel Dynamics 7.67% 7.11% 7.26% 8.56% 12.86% 13.16%

Nucor 23.89% 25.18% 29.52% 30.08% 27.96% 34.74%

USSC 41.82% 45.36% 40.56% 40.34% 44.48% 40.39%

AK steel 26.61% 22.36% 22.66% 21.02% 14.70% 11.71%Total assets: Industry 18,882,616 24,390,710 24,216,432 26,243,635 35,144,975 39,935,420

Sales revenue (net sales in thousands) 2003 2004 2005 2006 2007 2008 total per co. SDI

987,248 2,144,913 2,184,866 3,238,787 4,384,844 8,080,521 21,021,179Nucor 6,265,823 11,376,828 12,700,999 14,751,270 16,592,976 23,663,324 85,351,220USSC 16,873,000 15,715,000 14,039,000 13,975,000 16,873,000 23,817,000 101,292,000AK steel 4,041,700 5,217,300 5,647,400 6,069,000 7,003,000 7,644,300 35,622,700Total sales revenue: Industry 28,167,771 34,454,041 34,572,265 38,034,057 44,853,820 63,205,145 243,287,099

198

Industry growth

2004 2005 2006 2007 2008 5 yr average: Steel dynamics 117.26% 1.86% 48.24% 35.39% 84.28% 71.76%Nucor 81.57% 11.64% 16.14% 12.49% 42.61% 41.11%USSC -6.86% -10.66% -0.46% 20.74% 41.15% 10.98%AK steel 29.09% 8.24% 7.47% 15.39% 9.16% 17.34%Industry Totals: 221.06% 11.08% 71.39% 84.00% 177.21% 141.18%

PPE, net (in thousands) 2003 2004 2005 2006 2007 2008 5 year avg: Steel dynamics 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857 1,314,464Nucor 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861 3,118,739USSC 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000 4,824,500AK steel 243,390 232,450 225,750 213,340 206,590 2,061,300 530,470Total PPE: Industry 7,475,641 7,701,801 8,186,436 8,635,458 11,779,685 14,950,018 2,447,043

199

Steel and Iron: Basic Materials (in thousands) Steel Dynamics Nucor USSC AK Steel Industry Total Industry mean 2003 987,248 6,265,823 16,873,000 4,041,700 28,167,771 13,837,0742004 2,144,913 11,376,828 15,715,000 5,217,300 34,454,041 16,690,7922005 2,184,866 12,700,999 14,039,000 5,647,400 34,572,265 16,739,9162006 3,238,787 14,751,270 13,975,000 6,069,000 38,034,057 18,207,3322007 4,384,844 16,592,976 16,893,000 7,003,000 44,873,820 21,340,6992008 8,080,521 23,663,324 23,817,000 7,644,300 63,205,145 29,582,442

Sales revenue (in thousands) 2003 2004 2005 2006 2007 2008 total per co. Steel dynamics 987,248 2,144,913 2,184,866 3,238,787 4,384,844 8,080,521 21,021,179Nucor 6,265,823 11,376,828 12,700,999 14,751,270 16,592,976 23,663,324 85,351,220USSC 16,873,000 15,715,000 14,039,000 13,975,000 16,873,000 23,817,000 101,292,000AK steel 4,041,700 5,217,300 5,647,400 6,069,000 7,003,000 7,644,300 35,622,700Total sales revenue: Industry 28,167,771 34,454,041 34,572,265 38,034,057 44,853,820 63,205,145 243,287,099

200

Appendix 2:

2003 2004 2005 2006 2007 2008Steel Dyna 1.02 1.06 1 1.05 1.4 0.97AK Steel 1.11 1.05 0.99 1.02 1 0.97Nucor Cor 1.01 1.04 1 1 1.03 0.98U.S. Steel 1.03 1.04 0.99 1.01 1.02 1.01

2003 2004 2005 2006 2007 2008Steel Dyna 9.78 9.98 10.18 9.12 6.54 17.84AK Steel 10.12 8.25 9.91 8.71 10.37 16.27Nucor Cor 10.95 11.82 12.69 13.82 10.29 19.26U.S. Steel 8.63 8.86 9.26 9.4 8.77 10.48

2003 2004 2005 2006 2007 2008Steel Dyna 5.35 5.62 5.65 5.69 4.85 7.9AK Steel 5.53 7.65 6.99 7.08 10.83 13.49Nucor Cor 11.18 9.18 13.44 12.93 10.36 9.83U.S. Steel 7.37 11.79 9.58 9.8 7.4 9.02

2003 2004 2005 2006 2007 2008Steel Dyna ‐ 1.09 0.26 1.15 39.14 0.87AK Steel ‐0.3 0.88 0.9 1.82 0.86 0.78Nucor Cor 0 1.06 0.79 1.01 1.35 0.88U.S. Steel 1.07 1.04 ‐0.14 1.16 1.09 0.99

