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Is This Steel Company Making a Big Aluminum Mistake?

Steel is an important input into the U.S. economy, and Steel Dynamics (NASDAQ: STLD) has been riding the current demand spike to post record results. The stock has responded accordingly, up over 300% since its 2020 pandemic-driven bear-market lows. And now, after so much success in the steel space, it is doing something that is entirely out of character. Should investors be worried?

A sound foundation

One of the interesting things about Steel Dynamics is that it was cofounded by its CEO Mark Millett. Millett previously worked for domestic steel giant Nucor. Nucor has a long and impressive history behind it, noting that it has increased its dividend annually for nearly 50 consecutive years despite the fact that steel production is a highly cyclical industry. That's a testament to the way Nucor operates.

Image source: Getty Images.

Given this, it shouldn't come as too much of a surprise that Steel Dynamics, founded by a Nucor alum, has long followed a similar playbook. That includes a focus on electric arc mini-mills, which tend to be more flexible than older blast furnace technology. The two steel names also have vertically integrated business models, with operations from scrap collection (a key steel input) through steel production and ending with steel fabrication. That last factor is important because it allows Nucor and Steel Dynamics to take the commodity steel they produce and turn it into higher-margin products.

Steel Dynamics has also made a point of continuing to invest in its business over time, just like Nucor. That has allowed it to grow materially since its founding in 1993. In fact, the company is in the process of ramping up a new mill right now. But, despite the strong results of the company's historical approach, something material has changed.

A new direction

On July 19, Steel Dynamics announced that it was investing $2.2 billion in a new mill. Only this won't be a steel mill, it will be an aluminum production facility. Although there are similarities between this new venture and its core steel business, Steel Dynamics is clearly shifting away from its core approach.

Backing the move is Steel Dynamic's expectation of an aluminum supply deficit of 2 million tonnes. According to management, that deficit is currently being met by imports that amounted to around 25% of North American consumption in 2021. It believes it can undercut that foreign aluminum and, thus, build share in the space. With supply chain security an increasingly important issue, there's no reason to doubt that Steel Dynamics will find willing customers.

On the surface, this sounds like a strong plan. And yet, aluminum and steel aren't the same. Steel Dynamics will now have to navigate two separate industries with their own dynamics and cyclical tendencies. That's a big shift in approach that could add valuable diversification to its business, or if things don't go as the company hopes, it could result in the steel operations being dragged down by a smaller division that is distracting management.

It's worth noting that, not too long ago, aluminum giant Alcoa built up an aluminum fabricating business to go with its commodity aluminum production operations. That division was eventually broken out as a stand-alone company, and very quickly it started to struggle. Shares of the breakout company, Arconic, have underperformed Alcoa of late. That's not to suggest that Steel Dynamics can't find success in the aluminum space but to highlight that aluminum is just as tough a market as steel. Thus, this diversification effort isn't likely to be a slam dunk -- even for a well-run steel mill like Steel Dynamics.

Watch closely

Long-term investors in Steel Dynamics probably shouldn't jump ship and run -- at least not yet, anyway. (Nucor would be a strong alternative, however, if you do.) Management has proven very capable so far and has earned the benefit of the doubt. But, given the material change in direction here, investors should be paying very close attention to the progress of the new aluminum investment. If the company starts to struggle, it could easily turn into a very costly diversion.

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Reuben Gregg Brewer has positions in Nucor. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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