Some of the best spreads in recent memory haven’t been much help to the steel sector over the past year, and now it looks like the cycle is meaningfully slowing down. With steel prices declining around the globe, apparent demand softening, and growing worries about expanding capacity, coupled with shrinking spreads and sell-side forecasts for declining EBITDA, it doesn’t look like a particularly healthy set-up for ArcelorMittal (MT).
I wasn’t bullish on ArcelorMittal back in September, even though the shares “looked cheap” by multiple metrics, and the shares have fallen nearly another 30% since then. I still can’t really bring myself to want to own these shares myself, even though once again the valuation seems harsh by most metrics I can evaluate.
Shrinking Spreads And Fading Demand?
Steel prices are obviously important to profits, but they’re only part of the equation. The cost of inputs also looms large in steel spreads, and ArcelorMittal is starting to face some challenging conditions. In the EU, spreads have fallen sharply over the last six months, with Morgan Stanley recently highlighting a move from a well-above-average level of around $350/mt to around $270/mt more recently (still about 10% above the long-term average). That shrinkage was at least partly visible in ArcelorMittal’s recent earnings report, as EBITDA in the European business shrank 24% qoq on a reported basis and about 17% on a per-tonne basis to just $90 (about one-third to 40% lower than the spreads in the NAFTA, Brazil, and ACIS units).
There have also been signs of weakening spreads in ArcelorMittal’s key NAFTA business. While U.S. steel prices have remained stronger than in Europe, and electric arc spreads are still quite healthy for companies like Steel Dynamics (STLD) and Nucor (NUE), ArcelorMittal has seen weaker volumes in North America and blast furnace spreads have shrunk significantly since the middle of the year.
Given recent commentary from steel company executives at sell-side conferences as well as third-party research surveys, it does look like demand growth is moderating. The World Steel Association is forecasting just over 1% growth in world steel demand in 2019 after nearly 4% growth in 2018, and several companies have noted signs of slowing demand in both North America and the EU. It is worth mentioning that the outlook is still for positive demand growth, and coupled with rising capacity utilization that should offer some support for pricing, but the market doesn’t seem set up for the “rising prices, rising demand” couplet that investors typically want to see. Along those lines, prices for hot-rolled steel have continued to decline in recent months in both Europe and the U.S., with the U.S. starting to catch up to earlier declines in Europe.
China likewise remains a wild card. China’s steel industry has curtailed about 20% of its capacity over the past few years, and between environmental concerns, trade disputes, and recent weakness in China industrial and construction demand, it may well be reasonable to think that a lot of that capacity will remain sidelined. Still, depending upon supply-side restraint from China has never been a particularly successful strategy for commodity investors and I remain skeptical.
Investing At The Top?
One of the more controversial parts of the ArcelorMittal story has been management’s ongoing willingness to engage in M&A. Not only would many investors prefer to see management focus on net debt reduction and capital returns to shareholders, there’s a growing concern regarding capacity restarts and additions across the sector.
I understand why the market was rattled by the recent announcement from Steel Dynamics that it intends to start work on a new 3Mtpa plant in 2020 – typically these announcements come at or near the peak of the cycle. Likewise, it looks like 2019 capex spending across the sector will exceed the prior recent peak in 2011. Even if some of this is catch-up spending, it’s not the news an already-nervous market wants to see.
Specific to ArcelorMittal, the company has recently secured agreements to acquire Ilva in Europe and Essar in India. The cost for Ilva was not particularly high, and the company will be getting around 10Mtpa of high-quality flat capacity. Perhaps more importantly, a struggling player that had shown weak pricing discipline is now in better hands. With Essar, the joint venture structure (ArcelorMittal is buying it in partnership with Japan’s Nippon Steel and Sumitomo Metal Corp (or NSSMC)) and opportunities for the JV to self-fund limit the upfront cash obligations, and this gives ArcelorMittal an expandable asset in a market seeing healthy demand growth.
I understand the logic behind these deals and I think ArcelorMittal will have success in improving the operating efficiency of these businesses. Still, I think it creates more vulnerability to weakening global steel spreads over the next few years and the double-digit return on investment targets are far from “in the bag”.
ArcelorMittal management has said that they want to get to $6 billion in net debt before considering larger returns of capital to shareholders, and I believe that it will be a stretch to hit that mark before 2020 (and maybe not until 2021). Given that many investors are already impatient with ArcelorMittal’s capital management priorities, that is not going to win management any friends.
As far as the business goes, I think ArcelorMittal will be facing mid-single-digit to low double-digit price declines across its markets for the next two to three years. I likewise expect more pressure on costs as spreads normalize, and I expect EBITDA margins to shrink back toward 11% to 12%. That likely means that EBITDA will fall for the next three years (and possibly longer), but I would note that an 11% to 12% trough EBITDA margin is still pretty healthy next to what the company has done over the past 10 years.
In trying to value the stock fairly, EV/EBITDA is troublesome. You can use “full-cycle” multiples, past trough multiples, and so on, but it’s tough to use an EBITDA-driven methodology when EBITDA is likely to fall. Discounted cash flow is an option, but that’s rarely used in commodity stock valuation because of the difficulty of accurately modeling the cycles.
One option to consider is ROE-P/BV. There has been a pretty reliable correlation between ROE and P/BV multiples in steel over the years and cycles, and if ArcelorMittal can maintain a long-term ROE average around 7.5%, a fair value of $35 seems reasonable today. Looking at a downside scenario where the ROE falls to 5% would drive the fair value to $27.50 – still more than 15% above today’s price.
The Bottom Line
I have no problem admitting that ArcelorMittal confounds me today (as do other steel equities). I know from real world experience that it’s very tough to make money buying commodity stocks when prices are falling, spreads are shrinking, and EBITDA is expected to fall for multiple years. On the other hand, it looks like a lot of negativity is already priced into the shares and sector profitability (and/or management’s execution) will have to get much worse to “validate” today’s price. I can’t really recommend these shares given the worsening environment, but that valuation is looking more interesting.
Disclosure: I/we 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.