Acerinox has seen significant declines in end-market demand (leading to double-digit shipment declines), but a restocking cycle should be underway.
Acquiring VDM and diversifying into specialty alloys makes sense; VDM's margins aren't fantastic, but the company is under-exposed to the U.S. where Acerinox's strong position could offer synergy/cross-selling opportunities.
Acerinox has options to further refine and modify its asset base, including a possible sale or JV of its Bahru facility and a conversion of the Columbus mill.
Acerinox doesn't look massively undervalued, but I do see high single-digit to low-double-digit return potential.
These have been some interesting times for Acerinox (OTCPK:ANIOY) (ACX.MC), as this leading producer of stainless steel has had to navigate a weakening demand environment and volatile input prices. All things considered, I believe Acerinox management is doing pretty well, and I think the acquisition of VDM Metals will prove to be a savvy move down the line.
While I still liked Acerinox back in May, I thought there were other, better options to consider. Since then, Acerinox has done pretty well (local shares up 15%, the ADRs up closer to 20%), but Gerdau (GGB) and Aperam (OTC:APEMY) have done better, while Ternium (TX) has done worse (neither Gerdau nor Ternium compete in stainless). I still believe that Acerinox is undervalued, and while there is risk to the 2020 demand outlook, I like this company for its above-average productivity and efficiency, as well as its wider set of options to improve performance even further.
Venturing Into Specialty Alloys At A Reasonable Price
Acerinox’s lack of specialty alloy steel products (steel with nickel contents of 25% or more) was arguably a gap in the company’s line-up, and it’s one management has chosen to fill. Back in November, the company announced that it would acquire Germany’s VDM in a EUR 532M deal that values the company at 5.5x FY19 EBITDA and 6.2x a three-year average of EBITDA. Relatively to historical multiples around 7.5x for peer/rival Carpenter (CRS), that’s an interesting valuation, and I’d note it’s also less than Aperam was prepared to pay in 2018 (the deal was scuttled by anti-trust issues).
While the definition of “specialty alloy” can vary from source to source, and so too market size estimates, VDM is generally considered the leader in the market with mid-teens share. VDM is a bit larger than Berkshire Hathaway’s (BRK.A) PCC Metals Group (part of Precision Castparts) and Allegheny (ATI), as well as Aperam and Carpenter. Collectively, the top five account for around 60% of the market.
I can see a few reasons why Acerinox may not have had to pay up for this asset. First, EBITDA margins around 11% aren’t so special – Allegheny has been doing better over the last 12 months, and Carpenter meaningfully better. Second, VDM doesn’t have the large exposure to aerospace that has been characteristic of so many specialty alloy companies; VDM gets only a little more than 10% of its revenue from aerospace versus the more typical 30% or so for specialty alloys as a whole, and the company is far more exposed to chemical processing (37% of sales) and oil/gas (27%). Lower margins and more exposure to cyclical markets like oil/gas and autos would certainly explain a discounted valuation.
Even with those issues, I like the deal. This is a natural expansion of Acerinox’s markets/portfolio, and with VDM generating only 16% of its sales in the U.S. (versus around 40% for Acerinox), I see some real opportunities for long-term revenue synergy. Direct cost synergies should be relatively limited, but I also wouldn’t necessarily assume this would be the only deal Acerinox does in specialty alloys (though antitrust issues may mean that a large target like Allegheny or Carpenter is off limits).
Self-Help Still In Play
Two of the more significant bearish items on analyst agendas for Acerinox in recent quarters has been the lackluster performance at the South African hot melting plant (Columbus) and the Malaysian cold-rolling facility (Bahru). Columbus has been hurt by both weak demand and high energy costs (as well as inconsistent supply), while Bahru has been hurt by weak regional demand and a significant lack of capacity utilization. While both may be more or less breakeven on an EBITDA basis (Bahru, particularly), they’d still make them cash flow negative given ongoing maintenance capex needs.
I believe management has some options here that it may start exploring over the next year or two.
Investors may recall that Allegheny tried to get a special tariff exemption for its joint venture with Tsingshan to allow it to import stainless slab produced by Tsingshan in Indonesia and roll it at a facility in Pennsylvania. That tariff exemption was denied and the JV went forward anyway, but Allegheny has since said that the Midland plant will close unless that exemption is granted (and the CEO penned an op-ed in the Wall Street Journal about it). If that plant closes, Tsingshan, which is the largest producer of stainless in the world but lacks downstream capacity, could be a natural buyer of the Bahru plant. I don’t know how eager Acerinox management would be to sell, the plant has stayed breakeven through a difficult period and was built to leverage long-term growth potential in Asia, and I don’t know if a JV arrangement would be possible, but it could be an option.
Since the majority of the Columbus plant’s output goes to Bahru, the fate of those two operations is intertwined, but not inseparable. One option that Acerinox could consider with Columbus is to convert it to a ferritic stainless steel plant. Ferritic stainless is about 25% or so of the market, and it is a stainless type that has no nickel but a lot of chromium. It is typically used in autos, appliances, and industrial applications, but it generally does not get a premium price. The “but” is that such a conversion would allow Acerinox to access cheaper locally-sourced liquid ferrochrome. It may also be possible to “split the difference” and convert the plant to produce more duplex stainless (ferritic and austenitic), a higher-priced product that would still make at least some use of local ferrochrome.
Will Restocking Drive Better Shipments?
I haven’t seen the latest shipment data (for December), but November stainless shipments were down 12% year over year and at a three-year low. Following a double-digit sequential decline in shipments in the third quarter, Acerinox’s core end-markets have clearly slowed. Steel stocks have been rallying on the expectation (and hope) of a restocking cycle, and such a cycle pretty much has to happen if sell-side expectations of a second-half rebound in short-cycle industries is going to hold up.
Inventory levels do seem to be low, and I think at least some of the third quarter weakness at Acerinox was driven by customers holding off on orders in the hopes of a fall in nickel prices (which has happened). With pricing holding up okay and the prospect of improving volumes, Acerinox could see some upside in the next couple of quarters.
I liked Acerinox without VDM and I like it with VDM. I believe VDM can boost Acerinox’s long-term growth rate, though I still expect revenue to grow at a low single-digit rate over the long-term. Certainly it matters whether Acerinox can boost VDM’s exposure to U.S. customers and improve its margins, but VDM is only going to be a relatively small part of the combined company (I was looking for over EUR 425M in 2020 EBITDA without VDM). I’m still only expecting mid-single-digit long-term FCF margins from Acerinox; while it is an efficient operator (with productivity per employee higher than for Aperam and Outokumpu), it still has to compete in a commodity market and protectionism in the U.S. and EU can only help just so much (close to 20% of revenue comes from outside those protected regions).
The Bottom Line
Between both discounted cash flow and EV/EBITDA I believe Acerinox is undervalued, with return prospects in the high single-digit to low-double-digits on an annualized basis. The biggest near-term risks for Acerinox involve its end-market exposures, with Acerinox really needing a restocking and a return to growth among its industrial customers. Longer term, the uncertain future of protectionism would certainly count as a risk, but I believe Acerinox is well-placed to compete effectively, and I do think management has some options to further improve the company’s structure and operations.
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