By Bridget Freas, CFA
ArcelorMittal (MT) continues to be one of our favorite steelmakers on the basis of valuation and its competitive position, with geographically and operationally diversified assets in both steel and mining. While this is still a weak operating environment, we think market fears are overblown, given the company's emerging-market exposure, asset-optimization plans, and potential for asset sales, as well as our view that steel fundamentals, excluding Europe, will be stronger in 2012 and 2013 than in 2011.
The company looks well positioned to gain as we move through a still-difficult 2012, economic activity in Europe stabilizes, and the market gets more visibility on a full recovery of global steel consumption and the extent of the slowdown in China. Despite a shaky macro environment and underperformance relative to its peers that operate outside Europe, ArcelorMittal has remained profitable, and we see several opportunities for modest margin expansion in 2012.
We believe the current share price reflects persistent fears surrounding the extent of a decline in steel consumption growth in Europe and China, as well as concerns regarding the company's financial leverage, but the positive long-term fundamentals of the steel sector are unchanged. Meanwhile, management has improved the cost structure and identified several avenues to support operating cash flow. While there are few imminent catalysts, we expect the shares to recover as 2012 and 2013 prove to be years of slow progress, rather than a pullback, and macro concerns subside.
Our fair value estimate hinges on the long-term strength of ArcelorMittal's business model and positive sector trends, but we think the market is more concerned about what 2012 will bring. We expect 2012 to be only marginally better than 2011 for the company, but this also considers the high exposure to Europe, where we think ArcelorMittal's shipments are likely to decline. Management expects weaker earnings before interest, taxes, depreciation, and amortization in the first half of 2012 than a year ago, but only because of lower iron ore prices, which is actually a positive for the steel segments.
For the past two years, the mining business contributed about half of the company's earnings, compared with only about 10% in 2008. This has served as a hedge as soaring iron ore prices accelerated earnings at the mining operations while crippling margins at the steel segments. We are starting to see a widening in the spread between steel prices and iron ore prices, and while this may hurt profitability in the near term as steel demand lags, it will become a key driver for earnings improvement over the next few years as the steel segments once again overtake mining as the primary source of earnings power. Our long-term forecast for iron ore is $90 per metric ton, about 35% below current levels. We think ArcelorMittal's mining business can still generate operating margins of around 30% at this price, though well below 2011's 41%, as lower-cost supply comes on stream. The price of coking coal, another key raw material, has also started to decline as supply has increased, namely thanks to the recovery of Australia's coal exports following last year's flooding.
We Expect Improving Steel Fundamentals Overall
For the steel segments, the company foresees first-half total shipments in line with those of the first half of 2011, which would be a 6% sequential increase. Management believes European shipments and pricing bottomed in November-December and expects to see a sequential increase in prices and shipments in the first quarter for both Europe and North America. We think EBITDA at the European flat-rolled business (Flat Carbon Europe) probably has room to weaken further in the first quarter, given less exposure to rebounding spot prices and the full impact of production cuts made late in 2011, but this should be offset by stronger performance in North and South America (Flat Carbon Americas) as a result of the seasonal rebound in shipments, higher steel prices, and continued improvement in real demand in the region. Unlike the past two years, when the first half of the year was stronger than the latter half, we think EBITDA will sequentially improve slightly in the second half of 2012 based on our annual forecast for 3% steel shipment growth, 10% growth in mining production, essentially flat steel pricing, slightly lower raw-material costs, and the benefits of the asset optimization plan, which are second-half loaded.
Shipment levels have exhibited greater stability than EBITDA in the past two years because of the volatility we have seen in steel prices and input costs, not end market demand. These shortened price cycles have been more pronounced in flat-rolled rather than long products; the swings in profitability have been particularly evident in the Flat Carbon Americas segment because of its greater exposure to spot pricing and more pronounced seasonal trends in the United States. ArcelorMittal's volume growth has lagged real demand growth in the past two years because of destocking effects and additional production brought on line by competitors, but inventories in the supply chain are currently very low by historical standards, and we see fewer supply additions on the horizon for 2012 and 2013.
For 2012, management expects global steel consumption growth of 4.5%-5%, including 5% in China, 5.5% in the NAFTA countries, roughly flat in the European Union, and 5.7% for the rest of the world. This is about in line with forecasts made by the World Steel Association and commentary from other steel companies. Our shipment forecast for ArcelorMittal of 3% in 2012 assumes 5% growth in all steel segments other than Flat Carbon Europe, where we expect a 1% reduction. Apparent steel demand weakened in late 2011, but sentiment has improved with many global leading indicators rebounding. In the U.S., energy, equipment, and automotive end markets remain strong with some positive signs for the construction markets, with the Architectural Billings Index breaching 50 and the housing market appearing to have bottomed. Capacity utilization rates for steel producers in the U.S. are at a post-recession peak of nearly 80% despite increased supply. While raw-material prices and steel prices remain volatile, we are encouraged by signs of a widening spread relative to the last several months of 2011.