2003 2004 2005 2006 2007 2008Steel Dyna ‐414.64 10.16 ‐190.25 7.51 0.91 ‐17.03AK Steel ‐0.29 5.04 ‐6.87 3.32 ‐42.84 ‐3.13Nucor Cor 16.46 13.1 34.96 30.74 3.38 ‐18.46U.S. Steel 8.01 9.38 0.91 10.81 4.57 25.43

2003 2004 2005 2006 2007 2008Steel Dyna ‐227.3 5.88 7.39 5.78 ‐2.01 31.1AK Steel ‐0.16 ‐24.14 3.41 8.57 ‐4.43 ‐8.02Nucor Cor ‐51.2 7.52 ‐4.49 10.45 4 8.77U.S. Steel 9.5 ‐54.07 ‐0.26 12.14 1.71 26.26

Change form of Net Sales / Accounts Receivable

Change form of Net Sales / Inventory

Raw Net Sales / Cash Flows from Sales

Raw Net Sales / Accounts Receivable

Raw Net Sales / Inventory

Change form of Net Sales / Cash Flows from Sales

201

2003 2004 2005 2006 2007 2008Steel Dynamics 0.68 1.24 1.24 1.44 0.97 1.54Ak Steel 0.8 0.96 1.03 1.1 1.35 1.63

Nucor Corp. 1.39 1.85 1.78 1.87 1.69 1.70U.S. Steel 1.21 1.29 1.43 1.48 1.08 1.39

2003 2004 2005 2006 2007 2008Steel Dynamics 0.13 0.24 0.16 0.14 0.03 0.88

Ak Steel 0.54 ‐3.72 0.49 ‐3.23 1.02 2.97

Nucor Corp. ‐0.01 0.29 0.52 0.04 ‐0.81 0.82U.S. Steel ‐0.41 0.52 ‐0.13 0.26 0.05 0.54

2003 2004 2005 2006 2007 2008Steel Dynamics 0.01 0.12 0.06 0.08 0.01 0.02Ak Steel ‐0.14 ‐5.92 3.59 2.16 ‐12.54 ‐3.25

Nucor Corp. 0 0.19 0.39 0.04 ‐0.64 0.06U.S. Steel 0.09 0.23 ‐0.05 0.1 0.01 0.01

2003 2004 2005 2006 2007 2008Steel Dynamics 0.08 ‐0.25 4.42 ‐0.16 0.22 0.02Ak Steel ‐1.55 ‐0.13 0 3.05 0.03 0.03

Nucor Corp. 0.13 ‐0.23 0.62 ‐0.31 4.13 0.01U.S. Steel 0.48 ‐0.24 5.81 0.86 0.46 0.1

Cash Flow from Operations / Net Operating Assets

Total Accruals / Sales

Asset Turnover (Sales / Assets)

Cash Flow from Operations / Operating Income

202

2003 2004 2005 2006 2007 2008Steel Dynamics 5.72 4.06 1.66 2.15 0.5 0.97Ak Steel 0.02 2.75 12.22 14.2 2.92 1.35

Nucor Corp. ‐4.32 3.11 1.32 2.75 0.95 1.69U.S. Steel ‐17.29 1.49 0.06 2.19 0.23 1.08

2003 2004 2005 2006 2007 2008Steel Dynamics ‐ 0.26 0.51 0.12 ‐2.21 0.65

Ak Steel 0 1.13 ‐1.25 5.63 1.51 2.14

Nucor Corp. ‐ 0.31 2.01 ‐1.32 6.72 ‐0.73U.S. Steel ‐0.35 0.23 7.13 1.86 0.7 1.49

2003 2004 2005 2006 2007 2008Steel Dynamics 0.18 4.7 2.39 0.23 ‐0.14 0.27Ak Steel ‐0.14 ‐5.92 3.59 2.16 ‐12.54 0.65

Nucor Corp. 0.01 453.73 15.53 1092.78 ‐5.77 ‐0.58U.S. Steel 0.7 2.46 ‐2.59 1.56 ‐0.18 0.27

2003 2004 2005 2006 2007 2008Steel Dynamics 0.08 ‐2.14 ‐0.42 ‐0.34 4.64 0.05Ak Steel ‐1.55 ‐0.13 0 3.05 0.03 0.03

Nucor Corp. 0.13 ‐0.38 ‐0.53 ‐2.01 ‐39.54 0.79U.S. Steel 0.48 ‐1.02 ‐0.15 1.05 1.74 0.13

Asset Turnover (Sales / Assets)

Cash Flow from Operations / Operating Income

Cash Flow from Operations / Net Operating Assets

Total Accruals / Sales

203

Goodwill:

