Why Betting On ArcelorMittal Is A Bad Idea

| About: ArcelorMittal (MT)

Summary

ArcelorMittal's focus on mining operations will weigh on its steel business and offset any growth as weak iron ore pricing is expected going forward.

The steel business might also see some headwinds due to increasing usage of aluminum in the automotive industry.

ArcelorMittal has lowered its EBITDA forecast significantly, while the company also carries a huge debt burden, making it a stock to avoid.

It hasn't been smooth sailing for ArcelorMittal (NYSE:MT), the world's largest steel maker. The company's dependence on the mining business has hurt it considerably due to a drop in commodity prices. As such, despite reporting encouraging second-quarter results, where ArcelorMittal bounced back to profitability after two long years, its outlook left a lot to be desired.

Bad times ahead

Management provided a weak earnings forecast for the entire year on account of lower commodity prices. ArcelorMittal has been focusing on its mining operations, expecting the segment provide better returns than steel. But, due to declining iron ore prices, its operating income from mining fell a considerable 19% year over year in the previous quarter.

ArcelorMittal lowered its EBITDA forecast for the entire fiscal year to around $7 billion from the previous estimate of $8 billion. But, in spite of the declining iron ore prices and challenges in North American Free Trade agreement (NAFTA), its EBITDA for the quarter improved 9% year-over-year.

As reported by the Wall Street Journal, ArcelorMittal's mining business generates more than 20% of its earnings, even though it accounts for just 7% of sales. The Journal goes on to state:

"It mines around 65 million tons per year, so a $30 drop in the average iron ore price reduces profits by almost $2 billion.

Iron ore, because it only costs around $30 per ton to mine, is still more profitable than making steel. For example, in the second quarter, ArcelorMittal's margin for mining was 28%, compared to only 3.3% for steelmaking in North America. Investment in mining will continue, Mr. Mittal said. In the second quarter, even as prices dropped, it increased production 10.6% to 16.6 million tons."

No respite in iron ore pricing

Clearly, ArcelorMittal is in a double whammy situation. Its high-margin mining business is in a soup, and will continue to remain in a slide going forward as iron ore pricing is expected to remain weak. In addition, the prospects of the steel business might remain uncertain. As I wrote in a previous article:

"Iron ore prices dropped 18% year over year in the previous quarter. Looking ahead, the tumble is set to continue. According to a report, iron ore prices are expected to drop another 7.6% in 2015, averaging $97 per tonne. In the long run, iron ore price will drop to around $90 a tonne, according to Morningstar."

Steel demand might be choppy

On the other hand, while ArcelorMittal is resurgence in steel demand, the long-term prospects appear choppy. Usage of steel in the automotive industry is declining, and this might rob ArcelorMittal of a growth opportunity. This year, car sales across the globe are expected to rise to 85 million from around 82 million last year, according to IHS. The research firm forecasts that auto sales will clock an impressive 100 million by 2018.

At the same time, aluminum usage in the auto industry is growing at a terrific pace. According to Automotive News:

"The U.S. market for aluminum sheet is expected to be up fivefold this year from 2012 with the development of vehicles like Ford Motor Co.'s next generation F-150 full-size pickup truck, a more aluminum intensive model that is expected to be shown Monday at the Detroit auto show.

Demand is expected to continue its surge as automakers look to slash vehicle weights to boost fuel efficiency, industry executives and analysts said.

"The one thing that has proven itself to be accurate is that any forward forecast of the use of aluminum in automotive will change upward," Phil Martens, a former Ford executive who is now CEO of aluminum provider Novelis Inc., said in a telephone interview.

The U.S. market for aluminum sheet, which stood at less than 200 million pounds in 2012, is expected to hit 1 billion pounds this year, and then double from there by 2020 and reach 3.2 billion to 6.4 billion pounds by 2025, according to independent industry analyst Lloyd O'Carroll."

Thus, steel's loss will be aluminum's gain, and ArcelorMittal stands to lose out on the automotive market's growth.

Cost-cutting moves

In such circumstances, it becomes important for ArcelorMittal to focus on its strategy of cost optimization. At the same time, it is trying to offset decreasing iron ore prices with aggressive production. For example, it recently expanded its capacity at ArcelorMittal Mines Canada from 16 million tons to 24 million tons last year. With such a move, ArcelorMittal was able to achieve a strong run rate for both in-country production and shipments.

In addition, the company has expansion plans in the pipeline. After the successful completion of phase one in its iron ore project in Liberia, it is proceeding smoothly with the second phase expansion. The steel maker has received all the necessary clearances from the environment department, and it expects this project to be completed by the end of 2015.

However, until and unless there is a resurgence in iron ore pricing, it will be difficult for ArcelorMittal to improve its bottom line again. This looks unlikely any time soon.

Conclusion

ArcelorMittal's net debt (excluding cash) stands at a huge $17.4 billion. In addition, management has lowered its own earnings outlook for the entire year. The company is facing pressure in both steel and iron ore, so it would be wise for investors to avoid ArcelorMittal for now.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.