Executive summary
Although the steel sector hasn't always been an opportunity for investors. We have to focus on the right companies. Some steel manufacturers are heavily loaded with debt. In this article, I'd like to highlight Aperam (APEMY) which was spun off from ArcelorMittal in 2011. Since then, the company has become a leading global producer of stainless steel. Aperam provides customized services and solutions, while the group is focusing on improving its margins. Thanks to the relatively high and stable margins, Aperam succeeds in its strategy to benefit from an increasing global demand for electric vehicles. So Aperam isn't just a traditional commodity player, it is rather more diversified than its peers. Based on strong growth momentum for stainless steel and the net cash position, the market doesn't realize what kind of powerhouse Aperam is.
Given this discrepancy and a WACC of 8%, I think Aperam's fair value is 54-62% higher than today's share price. The reason for the chosen 8% WACC is arbitrary, but refers to the economic dependency of the steel sector resulting in a higer risk premium. However, there still is enough upside even with economic turmoils. The group is trying to benefit from the current discount by repurchasing shares.
Introduction
Aperam's business profile is split into three main divisions:
- Stainless and electrical steel
- Services and solutions
- Alloys & Specialties
Aperam is a leading global producer of stainless steel by production capacity. Electrical steel is going to be the key driver of this division. Electrical steel is a soft magnetic material. In such materials, an external magnetic field generates a magnetic flux density that is many times higher than would be the case in air. In simple terms, the magnetic field is strengthened by the soft magnetic materials. Flux density is key to the torque of an electric motor. Core losses are another important criterion for the efficiency of electric drives. These losses occur due to the constantly changing direction of the magnetic field; as a result, part of the energy used to power the electric motor is lost as heat. The level of core losses depends on the frequency with which the direction of the magnetic field changes – and of course on the quality of the electrical steel. In 2017, the group earned about 83.7% of its EBITDA from this division.
Services and solutions give Aperam the opportunity to directly distribute and sell its products. Aperam provides its clients with customized solutions. Last year, 12.6% of its EBITDA came from 'Services and solutions'.
The last major component is Alloys & Specialties. Aperam's Alloys & Specialties segment is the fourth largest producer of nickel alloys in the world. Aperam is specialized in the design, production, and transformation of various nickel alloys and certain specific stainless steels. Their products take the form of bars, semis, cold-rolled strips, wire and wire rods, and plates, and are offered in a wide range of grades. In 2017, Alloys & Specialities realized 8.4% of the Group's EBITDA. This division is Aperam's highest margin generator.
Aperam's share price has nosedived different times as a result of trade war tensions and declining commodity prices. However the stock is volatile, we have to keep in mind that the overall picture remains quite bright in the long-term.
Aperam's major competitors are Outokumpu, Acerinox, and ThyssenKrupp. Outokumpu has lower and more volatile margins and a net debt position, while Acernox is facing the same challenges. ThyssenKrupp could get a potential boost from synergies thanks to the merger with Tata Steel. The creation of a big industrial conglomerate could reduce supply chain uncertainties, while ThyssenKrupp could lift its margins and generate more cash flows to lower interest expenses.
Source: Google finance
Aperam is listed in Amsterdam and Brussels. Daily trading volumes are approximately 500,000 shares.
Positive elements
The background is excellent
Like for instance, oil major producers, Aperam strives to lower its costs and to upgrade its facilities (operating efficiency). Looking at the recent history, Aperam indeed succeeded in all of its projections:
Source: annual report 2017
It is a good sign that Aperam made progression when it comes to the simplification of the business and to reduce fixed costs. Nowadays, it is difficult for Aperam to find extra internal synergies. Nevertheless, the Group is focusing on strategic acquisitions to enhance its productivity (see later).
Although Aperam pays attention to growth investments, the net cash position won't be impacted. This should be a relief for investors.
Source: company presentation
Above all, these supplementary investments increase future cash flows as CapEx are spent more efficiently. One of the most interesting growth pillars is the automation of the business. In the early years, these investments seem to be capital-intensive, but in fact, they substantially reduce future needed CapEx. Shortening the production chain is another commitment Aperam has made to guarantee strong profitability.
Source: company presentation
As part of the management's efforts to become a more resilient company capable of responding to the volatile market environment, Aperam recorded a net financial cash position of U.S.$75 million at the end of December 2017, compared to a net financial debt position of U.S.$154 million at the end of December 2016. Comparing these excellent debt levels with prior results is hopeful as the net financial debt position of U.S.$1,066 million at the end of December 2010 has been eliminated. This achievement is based on a strong set of actions in optimizing Aperam's debt profile and interest costs. Below you can find the detailed graph concerning Aperam's financial situation.
Principal risks
Commodity prices and currencies have been volatile
Following the strong increase in 2016, the apparent demand in China during 2017 remained positive at around 5% higher than last year, keeping stainless raw materials Ferrochrome and Nickel under pressure resulting in higher volatility all along the year, with sudden spikes of both all over the year. As a consequence, transaction prices of stainless coils improved in a similar pattern over 2017 and remained at higher levels versus 2016. We also have to keep in mind that China hasn't been able to tackle the oversupply. Aperam's management predicts global demand is going to increase through 2022 whilst China addresses its surplus capacity. Aperam also hedged currency headwinds in an attempt to minimize the effects on its profitability.