Impairment of Goodwill (in thousands) 2003 2004 2005 2006 2007 2008Goodwill Before: 0.0 0.0 1,925.0 30,966.0 510,966.0 781,555.0Goowill After: 0.0 0.0 1,540.0 24,387.8 402,194.6 516,472.6Difference: 0.0 0.0 385.0 6,578.2 108,771.4 265,082.4

Total assets 1,448,439 1,733,619 1,755,762 2,216,051 4,008,487 4,472,022goodwill percent of TA, before &

after

0.00% 0.00% 0.11% 1.40% 12.75% 17.48%

0.00% 0.00% 0.09% 1.10% 10.03% 11.55%Impairment of Goodwill (in thousands) 0.00% 0.00% 0.02% 0.30% 2.71% 5.93%

2007 Goodwill as a Percent of Plant, Property and Equipment:(2007, in thousands)

Goodwill PPE % of PPE Steel Dynamics 510983 1652097 30.93%USSC 1712000 6688000 25.60%AK Steel 371000 20659000 1.80%Nucor 847887 3232998 26.23%


2003 2004 2005 2006 2007 2008 % Change, 5 yr:

SDI CGS 841,920 1,541,423 1,699,717 2,408,795 3,468,855 6,849,262

PPE 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857

CGS/PPE 84.10% 150.52% 169.98% 211.91% 209.97% 330.43% 292.91%

AKsteel CGS 3,886,900 4,553,600 4,996,800 5,452,700 5,919,000 6,491,100

PPE 2,433,900 2,324,500 2,257,500 2,133,400 2,065,900 2,061,300

CGS/PPE 159.70% 195.90% 221.34% 255.59% 286.51% 314.90% 97.19%

USSC CGS 974,000 1,039,000 931,000 963,000 1,172,000 1,288,000

PPE 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000

CGS/PPE 28.53% 28.65% 22.68% 21.74% 17.52% 19.27% -32.46%

Nucor CGS 5,996,547 9,174,611 10,108,805 11,284,606 13,462,927 19,612,283

PPE 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861

CGS/PPE 212.86% 325.54% 353.98% 395.06% 416.42% 474.66% 122.99%

204


2003 2004 2005 2006 2007 2008 % Change, 5 yr:

SDI Sales 987,248 2,144,913 2,184,866 3,238,787 4,384,844 8,080,521

PPE 1,001,116 1,024,044 999,969 1,136,703 1,652,097 2,072,857

Sales/PPE 98.61% 209.46% 218.49% 284.93% 265.41% 389.83% 295.30%

AKsteel Sales 4,041,700 5,217,300 5,647,400 6,069,000 7,003,000 7,644,300

PPE 2,433,900 2,324,500 2,257,500 2,133,400 2,065,900 2,061,300

Sales/PPE 166.06% 224.45% 250.16% 284.48% 338.98% 370.85% 123.32%

USSC Sales 16,873,000 15,715,000 14,039,000 13,975,000 16,873,000 23,817,000

PPE 3,414,000 3,627,000 4,105,000 4,429,000 6,688,000 6,684,000

Sales/PPE 494.23% 433.28% 342.00% 315.53% 252.29% 356.33% -27.90%

Nucor Sales 6,265,823 11,376,828 12,700,999 14,751,270 16,592,976 23,663,324

PPE 2,817,135 2,818,307 2,855,717 2,856,415 3,232,998 4,131,861

Sales/PPE 222.42% 403.68% 444.76% 516.43% 513.24% 572.70% 157.49%

205

Appendix 3:

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

Long-Term Liabilities Amount Rate Weight ResourcesSenior Secured Term A loan 503,800 6.50% 0.1618 SDI 10-K6 3⁄4% Senior Notes 500,000 6.75% 0.1606 SDI 10-K7 3⁄8% Senior Notes 700,000 7.38% 0.2248 SDI 10-K7 3/4% Senior Notes, Due 2016 500,000 7.75% 0.1606 SDI 10-K9 1⁄2% Senior Notes 500,000 7.50% 0.1606 SDI 10-KOther L-T Debt 15,361 2.87% 0.0049 10-yr Treasury Constant Maturity RateDeferred Income Taxes 365,494 2.87% 0.1174 10-yr Treasury Constant Maturity RateMinority Interest 8,427 2.87% 0.0027 10-yr Treasury Constant Maturity RateOther L-T Liabilities 65,626 2.87% 0.0211 10-yr Treasury Constant Maturity Rate

Cost of Debt

206

2003 2004 2005 2006 2007 2008Steel Dynamics 2.66 2.91 3.5 2.61 1.88 1.76AK Steel 1.74 2.82 2.49 2.73 2.49 2.73Nucor 3.06 2.98 3.24 3.29 3.21 3.45U.S. Steel 1.46 1.68 1.76 1.92 1.65 2.06Industry Average 2.23 2.60 2.75 2.64 2.31 2.50

