[2012 - SEP - 01] Thesis on ArcelorMittal (MT)
READER BEWARE: The following is my own biased and arbitrary analysis of ArcelorMittal which is based upon, alas, imperfect information. I am sharing it with you for my own amusement and with the hope of getting some feedback on my analysis. It is in no way a recommendation to buy MT (even though I am of the opinion that the stock is undervalued).
Steel Products & Industry Overview
Steel is an alloy made by combining iron and other elements such as carbon. There are 3 main ways of producing steel:
- Integrated steel making: coal is converted to coke in a coke oven, and then combined in a blast furnace with iron ore and limestone to produce pig iron, which is subsequently heated in an oxygen furnace, lowering the carbon content into desired levels. Once produced, the liquid steel is metallurgically refined and then transported to a caster to be shaped or rolled into its final form. It allows for the highest control and quality levels but, as a drawback, it comes at the energy intensive and highly expensive blast furnaces.
- Mini mills: Instead of processing raw inputs, mini mills employ electric arc furnaces to directly melt scrap steel, skipping many steps involved in integrated steel making. Mini-mills are generally characterized by lower costs of production and higher productivity than integrated steel-makers. These attributes are due in part to the lower capital costs and lower operating costs resulting from the streamlined melting process and more efficient plant layouts of mini-mills. Mini-mills are substantially dependent on scrap, which has been characterized by price volatility, generally rising prices and limited availability in recent years. Nucor (NYSE:NUE) thought to have succeeded mainly by producing solely through mini-mills, allowing for greater operating margins than those of integrated competitors.
- Integrated Mini mills: Innovative mini mills that produce their own raw materials instead of relying in steel scrap. Lakshmi Mittal (CEO & Chairman of ArcelorMittal) was one of the pioneers who championed the use of integrated mini mills. Integrated mini-mills are able to produce steel with the quality of an integrated producer, since scrap substitutes, such as direct reduced iron, are derived from virgin iron ore, which has fewer impurities than outright scrap.
Iron and steel products are widely used in the construction of roads, railways, other infrastructure, appliances, and buildings. Most large modern structures, such as stadiums and skyscrapers, bridges, and airports, are supported by a steel skeleton. Even those with a concrete structure will employ steel for reinforcing. In addition, it sees widespread use in major appliances and cars. Steel is used in a variety of other construction materials, such as bolts, nails, and screws. Other common applications include shipbuilding, pipeline transport, mining, offshore construction, aerospace, white goods (e.g. washing machines), heavy equipment such as bulldozers, office furniture, steel wool, tools, and armor. The steelmaking industry is highly cyclical, and its demand for products is correlated with macroeconomic trends.
There is a huge number of steelmakers worldwide. There are high barriers of entry (startup costs) and shipping costs are not modest, so demand is usually dealt with locally by few domestic producers or by producers from nearby countries. Competition is fierce however, which has led to lackluster returns on investments industry-wide.
ArcelorMittal is the world's largest steel producer, with an annual production capacity of approximately 125 million tons of crude steel for the year ended December 31, 2011. Steel shipments for the year ended December 31, 2011 totaled approximately 85.8 million tons, which amounted to slightly above 6% of the world's total steel output. MT's steel tonnage more than doubles the production volume of the second largest producer. ArcelorMittal is the largest producer of steel in North and South America and Africa, the fourth largest steel producer in the CIS region, and has a small presence in India and China. ArcelorMittal has a diversified portfolio of steel products across all steel-consuming industries, including the automotive, appliance, engineering, construction, energy and machinery industries. The company sells its products in local markets and through a centralized marketing organization to customers in approximately 174 countries.
The company's geographic diversification reduces sales volatility: The Americas represents 35% of total company sales, Europe 49%, Asia & Africa 16% respectively. While the Americas and Asia & Africa regions are expected to keep growing at satisfactory rates, management expects its European performance to lag significantly due to the stagnating macroeconomic context due to the sovereign debt crisis. Management estimates that European sales volume (tons) will not return to the peak achieved in 2007 until 2015. Nonetheless, positive sales growth is expected in all regions.
ArcelorMittal has also a high degree of product diversification relative to other steel companies. Its plants manufacture a broad range of finished and semi-finished steel products of different specifications, including many difficult and technically sophisticated products that it sells to demanding customers for use in high-end applications.
