ArcelorMittal (MT), as I expressed earlier here, is one of the most undervalued stocks. Since many investors are fearful about a double dip, steel producers have experienced generally high volatility. In this article, I will run you through my DCF model on ArcelorMittal and then triangulate the result against a review of the fundamentals of competitors US Steel (X) and Nucor (NUE). I find that the risk inherent in all of these companies will drive outperformance. The fear mongers are, in short, dead wrong.
First, let's begin with an assumption about the top-line. ArcelorMittal finished FY2011 with $94B in revenue, which represented a 20.4% gain off of the preceding years. I model 25.1% per annum growth over the next half decade or so- in-line with analyst projections.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures, and taxes. I model cost of goods sold eating 91% of revenue versus 4% for SG&A and 4.2% for capex. Taxes are estimated at 30% of adjusted EBIT (i.e. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 0.5% of revenue over the explicitly projected time period.
Ultimately, I find that the company will generate enough operating cash flow in 13 quarters to exceed its market value. By contrast, US Steel (X) and Nucor (NUE) would take between 20-35 quarters to do the same. This makes ArcelorMittal substantially undervalued.
Accordingly, the Street rates the firm a "strong buy" (according to NASDAQ). The price target currently states at $27.58, which is a 72.3% premium to the closing value on May 11, 2012. From a multiples perspective, ArcelorMittal is a bargain at 5.1x forward earnings.
With that said, US Steel and Nucor are also strong in terms of generating high risk-adjusted returns. They trade at 6.8x and 9.9x forward earnings, respectively.
US Steel has also showcased strong financial improvement:
After deducting cash used in investing activities and dividends paid, we have free cash flow of $363 million in the first quarter. We ended the quarter in a strong liquidity position with cash of $652 million and total liquidity of $2.5 billion. During the first quarter, we took advantage of strong, high-yield capital markets to reduce our 2013 debt maturities, which improves our near-term financial flexibility.
Consensus estimates forecast US Steel's EPS turning positive at $2.52 in 2012 and then growing by 48.8% and 18.9% in the following two years. Assuming a multiple of 11x and a conservative 2013 EPS of $3.69, the stock would hit $40.59 for 57% upside. While US steel is highly leveraged with net debt nearly exceeding market cap, the fundamentals are unusually cheap. At a Enterprise Value-to-EBITDA multiple of 6.3x, I also believe that the company has a chance of being taken private or being bought out. The advantage to taking the company private is that labor management would receive less scrutiny, and management could thus unlock value through breaking up the unions. An advantage to being bought out by a competitor is the increase to scale.
Consensus estimates forecast Nucor's EPS falling by 1.7% to $2.35 in 2012 and then growing by 57.9% and 21.3% in the following two years. Of the 21 revisions to EPS, all but one has fallen for a net change of -13.9%. This has ultimately set the bar very low for high risk-adjusted returns. With the dividend yield at 3.9%, the stock is also much safer than what many investors appreciate. Coupled with the beta of 1.3, I believe this will render Nucor an outperformer when the global economy hits full employment.
Disclaimer: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.