Investing in Steel: Just Plain Good Sense

| About: ArcelorMittal (MT)
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At $21 ArcelorMittal (NYSE:MT) yields 7.1%. The dividend of $1.50 per share is sustainable through an extended rough economic patch. Since 2000, world steel capacity utilization has increased from 85% to over 95%. Long term capacity growth is still required to satisfy growing needs of India, China and Russia amongst other emerging nations. In addition, demand from developed economies will likely increase in the short term because (a) re-development of infrastructure is required and (b) a time of crisis is a good time for government to boost spending. Steel demand can be expected to grow at somewhere between 3% and 5% per year over the coming decade.

In order to satisfy the long term requirements, steel prices need to remain at a level attractive to the industry. The prices have now dipped below the level where new investment is justified, which point to stress on capacity from future demand. The industry has responded by cutting production. ArcelorMittal as a leader has gone beyond cutting production and deferred expansion capex considerably.

In the short term we can expect utilization to fall back to 85% with steel prices remaining under pressure. Iron ore prices can also be expected to fall as demand from the steel industry drops. ArcelorMittal is somewhat insulated to input price risk as it controls 46% of its iron ore requirement; with a 35% cut in production 70% of its ore requirements is met from controlled sources.

Prices have now fallen well below the marginal cost of production. Two things can happen as long as long term demand growth continues, either the prices will rise or cost of inputs will fall. With the great de-leveraging in progress, there is a high chance that steel and ore prices will fall for at least a further 6 months; in the short term the cost of hot rolled coil could trade as low as $500.

Longer term, once distortion created by financial investors works its way out of the system; it is the real economy that matters. At this time, you can expect long term prices to rise to $850 to $900; at this level the industry can invest in capacity expansion with an anticipated ROIC of 15%. Spikes over the long term prices must be expected because there will be a shortage caused by deferral of brownfield and greenfield capacity expansion projects. During this period you can expect a bubble to form with steel prices rising to over $1,500 for HRC.

A reason to invest in steel quite separate from the real economy is in place too. The extent of government borrowing and rising deficits together with interest rate cuts has created a situation where long term inflation will rise. Near term, with the economy in contraction, inflation will remain subdued with some chance of deflation; however, the price for recovery will be paid by a moderately higher long term inflation rate - looking at an inflation target of 2% in the developed world is a story long past.

I believe that structural changes in the economy caused by globalization will lead to more tolerance towards inflation to a level of 3% to 3.5% before which a monetary response to constrain growth will not be initiated. With an expectation of rising long term inflation, it makes sense to invest in commodities when valuations make sense. It makes sense to avoid current cash as an asset class and focus on investing in assets with the ability to generate future cash flow.

When are the valuations right? Excluding intangibles, the book value of ArcelorMittal was $46.5 billion at the end of 2007; it is expected to be around $49.1 billion at the end of 2008. That is somewhere between $33 and $35 per share. The share trades at $21 presently. Since the market is not trading on valuation or fundamentals, the price could go down considerably further. For a long term investor, the yield of 7.1% more than protects the downside risk. My assessment of the fair value of the company is $60. At its peak during the next economic cycle, exuberance can lead to a bobble price of around $160 per share.

Disclosure: No position.