The stock of the world's largest steel producer, ArcelorMittal SA ADR (NYSE:MT), was recently downgraded from outperform to neutral by Credit Suisse. The firm also lowered the stock's price target from $20 to $17 stating that the company's weak Q2 FY 2014 financial performance was the reason behind the downgrade. The company is also involved in mining iron ore while its steel products include flat products such as sheet and plate and long steel products. It serves the automotive, construction, household appliance and packaging markets with a majority of sales generated from the American and European markets. Therefore, my article will focus on the company's prospects from the American and European steel markets along with the initiatives enacted by the company in order to improve its bottom line.
Let us begin by determining the materiality of the American and European steel markets followed by a discussion on the outlook of these markets.
America and EU Steel Market: Materiality and Outlook
Source: MT 20F 2013 Filing
The table above shows that the company generated 39% of its total revenue from the Americas and around 47% of its total revenue from Europe in FY 2013. Combined, both of these regions generated around 86% of the company's revenue in FY 2013. The table above also shows that both regions recorded declines in sales in FY 2013 in comparison to FY 2012. The company's sales from the Americas and Europe both recorded a 4% decline in FY 2013 in comparison to FY 2012 while the company as a whole recorded a 6% fall in its total sales for FY 2013 compared to FY 2012. Overall it can be seen that the two major geographic revenue driving regions of the company are facing trouble that are adversely affecting the company's top line and ultimately its bottom line.
The following chart shows that the U.S. and EU28 recorded negative apparent steel consumption growth in 2013 but the markets are expected to recover and grow in 2014. The U.S. and Brazil are both part of the company's Americas geographic region and are expected to record positive growth in apparent steel consumption in 2014.
The factors that will contribute to the recovery in these two geographic regions include end market growth prospects from construction, machinery and auto industries. Within the company's Americas geographic regions the U.S. alone generated around 20% of total sales made by the company in FY 2013.
The charts above show that the construction industry in both regions recorded a decline up until 2013 but is expected to recover in 2014 onwards. The machinery industry of both regions is also anticipated to record a steep rise in 2014 onwards. The auto industry is also expected to recover and improve in Europe and the U.S.
The volume of steel is regarded as an indicator and measure of development and economic progress in a region. A rise in urban population and industrialization around the globe is expected and is likely to increase the demand to build skyscrapers and public-transportation infrastructure. Previously, the Eurozone crises and slow-down in emerging economies negatively impacted the demand for steel. Steel production in Europe dropped by 1.8% year-on-year to 165.6 Mt of crude steel in 2013 but during Q4 of 2013, steel production in Europe recorded the first positive year-on-year movement since Q4 of 2011. The Financial Times poll of 15 steel analysts projects European steel production to grow by 2.4% in 2014. Along with expectations of stabilization of the Eurozone and its construction and automobile industries, this shows signs of recovery in the region's steel market.
Steel production in the U.S. recorded an annual drop of 2% to 87 Mt in 2013. Strong momentum in the region's automotive market along with turnaround in the construction sector will increase demand for steel in the U.S. in the coming year. The following charts illustrate the projection of recovery in U.S. housing starts and U.S. fixed investment on nonresidential structures for the coming years.
The following graphs show that U.S. auto sales and production are also projected to continue growth in the coming years.
All of these factors have contributed to a forecast rise in the apparent steel use for 2014 as stated in the following table.
Source: World Steel Association
Overall, the World Steel Association expects persistent recovery in the demand for steel in 2014 and anticipates global usage of steel to rise by 3.3% in 2014. This could result in an improvement in steel prices in the coming years.
According to Capital Economics, the steel price is anticipated to conclude 2014 at US$625/t and increase to US$650/t by the end of 2015. The steel price forecast by the EIU as shown in the following chart and also reflects the fact that steel prices have found a bottom after falling up until the beginning of 2014 and are expected to recover by 2016.
Bottom Line Outlook
The main inputs for the steel industry include iron ore, coking coal and energy sources. ArcelorMittal recorded nominal gross margin of 5.3% in FY 2013 that reflects the fact that 94.7% of the company's revenue is eaten up by the company's cost of sales. The company's cost of sales mainly consists of purchases of raw materials required for steel-making that include iron ore, coke and coking coal, scrap and alloys. In addition to the cost of raw materials the company's cost of sales also includes charges related to energy usage, electricity, repair and maintenance costs, direct labor costs and depreciation and impairment.
The company's cost of sales, excluding impairment losses and restructuring charges, decreased 5% in FY 2013 in comparison to FY 2012 due to lower raw material prices. Therefore, I will briefly discuss the outlook and forecast of the prices of major raw materials used by the company.
There are expectations of lower iron ore prices in the coming year as major global suppliers of iron ore are targeting a material increase in their output. The huge players of the industry include BHP Billiton Ltd (NYSE:BHP) and Rio Tinto Plc (NYSE:RIO). The output growth plans of these companies will result in a 19% increase in iron ore shipments from Australia, the largest iron ore exporter of the world, in 2014.
Morgan Stanley has recently cut its 2014 coking coal price estimate by 12% to $131/ton and 2015 estimate by 4% to $165/ton. The forces causing the decline in global prices of coking coal are lessening demand from Chinese and Japanese consumers. The following chart presents Metal Expert Consulting's export price forecast for Australian hard coal that projects a fall in $/ton, FOB Australia.
Source: Metal Expert Consulting
Therefore, forecasts that depict a decline in prices of major components of the company's cost of sales will support the company's bottom line in the coming years.
Although the company has been recording a decline in its financial performance for several years going forward the company is expected to recover its top and bottom lines. Recovery and growth in the American and EU steel markets, the revenue driving geographic markets of the company, is likely to support the company's top-line in the coming years. Both regions are set to show improvements in their construction and automotive industries to back growth in apparent steel consumption in the coming years. The major factor causing the company to register a net loss for the past two years is the company's huge cost of sales. The key components of the company's cost of sales, iron ore and coking coal, are both expected to record a decline in their prices during 2014. This suggests that the company has reached its bottom and is likely to enter its recovery phase soon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.