Reliance Steel & Aluminum (RS) is trading modestly lower today despite reporting a surprisingly strong Q2 report. In case you're not familiar, Reliance Steel is the largest metals service center company in North America. Through a network of more than 300 locations in 40 states and 13 countries outside of the US, Reliance provides metals processing services and distributes a full line of over 100,000 metal products to more than 125,000 customers in a broad range of industries.
Reliance focuses on small orders with quick turnaround and increasing levels of value-added processing. In 2017, Reliance's average order size was $1,740, approximately 48% of orders included value-added processing and approximately 40% of orders were delivered within 24 hours.
So they are a steel company but rather than producing steel, metals service centers like RS buy carbon steel, aluminum, stainless and alloy steel from primary metals producers (AKS, MT, NUE, STLD, X) and then process these materials to meet customer specifications using techniques such as blanking, leveling (or cutting-to-length), sawing, shape cutting, shearing and slitting, among others. These processing services save customers time, labor, and expense, reducing their overall manufacturing costs.
Specialized equipment used to process the metals requires high-volume production to be cost effective. Many manufacturers and their suppliers are not able or willing to invest in the necessary equipment to process the metals for their own manufacturing operations. As such, industry dynamics have created a niche in the market. Metals service centers purchase, process, and deliver metals to end-users in a more efficient and cost-effective manner than the end-user could achieve by dealing directly with the primary producer.
Turning to the Q2 results, EPS jumped 121% YoY to $3.10, which was well above prior guidance of $2.60-2.70. Revenue rose 20.8% year/year to $2.99 bln, which was in-line with market expectations. The guidance was quite bullish as well as RS expects Q3 EPS of $2.65-2.75, which was well above market expectations.
So what led to the big EPS beat for Q2? The main thing is that the metal pricing environment was significantly stronger than the company had anticipated, gaining strength as Q2 progressed, with prices increasing in each month of the quarter across all major commodities. Solid demand, coupled with ongoing Section 232 activity, drove metal price increases on almost every product it sells. As a result, average selling price per ton sold increased 9.6% from Q1, exceeding expectations of up 5% to 8%.
Tons sold in the quarter were down 0.7%, in-line with expectations given pre-buying activity by certain customers in Q1. However, underlying demand remained strong. Looking ahead, despite some continued uncertainty regarding trade actions, RS says it's encouraged by the positive pricing momentum and continuing solid demand conditions. All of this resulted in strong gross margin of 30.7% vs 28.4% last year and 29.7% in Q1.
Breaking the demand picture down by segment, aerospace demand remains strong and continues to be one of the company's top-performing end markets. Reliance maintains its positive outlook for aerospace as build rates and the backlog for orders of commercial planes continues to improve. Automotive demand continues to be strong. Reliance services the automotive market mainly through its toll processing operations in the US and Mexico. Non-residential construction demand, including infrastructure, continues to steadily improve. Heavy industry demand continues to strengthen, primarily related to construction and agricultural equipment. Energy (oil & gas) demand continues to recover slowly. However, rig counts and drilling activity continue to increase with mill lead times extending.
In sum, RS reported a very nice quarter. Probably the most important takeaways is that pricing has been much strong than expected. And we were impressed with the big Q3 EPS upside guidance. The muted reaction in the stock price indicates to us that perhaps investors were expecting strong EPS upside. The stock has been moving higher in recent weeks so maybe there is a bit of a sell the news reaction.