Investors Seem Surprisingly Willing To Buy ThyssenKrupp's Weird Brew

| About: ThyssenKrupp AG (TYEKF)
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ThyssenKrupp reported a solid beat with good second quarter revenue and earnings as steel demand recovers in Europe.

Management has been shuffling its steel asset base, selling a mill in Alabama, ensuring some capacity for Brazil, and taking back stainless and alloy assets from Outokumpu.

A split could unlock more value for shareholders, but the stock's multiple already seems to reflect a lot of that potential.

Imaging putting together bits and pieces of United Technologies (NYSE:UTX), U.S. Steel (NYSE:X), Technip (OTCQX:TKPPY), TRW Automotive (NYSE:TRW), and Allegheny Technologies (NYSE:ATI) and you might end up with something that resembles German conglomerate ThyssenKrupp (OTCPK:TYEKF) (TKAG.DE). ThyssenKrupp is the third-largest steelmaker in Europe, but also a large player in metal marketing/logistics, elevators, large-scale plant construction, and vehicle components.

It has been a while since ThyssenKrupp has reported good earnings or margins, a byproduct of the same steel down-cycle that has hit ArcelorMittal (NYSE:MT) and Salzgitter, but management has made some curious moves with respect to asset sales and take-backs. Investors seem confident in this name as a rebound and restructuring play, but it seems like a lot of improvement is already factored into the share price.

A Good Quarter Helps The Cause

ThyssenKrupp did no harm to the bull case with a good set of fiscal second quarter results. Overall sales rose 8%, beating expectations by about 3.5%. Over half of the company's business units (in revenue terms) saw double-digit growth - Industrial Solutions sales rose almost 12%, Components rose more than 14%, and Material Services rose almost 14%. Elevator Tech sales were up about 7% and Steel Americas was up more than 8%, while Steel Europe was the lone decliner at over 6% contraction. Steel Europe was impacted by disposals, though, and that hid the 20% qoq growth in sales volume.

ThyssenKrupp not only carried that top-line beat, but actually improved a bit through the profit line-items. EBITDA more than doubled from the year-ago period and adjusted EBIT was up 62%, beating sell-side expectations by more than 4%. Material Services was the only segment to see a yoy decline in profits, though the Steel Americas business had a loss in both periods. Industrial Solutions, Elevator, and Components all saw double-digit EBIT growth on a yoy basis.

ThyssenKrupp's Steel Business Is In A Weird Spot

ThyssenKrupp is the third-largest European steel company, but it has relatively little leverage to construction compared to ArcelorMittal or Salzgitter. Instead, the company is seeing good demand from its automotive end-markets, packaging customers, and steel processors. So although ThyssenKrupp isn't really a good play on a rebound in European construction, it still appears as though that long-awaited recovery in Europe is pulling up demand for the company's steel.

The company has been busy realigning operations, and not necessarily in the most optimal ways. The company agreed to sell its Alabama rolling mill to a joint venture between Nippon Steel and ArcelorMittal, but the company is keeping its CSA mill in Brazil. ThyssenKrupp secured a supply contract with ArcelorMittal/Nippon Steel to guarantee at least 40% utilization, but there is no downstream integration and it looks like a cash-consuming "swing producer" in an over-supplied market. Still, the company did manage to get $1.55 billion for that Alabama plant, so it wasn't a total loss.

The company's transactions with Outokumpu were even stranger at first glance. ThyssenKrupp wanted to get out of the stainless steel business, but has found itself taking back the AST and VDM businesses from Outokumpu in exchange for canceling a note and handing back an equity stake. The AST assets really don't make a lot of sense now, as they were repositioned to supply other Outokumpu mills with semi-finished product. The high-performance alloys of VDM don't make it a bad business per se, but it's not core to what ThyssenKrupp wants to do and the fact that Outokumpu couldn't sell it doesn't suggest a quick flip for ThyssenKrupp either.

Here's another way to look at this deal. Outokumpu is clearly struggling and ThyssenKrupp swapped EUR 1.5 billion of unsecured assets that could have gone to zero for EUR 0.7 billion of secured assets with upside and/or resale potential.

A Split Seems Like A "When", Not "If"

ThyssenKrupp management has been pretty steadfast in asserting that there is value in the conglomerate structure of the business as is, but the Street isn't buying that. The company has been selling non-core assets since 2011 and the next logical step is to split the business into Capital Goods (Ind. Solutions, Elevator Tech, Components) and Materials (Steel Europe/Americas, Material Services).

Industrial Solutions is home to a large European naval vessel builder and a plant technologies business that holds leading positions in chemicals, cement, metals/mining, and automotive where it competes with Technip, FLSmidth, Metso, Comau, and KUKA. To explain further, when a new chemical plant, cement plant, or automobile plant is built in Europe, there's a pretty fair chance ThyssenKrupp is playing a key role.

The Elevator Technology business, which contributes about a third of EBIT (more this quarter), is a little more self-explanatory. ThyssenKrupp trails United Technologies and Schindler and is basically tied with Kone for the third spot in global market share (13% to 14%) and holds the number five spot in the extremely important China market.

Components Tech includes a mobility business that is home to the third-largest producer of steering gears and columns for passenger vehicles and an infrastructure business that is home to the largest manufacturer of slew bearings for wind turbines.

It's difficult for me to see any real benefit in having these operations tied to a steel and metals marketing business (Steel Europe/Americas and Material Services), particularly when those steel operations may be a little too small to generate optimal operating leverage. Accordingly, I think management will concentrate on stabilizing its steel operations (including integrating or selling AST and VDM) and then splitting the business. That split should create a reasonably high-margin, FCF-generating capital goods business and a decent, albeit very cyclical, steel business that could perhaps merge with a peer to extract more operating synergies.

The Bottom Line

The European auto sector has remained healthier than expected, and that has certainly helped ThyssenKrupp as about a quarter of its sales go there. Just as ArcelorMittal can ride an improving steel sector higher, so too can ThyssenKrupp. My only problem is that ThyssenKrupp seems to have gotten a head start on that process, as investors have bid up the shares on the potential of further restructuring and a split.

Using a weighted average of the comparables, it seems like a fair forward EBITDA multiple for ThyssenKrupp is around 7.5x to 8.0x, depending on whether you want to assign a penalty for the unwieldy nature of this conglomerate. At 7.5x, ThyssenKrupp looks fairly valued, while an 8x multiple suggests about 5% upside from here. I wouldn't be quick to sell, as this European recovery story still has legs, but I also wouldn't be thinking of initiating a large long-term position at this price.

Should readers want to invest in ThyssenKrupp, I'd recommend investing in the XETRA-listed shares, as the U.S. ADR is not particularly liquid.

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.

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