For investors willing to take on a bit of risk, the iron and steel industry presents a few undervalued gems. In an earlier article, I argued that U.S. Steel (X) was a risky, but promising bet on the domestic economy. The fundamental headwind, however, for the industrial giant is that the manufacturing environment in Europe and United States is weak and expensive. ArcelorMittal (MT), on the other hand, is a larger steel producer with more global operations and greater profitability. Gross margins stand at 12% for the company compared with 6.4% for U.S. Steel. Over the last twelve months, both have lost nearly half of shareholder value and, in my view, are priced for a depression. Nevertheless, U.S. Steel's beta of 2.15 and low dividend yield of 0.76% may just be too much for investors to bear - to say nothing of current losses.
From a multiples perspective, ArcelorMittal is the cheaper of the two. It trades at a respective 13.9x and 7.3x past and forward earnings; U.S. Steel trades at 10.4x forward earnings. Both companies are highly leveraged with net debt of 96.3% of market value in the latter and 84.6% of market value in the former. While I view both companies as undervalued, the Street currently rates X a "hold" and MT a "strong buy."
Beyond multiples, perhaps the most convincing reason to be bullish on ArcelorMittal is that management is on track to reduce leverage and improve the supply chain. As the economy picks back up, the steel producer is thus in an ideal position to get the most out of increases to scale. Although net debt is likely to be higher in the fourth quarter of 2011 due to the Macarthur investment, current initiatives set the company on a solid trajectory to reducing this figure by $2.4B. These initiatives include shutting down two poorly performing blast furnaces, asset sales and restructuring.
Third-quarter results were decent and not surprising. Nevertheless, the fact that management remains firm on its outlook goals despite macro headwinds is a major reason for investor confidence. Highlights of the the third quarter included:
Health & Safety lost time injury frequency rate remained constant at 1.5x in 3Q 2011
3Q 2011 EBITDA increased by 11.4% to $2.4 billion compared with Q3 2010; EBITDA of $8.4 billion for first nine months 2011, 25.9% higher than first nine months 2010
3Q 2011 steel shipments of 21.1 Mt, 2.7% higher than 3Q 2010
3Q 2011 EBITDA per tonne of $114, 8.3% higher than 3Q 2010
3Q 2011 own iron ore production of 14.1 Mt, up 8.4% y-o-y; 6.7 Mt market price iron ore shipped (up 9.6% year-over-year)
Net debt at September 30, 2011 of $24.9 billion as compared with $25.0 billion at June 30, 2011
Going forward, I anticipate the company will benefit from the iron ore production in Libera, where it has invested more than $800M. And while steel shipments are likely to be lower in the fourth quarter than the preceding quarter, ArcelorMittal is in a favorable position to take market share from a competitor with greater bargaining power over input prices. Headwinds in China, and Europe, will make the business environment difficult for all steel players, but ArcelorMittal is taking the right steps now to prepare for the recovery. Reductions in costs, making the supply chain more efficient, and cleaning up the balance sheet will help to set it on a brighter path. With a dividend yield of 3.95% and a very low multiple that limits risk, the stock also has favorable risk asymmetry.
The consensus estimate is that EPS will increase by 7.9% to $2.18 in 2011, and then by 9.2% and a staggering 53.8% in the following two years. Of the 7 revisions to EPS, 2 have gone up. Assuming a multiple of 13x - lower than the current one but at the high-end of peers - and a conservative 2012 EPS estimate of $2.20, the rough intrinsic value of the steel giant is $28.60. That implies more than a 50% margin of safety to a supposedly risky stock. While high inventories in Europe and low steel prices are areas of concern, the company's fundamentals and initiatives are enough to make it an attractive investment. In agreement with the Street, I rate the shares a "strong buy."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.