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Shiv Kapoor, MaxKapital (364 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Today I am looking at Tenaris (TS). Back in 2008, just before the world ended, this company hit a high of over $70. Today in the new world it trades at $43.25. Tenaris business is the manufacture of steel pipe. And within its industry, it is a hard act to follow: most certainly the best amongst the rest.

Businesses where demand is highly cyclical are interesting. They are even more interesting when a return of demand is more a matter of when, rather than if. Sometimes it can be a good idea to buy a stock when investor apathy rises to the level where the "if demand returns" consideration overwhelms the "when demand returns" one.

Why Tenaris?

There is a lot of latent pent up demand for steel pipe. When you look at US there is a huge need for pipe, both to produce shale oil and gas and to realize its value by moving it from where it is to where it must be. Canada has much the same story for its oil sands. These markets have been held back by infrastructure constraints, environmental policy constraints and competition from unfairly traded imports. There is much pent up demand. The catalyst required here is clarity on Keystone, the environmental policy. Getting over the sequestration and debt limit hurdles is important too. These should not be long in coming.

Move on to Mexico. The demand for pipe from deepwater oil and shale gas has been held back by financial and operating constraints at Pemex, together with a very disappointing round for incentive based contracts in the Chicontepec basin. Energy and fiscal reform in Mexico is likely the biggest catalyst which will convert the pent up demand into actual demand. And it's happening as I write.

Look at Brazil where the demand for pipe from deepwater exploration is tremendous. But this too is held up by financial and operating constraints at Petrobras. Or look at Argentina where the potential demand for its shale oil and gas is high but held back by the country having a terrible instability leading to a poor investment climate.

Move on to Asia where demand for pipe in Saudi Arabia has been on hold for a while as there was no demand for production growth. This year the capital spending programs announced indicate significant demand for pipe in the coming years.

Look at China; they are weighed down by pollution. The reliance on coal based energy is high. The shift to gas based cleaner power is necessary. The pipe network required to transport gas across the country is potentially mind boggling. And it's not just gas transportation. China has a need for exploration of its massive shale assets too.

Look at Europe, where demand for gas from Russia rises. The demand for pipe to transport oil and gas from Ukraine and Azerbaijan for export is large too.

The fact of the matter is that there is resource available. And the resource needs to move from where it is, to where it needs to be. And like it or not, it will occur, if not now, then later. Even Warren Buffett believes that energy transportation infrastructure is a growth area. Why else would he have bought Burlington North Santa Fe? He's also added positions in Exxon Mobile (XOM) and Suncor (SU), while holding positions in Phillips 66 (PSX), so I guess he believes that oil and gas will move from where it is to where it's needed!

Perhaps 2013 marked the end of the worst for the steel industry in general and the steel pipe in particular.

Tenaris has been in a firm downtrend since the middle of September. Is it too early to buy?

Tenaris trades at a PE of 17.14 times trailing twelve months earnings. Over the past five years, the PE ratio has fallen as low as 6.41 and risen as high as 24.98. These PE's are very low relative to the sector and industry in which Tenaris operates. Tenaris has a beta of 1.74 compared with 1.12 for the Industry and 0.99 for the Sector. Its balance sheet is healthy with a debt to equity ratio of 10.43% compared with 35.96% for the Industry and 72.44% for the Sector.

It has a dividend yield of 1.99%, compared with 1.39% for the Industry and 1.89% for the Sector and a payout ratio of 19.70% compared with 26.71% for the Industry and 37.26% for the Sector. Operating margins over twelve months is 20.42%, far higher than comparable for the Industry and Sector, and operating margins over the past five years have averaged 21.91% compared with 7.07% for the Industry and 13.43% for the Sector. Return on equity over the past twelve months is 12.92% compared with 6.1% for the Industry and 11.5% for the Sector, and return on equity over the past five years has been 15.29% compared with 9.78% for the Industry and 13.61% for the Sector. Sales growth has been negative (1.35%) compared with 10.25% for the Industry and 4.58% for the Sector over the past twelve months, and 1.87% compared with 14.12% for the Industry and 12.92% for the Sector over the past five years. Earnings growth has been negative (13.14%) over the past twelve months, and negative (1.92%) over the past five years compared with 10.32% for the Industry and 14.67% for the Sector. Capital spending shrunk at (19.77%) over five years compared with positive 10.88% for the Industry and 17.57% for the Sector. Forward expectations for the year ended 31st December 2014 come in at an average of $3.07, with a high estimate of $3.50 and a low estimate of $2.76. The estimate for the year ended 31st December 2014 came in at an average of $3.62 twelve months ago. For the year ended 31st December 2013 the average estimate is $2.73, with a high estimate of $3.10 and a low estimate of $2.60. The estimate for the year ended 31st December 2013 averaged $3.28 twelve months ago.