2003 2004 2005 2006 2007 2008Steel Dynamics 1.09 1 1.3 0.97 0.78 0.48AK Steel 0.58 1.35 1.21 1.31 1.43 1.41Nucor 1.47 1.63 2.26 2.25 2.02 1.93U.S. Steel 0.72 1.11 1.12 1.19 0.83 1.08Industry Average 0.96 1.27 1.47 1.43 1.26 1.22









Cash‐to‐Cash Cycle

Liquidity and Operating Efficiency RatiosCurrent Ratio

Quick Asset Ratio

Inventory Turnover



207

2003 2004 2005 2006 2007 2008Steel Dynamics 0.16 0.28 0.22 0.26 0.21 0.15AK Steel 0.04 0.13 0.12 0.10 0.15 0.15Nucor 0.04 0.20 0.21 0.24 0.12 0.17U.S. Steel ‐0.01 0.11 0.10 0.11 0.06 0.12Industry Average 0.06 0.18 0.16 0.18 0.14 0.15

2003 2004 2005 2006 2007 2008Steel Dynamics 0.05 0.05 0.04 0.03 0.03 0.03

AK Steel 1.16 1.02 0.98 0.99 0.91 1.00

Nucor 0.03 0.04 0.04 0.04 0.03 0.03

U.S. Steel 0.08 0.05 0.05 0.04 0.03 0.03

Industry Average 0.33 0.29 0.28 0.28 0.25 0.27

2003 2004 2005 2006 2007 2008Steel Dynamics 0.098 0.236 0.18 0.204 0.158 0.105Steel Dynamics Restated 0.10 0.24 0.18 0.20 0.16 0.11AK Steel ‐0.15 0.01 0.01 0.00 0.08 0.00Nucor 0.01 0.15 0.16 0.19 0.14 0.11U.S. Steel ‐0.09 0.11 0.10 0.11 0.07 0.13Industry Average ‐0.01 0.15 0.13 0.14 0.12 0.09

2003 2004 2005 2006 2007 2008Steel Dynamics 0.05 0.14 0.10 0.12 0.09 0.06Steel Dynamics Restated 0.05 0.14 0.10 0.12 0.07 0.06AK Steel ‐0.14 0.05 0.00 0.00 0.06 0.00Nucor 0.01 0.10 0.10 0.12 0.09 0.08U.S. Steel ‐0.06 0.08 0.06 0.09 0.05 0.09Industry Average ‐0.02 0.10 0.07 0.09 0.07 0.06

2003 2004 2005 2006 2007 2008Steel Dynamics 0.77 1.48 1.26 1.84 1.95 1.79AK Steel 1.04 1.04 1.11 1.27 1.47Nucor 1.43 2.53 2.07 2.07 2.10 2.41U.S. Steel 1.07 1.27 1.43 1.48 1.08 1.48Industry Average 1.09 1.58 1.45 1.62 1.60 1.79

2003 2004 2005 2006 2007 2008Steel Dynamics 0.04 0.2 0.13 0.23 0.18 0.1Steel Dynamics Restated 0.04 0.20 0.13 0.22 0.13 0.11AK Steel 0.05 0.00 0.00 0.07 0.00Nucor 0.01 0.25 0.21 0.22 0.19 0.19U.S. Steel ‐0.06 1.03 0.09 0.13 0.06 0.13Industry Average 0.01 0.35 0.11 0.16 0.12 0.10

2003 2004 2005 2006 2007 2008Steel Dynamics 0.09 0.5 0.26 0.45 0.32 0.3Steel Dynamics Restated 0.09 0.50 0.26 0.44 0.23 -0.03

AK Steel ‐4.52 ‐0.01 0.05 0.93 0.00Nucor 0.03 0.48 0.38 0.41 0.31 0.36U.S. Steel ‐0.42 0.29 0.27 0.31 0.16 0.00Industry Average ‐0.05 ‐0.55 0.23 0.33 0.39 0.13

2003 2004 2005 2006 2007 2008Steel Dynamics 0.04 0.19 0.12 0.21 0.15 0.08Steel Dynamics Restated 0.03 0.19 0.11 0.19 0.10 0.11AK Steel 0.00020 0.00018 0.00018 0.00018 0.00019Nucor 0.00 0.10 0.18 0.15 0.09 0.12U.S. Steel ‐0.06 0.1 0.09 0.12 0.05 0.12Industry Average 0.00 0.12 0.10 0.13 0.08 0.08

2003 2004 2005 2006 2007 2008Steel Dynamics 0.10 0.39 0.24 0.38 0.44 0.26Steel Dynamics Restated 0.08 0.39 0.21 0.35 0.28 0.31AK Steel 0.00550 0.00456 0.00241 0.00108 0.00093Nucor 0.00 0.17 0.30 0.24 0.18 0.21U.S. Steel ‐0.46 0.28 0.26 0.30 0.14 0.40Industry Average ‐0.07 0.25 0.20 0.25 0.21 0.24

