Written on 8/19/08
Valuation: A DCF valuation of ArcelorMittal (MT) yields a price of $105/ADR, an upside potential of 39% to today’s closing price of $75.50. In the last three years, MT has traded in the PE range of 5 to 13; at an estimated FY-08 EPS of $13.23 the stock should trade in the $66-$169 range. MT also has 14 million shares to be repurchased of the total 44 million buy-back for FY-08.
Scenario Analysis: A scenario analysis shows that MT’s current stock price reflects low short term revenue growth at 3% or a low sustainable net profit margin of 6.5%; either one of which has a low probability.
Sector Analysis: It is increasingly difficult for smaller steel mills to compete without owning iron-ore and coking-coal mines. Coking-coal accounts for 20% while iron-ore accounts for 80% of total variable steel production expenses. Surge in raw material prices have pushed labor expenses to a small portion of the total cost and hence steel mills in developing nations don’t have a significant cost advantage vis-à-vis their western competitors. China forbids foreign controlling stake in steel producers since steel is a strategically important industry, leading to smaller inefficient steel mills which could change in the near future. Since 2005, China has been increasing steel export-taxes as part of its efforts to curb smokestack industries. In Jan 08, China raised export-taxes on coke, pig-iron and steel-billet to 25% from 15% and on rebar-rod from 10% to 15%. Chinese steel mills source iron-ore from global miners; increases in raw material prices since 2006 has led to margin deterioration. Fears about China dumping low-cost steel in the markets have subsided in 2008.
Since 2006, Asian-European central banks have been battling inflation by reducing liquidity. However, the mood of late has been changing from battling inflation to supporting modest growth. China’s politburo emphasized the importance of growth and omitted previous mentions of worries about inflation in its June statement. Vice premier Li Keqiang said on Aug 19 that China needed to increase domestic spending to keep growth on track as global economy weakened. India’s Prime-Minister emphasized growth in his Aug 15 speech and avoided the inflation rhetoric. The ECB and the Bank of England left interest rates unchanged in August, after multiple rate increases in the last one year, as signs of slowing economic growth left little room for rate increases.
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Growth Catalysts: Global Steel demand will be driven by the $75 billion earthquake reconstruction in China and greenfield infrastructure projects in Middle-East and India. The top-15 steel companies account for 35% of global capacity, while the top-3 miners control 70% of total iron-ore trade. We like MT’s unique three pronged growth model with vertical integration of steel, mining and distribution. MT has one of the highest raw material self-sufficiency (50%) amongst the top-10 steel producers in the world and sells 40% of its steel through its own distribution centers. It continues to acquire mines in some of the most politically unstable regions while a geographically diverse portfolio of mining assets reduces risk and freight costs. MT’s management three decades of experience and owns 43% of the company. With roughly half of its production base in the high growth Latin American, Asian, Central and Eastern-European markets, MT is ideally positioned to capture future growth.
The latest global steel consumption forecast predicts 6.77% year on year increase in steel consumption in the current year. The additions in the capacity are likely to be around 90 million tonnes which is just enough to meet the consumption without any spare capacity. Any delay in bringing new production online will result in a shortage of steel in 2008. The sector has seen a massive sell-off since July due to macroeconomic concerns but the existing supply-demand gap would shield it from short-term macro issues and owing to its unique business model, ArcelorMittal should continue to grow above the industry average.
Disclosure: The analyst and his company have a long position in MT.