ArcelorMittal (ADR) (NYSE:MT)

convexvalue (87.95) Submitted: 9/2/2012 12:40:49 AM : Start Price: $13.80 MT Score: -37.73

Fair Value Per Share: $28

Full article: http://seekingalpha.com/user/1423421/instablog

Thesis:
What does the future await for ArcelorMittal? In the past, despite a considerable degree of fragmentation in this industry, the average steelmaker has been profitable and managed to obtain reasonable returns on investment. High set up costs plus moderate to high shipping costs, allow for regional oligopolies that in turn, enable moderate profits to take place. I would humbly guess that:
•   To a considerable degree, this competitive dynamic will protrude further into the future, enabling similar levels of profitability to be achieved. The main difficulty would be presented by overcapacity in China, but this should not have a huge impact on ArcelorMittal's earning power given the small fraction of revenues that the company derives from the middle kingdom (<1.4%).
•   ArcelorMittal, is the biggest steelmaker on the planet. Thanks to its [1] massive scale (more bargaining power than other steelmakers when buying inputs), [2] vertical integration (cheaper and more stable supply of inputs thanks to partial self-sufficiency), [3] higher R&D expenditures than any other single steelmaker ($306 million in the last year), ArcelorMittal should be able to achieve similar profit margins and returns.
•   Even though past acquisitions have been sensible, they came at the cost of high debt levels to finance them, and retrospectively (came "The Great Recession") the capital structure was lacking in cushion in case of extreme downturns. The cyclicality of the steel industry should allow the biggest players to consolidate smaller firms during downturns, but given the current state of MT's balance sheet, I would argue that its future market share would grow at a slower pace than in the last decade given management's intention to deleverage. Also, it seems quite likely that the company is going to issue more shares in the future as a way of financing its short term. Share dilution will ensue.
•   Exposure to European debt and currency crisis: I have no idea what to make of it. I do guess it is unlikely that ECB will let the euro currency to fail and the EU to disintegrate. It seems likely that the European economies as a whole will suffer a lost decade, with economic stagnation or even moderate declines in GDP. Austerity measures leading to high taxation and lower consumer discretionary income will lower car, home appliances, and white goods demand. Infrastructure expenditures though, should be stable enough. I would daresay that worst case scenarios are very much present in everyone's expectations, and so I would argue that when investing in Europe at this time, there is a considerable degree of upside (most surprises are going to be on the good side, since most of the bad stuff is already discounted in prices). So, to me, the European picture seems to be bad - but not as bad as the market's. Management believes that steel volume will return to peak levels achieved in 2007 by 2015. I would be content if today's present tonnage and average steel prices remain constant.
•   The Africa & Asia segment will continue with its healthy growth in volume. Steel prices quite possibly will go up too. Africa & Asia will continue with its macro-momentum forward based on continuing infrastructure investments in the oil and gas industry. There is a huge political risk lurking in here (North-African, Middle-Eastern, and Central-Asian countries), but the upside seems quite appealing. Africa & Asia represent 16% of sales.
•   The Americas will resume its growth: USA itself represents almost 18% of the ArcelorMittal's sales. It appears that the housing market is bottoming (http://www.fool.com/investing/general/2012/08/24/believe-it-14-examples-of-why-housing-may-have-bot.aspx). Higher house prices and house building should boost consumer confidence and spending in consumer durables utilizing steel. The automobile industry also seems now to be in the uptrending part of the cycle, especially after governmental bailout of GM, and industry-wide newly stated employment contracts thanks to the temporarily benign relationship car companies have recently established with the UAW labor union. The big 3 American car companies have restructured themselves into leaner, more flexible companies. They all have a newly lower profit-sales breakpoint - and while profits are not a sure thing, bankruptcy seems very unlikely. Another unlikely event, but here on the upside, is a future infrastructure investment program in America. USA's power grid and energy infrastructure is lacking and needing significant investments. Tackling this problem would mean huge opportunities for the steelmakers, and ArcelorMittal would be one of the biggest beneficiaries of such a policy. Brazil, the next entry in the Americas segment, represents almost 8% of MT total sales. Brazil's economy seems to be cooling down owing to its overvalued currency and expensive exports, which can lead to lower growth GDP rates. However, steel demand does not seem to be decelerating. Competition is fierce, but regional steel prices do not exhibit significant overcapacity.
•   The dividend payment (quarterly div. of $0.1594 per share) is currently a fraction of what it used to be before the financial crisis developed (in 2008 the company was paying a quarterly div. of $0.3592 per share). I estimate that the company will increase the dividend payment to previous levels or even higher by mid 2015, after it finishes to repay soon-to-mature debt of about $12.5 billion (in installments of $2.8, $4, $3.7, and $2 billion in each respective year) according to management's plan to deleverage.