The production process is also diversified. In 2011, approximately 65.9 million tons of crude steel were produced through the basic oxygen furnace route, approximately 22.6 million tons through the electric arc furnace route and approximately 3.4 million tons of crude steel through the open hearth furnace route. This provides ArcelorMittal with greater flexibility in raw material and energy use.
Besides its main Steelmaking activities, ArcelorMittal also takes part in iron and coal mining, allowing for a significant vertical integration that lowers raw material costs and reduces earnings volatility. The company self-fulfilled 57% of its iron ore needs, 19% of its coal needs, 91% coke, and 48% scrap. Being such a mammoth player, ArcelorMittal managed to establish long term contracts with input suppliers at rates more favorable than what other steelmakers could.
In the last decade, ROE has averaged 20%, and since the Arcelor and Mittal consolidation in 2006, ROE has averaged 8%, which is satisfactory given the dismal macroeconomic context. This should speak for management's talent for making sensible strategic acquisitions. Successful merger integration history boosts confidence in the company's acquisition strategy and increases the likelihood that ArcelorMittal will be selected as the preferred bidder in future acquisition efforts.
Something worthy of being appreciated is that the Mittal family is the owner of more than 40% of the shares outstanding, taking 2 seats in the board of directors. While this will definitely have minority shareholders lacking in power, this family's incentives should be well aligned with long term shareholders. Lakshmi Mittal has proven his business skills by expanding a family-owned steel business into the world's largest producer. He pioneered the use of integrated mini-mills as a more efficient way of producing steel (though the use of electric arc furnaces) while maintaining the flexibility of an integrated process (without the need for high quality steel scrap). Lakshmi serves as both CEO and Chairman of the Board (roles that on would normally would like to be separated), and his son Aditya is the company's CFO. We think +40% ownership might partially isolate the company from short-term pressures, and indeed, we are of the opinion that the company's performance in the past decades speaks for the management's team talent and long term focus. Sign of this managerial flexibility and determination was shown, for instance, in 2008, year in which the management decided to cut in half its overall steel production owing to the hostile overall macroecon environment, avoiding huge losses that would had probably occurred if an alternative non-owner management had been in place.
ArcelorMittal counts with the highest level of R&D in the steelmaking industry, which should allow for comparable cost cutting and efficiency improvements in par with the top industry players.
Among the many risks that the company, we highlight the following:
- High levels of debt: Interest payments are close to $2.9 billion, while average free cash flows (net of capex and interest payments) are of about $3.1 billion. The leverage on ArcelorMittal is relatively high for a company in such a volatile and cyclical industry. Debt was liberally used to finance growth through acquisitions, but the debt levels have been retrospectively shown to be undesirable since such an inflexible capital structure makes the company fragile against macroeconomic shocks. This proved to be the case in the great recession which forced a significant cut in dividends to have a healthy coverage of interest payments. Management has tackled this issue effectively, and has erased $ 12 billion of long term debt in the last 3 years. Liquidity does not seem to be an issue, with a current ratio of about 1.38. Moreover, it has temporarily stopped growth acquisition in the Eurozone, with a lower level of capex than planned in previous years, to hoard more money to be able to face the coming maturity of its bonds issues in this current environment. While the debt levels are high, we deem S&P's recent downgrade too pessimistic, and even more so, a buying opportunity. The company still has in place a credit revolver facility of about $ 8 billion, has ample liquidity, healthy free cash flows, and has decreased its investments in acquisitions.
- Big investments in Europe: The company derives almost half of its revenues from European economies. Management expects almost flat levels of sales. There is an overwhelming level of political unrest and economic uncertainty regarding the future of the Euro and the EU as a going concern, and of the future fiscal and monetary policies that might be used in order to prevent the situation from deteriorating to an even higher extent.
- China: The company's position in China, the biggest steel consumer in the world (and fastest growing), is very small (1.4% of sales volume). Increasing significantly the company's position in China, could prove unprofitable, given that Chinese steelmaking industry is suffering from overcapacity (too much supply, which has lowered margins and returns on invested capital in that market). Investing big in China might end up destroying value for shareholders given the intense competition currently taking place, so we take comfort in the company's current exposure. There is risk that Chinese steelmakers will start expanding its frontiers given excessively cheap renminbi allowing for overly-competitive chinese exports, though higher fuel and shipping costs could help in keeping them at bay from conquiering new markets, shrinking MT's share of the pie.
