Posted on 03 Jul 2015
The history of the steel industry is one of peaks and valleys. Although most companies in this cyclical industry have seen a decrease in value over the past few years, ArcelorMittal (NYSE:MT) has been hit particularly hard:
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MT data by YCharts
The point of this article is to explain why shares of ArcelorMittal are a solid value at its current price and also present a safe way to bet on increased steel prices in the future. The reasons are the sheer size of the company, its focus on debt reduction, and its diversified operations.
When industries go through brutal shakeouts like the current steel crisis, it is often the largest companies that remain intact. In the case of worldwide steel producers, ArcelorMittal is second to none, producing 98 million tons of steel last year, while the second largest producer (Nippon Steel), produced only 49 million tons. Although somewhat obvious, I believe that no matter how low the price of steel goes, the largest producer in the world will use their advantages of scale to remain competitive, or will have the financial strength to outlast its smaller/overleveraged competitors. It is extremely difficult to displace a market leader in a capital intensive business such as steel, in which the most financially sound company can purchase its less efficient competitors in bankruptcy or on favorable terms to them.
Further, ArcelorMittal has the financial power to currently employ 1,400 full time researchers in 11 centers around the globe. While MT's smaller competitors are focusing on cutting employment to remain competitive, ArcelorMittal's researchers are focusing their energy on continuously innovating and improving their products for future growth. This advantage must not be understated.
Another attractive aspect of MT's business is their focus on debt reduction. Net debt has fallen from $32.5 billion in 2008 to $24 billion in 2011, and $16.6 billion today. Their stated goal is to get net debt to $15 billion by the end of this year. This focus on deleveraging will make the company healthier and more manageable going forward.
In an effort to measure the ability of MT to weather the current steel crisis, let's dig a bit deeper into its balance sheet. As it currently stands, MT has $2.8 billion in cash and $6 billion in available credit, for a total of $8.8 billion in liquidity. Looking at its recent ability to generate cash, MT has averaged $4.4 billion of cash flow from operations for the past 6 years. In a pessimistic scenario, let's assume that MT will only be able to average $3 billion in cash flow from operations for each of the next 2 years. Total cash flow from operations would be $6 billion. Subtracting $3 billion/year for estimated capex, $1.4 billion in annual interest expense, and $458 million of dividends/year leaves us with a 2015-2016 cash burn of $3.7 billion . Further, debt maturities of $1.8 billion come due in 2015 and $2.4 billion in 2016. At the end of 2016, total liquidity would be $900 million. However, the company would have 25% less debt, making it leaner going forward.
Although this is not a "world-beating" scenario, it shows that ArcelorMittal can afford to weather two years of depression like conditions without dilution or further debt issuance.
Comparing MT with U.S Steel (NYSE:X), POSCO (NYSE:PKX), Nucor (NYSE:NUE), Steel Dynamics (NASDAQ:STLD), and Kobe Steel (OTCPK:KBSTY), ArcelorMittal possesses one of the cheapest valuations of its competitors judging by EV/EBITDA:
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MT EV to EBITDA (TTM) data by YCharts
and Price/Book value:
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MT Price to Book Value data by YCharts
Another reason that MT can weather the storm is its diversified operations in over 60 countries. Its operations are heavily weighted in Europe (46.1% of steel shipments in 2014), but they also have operating segments in NAFTA (26.9% of shipments), ACIS (14.9% of shipments), and Brazil (12.1%). This global structure will allow its strongest segments (e.g U.S. auto) to cushion the blow of its underperforming segments (ACIS).
Additionally, ArcelorMittal produced the fourth most iron ore of any company worldwide last year. Most of that capacity sources directly into their own steel making facilities, but recently they have been focusing more effort on selling their excess capacity externally. In fact, they have ramped up their iron ore sales about 40% in the past two years, selling 14.4 million tons of iron last year. This is an important hedge that the company uses to guard against rising input costs. The fact that MT is ramping up its iron sales during a period of low prices will be a boon once the prices of the commodity rise off their lows.
Further, recent sources have speculated that China has already reached "peak steel consumption," which means that some of China's higher cost steel capacity will have to come offline in the coming years. In fact, China grew at its slowest pace since 1990 last year, and is forecasted to grow even slower this year. Since the glut in China cannot be fulfilled by demand domestically, they have been exporting all of their excess steel, leading to falling prices worldwide. This cannot happen indefinitely, as marginal producers will become non-competitive and will have to shutter operations. According to MT's 10-K, Asian steel producers, who have historically purchased raw materials on the seaborne market, are usually at the higher end of the cost curve. As China produces close to 50% of the world's steel, it is a foregone conclusion that some of that capacity will have to come offline in a continued steel depression.
The risks of investing in ArcelorMittal at this time are a lack of supply cuts from China, causing a prolonged period of low steel prices worldwide. China's government has been known to subsidize its local producers, so this is a wild card that cannot be logically forecasted. As supply continues to outstrip demand, common economic sense would indicate that the less efficient mines would have to close, but China may continue to support these marginal producers in the sake of job preservation. This is a risk that I cannot properly evaluate.
If MT faces an extended period of low cash flows, they will have to refinance their debt, most likely at higher interest rates, or dilute their equity. I believe that this is an unlikely scenario, but it is a risk nonetheless.
Although steel producers have been beaten down as of late, I believe that ArcelorMittal is one of the safest plays in the sector. Its size, focus on R&D, and diversified operations will allow it to survive the worst steel collapse in recent times. Further, reduced demand in China should reduce their higher cost production in the coming years, which will help balance worldwide supply and demand, leading to an increase in prices. Although not for the volatility-averse investor, ArcelorMittal presents a solid long term investment opportunity.