Weakness in Europe will cut deep as the recession unfolds, but more than one third of ArcelorMittal's shipments are to emerging markets. The company is already the largest steel producer in Brazil and Africa and the second largest in the Commonwealth of Independent States, and expansion plans are concentrated in Brazil and India. About 40% of EBITDA from the steel segments is generated from assets outside North America and the EU. While China is unlikely to repeat its prior couple of years of double-digit demand growth, we expect a soft landing in 2012, requiring steel demand in line with management's forecast of 5%. Steel consumption is a key component of early-stage economic development, and there is no reason China should be any different. Even while the past couple of years brought acceleration in China, a near-term cooling does not change the long-term growth story. The EU and U.S. are consuming 25%-35% less steel per capita than they did just five years ago, a trend that is not sustainable, while growth in Brazil and India is just starting to accelerate.
We view the company's decision to maintain capital expenditure plans and an annual dividend in 2012 as a sign of confidence. ArcelorMittal has suspended all steel capacity expansion for now, but after $4.8 billion in capital expenditures in 2011, it intends to spend $4 billion-$4.5 billion in 2012. About $3 billion is maintenance spending; the remaining $1 billion-$1.5 billion is focused on mining projects primarily in Canada, Liberia, and Brazil. The majority of these are expected to have an EBITDA payback period of less than 18 months, based on current prices. ArcelorMittal's last-minute cold feet about the Macarthur Coal deal indicates the company will pull back when it lacks confidence.
We do expect iron ore and coking coal prices to fall slowly over the next four years, but we do not view this as a risk to mining EBITDA growth, as any price risk is more than offset by volume growth and further supported by lower output costs per ton as production ramps, particularly for iron ore, which is a much larger component of the mining business.
ArcelorMittal's asset-optimization plan, sustainable cost-cutting efforts, and potential to sell noncore assets provide further protection against weaker-than-expected market conditions, in our view. In September 2011, the company outlined a plan targeting $1 billion of additional EBITDA by the end of 2012 through improvements in core assets--maximizing production at the lowest-cost facilities to increase productivity while scaling back production at less optimal plants to optimize output with no market share losses. It has idled several furnaces across Europe, including in Spain and France, and plans to permanently close 2.6 million tons of previously idled capacity in Belgium, which is expected to produce the bulk of the $1 billion in savings and will be heavily weighted to the back half of 2012. Management has also made strides to take costs out of the producing assets in the past two years, largely related to selling, general, and administrative and fixed costs. The firm had achieved about $4 billion in sustainable cost efficiencies as of the end of 2011, and it intends to achieve an additional $800 million by the end of 2012, largely related to variable costs and operational improvements. Finally, the company currently has $9 billion in investments in associates and joint ventures all over the world. Management believes there are significant noncore assets that do not contribute to the EBITDA line that could be sold at a reasonable valuation in 2012.
More Upside Potential Than Downside Risk for Next Two Years
Our fair value estimate is derived from our base-case forecast for ArcelorMittal, which assumes a low-growth scenario overall with a modest recession in Europe, soft landing in China, and continued slow progress in the U.S. Our bear-case scenario assumes a deeper euro debt crisis and a stalling of steel consumption growth rates in 2012-13, which produces a fair value estimate of $29, above where the shares currently trade. While there is a wide range and we are not at the very bottom, our earnings estimates for ArcelorMittal are below consensus for 2012 and 2013. The more bullish consensus forecast further illustrates our view that the market is more spooked than the underlying fundamentals suggest. There could be additional upside potential to our fair value estimate should steel market conditions improve more quickly than we expect.
Concerns about ArcelorMittal's hefty leverage are valid, but we think worries about a covenant breach or necessary share issuance are overblown. The company reached its net debt target of $22.5 billion at the end of 2011, six months ahead of schedule. The higher net debt earlier in 2011, which peaked in June at $25 billion, was mainly due to investment in working capital, largely inventories. A deep recession scenario would probably result in a working capital release that would alleviate any need for higher net debt. Barring the downside case, management expects to lower net debt further in 2012 on asset sales and lower investments in working capital, particularly through better pricing effects as steel prices rose significantly in 2011 and have little upside potential in 2012, in our view. At year-end 2011, the company had $12.5 billion in liquidity, and more than two thirds of the $26.4 billion of total debt is in bonds rather than more restrictive and shorter-term bank debt. A modest $2.8 billion comes due in 2012, and the average maturity is 6.3 years, improved from 2.6 years in 2008. This is before the company's recent issuance of $3.5 billion in new bonds (the majority are 5- or 10-year) and the retirement of $300 million of the 2013 notes. A covenant restricts the net debt/EBITDA ratio to a maximum of 3.5, but this only applies to the $1.7 billion in liquidity lines, not the term debt. The company's net debt/EBITDA ratio stood at 2.2 times at the end of 2011, and our forecast is 1.9 for year-end 2012.
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