From the above data from Reuters, we know that operating margins outperform the Industry by a wide margin over the long and short term. The return on equity also outperforms the Industry by a wide margin. Sales and earnings growth have been disappointing, but if we look at adjusted earnings on their recent presentation we see $1.97, $1.91, $2.26, $2.88 for the years ended 2009 to 2012 and $1.94 for the nine months ended September 2013. This stability of earnings in a very cyclical industry is nothing short of exceptional. The companies discipline on capital allocation is also evident in the cuts to capital spending at a time when sales and earnings were contracting. This too highlights superior management.

The dividend yield is outperforms the industry, and it does so with a lower payout ratio. The dividend yield suggests that in addition to disciplined capital allocation, the management is also committed to returning value to shareholders. The low payout ratio together with low leverage ratio indicates that as and when demand grows, the company should be well positioned to fund an aggressive expansion.

This company sets a high standard and is a hard act to follow, in both its Industry and Sector. A PE (ttm ) ratio of 17.14 is on the high side but consider that the second half of 2012 and 2013 were bottom cycle periods. Based on FY13 earnings expectations, the current year PE is expected to be 15.84, with forward year PE's coming in at 14.08.

What is Tenaris worth?

With beta at 1.74 we know that Tenaris is a high beta company. Thus to price the risk, our expected return must be higher.

Ahead in this post, I refer to a target rate of return. I calculate the target rate of return as the risk free rate (Rf ) plus beta multiplied by the difference between the market return (Rm ) and Rf, assuming that the ten year treasury currently yielding about 2.88% represents the risk free rate, and a 9% represents the very long term return from the market [Rf + Beta * (Rm - Rf)]. If we assume that the ten year treasury currently yielding about 2.88% represents the risk free rate, and a 9% represents the very long term return from the market, a stock with beta of 1.74 ought to deliver a target rate of return of 13.5%.

If we accept 8% as a very long term growth rate for the steel pipe industry, we have to consider what part of profits Tenaris needs to reinvest to drive that level of growth, assuming it can maintain a return on equity of 15%. We have earnings of $2.73 expected for the year ended 31st December 2013. To grow these earnings by 8%, we would need to grow earnings by $0.22 to arrive at target earnings of $2.95 for 2014. If the company were to reinvest 53.33% of the $2.73 in earnings, it would retain and reinvest $1.46. With a return on equity of 15%, this $1.46 or retained and reinvested profit would generate the $0.22 growth for next year. The remaining $1.27 ($2.73 less $1.46) is available to shareholders and can be returned to shareholders through a mix of dividends, buybacks or growth higher than the 8% level. For the stock, the indicated return is 10.94% (that is the $1.27 available to shareholders, divided by the $43.25 price plus the 8% growth rate). This is well below the target return expectation of 13.5%.

A value investor of the buy and hold variety would be most interested in this stock at around the $25 level. Thus there is downside of about 41% for the stock. This is unlikely to occur. Given the exceptional management quality, I don't believe this stock deserves a beta of 1.74. That likely occurred as a result of the crisis of 2008/2009 and the subsequent slowdown in China, which extracting a terrible toll on the investment cycle in general and the steel sector in particular. Over time I expect the beta to contract. It's difficult to predict where it might end up, but I'd speculate by saying a beta of 1.29 in line with the Materials Select Sector SPDR (XLB) is a reasonable expectation. With a 1.29 beta, the target long term return expectation falls to 10.77%. And this target return would be met at a price of $46.65.

As far as upside is concerned, forget value and look at price. Assuming that growth in pipe demand becomes apparent we can expect both earnings and the PE ratio to expand. If earnings for 2014 grow to $3.62, which was the estimate for 2014 a year ago, and a level far from impossible in a deeply cyclical industry, we could see prices hit $70. Occurrence of such a price move gives upside of 63%. A price of $70 with $3.62 in earnings indicates a multiple of 19.33, which is well below the five year high multiple of 25.

Would you buy Tenaris? I have no long positions in Tenaris, and no intent to initiate a long position either. It is a stock I follow, because it is a company whose management I admire and it operates in the steel pipe industry, an area in which I have very high long term conviction. Watching a high quality company provides insight into what I can expect from a substantial position in a lower quality pipe manufacturer in India (Welspun Corp). Welspun Corp is a sound pipe manufacturer. They don't offer quite the same quality as Tenaris, but they do have a presence in Little Rock, US and Saudi Arabia, both key growth markets. They also enjoy proximity to India, China and Russia which are also key growth markets. And last but not the least they are trading at near distress valuations after considering cyclically adjusted earnings or earnings potential. The stock trades at below Rs 40, compared with the Rs 220 Apollo paid in a private equity in public enterprise transaction not so long ago.

Source: 10 On 10 For Tenaris

Additional disclosure: I have long positions in Welspun Corp which is a pipe manufacturer listed in India.