Return on Equities



Profitability RatiosGross Profit Margin

Operating Expense Ratio


Net Profit Margin

Asset Turnover

Return on Assets

208

2003 2004 2005 2006 2007 2008Steel Dynamics 1.47 1.05 0.998 0.83 1.96 2.24Steel Dynamics Restated 1.47 1.05 1.00 0.82 1.88 1.92AK Steel ‐96.18 26.62 23.89 12.23 4.94 3.84Nucor 0.92 0.77 0.67 0.63 0.92 0.75U.S. Steel 6.17 1.75 1.95 1.42 1.81 2.25Industry Average (with out AK Steel) 2.51 1.16 1.15 0.93 1.64 1.79Industry Average (with AK Steel) ‐17.23 6.25 5.70 3.19 2.30 2.20

2003 2004 2005 2006 2007 2008Steel Dynamics 2.8 13.03 11.45 20.53 12.47 5.92AK Steel ‐5.05 0.28 0.44 ‐0.03 8.66 ‐0.15Nucor 3.72 78.46 480.97 ‐71.09 413.02 31.84U.S. Steel ‐6.62 12.28 10.33 14.85 7.29 17.79Industry Average ‐1.29 26.01 125.80 ‐8.94 110.36 13.85

2003 2004 2005 2006 2007 2008Steel Dynamics 10.71 15.51 45.87 187.82 624.2 13.8AK Steel ‐1.04 ‐ ‐ ‐ 55.35 118.71Nucor 1.50 2.18 4.26 4.36 2.80 4.68U.S. Steel 0.31 1.03 0.89 1.73 0.55 0.54Industry Average 2.87 6.24 17.01 64.64 170.72 34.43

2003 2004 2005 2006 2007 2008Steel Dynamics 2.04 2.95 2.95 3.43 2.13 2.73Steel Dynamics Restated 2.04 2.95 2.93 3.44 2.18 3.01AK Steel 0.54 0.43 1.17 1.27 0.49 ‐1.22Nucor 2.55 4.05 4.11 4.5 3.82 3.58U.S. Steel 2.28 2.51 3.77 2.69 2.32 3.96Industry Average 1.85 2.49 3.00 2.97 2.20 2.33

Capital Structure AnalysisDebt to Equity Ratio


Debt Service Margin

Z‐Score

Steel Dynamics, Adjusted IGR: 2001 2002 2003 2004 2005 2006 2007 2008 3.11% 19.13% 10.61% 19.03% 9.57% -1.20%

Steel Dynamics, Adjusted SGR: 2001 2002 2003 2004 2005 2006 2007 2008 7.68% 39.14% 21.18% 34.64% 27.62% -3.51%

Sales Growth Percentage:

2002 2003 2004 2005 2006 2007 2008raw avg.:

adj. avg.:

42.4% 14.2% 117.3% 1.9% 48.2% 35.4% 84.3% 49.1% 42.0%

209

Predicted Sales Growth Rates: 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-10.0% 5.0% 10.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%

Predicted Dividends Paid 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

dividends paid: 64,159 67,367 74,104 85,219 98,002 112,703 129,608 149,049 171,407 197,118

growth rate: -10% 5% 10% 15% 15% 15% 15% 15% 15% 15%

Regression Analysis

3 month

SUMMARY OUTPUT (24)

Regression StatisticsMultiple R 0.445098R Square 0.198112Adjusted R Square 0.161663Standard Error 0.1743Observations 24

ANOVAdf SS MS F ignificance F

Regression 1 0.165125 0.165125 5.435252 0.029295Residual 22 0.668367 0.03038Total 23 0.833492

Coefficientstandard Erro t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.048019 0.052069 0.922205 0.366425 -0.05997 0.156003912 -0.059966645 0.156003912X Variable 1 1.760057 0.754948 2.331363 0.029295 0.194391 3.325722835 0.194391171 3.325722835

210

SUMMARY OUTPUT (36)

Regression StatisticsMultiple R 0.381802R Square 0.145773Adjusted R Square 0.120648Standard Error 0.177421Observations 36



Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.058874 0.045891 1.282896 0.208205 -0.03439 0.152136 -0.03439 0.152136X Variable 1 1.781577 0.739629 2.408745 0.021574 0.278471 3.284683 0.278471 3.284683

SUMMARY OUTPUT (48)

Regression StatisticsMultiple R 0.420755R Square 0.177035Adjusted R 0.159145Standard E 0.165699Observatio 48



Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.072316 0.036824 1.96383 0.05561 -0.00181 0.146438 -0.00181 0.146438X Variable 2.044038 0.649787 3.145705 0.002903 0.736085 3.351991 0.736085 3.351991

211

SUMMARY OUTPUT (60)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.073058 0.028871 2.530482 0.014127 0.015266 0.13085 0.015266 0.13085X Variable 2.005018 0.557463 3.596681 0.000667 0.889134 3.120903 0.889134 3.120903

SUMMARY OUTPUT (72)



Regression 1 0.367171 0.367171 17.2562 9.09E-05Residual 70 1.489435 0.021278Total 71 1.856606

Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.059529 0.020978 2.837728 0.00594 0.01769 0.101368 0.01769 0.101368X Variable 1.78366 0.429378 4.154058 9.09E-05 0.927293 2.640028 0.927293 2.640028

212

1 Year

SUMMARY OUTPUT (24)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.055355 0.052447 1.055441 0.302677 -0.05341 0.164125 -0.05341 0.164125X Variable 1.807631 0.732905 2.46639 0.021914 0.287678 3.327583 0.287678 3.327583

SUMMARY OUTPUT (36)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.07301 0.016132 -4.52578 7.01E-05 -0.10579 -0.04023 -0.10579 -0.04023X Variable 1.666893 0.414573 4.020747 0.000305 0.824379 2.509406 0.824379 2.509406

213

SUMMARY OUTPUT (48)





SUMMARY OUTPUT (62)





214

SUMMARY OUTPUT (72)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.065302 0.021566 3.02803 0.003445 0.02229 0.108314 0.02229 0.108314X Variable 1.806518 0.425443 4.246206 6.57E-05 0.957999 2.655037 0.957999 2.655037

2 Year

SUMMARY OUTPUT (24)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.08408 0.023039 -3.64941 0.001413 -0.13186 -0.0363 -0.13186 -0.0363X Variable 2.068003 0.730927 2.829288 0.009763 0.552153 3.583852 0.552153 3.583852

215

SUMMARY OUTPUT (36)





SUMMARY OUTPUT (48)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.07882 0.015812 -4.98484 9.25E-06 -0.11065 -0.04699 -0.11065 -0.04699X Variable 1.903422 0.407645 4.669311 2.64E-05 1.082875 2.723969 1.082875 2.723969

216

SUMMARY OUTPUT (60)





SUMMARY OUTPUT (72)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.02252 0.012159 -1.8519 0.068257 -0.04677 0.001733 -0.04677 0.001733X Variable 0.681355 0.355533 1.916432 0.059394 -0.02773 1.390443 -0.02773 1.390443

217

5 Year

SUMMARY OUTPUT (24)





SUMMARY OUTPUT (36)





218

SUMMARY OUTPUT (48)





SUMMARY OUTPUT (62)





219

SUMMARY OUTPUT (72)





10 Year

SUMMARY OUTPUT (24)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.261539 0.086846 3.011538 0.006421 0.081432 0.441646 0.081432 0.441646X Variable -5.19037 1.563144 -3.32047 0.003107 -8.43213 -1.9486 -8.43213 -1.9486

220

SUMMARY OUTPUT (36)





SUMMARY OUTPUT (48)





221

SUMMARY OUTPUT (60)




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.112035 0.028505 3.930299 0.000229 0.054975 0.169095 0.054975 0.169095X Variable -2.47484 0.587225 -4.21447 8.86E-05 -3.6503 -1.29938 -3.6503 -1.29938

SUMMARY OUTPUT




Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.122923 0.026706 4.602898 1.81E-05 0.069661 0.176186 0.069661 0.176186X Variable -2.63368 0.560415 -4.69952 1.27E-05 -3.75139 -1.51597 -3.75139 -1.51597

222

Appendix 4:

Method of Comparables

Company EPS P/E BPS P/B EPS fore P/E fore g P.E.G EBITDA P/EBITDA DPS D/P FCF per P/FCF EV EV/EBITDAUSSteel 1.25 0.5 8.99 N/A 0.72 0.05 4.98 1.43

AKSteel 211 0.81 7.42 N/A 0.84 0.03 ‐7.34 0.91

Nucor 6.6 1.51 11.04 9.54 3.11 0.05 9.04 3.37

SDI 2.55 0.02 1.82 0.15 1.09 0.39 0.58 1.39SDI restated ‐0.29 0.01 1.60 0.15 1.84 0.39 0.58 1.62

Average 3.93 0.94 8.205 9.54 0.78 0.05 7.01 1.17Ratio Based Price 10.0 0.03 14.93 3.65 0.85 7.80 4.07 1.63Ratio Based Price (Restate) N/A 0.01 13.128 N/A 1.44 4.07 1.90

