Fears About Argentina And Mexico Have Ternium Looking Cheap

| About: Ternium S.A. (TX)
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Summary

Argentina represents more than 45% of current EBITDA, but the steel is sold in U.S. dollars and 30% of the costs are in Argentine pesos.

Ternium has over 7 million tons of capacity in Mexico, serving that country's fast-growing auto export sector.

Well-run and with partial integration of raw materials, Ternium routinely posts above-average margins but carries a below-average multiple.

Argentina is a mess right now, and the companies with ties to that country are paying the price - some deserved, some not so much. I would place Ternium (NYSE:TX) in the "not so much" camp, as although the company does generate a substantial amount of EBITDA in Argentina, the business isn't as vulnerable as valuation would suggest. More to the point, this is a well-run and growing Mexico-based steel company with some measure of influence over its input costs.

What It Is

Legally headquartered in Luxembourg, around 70% of Ternium's capacity is located in Mexico, where the company produces primarily flat-rolled steel for the automotive, machinery, and energy markets. More than half of the company's sales are within Mexico, though a meaningful percentage ultimately ends up in the United States (more than half of Mexico's auto production is exported to the United States). The company recently finished a capital investment cycle that saw the addition of 1.5 new tons of cold-rolled capacity and about 400k tons of galvanized capacity through a joint venture with Nippon Steel.

Argentina does matter, though. The company owns 61% of Siderar, the only steel company in Argentina with flat-roll capacity. Argentina accounted for about 47% of the company's fourth quarter EBITDA, but a few details about the business are important. The company invoices in U.S. dollars and about 30% of its costs are in Argentine pesos, helping to shield it from the impact of devaluations. Were demand in Argentina to fall off in the face of weaker economic conditions, the division would sell more of its steel on the export market (priced in U.S. dollars). While Argentina's 10% withholding tax on dividends paid outside the country is a drawback, it's not a major factor at present. It's also worth noting that the capacity additions in Mexico should reduce Argentina's contribution to EBITDA to 30% or less in the near future.

Some Advantages On The Cost Side

Taking a page from ArcelorMittal (NYSE:MT) and other integrated steel companies, Ternium has integrated a significant portion of its input costs. The company owns three iron ore mines in Mexico and uses them to supply more than half of its iron ore needs. The company also has a stake (48%) in a natural gas power plant being built in Mexico and is expected to take most of the plant's 900MW capacity.

Between integrating some of its raw material needs and focusing on higher-value steels for markets like autos, Ternium generates attractive margins. The company's EBITDA margins have been in the teens for some time, and 2013's 17.4% compares well with other Latin American steel producers like Gerdau (NYSE:GGB) at 11.5% and Usiminas at 13.7%, as well as Nucor (NYSE:NUE) at 8.1% and ArcelorMittal at 9%. Brazil's CSN (NYSE:SID) does beat Ternium, though, with a trailing EBITDA margin of more than 25%. As an aside, Ternium does hold an approximately 17% stake in Usiminas, while Ternium and ArcelorMittal are partners for the Pena Colorada iron mine in Mexico.

Addressing Markets With Good Long-Term Characteristics

Latin America's per-capita steel consumption is about 40% below the world average and while there has been growth in local capacity, much of that growth has gone to import substitution. The region still gets about one-quarter of its steel needs from imports, despite having some credible local reserves of raw materials (particularly iron ore in Brazil).

I am bullish on what Ternium can accomplish in this environment. In the last two years, Audi, Nissan, and Ford (NYSE:F) have made $1B-plus commitments to projects in Mexico and the liberalization and re-modernization of Mexico's energy sector could lead to significant demand for steel in the coming years. While autos may be the most easily quantifiable export product, it's not the only area where Mexico is a competitive exporter, and Ternium can feed this growing local market for high-quality steel.

Ternium has opportunities outside of Mexico as well. Sales to Argentina, Bolivia, Chile, Paraguay, and Uruguay make up nearly a third of revenue, and the company has a 54% stake in Colombia's Ferrasa. As imported steel makes up more than half of Colombia's steel use, import substitution is a credible opportunity here as well. There are definitely risks to this growth outlook; the company used to have operations in Venezuela before the government moved to nationalize Sidor, and it is unwise to take it for granted that governments in this area will always act rationally or in the long-term best interests of their own people.

Quality Operations Should Lead To Value Creation

Steel producers aren't typically evaluated (or bought and sold) on the basis of metrics like ROIC, nor are discounted FCF models often all that useful. That said, Ternium's performance has generally been above average over the long term in terms of both FCF generation and ROIC, with the weak global steel market of recent years weighing on margins since 2008 (as they have for ArcelorMittal, Gerdau, and most other steel companies).

I believe Ternium can outgrow the global steel market by virtue of ongoing import replacement in Mexico and growth in sectors like auto production and energy. I'm looking for long-term revenue growth in the neighborhood of 5%, with FCF margins in the mid-to-high single digits.

The Bottom Line

Turning to one of the favored methods for steel stock valuation, EV/EBITDA, Ternium carries what I believe is an unfair discount to its other Latin American rivals. Even with the risks in Argentina and the fact that the Rocca family controls about three-quarters of the company, I don't believe a penalty of more than one point to the EBITDA multiple is reasonable. At a 5x multiple (versus 5.5x for the sector), Ternium would trade above $34 and at a multiple closer to the global average of 6x, the shares would be worth more than $40.

I've been writing a lot recently about Latin American stocks that I believe have been beaten down too far and represent good plays on long-term fundamental growth trends. With Ternium's advantaged position in Mexico's steel industry, not to mention the possibility that Argentina bottoms out, I think this is a steel stock worth considering at today's multiple.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.