I wasn’t sure I would see a day when steel companies would be hailed as good stewards of capital, ArcelorMittal (MT) in particular, but I guess given everything that’s happened in the world since 2019, that’s further down the list of “things I didn’t expect to see…” As it stands, management is doing a great job here, putting more emphasis on quality over quantity and ensuring that shareholders share more of the benefits.
While I think many steel stocks have moved past the cyclical correction and prices should stabilize fairly quickly in the US and Europe, the reality is that sentiment remains a risk as margins are likely to fall further. Additionally, Russia’s invasion of Ukraine creates even more uncertainty for ArcelorMittal given the company’s extensive operations in that country.
I was neutral on these stocks (and the sector) in September, and while ArcelorMittal hasn’t done worse than the average steel stock since the invasion of Ukraine, the sector has underperformed the market. at large. These stocks look undervalued now, but I also see a long-term risk to sentiment on lower margins after the spike and the situation in Ukraine.
Investors who can afford to be patient (while assuming the risk of a bigger steel price correction and a bad outcome in Ukraine) may well see outsized rewards, but I’m not looking forward to pursue the high risks here, even though the management is doing a commendable job.
Ukraine is an important part of ArcelorMittal’s footprint
ArcelorMittal announced on Thursday March 3 that it was shutting down its steel operations in Ukraine’s Kryvyi Rih after previously reducing them to a “technical minimum” (about a third of normal production) in the interest of protecting its employees. Although I haven’t seen any reports of direct Russian attacks targeting facilities such as steel mills (and Ukraine is a major producer of steel exported to the EU), there have reportedly been airstrikes in the area from Kryvyi Rih.
ArcelorMittal’s steel operations in Ukraine (a blast furnace) produce about 6.5% of the company’s total production, and production here is in long products (bar, merchant bars, etc.). Ukrainian operations also account for around 20% of the company’s iron ore production. In total, ArcelorMittal’s Ukrainian operations probably represent around 6-9% of the company’s EBITDA.
This may seem callous in light of the human tragedy in Ukraine at the moment, but the larger impact on the European steel industry is difficult to assess at this stage. Ukraine and Russia collectively account for nearly a quarter of EU steel imports, and eliminating that supply could help put a floor under steel prices. On the other hand, the crisis led to a spike in energy prices, and energy costs were already a notable problem for European steelmakers, including ArcelorMittal and Voestalpine (OTCPK:VLPNY) as some companies chose to cut production in response to higher costs and low forward margins (European production was down 6% year-over-year in January).
Enjoying the fruits of record profits
Although steel prices have fallen significantly in recent months, with US prices recently about a third below the 12-month average, I believe healthy demand from end markets such as construction and Manufacturing across most of ArcelorMittal’s footprint should limit further near-term downward pressure on pricing.
With that, while ArcelorMittal will not enjoy the margins or profits it enjoyed in FY21, this year (2022) is shaping up to be another year of strong above-trend profitability, with margins EBITDA around 20% and maybe more than 20%. Free cash flow also appears to be quite strong for the year, with movements in working capital likely to lead to a new record for 2022.
Unlike past cycles, management’s behavior suggests a much more disciplined approach to capital allocation. While management has spoken of renewed interest in M&A, it has also committed to a net debt limit of $7 billion (from about $4 billion currently), and the nature of mergers and acquisitions seems different to me. I don’t see ArcelorMittal looking to buy volume for volume’s sake, but rather focusing its attention on better quality, higher margin varieties of steel and production processes, as well as improving supply ( such as the recent acquisition of a Scottish metals recycler) and assets that can help/advance the company’s decarbonization efforts.
Management raised dividend less than expected with Q4 earnings (to $0.38/share vs. average sell-side expectation of $0.45/share), and $1 billion buyback for the first half of 2022 may seem a little lean, but I expect the company to look for increased repurchase ability at the next shareholder meeting, and I think management is exercising careful caution about its dividend in light of uncertainties over steel prices and production costs over the next 12 months – the market is likely to react much better to larger buybacks down the road and/or special dividends, than a dividend cut because management has set an unsustainable bar.
ArcelorMittal expects global apparent steel consumption to grow by around 3% in 2022 excluding China, and with US capacity utilization of around 80% and EU capacity utilization of around 69 % in January, I see some near-term price support, especially with higher input costs likely to crowd out some marginal capacity in the EU. Longer term, however, I think there will be a steeper decline in 2023-24, and I don’t think we’ll see ArcelorMittal’s teen EBITDA margins again for some time.
I expect long-term low-digit revenue growth from ArcelorMittal, but believe continued business improvements will lead to sustained mid-single-digit FCF margins from a historical low-single digit trend . As I said, I think management made the smart move to prioritize profitability and returns over volumes, and that should support higher cash flow even in a less favorable market.
I value steel companies like ArcelorMittal through a combination of long-term discounted cash flow, a blended EV/EBITDA approach that uses next year’s EBITDA and my full cycle estimate, and a P/BV based on ROE. All of these approaches give me fair value in the low to mid $40s today, assuming low-single-digit revenue growth, long-term FCF margins averaging in the mid-digits, 5.6x my full-cycle EBITDA estimate ($9.8 billion), 3.75x my EBITDA estimate of 22 ($14 billion), and 0.8x my fiscal year book value estimate 22 ($59.10), based on an average ROE of 7.5% over fiscal years 23-25.
ArcelorMittal shares definitely look undervalued today, but at least some of that undervaluation looks appropriate given the risks and uncertainties surrounding Ukraine. Also, it’s worth mentioning again that the street doesn’t tend to favor steel stocks when the outlook for EBITDA/tonne and margins is trending down. That said, I believe the street has breached the bar here, and investors who can accept the outsized risks could see outsized returns if and when steel prices stabilize and the market revalues these stocks.