What does the future await for ArcelorMittal? In the past, despite a considerable degree of fragmentation in this industry, the average steelmaker has been profitable and managed to obtain reasonable returns on investment. High set up costs plus moderate to high shipping costs, allow for regional oligopolies that in turn, enable moderate profits to take place. I would humbly guess that:
- To a considerable degree, this competitive dynamic will protrude further into the future, enabling similar levels of profitability to be achieved. The main difficulty would be presented by overcapacity in China, but this should not have a huge impact on ArcelorMittal's earning power given the small fraction of revenues that the company derives from the middle kingdom (<1.4%).
- ArcelorMittal, is the biggest steelmaker on the planet. Thanks to its  massive scale (more bargaining power than other steelmakers when buying inputs),  vertical integration (cheaper and more stable supply of inputs thanks to partial self-sufficiency),  higher R&D expenditures than any other single steelmaker ($306 million in the last year), ArcelorMittal should be able to achieve similar profit margins and returns.
- Even though past acquisitions have been sensible, they came at the cost of high debt levels to finance them, and retrospectively (came "The Great Recession") the capital structure was lacking in cushion in case of extreme downturns. The cyclicality of the steel industry should allow the biggest players to consolidate smaller firms during downturns, but given the current state of MT's balance sheet, I would argue that its future market share would grow at a slower pace than in the last decade given management's intention to deleverage. Also, it seems quite likely that the company is going to issue more shares in the future as a way of financing its short term. Share dilution will ensue.
- Exposure to European debt and currency crisis: I have no idea what to make of it. I do guess it is unlikely that ECB will let the euro currency to fail and the EU to disintegrate. It seems likely that the European economies as a whole will suffer a lost decade, with economic stagnation or even moderate declines in GDP. Austerity measures leading to high taxation and lower consumer discretionary income will lower car, home appliances, and white goods demand. Infrastructure expenditures though, should be stable enough. I would daresay that worst case scenarios are very much present in everyone's expectations, and so I would argue that when investing in Europe at this time, there is a considerable degree of upside (most surprises are going to be on the good side, since most of the bad stuff is already discounted in prices). So, to me, the European picture seems to be bad - but not as bad as the market's. Management believes that steel volume will return to peak levels achieved in 2007 by 2015. I would be content if today's present tonnage and average steel prices remain constant.
- The Africa & Asia segment will continue with its healthy growth in volume. Steel prices quite possibly will go up too. Africa & Asia will continue with its macro-momentum forward based on continuing infrastructure investments in the oil and gas industry. There is a huge political risk lurking in here (North-African, Middle-Eastern, and Central-Asian countries), but the upside seems quite appealing. Africa & Asia represent 16% of sales.
- The Americas will resume its growth: USA itself represents almost 18% of the ArcelorMittal's sales. It appears that the housing market is bottoming (http://www.fool.com/investing/general/2012/08/24/believe-it-14-examples-of-why-housing-may-have-bot.aspx). Higher house prices and house building should boost consumer confidence and spending in consumer durables utilizing steel. The automobile industry also seems now to be in the uptrending part of the cycle, especially after governmental bailout of GM, and industry-wide newly stated employment contracts thanks to the temporarily benign relationship car companies have recently established with the UAW labor union. The big 3 American car companies have restructured themselves into leaner, more flexible companies. They all have a newly lower profit-sales breakpoint - and while profits are not a sure thing, bankruptcy seems very unlikely. Another unlikely event, but here on the upside, is a future infrastructure investment program in America. USA's power grid and energy infrastructure is lacking and needing significant investments. Tackling this problem would mean huge opportunities for the steelmakers, and ArcelorMittal would be one of the biggest beneficiaries of such a policy. Brazil, the next entry in the Americas segment, represents almost 8% of MT total sales. Brazil's economy seems to be cooling down owing to its overvalued currency and expensive exports, which can lead to lower growth GDP rates. However, steel demand does not seem to be decelerating. Competition is fierce, but regional steel prices do not exhibit significant overcapacity.
