ArcelorMittal: The Best Way to Play the Steel Industry

| About: ArcelorMittal (MT)

As worries about the global economy have become more intense over the last few weeks, stocks of businesses that operate in very economically sensitive industries have been clobbered.

ArcelorMittal's (NYSE:MT) share price has been no exception, as it is now trading near its 52-week low of $21.10.

There are several headwinds facing the global steel industry.

  • Increased input costs (Iron Ore)
  • Weakened pricing power due to increased production
  • Possible weakened demand

I believe these headwinds have been largely exaggerated and the current share price of MT is heavily undervalued.

Increased input costs, in the form of Iron ore, are extremely well managed by MT as it has an efficiently vertically integrated business structure. Per the 2010 annual report, ArcelorMittal provided 56% of the total iron-ore requirements from its own mines. Given MT's massive size and profits, it is able to expand its mining investments. After producing nearly 50 million tons of iron ore in 2010, MT aims to produce 100 million tons by 2015. MT has the amazing potential to provide more than 75% of its total input needs.

While pricing power is always going to be an issue for steel companies, the industry has experienced a plethora of activity leading to some serious consolidation. Major steel players like MT are at the forefront of the activity. Going forward, fewer, larger steel companies will be able to control prices much more effectively than they currently can. Mr. Lakshmi Mittal, the CEO, notes that the five largest steel producers only account for 16% of global production, while the three largest miners control 70% of iron ore production. This fragmentation will continue to be smoothed as more mergers and acquisitions inevitably occur within the industry.

As far as demand goes, a recession still seems highly unlikely, despite the current sentiment. While we are clearly seeing a bit of a downturn, many steel companies are still forecasting strong fourth quarter earnings, despite the fact that the fourth quarter is typically very weak for the industry as a whole. The World Steel Association is expecting record demand by 2013, as at least 71% of demand will come from emerging and developing economies. This dependence on emerging economies is very significant, as real growth is much more likely there than in developed countries such as the U.S. and Europe.

On a valuation basis, MT is trading at a shocking .59 price to book ratio. To be trading at roughly half its book value, when that value includes developed mines and massive production capacity, is odd to see. Additionally, despite the unreliability of analyst forecasts, MT is trading 5.75 times next year's earnings, and 9.92 times last year's earnings.

MT currently pays shareholders a 3.2% dividend, and it has grown that at a rate of 8.5% per year for the last five years. Management should be able to grow earnings at a quick enough pace to continue to raise the dividend without disrupting the current payout ratio of 38%.

ArcelorMittal is uniquely positioned, and has incredible leverage over less vertically integrated steel companies. The industry as a whole, while not currently a favorite, has a major catalyst going forward in deep consolidation. While most companies are struggling to deal with rising input costs, MT is only suffering marginally due to its advanced mining capacity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MT over the next 72 hours.