Seeking Alpha
Long/short equity, deep value, contrarian
Profile| Send Message|
( followers)

Summary

  • ArcelorMittal is the industry leader in steel shipments.
  • ArcelorMittal has the revenue base to increase EBITDA as markets stabilize and efficiencies take hold.
  • Arcelor Mittal trades at a significant discount to industry peers.

The irony of this post is not lost on me given the previous post that I published regarding Microsoft (NASDAQ:MSFT). While MSFT is an easy bet with a clean balance sheet, a tremendously profitable business model and a market domination of sorts, my next recommendation is not such an easy one with a balance sheet loaded with debt, a poor Return on Equity (RoE), shrinking margins and a challenging global operating environment.

Let me start by saying that I am invested in ArcelorMittal (NYSE:MT) for over a year now, based on the hypothesis that I had written about back then. So while I continue to hold my position and even add to it, I suspect the ride is not going to be a pretty one for the coming year or two.

I am going to begin with a table comparing some key metrics for MT and three other major steel producers that have been making news in the last couple of weeks. This comparison is important as I build a case for MT and I will refer back to this table while drawing my final conclusions.

ArcelorMittal

US Steel (NYSE:X)

AK Steel (NYSE:AKS)

Nucor (NYSE:NUE)

Price/Book

0.56

1.38

NA (negative book)

2.09

Price/Sales

0.34

0.28

0.22

0.79

EV/EBITDA

5.85

8.16

10.47

10.84

Debt/Equity

41.81

103.16

4398

55.6

Operating CF

3.32 Billion

1.38 Billion

-336 Million

1.04 Billion

Revenue

80 Billion

17 Billion

5.71 Billion

20.24 Billion

Highlights from the report published on Friday:

First the bad news:

  1. Surprising downward pressure on iron ore prices
  2. Brazilian economy showing signs of weakening
  3. China showing signs of weakening - especially in residential construction
  4. A 12% downward revision of EBITDA projection
  5. Heightened geo-political risk in certain regions - Ukraine, Liberia, etc.

Now for the good news:

  1. North America and Europe showing signs of strength
  2. Automotive segment showing growth
  3. Cost cutting effort taking shape - Fall in EBITDA projection is only 50% of the effect of fall in iron ore prices
  4. Debt levels reduced by over $1 billion.
  5. CAPEX spending for strategic growth being offset by divestitures

I would be the first one to admit that I am relatively new to investing in anything beyond the technology industry. In the last year or so, it has been hard to find real value in the technology sector as the markets rotated into this space in a big way. But when you get out of the technology space and start evaluating companies like MT, what is refreshing is the fact that you can analyze these stocks based on physical assets and their productivity rather than a heavy bias towards intellectual property that dominates the technology space.

On that note let's take a deeper look at the opportunity that MT provides in the coming years after a terrible quarterly announcement that they made on Friday.

  1. A large revenue base - $80 Billion and expected to grow 2-3%
  2. Currently less than 10% EBITDA conversion - $7.3 Billion and projected to be flat this year.
  3. A destabilized commodities environment with iron ore at $105 vs $120 expectation
  4. Decreasing net debt load - at just over $17 billion down by over a billion dollars and shrinking
  5. Increased cash levels over the past three years - at $6 billion
  6. Steel shipments increasing compared to the past three years.

From all the above notes, the thing to keep focus on is that the fundamental business at MT has not been damaged. They are still the leading steel producer for the global markets and continue to hold a very strong position in all the markets that they operate in. What they are struggling with right now is the glut in steel prices and a dip in iron ore prices, both of which hurt the operating income. There is also a significant amount of manufacturing optimization that MT needed to do to make its mines and mills more efficient. This has cost them dearly over the past three years and now they are finally getting out of it with most of the big maintenance work behind them. The biggest challenge that MT has right now on the balance sheet is the debt level that it holds. This is a considerable challenge given the amount of debt that is maturing in the short term (close to $4 billion). It also seems to be on top of mind for management as they curtail any excess spending in an effort to reduce the net debt to $15 billion this year. You have to like the focus they are keeping on that part of the balance sheet since it directly translates to returns for shareholders.

So let's look at what are the catalysts in the next 3-5 years that make me want to hold (and even add) to this position.

Stability in iron ore prices:

This is key to turning around the operating income of the company. MT has significantly increased its exposure to iron ore mining and the trends on this chart are not heartening. But at some point this is going to stabilize and that is going to help MT. The biggest benefit that MT will get is if the prices stabilize or rise. Assuming this stability will come in the next year or so, MT will have the ability to better predict the returns on the overall business.

Reduction of debt:

If the debt levels at MT are reduced at the current rate, the shareholders will start seeing better returns. The management's talking point currently is to review shareholder returns once debt level gets below $15 billion. This should happen by end of this year, which would make 2015-2016 a better year to hold the stock.

A recovering North America and Europe:

This is a big one on the positives of MT. As reported by US Steel and MT, North America is showing a revival of steel demand and so is Europe. This especially comes from the automotive industry and as both economies grow, I suspect this is only going to spread. With new infrastructure build out following years of conservation, both the continents will see increased demand and better steel pricing which is a boon for MT; which gets majority of its revenue from steel shipments.

Reduced pressures from China:

As the market digests the steel production coming from China and grows into it, the negative pressure that this puts in the steel industry should subside. Though this is a big drag on the market and possibly will continue to be unless demand picks up in China, MT should be able to leverage its global presence to muscle its way into a growing global economy.

Increased demand in India:

India has been a slow growing economy (Funny, we call a 5% growth in India slow these days) for the past couple of years. But with the political turmoil behind it, India should start seeing bigger build out of infrastructure in the coming years. This should increase demand in the Asia-Pacific region that MT operates in and should improve its overall comps from that area.

Brazil and Argentina:

The news out of these countries is not pretty this year and probably won't be for the next year or so. But in 2016, I think this story would start turning and this would mean that all the major regions that MT operates in would be firing on all cylinders by 2016.

Trading at half book value:

MT has a book value of about $27 and is currently trading just above $14. This makes it a great value investment if you truly believe in all the catalysts listed above. It is the debt level that is providing this opportunity. If you believe that the management has this on their radar, then you should be a buyer here.

With all this said, 2016 should be the year we all should look towards MT to have a great year. That would be the time when MT would have brought its debt levels under control and most of its operating challenges would be completely behind them as they start monetizing all the efficiencies that they are putting in place. With the current state of MT and its balance sheet, I would think that MT would be trading around $24 by early 2016. It would also have started returning cash to investors through increased dividends and possibly share buybacks.

The point of the comparison exercise at the beginning of the article was to demonstrate that MT is the best positioned in a turnaround scenario to return the most to a shareholder. With current market value discounted (EV to Book) a great deal compared to its competitors, MT has the revenue and operating cash flow, to convert more of its revenue into EBITDA and hence to the net income. As efficiencies take hold, prices stabilize and debt levels come down; it is not a stretch to think that MT would trade closer to 1 time book given the valuations the market is giving to its peers today. And that would be my payday.

This is why I hold MT today.

Disclosure: The author is long MT, MSFT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: ArcelorMittal: Why I Hold What I Hold