Ternium: Medium Quality For A Very Low Price

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About: Ternium S.A. (TX), Includes: USNZY
by: Ruerd Heeg
Summary

Ternium is a cheap stock based on low EV/EBIT and scores well on various metrics for measuring earnings quality.

Though there are many reasons to dislike the stock, I think the market is undervaluing it. The issues with the company do not warrant such a big discount.

Instead, there is much to like: favorable demographics for Latin America, planned efficiency and margin improvements, and potentially lower iron ore prices.

Ternium (TX) manufactures steel in Latin America with steel plants in Mexico, Brazil, Argentina and Colombia. There is a lot of background information available on the company. See for example the Wikipedia page for the company, also here in Spanish. See also the annual investor presentation from September 2018.

Ternium shares are cheap

The reason I discuss this company instead of another US-listed stock is its cheapness combined with a good score on many quality metrics. The company is cheap based on P/B, Price/Retained Earnings, Price/Free cash flow, dividend yield, Enterprise Value/Revenue, and Enterprise Value/EBIT. I can say this objectively since I rank global stocks with low EV/EBIT on several metrics and it turns out Ternium has one of the most favorable ranks. When we consider only stocks with a market cap of at least $500 million, Ternium is actually the cheapest stock in this list, globally!

Often cheapness comes with poor earnings quality, poor governance and poor chances of future growth. So, let's have a look at how Ternium scores on each of these three aspects.

Quality

While earnings quality is of course highly subjective, researchers have tried to quantify it. Wesley Gray and Tobias Carlisle have developed several quality metrics and used them to invest in larger quality stocks with low EV/EBIT. They report returns of about 17% for this advanced quantitative strategy. I am using the same quality metrics and rank stocks similarly. My conclusion is Ternium is not one of the very best quality stocks, but earnings quality is certainly good. In fact, when looking for stocks with market caps of at least $2 billion, Ternium is still among the 25 US-traded stocks with the best earnings quality.

Governance

Now governance. First, the company tries to put pressure on politicians against unfair steel dumping from, among others, China. I do not like this because it might imply the company finds it difficult to compete.

Second, the annual shareholder meeting is held in Luxembourg. That's where the company is incorporated, but the company's operations are thousands of miles away in Latin America. Management is from Argentina as well, and I think most investors are from Latin America and the US. So unless management wants to avoid certain questions from shareholders, it does not make much sense to hold annual meetings in Europe. I should add the company has quarterly conference calls during which questions from analysts are answered.

Third, large shareholders are Techint Holdings with 62.02% and Tenaris with 11.46%. Both companies are controlled by a company called San Faustin. The chairman, Paolo Rocca, and his family control San Faustin via the Dutch “brievenbusfirma” (letter box firm) Rocca & Partners Stichting Administratiekantoor Aandelen San Faustin. All remaining shares are with the US depository of ADSs.

I do not like a shareholder structure with such a dominant shareholder since it increases the probability of self-dealing. This is also very well possible at Ternium. I had a look at the related party transactions reported over 2018. The company bought steam from Tenaris for $11.9 million and sold $0.6 million of metal building components to Techint. The company also bought scrap steel from Tenaris for $8.9 million and sold $136 million of steel products to Tenaris. The company also bought mainly engineering and labor services for $88 million from San Faustin. These are just the most important related-party transactions.

Furthermore, together, the board and managers earned $19 million in 2018. The chairman got about $400k, which I find reasonable for a company of this size.

I do not like that related parties act both as purchaser and supplier, which increases the probability of irregularities with these transactions. However, I have no reason to believe these transactions were not at arm's length. It is just that for investors it is in practice impossible to verify this.

It was encouraging that director Martín Berardi owns 76,000 shares and director Rodrigo Piña owns 40,000 shares. I am not sure, however, if they still own these shares since the company mentioned it in the annual report filed in April 2018 but did not repeat it in the annual report filed in April 2019. Furthermore, the company has not diluted at least during the last 10 years and the company is a reliable dividend payer.