Discounted Dividends Model

Discounted Dividends ApproachShares oustanding: (in thousands) 181820

Relevant Valuation Item PerpTime: 0 1 2 3 4 5 6 7 8 9 10 11

ash Flow From Operations (Thousands) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019DPS (Dividends Per Share) 0.39 0.35 0.37 0.41 0.47 0.54 0.62 0.71 0.82 0.94 1.08 1.23

PV Factor 0.8631 0.7450 0.6430 0.5550 0.4790 0.4134 0.3568 0.3080 0.2658 0.2294 0.1980PV Dividend 0.3046 0.2760 0.2621 0.2601 0.2582 0.2563 0.2544 0.2525 0.2506 0.2487 0.2427

% 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

0.02 0.03 0.04 0.05 0.06 0.07 0.080.1018 9.87 10.75 11.91 13.52 15.91 19.79 27.240.1207 7.58 8.06 8.66 9.43 10.45 11.87 13.990.1397 6.49 6.82 7.22 7.72 8.35 9.18 10.330.1586 5.00 5.18 5.39 5.63 5.93 6.29 6.750.1779 4.21 4.32 4.46 4.61 4.79 5.00 5.250.1975 3.60 3.68 3.77 3.86 3.98 4.11 4.260.2164 3.15 3.20 3.26 3.33 3.40 3.49 3.59

223

Discounted Free Cash Flows Model

Discounted Free Cash Flow WACC(BT 0.0982 Kd 0.0652 Ke 0.1586

Time: 0 1 2 3 4 5 6 7 8 9 10 Perp: 11Year: 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Cash Flow From Operations (Thousands) 775,301 736,536 773,363 812,031 852,632 895,264 940,027 987,029 1,036,380 1,088,199 1,142,609 1,291,634Cash Flow From Investing Activities -669,234 -634,239 -667,404 -702,303 -739,028 -777,673 -818,338 -861,130 -906,160 -953,544 -1,003,406 -1,053,576

FCF Firm's Assets 106,067 102,297 105,959 109,727 113,605 117,591 121,689 125,899 130,220 134,655 139,203 157,358PV Factor (WACC or Ke?) 0.9218 0.8498 0.7833 0.7221 0.6657 0.6136 0.5657 0.5214 0.4807 0.4431PV YBY Free Cash Flows 94,300 90,040 85,954 82,035 78,276 74,671 71,215 67,902 64,726 61,681

% valueTotal PV YBY FCF 770,800 22% Pv of perpFCF Perp 2,811,523 78% 6,345,099Market Value of Assets (12/31/08) 3,582,323 100%Book Value Debt & Preferred Stock 3,629,691 0.02 0.03 0.04 0.05 0.06 0.07 0.08Market Value of Equity -47,368 0.0781 0.00 0.00 0.00 0.00 7.09 35.44 0.00divide by Shares to Get PPS at 12/31 -0.26 0.0848 0.00 0.00 0.00 0.00 0.00 10.40 65.49Time consistent Price (4/1/09) -0.27 0.0915 0.00 0.00 0.00 0.00 0.00 0.94 15.84Oberved Share Price (4/1/09) 8.98 0.0982 0.00 0.00 0.00 0.00 0.00 3.44 24.74

0.1050 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0WACC(BT) 0.0848 0.1118 0.00 0.00 0.00 0.00 0.00 0.00 0.00Perp Growth Rate 0.06 0.1186 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Residual Income Model

annual change in RI 65,815 ‐15,078 36,573 8,484 9,756 11,220 12,903 14,838 17,064All Items in Thousands of Dollars PERP:

Time: 0 1 2 3 4 5 6 7 8 9 10 11Year: 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Net Income (Thousands) 463,386 331,430 439,635 483,598 585,117 672,884 773,817 889,890 1,023,373 1,176,879 1,353,411 1,529,929Total Dividends (Thouands) 71,288 64,159 67,367 74,104 85,219 98,002 112,703 129,608 149,049 171,407 197,118 222,827Book Value Equity (Thousands) 1,623,886 1,891,157 2,263,424 2,672,919 3,172,816 3,747,698 4,408,813 5,169,094 6,043,418 7,048,890 8,205,183 9,512,285

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

Ke 0.1018 35.80 31.76 29.82 28.68 27.93Observed Share Price (4/1/2009) 8.98$ 0.1207 26.06 24.04 23.01 22.39 21.97Initial Cost of Equity (You Derive) 0.1586 0.1397 19.40 18.46 17.96 17.65 17.43Perpetuity Growth Rate (g) 0 0.1586 14.73 14.38 14.18 14.05 13.96

0.1779 12.76 12.60 12.50 12.44 12.400.1975 12.41 12.28 12.20 12.15 12.120.2164 9.77 9.82 9.85 9.87 9.88

224

Abnormal Earnings Growth Model

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:

