Steel Dynamics

Portfolio manager’s Letter February 2007

Steel Dynamics

Steel Dynamics reported their fourth quarter and annual earnings on January 23. Income for 2006 was $397 million or $3.77 a share, so at $38 dollars a share the company is selling at 10 times 2006 earnings. This compares to net income of $220 million or $2.17 a share in 2005. In the six years since 2000 the Steel Dynamics has increased its earnings from $54 million to today’s $397 million which is a somewhat startling rate of increase (for a steel company) in earnings of 39% per year. SDI appears to be a company with a high tech growth rate and a blue collar, rust belt valuation.

Steel Dynamics is an eleven year old company that claims to have the most modern steel operation in the United States. Until last year’s acquisition of West Virginia Steel (part of Roanoke Electric) was completely non-union. Beginning with production of flat roll steel in Butler Indiana in 1996 the Steel Dynamics added a fabricating operation at the same site in 2000, a structural and rail division in Columbia City Indiana in 2003, a bar products division in Pittsboro in 2004, and another fabricating plant in Lake City, Florida in 2005.

On April 11, 2006 the Steel Dynamics company completed its purchase of Roanoke Electric. Under the terms of the merger Roanoke shareholders received $110 million in cash and 4.5 million shares of Steel Dynamics stock with a value of $127 million. The cash portion of the purchase price was paid from the companies cash on hand, and potential dilution from the Stock portion of the price was more than eliminated by SDI’s stock repurchase program, which repurchased $246 million worth of the company stock during 2006. The company purchased Roanoke Electric Inc to diversify its product offering, provide additional penetration of the joist, truss; and girder markets, and to broaden its geographical presence. Roanoke Electric has manufacturing facilities in Roanoke Virginia and Huntington West Virginia.

Fourth Quarter Conference Call

This years earnings of $397 million was an increase of 79% from 2005. During the fourth quarter conference call management indicated that shipments for the first quarter of 2007 would likely be up 15% to 20% over 2006, and that orders for flat rolled steel which had been weak last year because of problems in the automotive and construction industries, had recovered to the extent that the Steel Dynamics’s flat rolled capacity was fully booked through the end of February and that it was looking to increase prices in March.

During the call, management said that Steel Dynamics plans on about $400 million in capital expansion projects for 2007. To the skeptic this might sound like a massive capacity expansion at the top of the business cycle, but they also indicated that expenditures in 2008 would be more in the area of $120 million to $150 million; and that the company would pay out a substantial portion of its future free cash flow to shareholders in the form of increased dividends or further stock buy-backs, and their record on this has been pretty good in the past.

The expansion planned for 2007 should increase the Steel Dynamics’s capacity to nearly 5.2 million tons for 2007, and 6.5 million tons by the end of 2008, an eventual increase of 38% from 4.7 million tons produced in 2006. About $200 million of this year’s capital spending will go to increase capacity and the Steel Dynamics’s structural steel plant in Columbia, Indiana. Approximately $35 million will go to expansion of the West Virginia Steel facility in Huntington West Virginia. The Steel Dynamics’s goal for all expansion or investment projects is a 20% return on the capital invested which with reasonable leverage will yield a substantially better return on shareholder equity.

In their merger with Roanoke Electric last year, they acquired West Virginia Steel, which is a small mill were employee’s have a contract with the United Steel workers. On the conference call management said they have a good relationship with the union. But indicated that it was unlikely they would acquire anymore union shops. Indeed it is difficult to see why employees would have a desire to join a union. In 2004 the average compensation for non-executive employees was $84,200 plus profit sharing, which averaged $18,200.

Yet in spite of, or perhaps because of, this high wage, the company remains one of the most productive steel companies in the United States with an operating margins that are about 15% higher than the average domestic steel producer.

Table compares Steel Dynamics to four other steel companies. It shows that SDI is smaller and faster growing than the others, and while its operating margin is slightly less than POSCO (the large Korean company that is currently the most profitable steel company in the world) it is a good deal higher than the other two American companies.

	Nucor Steel	US Steel	Steel Dynamics	POSCO
Debt to Equity Ratio	0.19	0.23	0.36	0.16
Market Capitalization (billions)	$19.2	$10.1	$3.5	$28.2
Revenue (billions)	$14.7	$15.7	$3.20	$28.1
Operating Income	$2.7	$1.7	$640	$6.0
Operating Margin	12.2%	10.8%	20.0%	21.4%
Earnings Per Share	$5.68	$11.18	$3.77	$13.5
P/E ratio	11.36	6.9	10.3	6.80
Five Year Growth of Revenue	27.8%	19.8%	39.7%	13.81%

Note on Monthly Performance Figures

Your monthly investment portfolio performance summary (the green pages) contains a section for each period that shows the performance of market indexes for you to use as benchmarks for the performance of your investment portfolio. For these reports data for the Wilshire and the S&P 500 indexes are copied from the published prices for those indexes on the last day of the period covered by the report.

These are the only figures that are available on a monthly basis. Therefore the data does not include the value of the dividends paid by the companies included in the indexes. For this reason the figures shown on the green sheets understate the actual returns of an Index funds based on these indexes by the amount of the dividends paid by the companies in the index.