Valuating businesses in cyclical industries is a tough thing to do (though not as hard as banks and insurance valuation - I wonder if I will ever be able to understand those things). As a rough approximation I use these figures: Average Annual Free Cash flow (this is, after interest payments and monstrous capital expenditures) in the PAST DECADE were of about $ 3.1 billion - with a high of $ 11 billion, and a low (and only negative year) of $ -3 billion. The average FCF margin (Free Cash Flows as a percentage of revenue) was of 5.4%. As I argued previously, I would bet on history (margins, returns, market share) repeating itself, though allowing for a somewhat more optimistic outlook for the future (assuming that another "Great Recession" is unlikely to occur), and a slower earnings power growth due to deleveraging (using funds to repay debt instead of performing acquisitions).
I can think of 3 scenarios:
•   Armageddon, European Union is dissolved, new currencies emerge, political unrest and expropriations in Africa & Asia, but the world keeps on needing to consume steel. Average Annual Free Cash flows: $1.5 billion. Nominal perpetual growth of 2% minus a 4% share dilution a year (issuing shares in exchange of cash as a way to financing), gives a value of $8,76.
•   The more likely scenario I presented previously: future is somewhat bright, similar to the past decade but without any extreme downturn (recessions: yes - another "Great Recession": no). If we average last decades FCF excluding the worst annual result, we would get a value of $3.8 billion - and this number is after CAPEX and interest payments. I chose a number slightly slower than that: I project earnings power of $3.5 billion a year. CFC would exhibit a CAGR of 7% for the next 10 years, a 2% yearly share dilution to finance short term liquidity needs, a 2% perpetual growth rate beginning in the eleventh year. This results in a per-share value of $ 31,40. This implies than in 2022 ArcelorMittal, thanks to its organic growth and acquisitions, would have revenues of $ 195 billion, and an average FCF margin of 4%.
•   Finally, an upper end scenario in which the European debt crisis is smoothly solved and worldwide growth resumes at a healthy pace. Let us project earnings power of $ 3.7 billion, growing at 7% for 10 years, then at 5% for 10 more years, then a perpetual growth rate of 2.5% thanks to growth in the Americas, Africa & Asia continue with its momentum, and European stability, all coupled with a 1% yearly dilution of shares. Present value of shares would be close to $39 a share.
When performing DCF I used a 10% discount rate. If we make the assumptions that the probabilities of the bad, the middle, and best scenarios are 15%, 80%, and 5% respectively, then we would obtain the following number:

FAIR VALUE PER SHARE: $28,40.

NOTE: I am aware that, in this rough DCF calculation, there is a money-value-of-time problem. I am using a smoothed-out average free cash flows, while in reality earnings are going to fluctuate wildly in an unpredictable manner. It would be considerably more pleasant (from a money-value-of-time perspective) to have a cyclical downturn at the end of our 10-year period - say in 2022 - than to have it next year, since we are going to weight the immediate future more heavily than the distant future. Nonetheless I deem these rough figures illuminating. As Keynes said "I'd rather be vaguely right than precisely wrong". Roughness in estimations reminds us to be aware of the limits and shortcomings of the DCF valuation methodology, and to look for big margins of safety.
The implied MKT Cap would be of around $ 44,3 billions, which is considerately below its all-time high of $137 billion in 2008.
More importantly: (As of 2012-Sep-01) the stock market price of MT is $14.70, which would indicate a pretty wide margin of safety relative to our Fair Value of $ 28,40. Metaphorically speaking, MT is trading at 51 cents on the dollar. This (arbitrary and subjective analysis) leads me to the conclude that MT is a BUY.
Not only you get a market leader in its industry at a significant discount to fair value, but you also get a projected dividend yield of 4.34%, that is quite likely to double in the next 4 yea