But the chairman and majority shareholder, Mr. Paolo Rocca, was indicted for bribery in November 2018 by the Argentina justice authorities. See also here (in Spanish). Before the financial crisis in 2008/2009, a steel factory in Venezuela got nationalized. After allegedly paying money to high ranked individuals working for the Argentina government, Ternium got $1.97 billion as compensation. Moreover, Ternium was one of the lucky companies actually getting fully paid by Venezuela. I think Ternium shareholders benefited as much from it as Mr. Paolo Rocca.

For this, Argentinian authorities requested preventive detention in December 2018. But last month charges against him in Argentina were lifted. So I suppose this is over in Argentina (see here), but there may also be investigations in Brazil, Italy and the US.

Besides these allegations, there are several issues with unions over, among others, allegations of violations of workers' rights, wage disputes and anti-union practices. See here and here.

Growth

I consider the countries of Ternium's most important 4 steel factories to be the best countries in Latin America due to their development stage, size and favorable demographics. In particular, demographics are a tailwind for the company with population growth of almost 1% per year and a young population. Furthermore, labor costs in Latin America are probably low enough for the company to compete with imported steel and even allow it to compete on overseas markets.

The company indeed hopes to benefit from increasing steel consumption in Latin America and the rest of the world. Furthermore, the company tries to increase production efficiency in Brazil and to expand its product range with more advanced products in Mexico. It will expand its research with a new lab in Mexico, close to a big car factory. Upgrading the product mix in Mexico is very important for the company since most of its revenue comes from Mexico. I think there is a lot of opportunity in Mexico since both Mexico and its big neighbor are huge importers of steel.

Dislikes: steel and iron ore prices

A short-term headwind is demand for steel and steel prices in Mexico. In particular, the company mentions lower demand for steel in Mexico because of low infrastructure investment and low construction activity. This is the reason gross margins were much lower during the last 2 quarters. This market has suffered from uncertainty from trade negotiations. Now the new trade deal, USMCA, is ready to be ratified. The company expects to benefit from this successor of NAFTA. Moreover, steel sales in Mexico have increased in the first quarter of 2019 already.

Another short-term headwind is the iron ore price. The price has increased, especially after the disaster at Vale (NYSE:VALE) in Brazil last February. Higher iron ore prices suppress margins of steel producers, including Ternium. This might improve soon for 2 reasons. First, I think spikes in commodity prices are usually short-lived because often new supply quickly ramps up. In the last conference call, the company mentioned iron ore supply is already normalizing.

Furthermore, the iron ore price is close to a 5-year high. Does that mean it will still go higher? Maybe, but more generally, investors should bet against 5-year highs. Just from the 5-year high price we know it is more likely the price of iron ore will decrease than increase.

Other things to like

The stock is pretty illiquid in terms of Trading Volume/Public Float. Stock market researchers have shown such stocks perform on average better than the market, especially if they are also value stocks. Also, the stock is cheaper than it looks to most investors: Sites like investing.com overestimate the market cap by about 2% because of the treasury shares.

Furthermore, the market value of the company's stake in Brazilian Usinas Siderurgicas de Minas Gerais (OTCPK:USNZY) is $260 million more than book value. Not a big difference considering the market cap of Ternium of nearly $5 billion, but it is still something to like.

Conclusion

I like to invest in companies like Ternium: overlooked companies with some reasons to dislike that are very cheap, preferably with reasonable earnings quality. A portfolio of such companies gives investors high returns and therefore I recommend this stock. The lower demand and prices for steel in Mexico are good reasons for a lower share price, but I think investors are overdoing it.

The reason I do not own the stock is I have to be very picky because I source many other ideas that are good on a statistical basis. I often find my best ideas among companies listed outside the US with market caps below $30 million. So I have much more choice than most investors. But for value investors limited to investing in larger US-listed stocks, this is a must have.

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.