- The dividend payment (quarterly div. of $0.1594 per share) is currently a fraction of what it used to be before the financial crisis developed (in 2008 the company was paying a quarterly div. of $0.3592 per share). I estimate that the company will increase the dividend payment to previous levels or even higher by mid 2015, after it finishes to repay soon-to-mature debt of about $12.5 billion (in installments of $2.8, $4, $3.7, and $2 billion in each respective year) according to management's plan to deleverage.
Valuating businesses in cyclical industries is a tough thing to do (though not as hard as banks and insurance valuation - I wonder if I will ever be able to understand those things). As a rough approximation I use these figures: Average Annual Free Cash flow (this is, after interest payments and monstrous capital expenditures) in the PAST DECADE were of about $ 3.1 billion - with a high of $ 11 billion, and a low (and only negative year) of $ -3 billion. The average FCF margin (Free Cash Flows as a percentage of revenue) was of 5.4%. As I argued previously, I would bet on history (margins, returns, market share) repeating itself, though allowing for a somewhat more optimistic outlook for the future (assuming that another "Great Recession" is unlikely to occur), and a slower earnings power growth due to deleveraging (using funds to repay debt instead of performing acquisitions).
I can think of 3 scenarios:
- Armageddon, European Union is dissolved, new currencies emerge, political unrest and expropriations in Africa & Asia, but the world keeps on needing to consume steel. Average Annual Free Cash flows: $1.5 billion. Nominal perpetual growth of 2% minus a 4% share dilution a year (issuing shares in exchange of cash as a way to financing), gives a value of $8,76.
- The more likely scenario I presented previously: future is somewhat bright, similar to the past decade but without any extreme downturn (recessions: yes - another "Great Recession": no). If we average last decades FCF excluding the worst annual result, we would get a value of $3.8 billion - and this number is after CAPEX and interest payments. I chose a number slightly slower than that: I project earnings power of $3.5 billion a year. CFC would exhibit a CAGR of 7% for the next 10 years, a 2% yearly share dilution to finance short term liquidity needs, a 2% perpetual growth rate beginning in the eleventh year. This results in a per-share value of $ 31,40. This implies than in 2022 ArcelorMittal, thanks to its organic growth and acquisitions, would have revenues of $ 195 billion, and an average FCF margin of 4%.
- Finally, an upper end scenario in which the European debt crisis is smoothly solved and worldwide growth resumes at a healthy pace. Let us project earnings power of $ 3.7 billion, growing at 7% for 10 years, then at 5% for 10 more years, then a perpetual growth rate of 2.5% thanks to growth in the Americas, Africa & Asia continue with its momentum, and European stability, all coupled with a 1% yearly dilution of shares. Present value of shares would be close to $39 a share.
When performing DCF I used a 10% discount rate. If we make the assumptions that the probabilities of the bad, the middle, and best scenarios are 15%, 80%, and 5% respectively, then we would obtain the following number:
FAIR VALUE PER SHARE: $28,40.
NOTE: I am aware that, in this rough DCF calculation, there is a money-value-of-time problem. I am using a smoothed-out average free cash flows, while in reality earnings are going to fluctuate wildly in an unpredictable manner. It would be considerably more pleasant (from a money-value-of-time perspective) to have a cyclical downturn at the end of our 10-year period - say in 2022 - than to have it next year, since we are going to weight the immediate future more heavily than the distant future. Nonetheless I deem these rough figures illuminating. As Keynes said "I'd rather be vaguely right than precisely wrong". Roughness in estimations reminds us to be aware of the limits and shortcomings of the DCF valuation methodology, and to look for big margins of safety.
The implied MKT Cap would be of around $ 44,3 billions, which is considerately below its all-time high of $137 billion in 2008.
More importantly: (As of 2012-Sep-01) the stock market price of MT is $14.70, which would indicate a pretty wide margin of safety relative to our Fair Value of $ 28,40. Metaphorically speaking, MT is trading at 51 cents on the dollar. This (arbitrary and subjective analysis) leads me to the conclude that MT is a BUY.
Not only you get a market leader in its industry at a significant discount to fair value, but you also get a projected dividend yield of 4.34%, that is quite likely to double in the next 4 years (after the company slashes $12.5 billion of debt maturing in the near future).
Disclosure: I am long MT.
Additional disclosure: I intend to add to my position in the following weeks.