Time: 0 1 2 3 4 5 6 7 8 9 10 11Year: 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Net Income (Thousands) 463,386 331,430 439,635 483,598 585,117 672,884 773,817 889,890 1,023,373 1,176,879 1,353,411 1,529,929 Total Dividends (Thousands) 71,288 64,159 67,367 74,104 85,219 98,002 112,703 129,608 149,049 171,407 197,118 222,827 Dividends Reinvested at 17% (Drip) 11,306 10,176 10,684 11,753 13,516 15,543 17,875 20,556 23,639 27,185 31,263 Cum-Dividend Earnings 342,736 449,810 494,283 596,870 686,400 789,360 907,764 1,043,929 1,200,518 1,380,596 1,561,192 Normal Earnings (Benchmark) 536,879 383,995 509,361 560,297 677,916 779,604 896,544 1,031,026 1,185,680 1,363,532 1,568,062 Abnormal Earning Growth (AEG) (negative = d (194,143) 65,815 (15,078) 36,573 8,484 9,756 11,220 12,903 14,838 17,064 19,624

PV Factor 1.1516 0.86 0.74 0.64 0.55 0.48 0.41 0.36 0.31 0.27 0.23 0.20PV of AEG (167,567) 49,030 (9,695) 20,297 4,064 4,034 4,004 3,974 3,944 3,915 3,886 Residual Income Check Figure 65,815 (15,078) 36,573 8,484 9,756 11,220 12,903 14,838 17,064 % change in annual aeg ‐134% ‐123% ‐343% ‐77% 15% 15% 15% 15% 15% 15%

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

-0.10 -0.20 -0.30 -0.40 -0.50Intrinsic Value Per Share (12/31/1987) 9.18$ 0.1018 44.22 40.98 39.35 38.37 37.72time consistent implied price 4/1/2009 9.53$ 0.1207 30.47 28.96 28.17 27.69 27.36April 1, 2009 observed price 8.98$ 0.1397 21.80 21.16 20.81 20.59 20.44Ke 0.1586 0.1586 16.13 15.93 15.82 15.74 15.69g ‐0.1 0.1779 12.20 12.22 12.23 12.24 12.24

0.1975 9.42 9.54 9.62 9.66 9.70Actual Price per share 0.2164 7.50 7.66 7.76 7.83 7.88

Long Run Residual Income Model

ROE .19

g-0.03 -0.04 -0.08 -0.38 0.13

0.1018 15.27 14.84 13.59 10.83 0.000.1302 12.65 12.44 11.83 10.29 2,762.64

Ke 0.1586 10.81 10.73 10.49 9.81 19.440.1875 9.43 9.43 9.41 9.36 9.730.2164 8.37 8.41 8.54 8.96 6.51

g = ‐.08Ke

0.1018 0.1302 0.1586 0.1875 0.21640.15 0.00 0.00 0.00 0.00 0.000.17 0.00 0.00 0.00 0.00 0.00

R 0.19 -0.03 -0.04 -0.08 -0.38 0.130.21 0.00 0.00 0.00 0.00 0.000.23 0.00 0.00 0.00 0.00 0.00

R0.15 0.17 0.19 0.21 0.23

-0.03 8.84 9.83 10.81 11.79 12.77-0.04 8.86 9.80 10.73 11.66 12.60

g -0.08 8.93 9.71 10.49 11.26 12.04-0.38 9.12 9.46 9.81 10.15 10.490.13 6.48 12.96 19.44 25.92 32.40

G Convergence:

225

Works Cited

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Association, World Steel. World Steel Association: TopSteel Producers 2007. 31 December 2007. 26 January 2009 <http://www.worldsteel.org/?action=storypages&id=284>.

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Investopedia.com. 15 March 2009. <http://www.investopedia.com>.

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Nucor Corporation. Annual Report. Form 10-K. Delaware, 2002-2008.

Opdyke, Jeff D. "Stimulus Plan Is the Big Hope For Steel Firms." 26 Janurary 2009. Wall Street Journal. 31 Janurary 2009 <http://online.wsj.com/article/SB123292542857713695.html#articleTabs%3Darticle>.

Palepu, Krishna G. and Paul M. Healy. Business Analysis and Valuation: Using Financial Statements. 4th Edition. Mason: Thompson Higher Education, 2008.

"Steel Dynamics Inc.: Profile: Knapheide Manufacturing." 26 January 2009. SteelDynamics.com . 31 January 2009 <http://www.steeldynamics.com/index.php?page_id=106>.

Steel Dynamics, Inc. Annual Report. Form 10-K. Indiana, 2002-2008.

SteelDynamics.com. Steel Dynamics Inc.: Profile: Knapheide Manufacturing. 31 January 2009. 26 January 2009 <http://www.steeldynamics.com/index.php?page_id=106>.

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FIN 3321-002 Financial Statement Analysis Texas Tech ...

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