Global economic cycle downturn, geopolitical risks, overcapacity in the stainless steel industry
Aperam’s business and results of operations are substantially affected by international, national and regional economic conditions, including geopolitical risks that might disrupt the economic activity in affected countries. The re-emergence of recessionary conditions or a period of weak growth in Europe, or slow growth in emerging economies that are, or are expected to become, would have a great impact on Aperam's results. Above all, substantial consumers of stainless and specialty steels (such as China, Brazil, Russia and India, as well as other emerging Asian markets and the Middle East) would have a material adverse effect on the stainless and specialty steel industry.
Overcapacity
In addition to economic conditions, the stainless steel industry is affected by global production capacity and fluctuations in stainless steel imports and exports. The stainless steel industry has historically suffered from structural overcapacity, particularly in Europe. Production capacity in the developing world, particularly China, has increased substantially with China being now the largest global stainless steel producer. The balance between China’s domestic production and consumption is accordingly an important factor impacting global stainless steel prices. Chinese stainless steel exports, or conditions favorable to them (such as excess capacity in China and/or higher market prices for stainless steel in markets outside of China), can have a significant impact on stainless steel prices in other markets, including Europe and South America. Over the short to medium term, Aperam is exposed to the risk of stainless steel production increases in China and other markets outstripping increases in real demand, which may weigh on price recovery in the industry as a whole.
China slowdown
A significant factor in the worldwide strengthening of stainless and specialty steel pricing in recent years has been the significant growth in consumption in China, which at times has outpaced its manufacturing capacity. At times, this has resulted in China being a net importer of stainless and specialty steel products, as well as a net importer of raw materials and supplies required for the manufacturing of these products. A reduction in China’s economic growth rate with a resulting reduction in stainless and specialty steel consumption, coupled with China’s expansion of steel-making capacity, could continue to have the effect of a substantial weakening of both domestic and global stainless and specialty steel demand and pricing.
The risks of price decreases
A significant price decrease of nickel would have a negative impact on apparent demand and base prices due to a “wait and see” behaviour from customers. Furthermore, nickel is listed on the LME and subject to speculation on the financial markets. Stainless and specialty steel production requires substantial amounts of raw materials (primarily nickel, chromium, molybdenum, stainless and carbon steel scrap, charcoal (biomass) and iron ore) which can lead to over-dependence on its main suppliers. Aperam is also exposed to price uncertainty and material margin squeeze with respect to each of these raw materials, which it purchases mainly under short and long-term contracts, but also on the spot market. Aperam operations in Brazil have a net long position in electricity which is mitigated through excess power sale to the market and which may result in losses depending on spot electricity prices.
Fluctuations in currency exchange rates
Aperam operates and sells its products globally, and a substantial portion of its assets, liabilities, costs, sales and income are denominated in currencies other than the U.S. dollar (Aperam’s reporting currency). Accordingly, currency fluctuations triggered by inflationary movements or other factors, especially the fluctuation of the value of the U.S. dollar relative to the euro and the Brazilian real, as well as fluctuations in the currencies of the other countries in which Aperam has significant operations and/or sales, could have a material impact on its results of operations.
Financial highlights of 2017
2017 was a decent year for Aperam, but net income was impacted by a lower tax expense. After deducting a tax rate of 22.7% (the same tax rate as in 2016), net income should have been 307.7M USD, which still is a good result. What happens at the cash flow statement is even more interesting.
I've calculated the adjusted FCF as followed:
Net income should be 307.7M USD. So total FCF is 307.7M + 172M + 31M + 36M + 18M + 6M + 4M + 10M - 7M - 8M - 186M = 383.7M USD. That's absolutely brilliant. FCF was far enough to cover the dividend of 121M USD and the 98M USD related to share repurchases.
Based on the current market cap of around 3,700M USD and a FCF of 383.7M USD, Aperam's FCF yield exceeds the 10% level. In my opinion, a too impressive which can't be ignored.
The first-half results of 2018
Aperam achieved strong operating results over the first half of 2018.
Source: company presentation
Aperam's financial position remained very robust, providing further dividend growth and buybacks. Since the Great Financial Crisis, these improvements have been leading to a robust company that is able to implement growth investments and to lift margins exponentially.
FCF came in at 165M + 70M + 43M - 88M = 190M USD. That's a strong number given recent volatility as a result of trade war tensions and the forgotten Brazilian trucker strikes.
Source: first-half results of 2018
Growth projections and conclusion
Aperam acquired VDM Metals this year for 438M euros, which is going to enhance the corporate structure and unlock synergies of around 20M euros by 2020. Aperam is still benefitting from growth trends and more domains for its products (pharma, oil industry, construction, transportation). If the oversupply diminishes, Aperam should be able to lift its margins and to continue shortening its supply chain.
Below you can collect the EBITDA and the dividend projections.
Source: market screener
Using a conservative WACC of 8% and a cash conversion rate of 66.90% (FCF/EBITDA), fair value amounts to 61.46 euros. If we implement a WACC of 7.5%, fair value stands at 65.53 euros. WACC is a pure arbitrary measure to take safety margin into account. As we all know, steel industry's profits can massively drop, when an economic disaster has occurred.
That's a decent upside potential of more than 54%. This is attractive enough to get more than 4.5% dividend yield and 3% return in buybacks. The excess cash is used for growth investments and smart acquisitions. At this point, investors should consider initiating a first position in Aperam.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
